Chapter 23

Firm Supply
 Firm Supply
 Derive the supply curve of a competitive
firm from its cost function using the
model of profit maximization.
 Market environment: perfectly
competitive market
 The firm is a market price-taker, although
the firm is free to vary its own price.
 Demand Curve facing a firm
 If the firm sets its own price above the
market price then the quantity
demanded from the firm is zero.
 If the firm sets its own price below the
market price then the quantity
demanded from the firm is the entire
market quantity-demanded.
 Demand Curve facing a firm
$/output unit

Market Supply

pe

Market Demand
Y
 Demand Curve facing a firm
$/output unit

Market Supply
p’
pe At a price of p’, zero is
demanded from the firm.

Market Demand
y
 Demand Curve facing a firm
$/output unit

Market Supply
p’
pe At a price of p’, zero is
demanded from the firm.
p”
Market Demand
y
At a price of p” the firm faces the entire
market demand.
 Demand Curve facing a firm
$/output unit

Market Supply
p’
pe At a price of p’, zero is
demanded from the firm.
p”
Market Demand
y
At a price of p” the firm faces the entire
market demand.
 Demand Curve facing a firm
$/output unit

p’
pe
p”
Market Demand
Y
 Smallness
 What does it mean to say that an
individual firm is “small relative to
the industry”?
 Smallness
$/output unit
Firm’s MC
Firm’s demand
pe
curve

y
The individual firm’s technology causes it
always to supply only a small part of the
total quantity demanded at the market price.
 Demand Curve facing a firm
 Although there is a limit in the
demand facing a firm, the firm’s
supply is much smaller than that
limit. It’s safe to say the demand
curve facing the firm is a horizontal
line.

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 The Firm’s Short-Run Supply
Decision
 Supply in the short run
 Each firm is a profit-maximizer and in
a short-run.
 Q: How does each firm choose its
output level?
 A: By solving
max  s ( y )  py  c s ( y ).
y 0
 The Firm’s Short-Run Supply
Decision
max Ps (y) = py - c s (y).
y³0
 Necessary condition?
MR of output = MC of output
p=MC
 Why?
 If y* is the profit maximizing output level, either
an increase or a decrease in y will make profit
smaller.
 If MR > MC, profit increases as y increases;
 If MR < MC, profit increases as y decreases.
 The Firm’s Short-Run Supply
Decision
 Then, p=MC(y) is a possible
candidate for the short run supply
curve.
 However, there may be some
problems.

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 Two output supply level?
$/output unit

For the downward

sloping part of MC, y
increases, profit
pe increases.

MCs(y)

y’ ys* y
 The Firm’s Short-Run Supply
Decision
$/output unit
So a profit-max. supply level
can lie only on
the upwards
sloping part
pe of the firm’s
MC curve.

MCs(y)

y’ ys* y
 The Firm’s Short-Run Supply
Decision
 Butnot every point on the upward-
sloping part of the firm’s MC curve
represents a profit-maximum.
 The Firm’s Short-Run Supply
Decision
 But not every point on the upward-
sloping part of the firm’s MC curve
represents a profit-maximum.
 The firm’s profit function is
 s ( y )  py  c s ( y )  py  F  c v ( y ).
 If the firm chooses y = 0 then its
profit is
 s ( y )  0  F  c v ( 0 )   F.
 The Firm’s Short-Run Supply
Decision
 Sothe firm will choose an output
level y > 0 only if
 s ( y )  py  F  c v ( y )   F .
 The Firm’s Short-Run Supply
Decision
 So the firm will choose an output
level y > 0 only if
 s ( y )  py  F  c v ( y )   F .
 I.e., only if
py  c ( y )  0
v
Equivalently, only if
cv ( y)
p  AVCs ( y ).
y
 The Firm’s Short-Run Supply
Decision
$/output unit
MCs(y)
ACs(y)
AVCs(y)

y
 The Firm’s Short-Run Supply
Decision
$/output unit
MCs(y)
ACs(y)
AVCs(y)

y
 The Firm’s Short-Run Supply
Decision
$/output unit
Shutdown
point MC s(y)
ACs(y)
AVCs(y)

The firm’s short-run

supply curve
y
 The Firm’s Short-Run Supply
Decision
 Case 1: y>0 with positive profit

 Case 2: y>0 with negative profit

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 The Firm’s Long-Run Supply
Decision
 The long-run is the circumstance in
which the firm can choose amongst
all of its short-run circumstances.
 How does the firm’s long-run supply
decision compare to its short-run
supply decisions?
 The Firm’s Long-Run Supply
Decision
A competitive firm’s long-run profit
function is
( y )  py  c( y ).
 Thelong-run cost c(y) of producing y
units of output consists only of
variable costs since all inputs are
variable in the long-run.
 The Firm’s Long-Run Supply
Decision
 Thefirm’s long-run supply level
decision is to
max  ( y )  py  c( y ).
y 0
 The
1st and 2nd-order maximization
conditions are, for y* > 0,
p  MC( y ) and
dMC( y )
 0.
dy
 The Firm’s Long-Run Supply
Decision
 Additionally, the firm’s economic
profit level must not be negative
since then the firm would exit the
industry. So,
( y )  py  c( y )  0
c( y )
 p  AC( y ).
y
 The Firm’s Long-Run Supply
Decision
$/output unit
MC(y)

AC(y)

y
 The Firm’s Long-Run Supply
Decision
$/output unit
MC(y)
The firm’s long-run
supply curve

AC(y)

y
 The Firm’s Long-Run Supply
Decision
 How is the firm’s long-run supply
curve related to all of its short-run
supply curves?
 The long-run supply curve intersect
once with the short-run supply curve.
 The long-run supply curve is flatter
than the short-run supply curve
(more elastic).
 The Firm’s Long & Short-Run
Supply Decisions
$/output unit
MC(y)

p’ AC(y)

ys* y
ys* is profit-maximizing in this short-run.
 The Firm’s Long & Short-Run
$/output unit Supply Decisions
MC(y)
Long-run supply curve

AC(y)

Short-run supply curves

 Producer’s Surplus
 Given the MC curve, the producer is
willing to sell the 1st unit of output at
price MC(1);
 She actually gets the market price p;
 For the 2nd unit, the producer is
willing to sell it at price MC(2);
 She actually gets the market price p;
…
 Producer’s Surplus
 Net Producer’s Surplus: the
difference between
– the minimum amount she would be
willing to sell the y* units for
– the amount she actually sells the
units for
 Producer’s Surplus Revisited
$/output unit
MCs(y)
p ACs(y)
AVCs(y)

y*(p) y
 Producer’s Surplus Revisited
$/output unit
MCs(y)
p ACs(y)
AVCs(y)
PS

y*(p) y
Producer’s Surplus Revisited

PS = Revenue - Variable Cost.

 Producer’s Surplus Revisited
$/output unit
MCs(y)
p ACs(y)
AVCs(y)

y*( p ) y*(p) y
c v (y * ( p)) = ò MC (z)d(z)
s
0
 Producer’s Surplus Revisited
$/output unit
MCs(y)
p ACs(y)
AVCs(y)
Revenue
= py*(p)

y*(p) y
 Producer’s Surplus Revisited
$/output unit
MCs(y)
p ACs(y)
AVCs(y)
Revenue
= py*(p)
cv(y*(p))
y*(p) y
 Producer’s Surplus Revisited
 PS = Revenue - Variable Cost.
 Profit = Revenue - Total Cost
= Revenue - Fixed Cost
- Variable Cost.
 So, PS = Profit + Fixed Cost.
 Only if fixed cost is zero (the long-
run) are PS and profit the same.
 Example

 Ifthe cost function is 𝒄 𝒚 = 𝒚𝟐 + 𝟏,

then,
 Short-run supply curve?
 Long-run supply curve?
 Producer’s surplus when p=4?
 Profit when p=4?

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