1. The Supply Curve and the Behavior of Firms
Chapter Six
The Supply Curve and the Behavior of Firms

2. Definition of a Firm
A firm: An organization that produces goods and services
Firms in the US can be classified as
A sole proprietorship
A partnership
A corporation
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3. Limited Liability Company (LLC)
Limited Liability Company (LLC) is a new type of business organization that firms started to use only starting the 1990s.
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4. Limited Liability Company (LLC) (cont’d)
A limited liability company (LLC)
Is a type of business ownership combining several features of corporation and partnership structures
Is not a corporation or a partnership
May be called a limited liability corporation although the correct terminology is limited liability company
Owners are called members not partners or shareholders
Number of members are unlimited and may be individuals, corporations, or other LLCs
Source: sbinformation.about.com
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5. A Price Taker in a Competitive Market
Competitive market – A market in which no firm has power to affect the market price of a good.
Price-taker – Any firm that takes the market price as given; this firm cannot affect the market price because the market is competitive.
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6. Competitive Markets Examples of Competitive Markets
The market for fresh bread
The pumpkin market
Note: a competitive market requires that there be at least several firms competing with one another. If there are one or two firms, then the market cannot be competitive.
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7. Competitive Markets (cont’d)
Because competitive markets are price takers, we can derive the supply curve of each firm by asking how much each firm is willing to supply at a given price.
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8. Other Types of Markets
The exact opposite of a competitive market is a monopoly.
Monopoly – A market where there is only one firm selling in the market. Unlike a competitive firm, the monopolist has the power to set the price of a good.
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9. Other Types of Markets (cont’d)
There is no supply curve in a monopoly, because the monopoly does not take prices as given.
We will discuss monopolies in Chapter 10. For the rest of the chapter, we will focus on price taking competitive firms.
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10. The Firm’s Profits
We assume that a firm’s objective is to maximize profits.
Profits – the total revenue received from selling the product minus the total costs of producing the product, or:
Profits = total revenue – total costs
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11. The Firm’s Profits (cont’d)
Total Revenue (generated from a product) – The price per unit multiplied by the quantity that the firm sells at that price.
Total Revenue
= price of the product X quantity sold at that price
= P X Q
Table 6.1 shows an example of calculating total revenue, using three different prices.
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12. Total Revenue
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13. Total Revenue (cont’d)
From Table 6.1, we can see that at any given quantity, higher prices will result in higher revenues. Similarly, at any given price, total revenue increases when the quantity sold increases.
Note that in a competitive market, the increase in revenue brought about by selling one more unit of the good is equal to the price of the good.
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14. Production and Cost
Total Cost – The sum of the fixed costs and the variable costs of production. This includes all costs such as salaries, rent, material costs, business permits, etc. In economics, the total costs should also include all opportunity costs.
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15. Short Run vs. Long Run
Short-Run – A time period where at least one input is fixed, and other inputs are allowed to vary. In our analyses, we usually allow the labor input to vary, and capital input to stay fixed in the short-run.
Long-Run – A time period long enough for all inputs (both capital and labor) to vary.
For this chapter, our analysis revolves around short-run decision making.
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16. The Production Function
Production function – A relationship that shows the quantity of output for any given amount of input.
Figure 6.3 shows a hypothetical short run production function relating the input used and the corresponding output. Since this is in the short run, capital is an input, but is kept fixed/constant.
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17. The Production Function (cont’d) Figure 6.3
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18. The Production Function (cont’d)
Marginal Product of Labor: The change in the production due to a one-unit increase in labor input (holding the capital input constant)
Diminishing (Marginal) returns to labor: A situation in which the increase in output due to a one unit increase in labor declines with increasing labor input (again, holding the capital input constant)
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19. The Production Function (cont’d)
From Figure 6.3, the marginal product of labor is the slope of the production function. Diminishing returns to labor is illustrated in Figure 6.3 as the flatter slope of the production function as the hours of work increase.
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20. The Production Function (cont’d)
Diminishing returns to labor occurs in the short run because increases in the labor input (holding the capital or other inputs constant) will result in a smaller share of the capital input per every worker. As a result, the additional worker will contribute less and less as more and more workers are hired.
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21. Costs
Fixed Costs – Costs of production that do not depend on the quantity of production. These are costs associated with the fixed input.
Variable Costs - Costs of production that vary with the quantity of production. These are costs associated with the variable input.
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22. Costs (cont’d)
Table 6.2 shows the relationship between the costs of production and the quantity of pumpkin produced. In order to increase the number of crates produced, the firm must hire more workers, resulting in an increase in the total costs of production.
Table 6.2 also shows how total costs are calculated, i.e., by adding the fixed costs and the variable costs at every level of production.
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23. Costs (cont’d)
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24. Marginal Costs
Marginal cost – the change in the total cost due to a one unit change in the quantity produced.
Table 6.3 shows how marginal cost is calculated.
Note: Since fixed costs do not change with the quantity produced, we can also calculate the
marginal cost from the change in the variable cost due to a one unit change in
the quantity produced.
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25. Marginal Costs (cont’d)
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26. Marginal Costs (cont’d)
Note that in Table 6.3, the rising marginal cost is due to the diminishing marginal product of labor. If the additional output from hiring one worker is declining and the cost of hiring the worker is constant, then the marginal cost of producing one more unit must be rising.
One thing we will show later is that the firm’s supply curve is derived directly from its marginal cost curve.
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27. Graphical Representation of Total Costs and Marginal Costs
With dollars (costs) on the Y-axis and the quantity of crates produced on the X-axis, we can plot the total cost curve using the first two columns of Table Similarly, we can also plot the marginal cost of producing pumpkins using the first and the last column in Table 6.3.
Figure 6.4 illustrates the total cost curve while Figure 6.5 illustrates the marginal cost curve.
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28. Total Costs Figure 6.4
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29. Marginal Costs Figure 6.5
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30. Profit Maximization and the Individual Firm’s Supply Curve
Profit Maximization: An assumption that firms try to achieve the highest possible level of profits (total revenues minus total costs) given their production function.
Table 6.4 shows the profits of the pumpkin firm, calculated from three different prices for a crate of pumpkins.
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31. Profit Maximization and the Individual Firm’s Supply Curve (cont’d)
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32. Profit Maximization and the Individual Firm’s Supply Curve (cont’d)
Note: From Table 6.4 , we can see that
At any level of quantity, the profit level is higher when the price level is higher.
While total revenue changes when the selling price changes, total cost does not change across the three panels.
If price = $35, profit at all levels of production is less than zero. It may seem fruitless to continue production, but shutting down may not be the best strategy in the short run.
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33. Profit Maximization and the Individual Firm’s Supply Curve (cont’d)
Why not shut down if price = $35?
If the firm shuts down, the firm’s profits equal -$50 (a loss of $50). However, the firm can minimize its loss by producing at Q = 2 since the loss is only $30.
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34. Profit Maximization and the Individual Firm’s Supply Curve (cont’d)
A Profit Graph
The firm’s profit can be illustrated graphically by putting the firms total revenue curve with the total cost curve in the same graph. This is done in Figure 6.6.
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35. A Profit Graph Figure 6.6
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36. A Profit Graph (cont’d)
From Figure 6.6, we can see that:
The total revenue curve of the competitive firm is a straight line. This is because the firm is a price taker, and additional quantities are sold a the same price.
2) The highest profit generated by the firm (at price =$70) occurs when the quantity is 3. Graphically, this is shown as the largest vertical distance between the Total Revenue line and the Total Cost line .
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37. A Profit Graph (cont’d)
At the profit maximizing quantity, the slope of the total cost curve is equal to the slope of the total revenue curve. Since the slope of the total cost curve equals the marginal cost and the slope of the total revenue curve is the price of the good, then profit maximizing implies that:
Marginal Revenue = Price = Marginal Cost
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38. A Profit Graph (cont’d)
The bottom panel on Figure 6.6 shows how profits increase and then decrease as production increases. When Q = 3, the price per crate reaches its maximum profit at $70.
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39. The Marginal Approach to Derive the Supply Curve
Marginal Revenue: The change in the total revenue resulting from a one-unit increase in the quantity sold.
The marginal revenue (MR) can be expressed as:
Note: for a competitive firm, the marginal revenue (the additional revenue that the firm gets from selling one more unit) is equal to the price of the good.
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40. The Marginal Approach to Derive the Supply Curve (cont’d)
A profit maximizing firm will choose to sell a good as long as the marginal cost is less than the price of the good. The marginal cost of producing the nth unit good represents the minimum price that the firm is willing to accept to sell the nth unit, as a firm will not want to produce a good knowing that the price it gets is lower.
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41. The Marginal Approach to Derive the Supply Curve (cont’d)
At any given price, the profit maximizing firm will determine the profit maximizing quantity given that price using the firm’s information on the marginal cost of producing that good. In essence, the firm’s marginal cost is the firm’s supply curve*.
*Note: As we will see in later chapters, this statement is not exactly correct. The firm’s
supply curve is the portion of the marginal cost curve above the shut-down point.
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42. The Marginal Approach to Derive the Supply Curve (cont’d)
Figures 6.7 and 6.8 show the pumpkin firm’s supply curve (and hence, the firm’s marginal cost of producing pumpkins).
Figure 6.7 shows the supply curve if the firm can only produce crates of pumpkins in discrete quantities, while Figure 6.8 shows the supply curve if the firm can adjust its production to small amounts (i.e., not require whole numbers).
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43. The Marginal Approach to Derive the Supply Curve (cont’d) Figure 6.7
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44. The Marginal Approach to Derive the Supply Curve (cont’d) Figure 6.8
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45. The Market Supply Curve
The market supply curve is obtained by horizontally summing each of the individual firm’s supply curves at every given price. Figure 6.9 shows how the supply curve of two individual firms are horizontally summed together to derive the market supply curve.
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46. The Market Supply Curve (cont’d)
Figure 6.9
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47. The Market Supply Curve (cont’d)
Note that the slope of the market supply curve in Figure 6.9 is flatter at any given price than either of the individual firm’s supply curve. The more firms there are in the market (holding all else constant), the flatter the market supply curve.
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48. Shifts in the Supply Curve
Changes in the marginal cost of production will result in a shift in the supply curve to the left or to the right. In Figure 6.10, an increase in the marginal cost shifts the supply curve up and to the left.
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49. Shifts in the Supply Curve (cont’d) Figure 6.10
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50. Producer Surplus
Producer Surplus - The difference between the price received by a firm for an additional item sold and the marginal cost of the item’s production; for the market as a whole, the producer surplus is the sum of all individual firm’s producer surplus; this can be calculated using the area above the supply curve and below the market price.
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51. Producer Surplus (cont’d)
Figure 6.11 and Figure 6.12 graphically illustrate the producer surplus for an individual firm and for the market.
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52. Producer Surplus (cont’d) Figure 6.11
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53. Producer Surplus (cont’d) Figure 6.12
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54. Producer Surplus (cont’d)
Notes:
1) An individual firm that is willing to sell the good higher than the market price (and hence, was unable to sell the good) will have a producer surplus equal to zero.
2) A higher price will result in a larger producer surplus for the market and the individual firm.
3) A lower price will result in a smaller producer surplus for the market and the individual firm.
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55. Key Terms Firm Price taker Competitive market Profits
Total revenue and total costs
Production function
Marginal product of labor
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56. Key Terms (cont’d) Diminishing marginal returns to labor
Fixed and variable costs
Marginal costs
Profit maximization
Marginal revenue
Producer surplus
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