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Causes of Supply and the Production Decision

This chapter explores the factors influencing the quantity of goods supplied by firms in a perfect competition market, such as the price of the good, price of inputs, and individual producer's production decision. It also discusses the relationship between marginal cost and the production decision, and how changes in technology, regulation, and number of producers affect supply.

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Causes of Supply and the Production Decision

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  1. Chapter 5 – Product Market Supply • This chapter examines the major causes of how much firms will supply of a specific good (under perfect competition), given the price of the good, the price of inputs (e.g. energy, and other causes that we will cover. • It also explains how we distinguish between individual and market supply, and goes further into the individual producer’s production decision.

  2. Price and Quantity Supplied: Direction of Change • Recall – the good’s own price (P) is a cause of quantity supplied of that good (QS). P  QS. • We’ll examine why in more detail.

  3. Marginal Cost • Marginal Cost (MC) – the change in total cost that a firm experiences as a result of increasing the quantity or output of the good it’s producing (Q). • Formula: MC = (Total Cost)/Q.

  4. Properties of Marginal Cost (MC) • MC > 0. Q  (Total Cost) • Comes from production function (relationship how inputs combine to produce output).

  5. The Law of Diminishing Returns and Marginal Cost • The Law of Diminishing Returns (LDR) necessarily implies increasing Marginal Cost. • In other words, beginning at the point of LDR,MC/Q > 0. • LDR  Total Cost increases at an increasing rate. It becomes more successively more expensive for the firm to produce the additional good.

  6. Marginal Cost and the Production Decision • Downward sloping part of MC curve: firm wouldn’t consider stopping production there. • Upward sloping part of MC curve: individual firm evaluates the marginal benefit versus the marginal cost (MC) of producing the additional good.

  7. Marginal Benefit to Production (Perfect Competition) • Marginal Benefit of producing the additional good = price that the good sells for in the market (P). • Perfect Competition  P is given to the individual producer.

  8. The Production Decision • Individual producer evaluates the marginal benefit (P) versus the marginal cost (MC) of producing the additional unit. • If P > MC, produce it and consider producing the next additional unit. • If P < MC, do not produce and in fact consider decreasing output. • If P = MC, produce the additional unit and stop there (first order condition).

  9. The Supply Curve is the Marginal Cost Curve (LDR) • Given price, the individual producer will increase production until P = MC. • Increase in price (P) implies that the producer will move up its MC curve, and increase the quantity supplied (QS).

  10. Individual Versus Market Supply • The Market Supply for any good is obtained by summing up the individual supplies for all the producers of this good. • Example – consider the supply of pizzas. • Suppose the producers consist of two firms, the Varsity and Cosmos.

  11. Supply of Pizzas Price ($)Varsity + Cosmos = Market 5.00 25 18 43 6.00 33 21 54 7.00 41 24 65 8.00 49 27 76 9.00 57 30 87 10.00 65 33 98

  12. Individual Firm’s Supply and Market Supply: Causes • Price of Good (P), P  QS. • Price of Inputs (PINPUT), PINPUT  QS. -- Labor (Wage Rate) -- Materials (e.g. Energy) -- Capital Stock • Technology (Tech), Tech  QS. • Regulatory Environment (Reg), Reg  QS . • Number of Producers (entry and exit) (Market Supply only)

  13. Supply: Graphical Description • Graph supply against the own price (P), upward sloping. • Changes in causes other than P, described as shifts of supply curve. • Changes that enhance supply shift the supply curve rightward. • Changes that hinder supply shift the supply curve leftward.

  14. Example 1: Technology Under Perfect Competition • Suppose that industries which produce calculators discover a more efficient way to make them (cheaper computer chips). • Technology  QS. • Increase in Technology increases Supply, described by rightward shift of supply curve. • As a result, P*, Q*.

  15. Example 2 -- The Effect of Increased Regulation • Suppose that government passes increased regulations on worker safety and workman’s compensation for all businesses. • Regulation  QS. • This change decreases the market quantity supplied, described by leftward shift of Supply curve. • As a result, P*, Q*. • Tradeoff – business performance versus worker protections.

  16. Example 3 -- Entry and Exit in Perfect Competition • Highly Favorable Markets  new firms enter  Market Supply increases (shifts rightward)  P*. • Highly Unfavorable Markets  firms exit  Market Supply decreases (shifts leftward)  P*.

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