The Supply Curve of the Firm and Market Supply

After you have worked through this section of the learning unit, you should be able to:

  • derive the supply curve for an individual firm under perfect completion

An individual firm under perfect competition is a price taker and changes in the market will influence its behaviour through changes in the price of the goods or services. In reaction to a change in the market price, the firm will change the quantity it produces.

Let's consider the case where an increase in the income of households leads to an increase in the market demand for fried chicken pieces. This impact is shown in diagram A, where the market demand curve shifts to the right, causing the equilibrium price to increase to R5. The impact on Funky Chicken is indicated in diagram B. Since Funky Chicken is a price taker, its individual demand curve shifts upwards to R5. At this new price of R5, the marginal revenue is greater than the marginal cost at an output level of 80. It is therefore in the interest of Funky Chicken to increase its output until marginal revenue is equal to marginal cost. This occurs at an output level of 100.

What we can conclude from this is that an increase in the price leads to an increase in the quantity supplied. We have now provided an explanation for why the supply curve is upward sloping – in other words, why it is that an increase in price leads to an increase in the quantity supplied, and vice versa. One can also view this from another angle and argue that owing to the law of increasing marginal cost, a firm will only be willing to supply a higher quantity if it can obtain a higher price.

We have also identified the shutdown point as point B – the point where the average revenue (AR) is equal to the average variable cost (AVC). At a price lower than P2, the firm will not be willing to supply goods and services. The part of the marginal cost curve that lies below point B is therefore not part of the supply curve of the firm. For instance, a point such as A, where the price is P1 and the average revenue (AR) is smaller than the average variable cost (AVC), is not part of the firm's supply curve.
The part of the marginal cost curve that lies above the shutdown point, point B , however, is part of the firm's supply curve. As the price rises from P2, the firm supplies a higher quantity. Note that even if it makes a loss, that is, between points B and C, it is still in the firm’s interest to supply the good since it is minimising its losses.

By adding all the different supply curves of firms together, one can obtain the market supply curve.

Activity

Study the graph below and answer the questions that follow:

  1. Which point is not part of the firm's supply curve?
  2. Which point is the shutdown point?
  3. Does the firm make an economic loss at point C?
  4. At which point on the supply curve does the firm make a normal profit?
  5. At which point on the supply curve does the firm make an economic profit?
  6. The supply curve runs from point ______ onwards.
Click to Show Answer
  1. Point A is not part of the supply curve since average revenue (AR) is smaller than average variable cost (AVC).
  2. Point B is the shutdown point since at this point average revenue (AR) is equal to average variable cost (AVC).
  3. It does. At point C, average revenue (AR) is less than average cost (AC) and the firm makes an economic loss.
  4. At point D, average revenue (AR) is equal to average cost (AC) and the firm makes a normal profit.
  5. At point E, average revenue (AR) is greater than average cost (AC) and the firm makes an economic profit.
  6. The supply curve runs from point B onwards.