The Firm’s Supply Decision-Competition
The logic behind the supply decision of an individual firm in a competitive market is straight forward. The first two characteristics of a competitive market-many smalls firms producing a standardized product-mean that each firm is a price taker. In a competitive market, a firm can sell as much or as little as it wishes without having any appreciable effect on the market price.
To earn as large a profit as possible, a firm in a competitive market will chose the output that makes marginal cost equal to the market price. If the firm were to produce q SD, marginal cost would be less than price. By increasing its output, the firm would increase its profit because the marginal cost of the additional output would fall short of the marginal revenue that the sale of the additional output would bring in. But by increasing its output, the firm world increase marginal cost, moving marginal cost closer to price. As long as marginal cost is less than the market price, the firm will gain by increasing its output. When the firm reaches the output the market its marginal cost equal to the market price, it will not profit by further increases in output.
A similar argument-which you should work through for yourself to make sure that you understand the logic involved-shows that if the price was P1 and the firm was producing more than q1 is the firm’s would maximize its profit by reducing its output until marginal cost was equal to price.
Sometimes, however, the firm will maximize its profit (actually, minimize its losses) in the short run by shutting down. If the firm shut down, its losses equal the rental cost of the fixed factors of production, a cost that must be covered no matter how much output is produced.
If the price falls below its average variable cost, the firm would lose even more than its fixed cost if it put output in the market. Not only would the firm lose its fixed cost, but it would have an additional loss on every unit sold: the shortfall of the price from the firm’s average available cost. To avoid such a loss, the profit-maximizing firm will shut down if the market price falls below the minimum average variable cost.
Combining the arguments of the preceding two paragraphs, we see that the supply curve of a single firm in a competitive industry is its marginal cost curve above the shutdown point.
