In this article, we will explain how the supply curve of a firm in a competitive market is derived from its marginal cost curve, and how the supply curve of the market is obtained by adding up the supply curves of all the firms in the market.
What is a Competitive Market?
A competitive market is one where there are many buyers and sellers of a homogeneous good, such that no individual buyer or seller can influence the market price. The standard examples of competitive markets are those for commodities, such as wheat, copper, or coffee. In a competitive market, each seller faces a horizontal demand curve at the market price, which means that the seller can sell as much as it wants at that price, but nothing more if it raises the price. The market price is determined by the intersection of the market demand and supply curves.
How is the Supply Curve of a Firm Derived?
The supply curve of a firm tells us how much output the firm is willing to bring to market at different prices. A profit-maximizing firm will choose the output level that equates its marginal revenue (MR) with its marginal cost (MC). In a competitive market, the marginal revenue of a firm is equal to the market price (P), since the firm can sell each additional unit at that price. Therefore, the profit-maximizing condition for a competitive firm is P = MC.
However, this condition does not always hold for every possible price. If the price is too low to cover the average variable cost (AVC) of production, then the firm will incur losses even if it shuts down and produces nothing. In this case, the firm will choose to exit the market in the short run. The minimum point of the AVC curve is called the shutdown point, and it determines the lowest price at which the firm will operate.
On the other hand, if the price is higher than the MC when production is at its maximum possible level in the short run, then the firm will produce at that level and earn positive profits. The maximum output level depends on the fixed factors of production, such as plant size and equipment, and it is determined by the point where the MC curve becomes vertical.
Therefore, we can summarize the supply decision of a competitive firm as follows:
- If P < AVC, then Q = 0 (shutdown)
- If P > MC at maximum output, then Q = maximum output
- Otherwise, P = MC
The segment of the MC curve that lies above the AVC curve and below the maximum output level is called the supply curve of the firm. It shows how much output the firm will supply at each price above its shutdown point.
Figure 1 shows an example of a firm’s cost curves and its supply curve. The supply curve is highlighted in red.
How is the Supply Curve of a Market Derived?
The supply curve of a market is obtained by adding up horizontally the supply curves of all the firms in that market. This means that for each possible price, we sum up how much each firm will supply at that price to get the total quantity supplied by the market.
The supply curve of a market reflects how responsive the market is to changes in price. The slope and shape of the market supply curve depend on two factors: (1) how many firms are in the market and (2) how similar or different are their cost structures.
If there are many firms in the market with similar cost structures, then the market supply curve will be relatively flat and elastic, meaning that a small change in price will lead to a large change in quantity supplied. This implies that the market is very competitive and sensitive to demand conditions.
If there are few firms in the market with different cost structures, then the market supply curve will be relatively steep and inelastic, meaning that a large change in price will lead to a small change in quantity supplied. This implies that the market is less competitive and more influenced by supply conditions.
Figure 2 shows an example of how four identical firms with the same cost curves as in Figure 1 form the market supply curve by adding up their individual supply curves. The market supply curve is highlighted in blue.
For any competitive market, the supply curve is closely related to the marginal cost of production. The supply curve of a firm is derived from its marginal cost curve, and it shows how much output the firm will produce at each price above its shutdown point. The supply curve of a market is derived from the supply curves of all the firms in that market, and it shows how much output the market will supply at each price. The slope and shape of the market supply curve depend on the number and similarity of the firms in the market. According to sitename, the supply curve for a competitive industry is just the horizontal sum of the marginal cost curves of all the individual firms belonging to the industry. This supply curve, based as it is on the short-run marginal cost curves of the firms in the industry, is the industry’s short-run supply curve.