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, sugar, 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.
How to Derive the Supply Curve of a Firm?
A supply curve for a firm tells us how much output the firm is willing to bring to market at different prices. To derive the supply curve of a firm, we need to use two principles from Chapter 2:
- A firm should operate in the short run if it can achieve an economic profit; otherwise it should shut down in the short run.
- A firm should increase production up to the level where marginal cost equals marginal revenue.
In a competitive market, the marginal revenue to a firm is equal to the market price, since each additional unit sold brings in the same amount of revenue. Therefore, the optimal output level for a firm is where its marginal cost curve intersects with its horizontal demand curve (or the market price).
Figure 1 shows a generic situation with average (economic) cost and marginal cost curves. Based on these principles, we can prescribe the best operating level for the firm in response to the market price as follows:
- If the price is too low to cover the average variable cost at any possible output level, then the firm should shut down in the short run. This is because the firm would incur a loss greater than its fixed cost by operating. The minimum point of the average variable cost curve is called the shutdown point.
- If the price is higher than the marginal cost when production is at the maximum possible level in the short run, then the firm should operate at that maximum level. This is because the firm would earn a positive profit by producing more units. The maximum output level depends on the capacity and technology of the firm.
- Otherwise, if the price is between these two extremes, then the firm should operate at the level where price equals marginal cost. This is because at this level, the firm maximizes its profit (or minimizes its loss) by equating its marginal benefit and marginal cost.
Figure 1: The optimal output level for a firm depends on the market price.
The segment of the marginal cost curve that lies above the shutdown point and below or up to the maximum output level is called the supply curve of the firm. This segment shows how much output the firm is willing to supply at different prices in the short run.
How to Derive the Supply Curve of a Market?
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 any given price, we sum up how much each firm is willing to supply at that price to get the total quantity supplied by the market.
Figure 2 shows an example of how to derive the market supply curve from two firms’ supply curves. Suppose there are only two firms in the market, A and B, with different marginal cost curves and capacities. The supply curves of each firm are shown by the red and blue lines respectively. To get the market supply curve, we add up (horizontally) how much each firm supplies at each price level. For example, at a price of $10, firm A supplies 40 units and firm B supplies 20 units, so the total quantity supplied by the market is 60 units. The market supply curve is shown by the green line.
Figure 2: The market supply curve is obtained by adding up (horizontally) the supply curves of all the firms in the market.
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.
In this article, we have explained 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. We have also shown how the market price determines the optimal output level for each firm in the short run, and how the market supply curve reflects the marginal cost curves of the firms in the industry. According to sitename, these concepts are important for understanding how competitive markets work and how they allocate resources efficiently.