Mod 05 Notes - 570.493 Module 5 Lecture Notes Supply...

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570.493 – Module 5 Lecture Notes Supply Understanding Supply In this module we are concerned with supply behavior and demand-supply equilibrium. We examine behavior and equilibrium by focusing on: Firm Supply Market Supply Demand-Supply Equilibrium – What does this mean? Firm Supply Recall the notion of demand: demand is the relationship between price of a good and the quantity demanded. A similar concept applies to the supply of goods. Supply is the relationship between the price of a good and the quantity supplied. In the case of demand, we reasoned that higher prices would result in smaller quantities being demanded. We then derived this result using utility theory. The opposite relationship is expected here: higher prices will result in larger quantities being supplied. We will use the theory of the firm (presented in Module 4) to derive this result. Specifically, it is derived from the marginal cost curve. In the case of demand, we began with the demand of an individual consumer. In this case, we begin with the supply behavior of an individual producer: a firm. To simplify the presentation, we assume that the market price of the good does not respond to changes in the behavior of the firm: that it is perceived as fixed. (We will relax this assumption later, as we consider the behavior of sellers in different kinds of markets.) Figure 5-1 shows a typical marginal cost curve for a firm. This "U-shaped" curve results from a total cost curve similar to the one shown as Figure 4-14 (an "S- shaped" total cost curve). As output increases, marginal cost begins high, falls to a minimum, then rises again. (Note that the marginal cost is not identified here as long run or short run. This condition is omitted for simplicity, but it will be seen later that most pricing and output decisions are based on short run curves.) - 1 -
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570.493 – Module 5 Lecture Notes Figure 5-1 Typical MC Curve Now consider two different possible market prices for the good (see Figure 5-2). The highest price is P a . At this price, the firm has an incentive to expand output to Q a , since every unit sold brings a price higher than the marginal cost of producing it. (Recall that MC is always the incremental cost of producing the marginal unit, so that price and MC can be compared unit by unit.) By the same logic, the firm will not want to produce more than Q a , since the next unit will cost more to produce that it can be sold for (MC>P). So, for a price equal to P a , the quantity supplied is Q a . This is a point on the firm's supply curve. Figure 5-2 Derivation of Supply Curve The lower price is P b . At this price, the first units produced will cost more to produce than they can be sold for. However, the firm has an incentive to produce these units anyway, because if it continues to expand production it will reach the area of lower MC, where can recoup the losses on the first units and possibly earn a profit. This will be the result for prices slightly higher than P b . But at P b , we
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