Economics 50: Intermediate Microeconomics

Summer 2010

Stanford University

Michael Bailey

Lecture 7: Firm Supply

Overview

In a perfectly competitive market, the upward sloping portion of the …rm’s marginal cost curve (that

is above AV C(y) in the short run, and above AC(y) in the long run) is its supply curve

The producer’s surplus is the area above the supply curve and below the price

The per-unit pro…t is py AC(y)

Producer’s surplus is equal to pro…t plus …xed costs

The …rm will shut down in the long run if py < AC(y); and will shut down in the short run if

py < AV C(y)

A market is in long run equilibrium when pro…ts are 0 and is characterized by py = M C(y) = min AC(y)

A monopolist sets a price that is a markup above marginal cost, and produces less than the competitive

equilibrium

A monopsonist sets a wage that is below the marginal revenue product, and hires less labor than the

competitive equilibrium

Firm Supply in a Perfectly Competitive Market

If the …rm is a price taker, then it will supply y (w; py ) to the market where y (w; py ) = f (xi (w; py )): Given

the cost function, the supply function solves y = arg max py y C(y): Notice that the …rst order condition of

this problem is:

@C(y)
py = 0
@y
=) py = M C(y)

Thus the marginal cost is the inverse supply curve. In a perfectly competitive market, the market price is

the marginal revenue to the …rm, since it takes the market price as given, and thus the pro…t-maximizing …rm

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equates the price with marginal cost. The second order condition of this problem puts another restriction

on the supply curve:

@ 2 C(y)
< 0
@y 2
@ 2 C(y) @M C(y)
=) = >0
@y 2 @y

The output where p = M C(y) is a maximum only if M C(y) is upward sloping, else the …rm could produce

another unit and marginal cost would be falling. So the inverse supply curve is the upward sloping region of

the marginal cost curve.

Figure 1: The …rm wants to maximize the di¤erence between revenue and cost

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 Figure 2: The maximum pro…t is where p = M C(y) and M C(y) is upward sloping

Figure 3: The upward-sloping portion of the marginal cost curve is the inverse supply curve

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Graphical Analysis

We can rewrite pro…ts as:

= py y C(y)
C(y)
= py y y
y
= py y yAC(y)

= y(py AC(y))
| {z }
p er unit

Thus the pro…t per unit is equal to py AC(y); the revenue per unit minus the cost per unit.

Revenue is the rectangle py y

Pro…ts are the rectangle y(py AC(y))

Figure 4: = y(py AC(y) which is the rectangle shown

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 Figure 5: When the price is less than AC(y); the …rm incurs a loss equal to y(py AC(y)

@V C(y)
Variable costs are the area under M C(y) M C(y) = @y

Producer’s surplus is the area above the supply curve (M C(y)) and below the price

Z p
PS = y (p)dp
Z0 p2
PS = y (p)dp
p1

Total Cost is the rectangle yAC(y) = C(y)

Therefore, producer’s surplus is equal to pro…ts plus total costs minus variable costs:

PS = + C(y) V C(y)

= + FC

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Figure 6: Revenue = 1 + 2 + 3 + 4; = 1 + 2; C(y) = y AC(y) = 3 + 4; Variable Costs = 2 + 4 (area under
M C(y)); P S = 1 + 3; F C = C(y) V C(y) = 3 2; =) P S = + F C

Shut Down Decision

The …rm would prefer to shut down and make 0 output if the pro…t from doing so were greater than the

pro…t from producing. The …rm will shut down if:

C(0) > max py y C(y)

In the long run, C(0) = 0 so we can write this condition as:

0 > py y C(y)
C(y)
=) = AC(y) > py
y

So in the long run, if the price is less than the average cost, the …rm will shut down and produce no

output.

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Figure 7: The long-run supply curve is the upward-sloping portion of the marginal cost curve that is above
AC(y): If p < AC(y); the …rm will shut down in the long run

In the short run, C(0) = F C; so the shut-down condition is:

FC > py y FC V C(y)
V C(y)
=) = AV C(y) > py
y

In the short run, the …rm will shut down if the price is less than the average variable cost. Why are the

conditions di¤erent? In the long run, the …rm can avoid all …xed costs and make a pro…t of 0; so the …rm

must make at least 0 pro…ts in the long run. In the short-run, the …rm will pay it’s …xed costs no matter

what, so it could be that …rm is making negative pro…t, but as long as the pro…t is greater than its …xed

costs, it is still more pro…table to produce than to shut down. Notice that if the price is greater than the

average variable cost, then each unit will make positive pro…t for the …rm, so it is better to produce, even if

those pro…ts are not enough to cover …xed costs, it is more pro…table than shutting down.

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Figure 8: The short-run supply curve is the upward-sloping portion of the marginal cost curve that is above
AV C(y): If p < AV C(y); the …rm will shut down in the short run

Long-run Market Equilibrium

In a perfectly competitive market, …rms are free to costlessly enter or leave the market (no barriers to entry).

If all …rms are identical, then if …rms are making positive pro…t, then …rms will enter the market which will

increase supply and lower the price. If …rms are making negative pro…t, then …rms will leave the market,

reducing supply and raising the price. The market is in equilibrium when no …rms want to enter or exit the

industry and is characterized by 0 pro…t, or p = AC(y). Therefore, the market is long-run equilibrium when:

p = M C(y) = min AC(y)

Since M C(y) = AC(y) at the minimum of AC(y); we can just write:

p = M C(y) = AC(y)

Remember that this means that economic pro…t is 0; the …rm could still be earning a large accounting

pro…t, but if we implicitly paid all factors according to their opportunity cost, it would just equal our pro…t.

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Figure 9: Initially, …rms in this industry make positive pro…ts. In the long run, …rms enter the industry
increasing supply. Firms will continue to enter until p = min AC(y)

Figure 10: Initially, …rms in this industry make negative pro…ts. In the long run, …rms exit the industry
decreasing supply. Firms will continue to exit until p = min AC(y)

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 wy 3
Example 1 The short-run cost function of the …rm is C(F; w; K; y) = F + 3K
; if all …rms are identical,

what will be the long-run quantity and price in the market when w = 16; F = 32; and K = 9?

At the long-run equilibrium, p = M C = AC:

wy 2 F wy 2
p = = +
K y 3K
3
wy wy 2
=) =F+
K 3K
2 wy 3
=) =F
3 K
3 FK
=) y 3 =
2 w
1
3
3 FK
=) y =
2 w
= 3

So for a …rm in this industry to make 0 pro…ts, each must be producing 3 units of output, and the price

must be:

wy 2
p =
K
3w
=
K
= 16

If there are N …rms in the industry, then the market quantity will be QS = 3N:

Example 2 The supply function of the 10 identical …rms in the industry is y (p) = 49 p2 : Each …rm has a
3 p p
cost function C(y) = 500 + y 2 =) M C(y) = 32 y and AC(y) = 500
y + y: The market demand is given by
50 2
QD = 9000 9 p : What is the short-run equilibrium? How many …rms will exist in this industry in the

long run?

3
= py y 500 y 2
X 4 40 2
QS = y (p) = 10 p2 = p
9 9
50 2
QD = 9000 p
9

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 A short-run equilibrium is where QD = QS :

40 2 50 2
p = 9000 p
9 9
=) p = 30

Q = 4000

y = 400

= $3500

Because there is positive pro…t, in the long run …rms enter the industry. Suppose that there are N …rms

in the industry. Then the market supply curve will be given by:

X 4 2 4N 2
QS = y (p) = N p = p
9 9

At the equilibrium, we must have supply equal to demand:

4N 2 50 2
QS = p = 9000 p
9 p 9
90 10
=) p = p
50 + 4N
36000N
Q =
50 + 4N
36000
y =
50 + 4N

We could solve for where the pro…t equals 0; but it is easier to …nd the output that minimizes the average

cost:

500 p
AC(y) = + y
y
2 1 1
=) 500y + y 2 =0
2
3
=) y 2 = 1000

=) y = 100
36000
=) = 100
50 + 4N
=) 36000 = 5000 + 400N
31000
=) N= = 77:5
400

In the long run, there are 77 …rms in the industry, so 67 …rms must have entered the industry.

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Monopoly

We now begin to relax some of the market constraints and consider a case where the …rm is not a price

taker. A monopoly is a market with only one seller, and as the sole seller has the power to set the price in

the market. However, the monopolist is constrained by the inverse demand curve, p(y); so if it sets a price

of p(y); it will be able to sell at most y units of output. We can write the pro…ts of the monopolist as:

max = p(y)y C(y)

The …rst-order condition of this problem is:

@p(y) @C(y)
y + p(y) =
@y @y
| {z } | {z }
M arginal Revenue M arginal Cost

As expected, the monopolist equates marginal revenue with marginal cost. The di¤erence between the

monopolist and the perfectly competitive …rm is the marginal revenue term. In a perfectly competitive

market, the …rm can sell all of its units of output at the market price, py ; and thus has M R(y) = py : The

monopolist also has a p(y) term in its marginal revenue, if it increases output by one unit, revenue will
@p(y)
increase by the price, p(y): However, the monopolist also has a @y y term in it’s marginal revenue, this is

because it is constrained by the demand curve. If the …rm increases its output by one unit, it must lower

the price on all of its output so the market clears, so the marginal revenue also changes by the change in
@p(y)
price times quantity, or @y y:

We can predict from the marginal revenue term that the monopolist will produce less than the perfectly

competitive …rm. For the marginal unit of output, the …rm has to lower the price on all of its units of outputs

for the market to clear. Due to this "negative" term dragging marginal revenue down, marginal revenue will

equal cost at a much lower output then the …rm that has M R = p:

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 It is instructional to rewrite the …rm’s optimal condition in terms of elasticities:

@p(y)
y + p(y) = M C(y)
@y
@p(y) y
=) p(y) + p(y) = M C(y)
@y p(y)
p(y)
=) + p(y) = M C(y)
"y;p
1
=) p(y) + 1 = M C(y)
"y;p
"y;p + 1
=) p(y) = M C(y)
"y;p
"y;p
=) p(y) = M C(y)
"y;p + 1

Thus the price the monopolist sets is a "markup" above marginal cost, and is referred to as "markup

pricing". Notice that the monopolist will never operate on the inelastic portion of the demand curve. If
"y;p
1 < "y;p < 0; then "y;p +1 is negative, and the optimal price would be negative, so the optimality condition

cannot hold. This is an intuitive result, on the inelastic portion of the demand curve, the monopolist could

decrease output and increase revenue (as we discussed in detail in the …rst part of the course). The …rm

would move to a lower cost because less output means it uses fewer inputs. More revenue and less cost

means pro…ts would be higher. We can’t use this logic to rule out the …rm operating on the elastic portion

of the demand curve. On the elastic portion, the …rm could decrease its price and increase revenue, but it

would have to produce more output, so costs would icnrease and the change in pro…ts is indeterminate. The

maximum pro…t is attained when M R = M C:

Example 3 Linear Demand p(y) = a bP

Revenue = p(y)y = ay by 2 and Marginal Revenue = a 2by: So marginal revenue is demand with twice

the slope. Notice that the inelastic portion of the demand curve corresponds to a negative marginal revenue.

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 Figure 11: The monopolist produces where M R(y) = M C(y)

Figure 12: The monopolist produces less than the competitive output (where p = M C(y)); capturing some
of the consumer’s surplus as an increased producer’s surplus, but creating deadweight loss (DWL)

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 b
Example 4 Constant Elasticity Demand Function p(y) = ay
"y;p
Because the elasticity is constant along the curve, we can plot the curve "y;p +1 M C(y) which is a

constant times marginal cost, or a marginal cost shifter. The monopolist will produce where this curve

intersects demand.

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p

0
0.0 0.2 0.4 0.6 0.8 1.0 1.2 1.4 1.6 1.8 2.0 2.2 2.4 2.6 2.8 3.0
y

"
Figure 13: Constant Elasticity Demand Function plotted with M C(y) and M C(y) "+1 : The monopolist
"
produces where p(y) = M C(y) "+1

Monopsony

A monopsony is a market with only one buyer, in contrast to a monopoly with only one seller. The monop-

sonist cannot take the prices of the good it is buying as constant because it is constrained by the supply

curve. For example, consider a …rm that is the only buyer of labor services. The …rm is constrained by the

labor supply curve and must o¤er a higher wage to attract more labor. We can write the supply function

in the labor market as w(L) which tells us how much labor, L; will be supplied at a given wage w(L): The

objective function of the …rm that only uses labor to produce an output is:

max py f (L) w(L)L

As always, the …rm sets marginal revenue equal to marginal cost:

@f (L) @w(L)
py = L + w(L)
@L
| {z } | @L {z }
M RP L M arginal Cost of Lab or

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 The marginal revenue term (marginal revenue product) is the same for the monopsonist, M RPL =

py M PL ; the marginal cost term is di¤erent. In the perfectly competitive case, this term is equal to w since

the …rm can hire all the labor at wants at a constant wage. The monopsonist is constrained by the supply

curve however, and if it wants to higher more labor, it must o¤er a higher wage, thus the marginal cost has
@w(L)
a w(L) term indicating it must pay a wage of w to the marginal worker, but it also has a @L L term,

indicating it must also o¤er this higher wage to all its labor.

From this equation we can already see that the monopsonist will hire less labor than in the competitive

equilibrium. When deciding to hire the marginal worker, the …rm must not only see if the M RPL is greater

than the wage, but also if the M RPL is greater than the wage plus the e¤ect of raising the wages for all

other workers. This additional productivity requirement on the marginal worker induces the …rm to set a

lower wage and higher fewer units of labor. Rewriting the optimal condition in terms of elasticities:

@w(L)
M RPL = L + w(L)
@L
@w(L) L
= w(L) + w(L)
@L w(L)
1
= w(L) +1
"L;w
"L;w + 1
= w(L)
"L;w
"L;w
=) M RPL = w(L)
"L;w+1

Because the elasticity of supply is positive, this means the …rm will set a wage that is less than the

M RPL ; as expected.

Example 5 Linear Supply w(L) = a + bL =) C(L) = aL + bL2 ; M C(y) = a + 2bL:

Notice that the marginal cost curve is the supply curve with twice the slope.

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 Figure 14: The monopsonist sets a wage where M C(y) = M RPL

Figure 15: The monopsonist sets a wage that is less than the competitive one, hiring too little labor than
is e¢ cient. The monopsonist captures some of the producer’s surplus (the surplus that would have gone
to labor suppliers) thus increasing consumer’s (i.e. the monopsonist’s) surplus, but creates deadweight loss
(DWL)

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