THE MARGINAL COST CURVE AND THE FIRM’S SUPPLY DECISION

To extend this analysis of profit maximization, consider the cost curves in Figure 1. These cost curves have the three features that, as we discussed in the previous chapter, are thought to describe most firms: The marginal-cost curve (MC) is upward sloping. The average-total-cost curve (ATC) is U-shaped. And the marginal-cost curve crosses the average-total-cost curve at the minimum of average total cost. The figure also shows a horizontal line at the market price (P). The price line is horizontal because the firm is
a price taker: The price of the firm’s output is the same regardless of the quantity that the firm decides to produce. Keep in mind that, for a competitive firm, the firm’s price equals both its average revenue (AR)and its marginal revenue (MR).

Figure 1 Profit Maximization for a Competitive Firm

A similar argument applies when output is at Q2 In this case,marginal cost is greater than marginal revenue. If the firm reduced production by 1.unit, the costs saved (MC0) would exceed the revenue lost (MRJ. Therefore, if marginal revenue is less than marginal cost, as it is at Q2 the firm can increase profit by reducing production.

• If marginal revenue is greater than marginal cost, the firm should increase its output.

• If marginal cost is greater than marginal revenue, the firm should decrease its output.

• At the profit-maximizing level of output, marginal revenue and marginal cost are exactly equal.

These rules are the key to rational decision making by a profit-maximizing firm. They apply not only to competitive firms but, as we will see in the next chapter, to other firms as well.

We can now see how the competitive firm decides the quantity of its good to supply to the market. Because a competitive firm is a price taker, its marginal revenue equals the market price. For any given price, the competitive firm’s profit-maximizing quantity of-output is found by looking at the intersection of the price with the marginal-cost curve. In Figure 1, that quantity of output .

Figure 2 Marginal Cost as the Competitive Firm’s Supply Curve

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