Short-Run Supply

In determining how much output to supply, the firm's objective is to maximize profits subject to two constraints: the consumers' demand for the firm's product and the firm's costs of production. Consumer demand determines the price at which a perfectly competitive firm may sell its output. The costs of production are determined by the technology the firm uses. The firm's profits are the difference between its total revenues and total costs.

Total revenue and marginal revenue. A firm's total revenue is 
the amount that the firm earns from sales of its output. If a firm decides to supply the amount Q of output and the price in the perfectly competitive market is P, the firm's total revenue is A firm's marginal revenue is the amount by which its total revenue changes in response to a 1-unit change in the firm's output. If a firm in a perfectly competitive market increases its output by 1 unit, it increases its total revenue by P × 1 = P. Hence, in a perfectly competitive market, the firm's marginal revenue is just equal to the market price, P.

Short‐run profit maximization. A firm maximizes its profits by choosing to supply the level of output where its marginal revenue equals its marginal cost. When marginal revenue exceeds marginal cost, the firm can earn greater profits by increasing its output. When marginal revenue is below marginal cost, the firm is losing money, and consequently, it must reduce its output. Profits are therefore maximized when the firm chooses the level of output where its marginal revenue equals its marginal cost.

Graphical illustration of short‐run profit maximization. The marginal revenue, marginal cost, and average total cost figures reported in the numerical example of Table are shown in the graph in Figure .

Short‐run losses and the shut‐down decision. When the firm's average total cost curve lies above its marginal revenue curve at the profit maximizing level of output, the firm is...