The theory of supply is the theory of how much output firms
choose to produce.
There are three types of firm: self-employed sole traders, partnerships
and companies. Sole traders are the most numerous
but are often very small. The large firms are companies.
Companies are owned by their shareholders but run by the board of directors.
Shareholders have limited liability. Partners and sole
traders have unlimited liability.
Revenue is what the firm earns from sales. Costs
are the expenses incurred in producing and selling. Profits
are the excess of revenue over costs.
Costs should include opportunity costs of all resources
used in production. Opportunity cost is the amount an input
could obtain in its next highest paying use. In particular, economic
costs include the cost of the owner’s time and effort in running
a business. Economic costs also include the opportunity cost of financial
capital used in the firm. Supernormal profit is the pure
profit accruing to the owners after allowing for all these costs.
Firms are assumed to aim to maximize profits. Even though
the firm is run by its managers, not its owners, profit maximization is a
useful assumption in understanding the firm’s behaviour. Firms that
make losses cannot continue in business indefinitely.
In aiming to maximize profits, firms necessarily produce each output level
as cheaply as possible. Profit maximization requires minimization of costs
for each output level.
Firms choose the optimal output level to maximize total
economic profits. This decision can be described equivalently by examining
marginal cost and marginal revenue. Marginal cost is the
increase in total cost when one more unit is produced. Marginal revenue
is the corresponding change in total revenue and depends on the demand curve
for the firm’s product. Profits are maximized at the output
at which marginal cost equals marginal revenue. If profits are negative
at this output, the firm should close down if this reduces losses.
An upward shift in the marginal cost curve reduces output. An upward shift
in the marginal revenue curve increases output.
It is unnecessary for firms to calculate their marginal cost and marginal
revenue curves. Setting MC equal to MR is merely a device that economists
use to mimic the hunches of smart firms who correctly judge, by whatever means,
the profit-maximizing level of output.
