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ECO204Y-2022/23Perfect Competition—Firm Supply Summary
All firms minimize costs to maximize profits. In previous chapters we examined how
firms minimize costs for any output level (given competitive input markets). We now
examine how firms choose the output they want to produce. We assume that firms want
to maximize profits. How a firm chooses output will depend on the market structure they
operate in.
We begin with the simple case of perfect competition in the output market. This means
that each firm is a price taker. This means the price it faces is independent of its own
actions—it can sell as much as it wants at the going market price. By making this
assumption we do not have to model other firms’ reactions to the firm’s decisions.
A sure sign of price taking behaviour is that the demand curve the firm faces is horizontal
(perfectly elastic) at the going market price.
The Short Run
The competitive firm maximizes the profits from its operations:
𝑀𝑎𝑥
𝜋 = 𝑝𝑦 − 𝐶! (𝑦)
𝑦
The first order condition for this problem is
𝜕𝐶! (𝑦)
𝑝− =0
𝜕𝑦
Or
𝑝 = 𝑆𝑀𝐶(𝑦)
Think of increasing output by one unit. The marginal benefit of this action is p. The
marginal cost of this action is 𝑆𝑀𝐶(𝑦). Therefore, the first order condition tells us the
produce where MB=MC.
Note if we consider reducing output by one unit the marginal benefit is the saved cost
𝑆𝑀𝐶(𝑦), and the marginal cost if the lost revenue p.
Whether we are increasing or reducing output we should continue doing so as long as for
each unit MB>MC and stop when MB=MC
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