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.
