Firm Supply Decisions, Market Equilibrium, and Monopoly Power

Posted on Mar 29, 2025 in Economy

Firm’s Short-Run Supply Curve

The firm’s decision to produce in the short run depends on whether the price covers average variable costs.

  • Below point 2 (minimum Average Variable Cost, AVC), the price does not cover variable costs, so the firm shuts down and produces nothing. There are no profits, and losses equal fixed costs.
  • From point 2 upwards, the firm’s short-run supply curve corresponds to its Marginal Cost (MC) curve above the minimum AVC.
  • Between point 2 (min AVC) and point 1 (minimum Average Total Cost, ATC), the firm covers all its variable costs and some of its fixed costs. It produces but incurs a loss smaller than its fixed costs.
  • At point 1, where MC = ATC, profits are zero (break-even point).
  • Above point 1, the price is greater than ATC, and the firm earns positive profits, which increase as output rises along the MC curve.

Note: Point 1 and Point 2 represent the minimum points of the ATC and AVC curves, respectively.

Profit Maximization under Perfect Competition

In a perfectly competitive market, the presence of positive economic profits attracts new entrants.

  • If a firm earns positive profits, its prices are likely attractive relative to costs.
  • New competitors entering the market increase market supply, driving the price down.
  • The long-run tendency under perfect competition is for firms to operate where price equals the minimum ATC (P = min ATC), which is also where MC = ATC. At this point, economic profit = 0.

The Firm’s Long-Run Supply Decision

In the long run, a firm can adjust all inputs, meaning all costs are variable. The firm can choose the optimal scale of operation from all its possible short-run scenarios.

A competitive firm’s long-run profit function is: Profit = p*y – c(y), where p is price, y is output, and c(y) is the long-run total cost.

The first and second-order conditions for profit maximization at an optimal output level y* > 0 are:

  1. P = MC(y) (Price equals Long-Run Marginal Cost)
  2. dMC(y)/dy > 0 (Long-Run Marginal Cost must be increasing)

Additionally, the firm’s economic profit must not be negative in the long run; otherwise, it would exit the industry.

Profit = p*y – c(y) ≥ 0

This implies:

p ≥ c(y)/y

Therefore, the price must be greater than or equal to the Long-Run Average Cost (AC): P ≥ AC.

Market Price Adjustments

If Prices Go Up

If the market price rises above the equilibrium price (p*), there will be an excess of supply (quantity supplied exceeds quantity demanded). Market forces will push the price down towards p*.

If Prices Go Down

If the market price falls below the equilibrium price (p*), there will be an excess of demand (quantity demanded exceeds quantity supplied). Market forces will push the price up towards p*.

Market Equilibrium Elasticity Cases

  • Perfectly Inelastic Supply: Quantity supplied is fixed and does not depend on the market price. Represented by a vertical supply curve. Supply elasticity (ES) = 0 → When price changes, quantity supplied does not change.
  • Perfectly Elastic Supply: Quantity supplied is extremely sensitive to the market price. Represented by a horizontal supply curve. Supply elasticity (ES) = ∞ → A small price change leads to an infinite change in quantity supplied (or zero supplied below that price). This can represent the long-run market supply curve in a constant-cost perfectly competitive industry.
  • Perfectly Inelastic Demand: Quantity demanded is fixed and does not depend on the market price. Represented by a vertical demand curve. Demand elasticity (ED) = 0 → When price changes, quantity demanded does not change.
  • Perfectly Elastic Demand: Quantity demanded is extremely sensitive to the market price. Represented by a horizontal demand curve. Demand elasticity (ED) = ∞ → Consumers demand an infinite amount at a specific price but nothing above it. This represents the demand curve faced by a single firm in perfect competition.

Imperfect Competition: Pure Monopoly

A pure monopoly is a market structure characterized by:

  • Single Seller: There is only one seller in the market. Therefore, it has no direct competitors.
  • Market Demand = Firm Demand: The monopolist’s demand curve is the same as the market demand curve because the firm level is the market level.
  • Downward-Sloping Demand: The demand function has a negative slope, unlike the horizontal demand curve faced by a firm in perfect competition.
  • Price-Setter: Monopolists are price-setters; they can alter the market price by adjusting their output level (y). Producing higher output generally requires lowering the price (p(y)).
  • Barriers to Entry: Significant barriers prevent other firms from entering the market. Natural monopolies can exist due to these barriers.

What Causes Monopolies?

Monopolies can arise from several sources:

  1. Legal Fiat: Government grants exclusive rights (e.g., US Postal Service for certain mail types).
  2. Patents: Legal protection grants temporary exclusive rights to produce or use a new invention (e.g., a new drug).
  3. Sole Ownership of a Resource: Exclusive control over a critical input (e.g., a unique mineral deposit, historically De Beers diamonds).
  4. Cartel Formation: Firms collude to act as a single monopolist (e.g., OPEC). Note: Cartels are often illegal and unstable.
  5. Economies of Scale (Natural Monopoly): Average total cost decreases as output increases over the relevant range of demand, making it efficient for only one firm to serve the market (e.g., local utility companies).
  6. Licensing and Certification: Government requirements or professional standards can limit entry (e.g., medical licenses for doctors), though this usually leads to limited competition rather than pure monopoly.