Recall from Chapter 2 "Key Measures and Relationships" the principle that a firm should operate in the short run if they can achieve an economic profit; otherwise the firm should shut down in the short run. If the firm decides it is profitable to operate, another principle from Chapter 2 "Key Measures and Relationships" stated that the firm should increase production up to the level where marginal cost equals marginal revenue. In the case of a flat demand curve, the marginal revenue to a firm is equal to the market price.
Based on this principle, we can prescribe the best operating level for the firm in response to the market price as follows:. Figure 6. Based on the preceding rule, a relationship between the market price and the optimal quantity supplied is the segment of the marginal cost curve that is above the shutdown price level and where the marginal cost curve is increasing, up to the point of maximum production. For prices higher than the marginal cost at maximum production, the firm would operate at maximum production.
Subsidies are funds given to firms to enable them to increase their supply or to reduce the price of their product to the consumer. A supply schedule shows the relationship between price and planned supply over a hypothetical range of prices.
For example, this supply schedule shows how many cans of cola would be supplied by a school or college canteen in a single week. The higher the price, the greater the quantity supplied. A supply curve is derived from a supply schedule. The upward slope of a supply curve illustrates the direct relationship between supply decisions and price. In this case, the supplier of cola would supply more cans at 80p compared with 60p. There are a number of explanations of this relationship, including the law of diminishing marginal returns.
The law of diminishing marginal returns explains what happens to the output of products when a firm uses more variable inputs while keeping a least one factor of production fixed.
Real capital, such as buildings, machinery, and equipment, is usually the factor kept fixed when demonstrating this principle. Economic theory predicts that, when employing these extra variable factors, such as labour, the marginal returns additional output from each extra unit of input will eventually diminish.
Take, for example, a hypothetical firm that has a factory in which computers are assembled. The machinery is fixed, and extra workers can be hired to increase the output of assembled computers. At first, the addition of extra workers creates a significant benefit because it becomes possible to divide up the labour, and for workers to specialise in undertaking one task. Initially, there are increasing marginal returns to each additional worker. Gradually, each additional worker contributes less than the one before so that total output of computers continues to rise, but at a decreasing rate.
The falling marginal returns from each successive worker leads to a rise in the cost of using them. Firms need to sell their extra output at a higher price so that they can pay the higher marginal cost of production. Hence, decisions to supply are largely determined by the marginal cost of production. The supply curve slopes upward, reflecting the higher price needed to cover the higher marginal cost of production.
These choices will be signaled globally to our partners and will not affect browsing data. We and our partners process data to: Actively scan device characteristics for identification. I Accept Show Purposes. Your Money. Personal Finance. Your Practice. Popular Courses. Part Of. Introduction to Microeconomics. Microeconomics vs. Supply and Demand Basics. Microeconomics Concepts. Economy Economics. What is the Law of Supply? Key Takeaways The law of supply says that a higher price will induce producers to supply a higher quantity to the market.
Supply in a market can be depicted as an upward sloping supply curve that shows how the quantity supplied will respond to various prices over a period of time. Because businesses seek to increase revenue, when they expect to receive a higher price, they will produce more.
What is the best example of the law of supply? What is the law of demand and supply? What are the types of law of supply? Compare Accounts. The offers that appear in this table are from partnerships from which Investopedia receives compensation. This compensation may impact how and where listings appear. Investopedia does not include all offers available in the marketplace. Related Terms Understanding the Law of Supply and Demand The law of supply and demand explains the interaction between the supply of and demand for a resource, and the effect on its price.
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