PERFECT COMPETITION, SHORT-RUN SUPPLY CURVE:

A perfectly competitive firm's supply curve is that portion of its marginal cost curve that lies
above the minimum of the average variable cost curve. A perfectly competitive firm maximizes
profit by producing the quantity of output that equates price and marginal cost. As such, the firm
moves along its positively-sloped marginal cost curve in response to changing prices.
A perfectly competitive firm maximizes profit by producing the quantity of output that equates
marginal revenue and marginal cost. In that price equals marginal revenue for a perfectly
competitive firm, price is also equal to marginal cost. In other words, the firm produces by
moving up and down along its marginal cost curve. The marginal cost curve is thus the perfectly
competitive firm's supply curve.

Because the marginal cost curve is positively sloped due to the law of diminishing marginal
returns, so too is the firm's supply curve. And because all firm's in a perfectly competitive
industry have positively-sloped marginal cost curves, the market supply curve for the entire
industry is also positively sloped. This offers a prime explanation for the law of supply.

Insight Into Supply

The analysis of the short-run production decisions for a perfectly competitive firm has direct
implications for the market supply curve and the law of supply. The primary conclusion is that a
perfectly competitive firm's short-run supply curve is that segment of its marginal cost curve that
lies above the average variable cost curve.

A perfectly competitive firm produces the quantity of output that equates marginal revenue,
which is equal to price, and marginal cost, as long as price exceeds average variable cost. The
profit-maximizing choices of output at alternative prices generates the perfectly competitive
firm's short-run supply curve.

Consider three key points:

1. A profit-maximizing firm produces the quantity of output that equates marginal revenue
and marginal cost (MR = MC).

2. A perfectly competitive firm is characterized by the equality between price and marginal
revenue (P = MR).

3. The law of diminishing marginal returns gives the marginal cost curve a positive slope.

Combining all three points means that a profit-maximizing perfectly competitive firm produces
the quantity of output that equates price and marginal cost (P = MC).
  An increase in the price, moves the profit-maximizing quantity to a higher point on the
positively-sloped marginal cost curve, and a larger production quantity.

 A decrease in the price, moves the profit-maximizing quantity to a lower point on the
positively-sloped marginal cost curve, and a smaller production quantity.

Working a Graph

To illustrate, consider the production and supply Short-Run Supply

decision made by Phil the zucchini grower, a
hypothetical firm. Because Phil is one of gadzillions
of zucchini producers, each producing identical
products and each with a relatively small part of the
overall market, he has no market control. As such,
Phil is a price taker. He must react to the price
determined by the interaction of market demand and
market supply, making adjustments in his own
production to accommodate higher or lower market
prices.

This graph displays Phil's U-shaped cost curves

representing his zucchini production. Note that all
three curves (average total cost, average variable cost,
and marginal cost) are U-shaped. The marginal cost
curve is U-shaped as a direct consequence of
increasing, then decreasing marginal returns.

As a profit-maximizing zucchini producer, Phil produces the quantity of zucchinis that equates
the going market price with marginal cost. Phil's supply response to changing prices can be
observed by... well... by changing prices then noting Phil's supply response.

One place to begin is with a price of say $4. A click of the [$4] button reveals that Phil
maximizes profit by producing 7 pounds of zucchinis. The quantity supplied by Phil at a $4 price
is thus 7 pounds zucchinis. This price/quantity supplied combination is one point on Phil's
zucchini supply curve. What might Phil do if he faces different prices.

Consider a higher price. A click of the [$6] button reveals that Phil maximizes profit in this case
by producing almost 8 pounds of zucchinis. This higher price induces Phil to increase his
quantity supplied from 7 to almost 8. How about an $8 price? A click of the [$8] button reveals
that Phil maximizes profit by producing about 8.5 pounds of zucchinis. Once again, a higher
price motivates Phil to increase his quantity supplied. Bumping the price up to $10, seen with a
click of the [$10] button results in an even greater quantity supplied, 9 pounds of zucchinis.
Does Phil reduce the quantity supplied if the price declines? Up to a point. That point being the
minimum of the average variable cost curve, about $2.75. If the price falls below this level, then
Phil shuts down production in the short run, incurring a lost equal to total fixed cost.

The conclusion from this analysis is that the marginal cost curve that lies above the average
variable cost is Phil's short-run supply curve. A click of the [Short-Run Supply] button highlights
Phil's zucchini supply curve.

Only Perfect Competition

This short-run supply curve explanation relies on Phil being a perfectly competitive price taker.
The marginal cost curve is a supply curve only because a perfectly competitive firm equates
price with marginal cost. This happens only because price is equal to marginal revenue for a
perfectly competitive firm. Should price and marginal revenue NOT be equal, then a profit-
maximizing firm does NOT equate price to marginal cost. As such, the marginal cost curve is
NOT the firm's supply curve.

Because perfect competition does not exist in the real world, most real world firms do not have
equality between price and marginal revenue, and thus do not equate price to marginal cost. In
fact, real world firms with varying degrees of market power do not have supply curves
comparable to that of an idealistic perfectly competitive firm. This recognition is a major
stumbling block in the explanation of the law of supply and the role that the law of supply is
plays in market analysis.

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Managerial economics (sometimes referred to as business economics) is a branch of economics
that applies microeconomic analysis to decision methods of businesses or other management
units. As such, it bridges economic theory and economics in practice. It draws heavily from
quantitative techniques such as regression analysis and correlation, Lagrangian calculus (linear).
If there is a unifying theme that runs through most of managerial economics it is the attempt to
optimize business decisions given the firm's objectives and given constraints imposed by
scarcity, for example through the use of operations research and programming.

Almost any business decision can be analyzed with managerial economics techniques, but it is
most commonly applied to:

 Risk analysis - various models are used to quantify risk and asymmetric information and to
employ them in decision rules to manage risk.
 Production analysis - microeconomic techniques are used to analyze production efficiency,
optimum factor allocation, costs, economies of scale and to estimate the firm's cost function.
 Pricing analysis - microeconomic techniques are used to analyze various pricing decisions
including transfer pricing, joint product pricing, price discrimination, price elasticity estimations,
and choosing the optimum pricing method.
 Capital budgeting - Investment theory is used to examine a firm's capital purchasing decisions.

At universities, the subject is taught primarily to advanced undergraduates and graduate business
schools. It is approached as an integration subject. That is, it integrates many concepts from a
wide variety of prerequisite courses. In many countries it is possible to read for a degree in
Business Economics which often covers managerial economics, financial economics, game
theory, business forecasting and industrial economics.