Theory of Supply

The theory of supply is the theory of how much output firms choose to produce. The principal assumption of the supply theory is that the producer ^will maintain the level of output at which he maximizes his profit.

Profit can be defined in terms of revenue and costs. Revenue is what the firm earns by selling goods or services in a given period such as a year. Costs are the expenses that are necessary for producing and selling goods or services during the period. Profit is the revenue from selling the output minus the costs of inputs used.

Costs should include opportunity costs of all resources used in production. Opportunity cost of a commodity is the amount an input can obtain in its best alternative use (best use elsewhere). In particular, costs include the owner's time and effort in running a business. Costs also include the opportunity cost of the financial capital used in the firm.

Aiming to get higher profits, firms obtain each output level as cheaply as possible. Firms choose the optimal output level to receive the highest profits. This decision can be described in terms of marginal cost and marginal revenue.

Marginal cost is the increase in total cost when one additional unit of output is produced.

Marginal revenue is the corresponding change in total revenue from selling one more unit of output.

As the individual firm has to be a price-taker¹, each firm's marginal revenue is the prevailing market price. Profits are the highest at the output level at which marginal cost is equal to marginal revenue, that is, to the market price of the output. If profits are negative at this output level, the firm should close down.

An increase in marginal cost reduces output. A rise in marginal revenue increases output. The optimal quantity also depends on the output prices as well as on the input costs. Of course, the optimal supply quantity is affected by such noneconomic factors as technology, environment, etc².

Making economic forecasts, it is necessary to know the effect of a price change on the whole output rather than the supply of individual firms.

Market supply is defined in terms of the alternative quantities of a commodity all firms in a particular market offer as price varies and as all other factors are assumed constant.

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