If a perfectly competitive firm is producing a quantity that generates P > MC, then profit

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

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.

• 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

Short-Run Supply

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

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.