Sector Transporte

Just as neoclassical economists assume that consumers act rationally to maximise their utility, they assume that manufacturers and sellers optimise their own welfare. While consumers choose an optimal bundle of goods subject to their budgetary and informational constraints, suppliers deter- mine the quantity of products that they should manufacture and sell to maximise their utility. While consumers make the purchase decisions that best satisfy their preferences, purveyors of goods make price and output decisions to maximise their profi t.

Consider rational behaviour on the production side of the economy. How many units of a good will a producer decide to make? Economists always think at the margin, so the pertinent question

FIRM BEHAVIOUR AND THE LAW OF SUPPLY | 19

is to ask: when will a fi rm produce one more unit? We can begin by answering this question nega- tively: a company will not manufacture another good if the price that it can obtain for the product is less than its average variable cost. This cost represents total variable cost – those costs that change depending on the fi rm’s output and which are to be distinguished from fi xed expenses, which do not vary according to the number of products sold – divided by the fi rm’s output (or total number of goods produced). This leads to a fi rst conclusion: no producer will supply an additional product if the available price is less than the average variable cost of manufacturing that good. 6

Would a rational manufacturer sell an additional product for less than the company’s average total cost? The answer is yes, in the short term, as long as the relevant price meets or exceeds average vari- able cost. This may seem like an odd result, as any sale at a price less than average total cost involves a company’s failing to break even. The mystery disappears when one recognises that, in the short term, fi xed costs are sunk, such that a company cannot recover them by exiting the market. If an available price exceeds average variable cost, but is less than average total cost, then the fi rm would rationally sell an additional unit at that price because, in doing so, it would reclaim its non- sunk costs.

Thus, we know that, in the short term, a producer will manufacture and sell a product if, and only if, the price it can command exceeds its average variable cost. A company’s average- variable- cost curve thus constitutes a fl oor, such that supply at prices below this curve will be zero.

This insight, however, does not explain how many units a rational company will decide to produce. The answer lies in the important concepts of marginal cost and marginal revenue. The former term constitutes the expense involved in selling one more unit. It is distinct from variable costs because marginal cost represents the increment in total cost involved in manufacturing one- more product, and can thus include both fi xed and variable costs. Marginal revenue represents the income that the company realises in selling the additional product.

Other than in strategic situations, such as certain oligopolistic markets in which a company must factor into its price/output decision the anticipated actions of its rivals, a fi rm with market power maximises profi t by adjusting its output until its marginal cost of production equals its marginal revenue. Intuitively, if the revenue achieved in selling one extra product exceeds the expense of making that product, then the company can increase profi t by selling that additional good. It will keep selling more goods until marginal cost and marginal revenue coincide. Any further sales past that point would reduce the fi rm’s profi t. It is worth noting that at least two factors limit the profi t- maximising level of output. First, most companies’ marginal cost of production eventually increases with rising output, which ensures that there will be a point where marginal revenue no longer exceeds marginal cost. Second, marginal revenue will eventually decrease with suffi ciently high prices because borderline consumers will abandon the higher- priced good in favour of substitutes at an accelerating rate.

Combining these insights, and under perfect competition which forces price to marginal cost, a fi rm’s short- term supply curve is the company’s marginal- cost curve above its average- variable- cost curve (the dashed portion below). This supply curve, given the relevant market price, deter- mines the quantity of a good that a profi t- maximising company operating in a perfectly competitive market would produce in the short term.

The short- term supply curve, unlike the demand curve, will slope upwards. There are two reasons for this. First, a higher price results in greater marginal revenue to the fi rm, which creates an incentive for it to increase production. Second, successive increases in output eventually lead to elevated costs, which mean that a rational company will require a higher price to increase output further. A standard supply curve for a given product, A, might therefore look like this:

6 An exception could lie in strategic reasons, such as predatory pricing or breaking into a network market (see discussion in Part 8). In such cases, a rational company might sell for less- than-average variable cost.

D. Market Equilibrium, and an Illustrative