Market Supply and Elasticity
For many important theories of the firm, economists assume that business
firms are rational. Rational business firm behavior is defined
as at tempting to maximize profits and minimize losses.
Economists recognize that firms will not strictly maximize profits. They
must make their decisions in the face of,uncertainty. Also,
firms are often so complex that top management directives
aimed at maximizing profits may be compromised. Moreover,
firms' top management often pursues goals that are not
completely consistent with profit maximization.
Economists and accountants do not define profit in the same way.
Accountants concentrate on the funds that flow to and from a
firm and tend to ignore implicit costs. What is considered
"nor mal " for a firm to earn, or the minimum that a
firm has to earn in order for it to be willing to continue in
its present business activity, is considered part of
"profit " by accountants, but is recognized as
"cost" by economists. Such cost is called "normal
profit." Profit in excess of this amount is called
"greater than- normal profit," or "economic
profit." "Less than-normal profit," or
"economic loss," will cause a firm to go out of
business in the long run.
The level of output at which a firm will maximize its profit or minimize
its loss may be identified by examining its total cost and total
revenue or its marginal cost and marginal revenue. A firm will
maximize its profit at the level of output at which its total
revenue exceeds its total cost by the greatest amount.
Similarly, a firm will maximize its profit at the level of
output at which its marginal cost is equal to its marginal
revenue, as long as marginal revenue is greater than marginal
cost at somewhat lower levels of output and marginal cost is
greater than marginal revenue at somewhat higher levels of
output.
In the long run, a firm will go out of business (exit from its industry)
if it cannot earn at least normal profit. In the short run, when
some of a firm's cost is fixed, it will operate if it can earn
enough to recover all of its variable cost and at least some of
its fixed cost. If, however, it cannot recover all of its
variable cost, the firm will shut down.
Price elasticity of supply measures the percentage change in the quantity
of a product sup plied
in response to a percentage change in the price of that product.
This is analogous to the price
elasticity of demand concept discussed in Chapter 7.
There are five categories of elasticity. Sup ply is elastic when the
percentage change in the quantity supplied is greater than the
percentage change in the price that generated it. Supply is in
elastic when the percentage change in the quantity supplied is
less than the percentage change in the price that generated it.
Supply is unitary elastic when the percentage change in the
quantity sup plied is exactly equal to the percentage change in
the price that generated it. Supply is perfectly in
elastic when a change in price causes no response at all in the
quantity supplied. Supply is infinitely elastic when a change in
price causes an infinite response in the quantity supplied.
The price elasticity of supply of a product depends on (a) the change in
average total cost that is incurred by a firm when it alters the
quantity level of its output and (b) the time that it takes a
firm to expand or to contract its output level in response to a
change in the price of the product.
