I know that the conventional explanation linking fall in cost of production and rise in supply is that a fall in cost of production of A means that it is more profitable to produce A. Thus, suppliers will be incentivised to produce more of A, hence rise in supply of A.

My question is - why should suppliers even want to produce more? Can't they just enjoy the higher profits attained automatically through the fall in COP? What exactly is the explanation for them wanting to produce more?

This is the missing link in many explanations I see and I hope to clarify this, thanks!

  • $\begingroup$ OMG SO SORRY I'll edit it $\endgroup$ – Charlz97 Dec 20 '17 at 8:38
  • $\begingroup$ Why would they settle for earning higher profits from the existing supply when they could earn higher profits from the existing supply and additional profit from supplying additional units? $\endgroup$ – Ubiquitous Dec 20 '17 at 8:51
  • $\begingroup$ @Ubiquitous Is it possible for a scenario whereby the cost incurred from supplying additional units outweighs the additional revenue gained from supplying additional units? $\endgroup$ – Charlz97 Dec 20 '17 at 9:16
  • $\begingroup$ Or is this an irrelevant question? $\endgroup$ – Charlz97 Dec 20 '17 at 9:17
  • $\begingroup$ @Charlz97 No. It must be true that the additional revenue from supplying the last unit is equal to the cost of that unit (otherwise, if the revenue were greater than cost then the firm could profitably increase supply; if it were less than cost then the firm would want to reduce supply). Now imagine we reduce the unit cost. Because revenue from the marginal unit was equal to cost before, it must now be strictly greater than cost so an increase in supply will strictly increase profit. $\endgroup$ – Ubiquitous Dec 20 '17 at 9:21

You can think about this using the basic theory of the firm that we teach in principles courses, such as this one. The specifics of the graph will change depending on the assumptions of the market it represents (perfect competition, monopoly, etc), but the story should be the same.

In brief, each individual firm makes a production decision so that marginal cost (MC) equals marginal revenue (MR), where "marginal" means the next unit of production. Keep in mind that a firm is always trying to maximize its profits. Therefore, if MC > MR (the cost of the next unit of production exceeds the revenue of the next unit of production), it means the firm could increase those profits by producing one unit less. If MC < MR, then they could increase profits by producing one unit more. Only when MC = MR can the firm no longer increase its profits by changing the quantity it produces.

If anything happens in the market to lower production costs, it means the firm's old production decision leaves them with MC < MR, and thus they should produce a higher quantity. Continuing to produce the same quantity would mean they're earning lower total profit than they could be.

Of course there are a lot of simplifying assumptions in this model, which is why it's one taught in principles classes. But that's the foundation of the idea you're asking about, I think.

  • $\begingroup$ Since marginal means "the NEXT unit of production", I can fully understand it in the context of MR > MC, if your revenue rises more than costs by producing 1 more unit, of course you would produce one more unit. However, if it's MC > MR, this only tells you that IF you produce one MORE unit, costs will rise more than revenue for the next unit produced. It only tells you not to produce more; it doesn't dictate that you should now produce LESS. What exactly am I missing here? $\endgroup$ – Charlz97 Dec 23 '17 at 1:30
  • $\begingroup$ @Charlz97 Think of it like an iterative process, where we start at zero (or some arbitrarily low number) and consider the next unit in succession, until we stop. The question, each time, is about the NEXT unit - we're not ever talking at all about the previous unit, because we already considered it. So when we say "produce less" here, we mean less than whatever amount that next unit would have us at. There is also the simplifying assumption that MC=MR exists as a whole number, rather than being some fraction of a unit we can't achieve. $\endgroup$ – Jeff Dec 23 '17 at 8:14
  • $\begingroup$ @Charlz97 Furthermore, we assume they will chose to produce the unit where MC=MR because we're talking about economic profits. That is, profits over and above all costs, like wages. So even at zero economic profits the firm is still "making money" in the colloquial sense. $\endgroup$ – Jeff Dec 23 '17 at 9:26

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