Question

D) Assuming this is a perfectly competitive market, explain how the supply curve of the steel market is derived. In your explanation, you need to explain the relationship between marginal cost, opportunity cost and reservation price, and how it determines the supply decisions made by the producer.

Answer 1

Market supply curve is the horizontal summation of individual supply functions by all respective firms operating in the market. These firms have a supply function determined by the marginal cost function which begins from a reservation price. This is the minimum price that any firm would like to receive the least and is equal to the minimum of average variable cost. In this manner, each firm must receive a price equal to or greater than the minimum of average variable cost to continue producing. This rising marginal cost function is then multiplied by the number of firms so that market supply function is carried out

Suppose that total cost is C = A + q + q^2, A being the fixed cost. Now the marginal cost is MC = 1 + 2q and so the AVC is 1 + q. Minimum of AVC is 1 and this becomes the reservation price. Supply function of a single firm is P = MC or P = 1 + 2q which is then solved for q = 0.5P - 0.5. For n firms, the market supply becomes nq = Qs = 0.5nP - 0.5n. For example, if there are 10 firms, market supply is Qs = 5P - 5.