In Chapter 6 , we went behind the scenes of the demand curve to
understand how it is determined by the behaviour of consumers. In this
chapter and the next, we go behind the scenes of the supply curve to
understand how it is determined by the behaviour of firms.
We begin by comparing the firms that we see in the real world with those
that appear in economic theory. Next we introduce the concepts of costs,
revenues, and profits, and we outline the key role that profits play in
determining the allocation of a nation’s resources. To determine the most
profitable quantity for a firm to produce and supply to the market, we
need to see how its costs vary with its output.
When examining the relationship between output and cost, time plays an
important role. In this chapter, we focus on the short run, where a firm
can change only some of its inputs, and output is governed by the famous
“law of diminishing returns.” In the next chapter we examine the firm’s
behaviour in the long run—when all the firm’s inputs are variable—and in
the very long run—when the state of technology changes. There we
encounter “scale economies” and firms’ incentives for research and
development.