Marginal Cost and the Firm’s Supply Curve
For a perfectly competitive firm, the marginal cost curve is identical to the firm’s supply curve starting from the minimum point on the average variable cost curve. To understand why this perhaps surprising insight holds true, first think about what the supply curve means. A firm checks the market price and then looks at its supply curve to decide what quantity to produce. Now, think about what it means to say that a firm will maximize its profits by producing at the quantity where P = MC. This rule means that the firm checks the market price, and then looks at its marginal cost to determine the quantity to produce—and makes sure that the price is greater than the minimum average variable cost. In other words, the marginal cost curve above the minimum point on the average variable cost curve becomes the firm’s supply curve.
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As discussed in the tutorial on Demand and Supply, many of the reasons that supply curves shift relate to underlying changes in costs. For example, a lower price of key inputs or new technologies that reduce production costs cause supply to shift to the right; in contrast, bad weather or added government regulations can add to costs of certain goods in a way that causes supply to shift to the left. These shifts in the firm’s supply curve can also be interpreted as shifts of the marginal cost curve. A shift in costs of production that increases marginal costs at all levels of output—and shifts MC to the left—will cause a perfectly competitive firm to produce less at any given market price. Conversely, a shift in costs of production that decreases marginal costs at all levels of output will shift MC to the right and as a result, a competitive firm will choose to expand its level of output at any given price. The following Work It Out feature will walk you through an example.
At What Price Should the Firm Continue Producing in the Short Run?
To determine the short-run economic condition of a firm in perfect competition, follow the steps outlined below. Use the data shown in this table.
| Q | P | TFC | TVC | TC | AVC | ATC | MC | TR | Profits |
|---|---|---|---|---|---|---|---|---|---|
| 0 | $28 | $20 | $0 | – | – | – | – | – | – |
| 1 | $28 | $20 | $20 | – | – | – | – | – | – |
| 2 | $28 | $20 | $25 | – | – | – | – | – | – |
| 3 | $28 | $20 | $35 | – | – | – | – | – | – |
| 4 | $28 | $20 | $52 | – | – | – | – | – | – |
| 5 | $28 | $20 | $80 | – | – | – | – | – | – |
Step 1. Determine the cost structure for the firm. For a given total fixed costs and variable costs, calculate total cost, average variable cost, average total cost, and marginal cost. Follow the formulas given in the Cost and Industry Structure tutorial. These calculations are shown in the table below.
| Q | P | TFC | TVC | TC (TFC+TVC) | AVC (TVC/Q) | ATC (TC/Q) | MC (TC2−TC1)/ (Q2−Q1) |
|---|---|---|---|---|---|---|---|
| 0 | $28 | $20 | $0 | $20+$0=$20 | – | – | – |
| 1 | $28 | $20 | $20 | $20+$20=$40 | $20/1=$20.00 | $40/1=$40.00 | ($40−$20)/ (1−0)= $20 |
| 2 | $28 | $20 | $25 | $20+$25=$45 | $25/2=$12.50 | $45/2=$22.50 | ($45−$40)/ (2−1)= $5 |
| 3 | $28 | $20 | $35 | $20+$35=$55 | $35/3=$11.67 | $55/3=$18.33 | ($55−$45)/ (3−2)= $10 |
| 4 | $28 | $20 | $52 | $20+$52=$72 | $52/4=$13.00 | $72/4=$18.00 | ($72−$55)/ (4−3)= $17 |
| 5 | $28 | $20 | $80 | $20+$80=$100 | $80/5=$16.00 | $100/5=$20.00 | ($100−$72)/ (5−4)= $28 |
Step 2. Determine the market price that the firm receives for its product. This should be given information, as the firm in perfect competition is a price taker. With the given price, calculate total revenue as equal to price multiplied by quantity for all output levels produced. In this example, the given price is $28. You can see that in the second column of the table below.
| Quantity | Price | Total Revenue (P × Q) |
|---|---|---|
| 0 | $28 | $28×0=$0 |
| 1 | $28 | $28×1=$28 |
| 2 | $28 | $28×2=$56 |
| 3 | $28 | $28×3=$84 |
| 4 | $28 | $28×4=$112 |
| 5 | $28 | $28×5=$140 |
Step 3. Calculate profits as total cost subtracted from total revenue, as shown in the table below.
| Quantity | Total Revenue | Total Cost | Profits (TR−TC) |
|---|---|---|---|
| 0 | $0 | $20 | $0−$20=−$20 |
| 1 | $28 | $40 | $28−$40=−$12 |
| 2 | $56 | $45 | $56−$45=$11 |
| 3 | $84 | $55 | $84−$55=$29 |
| 4 | $112 | $72 | $112−$72=$40 |
| 5 | $140 | $100 | $140−$100=$40 |
Step 4. To find the profit-maximizing output level, look at the Marginal Cost column (at every output level produced), as shown in the table below, and determine where it is equal to the market price. The output level where price equals the marginal cost is the output level that maximizes profits.
| Q | P | TFC | TVC | TC | AVC | ATC | MC | TR | Profits |
|---|---|---|---|---|---|---|---|---|---|
| 0 | $28 | $20 | $0 | $20 | – | – | – | $0 | −$20 |
| 1 | $28 | $20 | $20 | $40 | $20.00 | $40.00 | $20 | $28 | −$12 |
| 2 | $28 | $20 | $25 | $45 | $12.50 | $22.50 | $5 | $56 | $11 |
| 3 | $28 | $20 | $35 | $55 | $11.67 | $18.33 | $10 | $84 | $29 |
| 4 | $28 | $20 | $52 | $72 | $13.00 | $18.00 | $17 | $112 | $40 |
| 5 | $28 | $20 | $80 | $100 | $16.40 | $20.40 | $30 | $140 | $40 |
Step 5. Once you have determined the profit-maximizing output level (in this case, output quantity 5), you can look at the amount of profits made (in this case, $40).
Step 6. If the firm is making economic losses, the firm needs to determine whether it produces the output level where price equals marginal revenue and equals marginal cost or it shuts down and only incurs its fixed costs.
Step 7. For the output level where marginal revenue is equal to marginal cost, check if the market price is greater than the average variable cost of producing that output level.
- If P > AVC but P < ATC, then the firm continues to produce in the short-run, making economic losses.
- If P < AVC, then the firm stops producing and only incurs its fixed costs.
In this example, the price of $28 is greater than the AVC ($16.40) of producing 5 units of output, so the firm continues producing.