Why is marginal cost the supply curve?

Hey,

I don't understand why the marginal cost curve is the supply curve. I was reading on perfect competition and it says a firm must cover its variable costs in the short run.

Here's an example

If total revenue = £200,000
Total fixed cost = £200,000
Total variable cost = £80,000
Total cost = £280,000

TR - TC = -£80,000

Then the firm is making a loss of £80,000. So does that mean, the firm uses its £200,000 of total revenues to pay off the fixed costs whilst taking the £80,000 loss on variable costs? or does it mean the firm pays its £80,000 variable cost and £120,000 of it's fixed cost (meaning it still owes £80,000 on its fixed costs)?

Because it says, in the short run a firm has to cover it's variable costs to continue to operate. So that means, in the short run it doesn't cover all of its fixed costs does it?

But then how does that all link up to the marginal cost curve being the supply curve? It's above the SRAVC because it must cover variable costs, I got that. But why wouldn't a firm want to produce where the cost of producing its next good is smaller than its variable costs?

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Reply 1

KiiNGofLONDON

Nextmove

But then how does that all link up to the marginal cost curve being the supply curve?

MC=S because profit maximization occurs at P=MC, and we assume that all firms, unless told otherwise, are profit maximizers.

Reply 2

KiiNGofLONDON

Nextmove

But why wouldn't a firm want to produce where the cost of producing its next good is smaller than its variable costs?

Have you learned about the law of diminishing returns yet? The reason MC cuts AVC at it's lowest point is because, if MC is below AVC, it will bring the average cost per unit down (eg. current AVC= £10, MC of next unit = £8, after next unit, level of AVC after next unit will be lower than £10), and if the MC is higher than the AVC , it will bring the average cost per unit up (eg. current AVC =£10, MC of next unit = £12, after next unit, level of AVC after next unit will be higher than £10).

Producing at any point where MC<AVC means you could produce more units and bring down your average costs, but are choosing not to. That doesn't really make much sense does it?

Reply 3

KiiNGofLONDON

Nextmove

Because it says, in the short run a firm has to cover it's variable costs to continue to operate. So that means, in the short run it doesn't cover all of its fixed costs does it?

Exactly, no it doesn't. Fixed costs include things such as the initial cost of buying capital, and mortgage payments/rent, whereas variable costs include paying for your inputs (eg. milk and coffee beans for Starbucks) and paying your staff's wages. Clearly, if you want to stay in business paying your staff and suppliers is going to be your priority (you can miss a couple of mortgage payments without too much trouble being caused; if you don't pay your staff on Friday they won't show up the following Monday).

I hope that all helps.

Reply 4

TheKevinFang

9

Original post by KiiNGofLONDON

MC=S because profit maximization occurs at P=MC, and we assume that all firms, unless told otherwise, are profit maximizers.

Massive bump, I don't understand this can anyone explain this in a different way?

Reply 5

petermp

5

Original post by TheKevinFang

Massive bump, I don't understand this can anyone explain this in a different way?

Firstly do you understand the Profit maximising rule?
If so:

We know that a basic supply curve is the total amount of output a firm is willing to produce at a given price.
In a perfectly competitive market, we know that all firms (in the long-run) must produce at the profit-maximising level MC=MR, and given the nature of the market we also know that the Price will be the same as the Average Revenue and the Marginal Revenue. So you can conclude that P=AR=MR. Therefore if MC=MR, it must follow that P=MC.

If a perfectly competitive firm is producing where MC<MR, they aren't producing as much as they could be and as such are making a profit margin on each additional output (see Photo). Again due to the nature of the market, this isn't possible as the absolute contestability will lead others to enter and challenge the incumbents thereby raising the price to P. 300px-Economics_Perfect_competition.svg.png

300px-Economics_Perfect_competition.svg.png

The same applies for producing MC>MR - i.e. loss-making, which doesn't occur in a Perf.Comp market.

What can be drawn from this is that the MC curve will end up determining the level of Supply of the firms. You've got to look at the MC as a proportion of the supply curve, the addition to total cost from producing an extra unit of output (MC) will rise as the total output increases just as the total a firm is willing and able to supply will rise, and the point at which it stops producing will have a corresponding marginal cost.

It may be good to understand it but it isnt really necessary (for AQA). I got 100/100 UMS last year and dont think i've seen any questions that ask for such deep theory

Reply 6

TheKevinFang

9

Original post by petermp

Firstly do you understand the Profit maximising rule?
If so:

We know that a basic supply curve is the total amount of output a firm is willing to produce at a given price.
In a perfectly competitive market, we know that all firms (in the long-run) must produce at the profit-maximising level MC=MR, and given the nature of the market we also know that the Price will be the same as the Average Revenue and the Marginal Revenue. So you can conclude that P=AR=MR. Therefore if MC=MR, it must follow that P=MC.

If a perfectly competitive firm is producing where MC<MR, they aren't producing as much as they could be and as such are making a profit margin on each additional output (see Photo). Again due to the nature of the market, this isn't possible as the absolute contestability will lead others to enter and challenge the incumbents thereby raising the price to P. 300px-Economics_Perfect_competition.svg.png

The same applies for producing MC>MR - i.e. loss-making, which doesn't occur in a Perf.Comp market.

What can be drawn from this is that the MC curve will end up determining the level of Supply of the firms. You've got to look at the MC as a proportion of the supply curve, the addition to total cost from producing an extra unit of output (MC) will rise as the total output increases just as the total a firm is willing and able to supply will rise, and the point at which it stops producing will have a corresponding marginal cost.

It may be good to understand it but it isnt really necessary (for AQA). I got 100/100 UMS last year and dont think i've seen any questions that ask for such deep theory

Thanks.

Isn't abnormal profit Q(mc-mr) X AR - ATC though? (not Q(mc-mr) X AR - MC)?

Reply 7

petermp

5

Original post by TheKevinFang

Thanks.

Isn't abnormal profit Q(mc-mr) X AR - ATC though? (not Q(mc-mr) X AR - MC)?

Oh whoops yeah the diagram is wrong
If the Average cost was below P then yeah

In the above diagram the Abπ is 0

(edited 7 years ago)

Reply 8

TheKevinFang

9

Original post by petermp

Oh whoops yeah the diagram is wrong
If the Average cost was below P then yeah

In the above diagram the Abπ is 0

Thanks anyways.

So what you're saying is that in perfect competition a firm will supply a good so long as it covers their costs, so a firm will supply a marginal unit for the MC at that quantity?

Reply 9

petermp

5

Original post by TheKevinFang

Thanks anyways.

So what you're saying is that in perfect competition a firm will supply a good so long as it covers their costs, so a firm will supply a marginal unit for the MC at that quantity?

A marginal unit will only be added/produced by the market if the resulting marginal cost equates with the Marginal Revenue.
And yes, so long as it covers their costs. As I mentioned above, a perfectly competitive firm can't produce where the ATC is below Price (creating Abπ) as the absolute contestability (no barriers to entry) means firms will just enter the market to a point where the extra profit is whittled away.
Nor will they produce where ATC is above price (creating Loss) as the absence of barriers to exit (sunk costs) means the firm will simply exit the market when a loss is incurred. These occur only a very short-term basis and as such it can be said with a degree of certainty that Perfectly competitive firms can only produce at Normal Profit in the long-run.

Of course... this doesn't quite apply as much in the real world
yet.

Reply 10

charlie.R.12

11

I know this was 5 years ago but i have 2 questions. I get everything you guys have said about how p=AR=AC=MC in perfectly competitive markets and as they are profit maximisers they operate at this point therefore as P=MC we can say mc shows the quantit we are willing and able to produce for that price. Howver that raises my first question?
Is mc only = to supply in the long run as in the short run AR=MR an move up and down or does that not matter as price is set from the point on ar which is where MC=MR and as AR=MR they are at the same price?

And as for monpolies i am presuming mc isnt = to suply becuase the price where mc=mr is not the market price the market price is based on th qunatity at which mc=mr but the rice is taken from th AR curve as AR = price because it is revenue for one sale?

Why is marginal cost the supply curve?

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