[Nextmove]

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?

[KiiNGofLONDON]

(Original post by 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.

[KiiNGofLONDON]

(Original post by 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?

[KiiNGofLONDON]

(Original post by 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.