Understanding Firm Supply and Average Costs in Economics
Average Costs
Average Costs represent the cost per unit of output produced. It is calculated as: AC = Total Cost / Output. The average cost graph can be divided into three sections:
- Economies of Scale (Increasing Returns to Scale): This occurs when output increases by more than the proportional change in costs.
- Constant Returns to Scale (CRS): This occurs when output increases by the same proportional change as all average costs.
- Diseconomies of Scale (Decreasing Returns to Scale): This occurs when output increases by less than the proportional change in costs.
Factors Influencing Firm Supply
A firm’s supply depends on several factors, including technology, market environment, goals, and competitors’ behavior. Every firm must consider these factors when deciding how much output to produce.
Characteristics of a Perfectly Competitive Market
- There are many firms.
- The firms are homogeneous.
- The firms are price-takers, meaning they have no influence over the market price. Firms are free to vary their own prices:
- If a firm sets its price above the market price, the quantity demanded from the firm will be zero, and they will be forced out of the market since their clients will buy the homogeneous product from another firm.
- If a firm sets its price below the market price, the quantity demanded from the firm will be the entire market demand.
The Firm’s Short-Run Supply Decision
All firms aim to maximize profits in the short run. Each firm chooses its production level by identifying the output level that maximizes profits. This is represented by: Maximize Profit = Price (p) * Output (y) – Short-Run Cost (cs(y))
First Order Maximum Profit Condition
Profits = Total Revenue (TR) – Total Cost (TC) = p * y – TC
Taking the derivative with respect to output (y):
d(Profit)/dy = p – Marginal Cost (MC)
Setting the derivative equal to zero to find the maximum:
d(Profit)/dy = 0
Therefore: p – MC = 0
In a perfectly competitive market, the market price equals the marginal cost of production (p = MC).
Second Order Maximum Profit Condition
d(p – MC)/dy = -d(MC)/dy < 0 (always negative)
This implies that d(MC)/dy > 0, meaning the MC curve must be upward-sloping as output increases.
At point y’, P = MC, but MC slopes downwards, indicating profit minimization.
At point y*, P = MC, and MC slopes upwards, indicating profit maximization. A profit-maximizing supply level can only exist on the upward-sloping part of the firm’s MC curve.
However, not every point on the upward-sloping part of the MC curve represents profit maximization. The firm’s profit function is:
Profit = p * y – Fixed Cost (FC) – Variable Cost (VC(y))
If the firm chooses y = 0, its profits would be:
Profit = p * 0 – FC – VC(0) = -FC
A firm will choose to produce a positive amount of output (y > 0) only if it can cover its variable costs, resulting in a profit greater than -FC. Therefore:
p * y – VC(y) > 0
This simplifies to:
p = VC(y) / y = Average Variable Cost (AVC)
To cover fixed costs, firms produce from the point where P = AVC.
As seen in the graph, when P < AVC, there is no production. When P > AVC, production is positive.
When p < AVC, production is zero, and the firm’s short-run supply curve is a straight line along the y-axis until p reaches the point where it meets AVC (point 2). This point is called the shutdown point. In the short run, shutting down means producing no output, but the firm still exists in the industry and incurs its fixed costs. In the long run, the firm can exit the market, leaving the industry and ceasing to exist.