Costs Again: behind the supply curve
This chapter sets out the standard cost curve analysis, deriving the
cost curves from a standard production function with one input. It then puts the cost
curves together with marginal revenue curves to identify optimizing equilibria. It
concludes with examples that use this framework to analyze the effects of different
The short-run supply curve for a price-taking firm is just its marginal
cost curve above the average variable costs. The short-run supply curve for the entire
industry is the horizontal summation of the supply curves of the individual firms. The
long-run supply curve, however, depends on entry and exit of firms, along with scale
changes of the existing firms, and these things will likely affect the prices of inputs.
Whenever price is less than average costs, a firm should keep producing
so long as it can cover all its direct or variable costs and make some contribution toward
covering the overhead or fixed costs. Thats why many accountants look at something
called "contribution margin", which identifies the contribution to overhead.
This material can get bogged down in definitions and geometric
technicalities. While the details are important, the basic concepts are more important.
Also, please note that the label for ATC*
is incorrect in Figure 9-5.
To see the correct version
of Figure 9-5, please click here
Answers to Selected Discussion Questions
2. By increasing the capital in her bakery, Kayla would make
the labour more productive. The total output curve of Figure 9.1 and the average and
marginal product curves in Figure 9.2 would all shift upward. The shift would not
necessarily be a parallel type of shift or a rotation, but it would almost certainly be
upward in some fashion.
4. Spreading the overhead costs isnt the only cost consideration. Indeed, the
most important cost consideration is marginal costs. If producing one more unit adds more
to total costs than it does to total revenue, then that unit isnt worth producing,
even though producing it will help reduce average total costs.
5. A per-unit tax of $1/case would shift the ATC, AVC, and MC,
curves straight upward by $1 for every possible rate of output.
- The average fixed costs would not change. A per-unit tax would not have to be paid if
Kaylas Kookies were to halt production a per-unit tax is a variable and
marginal cost, but not a fixed cost.
- Yes, it would shift upward by $1 for each rate of output.
- The marginal cost curve would also shift upward by exactly $1.
6. When a licence fee is increased, variable and marginal costs remain unchanged.
Consider, for example, an increase in the licence fee for driving your car such an
increase adds nothing extra to the cost of driving an additional kilometre. Similarly, for
Kaylas Kookies, if a fixed cost increases, the marginal and variable costs are
unaffected. It costs her no more now than it did before to increase her output from, say
900 cases to 901 cases per day.
8. The impact of imposing a per-unit tax on price and quantity in an industry composed
of price-taking firms:
- Shift the ATC, AVC, and MC curves straight upward by the
amount of the per-unit tax. As marginal costs, rise, firms already in the industry will
cut back on their rates of output.
- The average costs rise above the revenues per unit (price); total costs exceed total
- No, some will want to exit as their fixed costs and fixed contracts come up for renewal.
Some may even want to exit immediately if their revenues dont cover even the
variable costs and hence make no contribution toward covering the fixed costs.
- Shift the supply curve in the graph on the left; shift it upward and to the left.
- The market price rises.
- As price rises, the net revenues become less negative and eventually reach zero. At that
point, firms will no longer have any incentive either to exit from or to enter into the
industry. Notice that each remaining firm will produce precisely the amount it was
producing before the per-unit tax was imposed. The industry will be producing less,
however, because there are fewer firms left in the industry.
- Steel: ATC, AVC, and MC all shift up causing short-run
negative net revenues. Firms exit until prices rise. But the final equilibrium for each
remaining firm may be to produce more or less than it did before, depending on how the
installation of the pollution control devices affects the shapes and locations of the
different cost curves.
- In the short run, price rises and net revenues are positive and existing firms try to
expand their output with their existing scale of operations. The positive net revenues
attract firms into the industry, shifting the market supply curve rightward until price
falls. Price will keep falling until net revenues are again equal to zero. If no other
prices change, the final price will be the same as the original price (i.e., the long-run
supply curve for the industry is horizontal), and each firm will be producing just what
they were before demand increased, but there will be more firms in the industry.
- An increase in the price of an input would shift the ATC, AVC, and MC
curves all upward, but the exact nature of the shift cannot be determined without
additional information. Incumbent firms would reduce their rates of output due to the
increase in MC. Nevertheless, net revenues would decline below zero and some
firms would exit. The market supply curve would shift leftward, and prices would rise
until net revenues again equaled zero. There would be fewer firms left in the industry and
prices would be higher.
- The reverse of b, above. Prices fall, firms cut back on production, and net revenues are
negative. Some firms exit, causing price to rise until net revenues are zero. If nothing
else changes and if prices of inputs are unaffected, the price will eventually return to
where it was originally and each of the remaining firms will produce what it did before
the decline in demand; industry output will be less, though, because there will be fewer
firms in the industry. Again, this answer assumes a horizontal long-run supply curve. If
you think other prices will change as the industry expands or contract, see the next
11. It seems more likely to me that most industries have positively-sloped supply
curves. After all, the science of economics is founded on the assumption of scarcity.
Unfortunately, the analysis that allows for input prices to increase as the industry
expands is more complex. To see this, work through your answer to Question 10 (b), but
this time assume that coal, iron ore and steelworkers all become more expensive as the
- As the industry expands, the ATC, AVC, and MC curves begin
to drift upward at the same time the market price is declining.
- Price will equal the minimum point on the new ATC curve at some price that
is higher than the original price. This point will, however, represent a new long-run
equilibrium in the industry. The industry long-run supply curve is upward sloping, and so
as demand increases, the price rises, even in the long run.
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