Chapter 9

 Costs Again: behind the supply curve

Key Concepts

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 changes.

Worth Emphasizing

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. That’s why many accountants look at something called "contribution margin", which identifies the contribution to overhead.

Other Tips

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 fig9-5 button.jpg (1968 bytes)

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 isn’t 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 isn’t 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.

  1. The average fixed costs would not change. A per-unit tax would not have to be paid if Kayla’s Kookies were to halt production — a per-unit tax is a variable and marginal cost, but not a fixed cost.
  2. Yes, it would shift upward by $1 for each rate of output.
  3. Yes.
  4. 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 Kayla’s 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:

  1. 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.
  2. The average costs rise above the revenues per unit (price); total costs exceed total revenues.
  3. 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 don’t cover even the variable costs and hence make no contribution toward covering the fixed costs.
  4. Shift the supply curve in the graph on the left; shift it upward and to the left.
  5. The market price rises.
  6. 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.

10. Applications:

  1. 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.
  2. 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.
  3. 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.
  4. 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 question.

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 industry expands.

  1. As the industry expands, the ATC, AVC, and MC curves begin to drift upward at the same time the market price is declining.
  2. 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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