Principles of Economics/Supply

Firm's production position


(Review the section on firm's costs if this looks strange.)

Long term, the firm produces at the point where marginal cost (and hence supply curve) intersects average total cost because at any higher point additional firms enter the industry and at any lower point the firm will earn negative profits (to be discussed later). This position is represented by the green point at Q*, equilibrium quantity. Extending this point to the y axis, we call this price P*, equilibrium price. The firm has to consider its fixed costs, which it satisfies at this level of output and price, along the green supply curve.

Market long run supply


In perfect competition, all the firms are more or less equal, in which the combination of their individual supply curves results in another market supply curve identical to them except that it is a multiple as large (stretched). (However, we will continue to show it as the same size.) We can remove everything else about the firm to see just this green supply curve. The 'common' component of the supply curve that textbooks often discuss is the positive-slope half, but we cannot ignore the first component.

Firm's short run minimum position


The minimum position at which the firm will produce instead of shutting down is shown by this alternative green point along its marginal cost / supply curve, where it intersects average variable cost. If a firm cannot sell for as much as what it costs to produce that additional unit (ignoring the fixed cost, which is unavoidable in the short run), and the units before that are unproductive as well, then the firm will close down and choose to suffer the fixed cost and not incur additional expenses from operating.

Firm's short and long run positions


Here both short and long run minimum positions for a firm's continued operation are shown. The long run position involves more output, indicating that a firm producing zero profits will produce at a higher level than one that is incurring losses from fixed costs will. It also requires a higher market price at P*, indicating that an industry has to be more profitable than the bare minimum for operating in the short run, in order to be worth it for the firm to not shut down. Producing at the long run position - where marginal cost/supply and hence market price (for supposedly all producers are doing the same thing) equals average total cost, ensures that the fixed costs are covered.