Supply and Cost
Supply and Cost
This domain covers the firm's supply decision and cost structure. The exam tests the law of supply, determinants and elasticity of supply, short-run cost curves, and the relationship between cost and revenue.
Core rules
- Supply is the quantity offered for sale at a given price in a given period. A change in price causes movement along the supply curve; changes in input prices, technology, taxes, subsidies or number of firms shift supply.
- The law of supply states a positive price-quantity relationship, other things equal. Elasticity of supply = percentage change in quantity supplied ÷ percentage change in price.
- In the short run, total cost = total fixed cost + total variable cost. TFC is constant; TVC varies with output. TC = TFC + TVC.
- Average cost AC = TC ÷ Q; average variable cost AVC = TVC ÷ Q; average fixed cost AFC = TFC ÷ Q; marginal cost MC = change in TC ÷ change in Q.
- MC cuts AC at AC minimum. AC falls when MC is below AC and rises when MC is above AC.
- Revenue: TR = P × Q; AR = TR ÷ Q; MR = change in TR ÷ change in Q. Under perfect competition, P = AR = MR.
Worked example
A firm's TC at 0, 1, 2 and 3 units is ₹20, ₹30, ₹38 and ₹48. TFC is ₹20. TVC is ₹0, ₹10, ₹18 and ₹28. MC for the first unit is 10, for the second 8, for the third 10. AC is ₹30, ₹19 and ₹16. Because MC (8) is below AC (19) at 2 units, AC is falling; at 3 units MC (10) is still below AC (16), so AC continues to fall.
Traps
Do not include fixed cost in marginal cost. Do not confuse a shift of supply with a movement along it. A vertical supply curve is perfectly inelastic, not elastic. In cost tables, calculate MC from TC, not from AC. Watch units and keep the distinction between accounting cost and economic cost.