Cost and Supply: Short-Run Curves and the Firm's Supply Decision
The exam tests cost classification, the shape of short-run cost curves, the MC–AC relationship, and how the supply curve is derived from marginal cost.
Core rules
- TC = TFC + TVC. TFC is constant, so AFC falls continuously; TVC starts at zero and rises with output.
- AC = TC/Q, AVC = TVC/Q, MC = ΔTC/ΔQ = ΔTVC/ΔQ, because fixed cost does not change with output.
- MC is U-shaped and cuts AVC and AC at their minimum points, from below.
- Short-run cost curves are U-shaped because of the law of variable proportions; long-run AC is the envelope of short-run AC curves.
- A competitive firm's short-run supply curve is the part of MC above minimum AVC. Shutdown point: P = minimum AVC; break-even point: P = minimum AC.
- Elasticity of supply = %ΔQ ÷ %ΔP and is positive; supply shifts with input prices, technology, taxes, subsidies and the number of sellers.
- Normal profit is part of cost as the implicit return to entrepreneurship; supernormal profit is revenue above total cost.
Worked example
Q = 0, 1, 2, 3 with TC = 20, 30, 42, 58. TFC = 20, so TVC = 0, 10, 22, 38; AC = 30, 21, 19.33; AVC = 10, 11, 12.67; MC = 10, 12, 16. At Q = 3, MC (16) lies below AC (19.33), which is exactly why AC is still falling. A market price of 14 covers AVC, so the firm keeps producing in the short run even though it is below break-even.
Traps
Computing MC as ΔTC/ΔQ including a change in fixed cost - it never changes. Believing MC cuts AC at AC's maximum. Confusing shutdown (P < min AVC) with break-even (P = min AC). Drawing a vertical firm supply curve under perfect competition.