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Costs and firms

Behind every supply curve is a firm deciding how much to make. That decision comes down to comparing the cost of one more unit with the revenue it brings.

Fixed vs variable costs

Fixed costs don't change with output in the short run — rent, machinery, insurance. Variable costs rise as you produce more — materials, hourly labor, power. Add them for total cost; the split matters because only variable costs change when a firm decides to make one more unit.

Marginal cost and marginal revenue

Marginal cost (MC) is the cost of producing one additional unit. Marginal revenue (MR) is the revenue from selling one more. Marginal cost typically falls at first, then rises as capacity gets strained — the familiar U-shaped curve.

The profit-maximizing rule

A firm maximizes profit by producing up to the quantity where MC = MR. Before that point each extra unit adds more revenue than cost, so make it; past that point each unit costs more than it earns, so stop. In perfect competition price equals marginal revenue, so the rule becomes produce where price = marginal cost — which is exactly why the supply curve looks the way it does.

Shutting down vs staying open

In the short run a firm keeps producing as long as price covers average variable cost, even at a loss, because fixed costs are already spent. If price can't cover variable cost, it shuts down. In the long run it exits unless it covers all costs.

Common exam traps

• Using average cost instead of marginal cost for the output decision.
• Treating sunk fixed costs as relevant to whether to produce one more unit.
• Forgetting that in competition, price = marginal revenue.

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