Question

A firm's marginal cost curve above the average variable cost curve is equal to the firm's individual supply curve. This means that every time a firm receives a price from the market it will be willing to supply the amount of output where the price equals marginal cost. What happens to the firm's individual supply curve if marginal costs increase?

Short answer

When marginal costs increase, the firm's individual supply curve, which is equal to its marginal cost curve above the average variable cost curve, will shift to the left (upwards). This is because the firm will require a higher price to cover the increased costs of production and will be willing to supply less output at any given price level.

Step-by-step solution

Understanding the Firm's Supply Curve

The firm's individual supply curve shows the quantity of output the firm is willing to produce at each price level. The supply curve is determined by the marginal cost, as the firm will produce output where the price received from the market equals the marginal cost of production.

Analyzing the Increase in Marginal Costs

If marginal costs increase, the costs associated with producing each additional unit of output will be higher. This implies that the firm will need to receive a higher price for each unit of output in order to cover the increased costs of production.

Impact on the Firm's Individual Supply Curve

As the marginal cost increases, the firm will require a higher price to produce the same quantity of output. Therefore, the firm's individual supply curve will shift upwards. At any given price level, the firm will be willing to supply less output than before, due to the higher marginal costs. Conversely, to produce the same quantity of output as before, the firm will now require a higher price. As a result, the individual supply curve will shift to the left (upwards). In conclusion, when the firm's marginal costs increase, the individual supply curve will shift to the left (upwards). This means that the firm will provide less output at each price level or will require a higher price to produce the same quantity of output as before.

Key concepts

Marginal Cost

Marginal cost is a fundamental economic concept that refers to the increase in total cost that arises from producing one additional unit of a good or service. It plays a critical role in a firm's production decisions.

Imagine a bakery that makes cakes. The cost of producing one more cake, after all the ovens are hot and staff are already at work, might include the cost of the additional ingredients and a little extra electricity. As long as the price the bakery gets for selling this additional cake exceeds the marginal cost, it is worth it for them to make more cakes.

However, if the ingredients become more expensive or if there is a need for additional staff for that extra cake, the marginal cost will rise. The main takeaway is that firms use marginal cost to determine how much of a product to supply at a given price. If the price they can charge is greater than the marginal cost, they will increase production, otherwise, they will produce less.

Average Variable Cost

The average variable cost (AVC) relates to the costs that vary with output. This includes costs such as raw materials and direct labor. Unlike fixed costs (like rent or managerial salaries), variable costs change as the firm alters its level of production.

If a toy manufacturer is calculating AVC, they will look at costs like plastic and wages for the assembly line workers. By adding all variable costs and dividing by the quantity of toys made, they will get the average cost per toy in terms of these variable inputs. Lower AVC generally indicates a more efficient production up to a certain point, after which costs can increase due to factors like overtime pay or machinery wear.

An important relationship exists between the AVC and the marginal cost (MC). Typically, when MC is below AVC, the AVC is falling. When MC is above AVC, the AVC is rising. If a firm's MC increases due to higher costs for raw materials, we can expect this to affect the AVC too, potentially leading to changes in their production decision-making.

Shifts in Supply Curve

When discussing supply curves, we often refer to graphical representations that show how much of a product a firm is willing to sell at varying price levels. When there are changes in production costs, technology, or other factors, the supply curve can shift.

Increased Marginal Costs and Supply Curve Shifts

If a company faces increased marginal costs, as in our exercise, it will adjust the quantity of goods it's willing to supply at a certain price. The curve will shift upwards and to the left. This upward shift means that at previous prices, less quantity will be supplied, reflecting a decreased willingness to sell at those prices due to increased production costs.

Other Factors Affecting Supply Curve Shifts

Beyond costs, other factors can shift the supply curve. These include technological improvements (shifting supply outwards), changes in the number of producers, taxation changes, and even natural events like extreme weather. All these factors can either increase or decrease the firm's ability or willingness to supply goods, thereby shifting the curve.

Understanding these shifts is crucial as they help economists and businesses predict market behavior and determine optimal production levels. A firm's responsiveness to price changes, known as elasticity of supply, also plays a significant role in the effects of supply curve shifts.