Individual Demand Market Demand

The consumer equilibrium condition determines the quantity of each good the individual
consumer will demand. As the example above illustrates, the individual consumer's demand
for a particular good—call it good X—will satisfy the law of demand and can therefore be
depicted by a downward‐sloping individual demand curve. The individual consumer,
however, is only one of many participants in the market for good X. The market demand
curve for good X includes the quantities of good X demanded by all participants in the
market for good X. The market demand curve is found by taking the horizontal
summation of all individual demand curves. For example, suppose that there were just two
consumers in the market for good X, Consumer 1 and Consumer 2. These two consumers
have different individual demand curves corresponding to their different preferences for
good X. The two individual demand curves are depicted in Figure , along with the market
demand curve for good X.

The market demand curve for good X is found by summing together the quantities that both
consumers demand at each price. For example, at a price of $1, Consumer 1 demands 2 units
while Consumer 2 demands 1 unit; so, the market demand is 2 + 1 = 3 units of good X. In
more general settings, where there are more than two consumers in the market for some good,
the same principle continues to apply; the market demand curve would be the horizontal
summation of all the market participants' individual demand curves.

Consumer Surplus

The difference between the maximum price that consumers are willing to pay for a good and
the market price that they actually pay for a good is referred to as the consumer surplus. The
determination of consumer surplus is illustrated in Figure , which depicts the market demand
curve for some good.

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The market price is $5, and the equilibrium quantity demanded is 5 units of the good. The
market demand curve reveals that consumers are willing to pay at least $9 for the first unit of
the good, $8 for the second unit, $7 for the third unit, and $6 for the fourth unit.

However, they can purchase 5 units of the good for just $5 per unit. Their surplus from the
first unit purchased is therefore $9 ‐ $5 = $4. Similarly, their surpluses from the second, third,
and fourth units purchased are $3, $2, and $1, respectively. These surpluses are illustrated by
the vertical bars drawn in Figure . The sum total of these surpluses is the consumer surplus: 

The value $10, however, is only a crude approximation of the true consumer surplus in this
example. The true consumer surplus is given by the area below the market demand curve and
above the market price. This area consists of a triangle with base of length 5 and height of
length 5. Applying the rule for the area of a triangle—one half the base multiplied by height
—one finds that the value of the consumer surplus in this example is actually 12.5.

Utility and Preferences

Individuals consume goods and services because they derive pleasure or satisfaction from
doing so. Economists use the term utility to describe the pleasure or satisfaction that a
consumer obtains from his or her consumption of goods and services. Utility is a subjective
measure of pleasure or satisfaction that varies from individual to individual according to each
individual's preferences. For example, if an individual's choices for a Saturday evening are to
watch television, go out to dinner, or go to a movie, then, depending on that individual's
preferences, he or she will attribute different levels of utility to each of these three activities.
Of course, it is not possible to measure utility, nor is it possible to claim that one individual's
utility is higher than another's. Utility is just a unitless measure that economists have found
useful in their explanation of consumer choice.

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Total and marginal utility. The utility that an individual receives from consuming a certain
amount of a particular good or service is referred to as that individual's total
utility. The marginal utility of a good or service is the addition to total utility that an
individual receives from consuming one more unit of that good or service.

Law of diminishing marginal utility. The law of diminishing marginal utility states that

the marginal utility that one receives from consuming successive units of the same good or
service will eventually decrease as the number of units consumed increases. As an example
of the law of diminishing marginal utility, consider the utility that one obtains from drinking
successive glasses of lemonade on a hot day. Suppose the first glass just begins to quench
one's thirst. After two glasses, however, the thirst has all but disappeared. A third glass of
lemonade might also provide some utility, but not as much as the second glass. A fourth glass
cannot be finished. In this example, the marginal utility—the addition to total utility that one
obtains from drinking lemonade on a hot day—is increasing for the first two glasses but is
decreasing beginning with the third glass and would continue to decrease if one were to
consume further glasses.

Production Costs and Firm Profits

The firm's primary objective in producing output is to maximize profits. The production of
output, however, involves certain costs that reduce the profits a firm can make. The
relationship between costs and profits is therefore critical to the firm's determination of how
much output to produce.

Explicit and implicit costs. A firm's explicit costs comprise all explicit payments to the
factors of production the firm uses. Wages paid to workers, payments to suppliers of raw
materials, and fees paid to bankers and lawyers are all included among the firm's explicit
costs.

A firm's implicit costs consist of the opportunity costs of using the firm's own resources

without receiving any explicit compensation for those resources. For example, a firm that
uses its own building for production purposes forgoes the income that it might receive from
renting the building out. As another example, consider the owner of a firm who works along
with his employees but does not draw a salary; the owner forgoes the opportunity to earn a
wage working for someone else. These implicit costs are not regarded as costs in an
accounting sense, but they are a part of the firm's costs of doing business, nonetheless. When
economists discuss costs, they have in mind both explicit and implicit costs.

Production Costs and Firm Profits

The firm's primary objective in producing output is to maximize profits. The production of
output, however, involves certain costs that reduce the profits a firm can make. The
relationship between costs and profits is therefore critical to the firm's determination of how
much output to produce.

Explicit and implicit costs. A firm's explicit costs comprise all explicit payments to the
factors of production the firm uses. Wages paid to workers, payments to suppliers of raw
materials, and fees paid to bankers and lawyers are all included among the firm's explicit
costs.

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A firm's implicit costs consist of the opportunity costs of using the firm's own resources
without receiving any explicit compensation for those resources. For example, a firm that
uses its own building for production purposes forgoes the income that it might receive from
renting the building out. As another example, consider the owner of a firm who works along
with his employees but does not draw a salary; the owner forgoes the opportunity to earn a
wage working for someone else. These implicit costs are not regarded as costs in an
accounting sense, but they are a part of the firm's costs of doing business, nonetheless. When
economists discuss costs, they have in mind both explicit and implicit costs.

Accounting profits, economic profits, and normal profits. The difference between explicit
and implicit costs is crucial to understanding the difference between accounting profits and
economic profits. Accounting profits are the firm's total revenues from sales of its output,
minus the firm's explicit costs. Economic profits are total revenues minus explicit and
implicit costs. Alternatively stated, economic profits are accounting profits minus implicit
costs. Thus, the difference between economic profits and accounting profits is that economic
profits include the firm's implicit costs and accounting profits do not.

A firm is said to make normal profits when its economic profits are zero. The fact that
economic profits are zero implies that the firm's reserves are enough to cover the firm's
explicit costs and all of its implicit costs, such as the rent that could be earned on the firm's
building or the salary the owner of the firm could earn elsewhere. These implicit costs add up
to the profits the firm would normally receive if it were properly compensated for the use of
its own resources—hence the name, normal profits.

Fixed and variable costs. In the short‐run, some of the input factors the firm uses in
production are fixed. The cost of these fixed factors are the firm's fixed costs. The firm's
fixed costs do not vary with increases in the firm's output.

The firm also employs a number of variable factors of production. The cost of these variable
factors of production are the firm's variable costs. In order to increase output, the firm must
increase the number of variable factors of production that it employs. Therefore, as firm
output increases, the firm's variable costs must also increase.

To illustrate the concepts of fixed and variable costs, consider again the example of a single
firm operating in the short‐run with a fixed amount of capital, 1 unit, and a variable amount
of labor. Suppose the cost of the single unit of capital is $100 and the cost of hiring each
worker is $20. The firm's fixed and variable costs are reported in Table .

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The fourth column of Table reports the variable cost that the firm incurs from hiring 1 to 6
workers at $20 each, while the fifth column reports the fixed cost of the single unit of capital
that the firm employs. The fixed cost of $100 is the same—no matter how many units of
output the firm produces.

Total and marginal costs. The firm's total cost of production is the sum of all its variable
and fixed costs. The firm's marginal cost is the per unit change in total cost that results from
a change in total product. The concepts of total and marginal cost are illustrated in Table .
The sixth column of this table reports the firm's total costs, which are simply the sum of its
variable and fixed costs. The seventh column reports the marginal cost associated with
different levels of output.

For example, when the firm increases its total product from 0 to 5 units of output, the change
in the firm's total costs is $120 – $100 = $20. The marginal cost for the first 5 units of output
is therefore $20/5 = $4. Similarly, when the firm increases its total product by 10 units, from
5 to 15 units of output, its total costs increase by $140 ‐ $120 = $20. The marginal cost for
the next 10 units produced is therefore $20/10 = $2.

Marginal cost and marginal product. The firm's marginal cost is related to its marginal

product. If one calculates the change in total cost for each different level of total product
reported and divides by the corresponding marginal product of labor reported, one arrives at
the marginal cost figure. The marginal cost falls at first, then starts to rise. This behavior is a
consequence of the relationship between marginal cost and marginal product and the law of
diminishing returns. As the marginal product of the variable input–labor– rises, the firm's

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total product incresses at a rate that is greater than the rate of new workers hired.
Consequently, the firm's marginal costs will be decreasing. Eventually, however, by the law
of diminishing returns, the marginal product of the variable factor will begin to decline; the
firm's total product will increase at a rate less than the rate at which new workers are hired.
The result is that the firm's marginal costs will begin rising.

Average variable, average fixed, and average total costs. The firm's variable, fixed, and
total costs can all be calculated on an average or per unit basis. Table reports the average
variable costs, average fixed costs, and average total costs for the numerical example of
Table .

When the firm produces 27 units of output, for example, the firm's variable costs from Table
are $80. The average variable cost per unit of output is therefore $80/27 = $2.96, as reported
in Table . The fixed cost corresponding to 27 units of output is $100; therefore, the average
fixed cost per unit of output is $100/27 = $3.70. The total cost of 27 units of output is $180;
so, the average total cost is $180/27 = $6.66.

Graphical depiction of costs. The variable, fixed, and total costs reported in Table are
shown in Figure . The marginal cost reported in Table along with the average variable,
average fixed, and average total costs reported in Table are shown in the graph in Figure (b).

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When costs are depicted graphically, they are referred to as cost curves. Figures (a) and (b)
reveal some of the interesting relationships that exist among the various cost curves. Note
first that the total cost curve is just the vertical summation of the variable cost curve and
the fixed cost curve. This also holds true for the average total cost curve, which is just the
vertical summation of the average variable cost curve and the average fixed cost curve.

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Second, note the relationship between the marginal cost curve and the total and variable cost
curves. The marginal cost curve reaches its minimum at the inflection point of the total and
variable cost curves. This should not be surprising because the slope of the total and variable
cost curves reveals the rate at which the firm's costs change as output increases, which is
precisely what marginal cost measures.

Finally, notice that the marginal cost curve intersects both the average variable cost curve and
the average total cost curve at the minimum points of both curves. This is in accordance with
the marginal‐average rule, which states that when marginal cost lies below average cost,
average cost is falling. When marginal cost lies above average cost, average cost is rising. It
follows, then, that the marginal cost curve will intersect the average variable and average
total cost curves at each of these curves' minimum points.

Long‐Run Costs

In the short‐run, some factors of production are fixed. Corresponding to each different level
of fixed factors, there will be a different short‐run average total cost curve (SATC). The
average total cost curve is just one of many SATCs that can be obtained by varying the
amount of the fixed factor, in this case, the amount of capital.

Long‐run average total cost curve. In the long‐run, all factors of production are variable,
and hence, all costs are variable. The long‐run average total cost curve (LATC) is found by
varying the amount of all factors of production. However, because each SATC corresponds to
a different level of the fixed factors of production, the LATC can be constructed by taking the
“lower envelope” of all the SATCs, as is illustrated in Figure .

The LATC is shown to be tangent to each of five different SATCs,

labeled SATC 1 through SATC 5 . In general, there will be a large number of SATCs, each of
which corresponds to a different level of the fixed factors the firm can employ in the short‐
run. Because there is such a large number of SATCs—more than just the five illustrated in

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Figure —the lower envelope of all the SATCs, which makes up the LATC, can be
approximated by a smooth, U‐shaped curve.

Economies of scale. The U‐shape of the LATC, depicted in Figure , reflects the changing

costs of production that the firm faces in the long‐run as it varies the level of its factors of
production and hence the level of its output. At low levels of output, a firm can usually
increase its output at a rate that exceeds the rate at which it increases its factor inputs. When
this situation occurs, the firm's average total costs are falling, and the firm is said to be
experiencing economies of scale.

At higher levels of output, the firm may find that its output increases at the same rate at
which it increases its factor inputs. In this case, the firm's average total costs remain constant,
and the firm is said to experience constant returns to scale. At even higher output levels, the
firm's output will tend to increase at a rate that is below the rate at which it increases its factor
inputs. In this situation, average total costs are rising, and the firm is said to
experience diseconomies of scale.

The firm's minimum efficient scale is the level of output at which economies of scale end
and constant returns to scale begin. The minimum efficient scale is indicated in Figure .

Production of Goods

The theory of the consumer is used to explain the market demand for goods and services.
The theory of the firm provides an explanation for the market supply of goods and services.
A firm is defined as any organization of individuals that purchases factors of production
(labor, capital, and raw materials) in order to produce goods and services that are sold to
consumers, governments, or other firms. The theory of the firm assumes that the firm's
primary objective is to maximize profits. In maximizing profits, firms are subject to two
constraints: the consumers' demand for their product and the costs of production.

Consider a firm that produces a single good. In order to produce this good, the firm must
employ or purchase a number of different factors of production. The firm's production
decision is to determine how much of each factor of production to employ.

Variable and fixed factors of production. In the short‐run, some of the factors of

production that the firm needs are available only in fixed quantities. For example, the size of
the firm's factory, its machinery, and other capital equipment cannot be varied on a day‐to‐
day basis. In the long‐run, the firm can adjust the size of its factory and its use of machinery
and equipment, but in the short‐run, the quantities of these factors of production are
considered fixed. The short‐run is defined as the period during which changes in certain
factors of production are not possible. The long‐run is defined as the period during
which all factors of production can be varied.

Other factors of production, however, are variable in the short‐run. For example, the number
of workers the firm employs or the quantities of raw materials the firm uses can be varied on
a day‐to‐day basis. A factor of production that can be varied in the short‐run is called
a variable factor of production. A factor of production that cannot be varied in the short‐run
is called a fixed factor of production. In the short‐run, a firm can increase its production of
goods and services only by increasing its use of variable factors of production.

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Total and marginal product. A firm combines its factors of production in order to produce
goods or output. The total amount of output the firm produces, the firm's total product,
depends on the quantities of factors that the firm purchases or employs. The marginal
product of a factor of production is the change in the firm's total product that results from an
increase in that factor by one unit, holding all other factors constant.

To better understand the concepts of total and marginal product, consider a firm that produces
a certain good using only labor and capital as inputs. Assume that the amount of capital the
firm uses is fixed at 1 unit. When the firm combines its fixed unit of capital with different
quantities of labor, it is able to vary its output or total product. The change in the firm's total
product, due to a 1‐unit increase in labor input, is referred to as the marginal product of
labor.

Table provides a simple numerical example. When the firm combines its fixed unit of capital
with one worker, its total product increases from 0 units to 5 units of the good. The marginal
product of the first worker is therefore 5 (5 ‐ 0 = 5). If the firm adds a second worker, its total
product increases to 15; the marginal product of the second worker is therefore 10 (15 ‐ 5 =
10). Continuing in this manner, it is possible to determine the marginal product of every
worker that the firm hires.

Law of diminishing returns. The law of diminishing returns says that as successive units

of a variable factor of production are combined with fixed factors of production, the marginal
product of the variable factor of production will eventually decline. The law of diminishing
returns is illustrated in Table . As more and more workers are combined with the firm's fixed
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amount of capital, the marginal product of labor eventually starts to decline; in Table ,
diminishing returns “set in” beginning with the third worker. Intuitively, if the firm's capital
is fixed at 1 unit, the production possibilities of the firm are limited. Adding more and more
workers cannot alleviate this situation and will eventually cause the marginal product of
additional workers to fall. Note that diminishing returns is a short‐run phenomenon that will
persist only as long as there are fixed factors of production; in the long‐run, it will be possible
to vary the amount of the fixed factor capital so as to eliminate the problem of diminishing
returns.

Long-Run Supply

In the long‐run, firms can vary all of their input factors. The ability to vary the amount of
input factors in the long‐run allows for the possibility that new firms will enter the market and
that some existing firms will exit the market. Recall that in a perfectly competitive market,
there are no barriers to the entry and exit of firms. New firms will be tempted to enter the
market if some of the existing firms in the market are earning positive economic
profits. Alternatively, existing firms may choose to leave the market if they are earning
losses. For these reasons, the number of firms in a perfectly competitive market is unlikely to
remain unchanged in the long‐run.

Zero economic profits. The entry and exit of firms, which is possible in the long‐run, will
eventually cause each firm's economic profits to fall to zero. Hence, in the long‐run each firm
earns normal profits. If some firms are earning positive economic profits in the short‐run, in
the long‐run new firms will enter the market and the increased competition will reduce all
firms' economic profits to zero. Firms that are earning negative economic profits (losses) in
the short‐run will have to either make some changes in their fixed factors of production in the
long‐run or choose to leave the market in the long‐run. A perfectly competitive market
achieves long‐run equilibrium when all firms are earning zero economic profits and when
the number of firms in the market is not changing.

Minimization of long‐run average total cost. In the long‐run, a perfectly competitive firm
can adjust the amount it uses of all factor inputs, including those that are fixed in the short‐
run. For example, in the long‐run, the firm can adjust the size of its factory. In making these
adjustments, the firm will seek to minimize its long‐run average total cost. If, in the short‐run,
the firm is operating below its minimum efficient scale and experiencing economies of scale,
in the long‐run it can adjust its use of factor inputs so as to increase its output to the
minimum efficient scale level.

Alternatively, if the firm is experiencing diseconomies of scale because its short‐run level of

output exceeds its minimum efficient scale, in the long‐run the firm can adjust its use of
factor inputs so as to reduce its output to the minimum efficient scale level. Thus, in the long‐
run the firm will be operating at the minimum point of its long‐run average total cost curve.

Graphical illustration of long‐run profit maximization. The long‐run equilibrium for an

individual firm in a perfectly competitive market is illustrated in Figure .

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The profit maximizing level of output, where marginal cost equals marginal revenue, results
in an equilibrium quantity of Q units of output. Because the firm's average total costs per unit
equal the firm's marginal revenue per unit, the firm is earning zero economic profits.
Furthermore, the firm is shown to be producing at the minimum point of its long‐run average
total cost curve, at the minimum efficient scale level of output.

Long‐run market supply curve. The short‐run market supply curve is just the horizontal
summation of all the individual firm's supply curves. The long‐run market supply curve is
found by examining the responsiveness of short‐run market supply to a change in market
demand. Consider the market demand and supply curves depicted in Figures (a) and (b).
Here, the market demand curves are labeled D 1, and D 2, while the short‐run market supply
curves are labeled S 1 and S 2.

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Figure (a) depicts demand and supply curves for a market or industry in which firms
face constant costs of production as output increases. At the intersection of D 1 and S 1, the
market is in long‐run equilibrium at a market price of P 1. An increase in demand
from D 1 to D 2 results in a new, higher market price of P 2. In the short‐run, existing firms in
this market will earn positive economic profits. In the long‐run, however, new firms will
enter, causing short‐run market supply to shift from S 1 to S 2 and driving the market price
back down to P 1. The long‐run market supply curve is therefore given by the horizontal line
at the market price, P 1

Figure (b) depicts demand and supply curves for a market or industry in which firms
face increasing costs of production as output increases. Starting from a market price of P 1,
an increase in demand from D 1 to D 2 increases the market price to P 2. In the short‐run, firms
are earning positive economic profits. In the long‐run, new firms will enter the market, the
short‐run supply curve will shift from S 1 to S 2, and the new market price will be P 3. The
new, long‐run market price of P 3 is greater than the old market price of P 1 because in an
increasing‐cost industry, the firm's average total costs rise as it produces more output. Thus,
the long‐run market supply curve in an increasing‐cost industry will be positively sloped.

Conditions for Perfect Competition

When economists analyze the production decisions of a firm, they take into account the
structure of the market in which the firm is operating. The structure of the market is
determined by four different market characteristics: the number and size of the firms in the
market, the ease with which firms may enter and exit the market, the degree to which firms'
products are differentiated, and the amount of information available to both buyers and sellers
regarding prices, product characteristics, and production techniques.

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Four characteristics or conditions must be present for a perfectly competitive market structure
to exist. First, there must be many firms in the market, none of which is large in terms of its
sales. Second, firms should be able to enter and exit the market easily. Third, each firm in the
market produces and sells a nondifferentiated or homogeneous product. Fourth, all firms and
consumers in the market have complete information about prices, product quality, and
production techniques.

Price‐taking behavior. A firm that is operating in a perfectly competitive market will be

a price‐taker. A price‐taker cannot control the price of the good it sells; it simply takes the
market price as given. The conditions that cause a market to be perfectly competitive also
cause the firms in that market to be price‐takers. When there are many firms, all producing
and selling the same product using the same inputs and technology, competition forces each
firm to charge the same market price for its good. Because each firm in the market sells the
same, homogeneous product, no single firm can increase the price that it charges above the
price charged by the other firms in the market without losing business. It is also impossible
for a single firm to affect the market price by changing the quantity of output it supplies
because, by assumption, there are many firms and each firm is small in size.

Demand in a Perfectly Competitive Market

The demand and supply curves for a perfectly competitive market are illustrated in Figure (a);
the demand curve for the output of an individual firm operating in this perfectly competitive
market is illustrated in Figure (b).

Note that the demand curve for the market, which includes all firms, is downward sloping,
while the demand curve for the individual firm is flat or perfectly elastic, reflecting the fact
that the individual takes the market price, P, as given. The difference in the slopes of the
market demand curve and the individual firm's demand curve is due to the assumption that
each firm is small in size. No matter how much output an individual firm provides, it will be
unable to affect the market price. Note that the individual firm's equilibrium quantity of
14 | P a g e
output will be completely determined by the amount of output the individual firm chooses to
supply.

Short-Run Supply

In determining how much output to supply, the firm's objective is to maximize profits subject
to two constraints: the consumers' demand for the firm's product and the firm's costs of
production. Consumer demand determines the price at which a perfectly competitive firm
may sell its output. The costs of production are determined by the technology the firm uses.
The firm's profits are the difference between its total revenues and total costs.

Total revenue and marginal revenue. A firm's total revenue is 

the dollar amount that the firm earns from sales of its output. If a firm decides to supply the
amount Q of output and the price in the perfectly competitive market is P, the firm's total
revenue is A firm's marginal revenue is the dollar amount by which its total revenue
changes in response to a 1-unit change in the firm's output. If a firm in a perfectly
competitive market increases its output by 1 unit, it increases its total revenue by P × 1 = P.
Hence, in a perfectly competitive market, the firm's marginal revenue is just equal to the
market price, P.

Short‐run profit maximization. A firm maximizes its profits by choosing to supply the
level of output where its marginal revenue equals its marginal cost. When marginal revenue
exceeds marginal cost, the firm can earn greater profits by increasing its output. When
marginal revenue is below marginal cost, the firm is losing money, and consequently, it must
reduce its output. Profits are therefore maximized when the firm chooses the level of output
where its marginal revenue equals its marginal cost.

To illustrate the concept of profit maximization, consider again the example of the firm that
produces a single good using only two inputs, labor and capital. In the short‐run, the amount
of capital the firm uses is fixed at 1 unit. Assume that this firm is competing with many other
firms in a perfectly competitive market. The price of the good sold in this market is $10 per
unit. The firm's costs of production for different levels of output are the same as those
considered in the numerical examples of the previous section, Theory of the Firm. These
costs, along with the firm's total and marginal revenues and its profits for different levels of
output, are reported in Table .

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Because the price of the good is $10, the firm's total revenue is 10 × total product. The firm's
marginal revenue is equal to the price of $10 per unit of total product. Notice that the
marginal cost of the 29th unit produced is $10, while the marginal revenue from the 29th unit
is also $10. Hence, the firm maximizes its profits by choosing to produce exactly 29 units of
output. In choosing to produce 29 units of output, the firm earns $90 ($290 − 200) in profits.

Graphical illustration of short‐run profit maximization. The marginal revenue, marginal

cost, and average total cost figures reported in the numerical example of Table are shown in
the graph in Figure.

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The firm's equilibrium supply of 29 units of output is determined by the intersection of the
marginal cost and marginal revenue curves (point d in Figure ). When the firm produces 29
units of output, its average total cost is found to be $6.90 (point c on the average total cost
curve in Figure ). The firm's profits are therefore given by the area of the shaded rectangle
labeled abed.

The area of this rectangle is easily calculated. The length of the rectangle is 29. The width is
the difference between the market price (the firm's marginal revenue), $10, and the firm's
average cost of producing 29 units, $6.90. This difference is ($10 × $6.90) = $3.10. Hence,
the area of rectangle abed is 29 × $3.1 = $90, the same amount reported in Table . In general,
the firm makes positive profits whenever its average total cost curve lies below its marginal
revenue curve.

Short‐run losses and the shut‐down decision. When the firm's average total cost curve
lies above its marginal revenue curve at the profit maximizing level of output, the firm is
experiencing losses and will have to consider whether to shut down its operations. In making
this determination, the firm will take into account its average variable costs rather than
its average total costs. The difference between the firm's average total costs and its average
variable costs is its average fixed costs. The firm must pay its fixed costs (for example, its
purchases of factory space and equipment), regardless of whether it produces any output.
Hence, the firm's fixed costs are considered sunk costs and will not have any bearing on
whether the firm decides to shut down. Thus, the firm will focus on its average variable costs
in determining whether to shut down.

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If the firm's average variable costs are less than its marginal revenue at the profit maximizing
level of output, the firm will not shut down in the short‐run. The firm is better off continuing
its operations because it can cover its variable costs and use any remaining revenues to pay
off some of its fixed costs. The fact that the firm can pay its variable costs is all that matters
because in the short‐run, the firm's fixed costs are sunk; the firm must pay its fixed costs
regardless of whether or not it decides to shut down. Of course, the firm will not continue to
incur losses indefinitely. In the long‐run, a firm that is incurring losses will have to either shut
down or reduce its fixed costs by changing its fixed factors of production in a manner that
makes the firm's operations profitable.

The case where the firm is incurring short‐run losses but continues to operate is illustrated
graphically in Figure (a). At the market price, P 1, the firm's profit maximizing quantity
is Q 1. At this quantity, the firm's average total cost curve lies above its marginal revenue
curve, which is the flat, dashed line denoting the price level, P 1. The firm's average variable
cost curve, however, lies below its marginal revenue curve, implying that the firm is able to
cover its variable costs. The firm's losses from producing quantity Q 1 at price P 1 are given
by the area of the shaded rectangle, abcd. Despite these losses, the firm will decide not to
shut down in the short‐run because it receives enough revenue to pay for its variable costs.

Figure (b) depicts a different scenario in which the firm's average total cost and average
variable cost curves both lie above its marginal revenue curve, which is the dashed line at
price P 2. The firm's losses are given by the area of the shaded rectangle, abed. In this
situation, the firm will have to shut down in the short‐run because it is unable to cover even
its variable costs. As a general rule, a firm will shut down production whenever its average
variable costs exceed its marginal revenue at the profit maximizing level of output. If this is

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not the case, the firm may continue its operations in the short‐run, even though it may be
experiencing losses.

Short‐run supply curve. The firm's short‐run supply curve is the portion of its marginal
cost curve that lies above its average variable cost curve. As the market price rises, the firm
will supply more of its product, in accordance with the law of supply. If, however, the market
price, which is the firm's marginal revenue curve, falls below the firm's average variable cost,
the firm will shut down and supply zero output.

The firm's short‐run supply curve is illustrated in Figures (a) and (b). Here, the firm's
short‐run supply curve is the portion of the marginal cost curve labeled ef. The market short‐
run supply curve, like the market demand curve, is simply the horizontal summation of all
the individual firms' short‐run supply curves.

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