This relationship between average and marginal costs helps us to understand how firms decide the level of output they need to produce.
For consumer behaviour, people act whenever the expected marginal benefit exceeds the expected marginal cost. Similarly, if firms are making decisions at the margin, they will be weighing up their marginal revenue (the revenue they receive from selling one extra unit) and the marginal cost. For simplicity, let’s assume that marginal revenue is the same regardless of how much you sell (e.g. €30). This is simply the market price of the good you are selling.
Let’s see how this impacts profit.
If marginal revenue exceeds marginal cost, it means you are selling the final product for more than the cost of making it. You will boost profit if you sell more. If, however, marginal revenue is lower than marginal cost, it costs you more to create the product than you can sell it for. In this case you will decide to produce less. And doing so will lead you to more profit. In equilibrium, you maximize profit (shown in orange) when marginal revenue equals marginal cost.
So far we’ve used the concept of diminishing returns to see why marginal costs increase as output does. But we can use another concept as well. Recollect that demand curves slope downwards because as we consume more, we place a lower value on consuming additional units. This is because we put them to satisfying less and less pressing needs.
Marginal cost curves slope upwards because the more we produce the greater the opportunity costs of using the inputs for any specific use. It’s not just that the more labour we use, the less productive it becomes when capital is fixed. It’s that the more labour we use for one production plan, the more labour is being kept from other potential uses.
The diagram above shows that MC cuts ATC at its minimum point, but in the short run we don’t need to cover all of our costs. We only need to cover variable costs.
If our marginal revenue hits the marginal cost curve above ATC, that’s great news because we’re making a profit! But provided it’s above AVC we will still be open for business.
When we put what we’ve learnt together, we can see that short-term output decisions are a two-step process.
Firstly, we need to consider whether we want to be open for business or not. And the shutdown con- dition states that provided revenue covers variable costs, we open. Secondly, if we’re open, we need to decide how much output to pro- duce. And we maximize profit when marginal revenue (i.e. price) equals marginal cost. When we put these two things together, we generate something of immense importance. A supply curve is simply the part of the marginal cost curve that allows you to cover your variable costs!
This theory helps to fully understand why supply curves are upward sloping: