Source: Image of Short Run Situations Graph created by Kate Eskra, Image of Short Run Supply Curve graph created by Kate Eskra
Hi. Welcome to economics. This is Kate. This tutorial is on the short run aggregate supply curve. As always, my key terms are in red and my examples are in green.
In this tutorial, I'll be showing you the following points on the graph-- when a firm is profitable, when the firm's breaking even, when the firm is going to operate, but at a loss, and then, finally, when the firm shuts down. If we look at all of these on the graph, you'll understand that the firm's short-run aggregate supply curve will be the marginal cost curve from above this shut-down point right here.
OK. So, a profit is when we take our revenues, subtract our costs, and if we're left over with anything, then we have a profit. So that means if our revenues exceed our costs, then the firm makes a profit. On the graph we look at it on a per-unit basis, so it's when price is greater than average total cost.
If the revenues are less than cost, then the firm sustains a loss. Again, when price is less than average total cost, the firm is losing money.
If the two are equal, then the firm is breaking even, and that's right where price will equal average total cost.
OK. So, why are we talking about average costs? Well, if the average costs that help the firm compare the costs at various production levels and then make decisions. So the average total cost curve is what we look at to see if it's a profit or loss overall. So if these are just covered, then the firm's considered to be breaking even. Anything better than that, if price is up above our average total cost, then that means the firm is making a profit.
It's our average variable cost curve that we need to look at before short-run decisions, whenever, especially, the firm is losing money. If the firm is profitable, we don't need to worry about this, because we know we're covering our variable costs if we're covering all of our costs. But if we're losing money, this is now where we need to look at our average variable cost curve and see, should we shut down or should we produce at a loss? The shut-down point that you'll see is where price equals our average variable cost. And the subject of this tutorial is to show you that the supply curve is going to be the marginal cost curve from above this point.
OK. So there are four different situations, like I said, that the firm can experience in the short run. The first one is the best-- profit. If price comes in and it is up above our average total cost-- which is right here-- then the firm is profitable. So anything up here would mean the firm is going to be profitable.
When the firm produces right where price comes in equal to average total cost, then we know that the firm is breaking even. OK? Because the price of the product is exactly covering, on average, all of the costs.
All right. Now we get to the area where it's not so good for the firm. If price is below average total cost, anywhere below this, the firm is not profitable. They're losing money. But now they have a decision to make. Now they have to look at their average variable cost. If price can at least cover variable costs, then they should operate at a loss in the short run. So that places them in this region here, between the break-even point and the shutdown point. Why should they consider operating? They're actually going to minimize their losses by doing this, because they have to pay their fixed expense regardless in the short run. They have to pay rent, for example. If they can at least cover these variable or operating expenses, like paying for all their workers, paying for all their materials, then they can put any money over and above that towards that fixed expense that they have to pay anyway.
But if they can't even afford to pay their workers and pay their materials and pay these variable expenses, if price comes in and is anywhere below this point, they should shut down in the short run. They still have to pay that fixed expense, that fixed cost, but they'll lose less money by doing that than on top of that also paying for all of their factors of production. OK? So if price is less than AVC, that's where they shut down. So that's why this is the point below which they would shut down. So that's going to make their short run supply curve anything above this point.
So here it is on a more clear graph for you. Because the firm will shut down when price does not cover AVC, this portion of the curve down here is not relevant. They're not going to produce down here. OK? They have to surpass this production threshold in order to justify producing. After that point, then they can realize some economies of scale, which is where their average costs actually begin to fall as they produce more. And this, then, becomes their short-run supply curve, because anything above this point, they will in fact produce. Here we're making a profit. Here we'll be breaking even. Here we're producing at a loss to minimize our losses in the short run.
So in this tutorial, we talked about how in the short run there are four different situations that can occur. The firm may be earning a profit, breaking even, operating at a loss, or shutting down. It's when the firm cannot cover their variable costs that they decide to shut down. So then, the short-run aggregate supply curve is the marginal cost curve above that shutdown point.
Thanks so much for listening. Have a great day.