4.4.1. Short Run Supply Curve of a Firm

Suppose the market price is p₁, which exceeds the minimum AVC. We start out by equating p with SMC on the rising part of the SMC curve; this leads to the output level q₁. Note also that the AVC at q₁ does not exceed the market price, p₁. Thus, all three conditions highlighted in section 3 are satisfied at q₁. Hence, when the market price is p₁, the firm’s output level in the short run is equal to q₁.

In this case, we consider when the market price is equal to or higher than the minimum average variable cost (AVC). The firm will choose to produce because the price they receive for their product is high enough to cover their variable costs. By equating the price (p₁) with the short-run marginal cost (SMC) of production, we determine the profit-maximizing output level, designated as q₁. Since the price is higher than the average variable cost at this output level, the firm can operate profitably.

Imagine a lemonade stand. If the price a customer is willing to pay for a glass of lemonade is greater than the cost of the lemons, sugar, and cups (average variable cost), the stand will continue to sell lemonade. For example, if selling lemonade costs 50 cents per glass but the market price is $1, the stand will produce as many glasses as they can sell at this price.

Suppose the market price is p₂, which is less than the minimum AVC. We have argued (see condition 3 in section 3) that if a profit-maximising firm produces a positive output in the short run, then the market price, p₂, must be greater than or equal to the AVC at that output level. But notice from Figure 4.7 that for all positive output levels, AVC strictly exceeds p₂. In other words, it cannot be the case that the firm supplies a positive output. So, if the market price is p₂, the firm produces zero output.

In this scenario, the market price is lower than the minimum average variable cost. Since the revenue from selling the product wouldn't even cover the variable costs of production, the firm cannot profitably produce any output. Therefore, the firm decides to shut down temporarily, and the output level remains at zero. This ensures that the firm does not incur losses from producing more than it can sell profitably.

Using the lemonade stand again, suppose the price customers are willing to pay drops to 25 cents while it still costs the stand 50 cents to make a glass. Since selling lemonade at this price means losing money, the stand will close until prices rise to ensure they don't incur losses.

Combining cases 1 and 2, we reach an important conclusion. A firm’s short run supply curve is based on its short run marginal cost curve (SMC) and the average variable cost curve (AVC). It is represented from and above the minimum AVC together with zero output for all prices strictly less than the minimum AVC.

The short run supply curve shows the relationship between market prices and the quantity a firm is willing to supply at those prices under short-run conditions. If market prices are above the minimum AVC, the firm supplies a positive output corresponding to its marginal cost. However, if market prices fall below this threshold, the firm does not produce at all because it cannot cover its variable costs.

Think of a baker who sells cakes. If they can sell cakes for $20 each and it costs them$10 in ingredients and labor (AVC) to make one cake, they will produce cakes. But if the price falls to $5, they won’t bake any cakes since they would lose$5 on each one sold. The short run supply curve captures this behavior: they will only supply cakes at prices that cover their costs.

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