Why the supply curve slopes upwards: marginal cost and the profit incentive

Overview

Law of supply and explain the profit reasoning behind it, supply curve be described as the firm's marginal cost curve and how a technological improvement affects marginal cost.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   State the law of supply and explain the profit reasoning behind it.

   Model answer

   The law of supply states that, other things being equal, the quantity of a good supplied rises as its price rises. The reasoning is that supply is driven by profit: a higher price raises the revenue earned from each unit while costs are unchanged, so output that was previously unprofitable now covers its costs and is worth producing. Producers therefore expand output, and higher-cost producers who were not supplying at all begin to do so.

2. 2

   Give three separate reasons why a higher price leads to a larger quantity supplied.

   Model answer

   First, existing firms expand output because the extra revenue from each additional unit now exceeds the extra cost of producing it. Second, firms that were previously unable to cover their costs at the lower price can now produce profitably and enter the market. Third, producers switch resources away from other goods whose prices have not risen, because the higher-priced good has become the more rewarding use of the same land, labour and capital.

3. 3

   Define marginal cost and explain how it is calculated from total cost figures.

   Model answer

   Marginal cost is the addition to total cost from producing one more unit of output. It is calculated by subtracting the total cost of producing a given quantity from the total cost of producing one unit more. Because fixed costs do not change with output, marginal cost consists only of the extra variable costs the additional unit requires.

4. 4

   A firm's total cost is £20 at zero output, £60 at one unit, £110 at two, £180 at three, £280 at four and £420 at five. Calculate the marginal cost of each unit.

   Model answer

   The marginal cost of the first unit is £60 − £20 = £40. The second is £110 − £60 = £50. The third is £180 − £110 = £70. The fourth is £280 − £180 = £100. The fifth is £420 − £280 = £140. Marginal cost rises steadily with output, from £40 for the first unit to £140 for the fifth.

5. 5

   Using the marginal costs £40, £50, £70, £100 and £140 for the first to fifth units, derive the firm's supply schedule at prices of £45, £60, £80, £120 and £150.

   Model answer

   A profit-maximising firm produces every unit whose marginal cost is covered by the price. At £45 only the first unit, costing £40, is worth making, so output is 1. At £60 the second unit, costing £50, is also worth making, giving 2. At £80 the third, costing £70, is added, giving 3. At £120 the fourth, costing £100, is added, giving 4. At £150 the fifth, costing £140, is added, giving 5. Quantity supplied rises from 1 to 5 units as the price rises from £45 to £150, which is an upward-sloping supply curve.

6. 6

   Using the total costs £20, £60, £110, £180, £280 and £420 for outputs of zero to five units, calculate the firm's profit at a price of £120 per unit and confirm that four units is the best output.

   Model answer

   At four units, total revenue is 4 × £120 = £480 and total cost is £280, giving a profit of £200. At three units, revenue is £360 against a cost of £180, a profit of £180, and at five units revenue is £600 against a cost of £420, a profit of £180. Four units therefore yields the highest profit. This is the output at which marginal cost, £100 for the fourth unit, is the last one below the price, while the fifth unit costs £140 to make and earns only £120, so producing it would reduce profit by £20.

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