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In a competitive market, the supply curve of a firm is derived from its marginal cost curve. Supply curve is that portion of the marginal cost curve which lies above the average variable cost curve.

As we already know, the aim of the firm is to maximize profits or minimize losses. The profits are increased by the difference between total receipts and total costs is maximized. When a firm undertakes the production of a particular commodity, it has to pay remuneration to all the factors of production employed. The remuneration or cost of the firm for a short period can be divided into two parts, fixed costs and variable costs.

If from the sale of the commodity produced, a firm is earning much more than what it has to spend on it. We say a firm is earning abnormal profits if the total revenue of the firm is equal to total cost, the firm is getting normal profits. In both these cases, it is profitable for the firm to produce the commodity. But if the total receipts fall short of total costs, then three situations can arise.

(i) A firm is not in position to meet its variable costs.

(ii) A firm is able to cover its variable costs.

(iii) A firm is covering its full variable costs and a part of the fixed costs.

Diagram:

Let us explain all above situations with the help of a diagram.

(1) In the figure. (15.7) there are three costs curves, AVC curve, ATC curve and MC curve. ATC curve includes the average variable cost and average fixed cost of a firm. Average variable cost is represented by the AVC curve which lies below the ATC curve. Let us suppose now that at price OM, a firm supplies an output equal to 01 because MR = MC at point I.

The total receipts of the firm at OM price are thus, equal to OILM, while the total costs are equal to OIKN. At this price, a firm is undergoing too much losses which are represented by the area MLKN. It is not even meeting its full variable cost as the AVC curve lies much above this price line. A firm shall have to close down its operations for minimizing losses in the short run (shut down cases).

(2) At price OF, a firm is in equilibrium at point E where MR = P = AR. It produces OD amount of output and is just able to cover its variable cost. The total receipts of the firm at OF price are equal to ODEF and the total cost ODGH. As the total receipts of the firm fall short of total cost, so it is not advantageous for the firm to carry on production in the short run. The firm shall close down its operation as the full fixed cost equal to the area FHGE is not met. The point E where MR = MC = minimum of AVC is also a shut down point of the firm.

(3) In case the price settles somewhere between F and G, then the firm will be meeting its full variable costs and a part of the fixed costs. It, may prefer to produce because if the concern is closed down the whole of the fixed cost is to be met. This, of course can happen in a short period. When the period is long the total receipts of the firm must be equal to total cost and the firm must earn normal profit.

(4) If the price in the market is OG, the firm is in equilibrium at point B. Here the total receipts of the firm, i.e., OABG are equal to the total cost, i.e., OABG. A firm is earning normal profits and it is profitable for it to carry on production. By normal profits in economics we mean the level of profit which is just sufficient to induce an entrepreneur to stay in the industry. The amount is equal to the remuneration which an entrepreneur can get in an alternative occupations. If the entrepreneur is not paid the amount equal to this normal profit, he will move to the other alternative industry where he could got this amount.

If price, rises above OG, then firm is getting abnormal profits. For instance, the firm is producing best level of output by equating MR = MC at point U and selling at price OZ, the total revenue of the firm will be OWUZ and total cost OWVP. There is thus an abnormal profit equal to PVU2.

Summing up, we can say, that if price falls below the lowest point on the AVC curve, the firm will not produce any output because it is not able to cover even its total variable costs. But if the price is such that it covers its total variable costs, then the firm may carry on production for a short period. So is also the case when it covers its full variable costs and a part of the fixed costs. In the long period, if the firm does not cover its full costs, it will have to dose down its operations sooner or later. So we conclude that the supply curve of the firm that can be regarded as that portion of the MC curve which lies above the AVC curve and not which lies below the AVC curve because it is only at the lowest point on the AVC curve that some output is forthcoming and not below this point.

The supply curve of the firm or the rising portion of the MC curve which lies above the AVC curve can be split up into two parts. One part consists of that portion which lies above the lowest point of the ATC curve. If the price line representing MR = AR intersects the MC curve at any point on this rising portion, the firm will be earning abnormal profit (see fig. 15.7). The second part of the supply curve of the firm extends from the lowest point of the AVC curve to the lowest, point of the ATC curve. If price line representing MR = AR passes through the lowest point of the AVC curve, the firm is covering only total variable costs. If the price line cuts the MC curve at any point above the lowest point of the AVC curve and below the lowest point of ATC curve, the firm will be meeting its total variable costs and a part of the fixed costs but not the total costs. The total costs are met only when the price line forms a tangent to the ATC curve.