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marginal cost curve becomes its supply curve
.
However, remember there is a minimum price level below which a firm will not supply. In the short run, 
a firm will only continue to supply if the selling price covers all its 
variable costs
.
At P
2
and Q
4
, the supplier's AR will be less than its AC but greater than its average variable cost (AVC). 
Because AC > AR the firm makes a loss, but some of its fixed costs are still paid for, because 
AR > AVC. 
If the firm had stopped producing altogether, it would still incur its fixed costs even though there will be 
no sales income to pay for any of these fixed costs. So it would have been financially worse off than it 
was by producing at a level where AR > AVC, even though it made a loss at this point.
Therefore, in the short run, the firm's
 supply curve 
is represented by the part of its
 marginal cost curve 
shown
 above 
the
 average variable cost curve (AVC)
.
Cost-plus pricing 
The idea of the marginal cost curve representing the supply curve is the traditional theory of a firm's 
short run supply curve. However, more recent theories of the firm incorporate a cost-plus pricing 
approach.
Under a cost-plus pricing approach, a firm adds a profit margin to its average cost at any level of output 
in order to establish its selling price. This alternative theory produces a horizontal supply curve.
 EXAM FOCUS POINT 
It is important that you remember that a firm will continue to produce in the short run if price is greater 
than average variable costs, even if price is less than average total costs.
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CHAPTER 4
//
MICROECONOMIC FACTORS 
 
105 
Price/
Quantity
AC
P
2
P
1
D
2
= AR
2
D
1
= AR
1
Q
3
Q
1
Q
2
Q
4
Profit
Supply
cost
Figure 6 Short run supply curves based on cost-plus pricing 
A rational (profit maximising, or loss minimising) firm will only supply where AR > AC. So the minimum 
and maximum levels of output occur at Q
1
and Q
2
respectively, at price P
1
; that is, where AR crosses the 
AC curve (AC = AR). 
Changes in the market price will lead to changes in output. (Note, we are still assuming a single, 
constant selling price for all firms in the industry.) A higher price (P
2
) will lead to a new supply curve, 
between Q
3
and Q
4
.
5.4 Long run supply curve 
In traditional theory, the