In order to conduct a cost analysis, it is essential to comprehend demand and supply curves. This requires understanding the factors, which may cause shifts in these curves and the impact those shifts might have on the cost function. These factors will vary depending on whether the objective is conducting a short-term or long-term cost analysis. When conducting a short-term analysis, we look at the short-run demand curve and the short-run supply curve, and vice versa.
Since this is a vast field and explaining each and every associated topic in detail would demand extensive efforts, so in this article, we will be discussing the short-term cost analysis while other relevant subjects will be touched upon in other articles, so bookmark the site.
The total demand of an industry can be calculated by horizontally adding the individual demand for each firm in that industry. This is referred to as aggregate demand. Similarly, to find the total supply of industry, the supply of all individual firms present in that industry is added horizontally. This is referred to as aggregate supply.
Each individual firm would always try to produce a certain quantity (it’s individual supply) in accordance with its optimal level of production. The optimal level of production for a firm can be defined as the point where its marginal revenue is the same as its marginal cost. This means that the cost of producing an additional unit would be the same as the benefit or revenue it would bring in. The marginal cost curve of a firm would also intersect with its average variable cost curve. Moreover, the average total cost curve at points where the average variable cost and the average total cost are at their lowest. When the average variable cost of a firm changes, marginal cost also changes. Since variable costs like the cost of raw material change often, each firm would have to continuously make changes in their production to complement their marginal cost.
The equilibrium point of a product is where the aggregate demand curve and the aggregate supply curve meet. If any one of these curves was to shift the equilibrium point would also automatically shift. The graphs below will help understand the changes to the equilibrium point and the cost function when each of these curves shifts.
A shift in the short-run demand curve may occur because of multiple reasons, for example, a change in the price of substitute products. In the long-term, additional factors like change in population can also cause the demand curve to shift but we will discuss that later.
An outward shift of the demand curve, as seen in the graph above, means that the aggregate demand has increased whereas an inward shift of the demand curve would have meant that the aggregate demand has decreased. Let’s assume that because of a drastic increase in the price of the substitute product, the short-run demand curve has shifted from D to D. The short-run supply curve has stayed constant at S. Due to the shift in the demand curve, the equilibrium point has also changed from E0 to E1, meaning that the equilibrium quantity has increased from Q0 to Q1 and the equilibrium price has increased from P0 to P1. As the cost has remained unchanged, the profit which was previously highlighted in the area labeled as A has now increased and also includes the area labeled as B.
A shift in the short-run supply curve may occur because of multiple reasons, for example, a change in the price of raw material. In the long-term, more factors like changes in technology can also cause the supply curve to shift but we will ignore those for now. An outward shift of the supply curve, as seen in the graph above, means that the aggregate supply has increased whereas an inward shift of the supply curve would have meant that the aggregate supply has decreased. Let’s assume that because of a reduction in the prices of raw material the short-run supply curve has shifted from S to S’. The short-run demand curve has stayed constant at D. Due to the shift in the supply curve, the equilibrium point has also changed from E0 to E2, meaning that the equilibrium quantity has increased from Q0 to Q2 and the equilibrium price has decreased from P0 to P2. As the price of raw materials decreased, it also affected the cost function, hence reducing the average total cost, average variable cost, and marginal cost to the new curves visible in red color. The profit which was previously highlighted in the area labeled as A has now changed to the area highlighted as C.