Deriving a Supply Curve

As the price of output changes, firms will find it in their financial best interest to change production levels. Firms will still produce up to the last unit
where MR is just equal to MC.

The graph below shows optimum production (Y*) levels for three different output prices, P 1, P2, and P3.

Observe that, as per unit output prices increase, the firm increases
optimum output (y*). The firm must receive a higher output price to
increase production, because the cost to produce additional units is
increasing.
Also observe that, if output prices are equal to P1, the firm is making a loss,
but will still continue to produce in the short-run. It is in the firm’s
financial interest to keep producing in the short-run because, when
*
producing y 1, the revenue per unit (P1) is still greater than variable costs
per unit (AVC). In other words, at P1, the firm is able to cover all variable
costs and a portion of fixed costs. If the firm stopped production, the firm
would still have to pay all fixed costs (in the short-run).
Given these two observations, the firm’s short run supply curve can be
derived.
The short-run supply curve shows the quantities of output (Y) a firm would
produce (supply) at different output prices (P) in the short-run and is equal
to the MC curve above the AVC curve (see graph below)
In the long run, a firm must cover all costs, including fixed costs. In the long-run, firm can only produce if the per unit output price is equal to or
greater than per unit costs (prices high enough to cover all costs).

Thus, the long-run supply curve shows the quantities of output (Y) a firm would produce (supply) at different output prices (P) in the long-run and is
equal to the MC curve above the ATC curve (see graph below).

The sum of all the individual firm supply curves is the market supply curve.