This document discusses the cost curves (MC, ATC, AVC) of a small oil drilling firm operating as a price taker. It shows the firm in equilibrium at point A where price equals marginal cost at the lowest point of the ATC curve, breaking even. If price decreases, quantity supplied decreases along the MC curve. The firm can withstand price decreases until price falls below the lowest point of the AVC curve, point D, at which point it should shut down as it is not covering any fixed costs or fully covering variable costs.

1. MC*
ATC*
AVC*
“A”
Price
Of
Oil
Quantity of Oil
Firm in the Oil Drilling Business
Qe
P=MR=AR=D*
Here are the cost curves (MC*, ATC*, AVC* and
implied AFC (we will get to this in a minute) ) for a firm
in the oil drilling business.

2. MC*
ATC*
AVC*
“A”
Price
Of
Oil
Quantity of Oil
Firm in the Oil Drilling Business
Qe
P=MR=AR=D*
I am going to assume that the typical firm is a small
producer relative to the whole market and they are
A “Price Taker”. So the Price (“P”)=MR=AR=Demand.
The Firms Demand Curve is “Perfectly ELASTIC” and
horizontal at
“P=MR=AR=D*.

3. MC*
ATC*
AVC*
“A”
Price
Of
Oil
Quantity of Oil
Firm in the Oil Drilling Business
Qe
P=MR=AR=D*
Assume the Firm is in equilibrium at Point “A”
where The Price = MC* at the Lowest Point of the ATC*
curve (Productive and Allocative Efficiency) .The firm is
“Breaking Even”. Meaning the price they receive per barrel
of oil at that point is equal to the ATC of producing that
barrel (Explicit + Implicit Opp Costs).
The sum of AVC and AFC = ATC
Let’s see what this looks like on this graph.

4. MC*
ATC*
AVC*
Price
Of
Oil
Quantity of Oil
Qe
P=MR=AR=D*
“B”AVC
“A”
Firm in the Oil Drilling Business
We know Point “A” is the ATC of Producing
the “Qe” barrel of oil (last one brought out of
the ground).
From Point “A” go down until you hit the AVC
curve at Point “B”. Go over to Price axis and
locate , in dollar terms, the AVC of
producing the “Qe” barrel of oil.

5. MC*
ATC*
AVC*
Price
Of
Oil
Quantity of Oil
Qe
P=MR=AR=D*
“B”AVC
Total Variable
Costs
“A”
Firm in the Oil Drilling Business
“AVC” represents the Average Variable Cost
of producing that last barrel of oil, “Qe”.
If we want to find the TOTAL VARIABLE COSTS
for the firm, then we multiply AVC to produce one
barrel of oil by the TOTAL QUANTITY at “Qe”.
The Area of Total Variable Cost is in BLUE.

6. MC*
ATC*
AVC*
Price
Of
Oil
Quantity of Oil
Qe
P=MR=AR=D*
“B”AVC
Total Variable
Costs
Total Fixed
Costs
“A”
Firm in the Oil Drilling Business
We know ATC=AVC +AFC, so the difference
between Point “A” and Point “B” is the Average Fixed Cost
of producing the “Qe” barrel of oil. The TOTAL
FIXED COSTS of producing all the barrels of oil
will be Average Fixed Cost of one barrel multiplied by the
TOTAL QUANTITY at “Qe”.
The Area of Total Fixed Costs is in RED.

7. MC*
ATC*
AVC*
Price
Of
Oil
Quantity of Oil
Qe
P=MR=AR=D*
“B”AVC
Total Variable
Costs
Total Fixed
Costs
P=MR=AR=D1
Q1
“C”
“A”
Firm in the Oil Drilling Business
Now, the Price the Firm receives for each barrel of oil
decreases to “P=MR=AR=D2”. We need to locate our
New Price (MR)= (MC) Marginal Cost profit maximizing
(Loss minimizing) quantity of output.
That will be Point “C” at “Q1”.
(Remember, when price decreases, quantity supplied decreases
(Law of Supply)
The firms Supply Curve is the Marginal Cost (MC) curve above
The lowest point of the AVC curve.
Movement ALONG the Supply Curve from “A” to “C”.
Notice our Total Fixed Cost and Total Variable Cost areas change—
like this…..

8. MC*
ATC*
AVC*
Price
Of
Oil
Quantity of Oil
Qe
P=MR=AR=D*
“B”AVC
Total Variable
Costs
Total Fixed
Costs
P=MR=AR=D 1
Q1
“C”
“A1” “A”
Firm in the Oil Drilling Business
It is IMPORTANT to notice what happened here
(toggle back one slide if you are not sure). We
Move to different points on our cost curves because
our Quantity Supplied changed.
(1) ATC is now higher (“A1”, not “A”)—no longer at
Productive Efficiency
(2) Variable Costs are less because we are producing
less.
(3) While the Total Fixed Cost remain the same, the
AFC that each barrel Of oil absorbs is higher than it was
before.
But a more important thing is happening
as a result….

9. MC*
ATC*
AVC*
Price
Of
Oil
Quantity of Oil
Qe
P=MR=AR=D*
“B”AVC
Total Variable
Costs
Fixed Costs
P=MR=AR=D 1
Q1
“C”Not making FC’s
“A”“A1”
Firm in the Oil Drilling Business
Given the new lower price, the firm is NOT
making all of its costs. The new price
allows the firm to make ALL its Variable Costs
and SOME of its Fixed Costs (remaining RED area).
The BLACK area represents TOTAL FIXED COSTS the firm
cannot meet due to the lower price.
Should this firm stay in business?

10. MC*
ATC*
AVC*
Price
Of
Oil
Quantity of Oil
Qe
P=MR=AR=D*
“B”AVC
Total Variable
Costs
Fixed Costs
P=MR=AR=D 1
Q1
“C”Not making FC’s
“A”“A1”
Firm in the Oil Drilling Business
Should this firm stay in business?
The economics and accounting say YES!
As long as the price is enough to meet the firms
Average Variable Costs, it should stay in business in
hope the price will go back up as some producers
exit the market or demand increases.
So, the firm and withstand a decrease in PRICE until
it FALLS BELOW….

11. MC*
ATC*
AVC*
Price
Of
Oil
Quantity of Oil
Qe
P=MR=AR=D*
“B”AVC
Total Variable
Costs
Fixed Costs
P=MR=AR=D2=
Q1
“C”Not making
FC’s
“D”
“E”
Q2
P=MR=AR=D 1
“A”“A1” …The LOWEST POINT of the AVC curve—Point “D”
Point “D” is considered the point of “Exit” or “Shut Down”
for the firm.
If the price drops below Point “D” it means the firm is
NOT making ANY of its Fixed Costs AND NOT making some
Of its VARIABLE COSTS. If the firm does not recover at least
the cost of producing the additional barrel of oil (the Variable
Cost) then it should not produce.
Firm in the Oil Drilling Business

12. MC*
ATC*
AVC*
Price
Of
Oil
Quantity of Oil
Qe
P=MR=AR=D*
“B”AVC
Total Variable
Costs
Fixed Costs
P=MR=AR=D2=
Q1
“C”Not making
FC’s
“D”
“E”
Q2
P=MR=AR=D 1
“A”“A1” …The LOWEST POINT of the AVC curve—Point “D”
Any Price BELOW Point “D” is considered the point of “Exit”
or “Shut Down” for the firm.
If the price drops below Point “D” it means the firm is
NOT making ANY of its Fixed Costs AND NOT making some
Of its VARIABLE COSTS. If the firm does not recover at least
the cost of producing the additional barrel of oil (the Variable
Cost) then it should not produce.
Firm in the Oil Drilling Business

13. MC*
ATC*
AVC*
Price
Of
Oil
Quantity of Oil
Qe
P=MR=AR=D*
“B”AVC
Total Variable
Costs
Fixed Costs
P=MR=AR=D2=
Q1
“C”Not making
FC’s
“D”
“E”
Q2
P=MR=AR=D 1
“A”“A1”
Notice again as the PRICE deceases the Quantity Supplied
decreases, movement ALONG the MC curve from Point
“C” to Point “D” (lowest point on AVC curve).
The AVC of producing fewer barrels decreases BUT the
ATC of producing fewer barrels INCREASES because FIXED
COSTS are being spread out over few barrels of oil—
Movement from Point “A1” to “E”.
Firm in the Oil Drilling Business

14. MC*
ATC*
AVC*
Price
Of
Oil
Quantity of Oil
Qe
P=MR=AR=D*
AVCP=MR=AR=D2=
Q1
“A”
“D” “Shut-Down” Rule—any price received BELOW
the Lowest Point of the AVC curve “C”. Not making ANY
contribution to AFC and just covering AVC.
Firm in the Oil Drilling Business