Mark Twain
Long-Run Costs and Output Decisions (Part B)
by
Charles Lamson
Minimizing Losses
A firm that is not earning positive profits or breaking even is suffering a loss. Firms suffering losses fall into two categories: (1) those that find it advantageous to shut down operations immediately and bear losses equal to fixed costs, and (2) those that continue to operate in the short run to minimize their losses. The most important thing to remember here is that firms cannot exit the industry in the short run. The firm can shut down, but it cannot get rid of its fixed costs by going out of business. Fixed costs must be paid in the short run no matter what the firm does.
Whether a firm suffering losses decides to produce or not to produce in the short run depends on the advantages and disadvantages of continuing production. If a firm shuts down, it earns no revenues and has no variable costs to bear. If it continues to produce, it both earns revenues and incurs variable costs. Because a firm must bear fixed costs whether or not it shuts down, its decision depends solely on whether revenues from operating are sufficient to cover variable costs. Operating profit (or loss) (sometimes called net operating revenue) is defined as total revenue (TR) minus total variable cost (TVC). In general:
Producing at a Loss to Offset Fixed Costs: Revisiting the Blue Velvet Car Wash Example from Last Post Suppose that competitive pressure pushes the price per wash down to $3. Total revenues for blue velvet would fall to $2,400 per week (800 cars * $3). If variable costs remained at $1,600, total cost would be $3,600 ($1,600 + $2,000 fixed costs), a figure higher than total revenues. The firm would then be suffering losses of $3,600 - $2,400 = $1,200.  In the long run, Blue Velvet may want to go out of business, but in the short run it is stuck, and it must decide what to do. The car wash has two options: operate or shut down. If it shuts down, it has no variable costs, but it also earns no revenues, and its losses will be equal to its fixed costs of $2,000 (Table 2, Case 1). If it decides to stay open (Table 2, Case 2), it will make operating profits. Revenues will be $2,400, more than sufficient to cover variable costs of $1,600. By operating, the firm gains $800 per week operating profits that it can use to offset its fixed costs. By operating, the firm reduces its losses from $2,000 to $1,200.  Graphic Presentation Figure 2 graphs a firm suffering losses. The market price, set to the forces of supply and demand, is P* = $3.50. If the firm decides to operate, it will do best by producing up to the point where price (marginal revenue) is equal to marginal cost---in this case, at an output of q* = 225 units.  Once again, total revenue (TR) is simply the product of price and quantity (P* * q*) = $3.50 * 225 = $787.50, or the area of rectangle P* Aq*0. Average total cost at q* = 225 is $4.10, and it is equal to the length of q* B. Total cost is the product of average total cost and q* (ATC * q*), or $4.10 * 225 = $922.50. Because total cost is greater than total revenue, the firm is suffering losses of $135, shown on the graph by the red-shaded rectangle. Operating profit---the difference between total revenue and total variable cost---can also be identified. On the graph, total revenue (as we said) is $787.50. Average variable cost at q* is the length of q* E. Total variable cost is the product of average variable cost and q* and is therefore equal to $3.10 * 225 = $697.50. Profit on operation is thus $797.50 - $697.50 = $90, the area of the pink shaded rectangle.  If we think only in averages, it seems logical that a firm in this position will continue to operate. As long as price (which is equal to average revenue per unit) is sufficient to cover average variable costs the firm stands to gain by operating instead of shutting down.  Shutting Down to Minimize Loss When revenues are insufficient to cover even variable costs, firms suffering losses find it advantageous to shut down, even in the short run. Suppose, for example, that competition and the availability of sophisticated new machinery push the price of a car wash all the way down to $1.50. Washing 800 cars per week would then yield revenues of only $1,200 (Table 3). With variable costs at $1,600 operating would mean losing an additional $400 over and above fixed costs of $2,000. This means that total losses would amount to $2,400. A profit-maximizing/loss-minimizing car wash would reduce its losses from $2,400 to $2,000 by shutting down, even in the short run.  Anytime that price (average revenue) is below the minimum point on the average variable cost curve, total revenue will be less than total variable cost, and the operating profit will be negative---that is, there will be a loss on operation. In other words, when price is below all points on the average variable cost curve, the firm will suffer operating losses at any possible output level the firm could choose. When this is the case, the firm will stop producing and bear losses equal to fixed costs. This is why the bottom of the average variable cost curve is called the shut-down point. At all prices above it, the MC curve shows the profit-maximizing level of output. At all prices below it, optimal short-run output is zero. We can now refine our earlier statement that a perfectly competitive firm's marginal cost curve is actually its short-run supply curve. Recall that a profit-maximizing perfectly competitive firm will produce up to the point at which P = MC. As we have just seen, though, a firm will shut down when P is less than the minimum point on the AVC curve. Also recall that the marginal cost curve intersects the AVC curve at AVC's lowest point. It therefore follows that the short run supply curve of a competitive firm is that portion of its marginal cost curve that lies above its average variable curve (Figure 3).   *CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 176-178* end |
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