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Unformatted text preview: 0 sweaters, marginal cost is $27, which exceeds the
marginal revenue of $25. If marginal revenue exceeds marginal cost, an increase in output increases economic profit.
If marginal revenue is less than marginal cost, an increase
in output decreases economic profit. If marginal revenue
equals marginal cost, economic profit is maximized.
animation 000200010270728684_CH10_p195-220.qxd 4:13 PM Page 200 CHAPTER 10 Perfect Competition Temporary Shutdown Decision
You’ve seen that a firm maximizes profit by producing the quantity at which marginal revenue (price)
equals marginal cost. But suppose that at this quantity, price is less than average total cost. In this case,
the firm incurs an economic loss. Maximum profit is
a loss (a minimum loss). What does the firm do?
If the firm expects the loss to be permanent, it
goes out of business. But if it expects the loss to be
temporary, the firm must decide whether to shut
down temporarily and produce no output, or to keep
producing. To make this decision, the firm compares
the loss from shutting down with the loss from producing and takes the action that minimizes its loss.
Loss Comparisons A firm’s economic loss equals total fixed cost, TFC, plus total variable cost minus total
revenue. Total variable cost equals average variable
cost, AVC, multiplied by the quantity produced, Q,
and total revenue equals price, P, multiplied by the
quantity Q. So
Economic loss = TFC + (AVC – P) Q. If the firm shuts down, it produces no output
(Q = 0). The firm has no variable costs and no revenue but it must pay its fixed costs, so its economic
loss equals total fixed cost.
If the firm produces, then in addition to its fixed
costs, it incurs variable costs. But it also receives revenue. Its economic loss equals total fixed cost—the
loss when shut down—plus total variable cost minus
total revenue. If total variable cost exceeds total revenue, this loss exceeds total fixed cost and the firm
shuts down. Equivalently, if average variable cost
exceeds price, this loss exceeds total fixed cost and the
firm shuts down.
The Shutdown Point A firm’s shutdown point is the
price and quantity at which it is indifferent between
producing and shutting down. The shutdown point
occurs at the price and the quantity at which average variable cost is a minimum. At the shutdown
point, the firm is minimizing its loss and its loss
equals total fixed cost. If the price falls below minimum average variable cost, the firm shuts down
temporarily and continues to incur a loss equal to
total fixed cost. At prices above minimum average
variable cost but below average total cost, the firm
produces the loss-minimizing output and incurs a
loss, but a loss that is less than total fixed cost. Figure 10.4 illustrates the firm’s shutdown decision and the shutdown point that we’ve just
described for Campus Sweaters.
The firm’s average variable cost curve is AVC and
the marginal cost curve is MC. Average variable cost
has a minimum of $17 a sweater when output is 7
sweaters a day. The MC curve intersects the AVC
curve at its minimum. (We explained this relationship between marginal cost and average cost in
Chapter 9; see pp. 181–182.)
The figure shows the marginal revenue curve MR
when the price is $17 a sweater, a price equal to minimum average variable cost.
Marginal revenue equals marginal cost at 7
sweaters a day, so this quantity maximizes economic
profit (minimizes economic loss). The ATC curve
shows that the firm’s average total cost of producing
7 sweaters a day is $20.14 a sweater. The firm incurs
a loss equal to $3.14 a sweater on 7 sweaters a day, so
its loss is $22 a day, which equals total fixed cost.
Price (dollars per sweater) 200 6/23/11 The Shutdown Decision
MC 30.00 ATC
point 15.00 0 4 7 13
Quantity (sweaters per day) The shutdown point is at minimum average variable cost. At
a price below minimum average variable cost, the firm
shuts down and produces no output. At a price equal to
minimum average variable cost, the firm is indifferent
between shutting down and producing no output or producing the output at minimum average variable cost. Either
way, the firm minimizes its economic loss and incurs a loss
equal to total fixed cost.
animation 000200010270728684_CH10_p195-220.qxd 6/23/11 4:13 PM Page 201 T he Firm’s Output Decision REVIEW QUIZ
3 Why does a firm in perfect competition
produce the quantity at which marginal cost
What is the lowest price at which a firm
produces an output? Explain why.
What is the relationship between a firm’s supply
curve, its marginal cost curve, and its average
variable cost curve? You can work these questions in Study
Plan 10.2 and get instant feedback. So far, we’ve studied a single firm in isolation.
We’ve seen that the firm’s profit-maximizing decision
depends on the market price, which it takes as given.
How is the market price determined? Let’s find out. FIGURE 10.5
Price and c...
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