blanchard_ch10

If output increases from 9 to 10 sweaters marginal

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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. FIGURE 10.4 Price (dollars per sweater) 200 6/23/11 The Shutdown Decision MC 30.00 ATC 25.00 AVC 20.14 17.00 MR Shutdown point 15.00 0 4 7 13 10 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 1 2 3 Why does a firm in perfect competition produce the quantity at which marginal cost equals price? 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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