The Short Run Profitability of a Competitive Firm

Figure 8.3 also shows the competitive firm's short-run profit. The distance AB is the difference between price and average cost at the output level q *, which is the average profit per unit of output. Segment BC measures the total number of units produced; Therefore, rectangle ABCD is the firm's total profit.

A firm need not always earn a profit in the short run, as Figure 8.4 shows. The major difference from Figure 8.3 is the higher fixed cost of production. This raises average total cost but does not change the average variable cost and

FIGURE 8.4 A Competitive Firm Incurring Losses. In the short run,a competitive firm may produce at a loss (because its fixed cost is high), if it can still generate revenues that more than cover its variable cost. The firm minimizes its losses by producing al q *, with losses ABCD. If the firm were to shut down, it would incur even greater losses equal to the fixed cost of production CBEF.

FIGURE 8.4 A Competitive Firm Incurring Losses. In the short run,a competitive firm may produce at a loss (because its fixed cost is high), if it can still generate revenues that more than cover its variable cost. The firm minimizes its losses by producing al q *, with losses ABCD. If the firm were to shut down, it would incur even greater losses equal to the fixed cost of production CBEF.

marginal cost curves. At the profit-maximizing output q *, the price P is less than average cost, so that line segment AB measures the average loss from production. Likewise, the shaded rectangle ABCD now measures the firm's total loss.

Why doesn't a firm that earns a loss leave the industry entirely? A firm might operate at a loss in the short run because it expects to earn a profit in the future as the price of its product increases or the cost of production falls. In fact, a firm has two choices in the short run: It can produce some output, or it can shut down its production temporarily. It will choose the more profitable (or the less unprofitable) of the two alternatives. In particular, a firm will find it profitable to shut down (produce no output) when the price of its product is less than the minimum average variable cost. In this situation, revenues from production will not cover variable costs, and losses will increase.

Figure 8.4 illustrates the case in which some production is appropriate. The output q* is at the point where short-run losses are minimized. It is cheaper in this case to operate at q* rather than to produce no output because price exceeds average variable cost atg*. Each unit produced yields more revenue than cost, thereby generating higher profit than if the firm were to produce nothing. (Total profit is still negative, however, because the fixed cost is high.) Line segment AE measures the difference between price and average variable cost, and rectangle AEFD measures the additional profit that can be earned by producing at q* rather than at 0.

To see this another way, recall that the difference between average total cost ATC and average variable cost AVC is average fixed cost AFC. Therefore, in Figure 8.4, line segment B£ represents the average fixed cost, and rectangle CBEF represents the total fixed cost of production. When the firm produces no output, its loss is equal to its total fixed cost CBEF. But when it produces at q*, its loss is reduced to the rectangle ABCD. Fixed cost, which is irrelevant to the firm's production decision in the short run, is crucial when determining whether the firm ought to leave the industry in the long run.

To summarize: The competitive firm produces no output if price is less than minimum average variable cost. When it does produce, it maximizes profit by choosing the output level at which price is equal to marginal cost. At this output level, profit is positive if price is greater than average total cost. The firm may operate at a loss in the short run. However, if it expects to continue to lose money over the long run, it will go out of business.

example 8.1 some cost considerations for managers

The application of the rule that marginal revenue should equal marginal cost depends on the manager's ability to estimate marginal cost.2 To obtain useful measures of cost, managers should keep three guidelines in mind.

2This example draws on the discussion of costs and managerial decision making in Thomas Nagle, The Strategy and Tactics of Pricing (Englewood Cliffs, N.J.: Prentice-Hall, 1987), Chapter 2.

First, when possible,overage variable cost should not be used as a substitutefor marginal cost. When marginal and average cost are nearly constant, there is little difference between them. However, when marginal and average cost are increasing sharply, the use of average variable cost can be misleading when deciding how much to produce. Suppose, for example, that a company has the following cost information:

Current output: 100 units per day, of which 25 units are produced during overtime

Materials cost: $500 per day

Labor cost: $2000 per day (regular) plus $1000 per day (overtime)

Average variable cost is easily calculated-it is the labor and materials cost ($3500) divided by 100 units per day, or $35 per unit. But the appropriate cost is marginal cost, which could be calculated as follows: Materials cost per unit is likely to be constant whatever the output level, so that marginal materials cost is $500/100 = $5 per unit. Since the marginal cost of labor is likely to involve overtime work only, it is obtained by noting that 25 of the 100 units were produced during the overtime period. The average overtime pay per unit of production, $1000/25 = $40 per unit, provides a good estimate of the marginal cost of labor. Therefore, the marginal cost of producing an additional unit of output is $45 per unit (the marginal materials cost plus the marginal labor cost); this is much larger than the average variable cost of $35. If the manager relied on average variable cost, too much output would be produced.

Second, a single item on a firm's accounting ledger may have two components, only one of which involves marginal cost. Suppose, for example, that a manager is trying to cut back production. She reduces the number of hours that some employees work and lays off others. But the salary of an employee who is laid off may not be an accurate measure of the marginal cost of production when cuts are made because union contracts often require the firm to pay laid-off employees part of their salary. In this case, the marginal cost of increasing production is not the same as the savings in marginal cost when production is decreased. The savings is the labor cost after the required layoff salary has been subtracted.

Third, all opportunity costs should be included in determining marginal cost. Suppose a department store wants to sell children's furniture. Instead of building a new selling area, the manager decides to use part of the third floor, which had been used for appliances, for the furniture. The marginal cost of this space is the profit that would have been earned had the store continued to sell appliances there, per unit of furniture sold. This opportunity cost measure may be much greater than what the store actually paid for that part of the building.

These three guidelines can help a manager to measure marginal cost correctly. Failure to do so can cause production to be too high or too low, and thereby reduce profit.

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