Chapter 13 (2) Flashcards
DECIDING HOW MUCH TO PRODUCE
considering all firms –> are price takers in a competitive market –> thus, cannot affect the price it receives for the products they sell.
-> We’ll assume that the market for its production inputs = perfectly competitive too
–> At any given quantity, therefore, the firm’s revenue & cost = determined by factors outside of its control
(in a competitive market) the only choice that such a company can make to affect its profit
to decide the QUANTITY of output to produce
–> It is tempting to assume that since the firm can sell any quantity it wants w/out driving down the prices –> the firm should simply produce as much as possible to maximize its revenues
–> However, profits depend not just on revenues, but also on costs!
Total cost includes both fixed & variable costs…
The profit-maximizing quantity corresponds to the quantity at which marginal revenue is equal to the marginal cost.
–> Therefore, these calculations lead us to a decision rule for deciding how much to produce: the profit-maximizing quantity = the one at which the marginal revenue of the last unit was exactly equal to the marginal cost
–> profit maximization occurs where MR = MC for a perfectly competitive firm.
MR (marginal revenue) -graph?
–> horizontal line at the price level
–>The point at which the marginal revenue curve intersects the marginal cost curve = shows the profit-maximizing quantity to produce
a change in the going price could change a firm’s decision about how much to produce
–> In this example, the firm finds that MR = MC at a production quantity of 3 rather than 4
–> The drop in price means that the firm is now losing $$ rather than making a profit
DECIDING WHEN TO OPERATE
the most extreme choice that a firm can make about how much to produce = to produce nothing at all
DECIDING WHEN TO OPERATE
(imagine what happens when the market price decreases) Figure 13-1
- -> The horizontal MR line = falls lower on the graph
- -> intersecting the MC curve at lower & lower quantities
- -> Note as from figure 13-1, that a price decrease
- -> lowers the profit-maximizing quantity
we know that in a perfectly competitive market
the market price = the same thing as the firm’s average revenue
–>As long as average revenue (i.e., the market price) remains above average total cost –> total revenue = will be higher than total cost & the firm will be making profits
- -> But if the market price = falls below the bottom of the firm’s ATC CURVE –> there is no level of output at which the firm can make a profit
- It’s bound to make a loss
Does that mean it should stop production?
answer depends on whether we are thinking in the SHORT RUN or the LONG RUN
When deciding the quantity to produce, a firm additionally must decide whether to:
–> Produce.
–> Shut-down in the short-run.
–>Exit the market in the long-run
SHUT DOWN
When a firm shuts down production, it avoids incurring variable costs–b/c the quantity produced = zero
SHUT DOWN (Short-run)
it is stuck w/ its fixed costs
–> they do not decrease when quantity falls to zero
SUNK COST
a cost that has already been incurred & cannot be refunded or recovered
–> Fixed cost like land / large machinery = usually sunk costs in the SHORT RUN
–>They have to be paid for regardless of how much the firm produces / whether it produces anything at all
–>Fixed costs = therefore irrelevant in deciding whether to shut down production in the short run
that decision depends entirely on the variable costs of production (to shut down)
If the market price (average revenue) = lower than ATC but higher than AVC
–> the firm should continue to produce in the short run
–> Doing so yields more revenue than variable cost
Profit-maximizing (loss-minimizing) level
The firm should produce at the level at which the market price = intersects the MC curve
–> The firm will be losing money at that point –> but it will lose $$$ than if it did not produce at all
however, if the market price (average revenue) drops BELOW the bottom of the AVC curve
–> it makes sense for the firm to stop production in the short run
–> As well as having to pay its fixed costs –> the firm will be losing additional $$ for every unit it produces
–> At that level, losses due to fixed costs = unavoidable
–> But at least the firm = won’t lose even more $$ by producing more?–each of which costs more to produce than the revenue it brings in
SHORT-RUN SHUTDOWN RULE:
SHUTDOWN IF P
above the shut down price
a firm’s short-run supply curve = the same as its MC curve
–> At each price –> the firm supply the profit-maximizing quantity
- ->Since marginal revenue = the same as price in a perfectly competitive market
- -> we can take a shortcut by simply reading the quantity corresponding to each price along the MC curve
Below the shutdown price
however, the firm will not produce at all
LONG RUN (total cost)
reasoning is different!
–> All costs become variable
–> Leases can expire & not be renewed; machinery cannot be sold
- -> Therefore, when deciding whether to exit in the long-run
- -> the firm should consider whether average revenue is > than the average TOTAL COST
–> If the market price (average revenue) = < than the lowest point on the ATC curve –> the firm should make a long-run decision to exit the market for good
EXIT RULE:
EXIT IF P < MIN (ATC)
shows the firm’s long-run supply curve –> illustrates the exit rule
At prices above average total cost: the firm will produce at the point where price = intersects marginal cost
–> At lower prices: the firm will choose to produce nothing –> and will exit the market
in making the long-run decision–> the firm will consider whether the market price (average revenue) likely to remain low in the long-run
IF it believes that the market price = has fallen ONLY in the short run & will increase again in the long run –> then it would not make sense to exit the market permanently
- ->This reasoning explains why a firm = might decide to halt production temporarily in the short run when price dips below AVC
- -> but it might not make the long-run decision to exit the market permanently
- -The firm could stop its variable costs (lay off workers, no more raw materials)
- -> but keep open the possibility of restarting production by retaining its machinery & premises
- -> in the hope that the price goes back up again
