When the price exceeds the average variable cost but not the average total cost?

However, if price falls below average total cost, then the firm incurs an economic loss. The question is whether the firm should keep producing in the short run and incur an operating loss or shut down awaiting a higher price. If price remains above average variable cost, then the firm generates enough revenue to pay all variable cost, plus a portion of fixed cost. So it produces the quantity that equates marginal revenue and marginal cost.

If the price falls below average variable cost, then the firm is better off shutting production in the short run. By producing any output, it does not generate enough revenue to cover variable cost let alone any fixed cost. The loss incurred is greater than fixed cost. The firm can incur a smaller loss by producing zero output and paying fixed cost.

Consider the decision facing Phil, a perfectly competitive gardener, when he produces and sells zucchinis. Like any profit-maximizing firm, Phil generally achieves a production level that equates marginal revenue and marginal cost. There are, however, exceptions--circumstances in which Phil does not equate marginal revenue and marginal cost.

Profit Maximization

This is the situation desired by all firms. A firm in this situation obviously remains in business, producing the profit-maximizing quantity of output.

Loss Minimization

However, the key question is whether or not Phil should stop producing in the short run or produce zucchinis at the output level that equates marginal revenue and marginal cost even though he is operating at a loss.

Consider the stop-producing option. Because this is short-run production, Phil incurs fixed cost whether or not he produces any zucchinis. If he produces 10 pounds of zucchinis, he incurs fixed cost. If he produces no zucchinis he incurs the same fixed cost. The only way to avoid the fixed cost is to sell off all of the fixed inputs and go out of business. Because the fixed input is changing, this option places Phil in the long run, which is NOT the current problem. If Phil produces no zucchinis, then he is faced with an economic loss equal to total fixed cost.

But what if Phil produces the quantity of zucchinis that equates marginal revenue and marginal cost? Even though price is less than average total cost (and Phil incurs an economic loss), price is greater than average variable cost. This means that Phil, by producing some zucchinis, receives enough revenue to pay ALL variable cost, with some left over to pay part of fixed cost. As such, Phil's economic loss by producing some zucchinis is less than the economic loss of total fixed cost incurred by producing no zucchinis at all.

In fact, keep in mind that total cost includes a normal profit. If price is less than average total cost but greater than average variable cost, Phil might not even realize that he is incurring an economic loss. He might actually have an accounting profit on his books. In the long run, Phil does not remain in business if he does not earn a normal profit. In the short run, Phil might be able to get by.

Shutdown

If Phil attempts to produce any zucchinis, the price is so low that he does not receive sufficient revenue to cover even his variable cost. Thus not only does his fixed cost go unpaid, a portion of his variable cost also goes unpaid. Phil minimizes his losses by shutting down production in the short run and awaiting higher prices. In the long run, of course, Phil simply leaves zucchini production should price remain below average variable cost.

Working the Curves

Profit and Loss

At the $4 market price Phil maximizes profit by producing 7 pounds of zucchinis, which generates a $7 profit. His average total cost is $3 per pound and his average variable cost is $2.57 per pound. This is the existing situation displayed in the diagram.

Because the current market price (which is average revenue) is greater than both average total cost and average variable cost, Phil generates enough revenue per unit of output to pay both per unit variable cost and per unit fixed cost.

But things can change. In particular, the market price can decline. Should it decline enough, falling below average total cost, then Phil incurs a loss. It can also decline so much that Phil is better off shutting down production entirely.

The three short-run production alternatives that Phil faces are:

• P > ATC: Total revenue exceeds total cost and Phil receives a positive economic profit. In this case, Phil maximizes profit by producing the quantity of output that equates marginal revenue and marginal cost. This is the initial situation displayed in the graph.


• ATC > P > AVC: Total revenue falls short of total cost, meaning Phil incurs an economic loss (or negative economic profit). In spite of the loss, because the price exceeds average variable cost, Phil can maximize profit (minimize loss) by producing the quantity of output that equates marginal revenue and marginal cost. Phil receives enough revenue to cover ALL variable cost plus a portion of fixed cost. The loss from production is less than the loss from NOT producing, which is total fixed cost. This can be displayed by clicking the [$2.60] button.


• P < AVC: Total revenue also falls short of total cost, and Phil incurs an economic loss (or negative economic profit). In this case Phil maximizes profit (that is, minimizes loss) by reducing the quantity of output to zero, or producing no output in the short run. By producing a positive quantity, Phil does not receive enough revenue to cover variable cost, let alone any fixed cost. The economic loss from producing is greater than the economic loss of NOT producing, which is total fixed cost. This can be illustrated by clicking the [$2.00] button.