March 23, 2018 

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LOSS MINIMIZATION RULE: A rule stating that firm minimizes economic loss by producing output in the short run that equates marginal revenue and marginal cost if price is less than average total cost but greater than average variable cost. In the short run, a firm incurs total fixed cost whether or not it produces any output. As such, if the market price is falls below average total cost, it must decide if the economic loss from producing the quantity of output that equates marginal revenue and marginal cost is more or less than the economic loss incurred with shutting down production in the short run (which is equal to total fixed cost).

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The proposition that prices adjust in the long run in response to market shortages or surpluses. This condition is most important for long-run macroeconomic activity and long-run aggregate market analysis. In particular, flexible prices are the key reason for the vertical slope of the long-run aggregate supply curve. This proposition is also central to the original classical theory of macroeconomics and to modern variations, including rational expectations, new classical theory, and supply-side economics.
Price flexibility ensures that long-run aggregate production is equal to full-employment production. In particular, changes in the price level are met by equal changes in resource prices, especially wages. A higher or lower price level might temporarily lead to an increase or decrease in real production, above or below the full-employment level, but in the long run, resource prices adjust and full-employment production is maintained.

Flexible Prices
Flexible Prices

To see how this works consider the exhibit to the right. This exhibit illustrates a typical product market, in this case for Wacky Willy Stuffed Amigos. The market is initially in equilibrium, given by the intersection of the demand and supply curves.

A shock of the Stuffed Amigos market can serve to illustrate flexible prices, and how price flexibility maintains full employment.

  • Market Demand Shock: The place to begin is with the demand side of the Stuffed Amigos market. In particular, suppose that the market demand decreases due to a an overall decline in aggregate demand throughout the economy. To illustrate this demand shock, click the [Demand Decrease] button. As might be expected, the equilibrium price of Stuffed Amigos declines and the equilibrium quantity is less.

  • Labor Demand Adjusts: With the decrease in the sales of Stuffed Amigos, production also declines. With less production, The Wacky Willy Company needs fewer inputs, including labor. This decrease in labor demand results in a lower wage. The declining wage underlies the movement along the market supply curve corresponding with a decline in production cost and a decrease in the quantity supplied. The microeconomic analysis of Stuffed Amigos exchange need not proceed further. However, in the macroeconomic analysis of aggregate product and resource markets, there is more to this story.

  • Labor Supply Reacts: The lower price level of Stuffed Amigos, combined with comparable decreases in the prices for other markets throughout the economy, results in a lower price level. This lower price level increases the real wage of Stuffed Amigos producing labor. These workers are thus inclined to increase their productivity and/or accept a lower wage.

  • Back to Market Supply: The adjustment on the supply-side of the labor market reduces the cost of producing Stuffed Amigos. This results in a rightward shift of the market supply curve, which can be illustrated by clicking the [Supply Increase] button. This rightward shift of the market supply curve results in a lower price and a greater quantity. As production increases, employment returns to the original full-employment level.
This macroeconomic adjustment to a decline in market demand is ONLY possible with flexible prices. If prices are not flexible, if the price of Stuffed Amigos does not decline, if the prices other goods does not decline, if the wages paid to Stuffed Amigos producing labor do not adjust, then the Stuffed Amigos market does not return to its original full-employment equilibrium level.


Recommended Citation:

FLEXIBLE PRICES, AmosWEB Encyclonomic WEB*pedia,, AmosWEB LLC, 2000-2018. [Accessed: March 23, 2018].

Check Out These Related Terms...

     | inflexible prices | long-run aggregate supply | full employment, long-run aggregate supply | long-run, macroeconomics | long-run aggregate supply curve | slope, long-run aggregate supply curve |

Or For A Little Background...

     | aggregate supply | aggregate demand | gross domestic product | price level | GDP price deflator | real gross domestic product | full employment | unemployment | frictional unemployment | structural unemployment | overemployment | macroeconomic markets | resource markets |

And For Further Study...

     | short-run aggregate supply | aggregate supply determinants | aggregate market analysis | aggregate market | short-run, macroeconomics | change in aggregate supply | change in real production | aggregate supply shifts | slope, short-run aggregate supply curve | business cycles | circular flow | Keynesian economics | monetary economics | short-run aggregate supply and market supply |

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