A monopoly guided by the pursuit of profit is inclined to produce no output if the quantity that equates marginal revenue and marginal cost in the short run incurs an economic loss greater than total fixed cost. The key to this shutdown production decision is a comparison of the loss incurred from producing with the loss incurred from not producing. If price is less than average variable cost, then the firm incurs a smaller loss by not producing than by producing.
One of Three Alternatives
Shutting down is one of three short-run production alternatives facing a monopoly. All three are displayed in the table to the right. The other two are profit maximization and loss minimization.
|Price and Cost||Result|
|P > ATC||Profit Maximization|
|ATC > P > AVC||Loss Minimization|
|P < AVC||Shutdown|
- With profit maximization, price exceeds average total cost at the quantity that equates marginal revenue and marginal cost. In this case, the firm generates an economic profit.
- With loss minimization, price exceeds average variable cost but is less than average total cost at the quantity that equates marginal revenue and marginal cost. In this case, the firm incurs a smaller loss by producing some output than by not producing any output.
Amblathan-Plus ProductionThe marginal approach to analyzing a monopoly's short-run production decision can be used to identify the economic loss alternative. The exhibit displayed here illustrates the short-run production decision by Feet-First Pharmaceutical, the monopoly producer of Amblathan-Plus, the only cure for the deadly (but hypothetical) foot ailment known as amblathanitis.
The three U-shaped cost curves used in this analysis provide all of the information needed on the cost side of the firm's decision. The demand curve facing the firm (which is also the firm's average revenue curves) and the corresponding marginal revenue curve provide all of the information needed on the revenue side.
|Profit and Loss|
For the time being, Feet-First Pharmaceutical maximizes profit by producing 6 ounces of Amblathan-Plus and charges a price of $7.50. This profit-maximizing situation depends on the existing market demand conditions. However, should this demand change, then maximizing a positive profit is not the primary concern of Feet-First Pharmaceutical. Its decision turns to minimizing loss. Click the [Less Demand] button to illustrate the situation facing Feet-First Pharmaceutical with a decrease in demand.
As the demand shifts leftward, the marginal revenue curve also shifts leftward. The new profit-maximizing intersection between marginal cost and marginal revenue is at 2 ounces of Amblathan-Plus. The price Feet-First Pharmaceutical charges for this quantity of production is then $5.50.
The key is that this new, lower price is less than average variable cost. This means that Feet-First Pharmaceutical does not generate enough revenue per ounce of Amblathan-Plus sold (average revenue = $5.50) to cover the variable cost of producing each ounce of Amblathan-Plus (average variable cost = $6), let alone total cost (average total cost = $11).
Feet-First Pharmaceutical clearly incurs an economic loss on each ounce of Amblathan-Plus produced and sold. In fact, if Feet-First Pharmaceutical produces 2 ounces of Amblathan-Plus, then its total cost is $22, but its total revenue is only $11. It incurs an economic loss of $11, a loss of $5.50 per ounce produced.
The Short-Run ChoicePerhaps Feet-First Pharmaceutical should stop producing. Perhaps it would be better off by NOT selling Amblathan-Plus. Unfortunately, Feet-First Pharmaceutical is faced with short-run fixed cost. Feet-First Pharmaceutical incurs a total fixed cost of $10 whether or not it engages in any short-run production. Even if it shuts down production, it still must pay this $10 of fixed cost.
As such, Feet-First Pharmaceutical is faced with a comparison between the loss incurred from producing with the loss incurred from not producing. Those are its two short-run choices. If it produces, it incurs a loss of $11. If it does not produce, it incurs a loss of $10.
The choice seems relatively obvious: Feet-First Pharmaceutical is better off not producing any Amblathan-Plus, incurring an economic loss of $10, and hoping for an increase in the demand. Should it produce any Amblathan-Plus, it incurs a greater loss than just paying total fixed cost.
Feet-First Pharmaceutical does not produce in the short run because it does not generate enough revenue to pay its variable cost, let alone any part of fixed cost. By producing 2 ounces of Amblathan-Plus, it generates $11 of total revenue. This revenue not only falls short of covering the $22 of total cost, neither is it enough to pay the $12 of total variable cost. This is why the economic loss from production is greater than total fixed cost.
Even though Feet-First Pharmaceutical has complete control of the supply-side of the market, it is still subject to the whims of the demand-side of the market. This $5.50 Amblathan-Plus price does not generate sufficient total revenue for Feet-First Pharmaceutical to pay ALL variable cost, let alone fixed cost. However, should demand change, then Feet-First Pharmaceutical would have to reevaluate its production decision. If the demand increases enough, Feet-First Pharmaceutical will be able to produce Amblathan-Plus in the short run.
MONOPOLY, SHUTDOWN, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2014. [Accessed: July 29, 2014].