AFC: The abbreviation for average fixed cost, which is fixed cost per unit of output, found by dividing total fixed cost by the quantity of output. Average fixed cost is one of three related cost averages. The other two are average variable cost and avarage total cost. Average fixed cost decreases with larger quantities of output. Because fixed cost is FIXED and does not change with the quantity of output, a given cost is spread more thinly per unit as quantity increases. A thousand dollars of fixed cost averages out to $10 per unit if only 100 units are produced. But if 10,000 units are produced, then the average shrinks to a mere 10 cents per unit.
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PERFECT COMPETITION, LOSS MINIMIZATION:
A perfectly competitive firm is presumed to produce the quantity of output that minimizes economic losses, if price is greater than average variable cost but less than average total cost. This is one of three short-run production alternatives facing a firm. The other two are profit maximization (if price exceeds average total cost) and shutdown (if price is less than average variable cost). A perfectly competitive firm guided by the pursuit of profit is inclined to produce the quantity of output that equates marginal revenue and marginal cost in the short run, even if it is incurring an economic loss. The key to this loss minimization production decision is a comparison of the loss incurred from producing with the loss incurred from not producing. If price exceeds average variable cost, then the firm incurs a smaller loss by producing than by not producing.
One of Three Alternatives
Loss minimization is one of three short-run production alternatives facing a perfectly competitive firm. All three are displayed in the table to the right. The other two are profit maximization and shutdown.
|Price and Cost
|P > ATC
|ATC > P > AVC
|P < AVC
- 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 shutdown, price is less than average variable cost at the quantity that equates marginal revenue and marginal cost. In this case, the firm incurs a smaller loss by producing no output and incurring a loss equal to total fixed cost.
Zucchini ProductionThe marginal approach to analyzing a perfectly competitive firm'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 Phil the perfectly competitive zucchini grower.
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 and marginal revenue curves) provides all of he information needed on the revenue side.
|Incurring a Loss
For the time being, Phil faces a $4 price for his zucchinis. As such he produces 7 pounds of zucchinis, which equates the $4 marginal revenue with marginal cost. However, should this price decline, say to $2.60 per pound, then maximizing a positive profit is not his primary concern. His decision turns to minimizing losses. Click the [$2.60] button to illustrate the situation facing Phil with a lower price.
The key to this lower price is that it intersects the marginal cost curve between the average total cost curve and the average variable cost curve. This is crucial. It means that Phil does not generate enough revenue per pound of zucchinis sold (average revenue = $2.60) to cover the cost of producing each pound of zucchinis (average total cost = $3).
Phil clearly incurs an economic loss on each pound of zucchinis produced and sold. In fact, if Phil produces 6.25 pounds of zucchinis (the quantity that equates marginal revenue and marginal cost), then his total cost is $18.75, but his total revenue is only $16.25. He incurs an economic loss of $2.50, a loss of $0.40 per pound produced.
The Short-Run ChoicePerhaps Phil should stop producing. Perhaps he would be better off by NOT selling zucchinis. Unfortunately, Phil is faced with short-run fixed cost. Phil incurs a total fixed cost of $3 whether or not he engages in any short-run production. Even if he shuts down production, he still must pay this $3 of fixed cost.
As such, Phil is faced with a comparison between the loss incurred from producing with the loss incurred from not producing. Those are his two short-run choices. If he produces, he incurs a loss of $2.50. If he does not produce, he incurs a loss of $3.
The choice seems relatively obvious: Phil is better to produce 6.25 pounds of zucchinis, incurring an economic loss of $2.50, and hoping for an increase in the price.
Phil continues to produce in the short run because he generates enough revenue to pay ALL of his variable cost, plus a portion of his fixed cost. By producing 6.25 pounds of zucchinis, he generates $16.25 of total revenue. While this revenue falls short of covering the $18.75 of total cost entirely, it is enough to pay the $15.75 of total variable cost, with an extra $0.50 left over to pay a portion of the $3 total fixed cost. This is why the economic loss from production is less than total fixed cost.
Because Phil has no market control, he is subject to the whims of the market price. This $2.60 zucchini price generates sufficient total revenue for Phil to pay ALL variable cost and some fixed cost. However, should this market price drop, then Phil would have to reevaluate his production decision. If the price declines enough, Phil will be forced to shut down production in the short run.
PERFECT COMPETITION, LOSS MINIMIZATION, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2024. [Accessed: March 4, 2024].
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