One of Three Alternatives

• 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 Production

Incurring a Loss

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.

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 Choice

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.