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SHORT-RUN PRODUCTION ALTERNATIVES:

A firm faces three production options in the short run based on a comparison between price, average total cost, and average variable cost. If price is greater than average total cost, a firm earns an economic profit by producing the quantity that equates marginal revenue with marginal cost. If price is less than average total cost but greater than average variable cost, a firm incurs an economic loss, but produces the quantity that equates marginal revenue with marginal cost. If price is less than average variable cost, a firm shuts down production in the short run, incurring an economic loss equal to total fixed cost.
The short-run production alternatives facing a firm depend on price, average total cost, and average variable cost. If price exceeds average total cost, then a firm generates an economic profit, that is, above normal profit, by producing at the quantity that equates marginal revenue and marginal 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.

Production Alternatives
Price and CostResult
P > ATCProfit Maximization
Produce the quantity that equates MR and MC. Generate positive economic profit.
ATC > P > AVCLoss Minimization
Produce the quantity that equates MR and MC. Incur economic loss less than fixed cost.
P < AVCShutdown
Stop producing in the short run. Incur economic loss equal to fixed cost.
This table presents the three basic production alternatives facing Phil (and other firms for that matter) in the short run. These alternatives can be given the titles: profit maximization, loss minimization, and shutdown.

Profit Maximization

The first alternative listed in the table is profit maximization. The two key criteria are that price is greater than average total cost (P > ATC) and that marginal revenue is equal to marginal cost (MR = MC). Because price (which is also average revenue) is greater than average total cost, total revenue is greater than total cost and Phil earns an economic profit. This economic profit is maximized when Phil's zucchini production equates marginal revenue with marginal cost. Keep in mind that total cost includes a normal profit, meaning that Phil also receives what can be termed above-normal profit.

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

The second alternative listed in the table is loss minimization. The two key criteria are that price is greater than average variable cost but less than average total cost (ATC > P > AVC) and that marginal revenue is equal to marginal cost (MR = MC). Because price (which is also average revenue) is less than average total cost, total revenue is less than total cost and Phil incurs an economic loss.

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

The third alternative listed in the table is shutdown. The key criterion is that price is less than average variable cost (P < AVC). Because price (which is also average revenue) is less than average variable cost, total revenue is not only less than total cost it is also less than total variable cost. As such, not only does Phil incur an economic loss by operating, that loss is greater than total fixed cost. If Phil did not produce any output, that is, shutdown production in the short run, then his economic loss is only total fixed cost.

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
Production Alternatives

Graphical insight into these production alternatives can be had with the exhibit displayed to the right. This graph displays three U-shaped cost curves--average total cost (ATC), average variable cost (AVC), and marginal cost (MC). It also displays the horizontal marginal revenue curve (MR).

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.

<= SHORT RUN, MICROECONOMICSSHORT-RUN PRODUCTION ANALYSIS =>


Recommended Citation:

SHORT-RUN PRODUCTION ALTERNATIVES, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2018. [Accessed: October 16, 2018].


Check Out These Related Terms...

     | perfect competition, profit maximization | perfect competition, breakeven output | perfect competition, loss minimization | perfect competition, short-run supply curve |


Or For A Little Background...

     | perfect competition | perfect competition, characteristics | production | U-shaped cost curves | total cost | average total cost | average variable cost | marginal cost | profit maximization | marginal revenue, perfect competition | efficiency | satisfaction | economic profit | normal profit |


And For Further Study...

     | perfect competition, demand | long run industry supply curve | perfect competition, long-run production analysis | perfect competition, efficiency | perfect competition, total analysis | perfect competition, marginal analysis | perfect competition, profit analysis |


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