A monopolistically 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
| Production Alternatives | | Price and Cost | Result |
|---|
| P > ATC | Profit Maximization |
| ATC > P > AVC | Loss Minimization |
| P < AVC | Shutdown |
Loss minimization is one of three short-run production alternatives facing a monopolistically competitive firm. All three are displayed in the table to the right. The other two are profit maximization and 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 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.
Deluxe Club Sandwich Production
The marginal approach to analyzing a monopolistically 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 Manny Mustard's House of Sandwich, a hypothetical monopolistically competitive firm that specializes in the production of Deluxe Club Sandwiches, a tasty luncheon meal enjoyed by Shady Valley residents.| Profit and Loss |  |
The three U-shaped cost curves used in this analysis provide all of the information needed on the cost side of the Manny's decision. The demand curve facing the firm (which is also the firm's average revenue curve) and the corresponding marginal revenue curve provide all of the information needed on the revenue side.For the time being, Manny maximizes profit by producing 6 sandwiches and charging a price of $4.95. This profit-maximizing situation depends on the existing demand conditions. Should this demand change, then maximizing a positive profit is not the primary concern of Manny. His decision turns to minimizing loss. Click the [Less Demand] button to illustrate the situation facing Manny 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 5 sandwiches. The price Manny charges for this quantity of production is then $3.15.
The key is that this new, lower price is between the average total cost curve and the average variable cost curve. This means that Manny does not generate enough revenue per sandwich sold (average revenue = $3.15) to cover the cost of producing each sandwich (average total cost = $3.69).
Manny clearly incurs an economic loss on each sandwich produced and sold. In fact, if Manny produces 5 sandwiches, then his total cost is $18.45, but his total revenue is only $15.75. He incurs an economic loss of $2.70, a loss of $0.54 per sandwich produced.
The Short-Run Choice
Perhaps Manny should stop producing. Perhaps he would be better off by NOT selling sandwiches. Unfortunately, Manny is faced with short-run fixed cost. Manny 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, Manny 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 $2.70. If he does not produce, he incurs a loss of $3.
The choice seems relatively obvious: Manny is better off producing 5 sandwiches, incurring an economic loss of $2.70, and hoping for an increase in the price.
Manny continues producing 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 5 sandwiches, he generates $15.75 of total revenue. While this revenue falls short of covering the $18.45 of total cost entirely, it is enough to pay the $15.45 of total variable cost, with an extra $0.30 left over to pay a portion of the $3 total fixed cost. Not much, but more than nothing. This is why the economic loss from production is less than total fixed cost.
Even though Manny has some degree of market control, he is still subject to the whims of the demand-side of the market. This $3.15 sandwiches price generates sufficient total revenue for Manny to pay ALL variable cost and some fixed cost. However, should this demand drop, then Manny would have to reevaluate its production decision. If the demand declines enough, Manny will be forced to shut down production in the short run.
MONOPOLISTIC COMPETITION, LOSS MINIMIZATION, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2024. [Accessed: April 26, 2024].
