Define PC: a type of market structure where there are infinite number of buyers and sellers who sell homogeneous product.
- two cases exist where a firm might shut down: in the short run and the long run
- in the long run, firms will shut down when they make subnormal profits, which is when the total costs are greater than total revenue. In the long run, because all factors of production are variable and there are no barriers to exit, firms are free to exit the market if they make losses. In the short run, such FOP might be fixed and the firms cannot leave. For instance, a rent contract of 1 year suggests that firms are free to leave only after 1 year.
- (2 diagrams: one showing supply and demand diagram with price, another showing the firm’s AC being higher than MC at the point where MC = MR)
- label diagram and explain because AC is higher than MC the area of total costs is bigger than total revenue, resulting in a loss. Ie firms will shut down since they are free to leave the market with no fixed FOP
- in the short run, firms will shut down when their average revenue cannot cover the average variable costs. This is because in the short run, the maximum losses that should be made is the fixed costs,
- in the short run there is at least one fixed variable, which is the fixed costs that the firms have to pay
- when average revenue is smaller than average variable costs, the firms make more losses than the maximum losses (which should just be the fixed costs)
Pricing and output decisions of firms refer to the revenue and quantity in theory of costs.
A firm might shut down if it meets the shutdown condition. Economically, this point refers to the case where the average revenue is not able to cover for at least the variable cost in a firm’s production (ie AR<= AVC).
In this case, because a firm’s total cost is made up fixed and variable cost, where fixed cost is the cost that cannot be changed in the short run, a firm’s maximum cost should be incurred due to the fixed cost only (since it cannot reduce or remove this cost in the near term). Hence, if a firm’s revenue does not cover for variable cost at least, it is incurring, on top of fixed cost, a short run variable cost, that could have been reduced or removed even if it shuts down and simply doesn’t do any operations.
For instance, if a firm’s average revenue is 1, but average variable cost is 2, then it loses an additional 1 for every unit sold/produced, in addition to fixed cost of X. So the firm would be better off shutting down and just incurring fixed cost in short run, ie the maximum cost is constrained to fixed cost.
Costs affect a firm’s pricing and output because a firm’s AR must definitely be set higher than at least the AVC, it need not be covering the entire ATC. In the short run, it could be below the ATC, signifiying that the firm is making an abnormal loss, but he should still continue with the business, because by doing so, he is reducing the loss incurred from fixed cost.