Chapter 23: Problem 3

Why might a firm continue to produce in the short run even though the market price is less than its avcrage total cost?

Short Answer

Expert verified

Answer: A firm might continue to produce in the short run even though the market price is less than its average total cost because it can still cover its variable costs, contributing towards fixed costs, which cannot be avoided in the short run. This helps the firm to limit its loss to some extent. However, if the market price falls below the average variable cost, the firm would then consider shutting down production since it would not be able to cover its variable costs.

Step by step solution

1. Define Average Total Cost and Marginal Cost

Average total cost (ATC) is the total cost of production divided by the quantity of output produced. This cost includes both fixed costs (costs that do not change with output quantity) and variable costs (costs that do change with output quantity). Mathematically, average total cost can be calculated as: ATC = (Total Cost) / (Quantity of Output) Marginal cost (MC) is the additional cost incurred to produce one more unit of output. In other words, it is the increase in the total cost when the output is increased by one unit. Mathematically, marginal cost can be calculated as: MC = Δ(Total Cost) / Δ(Quantity of Output)

2. Variable Costs and Fixed Costs

Variable costs are the costs that change with the output quantity, such as raw materials, labor expenses, and electricity consumed in the production process. Fixed costs are the costs that do not change with the output quantity, such as rent, salaries, and insurance premiums. In the short run, fixed costs cannot be avoided; they must be paid whether a firm produces output or not.

3. Relationship between Marginal Cost and Market Price

A firm produces goods as long as the marginal cost of production is less than or equal to the market price, as it will generate revenue that can cover the variable costs and contribute towards the fixed costs. If the marginal cost is greater than the market price, the firm is not generating enough revenue to cover its variable costs, and it would need to shut down or reduce output.

4. The Shutdown Decision

A firm makes the shutdown decision when the market price is less than the average variable cost. If the market price is above the average variable cost but less than the average total cost, the firm will continue to produce in the short run, as it can cover its variable costs and contribute towards fixed costs, limiting the loss to some extent.

5. Conclusion

A firm might continue to produce in the short run even though the market price is less than its average total cost because it can still cover its variable costs, and by producing, it contributes towards fixed costs, which cannot be avoided in the short run. This helps the firm to limit its loss to some extent. However, if the market price falls below the average variable cost, the firm would then consider shutting down production since it would not be able to cover its variable costs.