Suppose the fixed cost of production is $350 and the price is $55, complete the table.
Table 1. Different Costs of Production, Revenue and Profit/Loss for the Various Levels of the Output for a Perfectly Competitive Firm.
The average variable costs are the costs for the unit of the output. To calculate the average variable costs, it is necessary to find the variable costs first. As the total costs are already given in Table 1 and the fixed costs are $350, the variable costs can be calculated with the help of the following formula:
Variable Costs = Total Costs – Fixed Costs.
The received result for the various levels of the output is given in column 4 of Table 1. Now it is possible to calculate the average variable costs with the following formula:
Average Variable Costs = Variable Costs/Quantity (Carnrite, n.d., para. 2).
The result can be found in column 5 of Table 1. One can see, that the average variable costs of the perfectly competitive firm almost do not change in the certain range of the output (from 2 to 4 units), but then start growing significantly as the output grows.
The total revenue of the firm depends on its output and the market price of the product. As the market price is $55, one can use the following formula to calculate the total revenue:
Total Revenue = Price*Quantity (Hill, n.d., para. 2-3).
The received result can be seen in column 6 of Table 1.
Suppose you are producing 2 units of the output, if you want to produce one extra unit of the output, what would be the marginal cost?
Every firm takes an interest in what the costs will be if the output is extended. The marginal costs show the additional costs for each extra unit of the output and can be calculated with the following formula:
Marginal Costs = Δ Total Costs/Δ Quantity (Grimsley, n.d., para. 2-5).
The calculated result for each level of the given product’s volume is in column 7 of Table 1. Therefore, if the firm increases the output from 2 units to 3 units, the marginal costs will comprise $40. Moreover, it is important to notice, that the marginal costs do not depend on the fixed costs but depend on the variable cost’s changes. From Table 1, one can see that after their minimal value at the output of 2 units, the marginal costs increase as the variable costs increase.
If the market price is given as $55, how much output will the perfectly competitive firm produce to maximize profits?
The perfectly competitive firm cannot influence the current price, as the price is determined by the market due to the interaction of the supply and the demand. Therefore, the firm is only the price-taker. In such conditions, the only possible way to maximize profits is to regulate the output. The task of the firm is to estimate the optimal level of the output, which will ensure the maximization of the profits (or the minimization of the losses) (Pettinger, 2011, para. 8-9).
The maximal profit can be achieved, when the marginal revenue is equal to the marginal costs. On the perfectly competitive market, the marginal revenue is equal to the price. Therefore, the only possible condition for the perfectly competitive firm to maximize its profit is to define the level of the output when the price is equal to the marginal costs:
Price = Marginal Costs (Lee, n.d., para. 7).
As the market price is $55, and from column 7 of Table 1 one can see that the marginal costs are $55 at the output of 5 units, the conclusion is that the perfectly competitive firm has to produce 5 units to maximize profits. Furthermore, the increase of the output by one extra unit will reduce the firm’s profits.
Calculate the profit or loss.
To calculate the profit/loss of the perfectly competitive firm, one can use the following formula:
Profit/Loss = Total Revenue – Total Costs.
The received result is in column 8 of Table 1. Therefore, one can see that in the short-term perspective the perfectly competitive firm suffers losses. The loss can be minimized at the level of production of 5 units (-$285), that confirms the calculations in the previous task.
Should the firm always shut down in the short run when it experiences a loss?
The perfectly competitive firm can face the situation when the current market price in the short run does not bring the positive economic effect. And the firm cannot increase the current price, as the price is determined by the perfectly competitive market. Therefore, the firm has two possible ways: either to continue the unprofitable production process or to suspend its activity. However, the latter choice will mean, that the firm will suffer the loss of the fixed costs (-$350).
The decision of the firm should be taken pursuant to the firm’s average variable costs and the current market price. If the firm decides to shut down, its total revenue decreases to zero, and the loss will equal to the fixed costs. Therefore, while the price is higher than the average variable costs, the firm should continue its business activity. In this case, the received revenue will allow defraying the variable expenses and some part of the fixed costs, and the loss will be lower, than after the shutdown.
If the price equals to the average variable costs, it is all the same for the firm, either shut down or continue the production. Nevertheless, the firm is most likely to continue its business activity in order not to lose its customers and to ensure the work for the employees. The loss will not be higher, than after the shutdown.
And finally, if the price is lower than the average variable costs, the firm should shut down in order to avoid the unnecessary losses (Short-Run Supply, n.d., para. 9-10).
So, when the firm experiences a loss in the short run, it is not always necessary to shut down. There can be different scenarios. From Table 1 one can see that the current market price is higher than the average variable costs for each level of the output, therefore our perfectly competitive firm should continue its business activity and production process.
Reference List
Carnrite, J. (n.d.). Average Variable Cost (AVC): Definition, Function & Equation. Web.
Grimsley, S. (n.d.). Marginal Cost: Definition, Equation & Formula. Web.
Hill, A. (n.d.). Total Revenue in Economics: Definition & Formula. Web.
Lee, J. (n.d.). Firms in Perfectly Competitive Markets. Web.
Pettinger, T. (2011). Profit Maximization. Web.
Short-Run Supply. (n.d.). Web.