A Competitive Firm Incurring Losses:Industry Supply in Short Run

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Microeconomics ECO402

Lesson 23

A Competitive Firm Incurring Losses

Price

($ per

unit)

At q : MR = MC

and P < ATC

Losses = P- AC) x q

or ABCD

Would this producer

continue to produce

with a loss?

Output

Choosing Output in Short Run

Summary of Production Decisions

Profit is maximized when MC = MR

If P > ATC the firm is making profits.

If AVC < P < ATC the firm should produce at a loss.

If P < AVC < ATC the firm should shut-down.

The Short-Run Output of an Aluminum Smelting Plant

Cost

Observations

·Price between $1140 & $1300: q

(dollars per item)

= 600

·Price > $1300: q = 900

1400

·Price < $1140: q = 0

1300

1200

Question

1140

Should the firm stay in business

when P < $1140?

1100

Output

(tons per day)

300

600

900

Some Cost Considerations for Managers

Three guidelines for estimating marginal cost:

117

Microeconomics ECO402

1) Average variable cost should not be used as a substitute for marginal cost.

2) A single item on a firm's accounting ledger may have two components, only one of

which involves marginal cost.

3) All opportunity cost should be included in determining marginal cost.

A Competitive Firm's Short-Run Supply Curve

Price

($ per

The firm chooses the output level

unit)

where MR = MC, as long as the firm

is able to cover its variable cost of

production.

ATC

AVC

What happens

P = AVC

if P < AVC?

Output

Observations:

P = MR

MR = MC

P = MC

Supply is the amount of output for every possible price. Therefore:

If P = P1, then q = q1

If P = P2, then q = q2

Price

S = MC above AVC

($ per

unit)

ATC

AVC

P = AVC

Shut-down

Output

Observations:

Supply is upward sloping due to diminishing returns.

Higher price compensates the firm for higher cost of additional output and increases

total profit because it applies to all units.

Firm's Response to an Input Price Change

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Microeconomics ECO402

When the price of a firm's product changes, the firm changes its output level, so that the

marginal cost of production remains equal to the price.

Price

MC2

($ per

Input cost

unit)

Savings to the firm

increases

from reducing output

MC1 and MC shifts to

MC2

and q falls to q2.

Output

The Short-Run Production of Petroleum Products

The MC of producing a mix

Cost 27

SMC

of petroleum products from

($ per

crude oil increases sharply at

barrel)

several levels of output as

How much would

the refinery shifts from one

be produced if

processing unit to another.

P = $23?

P = $24-$25?

Output

(barrels/day)

8,000

9,000

10,000

11,000

Stepped SMC indicates a different production (cost) process at various capacity levels.

Observation:

With a stepped MC function, small changes in price may not trigger a change in output.

The short-run market supply curve shows the amount of output that the industry will

produce in the short-run for every possible price.

Consider, for simplicity, a competitive market with three firms:

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Microeconomics ECO402

Industry Supply in Short Run

The short-run

$ per

MC1

MC2

MC3

industry supply curve

unit

is the horizontal

summation of the supply

curves of the firms.

Question: If increasing

output raises input

costs, what impact

would it have on

market supply?

Quantity 21

4 5

7 8

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