Illustrate the SRATC, AVC, MC, and MR curves for a perfectly competitive firm that is operating at a loss. What is the output level that minimizes losses? Why is it more profitable to continue producing in the short run rather than shut down?
The Correct Answer and Explanation is :
In a perfectly competitive market, a firm’s Short-Run Average Total Cost (SRATC), Average Variable Cost (AVC), Marginal Cost (MC), and Marginal Revenue (MR) curves can be plotted to understand its production decisions when operating at a loss.
- SRATC Curve: This curve represents the firm’s total cost per unit of output. It is U-shaped, starting high, sloping downward as output increases due to economies of scale, and then sloping upward due to diseconomies of scale.
- AVC Curve: The Average Variable Cost curve shows the per-unit cost of variable inputs (e.g., labor and materials) as output increases. It is also typically U-shaped.
- MC Curve: The Marginal Cost curve represents the additional cost of producing one more unit of output. It intersects both the SRATC and AVC curves at their minimum points.
- MR Curve: In perfect competition, the Marginal Revenue curve is horizontal at the price level (P), because the firm is a price taker.
Loss-Minimizing Output:
In the short run, a firm will minimize its losses by producing at the output level where the price (P) equals the Marginal Cost (MC) curve. This point is where the firm maximizes its contribution toward fixed costs and minimizes losses. If the price is greater than the average variable cost (P > AVC), the firm continues production to cover some of its fixed costs, even though it is operating at a loss.
Why Continue Producing in the Short Run?
The firm should continue producing in the short run if the price covers its average variable costs (P ≥ AVC). This is because:
- If the firm shuts down, it still incurs its fixed costs, which would lead to greater losses than continuing to produce.
- By continuing to produce, the firm can cover some of its fixed costs and reduce its losses by earning revenue to cover at least part of the variable costs.
If the price falls below AVC, the firm should shut down, as it cannot even cover its variable costs, which would make continuing production more costly than halting.
Let me generate the curves for you now.
The graph above illustrates the cost and revenue curves for a perfectly competitive firm operating at a loss. Here’s an explanation of the key points:
- SRATC Curve (Blue): This curve represents the firm’s average total costs, which include both fixed and variable costs. It is U-shaped, showing the total cost per unit of output.
- AVC Curve (Green): This curve represents the average variable cost. It’s U-shaped and shows the cost per unit of variable inputs.
- MC Curve (Red): The marginal cost curve slopes upwards, reflecting the increasing costs associated with producing more output.
- MR Curve (Purple, Dashed Line): The marginal revenue curve is horizontal, as the firm is a price taker in perfect competition. The price (P) remains constant for all output levels.
The output level where MR = MC (at an output level of around 4 units in this example) minimizes the firm’s losses. This is the point at which the firm covers some of its variable costs and part of its fixed costs.
If the price (MR) were below the AVC, the firm would shut down, as it could not cover its variable costs, and the loss from continuing would be greater than the loss from shutting down. However, as long as the price is above the AVC but below the SRATC, the firm continues to produce to minimize its losses, as it is still covering some variable costs and contributing to fixed costs.
