Minimizing Losses in the Short Run

With the market price at $1,800 we’re in clover. But suppose consumer demand for stereo hi-fl sets nose-dives, and the market price falls to $1,100. A quick look at Table 23-3 shows that we’re going to lose money at this price, no matter what we do. The lowest total cost/unit at which we can produce is $1,200, at an output of five units.

What should we do to minimize our losses? One possibility would be to shut down. This way we’d lose $1,000 a month, the amount of our fixed costs, which continue whether we operate or not. But if we operate, producing three, four, or five units, we’ll be getting $1,100 per set produced and only having to spend $1,000 per set in variable (out-of-pocket) costs. This income will provide $100 per set left over to apply on our $1,000 of fixed costs, which we have to pay in any case. So we’d better operate, even though we lose money. By operating, we lose less than by shutting down altogether.

If the marginal-cost—marginal-revenue prin- ciple is a sound one, it ought to tell us now how many units to produce again this time. And it does. The answer is five. Producing every unit up to and including the fifth adds more to revenue than it does to costs. Marginal revenue for the fifth unit is $1,100; marginal cost is only $1,000. But marginal cost for the sixth set is $1,600, above marginal revenue. Our total loss at a five-set pro- duction rate figures out at $500 ($6,000 total cost less $5,500 total revenue), or only half the loss involved in shutting down completely. The prin- ciple for minimizing loss is the same as for maxi- mizing profit: If you operate at all, carry produc- tion up to the point where nwrginal costs equal marginal revenue, and no further. Compute the loss at any other level of output, and you’ll see that the rule is right.

The Decision To Shut Down in the Short Run

Would it ever pay us to shut down in the short run? Obviously yes. If price falls below $1,000, which is the lowest variable unit cost we can manage at any output level, we’d better close up shop. Suppose price is $900. No matter how many units we produce, our income is not even enough to cover our variable costs, much less pro- vide anything to help cover the $1,000 of fixed costs. Suppose we produce three units. They will cost $4,000 but will bring in only $2,700, leaving a loss of $1,300 compared with only $1,000 if we just shut down. At any price below the lowest variable-cost/unit point, we will minimize losses by shutting down altogether. This rule doesn’t con- tradict the marginal-cost—marginal-revenue prin- ciple for maximizing profits, since that principle tells us only what to do if we operate at all.

Grophicol Analysis of Short-run Behavior

This analysis can readily be put in graphical form. The cost curves in Fig. 23-2 are plotted from Table 23-3, and are the same as in Fig. 22-2 except for the addition of the marginal-cost curve. The marginal-cost curve, of course, shows the in- crement to total cost involved in increasing out- put by one unit at each stage. For example, the marginal cost involved in stepping up output from four to five units is $1,000; in going from five units to six it is $1,600.

FIG. 23-2 Profit is maximized by carrying production up to intersec-
tion of marginal-cost and marginal- revenue curves—if you operate at
all. Horizontal price lines also show marginal revenue at each price.

Three horizontal lines, AA, BB, and CC, have been added to show the market prices of $1,800, $1,100, and $900, respectively. These lines are the demand curves as seen by our firm when those are the prevailing market prices. The lines are also, of course, our marginal-revenue curves at the respective prices, since sale of one more hi-fl set adds just its price to our total revenue. With this graph, we can readily determine the maximum-profit or minimum-loss output for any given market price. The principle is the same as before: It will pay to increase output so long as marginal revenue is above marginal cost, if we  operate at all. We will minimize losses by shutting down completely if price falls below our lowest variable cost per unit.

Suppose the market price is $1,800 (line AA). At that price the marginal cost curve is still below marginal revenue (price) at six units, but above it at seven. We can tell by looking at the graph, therefore, that six units is the most profit- able level of output. Since the $1,800 price line is above the total-unit-cost curve at this point, we can also tell that this is a profitable situation. The actual profit can be computed by multiplying the profit per unit ($533) by six units, giving the same $3,200 profit we got by tabular computation. Similarly, with price at $1,100 (line BB), five units is the output that will minimize loss. Up to five units the marginal-cost curve is below the marginal-revenue (price) curve; at six units, it is above it.

And a quick glance at the $900 price situa- tion will tell us to close down immediately. The $900 price line (CC) is everywhere below the variable-unit-cost curve. At $900 we can’t even get enough revenue to cover variable costs, let alone accumulate anything to apply on fixed costs. If you can’t cover variable costs, it is better to shut down and minimize your loss by just paying the fixed cost of $1,000.

For a quick answer to the most profitable levels of output, the graphical approach has real advantages. For computing exact profit-and-loss figures, tabular data are often more satisfactory. But the answers are the same either way.

SHORT-RUN EQUILIBRIUM OF THE FIRM

When will the business firm be in short-run equilibrium? When it is maximizing its profit or minimizes its loss, given consumer demand and given its fixed costs which it cannot alter in the short run. It will then be in short-run equilibrium when it is producing just up to the point ‘where marginal cost is equal to marginal revenue (price). Only at that output is it maximizing its profit.

This concept of the equilThrium of the firm parallels the concept of the equilibrium of the household (or consumer) developed in Chapter 20. Both tell us the situation toward which an economic unit will move in trying to improve its economic position. In a real world of constant change, we would seldom expect to find firms actually in equilibrium for long. But whenever a household or firm is out of equilibrium, we can expect that economic unit to spend more or less, or produce more or less, so as to approach more closely its desired goal, be it maximum utility from spendable income for the household or maximum profit for the firm.

“Equilibrium” is thus an analytical concept. It is a position that would be achieved if the household or firm were free to adjust to the con- ditions specified, and if all other forces in the economy (the “givens”) remained unchanged until the new equilibrium was reached.

Note that this chapter is only about the short-run equilibrium toward which the firm will move under the conditions assumed. The firm may be in short-run equilibrium when it is making a large profit, no profit at all, or even a loss, de- pending on its costs and the price given by the market. But, as we shall see in Chapter 24, the short-run equilibrium may not last in the long run. Long-run and short-run equilibrium may be different.

For example, if the firm’s best short-run posi- tion unfortunately yields a loss (as with price B in Fig. 23-2), it is clear that the firm will go out of business in the long run to avoid incurring a continuing loss. If the firm is making a large profit (as with price A in Fig. 23-2), it is clear this will provide an incentive for new firms to move into the industry to make big profits too. If more firms do move in, we would expect the increased supply to push down the price and erode the short-run profit position of our firm. Remember: Short-run and long-run equilibrium positions may be differ- ent.