You are here

Producing to Minimize Economic Loss

25 April, 2016 - 09:12

Suppose the demand for radishes falls to D2, as shown in Panel (a) of Figure 9.7. The market price for radishes plunges to $0.18 per pound, which is below average total cost. Consequently Mr. Gortari experiences negative economic profits—a loss. Although the new market price falls short of average total cost, it still exceeds average variable cost, shown in Panel (b) as AVC. Therefore, Mr. Gortari should continue to produce an output at which marginal cost equals marginal revenue. These curves (labeled MC and MR2) intersect in Panel (b) at an output of 4,444 pounds of radishes per month.

media/image148.png
Figure 9.7 Suffering Economic Losses in the Short Run
 

Tony Gortari experiences a loss when price drops below ATC, as it does in Panel (b) as a result of a reduction in demand. If price is above AVC, however, he can minimize his losses by producing where MC equals MR2. Here, that occurs at an output of 4,444 pounds of radishes per month. The price is $0.18 per pound, and average total cost is $0.23 per pound. He loses $0.05 per pound, or $222.20 per month.

When producing 4,444 pounds of radishes per month, Mr. Gortari faces an average total cost of $0.23 per pound. At a price of $0.18 per pound, he loses a nickel on each pound produced. Total economic losses at an output of 4,444 pounds per month are thus $222.20 per month (=4,444×$0.05).

No producer likes a loss (that is, negative economic profit), but the loss solution shown in Figure 9.8 is the best Mr. Gortari can attain. Any level of production other than the one at which marginal cost equals marginal revenue would produce even greater losses.

Suppose Mr. Gortari were to shut down and produce no radishes. Ceasing production would reduce variable costs to zero, but he would still face fixed costs of $400 per month (recall that $400 was the vertical intercept of the total cost curve in Figure 9.6). By shutting down, Mr. Gortari would lose $400 per month. By continuing to produce, he loses only $222.20.

Mr. Gortari is better off producing where marginal cost equals marginal revenue because at that output price exceeds average variable cost. Average variable cost is $0.14 per pound, so by continuing to produce he covers his variable costs, with $0.04 per pound left over to apply to fixed costs. Whenever price is greater than average variable cost, the firm maximizes economic profit (or minimizes economic loss) by producing the output level at which marginal revenue and marginal cost curves intersect.