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| | Master the above and you will both ace exams and be able to run a successful business. Experienced business managers state that profitability is made by reducing expenses. This has certainly been true for Wal-Mart. It is constantly driving costs down with its suppliers. Remember: a penny saved is a penny earned. Actually, due to taxes, saving a penny is sometimes worth more than a penny earned. | | Master the above and you will both ace exams and be able to run a successful business. Experienced business managers state that profitability is made by reducing expenses. This has certainly been true for Wal-Mart. It is constantly driving costs down with its suppliers. Remember: a penny saved is a penny earned. Actually, due to taxes, saving a penny is sometimes worth more than a penny earned. |
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| − | == Applying Cost Measures to Perfect Competition == | + | == Honors Only: Applying Cost Measures to Perfect Competition == |
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| | When there is perfect competition, what can we learn from the cost measures? By applying logic to the assumption that there is perfect competition, we can learn a great deal. | | When there is perfect competition, what can we learn from the cost measures? By applying logic to the assumption that there is perfect competition, we can learn a great deal. |
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| | ''Answer'': Realize that the question is asking about the short run, so building a new factory or changing fixed costs is not possible. There is not enough time. Instead, the question is asking what can be done as a "quick fix" to the problem. What is the problem? The problem is that the price is LESS than the lowest average variable cost (AVC). Now we know that that a firm is losing money when the price, or marginal revenue, is less than marginal cost. A firm does not want to sell anything at less than marginal cost, because it loses money on it. | | ''Answer'': Realize that the question is asking about the short run, so building a new factory or changing fixed costs is not possible. There is not enough time. Instead, the question is asking what can be done as a "quick fix" to the problem. What is the problem? The problem is that the price is LESS than the lowest average variable cost (AVC). Now we know that that a firm is losing money when the price, or marginal revenue, is less than marginal cost. A firm does not want to sell anything at less than marginal cost, because it loses money on it. |
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| − | But how does marginal cost relate to AVC? There is no direct relation, except when Q=1 they are the same. Ah, but that is the key. Read the question again carefully, which is so important in Economics. The question says that the price (which is marginal revenue (MR)) is less than the MINIMUM AVC, so MR <MC when Q=1. That means the firm loses money on its first unit made, because MR<AVC for all Q that loss on the initial unit is never regained. The firm is best off by completely shutting down. | + | But how does marginal cost relate to AVC? The relationship is tricky. When Q=1, MC=AVC. But that does not solve our problem above. So let's read the question again carefully, which is so important in Economics. The question says that the price (which is marginal revenue (MR)) is less than the MINIMUM AVC. Can we find a way to define MC in terms of AVC for any unit Q? If we can, then we have solved the problem, because we know that MR is always less than AVC for any Q. |
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| | + | MC (for unit Q) equals TC (for unit Q) minus TC (for unit Q-1). In other words, MC is the difference in TC for each successive unit. But fixed cost (FC) does not change for each new unit: |
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| | + | :MC(Q) = TC(Q) - TC(Q-1) = [FC(Q) + TVC(Q)] - [FC(Q-1) + TVC(Q-1)] |
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| | + | The FC subtracts out because FC(Q)=FC(Q-1), and thus |
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| | + | :MC(Q) = TVC(Q) - TVC(Q-1) = AVC(Q)*Q - AVC(Q-1)*(Q-1) |
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| | + | Therefore MC(Q) is LESS THAN AVC(Q). But AVC(Q) is LESS THAN MR as stated in the question! Thus MC is always less than MR |
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| | + | That means the firm loses money on the first unit it makes, because MR<AVC for all Q that loss on the initial unit is never regained. The firm is best off by completely shutting down. |
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| | <continue discussion of other cost measures, and explain above better> | | <continue discussion of other cost measures, and explain above better> |