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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? 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. | + | 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. That means that MR is ALWAYS less than AVC, for all output 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:
| + | So let's compare the profit or loss of the firm at two points: when Q=0 (and thus AVC=0), and when Q>0 (and, as stated in the question, P<AVC, and thus MR<AVC). The firm is losing money for every Q>0, because it is spending more on AVC than it is bringing in as price or marginal revenue. The firm can reduce its loss by making Q=0. In other words, the firm is better off by completely shutting down. |
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| − | :MC(Q) = TC(Q) - TC(Q-1) = [FC(Q) + TVC(Q)] - [FC(Q-1) + TVC(Q-1)] | + | ''Question'': What is the firm's profit or loss when Q=0 in this problem? This is an honors homework problem. |
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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>
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| | == Obstacles to Reducing Costs == | | == Obstacles to Reducing Costs == |