# THE FIRM S PRODUCTION DECISIONS

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1 10 THE FIRM S PRODUCTION DECISIONS LEARNING OBJECTIVES In this chapter you will: Revisit the meaning of competition and a competitive market Look at the conditions under which a competitive firm will shut down temporarily Examine the conditions under which a firm will choose to exit a market See why sunk costs can be ignored in production decisions Cover the difference between normal and abnormal profit and how making normal or zero profit still means it is worth continuing in production See how the supply curve for a competitive firm is derived in the short run and the long run Cover the difference in the equilibrium position of a competitive firm in the short run and the long run After reading this chapter you should be able to: State the assumptions of the model of a highly competitive firm Calculate and draw cost and revenue curves and show the profit-maximizing output Show, using diagrams and basic maths, the conditions under which a firm will shut down temporarily and exit the market in the long run Explain the difference between normal and abnormal profit Explain why a firm will continue in production even if it makes zero profit Use diagrams to explain the short- and long-run equilibrium position for a firm in a highly competitive market 237

4 240 Part 4 Microeconomics The Economics of Firms in Markets FIGURE 10.1 Profit Maximization for a Competitive Firm This figure shows the marginal cost curve (), the average total cost curve () and the average variable cost curve (AVC). It also shows the market price (P), which equals marginal revenue (MR) and average revenue (AR). At the quantity Q 1, marginal revenue MR 1 exceeds marginal cost 1, so raising production increases profit. At the quantity Q 2 marginal cost 2 is above marginal revenue MR 2, so reducing production increases profit. The profit-maximizing quantity Q MAX is found where the horizontal price line intersects the marginal cost curve. Costs and revenue 2 P 5 MR 1 5 MR 2 The firm maximizes profit by producing the quantity at which marginal cost equals marginal revenue. P 5 AR 5 MR AVC 1 0 Q 1 Q MAX Q 2 Quantity FIGURE 10.2 Marginal Cost as the Competitive Firm s Supply Curve (1) An increase in the price from P 1 to P 2 leads to an increase in the firm s profit-maximizing quantity from Q 1 to Q 2. Because the marginal cost curve shows the quantity supplied by the firm at any given price, it is the firm s supply curve. P 2 P 1 AVC 0 Q 1 Q 2 Quantity Figure 10.2 shows how a competitive firm responds to an increase in the price which may have been caused by a change in global market conditions. Remember that competitive firms are price takers and have to accept the market price for their product. s of commodities such as grain, metals, sugar, cotton, coffee, pork bellies, oil and so on are set by organized international markets and so the individual firm has no power to influence price. When the price is P 1, the firm produces quantity Q 1,the

5 Chapter 10 The Firm s Production Decisions 241 FIGURE 10.3 Marginal Cost as the Competitive Firm s Supply Curve (2) A fall in the price from P 1 to P 2 leads to a decrease in the firm s profit-maximizing quantity from Q 1 to Q 2. The marginal cost curve shows the quantity supplied by the firm at any given price. P 1 P 2 0 Q 2 Q 1 Quantity quantity that equates marginal cost to the price (which remember is the same as marginal revenue). Assume that an outbreak of tuberculosis results in the need to slaughter a large proportion of dairy cattle and as a result there is a shortage of milk on the market. When the price rises to P 2, the individual firm finds that marginal revenue is now higher than marginal cost at the previous level of output, so the firm will seek to increase production (assuming it is not one of the firms whose dairy herd has been wiped out). The new profit-maximizing quantity is Q 2, at which marginal cost equals the new higher price. In essence, because the firm s marginal cost curve determines the quantity of the good the firm is willing to supply at any price, it is the competitive firm s supply curve. A similar, but reversed, situation would occur if the price fell for some reason as shown in Figure In this situation, the firm would find that at the initial equilibrium output level, Q 1, marginal cost would be greater than marginal revenue with a new price of P 2 and so the firm would look to cut back production to the new profit-maximizing output level Q 2. The Firm s Short-Run Decision to Shut Down Clearly, in reality, the profit-maximizing output might be hard to identify because it relies on the firm being able to identify all its costs and revenues accurately over a period of time and to have the capacity to expand and contract quickly in response to changing market conditions. We also know that firms make losses sometimes very big losses. If we assume that a firm exists to make a profit do we conclude that if it makes a loss it will shut down its operations? This is obviously not the case in some situations although at some point a decision to cease operating will be taken. How does the firm make that sort of decision? We can distinguish between a temporary shutdown of a firm and the permanent exit of a firm from the market. A shutdown refers to a short-run decision not to produce anything during a specific period of time because of current market conditions. This was the case with some firms in the automotive industry during the aftermath of the financial crisis in A number of firms decided to suspend production for varying periods of time while the market recovered and stocks were reduced.

6 242 Part 4 Microeconomics The Economics of Firms in Markets The decision to shut down a firm affects large numbers of people, not just employees who may lose their jobs, and can be a lengthy process and a costly decision to make. ANDREW ASHWIN This is different to a complete cessation of operations referred to as exit. Exit is a long-run decision to leave the market. The short-run and long-run decisions differ because most firms cannot avoid their fixed costs in the short run but can do so in the long run. A firm that shuts down temporarily still has to pay its fixed costs, whereas a firm that exits the market saves both its fixed and its variable costs. For example, consider the production decision that an oil producer faces. The cost of the land, and the capital equipment to drill and process oil, form part of the producer s fixed costs. If the firm decides to suspend the supply of oil for two months, the cost of the land and capital cannot be recovered. When making the short-run decision whether to shut down production for a period, the fixed cost of land and capital is said to be a sunk cost. By contrast, if the oil producer decides to leave the industry altogether, it can sell the land and some of the capital equipment. When making the long-run decision whether to exit the market, the cost of land and capital is not sunk. (We return to the issue of sunk costs shortly.) Now let s consider what determines a firm s shutdown decision in the short run. If the firm shuts down, it loses all revenue from the sale of the products it is not now producing and which could be sold. At the same time, it does not have to pay the variable costs of making its product (but must still pay the fixed costs). Common sense would tell us that a firm shuts down if the revenue that it would get from producing is less than its variable costs of production; it is simply not worth producing a product which costs more to produce than the revenue generated by its sale. Doing so would reduce profit or make any existing losses even greater. A little bit of mathematics can make this shutdown criterion more useful. If TR stands for total revenue and VC stands for variable costs, then the firm s decision can be written as: Shut down if TR < VC The firm shuts down if total revenue is less than variable cost. By dividing both sides of this inequality by the quantity Q, we can write it as: Shut down if TR/Q < VC/Q Notice that this can be further simplified. TR/Q is total revenue divided by quantity, which is average revenue (AR). For a competitive firm average revenue is simply the good s price P. Similarly, VC/Q is average variable cost AVC. Therefore, the firm s shutdown criterion is: Shut down if P < AVC That is, a firm chooses to shut down if the price of the good is less than the average variable cost of production. This is our common sense interpretation: when choosing to produce, the firm compares the price it receives for the typical unit to the average variable cost that it must incur to produce the typical unit. If the price doesn t cover the average variable cost, the firm is better off stopping production altogether. The firm can reopen in the future if conditions change so that price exceeds average variable cost.? what if the price the firm received was equal to AVC in the long run would the firm still be able to continue in production indefinitely? We now have a full description of a competitive firm s profit-maximizing strategy. If the firm produces anything, it produces the quantity at which marginal cost equals the price of the good. Yet if the price is less than average variable cost at that quantity, the firm is better off shutting down and not producing anything. These results are illustrated in Figure The competitive firm s short-run supply curve is the portion of its marginal cost curve that lies above average variable cost.

7 Chapter 10 The Firm s Production Decisions 243 FIGURE 10.4 The Competitive Firm s Short-Run Supply Curve In the short run, the competitive firm s supply curve is its marginal cost curve () above average variable cost (AVC). If the price falls below average variable cost, the firm is better off shutting down. Costs Firm s short-run supply curve AVC Firm shuts down if P, AVC 0 Quantity Sunk Costs Economists say that a cost is a sunk cost when it has already been committed and cannot be recovered. In a sense, a sunk cost is the opposite of an opportunity cost: an opportunity cost is what you have to give up if you choose to do one thing instead of another, whereas a sunk cost cannot be avoided, regardless of the choices you make. Because nothing can be done about sunk costs, you can ignore them when making decisions about various aspects of life, including business strategy. Our analysis of the firm s shutdown decision is one example of the importance of recognizing sunk costs. We assume that the firm cannot recover its fixed costs by temporarily stopping production. As a result, the firm s fixed costs are sunk in the short run, and the firm can safely ignore these costs when deciding how much to produce. The firm s short-run supply curve is the part of the marginal cost curve that lies above average variable cost, and the size of the fixed cost does not matter for this supply decision. sunk cost a cost that has already been committed and cannot be recovered The Firm s Long-Run Decision to Exit or Enter a Market The firm s long-run decision to exit the market is similar to its short-run decision in some respects. If the firm exits, it again will lose all revenue from the sale of its product, but now it saves on both fixed and variable costs of production. Thus, the firm exits the market if the revenue it would get from producing is less than its total costs. We can again make this criterion more useful by writing it mathematically. If TR stands for total revenue and TC stands for total cost, then the firm s criterion can be written as: Exit if TR < TC The firm exits if total revenue is less than total cost in the long run. By dividing both sides of this inequality by quantity Q, we can write it as: Exit if TR/Q < TC/Q We can simplify this further by noting that TR/Q is average revenue, which, of course for a competitive firm is the same as the price P, and that TC/Q is average total cost. Therefore, the firm s exit criterion is: Exit if P < That is, a firm chooses to exit if the price of the good is less than the average total cost of production.

8 244 Part 4 Microeconomics The Economics of Firms in Markets FIGURE 10.5 The Competitive Firm s Long-Run Supply Curve In the long run, the competitive firm s supply curve is its marginal cost curve () above average total cost (). If the price falls below average total cost, the firm is better off exiting the market. Costs Firm s long-run supply curve Firm exits if P, 0 Quantity One of the financial objectives for new firms starting up is to make profit. The entry criterion where some profit will be made is: Enter if P > The criterion for entry is exactly the opposite of the criterion for exit. We can now describe a competitive firm s long-run profit-maximizing strategy. If the firm is in the market, it aims to produce at the quantity at which marginal cost equals the price of the good. Yet if the price is less than average total cost at that quantity, the firm chooses to exit (or not enter) the market. These results are illustrated in Figure The competitive firm s long-run supply curve is the portion of its marginal cost curve that lies above average total cost. CASE STUDY Production Shutdowns Potash Corp, based in Saskatchewan, Canada, produces fertilizers for agriculture. It supplies around 20 per cent of the world s supply of potash, a key element in crop nutrients. Given its size, Potash Corp cannot be described as a highly competitive firm but it still faces many of the issues that firms in our model face. Demand for the firm s products is dependent on the state of the agriculture industry. The more acres of land that are farmed the higher the demand for fertilizers like potash and so the more incentive there is for Potash Corp to supply the market. However, if demand for its products falls then GETTY IMAGES By shutting down temporarily, Potash Corp will not have to pay the variable costs of operating machinery and mining potash given that sluggish demand for potash means prices may be lower than the variable costs of production.

9 Chapter 10 The Firm s Production Decisions 245 the company has to make decisions about production levels. In February 2012, the company announced a decision to temporarily shutdown production at one of its plants in Saskatchewan for four weeks. This decision followed temporary shutdowns in two other plants in Canada, one for 6 weeks which started in late December 2011 and the other from January 2012 for 8 weeks. The reason for the announcements was that demand for potash had slowed, partly due to the global economic position. Buyers were not replenishing stocks at a rate which made it viable to continue production and so the company moved to reduce supply until demand began to pick up. Potash Corp executives suggested that demand was expected to pick up in the northern hemisphere spring due to relatively high prices of crops and decisions by farmers to plant more acres as a result to take advantage of the higher crop prices. Annual production at the firm s Allan mine would be reduced by between to metric tonnes; according to reports, around 1.6 per cent of the firm s total annual production of potash. Potash Corp noted that workers at the plants would not be laid off, however, but instead would be deployed to other work within the company during the shutdown period. Measuring Profit in Our Graph for the Competitive Firm As we analyze exit and entry, it is useful to be able to analyze the firm s profit in more detail. Recall that profit (π) equals total revenue (TR) minus total cost (TC): π ¼ TR TC We can rewrite this definition by multiplying and dividing the right-hand side by Q: π ¼ððTR=qÞ ðtc=qþþ q But note that TR/Q is average revenue, which is the price P, and TC/Q is average total cost. Therefore: π =(P ) Q This way of expressing the firm s profit allows us to measure profit in our graphs. Panel (a) of Figure 10.6 shows a firm earning positive profit. As we have already discussed, the firm maximizes profit by producing the quantity at which price equals FIGURE 10.6 Profit as the Area Between and Average Total Cost The area of the shaded box between price and average total cost represents the firm s profit. The height of this box is price minus average total cost (P ), and the width of the box is the quantity of output (Q). In panel (a), price is above average total cost, so the firm has positive profit. In panel (b), price is less than average total cost, so the firm has losses. (a) A firm with profits (b) A firm with losses Profit P P 5 AR 5 MR P P 5 AR 5 MR Loss 0 Q (profit-maximizing quantity) Quantity 0 Q (loss-minimizing quantity) Quantity

11 Chapter 10 The Firm s Production Decisions 247 FIGURE 10.7 Market Supply with a Fixed Number of Firms When the number of firms in the market is fixed, the market supply curve, shown in panel (b), reflects the individual firms marginal cost curves, shown in panel (a). Here, in a market of 1000 firms, the quantity of output supplied to the market is 1000 times the quantity supplied by each firm. (a) Individual firm supply (b) Market supply Supply Quantity (firm) Quantity (market) the number of firms, decrease the quantity of the good supplied, and drive up prices and profits. At the end of this process of entry and exit, firms that remain in the market must be making zero economic profit. Pitfall Prevention When talking about zero economic profit, it is important to remember the distinction between economic profit and accounting profit introduced in Chapter 9. When an economist talks of zero profit they are referring to economic profit. Recall that we can write a firm s profits as: Profit ¼ (P ) Q This equation shows that an operating firm has zero profit if and only if the price of the good equals the average total cost of producing that good. If price is above average total cost, profit is positive, which encourages new firms to enter. If price is less than average total cost, profit is negative, which encourages some firms to exit. The process of entry and exit ends only when price and average total cost are driven to equality. This analysis has a surprising implication. We noted earlier in the chapter that competitive firms produce so that price equals marginal cost. We just noted that free entry and exit forces price to equal average total cost. But if price is to equal both marginal cost and average total cost, these two measures of cost must equal each other. Marginal cost and average total cost are equal, however, only when the firm is operating at the minimum of average total cost. Recall from Chapter 9 that the level of production with lowest average total cost is called the firm s efficient scale. Therefore, the long-run equilibrium of a competitive market with free entry and exit must have firms operating at their efficient scale. Panel (a) of Figure 10.8 shows a firm in such a long-run equilibrium. In this figure, price P equals marginal cost, so the firm is profit-maximizing. also equals average total cost, so profits are zero. New firms have no incentive to enter the market, and existing firms have no incentive to leave the market. From this analysis of firm behaviour, we can determine the long-run supply curve for the market. In a market with free entry and exit, there is only one price consistent with zero profit the minimum of average total cost. As a result, the long-run market supply curve must be horizontal at this price, as in panel (b) of Figure Any price above

13 Chapter 10 The Firm s Production Decisions 249 business. In the short run as we shall see, profit can be above zero or normal profit which is referred to as abnormal profit.? what if a firm earned profit which was only 1 per cent less than zero profit. Would it still be worthwhile continuing in production? abnormal profit the profit over and above normal profit A Shift in Demand in the Short Run and Long Run Because firms can enter and exit a market in the long run but not in the short run, the response of a market to a change in demand depends on the time horizon. To see this, let s trace the effects of a shift in demand. This analysis will show how a market responds over time, and it will show how entry and exit drive a market to its long-run equilibrium. Suppose the market for milk begins in long-run equilibrium. Firms are earning zero profit, so price equals the minimum of average total cost. Panel (a) of Figure 10.9 shows the situation. The long-run equilibrium is point A, the quantity sold in the market is Q 1, and the price is P 1. Now suppose scientists discover that milk has miraculous health benefits. As a result, the demand curve for milk shifts outward from D 1 to D 2, as in panel (b). The short-run equilibrium moves from point A to point B; as a result, the quantity rises from Q 1 to Q 2 and the price rises from P 1 to P 2. All of the existing firms respond to the higher price by raising the amount produced. Because each firm s supply curve reflects its marginal cost curve, how much they each increase production is determined by the marginal cost curve. In the new short-run equilibrium, the price of milk exceeds average total cost, so the firms are making positive or abnormal profit. Over time, the profit in this market encourages new firms to enter. Some farmers may switch to milk production from other farm products, for example. As the number of firms grows, the short-run supply curve shifts to the right from S 1 to S 2, as in panel (c), and this shift causes the price of milk to fall. Eventually, the price is driven back down to the minimum of average total cost, profits are zero and firms stop entering. Thus, the market reaches a new long-run equilibrium, point C. The price of milk has returned to P 1,butthequantity produced has risen to Q 3. Each firm is again producing at its efficient scale, but because more firms are in the dairy business, the quantity of milk produced and sold is higher. JEOPARDY PROBLEM When the Channel Tunnel was built between the United Kingdom and France, the cost of production rose dramatically but not surprisingly given the technical challenges of such an engineering project. Once opened it soon became clear that the firm which operated the tunnel, Eurotunnel, would never break even. Why might this situation have arisen and why is the tunnel still operational despite being loss making? NAUFRAGO PLANETÁRIO The Channel Tunnel what other use could it possibly have? Does this affect decisions on whether to shut or restructure the business?

14 250 Part 4 Microeconomics The Economics of Firms in Markets FIGURE 10.9 An Increase in Demand in the Short Run and Long Run The market starts in a long-run equilibrium, shown as point A in panel (a). In this equilibrium, each firm makes zero profit, and the price equals the minimum average total cost. Panel (b) shows what happens in the short run when demand rises from D 1 to D 2. The equilibrium goes from point A to point B, price rises from P 1 to P 2, and the quantity sold in the market rises from Q 1 to Q 2. Because price now exceeds average total cost, firms make profits, which over time encourage new firms to enter the market. This entry shifts the short-run supply curve to the right from S 1 to S 2 as shown in panel (c). In the new long-run equilibrium, point C, price has returned to P 1 but the quantity sold has increased to Q 3. Profits are again zero, price is back to the minimum of average total cost, but the market has more firms to satisfy the greater demand. (a) Initial condition Firm Market Short-run supply, S 1 P 1 P 1 A Long-run supply Demand, D 1 0 Quantity (firm) 0 Q 1 Quantity (market) (b) Short-run response Firm Market P 2 P 1 Profit P 2 P 1 A B S 1 D 2 Long-run supply D 1 0 Quantity (firm) 0 Q 1 Q 2 Quantity (market) (c) Long-run response Firm Market P 1 P 2 P 1 A B S 1 S 2 C D 2 Long-run supply D 1 0 Quantity (firm) 0 Q 1 Q 2 Q 3 Quantity (market) Why the Long-Run Supply Curve Might Slope Upward So far we have seen that entry and exit can cause the long-run market supply curve to be horizontal. The essence of our analysis is that there are a large number of potential entrants, each of which faces the same costs. As a result, the long-run market supply curve is horizontal at the minimum of average total cost. When the demand for the

15 Chapter 10 The Firm s Production Decisions 251 good increases, the long-run result is an increase in the number of firms and in the total quantity supplied, without any change in the price. The reality is that the assumptions we have made in our model do not hold in all cases. There are, as a result, two reasons that the long-run market supply curve might slope upward. The first is that some resources used in production may be available only in limited quantities. For example, consider the market for farm products. Anyone can choose to buy land and start a farm, but the quantity and quality of land is limited. As more people become farmers, the price of farmland is bid up, which raises the costs of all farmers in the market. Thus, an increase in demand for farm products cannot induce an increase in quantity supplied without also inducing a rise in farmers costs, which in turn means a rise in price. The result is a long-run market supply curve that is upward sloping, even with free entry into farming. A second reason for an upward sloping supply curve is that firms may have different costs. For example, consider the market for painters. Anyone can enter the market for painting services, but not everyone has the same costs. Costs vary in part because some people work faster than others, use different materials and equipment and because some people have better alternative uses of their time than others. For any given price, those with lower costs are more likely to enter than those with higher costs. To increase the quantity of painting services supplied, additional entrants must be encouraged to enter the market. Because these new entrants have higher costs, the price must rise to make entry profitable for them. Thus, the market supply curve for painting services slopes upward even with free entry into the market. Notice that if firms have different costs, some firms earn profit even in the long run. In this case, the price in the market reflects the average total cost of the marginal firm thefirmthatwouldexitthemarketifthepricewereanylower.thisfirmearns zero profit, but firms with lower costs earn positive profit. Entry does not eliminate this profit because would-be entrants have higher costs than firms already in the market. Higher-cost firms will enter only if the price rises, making the market profitable for them. Thus, for these two reasons, the long-run supply curve in a market may be upward sloping rather than horizontal, indicating that a higher price is necessary to induce a larger quantity supplied. Nevertheless, the basic lesson about entry and exit remains true. Because firms can enter and exit more easily in the long run than in the short run, the long-run supply curve is typically more elastic than the short-run supply curve. Quick Quiz In the long run with free entry and exit, is the price in a market equal to marginal cost, average total cost, both, or neither? Explain with a diagram. CONCLUSION: BEHIND THE SUPPLY CURVE We have been discussing the behaviour of competitive profit-maximizing firms. You may recall from Chapter 1 that one of the Ten Principles of Economics is that rational people think at the margin. This chapter has applied this idea to the competitive firm. Marginal analysis has given us a theory of the supply curve in a competitive market and, as a result, a deeper understanding of market outcomes. We have learned that when you buy a good from a firm in a competitive market, you can be assured that the price you pay is close to the cost of producing that good. In particular, if firms are competitive and profit-maximizing, the price of a good equals the

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