Question

Suppose a firm has a production technology which results in the commonly seen outcome of "U-shaped" Average Variable Cost (AVC), Average Total Cost (ATC) and Marginal Cost (MC). Further, suppose this firm sells its product in a market where the price of the good is externally set at P0. That is, the price is given to the firm and the firm cannot impact that price. Finally, for the entirety of this set of questions (7-9), assume we are in the Short Run for this firm. In graphing responses to Questions 7 through 9, put $ on the vertical axis and lower-case q (firm output) on the horizontal axis. Consider a scenario when the firm operates at a profit-maximizing level (produces a proft-maximizing quantity) yet (a) has negative profits at this outcome and (b) it does not choose to shut down. Graphically depict all relevant cost curves (ATC, AVC, AFC, MC) and label them as well as the price P0 and the equilibrium q0. Graphically indicate the area associated with negative profits made by the firm. Explain why this area represents negative profits. Explain the decision to keep producing in the face of negative profits.

Answer 1

In this short run, some of the factors of production are fixed. hence you can increase production by only increasing only one or a few inputs but you cannot increase all input. hence plant size is fixed.

now suppose we have a plant size which has cost curves SRAC1, SRAVC1 and SRMC1 and ATC1

where SRAC1=ATC+SRAVC!

hence at that plant size, the cost minimising output is Q1 and they produce at that point.

we can see that output level has SRAC>P

hence they are incurring a loss.

the amount of loss is (SRAC-P0)xQ1 which is represented by that green rectangular area.

now the question is why after getting loss they are still producing?

see, in the long run, they can increase their plant size, hence they can move towards plant size which has cost curves SRMC2, SRAC2. we can see at those outputs they are earning profit.(P>SRAC=LRAC). hence they'll wait until they can increase their fixed capitals and build bigger plants and move towards producing at any output betweenQ2 and Q3. but the profit maximising output will be at Q*.

there is no fixed cost in the long run.