Question

We produce Kentucky’s finest Velociraptor Repellent. Since we have been producing this deterrent, no one has seen one of those pesky critters in the entire state. Our economist has been able to put together some important pieces of information. He put MR = MC and calculated that are our profit maximizing output is 100 tons of this concoction.

Unfortunately, when he plots the costs on an ATC cost curve, he sees that the minimum ATC is at a quantity of 50. If we produce 45 tons, our average cost will increase. If we produce 55 tons, our average costs will increase as well. The farther we get from the Q-min, (quantity of 50), the higher our average costs are. This is a paradox. Our profit maximizing point of 100 units only works if we have the cost that occurs if we produce 50. If we expand our production to 100, our costs go up so much that we are losing money. What would you recommend that our firm do?

Answer 1

I will recommend that if the equality of marginal cost and marginal revenue is resulting in an output of 100 tons, then the firm should continue to produce it in the short run. It is true that at this level, there is a higher average cost, perhaps much more than the price per ton so that the firm is losing money.

However, note that you seems to be having a monopoly. in that case, your demand function must be downward sloping. You must be producing in the elastic portion of the demand function. If you reduce your production, you will have to increase the price. This indicates that you will receive a lower revenue because when price is increased in the elastic portion of the demand curve, total revenue is decreased.

This indicates that you will be losing more money because of lower production even though the average cost would reduce and the price will increase. All of this happens because the equality between the marginal revenue and the marginal cost determine the profit maximizing or loss minimising level of output irrespective of whether the firm is earning profit or losses. If you reduce output, you will be producing to the left of the equality between marginal revenue and marginal cost curves, in which case your losses will actually increase.

Thus I would recommend that you should continue to produce hundred tons.