Question

7. Apply the following concepts to this article. First clearly define the concept in your own words and explain how it applies to this article. i) Marginal analysis ii) Fixed costs iii) Variable costs iv) Shut-down point in the short-run?

Answer 1

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I have answered your question by clearly defining the mentioned concepts in my own words. However, there was no article attached in your question. Please let me know in case of any query in the comments.

Answer –

In the short run, there are two types of costs incurred by the firm. The costs can be classified into fixed costs and variable costs.

1) Fixed costs – The constant costs which are incurred by the firm irrespective of the level of output is known as fixed cost. This means that even when Q = 0, these costs are fixed and have to be incurred by the firm. In the short run, we see that there is at least one input used in production (for example – machines) which is fixed. So, the rent of the machine is fixed and has to be paid by the firm even when it does not produce any output. Thus, if fixed costs are constant and is spread through out the entire level of production, average fixed cost (i.e., fixed cost per unit of output) tends to decline as output increases.

2) Variable costs – Variable costs depend on the level of output produced by the firm. It is zero when no output is produced and average variable cost (i.e., variable cost per unit of output) increases over time as quantity produced by the firm increases. So, the costs associated with the factor of production that is not fixed and changes with the level of output (for example – labor) is known as variable costs.

3) Marginal analysis is a comparison done by the firms after taking into account the marginal revenue generated by an output and its marginal cost. Firms use this analysis to maximize their profits. Marginal revenue (MR) is the additional revenue earned by the firm when an extra unit of output is sold. Mathematically, MR = ∆TR/∆Q, where TR = total revenue and Q = quantity of output. On the other hand, marginal cost (MC) is the incremental cost incurred by the firm for producing one extra unit of output. Mathematically, MC = ∆TC/∆Q, where TC = total cost and Q = quantity of output.

4) Shut down point – If total revenue (TR) earned by the firm is less than total costs (TC), then the firm is incurring economic loss in the short run.

But if TR < TC i.e., PXQ<ATCXQ or, P<ATC, then it does not mean that the firm will cease production in the short run and shut down.

So, when will a firm decide to shut down in the short run?

If total revenue (PQ) covers the total variable cost (TVC) in the short run, then the firm will continue production. This is because as discussed above, if P > AVC, then the firm is recovering the entire variable cost associated with production and a part of the fixed cost as well. Now we know that fixed costs are constant and have to be paid by the firm even when quantity produced is zero. So, when a firm decides to shut down, it has to pay the fixed costs in the short run and by producing when P>AVC, the firm is minimizing its loss in the short run because it can recover a part of its fixed costs along with the entire variable cost associated with production. However, P < AVC, then the firm is not only losing the entire fixed cost but a part of the variable cost as well by continuing production in the short run. Thus, it is not minimizing losses in the short run. So, if the price falls below the AVC in the short run, then the firm will shut down. So, the point where P = min.AVC is known as the shut down point for the firm in the short run.