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The standard theory of the firm assumes that a business needs to make at least
normal profit in the long run to justify remaining in the industry but this is not
necessarily a strict requirement for a firm in the short term. Indeed many
businesses make operating losses when there is a fall in market demand causing
prices to fall and revenues to dip below costs.
In the short run the firm will continue to produce as long as total revenue covers
total variable costs or put another way, so long as Price per unit > or equal to
Average Variable Cost (AR = AVC). The reason for this is as follows. A businesss
fixed costs must be paid regardless of the level of output. If we make an
assumption these costs are sunk costs (i.e. they cannot be covered if the firm
shuts down) then the loss per unit would be greater if the firm were to shut
down, provided variable costs are covered.
Consider the cost and revenue curves facing a business in the short run shown in
the diagram below. The market equilibrium price is P1 which means that the
equilibrium output for the firm (where MR=MC) is at output Q2. The business is
making an economic loss at this price (AC > P1) but the price is high enough for
the business to cover all of its variable costs and also make some contribution to
its fixed costs. If we assume that most of the fixed costs are lost if the firm shuts
down, then the firm can justify continuing to produce in the short run, losses will
be greater if they close down.
In the second example in the diagram below, the market price is so low that the
firm is not covering its variable costs let alone the fixed costs. Losses can be cut
if the firm shuts down some of their productive capacity.
The shut down price for a business in the short run is assumed to be the price
which covers average variable cost. Therefore if price < AVC then the supplier is
better off closing down a plant. We can use the concept of the shut down price to
derive the competitive firms supply curve. The supply curve is the marginal cost
curve above the shut down point
Powergen said that it was receiving between 13 and 15 per megawatt hour, compared with
a cost of about 18 for gas-fired plant and costs of 40 per MWh for older, inefficient oilfired plant. The decline in electricity prices has pushed British Energy, the nuclear generator,
to the brink of insolvency, forcing the GoveIntroduction
The standard theory of the firm assumes that a business needs to make at least normal profit in the
long run to justify remaining in the industry but this is not necessarily a strict requirement for a
firm in the short term. Indeed many businesses make operating losses when there is a fall in market
demand causing prices to fall and revenues to dip below costs.
In industries with a high income elasticity of demand the market is likely to be sensitive to changes
in the economic cycle so that firms are likely to see significant changes in profitability at various
stages of the business cycle.
The Shut-Down Condition: Price and Variable Cost
In the short run the firm will continue to produce as long as total revenue covers total variable
costs or put another way, so long as Price per unit > or equal to Average Variable Cost (AR = AVC).
The reason for this is as follows. A businesss fixed costs must be paid regardless of the level of
output. If we make an assumption these costs are sunk costs (i.e. they cannot be covered if the
firm shuts down) then the loss per unit would be greater if the firm were to shut down, provided
variable costs are covered.
Consider the cost and revenue curves facing a business in the short run shown in the diagram below.
The market equilibrium price is P1 which means that the equilibrium output for the firm (where
MR=MC) is at output Q2. The business is making an economic loss at this price (AC > P1) but the
price is high enough for the business to cover all of its variable costs and also make some
contribution to its fixed costs. If we assume that most of the fixed costs are lost if the firm shuts
down, then the firm can justify continuing to produce in the short run, losses will be greater if they
close down.
In the second example in the diagram below, the market price is so low that the firm is not
covering its variable costs let alone the fixed costs. Losses can be cut if the firm shuts down some
of their productive capacity.
The shut down price for a business in the short run is assumed to be the price which covers average
variable cost. Therefore if price < AVC then the supplier is better off closing down a plant. We can
use the concept of the shut down price to derive the competitive firms supply curve. The supply
curve
is
the
marginal
cost
curve
above
the
shut
down
point
Example of the Shut-Down Price The UK Electricity Market
Powergen announced in October 2002 that it planned to shut-down more than a quarter of its UK
power stations, mothballing sufficient capacity to provide electricity for the whole of London. The
company said the electricity market was bust after a price slump. Powergen will close the power
station on the Isle of Grain in Kent and the Killingholme plant in Lincolnshire. UK electricity prices
have fallen by almost 40 per cent since 1998 as a result of intense competition and the introduction
of new trading arrangements, which have coincided with a decline in industry demand.
Powergen said that it was receiving between 13 and 15 per megawatt hour, compared with a cost
of about 18 for gas-fired plant and costs of 40 per MWh for older, inefficient oil-fired plant. The
decline in electricity prices has pushed British Energy, the nuclear generator, to the brink of
insolvency, forcing the Government to grant a 650 million emergency loan facility.
LEARNING OBJECTIVE
KEY POINTS
In the short run, there are both fixed and variable costs.
Efficient long run costs are sustained when the combination of outputs that a
firm produces results in the desired quantity of the goods at the lowest possible
cost.
Variable costs change with the output. Examples of variable costs include
employee wages and costs of raw materials.
The short run costs increase or decrease based on variable cost as well as the
rate of production. If a firm manages its short run costs well over time, it will be
more likely to succeed in reaching the desired long run costs and goals.
TERMS
fixed cost
Business expenses that are not dependent on the level of goods or services
produced by the business.
variable cost
A cost that changes with the change in volume of activity of an organization.
In economics, "short run" and "long run" are not broadly defined as a rest of
time. Rather, they are unique to each firm.
Differences
The main difference between long run and short run costs is that there are no
fixed factors in the long run; there are both fixed and variable factors in the short
run . In the long run the general price level, contractual wages, and expectations
adjust fully to the state of the economy. In the short run these variables do not
always adjust due to the condensed time period. In order to be successful a firm
must set realistic long run cost expectations. How the short run costs are
handled determines whether the firm will meet its future production and financial
goals.
Cost curve
Cost curve
This graph shows the relationship between long run and short run costs.
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Source: Boundless. Short Run and Long Run Costs. Boundless Economics.
Boundless, 14 Nov. 2014. Retrieved 09 Feb. 2015 from
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alternatives to profit maximisation theories
- Employees
- Managers
- Shareholders
- Customers
Each of these groups is likely to have different objectives or goals. The dominant
group at any moment in time can give greater emphasis to their own objectives for example the main price and output decisions may be taken at local level by
managers - with shareholders taking only a distant view of the company's
performance and strategy.
Satisficing
Alternatively, the firm may reward workers with higher wages in order to stop
industrial action.
This objective was initially developed by the work of Baumol (1959). Baumol's
research focused on the behaviour of manager-controlled businesses - where the
day-to-day decisions taken by managers are divorced from the shareholders (the
owners of the business). Baumol argued that annual salaries and other perks
might be more closely correlated with total sales revenue rather than bottom line
profits. An alternative view was put forward by Williamson (1963), who built a
model based on the concept of managerial satisfaction (utility). This can be
enhanced by success in raising sales revenue.
Limit Pricing
Firms may adopt predatory pricing policies by lowering prices to a level that
would force any new firms entering the industry to operate at a loss. This would
allow firms to sustain a monopoly position in a market.