With the widespread use of containerisation and development of giant distribution companies, such as UPS and DHL, transporting materials and goods around the world has become much faster and much cheaper. Instead of having to make parts in-house, companies can now use the logistics industry to obtain them at lower cost elsewhere, often from the other side of the world.
With improved systems for ordering materials, and deliveries becoming more and more reliable, firms no longer need keep large stocks of parts; they simply buy them as they need them. The same opportunity to save costs lies with the finished product: a company can keep lower levels of stocks when its own delivery mechanisms are more efficient.
*LOOKING AT THE MATHS
We can state the short- and long-run shut-down points algebraically. Remember that total profit ( TΠ ) is defined as
TΠ = TR − TC = TR − ( TFC + TVC ) (1) A negative value for TΠ means that the firm makes a loss. This will occur when
TR − ( TFC + TVC ) < 0 or
TR < ( TFC + TVC )
But when should the firm shut down?
Short-run shut-down point
If the firm shuts down, TR and TVC will be zero, but in the short run it will still incur total fixed costs ( TFC ) and thus
TΠ =−TFC (2)
In other words, it will make a loss equal to total fixed costs. From this it can be seen that the firm should close in the short run only if
TΠ < −TFC that is,
( TR − TFC − TVC ) < − TFC (3) In other words, the loss should not exceed fixed costs. Put another way (i.e. by rearranging (3)), it should continue in production as long as
TR ≥ TVC (4)
or, dividing both sides of (4) by quantity, where
AR ≥ AVC (5)
The firm, therefore, should shut down if
AR < AVC
This is shown in Figure 5.23 . Long-run shut-down point
In the long run, there are no fixed costs. Thus
TΠ = TR − TVC = TR − TC (6) If the firm shuts down, it will earn no revenue, but incur no costs.
Thus
TΠ = TR − TC = 0 − 0 = 0
The firm should therefore continue in production as long as ( TR − TC ) ≥ 0
that is, TR ≥ TC
or, dividing both sides by quantity, as long as
AR ≥ AC
(where AC in this case is long-run average cost). The firm, therefore, should shut down if
AR < AC
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Section summary
1. Total profit equals total revenue minus total cost. By definition, then, a firm’s profits will be maximised at the point where there is the greatest gap between total revenue and total cost.
2. Another way of finding the maximum profit point is to find the output where marginal revenue equals marginal cost. Having found this output, the level of maximum profit can be found by finding the average profit ( AR − AC ) and then multiplying it by the level of output.
3. Normal profit is the minimum profit that must be made to persuade a firm to stay in business in the long run. It is counted as part of the firm’s costs. Supernormal profit is any profit over and above normal profit.
4. For a firm that cannot make a profit at any level of output, the point where MR = MC represents the loss-minimising output.
5. In the short run, a firm will close down if it cannot cover its variable costs. In the long run, it will close down if it cannot make normal profits.
END OF CHAPTER QUESTIONS
1. The following table shows the average cost and average revenue (price) for a firm at each level of output.
Output 1 2 3 4 5 6 7 8 9 10
AC (£) 7.00 5.00 4.00 3.30 3.00 3.10 3.50 4.20 5.00 6.00
AR (£) 10.00 9.50 9.00 8.50 8.00 7.50 7.00 6.50 6.00 5.50
(a) Construct a table to show TC , MC , TR and MR at each level of output (put the figures for MC and MR midway between the output figures).
(b) Using MC and MR figures, find the profit- maximising output.
(c) Using TC and TR figures, check your answer to (b).
(d) Plot the AC , MC , AR and MR figures on a graph.
(e) Mark the profit-maximising output and the AR and AC at this output.
(f) Shade in an area to represent the level of profits at this output.
*2. Draw the isoquant corresponding to the following table, which shows the alternative combinations of labour and capital required to produce 100 units of output per day of good X.
K 16 20 26⅔ 40 60 80 100
L 200 160 120 80 53⅓ 40 32
(a) Assuming that capital costs are £20 per day and the wage rate is £10 per day, what is the least-cost method of producing 100 units? What will the daily total cost be? (Draw in a series of isocosts.) (b) Now assume that the wage rate rises to £20 per
day. Draw a new set of isocosts. What will be the least-cost method of producing 100 units now?
How much labour and capital will be used?
3. Choose two industries that you believe are very different. Identify factors used in those industries that in the short run are (a) fixed; (b) variable.
4. Taking the same industries, identify as many economies of scale as you can.
5. ‘Both short-run and long-run average cost curves may be -shaped, but the explanations for their respective shapes are quite different.’ Explain this statement.
6. Why do marginal cost curves intersect both the average variable cost curve and the average cost curve at their lowest point?
7. Draw a diagram like that in Figure 5.21 . Now illustrate the effect of a rise in demand for the product. Mark the new profit-maximising price and output. Will the profit- maximising output, price, average cost and profit necessarily be higher than before?
8. Why might it make sense for a firm which cannot sell its output at a profit to continue in production for the time being? For how long should the firm continue to produce at a loss?
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ONLINE RESOURCES 169
Online resources
Additional case studies in MyEconLab
5.1 Diminishing returns to nitrogen fertiliser. This case study provides a good illustration of diminishing returns in practice by showing the effects on grass yields of the application of increasing amounts of nitrogen fertiliser.
5.2 Deriving cost curves from total physical product information. This shows how total, average and marginal costs can be derived from total product information and the price of inputs.
5.3 Division of labour in a pin factory. This is the famous example of division of labour given by Adam Smith in his Wealth of Nations (1776).
5.4 Followers of fashion. This case study examines the effects of costs on prices of fashion-sensitive goods.
5.5 Putting on a duplicate. This examines the effects on marginal costs of additional passengers on a coach journey.
5.6 Comparing the behaviour of long-run and short-run costs. This is an application of isoquant analysis.
Maths Case 5.1 Total, average and marginal cost. Looking at the mathematical functions for these curves and deriving specific types of cost from a total cost equation.
Maths Case 5.2 Finding the optimum production point: Part 1 . Examples using the method of substituting the constraint equation into the objective function.
Maths Case 5.3 Finding the optimum production point: Part 2 . The same examples as in Maths Case 5.2 , but this time using the Lagrangian methods.
Maths Case 5.4 Total, average and marginal revenue. Looking at the mathematical functions for these curves for both price-taking and price-making firms and relating them to revenue curves.
Websites relevant to this chapter
Numbers and sections refer to websites listed in the Web Appendix and hotlinked from this book’s website at www.pearsoned.co.uk/sloman .
■ For news articles relevant to this chapter, see the Economic News section in MyEconLab.
■ For student resources relevant to this chapter, see sites C1–7, 9, 10, 14, 19, 20.
■ For a case study examining costs, see site D2.
■ For sites that look at companies, their scale of operation and market share, see B2 (third link); E4, 10; G7, 8.
■ For links to sites on various aspects of production and costs, see the sections Microeconomics in sites I7 and 11.
This book can be supported by MyEconLab, which contains a range of additional resources, including an online homework and tutorial system designed to test and build your understanding.
You need both an access card and a course ID to access MyEconLab:
1. Is your lecturer using MyEconLab? Ask your lecturer for your course ID.
2. Has an access card been included with the book at a reduced cost? Check the inside back cover of the book.
3. If you have a course ID but no access card, go to: http://www.myeconlab.com/ to buy access to this interactive study programme.