Will a profit-maximising firm in a competitive market produce a positive level of output in the short run if the market price is less than the minimum of AVC? Give an explanation.
It is not possible for a firm to produce for a firm to produce positive level of output in the short run if the price is less than the minimum of AVC. This is because as soon as the market price falls below the minimum of SAVC which implies that the firm is not able to cover its fixed as well as variable costs and thus it will stop production.
Let us understand this concept by taking an example.
At the point K price charged by the firm is on and output sold is 0q1 and the firm generates TR.
TR = P × Q
= OP × Oq1
= area (rectangle Oq1 LP)
And incurs the variable cost of TVC
TVC = SAVC × Quantity of output
= ON × Oq1
= area (rectangle Oq1KN)
Profit earned by the firm = TR – TC =TR – (TVC + TFC)
= TR – TVC – TFC
If the firm is not producing anything then at zero level of output the firms TR and VC will by zero.
However the firm has to bear TFC. Thus at zero level of output the profit earned by the firm is
Profit = π1 = TR – TVC – TFC
π1= TFC
Now if it produces Oq1 level of output then the profit earned will be
π2 = TR – TVC – TFC
= area (rectangle Oq1LP) – area (rectangle Oq1KN) – TFC
Or π2 = area (rectangle PLKN) – TFC
This implies that π1 is greater than π2. The firm incurs more loss if it produces Oq1 level of output than the loss associated with zero level of output. Thus the firm will stop production whenever P SAVC and therefore at profit maximising level of output the price must be greater than or equal to SAVC in the short run.
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