Question

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.

Answer 1

It is not possible 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 Oq₁, and the firm generates TR.

TR = P × Q

= OP × Oq₁

= area (rectangle Oq₁LP)

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 firm’s TR and TVC will be 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.