A firm currently uses 40,000 workers to produce 180,000 units of output per day. The daily wage per worker is $100, and the price of the firm's output is $28. The cost of other variable inputs is $500,000 per day. (Note: Assume that output is constant at the level of 180,000 units per day.) Assume that total fixed cost equals $1,200,000.
Total Variable Costs = (Number of Workers x Worker’s Daily Wage) + Other Variable Costs
TVC = (40 000 x $100) + $500 000 = $4 500 000
Total Costs = Total Variable Costs + Total Fixed Costs
TC = TVC + TFC = $4 500 000 + $1 200 000 = $5 700 000
Total Revenue = Price * Quantity
TR = $28 x 180 000 = $5 040 000
Average Variable Costs = Total Variable Costs / Units of Output per Day
AVC = $4 500 000 / 180 000 = $25
Average Total Costs = (Total Variable Costs + Total Fixed Costs) / Units of Output per Day
ATC = $5 700 000 / 180 000 = $31.67
Comparing the price of the good and average total costs shows that P < ATC ($28 < $31.67), which means that the firm is making a loss, which is the following:
Loss = Total Revenue – Total Costs
Loss = $5 040 000 – $5 700 000 = -$660 000
The calculations show that in the short run the firm is making losses in amount $660,000 per day and they can be shown as shaded area at the graph below.
In such situation the management should decide either continue to run a business or close production temporarily. In the first case the firm will make losses which are equal: Loss1 = (P – ATC) * Q while in the second case the firm will face losses which would be equal: Loss2 = - AFC * Q
According to the principles or microeconomics (Mankiw, 2014), if the price of the good falls down the average variable costs of production (P < AVC) a competitive firm in the short run should shut down. Indeed, if P < AVC, Loss1 > Loss 2 because by producing each unit the firm will lose the difference between AVC and P plus fixed costs. If the firm chooses to shut down, its loss would be equal fixed costs since fixed costs are kind of sunk costs in the short run and the firm does not need to pay for the variable costs. Shut down would be the most reasonable and loss minimization strategy.
In our case, P > AVC ($28 > $25) and the most suitable option for the firm would be further production despite of the losses in the short run since Loss1 < Loss 2. The price exceeds AVC and the firm continues to operate and produces the quantity at which the firm’s total revenue is higher than its total variable cost. Moreover, because the firm’s total revenue covers its total variable costs, the firm can use the difference to compensate at least part of its total fixed costs. Thus, the most cost-effective solution for the competitive firm in the short run would be conducting economic activities.
Mankiw N. (2014). Principles of Economics, 7th ed Retrieved from: https://books.google.com/books?id=ziwaCgAAQBAJ&pg=PA338&lpg=PA338&dq=typically+spend+between+10+and+20+percent+of+revenue+for+advertising&source=bl&ots=RUKPxNRO6G&sig=JfoHx0YY47YbF6iu39JKgvaDcRM&hl=uk&sa=X&ved=0ahUKEwjS7pDO44PKAhXFqXIKHcx1AvwQ6AEINTAD#v=onepage&q=shut%20down%20rule&f=false