Explain why a perfectly competitive firm will not produce in the short run if price is lower than average variable cost, but it will produce if price is below average total cost (but above average variable cost)?
Economics - Financial Markets
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First of all, that applies for firms of any market type: Perfect competition, but also monopolistic competition, oligopoly, and monopoly.
The easier point to understand involves average total cost (ATC). As you know, when AR (i.e., price) exceeds ATC, the firm is earning economic profits. Things are good. In perfect competition, however, this will be short-lived.
When AR = ATC, the firm is breaking even. This is fine, and is in fact what perfect competition will always tend to move toward.
When AR is less than ATC (but above AVC), the firm is making economic losses. Although this may sound bad, there are two things to consider.
(1) The firm may still be making accounting profits. That is, all explicit costs are covered, but some of the opportunity costs might not be. This just means that some of the owner's time and/or capital could be better spent elsewhere. However, for many firms (especially those starting out), there is a starting period where opportunity cost is high. Think of someone who leaves a high-paying job to start her own company (where she works long days).
(2) Fixed costs are covered, so it is still beneficial to produce. That is, despite earning an economic loss, it is still cheaper to produce than it is to do nothing. If P is less than ATC for a very long time (how long will depend on the firm), it might eventually close down even if P never drops below AVC.
That brings us to our next point: when P is less than average variable cost (AVC). When this occurs, the firm will shut down, since it actually costs them more money to produce than it does to do nothing. Think of a firm producing lemonade that it can sell for $1, but the sugar it needs for each glass costs them $2. Why would they produce when each glass of lemonade actually costs them more than they can receive as revenue? Answer: they won't.
Think of the profit-maximizing condition: when MR = MC. At an output beyond this point, marginal cost exceeds marginal revenue—each incremental unit costs more to produce than they will receive as revenue. It is silly to produce at this condition. P < AVC is the same idea, except it's for ALL units.
If this doesn't clear things up for you, please let me know.