8.4 understanding the short run output decision

• The short-run output decision is about determining how much a firm should produce to maximize profits or minimize losses. Here's a full breakdown of the key concepts:
• • MC is the additional cost of producing one more unit of output.
  • MR is the additional revenue gained from selling one more unit of output.
• The firm maximizes its profit by producing the quantity of output where MC = MR. At this point, producing more would increase costs more than revenue, and producing less would miss out on revenue opportunities.
• In the short run, the firm decides whether to produce or shut down by comparing the price (p) to its costs. The main rules are:

  • If price (p) ≥ AVC: The firm should produce at Q1, where MR = MC. Even if it incurs losses, it can still cover some or all of its variable costs and contribute towards fixed costs.
  • If price (p) < AVC: The firm should shut down because it cannot even cover its variable costs. Producing would result in greater losses than if it produced nothing.
• • Price > SATC: The firm produces at a profit.
  • If the price is above SATC, the firm covers all costs (fixed and variable) and earns a profit.
• Price between SAVC and SATC: The firm produces at a loss.

  • If the price is between SAVC and SATC, the firm can cover variable costs and some fixed costs but will incur a loss.
• 1. Price < SAVC: The firm produces zero output.

  • If the price is below SAVC, the firm cannot cover its variable costs, so it shuts down.
• Sunk costs refer to costs that have already been incurred and cannot be recovered. The main lesson about sunk costs is that they should not influence future decisions since they cannot be changed
• The firm should base decisions only on marginal cost (MC) and marginal revenue (MR).
• The firm has invested in special equipment that helps produce output but will have no resale value. In the second period, should the cost of this equipment be included in the firm’s marginal cost of production?

  No, the cost of the equipment is a sunk cost after the first period, so it should not be included in marginal cost calculations for the second period. The firm should only consider the costs and revenues that vary with production in the second period (i.e., marginal costs and marginal revenues).
• A Hollywood studio has invested $15 million in a movie, but they believe it will flop. Should they finish the movie?

  1. The $15 million is a sunk cost and should not influence the decision. The decision to continue production should be based on whether the expected revenue from finishing the movie will exceed the additional costs. If the revenue is less than the marginal cost of finishing, the studio should stop production.
• • The firm produces where MR = MC in the short run to maximize profit or minimize loss.
• If price ≥ AVC, the firm produces even if it's at a loss, as long as it can cover variable costs.
• If price < AVC, the firm shuts down to minimize losses because it can't cover its variable costs.
• Marginal cost intersects average total cost (ATC) and average variable cost (AVC) at their lowest points
• MC < ATC means ATC is falling, while MC > ATC means ATC is rising.
• Sunk costs should not affect future decisions. The focus should always be on marginal costs and benefits.
• Decisions should be based on the costs that can still be avoided and the benefits that can still be gained.