2 Short-Run Firm and Market Decisions

Price-taking and short-run costs

In a perfectly competitive market, an individual firm is a price taker: it takes the market price as given. Its short-run choices are how much to produce or whether to stop production temporarily, given that some inputs and costs are fixed.

For a price-taking firm, marginal revenue equals price, so $MR=P$. If the firm produces quantity $q$, its profit is total revenue minus total cost:

Short-run cost measures

• Total fixed cost (TFC): cost that does not vary with current output.

• Total variable cost (TVC): cost that varies with output.

• Average variable cost (AVC): variable cost per unit, calculated as $AVC=TVC/q$.

• Average total cost (ATC): total cost per unit, calculated as $ATC=TC/q$, where $TC=TFC+TVC$.

• Marginal cost (MC): the change in total cost from producing one additional unit.

Choosing output or shutdown

If a firm operates, it chooses the output where price equals marginal cost, $P=MC$, on the rising part of the marginal-cost curve. When $P>MC$, producing another unit adds more to revenue than to cost. When $MC>P$, producing that unit reduces profit. The firm compares its best producing option with shutting down before making its final decision.

A firm can produce at a loss and still be better off than shutting down. Because fixed costs generally remain payable when output is zero, the short-run shutdown decision depends on whether operating revenue covers variable costs:

• If price is below minimum average variable cost, the firm cannot cover its variable costs by operating. It should shut down temporarily, produce zero, and incur its fixed costs.

• If price is above minimum average variable cost, producing contributes something toward fixed costs. The firm should operate at the output where $P=MC$, even if it earns a loss.

• At exactly minimum average variable cost, the firm is indifferent between shutting down and producing at the shutdown-point output. Either choice gives a loss equal to fixed costs.

For example, suppose that at the firm’s best operating output, price is $\$8$ per unit, average variable cost is $\$6$, average total cost is $\$10$, and output is $100$ units. The operating contribution toward fixed costs is $(8-6)\times100=\$200$, while the total loss is $(10-8)\times100=\$200$. Shutting down would mean losing all of the firm’s $\$400$ fixed cost, so it should keep producing despite the loss. If price fell below minimum average variable cost, operating would add to the loss.

Shutdown is a temporary, short-run production decision made while unavoidable costs remain. Exit is a longer-run decision to leave the market when the firm can adjust all inputs.

The firm’s short-run supply

At each possible market price, the firm identifies the output where $P=MC$, provided that price covers minimum average variable cost. The firm’s short-run supply curve is the portion of its marginal-cost curve at and above minimum average variable cost. Below the shutdown price, the firm supplies zero. A higher price generally leads the firm to move up its rising marginal-cost curve and supply more.

A change in production costs can shift the firm’s supply curve by shifting marginal cost or average variable cost. Fixed cost does not affect the firm’s short-run supply decision because it is incurred whether the firm produces or shuts down, but it does affect profit or loss.

Market supply and equilibrium

Market supply is found by adding the quantities all firms are willing to supply at each price. This is a horizontal sum: if Firm A supplies $10$ units and Firm B supplies $15$ units at the same price, market quantity supplied at that price is $25$ units. Firms may have different costs and shutdown prices, so some may supply nothing at a price where other firms operate.

Market demand and market supply determine the competitive-market equilibrium, where quantity demanded equals quantity supplied. At a price above equilibrium, a surplus tends to put downward pressure on price. Below equilibrium, a shortage tends to put upward pressure on price. The resulting market price is the price each competitive firm takes as given when choosing its own output.