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Short Run Production Decision

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# Short Run Production Decision

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## Short-run production decision meaning

In perfect competition, each seller takes the market price as given, because they have no market power and cannot set their own price. At any higher price, consumers will purchase entirely from other sellers, and the firm will make no profit at all. At any lower price, the firm is not maximizing profit, because those same customers would all have purchased at the market price.

In perfect competition, the market price signifies several things. First, even though market demand is downward sloping, the demand facing an individual firm (Di) is a horizontal line at the market price. Demand for the firm's product is perfectly elastic because many firms sell identical products. The flat demand curve also tells us that, at the market price, consumers are willing and able to purchase any number of units that the seller produces. Finally, the demand at the market price level is also equal to the marginal revenue and the average revenue.

Market Price in Perfect Competition: $MR=D=AR= P$ $MR={D}_{i}=AR=P$

Because the firm takes the market price as given, instead it can only choose what quantity to produce. How does the firm decide? By maximizing the firm's profit: $TR-TC$

As long as the firm's marginal cost is increasing, the profit-maximizing production is where the marginal revenue equals the marginal cost: $MR=MC$

In perfect competition, since marginal revenue is just the market price, this rule becomes: $P=MC$ $P=MC.$

The profit maximization rule in perfect competition is: $P=MC$ $P=MC.$

The profit-maximizing firm produces at the quantity where the marginal cost curve and the market price line intersect. This is illustrated in Figure 1 panel (a). At any lower quantity, there are additional units that could be produced for a profit, because marginal revenue is greater than marginal cost (MR > MC) for those additional units. At any higher quantity, the additional units would be so costly to produce that the seller loses money on them because the marginal cost is greater than marginal revenue (MC > MR) for those units.

Fig. 1 - Firm's production in perfect competition

## Short-run decision example

Consider an example of a farmer who is deciding how much corn to plant. The farmer will be selling the corn in a perfectly competitive market where the price is $10 per bushel. The farmer figured that planting corn incurs an opportunity cost of$5, and there are no other fixed costs. However, the farmer's access to water for irrigation is heavily regulated and becomes more costly with each gallon used. Therefore, in our example, the farmer pays an increasing marginal cost for each additional bushel of corn produced.

Table 1. Farmer's Costs for Planting Corn

 Quantity of Corn (bushels produced) Fixed Cost Marginal Cost Total Cost (TC) Average Total Cost Average Variable Cost Total Revenue (TR) Profit (TR-TC) 1 5 4 9 9 4 10 1 2 5 6 15 7.5 5 20 5 3 5 8 23 7.7 6 30 7 4 5 10 33 8.3 7 40 7 5 5 12 45 9 8 50 5

The farmer maximizes profit by producing up to the point where MR = MC. From our example, we know that the marginal revenue = 10$, so all we have to do is find where marginal cost is equal to 10$ and that is at the quantity level of 4 bushels! So the farmer produces four bushels of corn. Profit is maximized at either three or four bushels of corn, so these two options are equivalent. This tells us that, at four bushels, the marginal revenue of the last unit produced was exactly equal to the marginal cost of producing it.

## Types of short-run production decisions

In the current period, which we can think of as the short run, a firm has two decisions to make. The first decision is whether to produce at all, and the second decision is how much to produce. If the answer to the first question is that it is not profitable to produce, then the second question is moot. Thus, the firm actually has two types of short-run production decisions.

• First type: Whether to produce at all
• Second type: What quantity to produce at the given market price

Because firms in perfect competition are price-takers, there is no decision to be made about what price to charge, only how much to produce.

The firm decides whether to produce at all by comparing the given market price to the firm's minimum average variable cost. If the market price is at least as high as the minimum average variable cost, it is profit-maximizing to produce in the current period, even if that means taking a financial loss.

If the market price is below the firm's minimum average variable cost, it is more profitable to shutdown and not produce any units at all. This also means taking a financial loss, but it avoids the even greater loss of producing units that cost more to produce than consumers are willing to pay.

For a given market price, the marginal cost curve itself maps out the firm's optimal quantity for each level of the market price. The individual firm's supply curve, then, is the marginal cost curve—specifically the section that lies above the minimum average variable cost. This section is shown in Figure 2 as a thicker portion of the MC curve. Below the minimum average variable cost, the firm's quantity supplied is zero. Above that point, the quantity supplied is given by the points on the marginal cost curve. Figure 2 shows the individual firm's supply curve and corresponding quantities at three possible market prices.

Fig. 2 - Individual firm's supply curve in perfect competition

## Impact of fixed cost on a firm's short-run production decisions

In the short run, some costs are fixed. For example, the compensation of non-hourly workers is fixed regardless of production output. When the firm decides how many units to produce, any fixed costs for the current period are sunk. The size of these fixed costs has no impact on the firm's short-run production decision. Instead, the short-run production decision is based only on the market price and the variable costs (specifically marginal cost and average variable cost).

However, fixed costs can impact the amount of profit that the firm receives at the chosen quantity level. If fixed costs are sufficiently small that the average total cost (at the chosen quantity level) lies below the market price, then the firm is making a profit in the short run. Alternatively, if fixed costs are sufficiently large that the average total cost (at the chosen quantity level) lies above the market price, then the firm is taking a loss in the short run. Taking a loss may still be the profit-maximizing outcome because the fixed costs are already sunk.

## Effects of variable cost on short-run production decision

Variable cost is the basis of a firm's short-run production decision. Specifically, the minimum average variable cost determines the firm's shutdown point. If the market price is below the firm's minimum average variable cost, the profit-maximizing quantity for the current period is zero. This is because, at any quantity level, the market price fails to cover the average variable cost of producing the units (not to mention contributing to the fixed costs that have been incurred for the current period).

Firms with higher variable costs will require a higher market price in order to continue producing. For a given market price, a firm with a higher marginal cost will produce a smaller number of units because they produce only up until MR = MC. At the same market price, a firm with a lower marginal cost will produce more units for the same reason.

The firm's minimum average variable cost is the firm's shutdown price. Any price below this would force the firm out of business. Profit-maximizing quantity, in that case, is zero. However, above minimum AVC, the marginal cost curve reveals the firm's profit-maximizing quantity for each given market price. This is why that section of marginal cost is shown with a thicker line in Figure 2. It is the firms' individual supply curve.

## Short Run Production Decision - Key takeaways

• Firms in perfect competition are price-takers with no market power
• Demand facing an individual firm is given by MR = Di = AR = P
• Firms maximize profits by setting MR = MC, which means P = MC
• In the short run, some costs are fixed
• Firms shut down their production if the market price is below their minimum average variable cost
• Firms produce at a loss if the market price is above the minimum average variable cost but below the minimum total cost
• Firms make a positive economic profit, even in equilibrium, if the market price is above the minimum average total cost

A perfectly competitive firm's short-run decision is how many units to produce in the current period taking the market price as given. The short-run production decision is based on variable costs, and not fixed costs, which are sunk.

If a tomato farmer has a fixed amount of land available to plant tomatoes this season, the farmer looks at the market price of tomatoes and the growing costs. Using this information, the farmer decides how many tomatoes to produce in the current season.

In the current period (i.e. the short run), a firm's profit-maximizing production decision is based on variable costs, since the fixed costs are sunk. However, in the long run, all costs are variable, and all economic costs must be covered in order to turn a profit. Therefore, the long-run decision takes into account potential fixed investments that could allow the firm to operate on a lower short-run AVC curve.

A short-run decision is any decision in which there is a fixed cost that is already sunk. A restaurant owner who has already paid the monthly rent still has to decide how many hours to stay open. The cost of the rent is sunk regardless of whether the restaurant is open 24/7 or shuts down entirely. Thus, the short-run decision about how many hours to operate is based only on variable costs (hourly wages, additional power and water, ingredients, etc.).

In short-run equilibrium in perfect competition, the number of firms is large and it is also fixed. With a constant number of firms in the market, the price level has a direct impact on profits. If the market price is above ATC, then firms are making positive economic profits, even in equilibrium.

## Test your knowledge with multiple choice flashcards

Which of the following can be subtracted from average revenue to get the firm's average profit?

What is the slope of market demand in perfection competition?

Which of the following CANNOT be true of short-run equilibrium in perfect competition:

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