Generally, we think that in a situation when average total cost of a product exceeds unit price, the firm should stop production. But this is not true. Consider the case shown in diagram 10.7.
Here, the profit-maximising output and price of a firm are ‘Od’ and ‘OP’ respectively, since both first and second order conditions of profit maximisation are satisfied at point b. At ‘Od’ quantity of output, per unit average cost becomes ‘ad’, which is composed of per unit variable cost of ‘cd’ and per unit fixed cost of ‘ac’.
At this output level, price ‘OP’ (or ‘bd’) cannot recover total cost of production. Price (bd) can recover average variable cost (cd) and a part of average total cost (be). In this situation, it is wise for the firm to continue production.
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The question is ‘why’? It is because if the firm stops production, it can save variable costs since it need not buy inputs, but at the same time it will not be able to recover any part of fixed costs. In other words, if the firm discontinues production, out of ‘ad’ amount of average total cost per unit of output, the firm can save ‘ad’ amount of variable cost and it has to accept unrecovered fixed cost.
On the other hand, if the firm continues its business, it can charge ‘OP’ (or ‘bd’) price which not only recovers per unit variable cost of ‘cd’ amount, but also a part of fixed cost i.e., ‘be’ is recovered. Thus, in case the firm operates, per unit loss equals to ‘ab’ amount, whereas close down of the firm entails per unit loss of ‘bc’ amount.
When the lowest point of the AVC curve touches the point where MC intersects MR (point ‘b’ of figure 10.8), price is just sufficient to recovervariable cost only and obviously the firm is indifferent whether to continue production or not.
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Because if it stops production, it will be able to save variable costs and if it decides to produce it will be able to recover variable costs only. Point ‘b’ is known as Shut down point, because if AVC increases marginally (represented by a shift from AVC to dotted AVC’), it would be wise for the firm to stop production as in this situation price will not be able to recover even the variable cost of production [i.e., b’d > price (bd)].
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WORKED OUT NUMERICAL PROBLEM # 1
