(a) Distinguish between fixed and variable costs. (b) Under which conditions will a firm continue to operate at a loss in the short run? (Use figures or a d...
Question 1 Report
(a) Distinguish between fixed and variable costs.
(b) Under which conditions will a firm continue to operate at a loss in the short run? (Use figures or a diagram to explain your answer).
Answer Details
(a) Fixed costs versus variable costs.
| Fixed costs | Variable costs |
|---|---|
| Do not change with the level of output. | Change directly with the level of output. |
| Must be paid even when output is zero. | Are zero when output is zero. |
| Examples: rent, insurance, salaries of permanent staff, interest on loans. | Examples: raw materials, fuel, wages of casual labour, power used in production. |
| Also called overhead or supplementary costs; exist only in the short run. | Also called prime or direct costs. |
(b) When a firm will continue to operate at a loss in the short run. In the short run some costs are fixed and must be paid whether or not the firm produces. A firm should keep producing, even at a loss, as long as the price it receives at least covers its average variable cost. The reason is that by producing it earns revenue that covers all its variable costs and makes some contribution towards the unavoidable fixed costs; shutting down would still leave the whole of the fixed cost to be paid, so the loss would be larger.
The rule can be stated as:
- If \(P \geq AVC\): continue producing in the short run, because revenue covers variable cost and helps pay part of fixed cost.
- If \(P < AVC\): shut down, because each unit sold loses more than the fixed cost alone; producing makes the loss worse.
Worked illustration. Suppose fixed cost is \(N400\), and to produce 100 units the variable cost is \(N600\), so average variable cost is \(N6\) per unit. Total cost is \(N1000\), so average total cost is \(N10\) per unit.
- If the price is \(N8\): revenue \(= 100\times 8 = N800\). This is below total cost of \(N1000\), so there is a loss of \(N200\). But \(N8\) is above the \(N6\) average variable cost, so revenue covers the \(N600\) variable cost and contributes \(N200\) towards fixed cost. If the firm shut down it would lose the full \(N400\) fixed cost. Producing (loss \(N200\)) is better than shutting down (loss \(N400\)), so the firm continues.
- If the price fell to \(N5\): revenue \(= N500\), which does not even cover the \(N600\) variable cost. The firm should shut down, because producing would lose more than the \(N400\) fixed cost.
So a firm continues to operate at a loss in the short run only while price is at least equal to average variable cost. This is called the shut-down point: it lies at the minimum of the average variable cost curve.
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