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Short-run Supply in a Perfectly Competitive Market
In determining how much output to supply, the firm's objective is to maximize profits subject to two constraints: the consumers' demand for the firm's product and the firm's costs of production. Consumer demand
determines the price at which a perfectly competitive firm may sell its output. The costs of production are determined by the technology the firm uses. The firm's profits are the difference between its total revenues and total costs. A firm's total revenue is the dollar amount that the firm earns from sales of its output. A firm's marginal revenue is the dollar amount by which its total revenue changes in response to a 1-unit change in the firm's output. A firm maximizes its profits by choosing to supply the level of output where its marginal revenue equals its marginal costs. When marginal revenue exceeds marginal cost, the firm can earn greater profits by increasing its output. When marginal revenue is below marginal cost, the firm is losing money, and consequently, it must reduce its output. Profits are therefore maximized when the firm chooses the level of output where its marginal revenue equals its marginal cost.
Short-run losses and the shut-down decision. When the firm's average total cost curve lies above its marginal revenue curve at the profit maximizing level of output, the firm is experiencing losses and will have to consider to shut down its operations. In making this determination, the firm will take into account its average variable costs rather than its average total costs. The difference between the firm's average total costs and its average variable costs is its average fixed costs. The firm must pay its fixed costs (for example, its purchases of factory space and equipment), regardless of whether it produces any output. Hence, the firm's fixed costs are considered sunk costs and will not have any bearing on whether the firm decides to shut down. Thus, the firm will focus on its average variable costs in determining whether to shut down.
If the firm's average variable costs are less than its marginal revenue at the profit maximizing level of output, the firm will not shut down in the short run. The firm is better off continuing its operations because it can cover its variable costs and use any remaining revenues to pay off some of its fixed costs. The fact that the firm can pay its variable costs is all that matters because in the short-run, the firm's fixed costs are sunk; the firm must pay its fixed costs regardless of whether or not it decides to shut down. Of course, the firm will not continue to incur loses indefinitely. In the long-run, the firm will have to either shut down or reduce its fixed costs by changing its fixed factors of production in a manner that makes the firm's operations profitable.
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