Principles of Microeconomics / Unit 7 MIC 0639 review, 2 to 3 minutes
One Price-Taking Firm from a Price Cut to Exit
The idea
One firm's cost table answers every short-run and long-run question this unit asks, and following one farm from good times to exit puts the questions in the order a firm meets them. Start with the market price high. The firm applies the marginal rule, producing every unit whose marginal cost is at or below the price, and reads its profit as price minus average total cost at that quantity, times the quantity. That profit is a signal to others, and entry follows. Now the price falls. The firm applies the same rule and finds a smaller quantity, and now price sits below average total cost: a loss. Before accepting it, the firm runs the shutdown test. If price is at or above average variable cost, operating loses less than the fixed cost it owes anyway, so it operates at a loss. If price falls below average variable cost, every unit adds to the loss and it shuts down, still paying the fixed cost. Either way the loss is a signal in the other direction. In the long run the firm can shed its fixed inputs, and if the price has not recovered it exits. Exit shifts market supply left and raises the price for the survivors, until the price is back at minimum average total cost and the remaining firms earn a normal profit. The two breakpoints organize everything: the break-even price at minimum average total cost separates profit from loss, and the shutdown price at minimum average variable cost separates operating at a loss from producing nothing.
In practice
Worked example: the strawberry farm, fixed cost sixty, marginal costs twenty, twelve, ten, twelve, sixteen, twenty, twenty-four, twenty-eight. At thirty dollars it grows eight flats and earns thirty-eight. Entry pushes the price to twenty-five; it grows seven and earns about a dollar, zero for practical purposes. A demand slump takes the price to twenty; it grows six and loses thirty, but twenty is above the average variable cost of fifteen, so it keeps growing. A worse season takes the price to twelve; the rule says four flats, but average variable cost there is thirteen fifty, above the price, so it shuts down and loses the sixty of fixed cost instead of sixty-six. If twelve dollars persists into the long run, the farm sells its land and exits; with fewer farms the price recovers toward twenty-five for those that remain.
Where people slip
Three cautions. The marginal rule never changes; what changes with the price is the quantity it returns and whether that quantity profits. The shutdown test uses average variable cost, and a firm below average total cost but above average variable cost is right to keep going. And exit, not shutdown, is what restores the price; a shut-down firm still counts as capacity waiting to return.
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