9781118041581

Cost Analysis and Optimal Decisions 257

point of minimum average cost. Figure 6.6 shows the problem with this con-

tention: The profit-maximizing output Q* falls well short of Qmin. In fact, if

the firm were to produce at Qmin, it would suffer an economic loss. (The

demand line falls below the average-cost curve at Qmin.)

The general point is that the firm’s optimal output depends on demandas

well as cost. In Figure 6.6, the level of demand for the firm’s product is insuf-

ficient to justify exploiting all economies of scale. However, we easily could

depict a much higher level of demand—one that pushes the firm to an output

well above Qmin, that is, into the range of increasing average cost. The figure

shows part of a (hypothetical) demand curve and the associated marginal rev-

enue curve that intersects marginal cost at output Q. For this level of demand,

Q(a quantity much greater than Qmin) is the profit-maximizing output.

The second fallacy works in the opposite direction of the first. It states

that if the current output and price are unsatisfactory, the firm should raise

its price to increase profits. The intuitive appeal of this “rule” is obvious. If

price is too low relative to average cost, the remedy is to increase price.

However, this contention is not necessarily so. In Figure 6.6, raising price is

appropriate only if the current price is lower than P* (with output greater

than Q*). If price is already greater than P*, further price increases only

reduce profits. In fact, the figure can readily demonstrate the classic fallacy of

managing the product out of business. Suppose management makes the mis-

take of setting its output at Q. Here the firm’s price Pis slightly below aver-

age cost, so the firm is incurring a loss. As a remedy, the firm raises price. Does

this improve profits? No. The increase in price causes a decrease in quantity

(which is expected) but also an increase in average cost (perhaps unex-

pected). At a higher price and lower output, the firm still is generating a loss.

If it raises price again, its volume will shrink further and its price still will fail

to catch up with its increasing average cost. By using this strategy, the firm

quickly would price itself out of the market.

The Shut-Down Rule

Under adverse economic conditions, managers face the decision of whether

to cease production of a product altogether, that is, whether to shut down.

Although the choice may appear obvious (shut down if the product is gener-

ating monetary losses), a correct decision requires a careful weighing of rele-

vant options. These alternatives differ depending on the firm’s time horizon.

In the short run, many of the firm’s inputs are fixed. Suppose the firm is

producing a single item that is incurring economic losses—total cost exceeds

revenues or, equivalently, average total cost exceeds price. Figure 6.7 displays

the situation. At the firm’s current output, average cost exceeds price: AC P*;

the firm is earning negative economic profit. Should the firm cease production

and shut down? The answer is no. To see this, write the firm’s profit as

c06CostAnalysis.qxd 9/29/11 1:46 PM Page 257