If the average cost curve of the firm lies above the average revenue (price) curve, the firm suffers losses, as shown by the shaded area in Fig. 10.4. Here, the equilibrium point is below the break-even point. In this case, the average cost of the firm corresponding to its equilibrium output OQ is equal to BQ, which is greater than the equilibrium price EQ.
The loss per unit of output incurred by the firm is EQ – BQ = EB. The overall losses suffered by the competitive firm under consideration from the sale of equilibrium output are ‘loss per unit of output x equilibrium quantity’, i.e., EB x OQ = Area (APEB). Alternatively,
Total Losses = Total Cost – Total Revenue
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= Average Cost x Equilibrium Quantity – Price x Equilibrium Quantity
= BQ x OQ – OP x OQ
= Area (OABQ – OPEQ)
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= Area (APEB)
Fig. 10.4: Short-Run Equilibrium of a Competitive Firm Suffering Losses
The competitive firm suffers losses in the short-run, when it cannot cover the full average cost (AC). In such situations, the firm tries to minimise the losses. The competitive firm will be willing to bear the loss, provided price (or total revenue) at least covers the average variable cost (or total variable cost).
In the present case, the competitive firm will continue to produce, since, it is able to cover the entire average variable cost (AVC) and a part of fixed cost (EC per unit of output). Here, price is less than AC, but greater than AVC. If the firm ceases production, it will continue to incur full fixed cost (indicated by the gap between AC and AVC) though variable costs will be avoidable.
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In that situation, the losses of the firm would be much higher (loss per unit of output x quantity, i.e., BC x OQ = Area (P1ABC)), since, otherwise by continuing to produce, the firm was able to cover a part of the fixed cost. Thus, in the present case, the firm is minimising its losses by choosing to produce and sell.
So long as these losses are less than the fixed costs (i.e., when equilibrium price is greater than AVC, but, less than AC), a prudent firm will continue to operate the business rather than to stop production. In other words, if the firm is incurring losses in the short-run, the maximum losses it can bear do not exceed total fixed costs. However, the firm cannot bear losses on the variable costs in the short-run.
When the AVC is greater than the market price (i.e., AVC curve is above AR curve), the competitive firm should temporarily suspend the operations in the short run to avoid loss on variable costs, i.e., the losses over and above the fixed cost.
With no production and consequent zero sales (revenue), the losses equal to fixed cost will still be there, since, fixed cost is unavoidable in the short-run.
The firm in such a situation will prefer to incur this loss by closing down and will avoid the losses incurred on variable costs. Further, if, the AVC is just equal to the market price (i.e., AVC curve touches equilibrium point ‘E’ in Fig 16.4), losses are equal to fixed costs and the competitive firm will be in a position of indecision.
The decision to operate or shut down in that situation will depend upon future demand. If the firm expects the demand to expand in future, it will continue to operate in the short-run, otherwise ‘not’.