Cost Analysis and Optimal Decisions
In sum, the firm should continue production because the product generates a positive contribution, thereby minimizing the firm’s loss. The firm suffers an economic loss in the short run; nevertheless, this is better than shutting down. Thus, we have the following general rule: In the short run, the firm should continue to produce as long as price exceeds average variable cost. Assuming it does produce, the firm maximizes contribution (and minimizes any losses) by setting marginal revenue equal to marginal cost. In the long run, all inputs and all costs are variable. (For instance, a firm that leases its plant and equipment can shed these costs if it chooses not to renew its two-year lease. The firm can also downsize its workforce over time.) In the long run, the firm should continue operating only if it expects to earn a nonnegative economic profit. A firm that suffers persistent economic losses will be forced to exit the industry.
Earlier we noted that the repair firm’s cost function is C ⴝ 270 ⴙ 30Q ⴙ .3Q2. Suppose demand is given by P ⴝ 50 ⴚ .2Q. What is the firm’s optimal course of action in the short run? In the long run?
Multiple Products In the previous section, we noted that the prevalence of multiproduct firms is explained by economies of scope. The implication of such economies is that the firm can produce multiple products at a total cost that is lower than the sum of the items’ costs if they were produced separately. As we shall see, managers must be careful to pay attention to relevant costs in a multiproduct environment. To illustrate, consider a firm that produces two products in a common facility. The firm’s total cost of production is described as C FC VC1 VC2, where FC denotes the total fixed costs shared by the products. The separate variable costs for the products also are included and depend directly on the output levels of each product. The firm’s total profit is
(R1 VC1) (R2 VC2) FC,
[6.6]
where R1 and R2 denote the products’ revenues. As noted earlier, each term in parentheses is the product’s contribution. The firm’s total profit is the sum of its products’ contributions minus its total fixed costs.
CHECK STATION 4
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