Friday, September 14, 2012

Making Losses But Still Producing

One of the topics that occurs in some of the courses that I teach is the question about whether a firm should produce or shut-down (temporarily cease operations).  In class I make the case that if a firm will make a profit - then it's a no-brainer that the firm should produce.  The more interesting question is with regard to what if the firm knows that it will be making a loss; then what?  Well, sometimes the firm is economically better off by staying open and producing and sometimes not.  The dividing line is whether the firm is able to charge a price such that it covers its per unit production costs - or what I call average variable costs.  If the price is greater than (or equal to) average variable costs, then the firm has an incentive to produce, even if it knows that it will make a loss, since by doing so it can also cover some of its fixed costs, assuming that price is greater than average variable cost.  Here is a nice example of just that in the chain restaurant industry.

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