- Fixed, variable, and marginal cost
- Marginal cost, average variable cost, and average total cost
- Graphs of MC, AVC and ATC
- Marginal revenue and marginal cost
- Short-run production costs: foundational concepts
- Marginal revenue below average total cost
- How costs change when fixed and variable costs change
- Graphical impact of cost changes on marginal and average costs
- Short-run production costs
Marginal revenue below average total cost
People sometimes assume that a firm that isn't earning a profit should immediately shut down. In this video, we explore why that might not actually be a very good idea, and why it might be rational to produce at a loss. Created by Sal Khan.
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- How is it a 1000$ per week loss. Coz fixed cost is only one time. So if we produce for more than a month we would actually lose more money??(5 votes)
- Fixed costs don't mean one time; it means they don't vary with output (so it's always $1000 no matter how much orange juice—including none—is produced).
Yes, if you continued to produce based on this data you would keep losing money. However, as Sal says, you are better off producing where MR=MC because P is greater than AVC, which means you are covering at least some of your fixed costs. If you produce there, you lose $240 per week, but if you shut down you lose $1000 per week (since you still owe the fixed cost no matter what). Obviously, it's better to produce.
Here's another way to think about it. You buy a car to drive to work. The car costs $100 per month, gas to work and back costs $50 per month, and your job pays $125 per month. The car is a fixed cost—you pay it no matter how much (or little) you drive. The gas is a variable cost—you pay it based on how much you drive. It's $50 if you go to work each month, and $0 if you don't.
You might think, "I'm losing money by going to work, so I may as well not go!" Sure enough, you are losing $25 per month. However, although you would save $50 in gas by not going to work, you would also lose the $125 income that was paying for the gas and some of the car payment. By not going to work, you are now losing $100 per month (you still pay for the car).
Hope that helps.(33 votes)
- Incase the market price is below the ATC, won't you losses will be minimum (area of the rectangle Units*(ATC-MP) ) when ATC is minimum? So shouldn't ATC be used to determine the quantity to be produced over MC in case of loss?(6 votes)
- If you produced at the point where ATC is at a minimum, then your marginal cost would be higher than your marginal revenue. If this was the case then you would be making negative profit on every gallon you sold over 8000 dollars, so although your total costs would be lower, you would be making more of a loss due to MC being higher than MR. Sal covers this at the end of this video if you listen again :)(4 votes)
- Why does Marginal Cost = Marginal Revenue?(1 vote)
- It's not the fact that they're equal, but where they are equal that is important.
That is, where MR = MC is the quantity where profit is maximized.(12 votes)
- I'm lost at4:00. Didn't we learn in the last video that 9000 was the ideal quantity to produce?(1 vote)
- In the beginning of the previous and this video there are two assumptions made:
- in the previous video it is assumed that the price is 0.5 dollar / gallon
- in this video it is assumed that the price is 0.45 dollar / gallon
The decrease of the price was made to demostrate how the orange producer suffers a loss, but still in the short run, it is worth still running the company.
See, no reason to be lost :)(8 votes)
- Why is it that you're maximizing profits where marginal revenue equals marginal cost, wouldn't you be making more money if your marginal revenue was above marginal cost? Thanks.(1 vote)
- No. Marginal revenue is the amount of money you get from selling the next incremental unit. Marginal cost is the amount of money you pay to make the next incremental unit. If marginal revenue were greater than marginal cost, than that means you could make more money by selling the next incremental unit. That means that you haven't maximized your profit yet.(6 votes)
- when mc is equal to mr, the producer will make no profit. right?
i mean ,i don't understand why there is not a MR curve which make it more clear.
shouldn't the profit is the area below MR curve(3 votes)
- When we say MC=MR, we are normally talking about the single point at which they intersect. We are not saying that MC(Q)=MR(Q) for all Q. The profit is the area between the MR curve and the MC curve. The point at which they intersect is the point at which that area is maximized.(2 votes)
- When there is a negative profit or loss, is it a negative economic profit or a negative accounting profit?(3 votes)
- In this case, the negative 240 dollars is a negative accounting profit as opportunity costs haven't been take into consideration.(1 vote)
- I've been told that it costs 1.8 cents to produce a U.S. penny. I have never completely understood why pennies are still being made in the U.S., but does this same reasoning apply in that scenario? That MC must equal MR, otherwise there would be that loss of $1000 (or whatever amount that would be substituted in for this example)? Or is this specifically only for the short-term, in order to cut losses until a more permanent solution is made?(2 votes)
- The marginal revenue from making 1 penny is 1¢, no more or less. If the marginal cost of making a penny is 1.8¢, then it is clearly unprofitable for the US Treasury to make pennies. However, governments aren't known for doing things profitably.(3 votes)
- So what happens when Average variable cost is higher than the Marginal cost?
On a side note, what's a simple way to remember what the variable cost is?(2 votes)
- If AVC is higher than MC, production should stop because revenue does not cover fixed or variable cost. Variable cost is total cost - fixed cost.(2 votes)
- When MR = MC are you not only breaking even? I'm confused, how do you maximize profit when breaking even? Or is it the point where the maximum amount of profit has been made and no more profit is possible?(2 votes)
- When Marginal Revenue equals Marginal Cost, you have made the maximum amount of profit possible. That is what it means to maximize profit. The actual profit you get might be anything; it can even be negative, but the point at which marginal revenue equals marginal cost is the best you can do for yourself.(2 votes)
In the last video, we finished up asking ourselves, how much do we produce if the market price is at $0.45? And just going with the logic that we introduced in the last video, you want to produce as much as possible to spread out the fixed cost. But you don't want to produce so much that the marginal cost is higher than your marginal revenue. And your marginal revenue is your market price. Every unit, every incremental unit, you're going to get $0.45. So you want to look at the quantity where your marginal revenue, the $0.45, is equal to your marginal cost. So we could look at it over here. So if we look at our marginal revenue, let's say $0.45 is right over there. You want to look where the $0.45 is equal to your marginal cost. And it looks like it is right over there. Now we could even see it on our table. When does our marginal cost equal $0.45? It equals that when we produce 8,000 gallons of our juice. Now the reason why this is somewhat interesting is at that point the amount of revenue that we're getting per unit, our marginal revenue, is less than our total cost per unit. We're selling each unit at $0.45, but our total cost for each of those units is $0.48 on average. So this right over here is our total cost. So you might say, look, I'm making a loss on every unit. The total amount of revenue I'm getting is a smaller rectangle over here. It's the quantity times the marginal revenue per unit. So this is the amount of revenue that I'm getting. Let me color it in carefully. That is the amount of revenue that I'm getting. While my costs are this larger rectangle. My quantity times my average total cost per unit. And so what I end up with is if you take that revenue and you subtract out that quantity, you end up with a loss of exactly this much. You are operating, in this situation, at a loss. You're operating at a loss when you are producing 8,000 units and you're getting $0.45 per unit. So does it make sense for you to do this? And we can even figure out the loss. You are producing 8,000 units. You're selling them for $0.45 a unit. And it costs you $0.48 per unit to produce them on average when you put all the costs in, $0.48 cents per unit. So you are losing $0.03 per unit, I guess gallon. We're talking about orange juice here. And it's times 8,000 gallons, means that we are losing we are losing $240. 8,000 times $0.06 is 24,000 cents, which is the same thing as $240. So does it make sense for us to do this? Well, one way to think about it, let's say we didn't do it. Let's say we're like, hey, I'm not going to produce any gallons. Well then what's going to be our loss? Well, we're assuming that this is our fixed cost. We've already committed ourselves to this expenditure right over here. Whether we produce no drops of orange juice, we are still going to be spending $1,000/ So if we produce nothing, we are guaranteeing ourselves a weekly loss of $1,000. And so this is at least better than that. So by starting to produce some units, we are at least able to offset some of that loss. And we're spreading out that fixed costs over more and more and more gallons. And you might say, hey, well why don't I just keep producing more and more units? Why don't I go here and maybe I produce 9,000 units where the marginal cost all of a sudden is higher than our marginal revenue? And the reason why that won't make any sense to do is because if you produce that many units, then all of a sudden each of those incremental units that you're producing beyond the 8,000, you're losing money on those. That 8,000 in first unit, the marginal cost is going to be higher than the marginal revenue that you're bringing in on that unit. So you're going to be losing money. You're going to start having a lower profit than even the negative $240 loss. It'll start going at a negative 240 something, negative 250, and so forth and so one. So you still don't want to produce beyond that point. And we'll touch more deeply on it in future videos, but this is essentially what differentiates the short-term supply curve from the long-run supply curve. In the short-term, we're going to assume that we have these fixed costs. And so it's just going to make sense to produce equivalent to our marginal cost. But over the long-run, maybe our fixed items, our capital, our machinery wears off or maybe the contract for my employees wear off, and then we have a different cost structure over the long-term. But we'll think about that in another video. But the simple answer is, assuming these really are your fixed costs, you still want to produce as many units as possible so that your marginal cost is equal to your marginal revenue, which in this case is the market price. We are price takers. So it actually is a rational thing to produce 8,000 units and take a loss on that and take a $240 per week loss as opposed to just producing nothing and taking $1,000 per week loss. Now it might not be rational once these things have been worn out-- your robots and the employees' contracts. It might not be rational to continue them past their term. And we'll think about that more because obviously, we are running at a loss. This is not necessarily a good business to be in, but now that we've gotten into the business, we might as well stay in it in order to recoup some of our costs here or at least spread them out, or at least not have $1,000 per week loss. Anyway, see you in the next video.