Costs, competition and a firm’s production decision

Learning goals

• Distinguish a short-run shutdown from a long-run exit decision.
• Connect market power, marginal decisions and concentration evidence.

Draft · approximately 45 minutes, excluding further revision.

Separate sunk, variable and total costs

A profit-seeking firm chooses a feasible output where marginal revenue equals marginal cost on the relevant increasing marginal-cost range, then checks boundaries and whether operating is worthwhile. Under perfect competition it takes price as given, so MR=P. In the short run, fixed sunk costs remain even if production stops; operate only when revenue covers avoidable variable costs. The usual shutdown threshold is minimum average variable cost. Long-run survival requires covering all economic costs, including opportunity costs.

Break-even output with constant price and unit variable cost is fixed cost divided by unit contribution, provided price exceeds unit variable cost. This accounting shortcut is not the general shutdown condition. Economies of scale lower long-run average cost as scale rises; diseconomies raise it. A firm can have declining average cost while marginal cost is positive.

Market structure changes the pricing problem

A monopolist or differentiated competitor faces a downward-sloping demand curve: selling an extra unit may require a lower price on other units, so MR can be below price. A monopolistically competitive market has differentiated products and entry; long-run entry can erode economic profit while leaving price above marginal cost. Monopoly involves stronger entry barriers; it does not remove the demand constraint.

In an oligopoly, a price or quantity decision depends on expected rival responses. Cournot quantity competition, Bertrand price competition and collusive arrangements answer different strategic questions; collusion may be unlawful and unstable. A concentration ratio sums leading market shares; HHI sums squared shares. Neither alone establishes competitive conduct: market definition, entry threats, substitutes and ownership links matter.

Formula and assumptions

Profit = (P−AVC)Q−FC; break-even Q = FC/(P−unit VC); HHI = Σ market share²

A production choice with fixed costs

1. At Q=100, price=20, AVC=15 and fixed cost=800. Revenue=2,000; variable cost=1,500; operating profit=−300.
2. Shutting down would lose the full fixed cost 800 if it is unavoidable. Operating loses 300, so it is the better short-run choice at this feasible output; long-run viability still needs review.
3. With the same constant unit contribution 5, break-even output=800/5=160. For market shares 40%,30%,20%,10%, HHI=1,600+900+400+100=3,000 using percentage shares.

Calculation lab

Errors to catch

• Rejecting all loss-making short-run production without checking avoidable costs.
• Treating a concentration measure as conclusive proof of market power.

Original knowledge check

Answer every question before checking. Review explanations after submitting; retry starts a new attempt.

Sources and coverage status

These original lessons are drafts. Public outlines are used to check scope; the official learning-outcome text and proprietary question banks are not reproduced here. Follow the source for exam-year requirements and updates.

• Reference · www.cfainstitute.org