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Firms in a competitive industry have freedom to enter or exit. With the presence of Super
Normal profits, outside firms start entering the industry.
If, however, some firms are suffering Sub Normal profits or losses, they will not take
the decision to withdraw from the market immediately in the short run.
They will prefer to wait and find out whether market conditions improve to their
advantage.
If they continue to make losses even in the long run the firms will have ultimately to
leave the industry.
This decision is governed by the behavior of the firms Average Variable Cost curve
(AVC).
So long as market price is above AVC the firm will cover all its variable costs and the
same fixed costs as well.
If the price falls below AVC the firm will have to close down and to stop productive
activity.
This is because variable cost is current expenditure which a firm must expect to cover at
market price.
If it is unable to cover fixed costs the firm can wait and hope to cover them in the long
run.
ESSENTIALS
A.V.C. i.e. AVERAGE VARIABLE COST IS THE RATIO BETWEEN
TOTAL VARIABLE COST AND TOTAL OUTPUT(Q1 + Q2= Q).
THUS FUNCTIONALLY, A.V.C. = TOTAL VARIABLE COST/TOTAL
OUTPUT i.e T.V.C./T.O.(T.O. = TOTAL OUTPUT)
S.A.C i.e. THE SHORT RUN AVERAGE COST. IT IS THE SUMMATION
OF AVERAGE FIXED COST AND THE AVERAGE VARIABLE COST.
THUS FUNCTIONALLY, S.A.C. = A.F.C. + A.V.C., WHERE A.F.C. =
AVERAGE FIXED COST AND A.V.C. = AVERAGE VARIABLE COST.
S.M.C. i.e. THE SHORT RUN MARGINAL COST, IS THE RATIO
BETWEEN THE CHANGE IN TOTAL COST IN RELATION TO THE
CHANGE IN TOTAL OUTPUT(Q).
FUNCTIONALLY S.M.C. = T.C./ Q, WHERE REPRESENTS THE
change WHETHER ITS increase or decrease.
NOW, MOVE TO THE ANALYSIS PART.
S.M.C. INTERSECTS A.V.C AND S.A.C. CURVE TO ITS MINIMUM
FROM below AND AT THE POINT OF MINIMUM OF A.V.C. THAT IS
POINT A WHERE A.V.C.=S.M.C. AND AT THE POINT OF MINIMUM
OF S.A.C. THAT IS B WHERE S.A.C. = S.M.C.
AFTER THIS INTERSECTION POINT ALL S.M.C., A.V.C. AND S.A.C.
CURVES ARE RISING. BUT THE RISE IN S.M.C. CURVE IS GREATER
THAN A.V.C. AND S.A.C. CURVE.
CONCLUSION: THIS YIELDS THAT when price is as high as P(i.e. COST) the
firm makes normal profits. If the price falls to P1 then the firm still covers
all its variable costs plus part of the fixed costs. If the price
further falls to P2 the firm cannot cover even its variable costs. It is then
advisable that the firm should close down. Therefore Shutdown point for a firm is
one where price is just equal to its Average Variable Cost or below AVC.
LONG-RUN CONCEPT
DIFFERENT HERE.
LETS SEE THE ABOVE DIAGRAM.
COST.
IN THE BEGINNING BOTH L.R.M.C. AND L.R.A.C. CURVES ARE FALLING
BUT FALL IN L.R.M.C. CURVE IS GREATER THAN L.R.A.C. CURVE.
L.R.M.C CURVE INTERSECTS L.R.A.C. CURVE TO ITS MINIMUM POINT
FROM BELOW AND AT THIS POINT A L.R.A.C. = L.R.M.C.
AFTER THIS INTERSECTION POINT, BOTH L.R.M.C. AND L.R.A.C. ARE
RISING BUT RISE IN L.R.M.C, CURVE IS GREATER THAN L.R.A.C. CURVE.
ESSENTIALS
THUS FUNCTIONALLY, L.R.A.C. = TOTAL COST/TOTAL OUT PUT, LONG
RUN AVERAGE COST IS THE RATIO BETWEEN TOTAL COST AND TOTAL
OUTPUT.
THUS FUNCTIONALLY, L.R.M.C. =
T.C./
Q, WHERE