What this lesson teaches
I can explain the strategies firms use to raise revenue or cut unit costs: growth, pricing, price discrimination, innovation, marketing and collusion.
Syllabus 9570, 2.2.3(a). Firms' Decisions and Strategies: Firms make decisions and engage in pricing, cost and product differentiation strategies aimed at raising revenue and/or lowering unit costs. These include:; growth, diversification and shut-down; price competition; third degree price discrimination; innovation, research and development; marketing; collusion with other firms
Make a guess
A stall takes in $500 a week, spends $400 on ingredients and wages, and pays $300 rent whether it opens or not. Should it open next week?
- Yes. It loses $200 open, but $300 closed.
- Yes, because $500 is more than its $300 rent.
- No. It makes a loss, so it should close.
Show the answer
Yes. It loses $200 open, but $300 closed.
Opening covers its variable costs and adds $100 towards rent. Closing saves the $400 of variable costs but still leaves the full $300 rent.
In the short run, a firm stays open if revenue covers variable cost; in the long run, it must cover all its costs.
In the short run, a firm must pay its fixed costs, such as rent, whether it opens or not. So the question is whether opening adds more to revenue than to cost.
If revenue covers variable cost (price is at least AVC), opening helps pay part of the fixed costs. The firm should stay open, even at a loss.
If revenue does not cover variable cost (price is below AVC), every unit adds to the loss, so the firm should shut down temporarily.
In the long run, all costs can be avoided. A firm that cannot cover its total costs (price is below AC) should leave the industry.
- Short run
- Stay open if P is at least AVC.
- Long run
- Exit if P is below AC.
Worked example: Open at a loss, or close?
This week, a shop can earn $80 in revenue with $60 of variable costs. It pays $35 of rent whether it opens or not.
- Open: $80 - $60 - $35 = a $15 loss.
- Closed: it still pays the rent, a $35 loss.
- Opening is better: the $20 left after variable costs helps pay the rent.
- When the lease comes up for renewal, the rent can be avoided, so the shop should leave if it cannot cover all its costs.
Watch out for this
A firm making a loss should close immediately.
In the short run, it should stay open if revenue covers variable cost, because closing does not save the fixed costs.
Check your understanding
A stall's weekly revenue is $500, variable costs are $550 and rent is $300. What should it do in the short run?
- Shut down: revenue does not cover variable cost.
- Raise its price until revenue covers the full $850 of costs.
- Stay open, because it must pay the $300 rent whether it opens or not.
Show the answer
Shut down: revenue does not cover variable cost.
Right. Opening loses $50 more than closing, on top of the rent.