What this lesson teaches
I can explain a firm's cost and revenue concepts in the short run and the long run.
Syllabus 9570, 2.2.2(a). Cost and Revenue: Firms' cost and revenue concepts in the short run and long run
Make a guess
A cafe's rent rises by $2,000 a month. Its prices, ingredient costs and customers are unchanged. Should a profit-maximising owner raise prices?
- No. Rent is fixed, so the best price is unchanged.
- Yes, so that customers share the burden of the higher rent.
- Yes, because higher costs always mean higher prices.
Show the answer
No. Rent is fixed, so the best price is unchanged.
Rent does not change the cost of making one more drink, so MC is unchanged. Output where MR = MC, and the price, stay put; profit falls.
A rise in fixed cost lowers profit but does not change the best output; a rise in variable cost does.
A rise in fixed cost, such as higher rent, raises AC but not MC. Since the best output is where MR = MC, output and price do not change. Profit falls.
A rise in variable cost, such as higher wages or ingredient prices, raises both AC and MC. MC now meets MR at a lower output, so the firm produces less and charges more.
In the short run, a firm keeps producing as long as price covers average variable cost (P is at least AVC), because it has to pay its fixed costs anyway. If price falls below AVC, it should shut down.
In the long run, a firm must cover all its costs (P is at least AC). If it cannot, it leaves the industry.
- Fixed cost rises
- AC up, MC unchanged: same price and output, less profit.
- Variable cost rises
- MC up: lower output, higher price.
- Shut down
- Short run: if P < AVC. Long run: exit if P < AC.
Worked example: The workshop's rent rises
The workshop's weekly fixed charge rises from $18 to $30. Its revenue and variable costs are unchanged.
- Every level of output now costs $12 more a week.
- MC does not change, so 3 batches is still the best output.
- Profit at 3 batches falls from $18 to $6.
- In the short run it keeps producing, since revenue covers variable cost. In the long run it stays only if profit is at least normal profit.
Watch out for this
When rent rises, the firm should raise its price to pass it on.
Rent is a fixed cost, so it does not change MC or the profit-maximising output and price. Profit falls instead.
Check your understanding
A hawker's ingredient costs rise. What happens to her profit-maximising output?
- It falls, because MC rises.
- It rises, to spread the higher costs.
- It stays the same, because costs do not affect output.
Show the answer
It falls, because MC rises.
Right. Ingredients are a variable cost, so MC shifts up and meets MR at a lower output.