The following example of two firms that produce cold drinks in a perfectly competitive market illustrates why it is in the interest of a firm to continue its production even if it makes a loss:
Given that the price of a cold drink is R5 and that each firm produces a 1 000 cold drinks, their total revenue (TR) – that is, the price times the quantity (P x Q) – is R5 000. Both firms face the same fixed cost of R2 000.
Their variable costs, however, differ. In the case of firm 1, the variable cost (VC) is R4 000, while for firm 2, it is R5 500. The reason for the difference in the variable costs might be that firm 1 is more efficient in using its resources than firm 2. The total cost of production (TC) for firm 1 to produce 1 000 cold drinks is therefore R2 000 (the fixed cost) + R4 000 (the variable cost) = R6 000; and for firm 2, it is R2 000 (fixed cost) + R5 500 (variable cost) = R7 500. In both cases, the total revenue is smaller than the total cost, and both firms make a loss. The total loss for firm 1 is R5 000 – R6 000 = -R1 000, while for firm 2, it is R5 000 – R7 500 = -R2 500.
Table: The shutdown point
Firm 1 | Firm 2 | |||
Total revenue (TR) | R5 000 | R5 000 | ||
Fixed cost (FC) Variable cost (VC) Total cost (TC) |
- R6 000 |
R2 000 |
- R7 500 |
R2 000 |
Total loss if it stays in business | -R1 000 | -R2 500 | ||
Total loss if it shuts down | -R2 000 | -R2 000 |
Should both firms shut down their production? Not necessarily, let's see why:
In the case of firm 1, it should keep on producing since it would only lose R1 000 as opposed to R2 000, while firm 2 should shut down its business because by doing so it would only lose R2 000. If it decides to keep the business open, it would lose R2 500. In this case, we say that firms are minimising their losses.