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Loss Minimization

Firms do not earn a profit at all times. Occasionally, a firm will incur a loss, that is, total cost exceeds total revenue. But how should a manager react at that time? Should the manager stop operating the firm? Should the manager continue to operate the business even though the firm is incurring a loss?

The general response is that a manager may continue to operate a business in the short-run even though it is incurring a loss. The reason is that if a firm stops operating, it is still incurring its fixed costs, that is, the cost associated with the fixed inputs. Fixed inputs were described in another section as those inputs that cannot be changed in the time period being considered by the manager. Restated, in the short run, there is not enough time to expand the fixed input (such as construct another building) or there is not enough to time contract or reduce the fixed input (such as sell a manufacturing building).

In the short run, the cost of the fixed input (e.g., depreciation, maintenance, interest on debt associated with the asset, opportunity cost on equity invested in the asset) is going to be incurred whether or not the business is being operated.

Variable costs, on the other hand, drop to zero when the business is shut down because the variable inputs are no longer being purchased, e.g., some utilities, fuel, and labor.

The manager's decision is "is the business "better off" continuing to operate and thereby earning some revenue but incurring variable and fixed costs, or is the business "better off" to stop operating, earn no revenue, incur no variable cost, but continue to incur fixed cost."

The answer is "as long as the business is generating enough revenue to pay all variable cost and some fixed cost, the business will incur a smaller loss than if the business shut down and paid none of its fixed cost."

Operate the business as long as TR > TVC, even though TR < TC.

Graph 26

Graph 27

How long will a business operate at a loss?

This is a tricky question. First, if revenue drops further so it is less than variable cost, the manager will cease operation.

Second, what if revenue does not drop any further? Will the business continue to operate at a loss for an indefinite time? The answer is "no" but the reason, as explained by economic theory, may not be immediately clear.

The assumption is that the manager is thinking about the short run; that is, a time period wherein there is time to vary the level of some inputs (variable inputs) but there is not enough time to vary other inputs (fixed inputs). As the manager thinks about a longer time period, more inputs become variable; more cost become variable. As more cost become variable, the revenue needs to pay a greater portion of the total cost to justify continuing to operate at a loss.

Another way to describe a fixed input/cost becoming a variable input/cost is to consider a long-term (fixed?) asset that needs to be replaced because it is worn out. This long-term asset that needs to be replaced is no longer a fixed input, but is now a variable input and the cost of the replacement asset is now a variable cost. The need to replace a long-term asset shifts fixed cost to variable cost. Needing to replace a worn out piece of major equipment is an example of a long-term asset that is a variable input/cost.

Graph 28

Even without a change a revenue, an unprofitable firm will cease operation when there is enough time to sell or consume its fixed assets.

The manager will cease operation when enough time has passed that fixed inputs/costs are now considered variable inputs/costs and the revenue is not enough to pay all the costs that are now variable.

In summary: a business will continue to produce in the short-run even though the firm is experiencing a loss (i.e., P < ATC; TR < TC) as long as the price of output exceeds average variable cost (P > AVC; TR > TVC).  Restated, a business will operate to minimize loss as long as TR exceeds TVC. In this situation, all variable costs and  some portion of fixed cost are being paid; when the firm ceases operation, none of the fixed cost is paid.

When revenue is not enough to pay total variable cost, the firm will stop producing.

Thought Question

• Will a manager always decrease production when the price of the output declines? Why? How does this decision relate to the manager's other goals? How does this decision relate to the manager's perception about 1) the value of the manager's labor, 2) the manager's trade-off between time away from work and the manager's goal for family income, and 3) the manager's willingness and ability to assume risk?

• An example from years ago. A dairy farmer was being interviewed about a recent drop in the price of milk. The farmer was asked what he will do in response to the drop in price. He said, "I guess I will milk more cows." This is inconsistent with economic theory. Was the farmer wrong? Is theory wrong? Is theory only "telling part of the story?"

Summary: How much to Produce

• Marginal Value Product (MVP) -- additional revenue that results from using one more unit of variable input
• Marginal Input Cost (MIC) -- additional cost that arises from using one more unit of variable input
• Decision rule:  use additional units of variable input as long as the additional revenue (MVP) exceeds the additional cost (MIC)

• Marginal Cost (MC) -- additional cost that arises from producing one more unit of output
• Marginal Revenue (MR) -- additional revenue that results from producing and selling one more unit of output
• Decision rule:  produce additional output as long as revenue from the additional output (MR) exceeds the cost of producing additional output (MC)

• The marginal value product (MVP) in stage II is that firm's demand for the variable input; that is, as the price of variable input decreases, the firm will increase its use of the variable input.
• The marginal cost (MC) above average variable cost is that firm's supply of the output; that is, as the price of the output increases, the firm will produce a larger quantity of the output.

• Do not produce where total physical product is maximized unless the variable input is free or the price for the output is infinite (neither condition is likely).

• Produce in the short-run (that is, some inputs are fixed and some inputs are variable) even though the firm is suffering a loss as long as revenue exceeds total variable cost.  In such a situation, although all costs are not being paid, at least all variable costs are being paid and some fixed cost.  This is better than not producing at all because without any production, none of the fixed cost will be paid.

Managers may also want to consider the economic theory that explains deciding how to produce and what to produce.

Last Updated October 22, 2009

Email: David.Saxowsky@ndsu.edu

This material is intended for educational purposes only. It is not a substitute for competent professional advice. Seek appropriate advice for answers to your specific questions.

E-Mail:sswandal@ndsuext.nodak.edu
Published by Agricusiness and Applied Economics
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