(a) Distinguish between fixed and variable costs.
(b) Under which conditions will a firm continue to operate at a loss in the short run? (Use figures or a diagram to explain your answer).
Explanation
(a) Fixed Costs are costs that do not vary with the scale of production. Examples of fixed costs are rent, rates and depreciation charges. Variable Costs on the other hand, are costs that vary or change with the scale or volume of production. For example, to increase production, a firm must purchase more raw materials, employ more workers and pay for more electricity supply. So, while fixed cost is constant, variable cost is not constant.
(b) Suppose a firm's total cost is $200,000 made up of variable cost (such as labour and raw materials) and made up of fixed cost (such as interest payment and rent). If the firm's total revenue is $240,000, it is making a loss of $60,000, but the total revenue of $240,000 pays all the firm's variable cost of $200,000 and also pays $40,000 of the fixed costs. Therefore, as long as the firm can pay all its variable cost and part of the fixed cost, it would be advisable for the firm to continue in operation although it operates at a loss.
The firm will remain in business, so long as it can cover its variable costs and have something left over to help meet its fixed costs. Loss minimizing output is OQ\(_1\) and price is OP\(_1\). Average revenue, therefore, exceeds average variable cost Q\(_1\)V. In this case, the firm producing nothing, would be spending P\(_3\)P\(_2\)RV as total cost. Producing at output Q at price P\(_1\) covers the average variable cost and part of the average fixed cost by the portion P\(_3\)P\(_1\)QV. It is obviously better to remain in production in the short run and lose P\(_1\)P\(_2\)RQ than to close down production and lose P\(_3\)P\(_2\)QV