Exercise 6.1:
Why does the price of electronic instruments continue to fall even as the demand for them increases?

Many years ago a Texas Instruments TI-6 calculator cost $128.97. You can now get a calculator, which will do everything that one did (add, subtract, divide, multiply and store one number in memory) as a prize in a Cracker Jacks box. An early home computer with an amazing amount of memory-64K-cost from roughly $200 (Commodore 64) to $650 (Apple II-e and IBM PCjr) in 1983. To get that in perspective a standard 3-½ inch diskette holds 1.44mb, just over 23 times the memory of these computers. The same computing power now comes in calculators given away as marketing gifts for anyone who visits "the booth" at the local computer show.

The same $650 today buys a pretty impressive home computer, monitor, printer and all. Meanwhile the demand for home computers has risen. Why has the price come down so dramatically? It is a matter of supply. During the past seventeen years the cost of producing computers has fallen a great deal. Chips have gotten more powerful, drives and disks have increased in both speed and capacity and the manufacturing costs have fallen as new technologies have come into play. Looking at it from a supply and demand viewpoint:

The supply and demand curves have both shifted right as indicated by the arrows. Supply is moving in response to lowered costs and demand is moving in response to increased usefulness and the fashion of having a home computer. Costs are falling much more quickly than desire in increasing, resulting in shifts like S to S' and D to D'. The result is, as we have seen, a dramatic drop in the price of home computers.

In the interests of "truth in advertising" this model does not completely capture what is happening in the computer market, since so much is being driven by the increased computing power in the machines. This diagram does not capture the difference in quality between the computers of 1983 and the present, but it does provide a model through which we can see the fundamental characteristics of the shift.

Exercise 6.2:
Why Do Some Firms Continue to Produce When They are Losing Money?

Sometimes a firm continues to operate even when it is obvious to many people that the firm is losing money. Why would a firm continue to produce at a loss? The basic answer is that the firm will lose LESS by continuing to operate in the short-run than it would if it shut-down and produced 0. The firm is in the unenviable position of MINIMIZING LOSSES by continuing to produce, rather than maximizing profits.

To understand why the firm is better off (i.e. loses less) by producing, first remember that this happens in the SHORT-RUN. In the long-run, if the firm is losing money it will certainly shut-down. However, in the short-run at least one factor of production is fixed. For example, the firm may have a lease that does not expire for months and therefore its rent costs are fixed in the short-run. The firm must continue to pay rent for as long as the lease specifies (the short-run) but once the lease expires the firm may shut-down and no longer have to pay rent (the long-run).

When a firm is losing money in the short-run, it can either continue to produce the profit-maximizing quantity at a loss, or shut-down (produce zero). If the firm shuts down, it earns no revenue but must continue to pay its fixed costs. Therefore it losses if it shuts down equal its total fixed costs (TFC). If the firm loses more than its fixed costs when it produces the profit-maximizing quantity, then it should shut-down since shutting down results in lower losses. But if the firm loses less than its fixed costs by continuing to produce then it is better off producing.

Therefore the firm should continue to produce if the total revenue it earns (TR) at least covers its total variable costs (TVC). Any revenue in excess of TVC can be used to pay at least part of the firms fixed costs (which is better than not paying any of them!). The shut-down rule can be stated as:

Shut down if TR < TVC

If we divide each side by Q, the rule can also be stated as:

Shut down if (P x Q)/Q < TVC/Q

Or P < AVC

If the firm isn't even earning enough on each unit to pay for the variable costs (that increase as more is produced), then it loses more for every additional unit it sells. The loss gets bigger and bigger the more the firm produces. The best situation is for the firm to shut down and produce 0.

However, if the firm can cover the variable costs of producing, and have even a little bit to apply toward paying fixed costs, that's better than paying none of the fixed costs.

Remember, in the short run, firms must pay fixed costs whether they produce or not. So it is the variable costs that must be considered when determining whether a firm should shut down or produce!