Check Your Understanding

1. Question

   Draw a short-run diagram showing a U-shaped average total cost curve, a U-shaped average variable cost curve, and a “swoosh”-shaped marginal cost curve. On it, indicate the range of prices for which the following actions are optimal.

   1. The firm shuts down immediately.

      
      The firm should shut down immediately when price is less than minimum average variable cost, the shut-down price. In the accompanying diagram, this is optimal for prices in the range from 0 to P₁.

   2. The firm operates in the short run despite sustaining a loss.

      When the price is greater than the minimum average variable cost (the shut-down price) but less than the minimum average total cost (the break-even price), the firm should continue to operate in the short run even though it is incurring a loss. This is optimal for prices in the range from P₁ to P₂.

   3. The firm operates while making a profit.

      When the price exceeds the minimum average total cost (the break-even price), the firm makes a profit. This happens for prices in excess of P₂.

2. Question

   The state of Maine has a very active lobster industry, which harvests lobsters during the summer months. During the rest of the year, lobsters can be obtained by restaurants from producers in other parts of the world, but at a much higher price. Maine is also full of “lobster shacks,” roadside restaurants serving lobster dishes that are open only during the summer. Supposing that the market demand for lobster dishes remains the same throughout the year, explain why it is optimal for lobster shacks to operate only during the summer.

   This is an example of a temporary shut-down by a firm when the market price lies below the shut-down price, the minimum average variable cost. The market price is the price of a lobster meal and the variable cost is the cost of the lobster, employee wages, and other expenses that increase as more meals are served. In this example, however, it is the average variable cost curve rather than the market price that shifts over time, due to seasonal changes in the cost of lobsters. Maine lobster shacks have relatively low average variable cost during the summer, when cheap Maine lobsters are available; during the rest of the year, their average variable cost is relatively high due to the high cost of imported lobsters. Thus, the lobster shacks are open for business during the summer, when the market price is above their minimum average variable cost; but they close during the rest of the year, when the price lies below their minimum average variable cost.