The firm is considering closing dow

The firm is considering closing down. What advice could you give the management to help them regain profit and remain in the industry. Use Figure 5.17 and the basic model developed in this chapter to illustrate your advice. The current loss-making situation is illustrated in Figure 5.17. (This diagram is adapted from Figure 5.15a, Section 5.10 of this chapter.)

In Figure 5.17 the total cost (TC) curve lies above the total revenue (TR) curve at all level of level of output. To minimize losses the firm should produce Q1 where the difference between TC and TR is minimised. Marginal cost (MC) equals marginal revenue (MR) at this output as a tangent drawn to the TC curve (representing the value of MC) has the same slope as a tangent drawn to the TR curve (representing MR). The price required to sell Q1 (i.e. P1) is represented by the slope of the ray drawn from the origin to that point on the TR curve. Although the firm makes a loss at Q1, (the profit function is below the horizontal axis) losses are greater at all other level of output. In the short run the firm has the option of ceasing production, incurring a loss equal to total fixed cost (TFC). However, in selling Q1 the revenue generated more than covers total variable cost (TVC) and therefore helps pay some of the burden of fixed cost.

The initial advice to the firm is therefore to set a price and to minimize losses. Having done so, any temptation to then increase price (which at face value might appear to many observers a possible solution to a loss-making situation) only makes the situation worse, as would seeking a solution through lowering price to generate more sales.