---
title: Firm Costs, Pricing, and Competition
url: https://doc.liz6.com/en/general-education/economics-foundations/09-production-costs-and-profit
locale: en
area: general-education
tags:
- General Education
- Economics Foundations
- General education
- Economics foundations
date: 2026-09-12
modified: 2026-09-12
description: 'A small shop earns 160 yuan a day but still incurs a loss of 15 yuan. Should the owner close down immediately? Some say, "If you''re losing money, stop doing it," while others argue, "Having some income is better than none." Both statements miss a crucial step: What additional revenue and costs does continuing operations today generate, and which costs can be avoided by shutting down?'
---
# Firm Costs, Pricing, and Competition
Prerequisites: [Economic Choice and Analysis](/en/general-education/economics-foundations/01-models-and-evidence) · [Market Prices and Elasticity](/en/general-education/economics-foundations/05-supply-demand-and-equilibrium)
A small shop earns 160 yuan a day but still incurs a loss of 15 yuan. Should the owner close down immediately? Some say, "If you're losing money, stop doing it," while others argue, "Having some income is better than none." Both statements miss a crucial step: What additional revenue and costs does continuing operations today generate, and which costs can be avoided by shutting down?
This article uses the same cost table to sequentially compare output levels, short-term shutdown, long-term exit, and pricing. The numbers are set for teaching purposes; the currency unit is yuan, and the quantity unit is daily batches; costs include the relevant opportunity costs of resources used, not just cash outflows.
## Separate Fixed and Variable Costs First
The sunk store rent of 60 yuan has already been incurred today and will be paid regardless of whether production occurs. Variable costs increase with output, including raw materials and additional labor:
| Output Q | Variable Cost VC | Total Cost TC=60+VC | Marginal Cost MC of This Batch |
| --- | ---: | ---: | --- |
| 0 | 0 | 60 | — |
| 1 | 20 | 80 | 20 |
| 2 | 45 | 105 | 25 |
| 3 | 75 | 135 | 30 |
| 4 | 115 | 175 | 40 |
| 5 | 170 | 230 | 55 |
Average cost answers "how much is allocated per batch on average," while marginal cost answers "how much increases for the next batch." The marginal cost of the fourth batch is `115−75=40`, not the total cost 175 divided by 4. Early batches use idle equipment, while later batches require overtime or congested arrangements, leading to rising incremental costs; this is a setting in this example and does not imply that marginal costs necessarily increase in all production stages.
Fixed and variable costs also depend on the time horizon. Rent that cannot be refunded today is fixed and sunk, but it can be avoided before renewing the lease next year; treating "fixed costs never affect decisions" as a slogan misses the issue of whether to enter or exit the market.
## How a Price Taker Chooses Output
First, assume the market price is 50 per batch. The shop is too small to influence the price, so all produced batches can be sold at this price. Each additional batch brings in 50 in revenue; comparing this with the marginal costs in the table: the first four batches have marginal costs of 20, 25, 30, and 40, all lower than 50, while the fifth batch has a marginal cost of 55, which is higher than 50.
Directly recalculating profits: at Q=3, profit is `150−135=15`; at Q=4, profit is `200−175=25`; at Q=5, profit is `250−230=20`. Producing four batches maximizes profit. Neither maximizing output nor minimizing average cost automatically gives that answer.
Continuous differentiable models often write the internal optimum as marginal revenue equal to marginal cost. Since output in this table is discrete, there is no need to find an exact equality cell; check all feasible batches, or find the stopping point where marginal revenue and cost monotonically cross. If there are startup thresholds or non-monotonic revenues, it is even more necessary to compare complete scenarios.
## Why Continuing Operations May Be Rational When Losing Money
Now the price drops to 40. Profit at Q=3 is `120−135=−15`, at Q=4 it is `160−175=−15`, and at Q=0 it is −60. Producing three or four batches is optimal in this example; the fourth batch's additional revenue exactly covers the additional cost, leaving the owner indifferent.
Although continuing operations still results in a loss of 15, it loses 45 less than shutting down (which would result in a loss of 60), because operating revenue covers variable costs and contributes an additional 45. One cannot directly infer that a shutdown is necessary in the short term simply because "total profit is negative."
Now lower the price to 15. Even the variable cost of the first batch, 20, cannot be covered; any positive output is worse than shutting down, so Q=0 should be chosen in the model. Generally, one must compare avoidable costs; in the standard competitive model, shutdown occurs when price is below the minimum average variable cost. In contrast, in the long run, exit may be reasonable if total costs, including avoidable fixed costs and normal opportunity returns, cannot be covered.
This explains the choice within a specific time window, not a suggestion that real-world enterprises should indefinitely bear losses. Whether cash can hold out, how contracts are structured, and whether equipment can be sold must be listed separately. Historical amounts already lost are not the revenue from producing another batch.
## When There Is Pricing Power, Selling One More Batch Changes Revenue from Existing Sales
The same shop now sells differentiated products and can choose a uniform price, but lowering the price allows selling more. Suppose demand is `P=80−10Q`, continuing to use the same cost table. In each scenario, all batches are sold at the same price:
| Q | Uniform Price P | Revenue P×Q | Marginal Revenue | Profit |
| --- | ---: | ---: | ---: | ---: |
| 0 | — | 0 | — | −60 |
| 1 | 70 | 70 | 70 | −10 |
| 2 | 60 | 120 | 50 | 15 |
| 3 | 50 | 150 | 30 | 15 |
| 4 | 40 | 160 | 10 | −15 |
| 5 | 30 | 150 | −10 | −80 |
The second batch is sold at 60, but the additional revenue is only 50: the new batch brings in 60, but the previous batch's price drops from 70 to 60, losing 10 in revenue. The third batch is similar; it adds 50 in revenue, but the first two batches each lose 10, resulting in a net increase of 30. Marginal revenue is lower than price, which is the result of a uniform price cut affecting all sales volumes.
In this table, profits at Q=2 and Q=3 are both 15; the marginal revenue of the third batch exactly equals the marginal cost, making the owner indifferent. Although the fourth batch still increases operating revenue by 10, it increases costs by 40, so profit decreases. Looking only at sales growth can mistake an unprofitable expansion for success.
This also connects elasticity and pricing: demand responsiveness determines the changes in volume and revenue resulting from price adjustments, while costs determine whether these additional sales are worth producing. A fixed proportion "cost-plus" pricing does not automatically satisfy these two constraints; if customers are unwilling to pay, even a reasonable marked price will not transact on its own.
## What Competition Changes
After a neighboring store enters, customer substitution options increase, and the shop's original demand relationship may shift inward and become more price-sensitive. To maintain sales volume, prices may have to be lowered; to maintain profits, costs, quality, or service may need to be improved. It is not that simply "wanting to raise prices" confers market power; the key is how much demand is retained after a price hike and whether other firms can enter.
In the standard long-run perfect competition model, conditions such as free entry and exit can drive economic profits toward zero. This zero has already deducted opportunity costs such as the owner's labor and own capital; it does not mean the owner has no salary, nor does it mean accounting profit must be zero. Real-world entry barriers, differentiation, and scale effects will change the outcome.
Low costs do not automatically mean better social outcomes. If prices are higher than marginal resource costs, some transactions where valuation exceeds cost may not occur; conversely, if industries with high fixed costs charge only marginal cost, they may not be able to cover total costs. When discussing competition, scale, and regulation, one should first clarify technology and cost structures, rather than judging solely based on the size of the enterprise.
## Making Decisions After Changing Conditions
When the price is 40, the landlord is willing to refund 50 yuan of the store rent if the shop shuts down for the day. Should the shop continue operating or shut down?
Expand Reasoning
The best profit from continuing operations remains −15; if shutting down, only the unreimbursed 10 is lost, resulting in a profit of −10, so shutting down is better. The previous condition of "losing 60 by shutting down" has changed, and old conclusions cannot be applied. The refundable 50 is the opportunity cost of this operational decision and should be included in the comparison.
Expand Reasoning
He mistook the selling price of the fourth batch for marginal revenue. To sell the fourth batch, the prices of the first three batches each dropped by 10, so total revenue only increased from 150 to 160, an increase of 10; the additional cost is 40, so profit decreases by 30. If different prices could be charged to different buyers, the pricing rules and demand would need to be redefined; one cannot directly use a uniform price table to support conclusions under a different regime.