A Level Economics 9708: Supernormal Profit, Subnormal Profit and the Shutdown Price

Fenwick Dairy is a small, price-taking milk producer. In both of the months described below it produces the same 500 litres of milk per day, and at this output its total fixed cost is $100 per day and its total variable cost is $275 per day; neither cost changes between the two months, since the scale of the farm and its daily output stay the same.

(a) Calculate Fenwick Dairy's total cost per day and its average total cost per litre at this output. [2]

(b) In Month 1, the market price of milk is $0.90 per litre. Calculate Fenwick Dairy's total revenue and profit per day at this price, and state whether it is earning normal, supernormal or subnormal profit. [3]

(c) In Month 2, a bumper regional harvest of milk elsewhere pushes the market price down to $0.60 per litre, while Fenwick Dairy's costs are unchanged. Calculate Fenwick Dairy's profit (or loss) per day at this new price, and state whether it is earning normal, supernormal or subnormal profit. [3]

(d) Calculate Fenwick Dairy's average variable cost per litre, and use it to explain whether the farm should continue producing in the short run at the Month 2 price, or shut down immediately. [3]

Part (a): Total cost and average total cost

Total cost is total fixed cost plus total variable cost: $TC = TFC + TVC = 100 + 275 = 375$

This is $375 per day.

Average total cost is total cost divided by output: $AC = \frac{375}{500} = 0.75$

This is $0.75 per litre.

Part (b): Month 1. Price of $0.90 per litre

Total revenue: $TR = 0.90 \times 500 = 450$

This is $450 per day.

Profit: $\text{Profit} = TR - TC = 450 - 375 = 75$

This is a profit of $75 per day. Since the price of $0.90 per litre exceeds average cost of $0.75 per litre, Fenwick Dairy is earning supernormal profit, a return above the normal profit already included within its average cost.

Part (c): Month 2. Price falls to $0.60 per litre

Total revenue: $TR = 0.60 \times 500 = 300$

This is $300 per day.

Profit: $\text{Profit} = TR - TC = 300 - 375 = -75$

This is a loss of $75 per day. Since the price of $0.60 per litre is now below average cost of $0.75 per litre, Fenwick Dairy is earning subnormal profit. A return below what is needed to keep resources in this use in the long run.

Part (d): Average variable cost and the short-run shutdown decision

Average variable cost: $AVC = \frac{275}{500} = 0.55$

This is $0.55 per litre.

The short-run shutdown rule compares price to average variable cost, not average total cost: a firm should keep producing in the short run as long as price covers at least its average variable cost, because every unit sold then earns something towards fixed costs that would otherwise be lost completely. Here, the Month 2 price of $0.60 is still above average variable cost of $0.55, so each litre sold contributes $0.60 - 0.55 = 0.05$ dollars towards fixed costs.

This can be checked directly: if Fenwick Dairy shut down immediately, it would still have to pay its total fixed cost of $100 per day while earning no revenue at all, a loss of $100 per day. By continuing to produce, its loss is only $75 per day (from Part (c)). Smaller than the $100 it would lose by shutting down. So Fenwick Dairy should continue producing in the short run at the Month 2 price, despite making a loss, and should only shut down immediately if price fell below average variable cost of $0.55 per litre.

Final answers

(a) Total cost $=$ $375 per day; average total cost $=$ $0.75 per litre
(b) Total revenue $=$ $450 per day; profit $=$ $75 per day, supernormal profit
(c) Total revenue $=$ $300 per day; loss $=$ $75 per day, subnormal profit
(d) Average variable cost $=$ $0.55 per litre; since price ($0.60) still exceeds AVC, Fenwick Dairy should continue producing in the short run rather than shut down immediately