Hi folks,  this is chapter 12, part 2.  IN part 2 we
discussed losses, but we did not discuss
what you should do about them.   Most folks are
inclined to think if you're making
losses you should shut down immediately. 
That's actually not the case in most
situations.  I want to walk you through the
logic of how to figure out whether or
not you actually are going to shut down
or you're going to continue to operate
at a loss in the short run.
Here's a
brief overview.  I want you to start
thinking about how you would make this
decision.  Just because you're making
losses doesn't mean you can walk away. 
So if your business is making losses
you might think well I'm just going to
quit,  which essentially means that you're
going to put output equal to zero.  Even
if you make output equal to zero you
still do not get rid of your fixed costs. 
Your landlord still wants to get paid,
right? They don't care if you're actually
working or not, they expect a check for
the rent... So really the critical issue is
whether or not operating at the best
possible q-star
even if it's a loss will produce a
smaller loss than choosing to shut down
and make nothing.  In order to do this
we're going to need to get our AVC into
the picture.  We developed the AVC in
Chapter 11... and the minimum point of the
average variable cost is essentially the
tipping point.  Once your product is not
selling for a price that's at least as large as
your AVC, 
then you need to shut down.   In fact
you're going to be more or less forced
to shut down.  If your price is above the
minimum of the AVC, then you can make
what we call operating losses.  These
operating losses are going to be smaller
than the fixed costs,  which you're going
to have to pay even if you choose to
produce zero output.
So let's take a look at this.  The situation
in front of us if you've got a price
that is actually going to be smaller
than our ATC,  but it is going to be
larger than our AVC,  once we pick our Q
star.... so just like always we're going to
head out here and we are going to find
the intersection of our MR and our MC...
and head down and grab our Q star... that's
the best Q that we can get.... and of
course this is our total revenue box.  So
let's say that we've got 11 for a price
and let's say that our quantity is 300. 
We're going to be able to come over here
and go 11 times 300 for our total
revenue,  and then we are going to want to
subtract out our total cost. 
Now we're going to make 300 units, so we
need to plug 300 into our average total
cost function.  We're going to see that
our average total cost of making 300
units $13.  13 times 300 will give us our
total costs and we get a problem on our hands. We've
got a problem on our hands because we
are going to be making negative $600, you
have an economic loss of $600... and that
would be represented by this are
here... and this loss is going to be an
operating loss though,  because we are
going to actually choose to continue to
produce at that.  So operating losses are
the losses generating from producing Q
star, right?.... so it's a $600 economic loss
at q equals 300.
On the next slide we'll talk about why
in fact it's a good idea to operate at a
loss.
All right so we've got the same
basic setup here.  Our price is still 11
dollars.  We've already discovered that if
we choose to make our 300 units at $11
and an average total cost of $13, then we are
going to end up with a negative $600
operating loss at Q equals 300. What happens if we just  said, "Nah...not
not into it...
shutting down... we're going to go to Q
equals zero"  The reason that we don't
want to do that is because we still have
fixed costs that we have to pay in this
scenario. I'm going to prove to you that
fixed costs are going to give you a
larger loss than the operating loss
that you take by producing at Q equals
300.   So going back to our last slide we
knew that our total cost were equal to
13 times 300... and I want to remind you of an accounting
relationship that we learned back in
chapter 11.  Our total cost are equal to
our fixed cost plus our variable cost.
Well if we shut down we're going to have
to pay our fixed cost, but we can get rid
of our variable cost.  So let's figure out
what our variable costs are... and we'll do
these variables in purple.  We're going to
take our 300 and we are going to go up
here until we run into our AVC... and when
we run into our ABC we're going to find
out that our average variable cost is
eight dollars.   Eight dollars AVC times
300 units will convert our average into
a normal variable cost.  Well what you've
got going on here is 13 times 300 for total
costs and 8 times 300 for variable cost...
so of course the difference between
total and variable cost is going to
leave us with our fixed costs.   So 5 times
300 is equal to our fixed costs... and
another way of seeing this....[I want to
remind you that the difference between
ATC and AVC no matter where you're at is
always equal to average fixed cost]... well
we're just going to use 300 because
that's what we're doing with everything
else.... and the difference right here is 5. 
13 minus 8 is 5 is where I'm getting
this number from.  Five times 300 tells
you that our fixed costs are equal to
$1,500.  Now if we shut down and produce
zero output we still have to pay
$1,500.  $1,500 is equivalent to our shut
down loss,  and of course $1,500 is greater
than $600.  If we operate we only lose 600. 
If we shut down we lose 1500 dollars
every single month,  or whatever our unit
of time that we're measuring over is here.
so the moral of the story here is sometimes
it makes sense to actually operate at
your q-star, right?... our Q star was generating us only a loss of 600.
If we shut down we would have
taken a loss of 1500... here.   We don't want to
do that.  So the question you probably got
in mind then is well when do we shut
down.  You're going to shut down when your
price reaches the minimum of your AVC.
I'll show you that on the next slide.
Okay let's take a look at what happens
when your price falls to the minimum of
the AVC.  What you're going to see here is
that your price is actually going to be
equal to your AVC and that means that
your total revenue box (your P times Q) is
actually going to be equal to your
variable costs,  because your Q when you
run up and run into your AVC (we'll do it
purple here) this is going to give you an
AVC that's equal to your price.  So AVC
times Q gives you your variable costs,  right?
VC equals Q times AVC... that's going to give
you your purple box here.  Your green box is
your revenue one,  and you're going to be
able to see that at this Q star if we
plug this into your average total cost
this is going to give you your ATC.  Well
ATC minus AVC gives us  AFC.   AFC is the
difference between ATC and AVC, this guy
here.  Well that height by that blue
bracket is equal to your AFC, and then
AFC is going to multiply by Q star
again here and this will give us our
fixed cost.  So what we've basically got
going on here is the blue box plus your
purple box is going to add up and equal
your red box.  So it looks like this
essentially.  Here's your ATC part of that
is fixed cost and part of that is
variable costs. 
Well we know that your green revenue box
is large enough to cover your variable
costs.  It's not covering any of your fixed
costs though.  Your fixed costs are what you
earn if you shut down,  so if you can't
cover any of your fixed cost then the
loss that you're going to take by
operating is equal to the same loss you
take if you shut down.  You may as well
just shut down.  Now if your green box
actually falls even lower because your
price falls, then you're not only covering....your not
covering you're fixed costs,
you're also not covering all of your variable any longer anymore,   this area in
here.
The point that I'm making is that if this P falls below the minimum of the
AVC you want to shutdown.
In fact it's pretty much impossible to keep operating.  If  you
can't pay your variable cost your
bouncing payroll checks and you're not
paying your vendors.  No one's going to
work for you and no one's going to give you
any more inputs, so keep that in mind.
One last thing that I want to cover here is
going to circle back and talk about our
bigger project of how the utility theory of value
is trying to explain prices.  We knew that
the demand curve was essentially coming
from our consumer.. right?? Our individual
marginal utility curve we're helping us
decide when we purchased and at what
prices we'd purchase.  So on this last slide
that we were just on I hope you realize
that the curve that we kept referencing
again and again and again was our
marginal cost curve.  We kept looking at
the market price seeing where it
intersected with the marginal cost curve
and that was essentially generating our
quantity supplied... and the only part of
that marginal cost curve
that we were actually willing to produce at 
was the portion that was above the
minimum of our AVC.  So what we're really
talking about then that our marginal
cost curves above the minimum of the AVC
is really our individual firm'ds supply curve.
So if we understand how we get
individual firm supply curves all we have
to do is add them all together to get to
a market ....So we've got a supply curve and a
demand curve for the market... and of
course supply intersecting with demand
is where we find our equilibrium prices. 
So utility theory of value believes they
have a price theory.  A theory about why prices
are what they are.  It's a reflection of
consumers and firms engaging in
maximizing behavior.  Firms and consumers
are both making decisions on the margin
and following the golden rule.  Their
behavior leads to market equilibrium
prices.  Okay I think that will probably
do it for chapter 12.  There's some other
good stuff in there that I want you to
make sure you read.  but these are the
major points.
