The ultimate object of an individual firm is to maximize its profits. During market period time is so short that a firm cannot raise its output.
The firm’s effort is mainly to project its reservation price. But in the short-run every firm has to take two vital decisions.
- Whether to produce of not and
- How much to produce?
So far as the first decision is concerned, whether the firm will produce or not will depend upon the relationship of price to cost of production of the firm. Two costs are specially important during the short period, viz. (i) Prime Cost,(ii) Supplementary cost, Prime cost is also known at average variable cost(AVC). This includes the cost of raw materials, transportation cost, wages of the ordinary labor etc. Supplementary cost is also known as fixed cost. It includes the interest on capital, cost of machinery, wages of the technical labor etc. It is not possible for a firm to cover the fixed cost during short period. The firm will decide to produce, if it is able to cover the average variable cost (AVC), otherwise, it will stop production. When the firm fails to cover the average variable cost, such a situation is termed as shut down point. Shut down point refers to a situation when the firm is forced to stop its production. Relationship between price and cost has been explained in Fig. Below.
Fig. (i) explains the equilibrium of the firm A. Firm A is said to be in equilibrium when it maximize profits and minimizes losses. It attains equilibrium at point P where the marginal cost (MC) is equal to the marginal revenue (MR) A careful study of the behavior of cost curve shows that firm.’ A get excess profit equal to PM per unit and the total profits are equal to KPML. The reason for the excess profits is that the AR is more than the AC.
Fig. (ii) Explains the equilibrium of firm B. Firm B attains equilibrium at point P where MC is equal to MR. The firm suffers losses equal to MP per losses to firm B are equal to the area KPML. In spite of these losses firm B will decide to produce because it is able to recover the average variable cost.
Fig.(iii) Explains that the firm C attains equilibrium at point P where the MC is equal to MR. Firm C receives only the normal profits because the average cost is equal to the average revenue or price.
Fig. (iv) explains the cost behavior of firm D. Firm D decides to stop production because price is so low that it fails to recover the average variable cost. Point P can be called the shut down point. Below the point P firm D will produce nothing at all.
- If AR = AC, the firm will receive normal profits.
- If AR > AC, the firm will receive abnormal profits.
- If AR < AC, the firm will suffer losses.
- If AR < AVC, the firm will stop production.
The second decision which every individual firm has to take its about the size of output. A Firm will naturally opt for that level of output, which provides maximum profits at a given price. According to J.S. Vision, “The usual motive of business from will be to choose that output which will maximize its aggregate profits for the period under consideration.” To find the most profitable output the firm will logically add to its output as long as the marginal cost of additions output is less than the marginal receipts of the output. In other words, the firm will maximize its profits when the marginal cost equals the marginal revenue (MC = MR).