Page 293 - The Principle of Economics

CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 299
MC
ATC AVC
Firm’s short-run supply curve
Costs
Figure 14-3
THE COMPETITIVE FIRM’S SHORT- RUN SUPPLY CURVE. In the short run, the competitive firm’s supply curve is its marginal-cost curve (MC) above average variable cost (AVC). If the price falls below average variable cost, the firm is better off shutting down.
Firm shuts down if P 􏰂 AVC
0 Quantity
do one thing instead of another, whereas a sunk cost cannot be avoided, regardless of the choices you make. Because nothing can be done about sunk costs, you can ignore them when making decisions about various aspects of life, including busi- ness strategy.
Our analysis of the firm’s shutdown decision is one example of the irrelevance of sunk costs. We assume that the firm cannot recover its fixed costs by temporar- ily stopping production. As a result, the firm’s fixed costs are sunk in the short run, and the firm can safely ignore these costs when deciding how much to produce. The firm’s short-run supply curve is the part of the marginal-cost curve that lies above average variable cost, and the size of the fixed cost does not matter for this supply decision.
The irrelevance of sunk costs explains how real businesses make decisions. In the early 1990s, for instance, most of the major airlines reported large losses. In one year, American Airlines, Delta, and USAir each lost more than $400 million. Yet de- spite the losses, these airlines continued to sell tickets and fly passengers. At first, this decision might seem surprising: If the airlines were losing money flying planes, why didn’t the owners of the airlines just shut down their businesses?
To understand this behavior, we must acknowledge that many of the airlines’ costs are sunk in the short run. If an airline has bought a plane and cannot resell it, then the cost of the plane is sunk. The opportunity cost of a flight includes only the variable costs of fuel and the wages of pilots and flight attendants. As long as the total revenue from flying exceeds these variable costs, the airlines should continue operating. And, in fact, they did.
The irrelevance of sunk costs is also important for personal decisions. Imagine, for instance, that you place a $10 value on seeing a newly released movie. You buy a ticket for $7, but before entering the theater, you lose the ticket. Should you buy another ticket? Or should you now go home and refuse to pay a total of $14 to see the movie? The answer is that you should buy another ticket. The benefit of seeing