Question

How does the average cost curve help to show whether a firm is making profits or losses?

Short answer

The average cost curve represents the per-unit cost of producing a specific quantity of output. Profits occur when a firm's average revenue (market price) is higher than its average cost, and losses occur when average revenue is lower than average cost. To determine if a firm is making profits or losses, compare the average cost curve with the market price. If the market price is higher than the average cost at the production point, the firm is making a profit. If the market price is lower than the average cost at the production point, the firm is making a loss. The breakeven point is where the firm's average revenue equals its average cost, indicating neither profit nor loss.

Step-by-step solution

Understand the Average Cost Curve

The average cost curve represents the per-unit cost of producing a certain quantity of output. It is the total cost of production divided by the total number of units produced. The average cost curve is usually U-shaped because of economies of scale and diseconomies of scale. When a firm produces goods and services at a lower average cost, it can sell those goods and services at a lower price, making it more competitive in the market.

Identify Profit and Loss Situations

Profits occur when the firm's total revenue is greater than its total costs, while losses occur when the firm's total revenue is less than its total costs. This can also be understood at the per-unit level. If a firm's average revenue (or market price) is higher than its average cost, the firm is making profits. If the average revenue is less than the average cost, the firm is making losses.

Compare Average Cost Curve with Market Price

In order to use the average cost curve to determine if a firm is making profits or losses, we need to compare the average cost curve with the level of market price (which equals the average revenue of the goods produced). If the market price is higher than the average cost at the point where the firm is producing, the firm is making a profit. If the market price is lower than the average cost at the point where the firm is producing, the firm is making a loss.

Determine Breakeven Point

The breakeven point is the level of output where a firm's total revenue is equal to its total cost, or where its average revenue is equal to its average cost. At this point, the firm is neither making a profit nor a loss. When the average cost curve is compared to the market price, and they intersect at a point, that is the level of output where the firm breaks even.