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If the firm is making profits, that is, if \(p\) is greater than the average cost, then all is well, they will continue producing and selling goods. If \(p\) is less than \(ATC\), however, the firm is losing money.
\(p < ATC: \text{the firm is losing money}\)
How will the firm respond to this? Firms make decisions differently for the short run and the long run.
The Short Run
In the short run, (in economic terms, the immediate future), it is not feasible to "close shop" immediately. There are leases to end, bills to pay, creditors to pay off, and other concerns to take care of first. In such a case, the firm can make two choices: either to continue producing and selling goods for the time being (in order to minimize losses), or to stop production altogether (to cut losses).
How does a firm decide which path to take? This decision is based on the firm's variable costs. If the price is less than \(ATC\) but still higher than \(AVC \), the firm will continue production. But if the price is lower than the average variable cost, the firm will shut down.
\(p > AVC: \text{continue production in the short run}\)
\(p < AVC: \text{stop production in the short run}\)
Why is this? Think about it this way: in the first case, the firm is losing money in the big picture, but each unit makes money. Continuing to produce helps to minimize overall losses. It doesn’t make the firm profitable, but it makes it less unprofitable.
In the second case, each additional unit of goods incurs more costs than it earns in revenue, since the average variable costs are higher than the selling price of the goods. It doesn't make sense for the firm to keep producing, since it will only make their losses even greater.
The Long Run
In the long run, firms make the decision either to stay in the market, or to leave the market. (Leaving the market is different from stopping production: a firm can temporarily halt production with the intention of starting up once it becomes profitable again. Leaving the market is much more permanent.) How do they make this decision?
Firms still look at the relationship between their average total cost (\(ATC\)) and the market price. In the short run, firms will sometimes decide to continue production even if their costs exceed the market price. But in the long run, firms will exit the market if \(p < ATC\), since they are losing money, and they have the option to leave the market. When prices rise in a market, more firms will enter, since they will be able to produce goods at a lower average cost than the market price. When the price falls, however, those firms who cannot produce at \(ATC \leq pATC \leq p\) have to exit. Firms will produce at their minimum \(ATC\) in order to make as much money as possible, and to avoid having to leave the market.
This means that any firm that cannot produce at an average cost below the market price will be forced out of the market, and in the long run, firms will earn no profits from producing and selling their goods. Competition forces firms with higher costs to either cut costs or leave the market until the market price is equal to the average cost incurred by firms still in the market.
In the long run, therefore, \(p = ATC\).
