In any economy
, there's going to be a fair number of business
es that operate at a loss. While some go under
, others remain in the red
for years, chugging away. Although at first glance it seems strange that these firm
s would stay in business while bleeding money, economics
explains when operating with negative profit
is justified and when it's a clear sign to stop working.
In the short run, every firm has fixed costs, which are independent of the amount of product shipped, and variable costs, which depend on the quantity. Example of the first are the lease on space, the extortion paid to local governments in the form of business licenses, and other expenses that create a barrier to entry. The latter is composed of things like wages, various materials, services and equipment required for products and such.
The difference between the two is important for determining the optimal profit, and for deciding whether a company should remain in business. Basically, as long as a company's variable costs are paid for, it should remain in business, as it's covering the funds put out for the product created and paying for part of the fixed costs. Even if the company goes out of business, those fixed costs will still exist, so any possibility of paying them off should be taken.
Examining the equations behind this reasoning reveals a simple rule of thumb for determining a firm's health. When quantity = 0, profit = - total fixed costs. When quantity = optimal quantity, profit = total revenue - total variable costs - total fixed costs. We then assume the second scenario loses less money than the first, revealing - total fixed costs < total revenue - total variable costs - total fixed costs. This collapses to 0 < total revenue - total variable costs, which simplifies to total variable costs < total revenue. Since total revenue = price * quantity, we can divide by quantity to get price > average variable cost. So as long as the price of the product is larger than the cost of specifically producing it, as opposed to the cost of simply existing as a business, you're golden... in the short term. Fall below that level of profitability, and a firm should probably stop production soon.