A family bakery under pressure from a supermarket
Fictional classroom economic model. Named places, quantities, prices and concession conditions below are supplied scenario assumptions, not a report of current policy, business accounts or an actual recommendation. A family bakery in Paphos sells bread in a local market where many small bakeries and one supermarket in-store bakery sell a similar loaf. The market price is currently €2.20 per loaf. The bakery produces 4,000 loaves per month. Fixed costs are €1,800 per month. At 4,000 loaves, average variable cost is €1.40, marginal cost is €1.70, and average total cost is €1.85. The supermarket opens a new baking line and the market price falls to €1.70. At 3,500 loaves the bakery's marginal cost would be €1.55; at 4,500 loaves it would be €1.85. The owner can shut down at one month's notice and avoid all fixed costs only after six months because of a lease. For the output calculation, assume the bakery is a price taker, can sell the supplied quantities, and has a marginal-cost curve increasing over its feasible output range with a single crossing at 4,000 loaves. The owner asks whether to close, keep producing or expand.
1. Calculate the bakery's profit at €2.20 and at €1.70 if it continues to produce 4,000 loaves. Decide whether it should shut down immediately.
Read the worked answer
At €2.20: TR = 4,000 × 2.20 = €8,800. Total variable cost = 4,000 × 1.40 = €5,600. Total cost = €1,800 + €5,600 = €7,400. Profit = €1,400. Average total cost is 7,400/4,000 = €1.85, which is below price, so the bakery is profitable.
At €1.70: TR = 4,000 × 1.70 = €6,800. Total cost is still €7,400 if costs do not change. Loss = −€600.
Shutdown test: If the bakery shuts immediately, it still pays the lease, so its loss is the fixed cost of €1,800. If it produces, it loses €600. Producing is better because revenue €6,800 covers variable cost €5,600 and leaves a contribution of €1,200 toward fixed costs. The loss is reduced by €1,200 compared with shutdown. Therefore the bakery should continue producing in the short run, not close immediately.
Caveat: This assumes the €1.40 average variable cost and €1,800 fixed cost are accurate and that the lease cannot be exited. If the owner can sublet the premises or negotiate an exit below €600, shutdown becomes rational.
2. Using the marginal cost figures, decide the profit-maximising output at €1.70. Explain how the market is likely to adjust in the long run.
Read the worked answer
Output choice: The bakery should produce where price equals marginal cost, provided price covers average variable cost. At €1.70:
- At 3,500 loaves, MC = €1.55 < €1.70, so expanding adds more to revenue than to cost.
- At 4,000 loaves, MC = €1.70 = price, so this is the best output among the stated points.
- At 4,500 loaves, MC = €1.85 > €1.70, so expanding would reduce profit.
Thus the profit-maximising output is 4,000 loaves. The bakery makes a loss of €600, but this is smaller than the €1,800 loss from shutting down.
Long-run adjustment: The market has many similar sellers and low barriers, so it resembles perfect competition. A price of €1.70 is below average total cost at the current scale. Some bakeries will exit, reducing market supply and pushing the price back up. Remaining firms will adjust scale and cost. In the long run, the bakery cannot keep making losses: it must renegotiate the lease, reduce fixed costs, differentiate its bread, or exit. If the supermarket's lower price is temporary, waiting may be rational; if it is permanent, exit or repositioning is likely.