Modes of operation

It is assumed that all firms are following rational decision-making, and will produce at the profit-maximizing output. Given this assumption, there are four categories in which a firm's profit may be considered.

• A firm is said to be making an economic profit when its average total cost is less than the price of each additional product at the profit-maximizing output. The economic profit is equal to the quantity output multiplied by the difference between the average total cost and the price.
• A firm is said to be making a normal profit when its economic profit equals zero. This occurs where average total cost equals price at the profit-maximizing output.
• If the price is between average total cost and average variable cost at the profit-maximizing output, then the firm is said to be in a loss-minimizing condition. The firm should still continue to produce, however, since its loss would be larger if it were to stop producing. By continuing production, the firm can offset its variable cost and at least part of its fixed cost, but by stopping completely it would lose the entirety of its fixed cost.
• If the price is below average variable cost at the profit-maximizing output, the firm should go into shutdown. Losses are minimized by not producing at all, since any production would not generate returns significant enough to offset any fixed cost and part of the variable cost. By not producing, the firm loses only its fixed cost. By losing this fixed cost the company faces a challenge. It must either exit the market or remain in the market and risk a complete loss.

Market failure

In microeconomics, the term "market failure" does not mean that a given market has ceased functioning. Instead, a market failure is a situation in which a given market does not efficiently organize production or allocate goods and services to consumers. Economists normally apply the term to situations where the assumptions of the First Welfare Theorem fail leading to the market outcome no longer being on the Pareto frontier. On the other hand, in a political context, stakeholders may use the term market failure to refer to situations where market forces do not serve the public interest.

The four main types or causes of market failure are:

• Monopolies or other cases of abuse of market power where a "single buyer or seller can exert significant influence over prices or output". Abuse of market power can be reduced by using antitrust regulations.^[5]
• Externalities, which occur in cases where the "market does not take into account the impact of an economic activity on outsiders." There are positive externalities and negative externalities.^[5] Positive externalities occur in cases such as when a television program on family health improves the public's health. Negative externalities occur in cases such as when a company’s processes pollutes air or waterways. Negative externalities can be reduced by using government regulations, taxes, or subsidies, or by using property rights to force companies and individuals to take the impacts of their economic activity into account.
• Public goods are goods that have the characteristics that they are non-excludable and non-rivalrous and include national defense^[5], public transportation, federal highways, and public health initiatives such as draining mosquito-breeding marshes. For example, if draining mosquito-breeding marshes was left to the private market, far fewer marshes would probably be drained. To provide a good supply of public goods, nations typically use taxes that compel all residents to pay for these public goods (due to scarce knowledge of the positive externalities to third parties/social welfare); and
• Cases where there is asymmetric information or uncertainty (information inefficiency).^[5] Information asymmetry occurs when one party to a transaction has more or better information than the other party. For example, used-car salespeople may know whether a used car has been used as a delivery vehicle or taxi, information that may not be available to buyers. Typically it is the seller that knows more about the product than the buyer, but this is not always the case. An example of a situation where the buyer may have better information than the seller would be an estate sale of a house, as required by a last will and testament. A real estate broker buying this house may have more knowledge about the house than the family members of the deceased.

This situation was first described by Kenneth J. Arrow in a seminal article on health care in 1963 entitled "Uncertainty and the Welfare Economics of Medical Care," in the American Economic Review. George Akerlof later used the term asymmetric information in his 1970 work The Market for Lemons. Akerlof noticed that, in such a market, the average value of the commodity tends to go down, even for those of perfectly good quality, because the buyer has no way of knowing whether the product they are buying will turn out to be a "lemon" (a defective product).