If at the MC = ?MR output, AVC exceeds price:
Multiple Choice
- the firm should produce the MC = ?MR output and realize an economic profit.
- the firm should shut down in the short run.
- the firm should expand its plant.
- new firms will enter this industry.
The correct answer and explanation is:
Correct Answer: The firm should shut down in the short run.
Explanation:
In a perfectly competitive market, firms maximize profit by producing at the point where marginal cost (MC) equals marginal revenue (MR). However, if the average variable cost (AVC) exceeds the market price, the firm is unable to cover its variable costs, meaning it incurs a loss greater than its fixed costs on each unit produced.
Why Should the Firm Shut Down?
- Short-run shutdown condition: The firm should shut down in the short run if price (P) < AVC because continuing production would only increase its losses.
- Fixed costs are already incurred: If the firm shuts down, it only loses its fixed costs (FC), which it has to pay regardless of production.
- Avoiding additional losses: If the firm keeps operating when P < AVC, it incurs both fixed costs and additional variable costs, leading to greater losses than shutting down completely.
Comparison with Other Choices
- Producing at MC = MR and earning an economic profit – Incorrect. A firm earns economic profit only if price is greater than average total cost (P > ATC). If AVC exceeds price, the firm is making a loss, not a profit.
- Expanding the plant – Incorrect. If the firm is making a loss, it should not invest in expansion. Expansion is considered when demand increases and firms are profitable.
- New firms entering the industry – Incorrect. New firms enter only when there is economic profit. If firms are shutting down, new entrants will be discouraged.
Thus, the correct decision is to shut down in the short run to minimize losses.