If at the MC = MR output, AVC exceeds price,
Multiple Choice
new firms will enter this industry.
the firm should produce the MC = ?MR output and realize an economic profit.
some firms should shut down in the short-run.
the firm should expand its plant.
The correct answer and explanation is :
The correct answer is: “some firms should shut down in the short-run.”
Explanation:
In a perfectly competitive market, firms aim to maximize profit by producing at the output where Marginal Cost (MC) equals Marginal Revenue (MR). This is the point where a firm will typically adjust its production to either maximize its profit or minimize its losses in the short run.
However, when Average Variable Cost (AVC) exceeds the market price, the firm is not covering its variable costs. In this situation, it would be better for the firm to shut down in the short run rather than continue producing.
Here’s why:
- The Relationship Between AVC and Price:
- If AVC exceeds the price, the firm is incurring a loss on each unit produced because the price it receives for its goods is not sufficient to cover its variable costs. Variable costs are those that change with the level of output (e.g., labor, raw materials), and if these costs cannot be covered, the firm is losing money for every additional unit produced.
- In the short run, a firm should produce if the price is at least equal to or greater than AVC. When price is below AVC, it means the firm is unable to cover its variable costs, which results in operating at a loss.
- Short-Run Shutdown Decision:
- The decision to shut down in the short run is based on whether the firm can at least cover its variable costs. If Price < AVC, the firm should halt production in the short run to minimize losses. Continuing production would only worsen the losses, as the firm would not be able to contribute anything towards covering its fixed costs, which it must pay even if it shuts down temporarily.
- Why Not Other Options?:
- New firms entering the industry: This would happen in the long run when firms are earning positive economic profits, not when they are incurring losses due to AVC being higher than the price.
- Expanding the plant: Expanding the plant would only be useful if the firm were making a profit or at least covering its total costs (including fixed costs), which is not the case when AVC exceeds the price.
- Producing at MC = MR: While producing at the MC = MR output is the profit-maximizing condition, it only applies when the firm is covering its variable and fixed costs. If AVC > price, producing at this output results in losses.
Thus, when AVC exceeds price, firms should shut down in the short run to avoid incurring further losses.