Question

1. Jay’s Café, one of many competitive restaurants in town, sells its “Café Special” (the only item on the menu) for $6.00. The costs of waiters, cooks, food, and other variable costs average out to $4 per meal; the cost of the lease, insurance, and other such fixed expenses average out to $3 per meal.
   1. Given these numbers, holding all else constant, should Jay’s Café stay open in the short run, immediately exit the business, or raise prices above the perfectly competitive level of $6? Explain your answer.
2. 2. Given these numbers, if Jay were unable to change his cost structure, should he plan to go out of business in the long run? Explain your answer.

Please draw the diagram and explain step by step.

Answer 1

a) The firm should continue to stay in business and carry on its operations till Price per unit is greater than Average Variable Cost .If the price falls below average variable cost, then the firm is better off shutting production in the short run. By producing any output, it does not generate enough revenue to cover variable cost In this case the price per unit is $6 and it is greater than AVC of $4. So, firm should continue its operations.

b) In the long run all costs are variable and there is no fixed cost. This means that average variable cost in long run will be $4 + $3 = $7. So, Price < AVC as $6 < $7. This means that firm should shutdown in the long run.

A shutdown point is a level of operations at which a company experiences no benefit for continuing operations and therefore decides to shut down temporarily (or in some cases permanently). It results from the combination of output and price where the company earns just enough revenue to cover its total variable costs.

The Shut Down Price is the price below the AVC.

The low price P3 is less than average variable cost and the firm is making a heavy loss.Assuming that the fixed costs are lost if production is closed down, if the firm shuts down it will lose distance AB per unit and if continues to supply, the loss of AC per unit.