In this chapter we suggested that whenever market price fell below average variable costs, the firm...

In this chapter we suggested that whenever market price fell below average variable costs, the firm will shut down. At that point, revenue is not covering its variable costs and the firm is losing more money than it would if it shut down and lost its fixed costs. Clearly, shutting the firm down is more complicated than that. Under what circumstances might the firm continue to operate even though prices are below average variable costs?

a. It would not continue to operate. The firm would not want to continue to suffer losses.

b. The firm would continue to operate because it is covering fixed costs even though average variable costs are not being covered.

c. The firm would continue to operate because it knows that other firms are leaving the industry so once those firms leave the industry, its profits will increase.

d. It would continue to operate if the firm knew that it could generate a profit in the long run.

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Question - In this chapter we suggested that whenever market price fell below average variable costs, the firm will shut down. At that point, revenue is not covering its variable costs and the firm is losing more money than it would if it shut down and lost its fixed costs. Clearly, shutting the firm down is more complicated than that. Under what circumstances might the firm continue to operate even though prices are below average variable costs?

a. It would not continue to operate. The firm would not want to continue to suffer losses.

b. The firm would continue to operate because it is covering fixed costs even though average variable costs are not being covered.

c. The firm would continue to operate because it knows that other firms are leaving the industry so once those firms leave the industry, its profits will increase.

d. It would continue to operate if the firm knew that it could generate a profit in the long run.

Answer – If the market price (P) is below Average Variable Cost (AVC) i.e., P < AVC, then it would not continue to operate. The firm would shut down in the short run because the firm would not want to continue to suffer losses (Option A). This is because if the firm continues to operate, then not only is it losing the entire fixed costs but a part of the variable cost as well and the loss is not being minimized. By shutting down it does not mean that the firm would leave the market because it knows that the loss incurring firms would leave the industry in the long run and it would earn zero economic profits in the long run. So, it would choose to shut down and not continue production in the short run.

Thus, Option A is the correct answer.

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Rahul Sunny answered 2 years ago

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