Question

In the short run a firm has noticed that the price of their most important fixed input has risen. What impact will this have on profit? Why? What if this increase in price had occurred in the long run? Why is this different than in the short run?

Answer 1

The increase in fixed cost like lease payment, insurance, salaries and interest on borrowed fund etc increases the average total cost of the firms in shortrun. The increase in total cost will reduce the profit of the firm. If the price is equal to average total cost, the firm start to incur loss. If the market price is above the ATC in shortrun the increase in fixed cost will lowers the profit of the firm.

In longrun the price is equal to ATC. Thus the firms are in break even or earning zero economic profit. No price other than a price equal to ATC exists in longrun due to the free entry and exit of the firms. In shortrun if the fixed cost increase, the firms will quit the industry in longrun and the price will increase due to the fall in supply out of the exit of the firm. So the loss in shortrun due to increased fixed cost will be fully covered by the increase in price to the level of ATC.