a) Why do the long run average costs decline first and then begin to rise? Is...

a) Why do the long run average costs decline first and then begin to rise? Is this pattern observed in the real world? Can you give examples of this?

b) Why would a firm choose to operate at a loss in the short run? Explain carefully.

Solutions

Expert Solution

(a) In the initial stages of production, a firm experiences economies of scale, therefore average total cost (ATC) falls with increase in output and ATC curve is falling. After reaching the minimum efficient scale of production, eventually diseconomies of scale sets in and ATC starts to increase with increase in output, therefore ATC curve starts rising. This gives the ATC curve a U-shape.

This pattern is often observed in real life. In initial stages of growth, companies are cost-conscious and focus on effective cost management, managing to achieve economies of scale. With higher growth, inefficiencies start setting in, leading to a rise in average cost as they expand and produce more, so their ATC curve start rising.

(b) In the short run a firm will operate at a loss if its price is higher than average variable cost (AVC). If the firm can just cover its variable costs with its revenue, then its loss equals the fixed costs which the firm cannot avoid in short run and has to incur even if it shuts down. Therefore, the higher the price is compared to AVC, the lower the loss and so the firm continues to operate.

Rahul Sunny answered 1 year ago

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