Question

The following questions are based on the key below. Assume that you are given cost and price data for a number of competitive firms at their present output levels. In all cases the marginal cost is increasing. With this information, indicate whether each firm should, in the short run:

1. produce more

2. produce less.

3. shut down

4. cannot be determined from the information.

Refer to the information above to answer this question. If the price exceeds the firm's average variable costs but is less than its marginal cost what should the firm do? Select one:

A. 1.

B. 2.

C. 3.

D. 4.

Answer 1

Answer – Assume that you are given cost and price data for a number of competitive firms at their present output levels. In all cases the marginal cost is increasing. However, what each firm should do in the short run cannot be determined from the information (Option 4). This is because we do have any data given for AVC.

Now, if the price (P) exceeds the firm's average variable cost (AVC), then the firm should NOT shut down in the short run. Even if P is less than ATC i.e., the firm is incurring loss in the short run, if P > AVC, then the firm should continue production in the short run.

Now, it is to be kept in mind that for perfectly competitive firms, the profit maximizing condition is P = MR = MC. But it has been mentioned in the question that P < MC, then the firm should decrease the production from current output level. This is because, when P < MC, then the additional revenue earned by the firm is lower than the additional cost incurred by the firm for producing that output and thus, the firm should lower its output to satisfy the profit maximizing condition of P = MC.

So, Option B is the correct answer.