Question

Suppose a perfectly competitive firm in the short-run is currently producing an output level of 50,000 units, charging a price per unit of $4. The firm incurs variable costs of $280,000 in producing this level of output. It also has fixed costs of $60,000.

a) Calculate the economic profit (or loss) from the firm producing and selling these 50,000 units of output. Show all your work. (2 points)

b) Calculate the economic profit (or loss) from the firm shutting down and producing zero units. (3 points)

c) Given the correct answers to both a) and b), should this firm maintain production, should it shut down, or should it exit the industry? Why? (3 points)

d) How would your answer change (if it were to change) if the firm’s fixed costs were actually $100,000? Explain. (3 points)

Answer 1

(a)

Current output = 50,000 units

Price per unit = $4

Calculate the Total Revenue -

TR = Current output * Price per unit

TR = 50,000 * $4 = $200,000

The total revenue is $200,000

Variable cost = $280,000

Fixed cost = $60,000

Total cost = Variable cost + Fixed cost

Total cost = $280,000 + $60,000 = $340,000

Calculate the economic profit -

Economic profit = Total revenue - Total cost

Economic profit = $200,000 - $340,000 = -$140,000

The negative economic profit implies economic loss.

So,

The economic loss from the firm producing and selling these 50,000 units of output is $140,000.

(b)

If the firm shuts down and produce zero units then also it has to incur fixed cost.

So, in such case, its loss will be equal to the amount of fixed cost.

The fixed cost is $60,000.

Thus,

The economic loss from the firm shutting down and producing zero units is $60,000.

(c)

In case firm operates and produces and sells 50,000 units, it incurs a loss of $140,000.

In case firm shuts down and produce 0 units, it incurs a loss of $60,000.

The main aim of firm is to maximize profit or minimize loss.

The loss would be minimized, if firm shuts down and produce 0 units.

So,

The firm should shut down.

(d)

Now, fixed cost of firm is $100,000.

Current output = 50,000 units

Price per unit = $4

Calculate the Total Revenue -

TR = Current output * Price per unit

TR = 50,000 * $4 = $200,000

The total revenue is $200,000

Variable cost = $280,000

Fixed cost = $100,000

Total cost = Variable cost + Fixed cost

Total cost = $280,000 + $100,000 = $380,000

Calculate the economic profit -

Economic profit = Total revenue - Total cost

Economic profit = $200,000 - $380,000 = -$180,000

The negative economic profit implies economic loss.

So,

The economic loss from the firm producing and selling these 50,000 units of output is $180,000.

If the firm shuts down and produce zero units then also it has to incur fixed cost.

So, in such case, its loss will be equal to the amount of fixed cost.

The fixed cost is $100,000.

Thus,

The economic loss from the firm shutting down and producing zero units is $100,000.

In case firm operates and produces and sells 50,000 units, it incurs a loss of $180,000.

In case firm shuts down and produce 0 units, it incurs a loss of $100,000.

The main aim of firm is to maximize profit or minimize loss.

The loss would be minimized, if firm shuts down and produce 0 units.

So,

The firm should shut down.