Question

Question 2. Suppose you are a consultant for a firm that is perfectly competitive. The firm is worried only about its policies in the short run. What would you recommend in terms of quantity changes (raise, cut, shut down or stay put) and price changes (raise, cut, stay put) in each of the following situations: a. [15 points] P $19 MC $14 AVC $20 b. [15 points] P S11MC S106 AVC $107 Notations/Abbreviations: P- price; MC-marginal cost; AVC- average variable cost ATC average total cost

Answer 1

CASE 1.

PRICE= 19

MC= 14

AVC= 20

since the price is less than the average variable cost, the firm is not able to cover its fixed as well as its variable cost. thus the firm should SHUT DOWN immediately. the loss will increase if it keeps on producing since it will not be able to cover even its variable costs. the price cannot be influenced any how because this is perfect competition and every firm is a price taker. market decides the price and firm accepts it.

CASE 2.

PRICE = 11

MC = 10.6

AVC= 10.7 ( I THINK YOU MADE A MISTAKE WITH THE QUES, MC AND AVC SHOULD BE 10.6 AND 10.7 , THEN ONLY IT MAKES SENSE)

now in this case since the AVC is less than price, it means that firm is able to cover its variable cost. thus the firm will NOT SHUT DOWN AND CONTINUE TO PRODUCE. when MC is constant, it is equal to AVERAGE COST. thus our AC IS ALSO 10.6. thus the firm is making a profit of 0.4 dollar per unit if it charges 11 dollars. thus in the equilibrium, the price is equal to MC for perfect competition. so price should fall to 10.6 and the firm should continue to produce as they are experiencing normal profits.