Question

By shutting down when price is less than average variable cost at the profit-maximizing level of output, a perfectly competitive firm will limit its losses to its:

A) total fixed costs. B) total variable costs. C) marginal costs. D) total costs.

Answer 1

The correct answer is (A) total fixed costs..

Profit = TR - TC

where TR = Total Revenue = P*Q, TC = Total Cost = TFC + TVC

=> Profit = TR - TVC - TFC

where TFC = Total; fixed cost, TVC = Total Variable cost = AVC*Q, P = Price and Q = quantity.

Now suppose it shut downs. When a firm shut down in the short run it will not produce any quantity(Q) and Hence TR = P*Q = 0.

TVC is that portion of cost which depends on amount of output produced and thus when no output is produced then TVC = Total variable cost = 0. Thus, When a firm shut down in the short run, TVC = 0

TFC is the total fixed cost which is independent of amount of output produced and thus TFC is constant whether you produces or not and whatever you produces.

Thus TFC = Fixed (Constant) when you produces 0 unit or you produces 1000 units TFC will remain same.

Hence, When firm shut downs he will still incur TFC = Total Fixed cost.

Thus Profit when a firm shut downs = TR - TVC - TFC = 0 - 0 - TFC = -TFC(negative sign suggest that it incurrs loss)

Hence When a firm shut downs it in curs a loss of Total fixed cost(TFC).

Suppose P < AVC => P*Q < AVC*Q = TVC => TR < TVC => TR - TVC < 0 => Profit = TR - TVC - TFC < 0 - TFC

Hence losses will be more if you produces when Price is lesser than AVC.

Hence losses will reduce to Total fixed cost when a firm shut downs.

Hence, the correct answer is (A) total fixed costs..