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IAI Actuarial Core Principles · Business Economics · Profit maximisation under perfect competition and monopoly

A firm in a perfectly competitive market is currently producing at the output where marginal cost equals the market price, and the price is above average variable cost but below average total cost. What is the best short-run decision for the firm?

The firm should continue producing where price equals marginal cost. Price exceeds average variable cost, so revenue covers all variable costs and part of fixed costs. Closing would lose all fixed costs, so producing minimises the loss. A price taker cannot raise its price.

  1. AContinue producing at this output, because it minimises its loss and covers all variable costsCorrect
  2. BShut down immediately, because it is making a loss
  3. CRaise its price to cover average total cost
  4. DExpand output until average total cost equals marginal cost
  5. Reduce output to where average variable cost is at its minimum

Explanation

In the short run, a firm should keep producing if price covers average variable cost, since the surplus over AVC contributes to fixed costs. Producing where P = MC then minimises the loss. Shutting down would lose the whole fixed cost, which is a bigger loss. A price taker also cannot raise its price.

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