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IAI Actuarial Core Principles · Business Economics · Production, costs, revenue and profit in price and output decisions

A perfectly competitive firm in the short run faces a market price of Rs 50. At its profit-maximising output its average total cost is Rs 58 and its average variable cost is Rs 44. What should the firm do?

The firm should keep producing in the short run. Although price Rs 50 is below average total cost Rs 58, it exceeds average variable cost Rs 44, so each unit contributes towards fixed costs and losses are smaller than from shutting down.

  1. AShut down immediately because it makes a loss
  2. BContinue producing in the short run, because price covers average variable costCorrect
  3. CRaise price to Rs 58 to break even
  4. DProduce where average total cost is lowest regardless of price
  5. Expand output until price equals average total cost

Explanation

Price Rs 50 is below ATC (Rs 58), so a loss is made, but it exceeds AVC (Rs 44). Each unit contributes Rs 6 toward fixed costs, so the loss is smaller than if it shut down. A price-taker cannot raise its price to Rs 58.

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