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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 30. At its best output, average total cost is Rs 35 and average variable cost is Rs 25. What should the firm do?

The firm should keep producing in the short run. Its price of Rs 30 exceeds average variable cost of Rs 25, so revenue covers all variable costs and part of fixed costs, making the loss smaller than if it shut down.

  1. AShut down immediately because it makes a loss
  2. BContinue producing, since price covers average variable cost and limits the lossCorrect
  3. CRaise price to Rs 35 to break even
  4. DProduce where average total cost is minimum regardless of price
  5. Produce more until marginal revenue equals average total cost

Explanation

Price (30) exceeds AVC (25), so each unit contributes Rs 5 towards fixed costs. Shutting down would lose the whole fixed cost, which is larger than the loss from producing. A price taker cannot raise its price to Rs 35.

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