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CMA Foundation · Fundamentals of Business Economics and Management · Forms of Market

A perfectly competitive firm sells 1,000 units at Rs 40 per unit. Its average variable cost is Rs 35 and average total cost is Rs 45 at this output. What is the best short-run decision?

The firm should continue producing in the short run. Price of Rs 40 exceeds average variable cost of Rs 35, so it recovers Rs 5,000 of fixed cost, cutting the loss to Rs 5,000 instead of the Rs 10,000 fixed cost lost on shutdown.

  1. AShut down, because the firm is making a loss
  2. BContinue producing, because price covers average variable cost and part of fixed cost is recoveredCorrect
  3. CRaise the price to Rs 45 to cover average total cost
  4. DShut down, because price is below average total cost

Explanation

Loss per unit is 45 - 40 = Rs 5, so total loss is Rs 5,000. If it shut down, it would lose all fixed cost, which is (45 - 35) x 1,000 = Rs 10,000. Producing yields a contribution of (40 - 35) x 1,000 = Rs 5,000 towards fixed cost, so the loss falls to Rs 5,000. Raising price is impossible for a price taker.

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