Question

Suppose you are given the following annual data for Firm XYZ, where you are the general manager:

                        Number of units sold             26,000

                        Price per unit                          $32

                        Total variable costs                 $650,000

                        Total fixed costs                     $700,000

            a) In the short-run, should this firm continue operating, shut down, or exit the industry?                               Why?

            b) If 26,000 units is the profit maximizing level of output, does the firm’s current price per unit exceed the average variable cost? Calculate and show.

Answer 1

a) The firm should​ continue operating in the short run.

Quantity (Q)= 26000

Price (P)= $32

Total variable cost = $650000

Total fixed cost = $700000

Total revenue = P*Q = 26000*32 = 832000

Total cost = 650000+700000 = 1350000

Profit = 832000 - 1350000 = -518000

The firm earns a loss of $518000 if it produces at current level.

If firm shuts down, its losses will be equal to the fixed costs. So, it makes a loss of $700000 if it shuts down.

So, the firm makes less losses if it continues than it shuts down. Therefore, it should continue operating.

b)

The firm current price​​ exceeds the Average variable cost.

Current price = $32

Total variable cost = $650000

Quantity = 26000

Average variable cost =

Total variable cost/ Quantity

= 650000/26000 = 25

Average variable cost = $25

Therefore, current price exceeds the average variable cost.