Question

Suppose a competitive firm has laid out a business plan (a decision about how much to produce) that it believes will maximize profits at market prices. Suddenly the owners are told that one of the fixed costs they thought they faced has unexpectedly increased (e.g. the cost of an annual license fee they must pay to operate was doubled). Suppose that the cost increase is not so large as to drive the firm out of business. The firm will respond to this higher total costs by (hint: marginal analysis):

reducing production Q to economize on total costs

increasing production Q to restore profits to their initial level.

leave production Q and Price unchanged

raising prices to pass the higher cost onto consumers.

Answer 1

A competitive firm Choose its equilibrium quantity where price is equals to Marginal cost.

Marginal cost refers to the change in Total variable cost due to a unit change in output.

In the graph below, before rise in fixed cost TC is the total cost curve, MC is the marginal cost curve and horizontal line is the demand curve or price curve.

Initially equilibrium is at point A where Price is P* and quantity is Q*.

After the rise in fixed cost, total cost increases from TC to TC1 but this change is due to fixed cost and marginal cost does not include change in fixed cost so MC remain the same so equilibrium point, price and quantity also remains the same.

So, The firm will respond to this higher total costs by leaving production Q and Price unchanged.