Question

A profit

maximizing

firm has an average total cost of $4, but it gets a price of $3 for each good it

sells.

a.

What would you advise the

firm to do if you know average variable costs were $2.50?

b.

What would you advice the firm to do if you know average variable costs were $3.50?

Answer 1

a) When the ATC is $4, P=$3 and AVC=$2.50

a) I would advise the firm to continue to produce in the short run as long as the price is equal to or above its AVC, because it is able to recover its average variable cost and by continuing to produce it will minimize its losses.It should exit the market in the long run as it is incurring losses.

b) If the average variable cost were equal to $3.50 then the firm should shut down in the short run as it is unable to recover its average variable cost and by shutting down it will minimize its losses and incur only fixed cost.It should exit the market in the long run as it is incurring losses.