Questions: Competitive Firm Output Decision and Supply

Question 1

A competitive firm's average variable cost is $8 and its average total cost is $12. The market price is $10. What should the firm do in the short run?

• A. Shut down immediately, since the price doesn't cover average total cost
• B. Continue producing, since the price covers average variable cost and reduces losses compared to shutting down
• C. Reduce output to zero and exit the industry
• D. Raise its price to $12 to cover average total cost

Answer: (B)

In the short run, fixed costs are sunk — the firm pays them whether it operates or not. As long as price covers average variable cost (P ≥ min AVC), operating generates revenue that offsets at least some fixed costs. Here P = $10 > AVC = $8, so continuing to produce reduces the total loss. The firm should only shut down if P falls below min AVC — the shutdown point. Option A is the most tempting wrong answer because losing money feels like it should mean shutting down, but sunk fixed costs change the calculus.

Question 2

Which portion of a competitive firm's cost curves defines its short-run supply curve?

• A. The marginal cost curve above the minimum of average total cost
• B. The average variable cost curve above its minimum
• C. The marginal cost curve above the minimum of average variable cost
• D. The entire marginal cost curve for all positive output levels

Answer: (C)

The firm produces where P = MC, but only operates when P ≥ min AVC (the shutdown point). Below min AVC, quantity supplied = 0. So the short-run supply curve traces the MC curve for all prices at or above the minimum of AVC. This is distinct from the long-run threshold (min ATC) — in the short run, fixed costs are sunk, so the relevant floor is AVC, not ATC.

Question 3

A competitive firm that is earning an economic loss should usually shut down in the short run to minimize its losses.

• T. True
• F. False

Answer: False

A loss-making firm should shut down only if price falls below minimum average variable cost. If P is between min AVC and min ATC, the firm is losing money but covers its variable costs — operating costs less than shutting down, because fixed costs must be paid regardless. Shutting down when P > min AVC means forfeiting revenue that would have partially offset unavoidable fixed costs. The shutdown rule is about variable costs, not total costs.

Question 4

At the long-run competitive equilibrium, the market price equals both the firm's marginal cost and its minimum average total cost.

• T. True
• F. False

Answer: True

This triple equality — P = MC = min ATC — is the defining condition of long-run competitive equilibrium. Free entry drives economic profits to zero, pushing price down to min ATC (the break-even point). Simultaneously, the P = MC condition holds because firms are profit-maximizing price-takers. This intersection is also where allocative efficiency (P = MC) and productive efficiency (min ATC) coincide — a benchmark against which other market structures are compared.

Question 5

Explain why a competitive firm's short-run shutdown condition is P < min AVC rather than P < min ATC.

Model answer: In the short run, fixed costs are sunk — the firm pays them regardless of whether it operates. The decision to produce or not therefore depends only on whether revenue covers the costs that operating actually causes: variable costs. If P ≥ min AVC, the firm recovers its variable costs and contributes something toward the unavoidable fixed costs, making operating better than shutting down. Only when P < min AVC does every unit produced deepen the loss beyond the fixed costs alone — at that point, earning zero revenue from shutdown is actually better. In the long run, fixed costs become avoidable (the firm can exit), so the threshold shifts up to min ATC.

The key is distinguishing sunk costs (irrelevant to short-run decisions) from variable costs (the costs that operating actually creates). Short-run shutdown is about whether you're covering your avoidable costs, not your total costs.