If price is above the average variable cost but below the average total cost of a representative firm in a competitive industry
The correct answer and explanation is:
If the price is above the average variable cost (AVC) but below the average total cost (ATC) of a representative firm in a competitive industry, the firm will continue to produce in the short run, but it will be incurring losses. The key factors to understand in this situation are the relationship between price, AVC, and ATC, and how they affect the firm’s decisions.
The average variable cost represents the cost of production that changes with the level of output, such as wages and raw materials. The average total cost includes both fixed and variable costs, which means it takes into account the total cost per unit of output, including all costs.
When the price is above the AVC but below the ATC, the firm is covering its variable costs but is unable to cover its total costs, which means it is operating at a loss. However, by continuing production, the firm is still able to contribute towards covering its fixed costs, even though it is not making a profit. In the short run, the firm will continue to produce as long as the price covers the AVC because shutting down would result in a larger loss equal to the total fixed costs.
This situation is temporary, and in the long run, firms in a competitive market will exit the industry if they are unable to earn enough to cover their total costs. As firms exit, the market supply will decrease, causing the price to rise. In the long run, the price will settle at the point where firms in the market are earning normal profits, meaning the price equals the ATC. Until then, firms experiencing losses will continue to operate in the short run, accepting losses as long as they can cover their variable costs.