Consider a perfectly competitive firm When the market price is equal to the firm’s marginal cost but below its average variable cost, the firm
The correct answer and explanation is:
The correct answer is: Shuts down in the short run.
Explanation:
In a perfectly competitive market, firms produce at a level where their marginal cost (MC) equals the market price (P) in the long run, maximizing efficiency. However, in the short run, if the market price is equal to the firm’s marginal cost but below the average variable cost (AVC), the firm is experiencing a situation where it is not covering its variable costs.
The Average Variable Cost represents the cost per unit of output that varies with the level of production. If the price is lower than the AVC, the firm is not covering the costs of production that change with output, such as wages or raw materials. This means that for every unit of output, the firm is losing more money than it would if it simply stopped production.
In the short run, a firm can only survive if it covers its variable costs, because the fixed costs (such as rent and machinery) must still be paid whether the firm produces or not. If the price is below AVC, the firm’s losses exceed the fixed costs, and it is better off temporarily shutting down to minimize its losses.
When a firm shuts down, it halts production temporarily and only incurs fixed costs, which are typically lower than the losses incurred if it continues to produce under these conditions. This decision is made to avoid incurring additional losses in the short run, as continuing production would only increase the firm’s financial difficulties.
If the market price continues to stay below the AVC in the long run, the firm may have to exit the industry entirely, as it is not sustainable to continue operating under such conditions. In a competitive market, firms that cannot cover their costs, both fixed and variable, will ultimately exit the market, leading to market adjustments over time.