Question

3. The following graph shows the cost and revenue curves for a firm in a perfectly competitive market. 90 80 D=MR 70 60 ATC Price and cost ($) 50 AVC 40 30 MC 20 10 0 10 20 30 40 50 60 70 80 90 a) Assume that new firms enter this market and that drives the price down to $35 per unit. Will the firm continue to produce or shut down? Explain your answer.

Answer 1

If new firms enter the market and drive down price to 35 , the firm should continue to produce. There is no need for the firm to shut not down.

When price is 35 , price charged by the firm is less than minimum average variable cost 40 and the firm is incurring losses. But the firm is still able to cover its variable costs, as the pricd lies above minimum average variable cost .  

Minimum average variable cost ( AVC) =30

P> Minimum AVC

35>30

As per the rule of shutdown, a firm should shut down only if price is less than or equal to AVC.

In our example, firm is better off continuing its operations because it can cover its variable costs and use any remaining revenues to pay off its fixed costs.However firm wouldnt incur losses indefinitely. ln the long run, many loss making firms would exit the market and supply would go down and price would go up to the level of minimum long run average cost.