If price covers average variable costs but not total costs, what should a firm do in the short run?

If price covers average variable costs but not total costs, what should a firm do in the short run?

• A. Shut down immediately
• B. Exit the market
• C. Continue operating to cover part of fixed costs
• D. Increase price

Answer: (C)

In the short run, a firm should keep producing as long as price covers average variable costs. If price covers AVC but not total costs, the firm can cover its variable costs and still contribute to fixed costs. Producing gives revenue that pays for the variable costs and reduces losses by the portion that exceeds AVC, because the loss equals fixed costs minus the contribution (P − AVC) per unit times quantity. If you shut down, you’d still incur fixed costs, so losses would be larger. Increasing price isn’t something the firm can reliably control in the short run, and exiting the market is a longer-run decision. So the best move is to continue operating to lessen losses by covering part of the fixed costs.

In the short run, a firm should keep producing as long as price covers average variable costs. If price covers AVC but not total costs, the firm can cover its variable costs and still contribute to fixed costs. Producing gives revenue that pays for the variable costs and reduces losses by the portion that exceeds AVC, because the loss equals fixed costs minus the contribution (P − AVC) per unit times quantity. If you shut down, you’d still incur fixed costs, so losses would be larger. Increasing price isn’t something the firm can reliably control in the short run, and exiting the market is a longer-run decision. So the best move is to continue operating to lessen losses by covering part of the fixed costs.