CFA Level IEconomicsEasy
A perfectly competitive firm's price is $8 per unit. At its current output, average variable cost (AVC) is $9 and average total cost (ATC) is $12. In the short run, the firm should:
- AShut down immediately, since price is below average variable cost
- BIncrease output until price equals average total cost to break even
- CShut down only if price falls below average total cost
- DContinue producing, since the loss will be smaller than total fixed costs
Show answer & explanationAnswer & explanation
Correct answer: A. Shut down immediately, since price is below average variable cost
Because price ($8) is below AVC ($9), the firm cannot even cover its variable costs, so producing would generate a loss greater than fixed costs alone. The short-run shutdown rule states that a firm should cease production when P < AVC, limiting its loss to fixed costs.
Why the other options are wrong
- B. Incorrect—the firm cannot reach P=ATC in the short run when price is below even AVC.
- C. Incorrect—the shutdown rule uses AVC, not ATC, as the short-run threshold.
- D. Incorrect—producing when P<AVC increases losses beyond fixed costs, not below them.
Short-Run Shutdown Rule
A perfectly competitive firm should shut down in the short run if price falls below average variable cost, since it cannot cover variable costs.
- Shutdown point: P < AVC
- Firm operates at a loss if AVC < P < ATC
- Long-run exit occurs when P < ATC persistently
Memory trick: 'AVC or bust' — if price can't cover variable cost, shut the doors.