Explanation
In a perfectly competitive market, a firm's short-run shutdown decision is based on whether it can cover its variable costs, not its fixed costs.
Key Concepts:
- Shutdown Point: In the short run, a firm will shut down production when price (average revenue) falls below average variable cost (AVC).
- Fixed Costs: Fixed costs are sunk in the short run and must be paid regardless of production level.
- Variable Costs: Variable costs can be avoided by shutting down production.
Analysis of Options:
- Option A: Average total cost includes both fixed and variable costs. A firm may continue operating even if ATC > MR as long as it can cover variable costs.
- Option B: Average fixed cost is irrelevant for shutdown decisions since fixed costs are sunk in the short run.
- Option C: CORRECT. When average variable cost > average revenue (price), the firm cannot cover its variable costs and should shut down to minimize losses.
Economic Rationale:
- If P < AVC, the firm loses money on every unit produced.
- By shutting down, the firm only loses its fixed costs.
- By continuing to operate when P < AVC, the firm loses both fixed costs AND the difference between AVC and P on each unit.
Example: If AVC = $10, P = $8, and fixed costs = $1000:
- Operating: Loss = Fixed costs + (AVC - P) × Q =
$1000 + $2 × Q
- Shutting down: Loss = Fixed costs =
$1000
- Clearly, shutting down minimizes losses when P < AVC.
