Figure 15-1Suppose that a firm in a competitive market has the following cost curves:Refer to Figure 15-1. If the market price is $5, the firm will earn

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We start by restating the setup: in a competitive market, a firm sets output where price (P) equals marginal cost (MC) in the short run, provided P covers average variable costs (AVC). The question gives P = 5 and asks what the firm earns.

- Step through the decision rule: In perfect competition, produce where P = MC as long as P ≥ AVC. If P < AVC, the firm should shut down immediately and produce zero output, since it cannot cover its variable costs.

- Evaluate the shutdown condition: From the graph, observe the AVC curve and the MC curve. At the output level where MC would equal P = 5, check whether AVC at that output is above or below 5. If AVC at the profit-maximizing quantity (where MC ≈ 5) is greater than 5, then the firm would incur losses that exceed fixed costs, and it should shut down. If AVC is below 5, the firm would operate, albeit with losses, but not shut down.

- Compare to the given option: The provided choice states that the firm earns negative economic profits and shuts down. This outcome aligns with the shutdown condition when price is not sufficient to cover variable costs. If the market price of 5 is below AVC at the relevant output level, the firm cannot cover its variable costs and should shut down, resulting in zero output and losses equal to fixed costs (i.e., negative economic profits would be avoided by producing nothing).

- Why the other possibilities (if considered) would be incorrect in this scenario: If the price were above AVC but still below ATC, the firm would continue operating in the short run but incur economic losses, not shut down; in that case, the correct statement would be produce with negative economic profit, but not shut down. If price were above ATC, the firm would earn positive economic profits. If price were below AVC, shutdown is the rational choice, regardless of ATC.

- Summary reasoning aligned with the stated answer: With P = 5, the firm cannot cover its variable costs at the profit-maximizing output, so the optimal short-run decision is to shut down, yielding zero output and economic losses equal to fixed costs, i.e., negative economic profits avoided by production. Therefore, the conclusion “negative economic profits and shut down” is consistent with the standard short-run shutdown rule in perfect competition when P < AVC at the relevant MC.

Figure 15-1Suppose that a firm in a competitive market has the following cost curves:Refer to Figure 15-1. If the market price is $5, the firm will earn

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Figure 15-1Suppose that a firm in a competitive market has the following cost curves:Refer to Figure 15-1. If the market price is $5, the firm will earn

View Explanation

Log in for full answers

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