A firm producing women handbags faces a perfectly competitive market in the economy. It finds that price of the handbag in short run, is less than the average variable cost incurred by the firm in production of the bag. Also in long run, price is less than the average cost incurred to produce the bag. Should the firm continue operating in the market on the same pace or should either do some alterations in revenue/cost structure or shut down its operations.
Answer & explanation
Correct answer: option 2
The correct answer is Option 2: The firm should either do some alterations in revenue/cost structure or shut down its operations.
In a perfectly competitive market, the firm's decision depends on price (P) in relation to costs:
1️⃣ Short Run Decision:
- If P < AVC (Average Variable Cost), the firm should shut down immediately because it cannot cover its variable costs.
- Continuing to operate would result in greater losses than shutting down since each unit produced adds more loss than revenue.
2️⃣ Long Run Decision:
- If P < AC (Average Cost) in the long run, the firm cannot earn normal profit, meaning it will eventually have to exit the market.
- However, if the firm can reduce costs or increase revenue (e.g., by improving efficiency, lowering input costs, or innovating), it might survive.