A competitive firm compares the market price with its AVC to decide whether to produce in the short run, but with its LRAC in the long run. Why?
Answer & explanation
Correct answer: option 2
The correct answer is Option (2) → In the short run the firm must bear its fixed cost even at zero output, while in the long run a firm that shuts down has zero profit.
A firm produces only if that is better than shutting down. In the short run, shutting down still leaves a loss equal to TFC; in the long run it gives zero profit. So the test differs.
Option (1) In the short run the firm earns normal profit at every output, while in the long run it earns super-normal profit. — Incorrect. Profit changes with output and price. A firm does not earn normal profit at every output in the short run.
Option (2) In the short run the firm must bear its fixed cost even at zero output, while in the long run a firm that shuts down has zero profit. — Correct. In the short run the firm loses TFC anyway, so it produces if the price covers its AVC. In the long run there is no fixed cost, so the price must cover the whole LRAC.
Option (3) In the short run the firm has no fixed cost at zero output, while in the long run it must still pay its fixed cost. — Incorrect. This turns the two periods around. The fixed cost must be paid in the short run; in the long run there is no fixed cost.
Option (4) In the short run AVC is the firm’s only cost, while in the long run normal profit is added to its costs. — Incorrect. In the short run the firm has a fixed cost as well as a variable cost. Normal profit is a part of total cost in both periods.
NCERT (2026-27): “4.3.3 Condition 3 … Since output is zero, TR and TVC are zero as well. Hence, the firm’s profit at zero output is equal to – TFC. But, the area of rectangle OpAq1 is strictly less than the area of rectangle OEBq1. Hence, the firm’s profit at q1 is [(area EBAp)-TFC], which is strictly less than what it obtains by not producing at all. So, the firm will choose not to produce at all, and exit from the market.” “Case 2: Price must be greater than or equal to AC in the long run … Since the area of rectangle OEBq1 is larger than the area of rectangle OpAq1, the firm incurs a loss at the output level q1. But, in the long run set-up, a firm that shuts down production has a profit of zero. Again, the firm chooses to exit in this case.” |