If A Perfectly Competitive Firm Incurs An Economic Loss

1. If A Perfectly Competitive Firm Incurs An Economic Loss It Should

Identify the appropriate response for a perfectly competitive firm experiencing economic loss over the short and long term, including decisions about shutting down, adjusting prices, and considerations regarding fixed costs.

In a perfectly competitive market, firms face pressures to optimize their operations when experiencing economic losses. The short-term decision often involves assessing whether the firm should continue producing or cease operations temporarily, especially considering fixed costs, which are unrecoverable in the short run. In the long run, sustained losses typically lead to exit from the market, as firms cannot sustain unprofitable operations indefinitely.

Specifically, if a firm incurs an economic loss, the decision to shut down depends on whether the revenue can cover variable costs. If revenues are insufficient to cover variable costs, the firm should shut down immediately to minimize losses. Conversely, if revenues cover variable costs but not fixed costs, the firm might continue operating in the short run to minimize losses, as fixed costs are sunk in the short term. In the long run, if losses persist, exit becomes inevitable because the firm cannot cover total costs, including fixed costs.

Therefore, the appropriate answer regarding the shutdown decision is: D. shut down if this loss exceeds fixed cost, considering the importance of variable costs in the short-term decision-making process, and the eventual exit if losses persist long-term.

Sample Paper For Above instruction

In perfectly competitive markets, firms operate under the assumption that price is determined by the intersection of supply and demand, and individual firms are price takers. When such a firm experiences an economic loss, it faces critical decisions that impact its sustainability and future viability. The core of this decision-making process revolves around understanding the nature of short-term versus long-term responses to sustained losses, particularly in relation to fixed and variable costs.

In the short run, a firm encountering an economic loss will evaluate whether it can cover its variable costs — costs that change with the level of output. If the revenue generated from sales does not cover variable costs, the firm should cease operations immediately. This is because continuing production would increase losses beyond what could be minimized by shutting down, as fixed costs would be incurred regardless of production level. Conversely, if revenues cover variable costs but not fixed costs, the firm should continue operating temporarily to cover some fixed costs, thereby minimizing losses until market conditions improve or costs are adjusted.

Mathematically, the shutdown point occurs where price equals the minimum average variable cost (AVC). This point explains that as long as price remains above AVC, the firm will continue production—even at a loss—because covering variable costs contributes to fixed costs. If the price falls below AVC, shutting down minimizes losses to fixed costs alone, which is preferable to operating at a loss greater than fixed costs.

Looking beyond the short run, in the long run, the firm’s sustainability depends on whether it can at least break even, covering all costs, including fixed costs. If losses persist over an extended period, the firm should exit the market to prevent ongoing unprofitable operations. This decision aligns with the entry and exit theory of perfect competition, which stipulates that firms will enter or exit the market based on profit signals — positive profits attract new firms, while persistent losses lead to market exit.

Furthermore, the decision hinges on the concept of fixed costs, which are costs that cannot be recovered once incurred. If the losses an enterprise sustains surpass its fixed costs, and it cannot cover variable costs, shutdown is optimal. If fixed costs are involved but the firm can still operate at a loss in the short run without worsening its position, it might choose to continue, banking on future market improvements or cost reductions.

In conclusion, for a perfectly competitive firm experiencing an economic loss, the immediate and long-term responses depend on the relationship between market price, variable costs, fixed costs, and the overall profitability outlook. The optimal short-term decision involves shutting down if losses exceed variable costs, and the long-term decision involves exiting the market if losses persist, as the firm can no longer operate profitably.

References

• Perloff, J. M. (2017). Microeconomics (8th ed.). Pearson.
• Pindyck, R. S., & Rubinfeld, D. L. (2018). Microeconomics (9th ed.). Pearson.
• Frank, R. H., & Bernanke, B. S. (2019). Principles of Economics (7th ed.). McGraw-Hill Education.
• Varian, H. R. (2014). Intermediate Microeconomics: A Modern Approach (9th ed.). W.W. Norton & Company.
• Mankiw, N. G. (2020). Principles of Economics (9th ed.). Cengage Learning.
• Green, C. P., & Salkind, N. J. (2011). Using SPSS for Windows and Macintosh: Analyzing and Understanding Data (6th ed.). Pearson.
• Booth, A. L., & Cleary, S. (Eds.). (2017). The Economics of Competition Policy. Edward Elgar Publishing.
• Stiglitz, J. E., & Walsh, C. E. (2002). Economics. W. W. Norton & Company.
• Marshall, A. (1920). Principles of Economics. Macmillan.
• Martins, P. (2020). Microeconomics: Principles and Analysis. Routledge.