Suppose you are hired as an economic consultant for Profmax Consulting Company.

Question

Suppose you are hired as an economic consultant for Profmax Consulting Company. Your job is to advise the company's clients on the appropriate action to take in the short run in order to maximize the profits (or minimize the losses) of each firm. The firms you analyze produce different products, and each operates independently in a different perfectly competitive market. You may assume that each firm is currently operating at an output level where marginal cost is increasing. Fill in the missing information, and make your suggestions about the appropriate action for each by placing one of the following recommendation letters in the last row of the table of information that follows. Recommendations: C  = currently operating at the correct level of output, no action necessary. I = increase the level of output. D = decrease the level of output. SD = shut down the plant. Choose one scenario from A, B, or C and back up your recommendation

Explanation / Answer

Working notes:

(1) TR = P x Q, so P = TR / Q

(2) TC = VC + FC. So,

VC = TC - FC

FC = TC - VC

(3) ATC = TC / Q

(4) AVC = VC / Q

(5) AFC = FC / Q = ATC + AVC

(6) MC = Change in TC / Change in Q

(7) A perfectly competitive firm maximizes profit by equating P with MC. It will shut down in short run if P < AVC. It stays in market if long run if economic profits are non-negative, but will exit if economic profit is negative i.e. there is a loss, were

Profit = Q x (P - ATC) and Loss = Q x (ATC - P)

Chosen scenario: A

Therefore,

(a) P = MC = $4 (= TR / Q = $2800 / 700)

(b) FC = TC - VC = $(2975 - 2450) = $525

(c) ATC = TC / Q = $2975 / 700 = $4.25

(d) AVC = VC / Q = $2450 / 700 = $3.5

(e) AFC = FC / Q = $525 / 70 = $7.5

(f) Loss = Q x (ATC - P) = 700 x $(4.25 - 4) = 700 x $0.25 = $175

Recommendation: SD

Since it makes economic loss of $175, and it exits the industry.

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