Question

$\mathrm{Al}$ and George's used car lot has total revenue of $\mathrm{\$}5$ million, fixed costs of $\mathrm{\$}8$ million, and variable costs of $\mathrm{\$}4$ million. In the short run the firm will _____, and in the long run it will _____. a) shut down, go out of business b) shut down, stay in business c) operate, stay in business d) operate, go out of business

Short answer

In the short run, the firm will operate, and in the long run, it will go out of business.

Step-by-step solution

Calculate the total profit

Total profit is calculated using the formula: Total Profit = Total Revenue - Total Costs, where Total Costs = Fixed Costs + Variable Costs. Using the given data, we can calculate the total profit as follows: Total Revenue = $5 million Fixed Costs = $8 million Variable Costs = $4 million Total Costs = Fixed Costs + Variable Costs = $8million+$4 million = $12 million Total Profit = Total Revenue - Total Costs Total Profit = $5million-$12 million = -$7 million The total profit is negative, which implies that the firm is currently incurring losses.

Decide action in the short run

In the short run, a firm should shut down if its total revenue is lower than its variable costs. Otherwise, it should continue to operate. Comparing the total revenue and variable costs in our problem: Total Revenue = $5 million Variable Costs = $4 million Since the total revenue is greater than the variable costs, the firm should continue to operate in the short run.

Decide action in the long run

In the long run, a firm should go out of business if it continues to incur losses, which are indicated by negative total profits. If a firm can make a profit, it should stay in business. In our problem, Total Profit = -$7 million Since the total profit is negative, the firm will go out of business in the long run. The correct answer is: d) operate, go out of business

Key concepts

Total Revenue

Total revenue is one of the critical components in analyzing a business's financial health, particularly in profit maximization strategies. It refers to the total amount of money a firm earns from selling its goods or services before any expenses are subtracted. In the context of Al and George's used car lot, their total revenue amounts to $5 million.
Total revenue helps companies understand their sales performance and is calculated by multiplying the price of goods by the quantity sold. For businesses, keeping track of total revenue is essential because it serves as a starting point for calculating other financial metrics like profit. It offers a straightforward view of whether the business is generating enough income to cover its costs.
In financial decision-making, total revenue plays a crucial role in the short-run analysis. As seen in Al and George's scenario, their revenue was compared to variable costs to decide whether to continue operations. This measure helps businesses navigate times of uncertainty, indicating when it might be necessary to adjust prices or strategies to enhance profitability.

Fixed Costs

Fixed costs are the expenses that do not change with the level of goods or services a company produces. These costs remain constant regardless of business activity levels. Examples include rent, salaries, and insurance. Al and George's fixed costs total $8 million, a significant figure in their financial considerations.
Understanding fixed costs is vital for any business, as they do not fluctuate with production levels, meaning they must be paid regardless of sales. These costs can exert a considerable burden if revenue levels drop, as found in Al and George's situation.
In the long run, fixed costs become crucial as they do not shrink with reduced production. This constancy means businesses must ensure that they're covering these costs with sufficient revenue. Otherwise, they face the risk of incurring losses, as Al and George did with a negative total profit of $7 million. Such financial awareness helps businesses plan effectively for both the short and long term.

Variable Costs

Variable costs differ from fixed costs in that they vary with the production volume of goods or services. These costs increase or decrease depending on how much the company produces or sells. In the used car lot scenario, Al and George's variable costs are $4 million.
Understanding variable costs is crucial for daily operational decisions. It's these costs that get compared to total revenue when deciding whether to keep operating in the short run, as was done in this case. If total revenue exceeds variable costs, as it does here, operation can continue in the short term, as this would cover at least some costs and minimize losses.
For long-term planning, analyzing variable costs helps businesses with pricing strategies, cost management, and profit maximization tactics. By managing variable costs effectively, companies can quickly adapt to changing demands and production requirements, aiding in maintaining profitability even when fixed costs impose ongoing obligations.