Question

Which statement is true? (LO8) a) A firm will operate in the short run when total revenue exceeds fixed costs. b) A firm will operate in the short run when total revenue exceeds variable costs. c) A firm will shut down when total cost equals total revenue. d) None of the above.

Short answer

A firm will operate in the short run when total revenue exceeds variable costs (b).

Step-by-step solution

Statement a

A firm will operate in the short run when total revenue exceeds fixed costs. This statement is not necessarily true because just covering the fixed costs won't guarantee covering the variable costs, which are essential for the firm's continuous production. If the variable costs are not covered, the firm will operate at a loss.

Statement b

A firm will operate in the short run when total revenue exceeds variable costs. This statement is true because, in the short run, a firm will continue to operate if it can cover its variable costs, even if it does not completely cover its fixed costs. Covering the variable costs ensures that the firm does not incur additional losses.

Statement c

A firm will shut down when total cost equals total revenue. This statement is not true because when total cost equals total revenue, it means that the firm breaks even. The firm may decide to continue operating to cover both fixed and variable costs, expecting improvements in future revenue.

Statement d

None of the above. This statement is not true because Statement b is correct. So, the correct answer to this exercise is: A firm will operate in the short run when total revenue exceeds variable costs (b).

Key concepts

Total Revenue

Understanding total revenue is fundamental when analyzing a firm's performance. It represents the total amount of money that a company receives from selling its goods or services. Mathematically, it is calculated by multiplying the price at which goods or services are sold by the quantity sold, written as: \( Total\ Revenue = Price \times Quantity \).

For a company making decisions in the short run, assessing whether the total revenue can cover the costs incurred in the production process is essential. If total revenue falls short, the company might not even be able to cover variable costs, resulting in operational losses. Hence, total revenue is a starting gauge for a firm's viability in the short term.

Fixed Costs

When we discuss fixed costs, we refer to expenses that do not change with the level of goods or services a company produces over a certain period. Examples include rent, salaries of full-time employees, and insurance premiums. These costs remain constant regardless of the firm's production volume.

For a business in the short run, fixed costs must be met irrespective of the company's operational status. Unlike variable costs, fixed costs do not fluctuate with production and hence are a necessary consideration when deciding whether to continue or halt operations. While generating revenue to cover fixed costs is necessary, it is not the sole indicator of whether a firm should continue operations in the short run.

Variable Costs

Conversely, variable costs change with the level of output a firm produces. This category includes raw materials, direct labor costs, and utilities like electricity, which can increase or decrease based on how much the firm is producing.

In the context of short-run operations, whether a firm exceeds its variable costs with its total revenue is a critical determinant for continued operation. If a firm's total revenue is less than its variable costs, it will incur losses on each additional unit produced, which could lead the firm to consider shutting down operations temporarily.

Shutdown Point

The shutdown point refers to a situation in economic theory where a firm discontinues production in the short run. This point is reached when the total revenue of a firm is not enough to cover the variable costs associated with production. At this juncture, continuing operations would mean the firm incurs greater losses.

Determining the shutdown point involves comparing total revenue to variable costs. If the revenue generated does not even meet the variable costs, the firm is better off stopping production temporarily because the losses involved in keeping the business running exceed the costs saved by not producing anything. Reaching the shutdown point does not necessarily mean the firm goes out of business entirely; it can simply indicate a temporary halt in production until conditions improve.