Question

At its best possible output level, a firm has total revenue of \(\$ 3,500\) per day and total cost of \(\$ 7,000\) per day. What should this firm do in the short run if: a. the firm has total fixed costs of \(\$ 3,000\) per day? b. the firm has total variable costs of \(\$ 3,000\) per day?

Short answer

In both scenarios, the firm should continue operating in the short run. Although the firm is making a loss, in the short run, as long as it can cover its variable costs and contribute some towards its fixed costs (scenario A) or cover all of its variable costs and some fixed costs (scenario B), it should stay in business.

Step-by-step solution

Understand Key Terms

Fixed costs are costs that do not change with the level of output. Variable costs are costs that change with the level of output. Total costs are the sum of fixed and variable costs. Total revenue is the amount the firm earns from selling its product.

Evaluate Scenario A: Total Fixed Costs

In this scenario, the firm has total fixed costs of $3,000 per day. This means even if the firm isn’t producing, the firm still has to pay $3,000. However, the total revenue is $3,500 per day while total cost is $7,000. As such, the firm is making a loss of $3,500 ($7,000 - $3,500). However, since the total revenue of $3,500 covers the fixed cost of $3,000, the firm should continue operating in the short run because it can cover its fixed costs and some of its variable costs.

Evaluate Scenario B: Total Variable Costs

In this second scenario, the firm has total variable costs of $3,000 per day. The firm is again making a loss of $3,500. However, the total revenue of $3,500 covers the variable cost of $3,000. The firm should continue operating because by doing so, it is able to cover all of its variable costs and contribute $500 ($3,500 - $3,000) toward the payment of fixed costs even though it is running at a loss.