Final answer:
Profits of a firm with a 50 percent contribution margin are more sensitive to price decreases than to price increases due to the larger increase in volume required to cover fixed and variable costs when prices fall. Maintaining prices above average variable costs is crucial for remaining operational, even below the break-even point. A profit-maximizing firm will seek the output level where losses are minimized when total costs exceed total revenues.
Step-by-step explanation:
When analyzing sensitivity of profits to price changes, it is important to consider the contribution margin and the potential effects on volume hurdle, which is the quantity that must be sold to cover variable and fixed costs. A firm with a 50 percent contribution margin that experiences a price decrease of 40 percent will have to sell a significantly higher volume to maintain the same level of profits because profits decrease at a higher rate with a price decrease than they do with a price increase, given the contribution margin remains constant.
The break-even point is a critical concept in this context as it indicates the price level at which a firm's total revenues exactly cover its total costs, allowing no profit or loss. According to Figure 8.6, a firm must keep the price above the average variable cost to justify remaining open, even if operating at a loss below the break-even point. In instances where total revenue falls below total costs at all levels of output, a profit-maximizing firm will aim for the output level where the loss is minimized.
Generally, for a firm with positive contribution margins, profits are more sensitive to price decreases than to price increases due to the amplified effect of reduced income on the inability to cover fixed costs, even when variable costs are proportionately covered by the reduced price.