Final answer:
If the contribution margin is not sufficient to cover fixed costs, a business will suffer a net operating loss. In the short term, firms can operate with a loss if variable costs are covered, but in the long term, persistent losses may lead to an exit from the market. Additionally, prices below AVC can prompt a firm to shut down to minimize losses.
Step-by-step explanation:
If the contribution margin is not sufficient to cover the fixed costs, a company will experience a net operating loss. A contribution margin represents the portion of sales revenue that is not consumed by variable costs and so contributes to the coverage of fixed costs.
Firms in the short run may continue operating despite making losses if they can cover their variable costs with revenue, which suggests that they are in a position to cover at least some portion of their fixed costs. However, if these conditions persist into the long run, firms may face an exit scenario where they cease production to stem ongoing losses.
This dynamic applies across various industries, including the insurance sector, where companies might incur losses if they cannot balance premiums with the cost of claims. If contributions from premiums are insufficient to cover the insured risks, companies may have to consider raising premiums, which could further discourage low or medium-risk individuals from purchasing insurance, thus exacerbating the losses.
Moreover, if a firm's price falls below the average variable cost (AVC), it will not be able to earn enough revenue to cover its variable costs. In such a situation, the firm would minimize losses by shutting down production and only incurring fixed costs, instead of operating and losing additional sums covering both fixed and some variable costs.