Final answer:
If the market price is greater than the average variable cost (P > AVC), the firm should maintain its current level of output (option 3: Maintain Q) in the short run, even if it's making economic losses, because it is preferable to shutting down and bearing the entire fixed costs.
Step-by-step explanation:
Understanding Production Decisions in the Short Run
When analyzing whether a firm should continue producing in the short run, it's important to compare the market price (P) to the average variable cost (AVC) and the total revenue (TR) to the total variable cost (TVC). If P > AVC or TR > TVC, then the firm is covering its variable costs and should continue producing despite possibly making economic losses. The reason is, as long as the price covers the variable costs, the contribution towards the fixed costs is positive. Hence, making some losses is better than shutting down immediately, as shutting down would mean taking on the full burden of fixed costs without generating any revenue.
It is also important to consider that if P < AVC, the firm should shut down in the short run because it would not cover its variable costs, thus, increasing losses by continuing production.
The next step for a firm that finds P > AVC is to continue to produce (option 3: Maintain Q) in the short run and not increase or decrease output drastically. It will operate at a loss if P < ATC, but shutting down would lead to even greater losses. In the given example, since the price of $28 is greater than the AVC ($16.40), the firm should continue producing.