Question

Brewsters, a ice cream company, has been fairly successful in its market. Lydia sees an opportunity for profit and enters the market. After producing her profit-maximizing level of output, she finds that her average total cost per unit is $5, her average variable cost per unit is $3, and the market price is $2.50. In the short run, Lydia should _______.

A. stay in business even though she is suffering a loss.
B. shut down her business.
C. expand production because she is making a positive economic profit.

Answer 1

Answer: B. Shut down her business

Step-by-step explanation:

Lydia has a decision to make. In this scenario she is making less her costs and so is suffering a loss. She must make a decision to either SHUT DOWN or KEEP GOING.

In this case however it would seem as though her only decision is to Shut Down.

Why?

The Shut Down Rule states that, “in the short run a firm should continue to operate if price exceeds average variable costs...". Her Average Variable costs here exceed the market price so Shutting Down is her best option.

If the price exceeded her Variable Costs at least, she could stay in the market a bit longer as the Fixed Costs have already been committed to. But with her Variable Costs more than the Market Price, SHUTTING DOWN is her best option.

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