You’ve been hired by an unprofitable firm to determine whether it should shut down its unprofitable operation.

The firm currently uses 70 workers to produce 300 units of output per day. The daily wage (per worker) is $100, and the price of the firm’s output is $30. Although you don’t know the firm’s fixed cost, you know that it is high enough that the firm’s total costs exceed its total revenue. Should the firm continue to operate at a loss?

I would think not.

Consider the choices facing an unprofitable (and perfectly competitive) firm. The firm currently produces 100 units per day and sells them at a price of $22 each. At the current output quantity, the total cost is $3,000 per day, the variable cost is $2,500 per day, and the marginal cost is $45.
a. Evaluate the following statement from the firm's accountant: "Given our current production level, our variable cost ($2,500) exceeds our total revenue ($2,200). We should shut down our production facility."
I would say that I would agree the accountant if the price, like it is here, is less than the variable cost then shut down.

We generally say that if revenue exceeds variable costs, then the firm should continue to produce IN THE SHORT RUN, even if there is a loss.

In a) it depends what the fixed costs are. If they are sunk costs, with no hope of recovery (no scrap value), then definately continue to produce. If the fixed costs stop being costs if the firm shuts down, (e.g., rent) then perhaps the firm should shut down, especially if there is no positive expected changes in the market.

Bot Bot answered
1 year ago

In the first scenario, let's analyze the firm's situation. The firm has a daily revenue of $9,000 (300 units x $30) and a total daily variable cost of $7,000 (70 workers x $100). In this case, the revenue exceeds the variable cost, meaning the firm should continue to operate in the short run as it is still able to cover the variable costs and contribute to fixed costs.

Coming to the second scenario (a), the accountant points out that the variable cost ($2,500) exceeds the total revenue ($2,200), which indicates a short-term loss. However, without knowing the fixed costs and their nature, it is difficult to determine whether the company should shut down immediately. If the fixed costs are sunk costs or there is a positive expected change in the market, then the firm should continue to operate in the short run. If the fixed costs can be avoided by shutting down the firm, then it may be a wise decision to shut down.

Overall, based on the information provided, it is important to consider whether revenue exceeds variable costs and the nature of fixed costs in deciding whether a firm should continue to operate in the short run.

Step-by-Step Bot Step-by-Step Bot answered
8 months ago

b. Consider the following scenario: If the firm shuts down, it will incur a loss equal to its fixed costs, but if it continues to operate, it will incur a loss from its variable costs. Should the firm shut down?

In this scenario, the firm should compare the loss from shutting down (equal to fixed costs) with the loss from continuing to operate (equal to variable costs). If the loss from shutting down is less than the loss from continuing to operate, then the firm should shut down. However, if the loss from continuing to operate is less than the loss from shutting down, then the firm should continue its operations, even if it means incurring a loss.

Ultimately, the decision to shut down or continue operating will depend on the specific values of the fixed costs and variable costs incurred by the firm.

Explain Bot Explain Bot answered
8 months ago

To determine whether the firm should shut down its production facility at the current production level, we need to assess whether it can cover its variable costs with its total revenue. Variable costs refer to costs that change with the level of production, such as wages and materials.

In this scenario, the firm's accountant states that the variable cost is $2,500 per day, which exceeds the total revenue of $2,200. Based on this information, the accountant suggests shutting down the production facility.

In general, if revenue exceeds variable costs, it is advisable for the firm to continue producing in the short run, even if there is a loss. However, the decision also depends on the nature of fixed costs.

If the fixed costs are sunk costs, which means they have no hope of recovery and no scrap value, then the firm should definitely continue production. This is because shutting down would not eliminate the fixed costs, and the firm would incur losses without generating any revenue.

On the other hand, if the fixed costs can be avoided by shutting down the production facility (e.g., rent ceases to be a cost), then it might be more favorable to shut down, especially if there are no positive expected changes in the market.

Therefore, whether the firm should shut down its production facility at the current production level depends on the nature and magnitude of its fixed costs, as well as any expected changes in the market. If the fixed costs are significant and irrecoverable, it might be more prudent to continue producing even at a loss. However, if the fixed costs can be avoided and the market conditions are unfavorable, shutting down might be the better option.

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