Theory question 105
Theory of Costs and RevenueSection B (answer four questions only from this section)
(a) Distinguish between fixed and variable costs.
(b) Under which conditions will a firm continue to operate at a loss in the short run? (Use figures or a diagram to explain your answer).
Show the model answer
(a) Fixed costs do not vary with output and are paid even when nothing is produced (rent, insurance, salaries of permanent staff, depreciation). Variable costs vary directly with output and are zero at zero output (raw materials, fuel, wages of casual workers).
(b) In the short run a firm continues to produce at a loss as long as price (average revenue) covers average variable cost (P ≥ AVC).
It then pays all variable costs and part of the fixed costs; if it shut down it would still lose all its fixed costs, so producing reduces the loss.
Example: fixed cost ₦100, variable cost ₦300, revenue ₦350: producing gives a loss of ₦50, shutting down a loss of ₦100, so it keeps producing.
Diagram: AC and AVC curves with price line between minimum AVC and minimum AC; the firm produces where MC = MR.
If price falls below AVC, the firm shuts down (shut-down point at minimum AVC).
The key condition is price ≥ average variable cost.