CFA Practice Question

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CFA Practice Question

You've been hired by an unprofitable firm to determine whether it should shut down its 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. The cost of the other variable inputs is $500 per day. Although you don't know the firm's fixed costs, you do know that they are high enough that the firm's total cost exceeds total revenue. What is the best recommendation you can make, based on the information that you have?

A. Exit the industry in the long run.
B. Shut down in the short run.
C. Continue to produce in the short run.
Correct Answer: C

Total revenue = (30)(300) = $9,000. Variable cost = (70)(100) + 500 = $7,500. Average variable cost = 7,500/300 = $25. Since 30 > 25, P>AVC, and the firm should not shut down in the short run since they are covering variable costs (and some of fixed costs). There is not enough information to tell what the firm should do in the long run.

User Contributed Comments 6

User Comment
Done Could it also be that TR > VC which could be 9000 > 7500?
sajgon yes
hdavid57 Is it important to know how much the fixed costs are? Or is it just important to know that the variable costs are covered? Obviously, in the short term, the answer to the second question is yes. The fixed costs are going to be there, whether they are covered or not, so the key point here is that a firm doesn't need to be operating at a profit in order to continue for the short-term. In the long-run, where the fixed costs become variable, the firm can decide whether making adjustments to PP&E or other variable costs will enable it to maximize profits.
southeuro the key is that the firm should cover ALL of variable costs AND ANY (even if it's $1) amount from its fixed costs to continue operating in the short run.
J0rdanl There's not enough information to know if the firm should exit in the long run?

Question says that we know TR<TC, and book says to exit the market in the long run when this is the case. I'd like to know why the answer cannot be both A and C.
babycdq Agree with J0rdanl
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