A friend owns an ice cream shop. Aware of your current studies in economics, the
ID: 1250646 • Letter: A
Question
A friend owns an ice cream shop. Aware of your current studies in economics, the friend asks for your help in determining what she should do regarding her shop in the winter. Her shop is very profitable in the spring, summer, and fall. However, she gives you the following data for the profit maximizing level of production regarding the winter (assume she only sells ice cream cones):· Average Fixed Cost = $2
· Average Variable Cost = $1
· Marginal Revenue = $1.50
a) Other things constant, should your friend continue to operate in the winter months? Be sure to explain to her why she should or should not continue to operate.
b) In the following year, your friend asks for your help again. All of the data remain the same; however your friend finds that she is no longer profitable in the spring, summer, or fall months. What advice would you give to her under these circumstances? Why?
Explanation / Answer
a. Since average variable costs are less than marginal revenue in the short run the firm should not shut down because the fixed costs are sunk and the only costs that should be considered are the variable costs which are less than the revenue. b. In the long run if the firm is not profitable it should shut down because the firm will incur the costs of remaining open while not making a profit. If they closed in the long run profits would be zero instead of negative.