Shazam, a maker of magic wands, is selling in a purely competitive market. Its output is 500 wands, which sell for $10 each. At this level of output, the marginal cost is $10 and the average variable cost is $12. Should the firm increase output, decrease output, or not produce? Why?

not produce

Explanation:

Applying the costs-volume profit analysis concept, Shazam should stop production immediately to prevent further losses. According to the concept, the contribution margin per unit should be sufficient to cover for fixed cost and profitability. The contribution margin per unit is calculated by subtracting variable costs from the selling price.

For Shazam, the marginal cost is $10; the average variable cost is $12, while the selling price is $10. The contribution margin per unit will be - $2 ($10 - $12). The revenue from the sale of an item is not sufficient to cover variable costs, let alone fixed costs. The Shazam is incurring a loss of - $2 for every unit sold before fixed costs are considered. The firm should stop further production because, as per the current price - set up, each sale is a loss.