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The Shut-Down Condition in Economics
Production in the Short Run
Economists distinguish the short run from the long run in competitive markets by, among other things, noting that in the short run companies that have decided to enter an industry have already paid their fixed costs and can’t fully exit an industry. For example, over short time horizons, many companies are committed to paying a lease on office or retail space and must do so regardless of whether or not they produce any output.
In economic terms, these up-front costs are considered sunk costs- costs that have already been paid (or have been committed to be paid) and can’t be recovered. (Note, however, that the cost of the lease wouldn’t be a sunk cost if the company could sublet the space to another company.) If, in the short run, a firm in a competitive market faces these sunk costs, how does it decide when to produce output and when to shut down and produce nothing?
Profit if a Firm Decides to Produce
If a firm decides to produce output, it will select the quantity of output that maximizes its profit (or, if positive profit is not possible, minimizes its loss). Its profit will then be equal to its total revenue minus total cost. With a little arithmetic manipulation as well as the definitions of revenue and costs, we can also say that profit is equal to output price times quantity produced minus total fixed cost minus total variable cost.
To take this one step further, we can note that total variable cost is equal to average variable cost times the quantity produced, which gives us that the firm’s profit equals output price times quantity minus total fixed cost minus average variable cost times quantity, as shown above.
Profit if a Firm Decides to Shut Down
If the firm decides to shut down and not produce any output, its revenue by definition is zero. Its variable cost of production is also zero by definition, so the firm’s total cost of production is equal to its fixed cost. The firm’s profit, therefore, is equal to zero minus total fixed cost, as shown above.
The Shut-Down Condition
Intuitively, a firm wants to produce if the profit from doing so it at least as large as the profit from shutting down. (Technically, the firm is indifferent between producing and not producing if both options yield the same level of profit.) Therefore, we can compare the profits that we derived in the previous steps to figure out when the firm will actually be willing to produce. To do this, we just set up the appropriate inequality, as shown above.
Fixed Costs and the Shut-Down Condition
We can do a bit of algebra to simplify our shut-down condition and provide a clearer picture. The first thing to notice when we do this is that fixed cost cancels out in our inequality and is therefore not a factor in our decision regarding whether or not to shut down. This makes sense since the fixed cost is present regardless of which course of action is taken and therefore logically shouldn’t be a factor in the decision.
The Shut-Down Condition
We can simplify the inequality even further and arrive at the conclusion that the firm will want to produce if the price it receives for its output is at least as large as its average variable cost of production at the profit-maximizing quantity of output, as shown above.
Because the firm will produce at the profit maximizing quantity, which is the quantity where the price of its output is equal to its marginal cost of production, we can conclude that the firm will choose to produce whenever the price it receives for its output is at least as large as the minimum average variable cost that it can achieve. This is simply the result of the fact that marginal cost intersects average variable cost at average variable cost’s minimum.
The observation that a firm will produce in the short run if it receives a price for its output that is at least a large as the minimum average variable cost it can achieve is known as the shut-down condition.
The Shut-Down Condition in Graph Form
We can also show the shut-down condition graphically. In the diagram above, the firm will be willing to produce at prices greater than or equal to Pmin, since this is the minimum value of the average variable cost curve. At prices below Pmin, the firm will decide to shut down and produce a quantity of zero instead.
Some Notes About the Shut-Down Condition
It’s important to keep in mind that the shut-down condition is a short-run phenomenon, and the condition for a firm to stay in an industry in the long run is not the same as the shut-down condition. This is because, in the short run, a firm might produce even if producing results in an economic loss because not producing would result in an even bigger loss. (In other words, producing is beneficial if it at least brings in enough revenue to start covering the sunk fixed costs.)
It’s also helpful to note that, while the shut-down condition was described here in the context of a firm in a competitive market, the logic that a firm will be willing to produce in the short run as long as the revenue from doing so covers the variable (i.e. recoverable) costs of production holds for companies in any type of market.
Shut Down Price (Short Run) | tutor2u – The shut down price is the minimum price a business needs to justify remaining in the market in the short run. A business needs to make at least normal profit in the long run to justify remaining in an industry but in the short run a firm will continue to produce as long as total revenue covers total variable costs or price per unit > or equal to average variable cost (AR = AVC).142) In the short run a perfectly competitive seller will shut down if: A) price is less than average fixed cost at all output levels. B) there is no point at which marginal revenue and marginal cost are equal. C) price is less than average variable cost at all output levels. D) it cannot produce at an economic profit. Answer: C 143) If at the MC = MR output, AVC exceeds price: A) the firmAQA, Edexcel, OCR, IB, Eduqas, WJEC A business needs to make at least normal profit in the long run to justify remaining in an industry but in the short run a firm will produce as long as price per unit > or equal to average variable cost (AR = AVC). This is called the shutdown price in a competitive market.
If a perfectly competitive firm shuts down in the short – A competitive firm in the short run can determine the profit maximizing or loss from ECON 202 at Old Dominion UniversityThe short-run shutdown case for a purely competitive firm This market looks very similar to the loss-minimizing case, except that both the ATC and AVC curves are above the MR = P curve. Even if the firm produces where MC = MR, it cannot . recover its variable costs. Therefore, the firm should shut down. Let's look at numbers, using theIf a purely competitive firm shuts down in the short run: it will realize a loss equal to its explicit costs. its loss will be zero. it will realize a loss equal to its total fixed costs. it will realize a loss equal to its total variable costs.
Perfect Competition – The Shut Down Price | tutor2u – Short-Run Shut-Down Decision of a Perfectly Competitive Firm To do 1 min read If a firm shuts down operation in the short-run, it will incur a loss equal to its Total Fixed Cost (TFC) because no variable cost will be incurred.If all fixed costs are non-sunk, then (a competitive) firm would shut down if the price were below average total costs. Short-run shutdown compared to long-run exit. A decision to shut down means that the firm is temporarily suspending production. It does not mean that the firm is going out of business (exiting the industry).Question 29 A monopolistically competitive firm will shut down in the short run if: Not yet answered Marked out of 1.00 Select one: a. It can not cover its fixed costs. Flag question b. If it can not cover its total costs. C. If it can not attain normal profits. O d. If it can not cover its variable costs.