Perfect Competition - The Shutdown Point

The Shutdown Point

In the short run, a firm operating at a loss must decide whether to continue to operate or temporarily shutdown. The shutdown rule states "in the short run a firm should continue to operate if price exceeds average variable costs." Restated, the rule is that for a firm to continue producing in the short run it must earn sufficient revenue to cover its variable costs. The rationale for the rule is straightforward. By shutting down a firm avoids all variable costs. However, the firm must still pay fixed costs. Because fixed cost must be paid regardless of whether a firm operates they should not be considered in deciding whether to produce or shutdown. Thus in determining whether to shut down a firm should compare total revenue to total variable costs (VC) rather than total costs (FC + VC). If the revenue the firm is receiving is greater than its total variable cost (R > VC) then the firm is covering all variable cost plus there is additional revenue ("contribution"), which can be applied to fixed costs. (The size of the fixed costs is irrelevant as it is a sunk cost. The same consideration is used whether fixed costs are one dollar or one million dollars.) On the other hand if VC > R then the firm is not even covering its production costs and it should immediately shut down. The rule is conventionally stated in terms of price (average revenue) and average variable costs. The rules are equivalent (If you divide both sides of inequality TR > TVC by Q gives P > AVC). If the firm decides to operate, the firm will continue to produce where marginal revenue equals marginal costs because these conditions insure not only profit maximization (loss minimization) but also maximum contribution.

Another way to state the rule is that a firm should compare the profits from operating to those realized if it shutdown and select the option that produces the greater profit. A firm that is shutdown is generating zero revenue and incurring no variable costs. However, the firm still has to pay fixed cost. So the firm's profit equals fixed costs or −FC. An operating firm is generating revenue, incurring variable costs and paying fixed costs. The operating firm's profit is R − VC − FC. The firm should continue to operate if R − VC − FC ≥ −FC, which simplified is R ≥ VC. The difference between revenue, R, and variable costs, VC, is the contribution to fixed costs and any contribution is better than none. Thus, if R ≥ VC then firm should operate. If R < VC the firm should shut down.

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).] If market conditions improve, and prices increase, the firm can resume production. Shutting down is a short-run decision. A firm that has shut down is not producing. The firm still retains its capital assets; however, the firm cannot leave the industry or avoid its fixed costs in the short run. Exit is a long-term decision. A firm that has exited an industry has avoided all commitments and freed all capital for use in more profitable enterprises.

However, a firm cannot continue to incur losses indefinitely. In the long run, the firm will have to earn sufficient revenue to cover all its expenses and must decide whether to continue in business or to leave the industry and pursue profits elsewhere. The long-run decision is based on the relationship of the price and long-run average costs. If P ≥ AC then the firm will not exit the industry. If P < AC, then the firm will exit the industry. These comparisons will be made after the firm has made the necessary and feasible long-term adjustments. In the long run a firm operates where marginal revenue equals long-run marginal costs.