The Shut-Down Decision

You’ll be able to

Apply the shut-down rule comparing price with average variable cost
Explain why a firm may rationally operate at a loss in the short run
Distinguish the short-run shut-down point from long-run exit

A loss is not automatically a reason to stop

In the short run, fixed cost is sunk — it is paid whether the firm produces or not. So the question is not whether the firm is profitable but whether producing does better than not producing. If revenue covers variable cost with something left over, that surplus reduces the loss on fixed cost. Shutting down would mean losing the whole of fixed cost instead.

The short-run rules

P ≥ ATC → profit, produce · AVC ≤ P < ATC → loss but PRODUCE (covering variable cost) · P < AVC → SHUT DOWN

The shut-down point is the minimum of AVC. Below it, every unit produced adds to the loss.

Why the boundary is minimum AVC

If price is below average variable cost, then each unit sold brings in less than it costs in variable terms — producing makes the loss worse than the fixed cost alone. If price is at or above AVC, each unit contributes something toward fixed cost, so producing is the lesser loss. The minimum of AVC is therefore the exact boundary, and this is why the supply curve of a competitive firm is its MC curve above minimum AVC.

Short-run shut-down versus long-run exit

These are different decisions. Shutting down is temporary: the firm produces nothing but still owns its plant and still pays fixed cost. Exiting is permanent: it sells the plant and leaves the industry, so it no longer pays fixed cost at all. The exit condition is therefore stricter and long-run — a firm exits when price is below ATC persistently, because in the long run there is no fixed cost to salvage by staying.

Worked example

A competitive firm faces a price of $14. At its profit-maximizing output of 500 units, ATC is $17 and AVC is $12. Should it produce, and what is the outcome either way?

1.Price $14 is below ATC $17, so the firm makes a loss whatever it does.
2.Price $14 is above AVC $12, so each unit contributes $2 toward fixed cost.
3.Producing: loss = (17 − 14) × 500 = $1,500.
4.Shutting down: total fixed cost = (17 − 12) × 500 = $2,500, all of it lost.

Answer: Produce. The loss of $1,500 is smaller than the $2,500 loss from shutting down, because the $2 per-unit contribution over 500 units offsets $1,000 of fixed cost. In the long run, if the price stays at $14 the firm should exit.

Watch out

Compare price with AVC to decide whether to produce, and with ATC to decide whether there is a profit. Using ATC for the shut-down decision closes firms that should keep operating, which is the most common error in this topic.

Checkpoint

A firm's price is above average variable cost but below average total cost. In the short run it should:

Checkpoint

A competitive firm's short-run supply curve is:

Checkpoint

The difference between shutting down and exiting is that a firm that shuts down:

On the exam

Show the loss both ways — producing and shutting down — when a free response asks whether a firm should continue. The comparison is the argument, and stating only the rule without the two loss figures often loses a point.

Answer the 3 checkpoints as you read.