THE FIRM’S SHORT RUN DECISION TO SHUT DOWN

So far, we have been analyzing the question of how much a competitive firm will produce. In certain circumstances, however, the firm will decide to shut down and not produce anything at a.

Here we should distinguish between a temporary shutdown of a firm and the permanent exit of a firm from the market. A shutdown refers to a short-run decision not to produce anything during a specific period of time because of current market conditions. Exit refers to a long-run decision to leave the market. The short-run and long-run decisions differ because most firms cannot avoid their fixed costs in the short run but can do so in the run. That is, a firm that shuts down temporarily still has to pay its fixed costs, whereas a firm that exits the market does not have to pay any costs at all, fixed or variable.

For example.: consider the production de~ision that a farmer faces. The cost of the land is one of the farmer’s fixed costs. If the farmer decides not to produce any crops one season, the land lies fallow, and he cannot recover this cost. When making the short-run decision whether to shut down for a season. the fixed cost of land is said to be a sunk cost. By contrast, if the farmer decides to leave farming altogether, he can sell the land. When making the long-run decision whether to exit the market, the cost of land is not sunk. (We return to the issue of sunk costs shortly.).

Now let’s consider what determines a firm’s shutdown decision. If the firm shuts down, it loses all revenue from the sale of its product. At the same time, it saves the variable costs of making its product (but must still pay the fixed costs). Thus, the firm shuts down if the revenue that it would get from producing is less than its variable costs of production.

The firm shuts down if total revenue is less than variable cost. By dividing both sides of this inequality by the quantity Q, we can write it as.

That is, a firm chooses to shut down if the price of the good is less than the average variable cost of production. This criterion is intuitive: When choosing to produce, the firm compares the price it receive  for the typical unit to the average variable cost that it must incur to produce the typical unit. If the price doesn’t cover the average variable cost, ‘the firm is better off stopping production altogether. Tootle firm  be losing money (since it still has to pal fixed costs), but it would lose even more money staying open. The firm can reopen in the future if conditions change so that price exceeds average variable cost.

We now have a full description of a competitive firm’s profit-maximizing strategy. If the firm produces
anything, it produces the quantity at which marginal cost equals the price of the good. Yet if the price is less
than average variable cost at that quantity, the firm is better off shutting down and not producing anything.
These results are illustrated in Figure 3. The competitive firm 50 short-run supply curve is the portion of its
marginal-cost curve that lies above average variable cost.

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