Wednesday, June 22, 2011

Shut Down Conditions of a Firm - Short Run and Long Run

Short Run Decision

In the short run, a profit-maximizing firm will:

increase production if marginal revenue is greater than marginal cost
decrease production if marginal revenue is less than marginal cost

The shutdown rule is that in the short run a firm should continue to operate if price is greater than average variable costs. In the short run a firm must earn sufficient revenue to cover its variable costs. When a firm shuts down operation, it does not incur any variable cost. However, the firm still has to bear its fixed costs. Because fixed cost must be paid irrespective of whether a firm operates or not, fixed costs should not be considered in deciding whether to produce or shutdown.

Total variable cost/Quantity = Average variable cost (AVC)
Total Fixed cost/Quantity = Average Fixed cost (AFC)
Average variable cost (AVC) + Average Fixed cost (AFC) = Average total cost or Average cost (ATC/AC)

1. When P > AVC, the firm is covering all variable cost plus there is additional revenue or contribution, which can be applied to fixed costs. The size of the fixed costs is not relevant in this regard as it is already spent.
a) P < AC - part of fixed cost remains uncovered. The firm will continue production.
b) P = AC - The firm is at break even earning only normal profit. It is at minimum average cost. The firm will continue production.
c) P > AC - the firm is making economic profit. The firm will continue production.
2. P = AVC - Whole fixed cost remains uncovered, but covering the whole variable cost. The firm will continue production.

3. P < AVC - The firm cannot cover even the variable expenses. This is a shut down point. The shut down point is at the minimum of the average variable cost curve.

When a firm decides to shut down, it is really a temporary suspension of production. The firm is not going out of the industry. It may again resume production if situation becomes favourable. Hence shutting down is a short-run affair. A firm that has decided to shut down operations cannot avoid its fixed costs.

Long Run Decision

Leaving the industry is a decision that can only be taken in the long run. When a firm exits, it basically winds up all its operations. The capital resources thus get free for use in another venture. In the long run, so long as the price is greater than or equal to average variable cost, the firm should not wind up its operations. If marginal revenue is equal to marginal cost, the firm should operate. If price is less than average variable cost and total revenue is less than total cost, it is advisable for the firm to leave the industry.

Also read: Perfect Competition - Short Run Equilibrium
Perfect Competition - Long Run Equilibrium

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