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

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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

Perfect Competition - Long Run Equilibrium

Before reading this, read: Perfect Competition - Short Run Equilibrium

The long run is a period of time in which the quantities of all inputs are variable. The distinction between short run and long run varies from one industry to another. The plant capacity, which is considered as fixed in the short run, can also be considered as variable in the long run. It is assumed that in the long run all firms have made necessary long-term adjustments. The short run is a period of time in which the quantity of at least one input is fixed and the quantities of the other inputs can be varied.

In the long run it is impossible for a perfectly competitive firm to hold on to its short run economic or supernormal profit. The firm, in the long run, earns just enough profit to cover its economic (opportunity) costs.

As there is supernormal profit in the short run, new firms enter the industry. On the other hand, less efficient firms may be forced to move out of the industry. As new firms enter into the industry, they increase the supply of the product in the market. Competition among all the firms brings down the price of the product. More and more new firms, offering products at lower prices, bring down the market price of the product further.

The market price of the product, and with it the demand, will thus keep coming down until all the firms earn only normal profits. All of the economic or supernormal profit gets wiped out or disappears. Only in perfect competition P = AR = MR. Firms thus have no eagerness to enter or exit the industry. As short run economic profit disappears, there is no incentive for other firms to enter the industry. As the firms do not incur economic loss or earn below-normal profit, there is no urge for the firms to leave the industry.

As there is only 'normal profit', revenue is equal to cost, or average revenue (AR) is equal to average cost (AC). Equilibrium occurs where the AR curve (demand curve) is tangent to the AC curve at the only possible point of tangency, the minimum point. At the equilibrium point D, the equilibrium condition P=AC=AR=MC=MR is satisfied.

Equilibrium output OB is the profit-maximizing output as MC=MR. Equilibrium price is OA. Rectangle OADB represents the total cost, which is equal to total cost.

The firm's long run supply curve is the long run marginal cost curve above the minimum long run average cost curve (AC curve).

Remember that marginal cost rises less sharply in the long run, making the long run marginal cost curve flatter than what it is in the short run.

Also read: Shut down Conditions of a firm

Perfect Competition - Short Run Equilibrium

In the model of price and output determination under perfectly competitive market conditions, price is determined by the impersonal market forces of supply and demand, and not by individual actions of buyers and sellers. The individual firm in such a market may be said to be a price-taker. Perfect competition is used by economists not so much as an attainable goal, but as a pure state against which all other markets can be measured.

For a market to be perfectly competitive, the following necessary conditions must, in general, prevail.

1. There must be many firms acting independently. Each firm is small enough relative to the size of the market, so that a single firm's decision to either stop production entirely or to produce to full capacity will not have any perceptible effect on market supply to cause a change in market price.

2. Entry and exit from the market are free and frictionless for both the firms and consumers.

3. The products offered for sale are homogeneous and divisible into small units.

5. Buyers and sellers have perfect knowledge about the market conditions.

6. Price is determined by the impersonal market forces of supply and demand, and not by individual actions of buyers and sellers. The individual firm in such a market may be said to be a price-taker.

7. There is perfect knowledge among consumers about the price at which goods are being sold in the market. Sellers thus cannot manipulate the commodity price and thereby exploit the consumer.

8. There is perfect mobility of goods and factors of production among firms. Uniformity in factor prices is prevalent in the market.

If these necessary conditions prevail, the firm can lose its entire market if it sets its price above the market price. It can also expect no gain by lowering price, since it can sell all it wishes to produce at the market price. The competitive firm has no price discretion. Market price will not be affected by the independent action of a single firm. No firm is able to influence market price.

The objective of each firm is to maximize profit. Profit is the difference between revenue and cost of production. Marginal cost (MC) is the cost incurred to produce an additional unit of the product. If the per unit price of a commodity is greater than the marginal cost, the firm will be interested in producing more of the commodity. On the other hand if price falls below marginal cost, the firm will curtail its production.

Equilibrium condition will prevail at a point where profit is maximized. This happens where price is equal to marginal cost (P = MC). Also at the point of equilibrium, the marginal cost curve must be upward sloping.

Average Revenue (AR) = Total Revenue/No. of units sold.

Since the price is set by impersonal forces of supply and demand and every individual firm is a price taker, the average revenue (AR) curve is a straight line, parallel to the X-axis. Price always remains the same and is equal to AR. Marginal revenue (MR) is the price at which an additional unit may be sold. Since this can be done only at the current market price, marginal revenue is equal to average revenue (MR=AR) and the marginal revenue curve is the same as the average revenue curve (MR curve = AR curve). This is the demand curve for the firm. It is perfectly elastic as it is parallel to the X-axis.

The short run is a period of time in which the quantity of at least one input is fixed and the quantities of the other inputs can be varied. In the short run an increase in the variable input results in an increase in the marginal productivity of the variable input. When first few quantities of a variable input are added to a fixed input, marginal returns from the variable input flow in an increasing rate.

As marginal returns flow in an increasing rate and average fixed cost starts declining, the marginal cost per unit starts falling and the marginal cost curve shows a downward slope. After some time, as more and more of the variable input is combined with the fixed input, the marginal productivity of the variable input eventually starts declining.

So with diminishing returns, the marginal cost per unit starts increasing and the marginal cost curve starts showing an upward trend. This explains the U-shape of the marginal cost curve.

Short Run Equilibrium of a perfectly competitive firm

In the short run total fixed cost remains unchanged. So any change in total cost is caused by changes in the total variable cost in the short run. Marginal cost is the cause of change in total cost or total variable cost. Marginal cost is defined as additional variable cost incurred due to an additional change in output.
Similarly the average cost curve also takes an U-shape like the marginal cost curve. As production increases, both marginal cost curve and the average cost curve rises due to the Law of Diminishing Marginal Productivity. As the MC curve lies below the AC curve, while rising it cuts the AC curve at its minimum point. A perfectly competitive firm's supply curve is the portion of its marginal cost curve that lies above the minimum of the average (variable) cost curve.

In the short run, the demand curve, namely the average revenue curve, and the supply curve, namely the marginal cost curve, intersects at two places, E' and E. The profit maximizing P = MC is satisfied at both the points. If the firm continues to produce even after E', it will still be able to increase its revenue as marginal revenue or price will continue to be greater than marginal cost till the point E. So the firm continues production up to point E. Thus E is the point of profit maximization. E' is the point of loss minimization since until E' the marginal cost curve lies above the marginal revenue curve. E is the profit-maximizing point where the MC (supply) curve cuts the MR (demand) curve from below. Equilibrium output is OB and equilibrium price is OC. Rectangle OCEB shows the total revenue and rectangle OADB shows the total cost. Profit is shown by the rectangle ACED, which is basically 'economic profit'.

A few points

1. Price = Marginal cost (P=MC) shows the economic efficiency of the firm.
2. Marginal cost=Marginal revenue (MC=MR) is the standard condition for profit maximization. This gives the highest economic profit to the firm.
3. Price=Average revenue=Marginal revenue (P=AR=MR) shows that
a) a perfectly competitive firm has no market control
b) price is determined by the combined forces of demand and supply. The firm can sell any or all of its production at this going market price.
c) the firm is a price-taker.
d) the firm faces a perfectly elastic demand curve equal to market price.

Also read: Perfect Competition - Long Run Equilibrium
Shut down Conditions of a firm

Opportunity Cost, Normal Profit, Economic Profit and Accounting Profit

Opportunity Cost:

Supply of economic resources is limited. Scarcity is fundamental to the study of economics. If certain resources are used somewhere, it can no longer be used anywhere else. When such limited resources are used to satisfy certain wants or needs, it means many alternative uses of those resources automatically get overlooked. All those alternatives that get overlooked can be evaluated in terms of returns or satisfaction that could have been derived out of them, had the resources in question been put into use in each of such alternatives, or had each of such alternatives been pursued. The highest valued return or satisfaction thus foregone in the pursuit of one activity is called the Opportunity cost. This is because of the mutually exclusive nature of the use of such economic resources. Doing one thing means foregoing many others. Economic wants are unlimited but resources are limited. Thus opportunity cost is the highest valued foregone or sacrificed return from an alternative use.

Put in another way, Opportunity cost is the benefits or returns a firm could have received by taking an alternative course of action.

An opportunity cost can be either explicit, usually involving a monetary payment, or implicit, which does not involve a monetary transaction. Opportunity cost is also known as economic cost. In economics, cost primarily means economic cost. It is different from the term 'cost' used by accountants, which is more financial by nature. However, all economic costs are not accounting costs and vice versa.

Opportunity cost does not consider all alternatives foregone. It is concerned only with the foregone alternative use that would have fetched the highest return or satisfaction. When a particular activity is pursued, it is assumed that it is the most beneficial and economic use of the resources that are being used to pursue that activity.

Normal Profit:

Normal profit is the opportunity cost of using entrepreneurial abilities in the production of a commodity, or the profit that could be received by entrepreneurship in another business venture. Entrepreneurship used in the production of a certain commodity can as well be used in the production of another commodity. But both cannot be done together. Profit that could have been earned from the venture that is foregone is the opportunity cost of the venture that is undertaken. This is termed as the normal profit. Normal profit represents the total opportunity costs (both explicit and implicit) of a venture to an entrepreneur.

Use of every resource has an opportunity cost. Like the opportunity cost of all other resources, normal profit (foregone profit) is deducted from revenue to determine the economic profit. It is however, never included as an accounting cost when accounting profit is calculated.

Thus, normal profit is the profit that could be earned in another activity elsewhere. It is the profit that could be earned in an alternative venture.

Normal profit is different from accounting profit because opportunity cost is taken into consideration.

Normal profit is the minimum level of profit needed for a firm to remain competitive in the market.

Normal Profit + economic profit = accounting profit (current activity profit)

Or, Current activity profit (accounting profit) - normal profit = economic profit

If economic profit is greater that zero, Then the current activity is better; it is giving more earning.

If economic profit is less than zero, (though accounting profit from current activity is positive), switching entrepreneurship to the other activity is advisable. That would generate more earning.

Normal profit is not deducted from revenue to calculate accounting profit. The foregone profit is the opportunity cost of entrepreneurship and is deducted from revenue to calculate economic profit.

Economic Profit:

Economic profit is the difference between the total opportunity cost of production and the total revenue received by a firm. Economic profit is what remains after all opportunity costs associated with production, including normal profit (entrepreneurial opportunity cost) is deducted from the revenue generated by the production. Opportunity costs are the alternative returns foregone by using the chosen inputs.

Economic profit acts as an indicator when the focus is turned towards efficiency. In a perfect world, no firm receives economic profit. Firms receive economic profit only when price exceeds opportunity cost of production (including entrepreneurial opportunity cost).

Economic profit = Total revenue - total (opportunity) cost (including normal profit).

A firm can stay in business without economic profit or supernormal profit or above-normal profit. It can continue producing goods and services so long as it is able to pay all opportunity costs. One critical opportunity cost is normal profit. Because accounting profit is generally the combination of normal profit and economic profit, zero economic profit does not mean zero accounting profit. A firm can continue by earning normal profit only.

Total revenue - Opportunity cost of all resources associated with production (including opportunity cost of entrepreneurship)
= Economic profit

Total Revenue - $100 million
Total Cost - $60 million
Entrepreneurial opportunity cost or normal profit (Profit that can be earned from alternative venture) - $30 million

Current activity profit (accounting profit) = $(100 - 60) million = $40 million

Current activity profit (accounting profit) - normal profit = economic profit
That is, $(40 - 30) million = $10 million (economic profit)

In another way,

Total revenue - Opportunity cost of all resources associated with production (including opportunity cost of entrepreneurship)

= Economic profit

That is, ${100 - (60+30)} million = $10 million (economic profit)

Accounting Profit:

Accounting profit is the difference between total revenue earned and the explicit accounting costs incurred to earn the revenue.

Accounting profit differs from economic profit because there is a difference between accounting cost and economic cost. Some accounting costs are not economic costs, and vice versa.

In reality, opportunity costs of all other resources associated with production tends to be equal to explicit accounting cost incurred to earn the revenue.