Economics Short Run Shutdown Condition

Short Run Shut Down Condition

Criteria For Shutdown

• A firm should consider shutting down if it cannot cover its variable costs.
• The shutdown point occurs when the price falls below the average variable cost (AVC).
• Short-run decisions focus on covering variable costs; fixed costs are sunk in the short run.
• If total revenue (TR) is less than total variable cost (TVC), the firm incurs losses greater than its fixed costs.

Fixed Vs Variable Costs

• Fixed Costs:
  • Costs that do not change with the level of output (e.g., rent, salaries).
  • Must be paid regardless of production levels.
• Variable Costs:
  • Costs that change directly with the level of output (e.g., raw materials, labor).
  • Relevant in the short run for decision-making about production.
• In short-run shutdown decisions, only variable costs are considered for covering production.

Price And Average Variable Cost

• Price:
  • The market price at which a firm can sell its product.
  • Determines revenue and influences the decision to operate or shut down.
• Average Variable Cost (AVC):
  • Total variable cost divided by the quantity of output.
  • A key metric for determining the shutdown point.
• If Price < AVC, the firm should shut down to minimize losses.
• If Price = AVC, the firm breaks even on variable costs; it may continue operating.
• If Price > AVC, the firm covers variable costs and contributes to fixed costs; it should remain in operation.

Criteria for Shutdown

• A firm should shut down operations if it fails to cover variable costs.
• The shutdown point is reached when the price drops below the average variable cost (AVC).
• Short-run decisions emphasize variable costs, since fixed costs are considered sunk.
• If total revenue (TR) is less than total variable costs (TVC), the firm suffers larger losses than its fixed costs.

Fixed vs Variable Costs

• Fixed Costs:
  • Remain constant regardless of production levels (e.g., rent, salaries).
  • Obligatory payments exist regardless of output.
• Variable Costs:
  • Fluctuate based on output levels (e.g., raw materials, labor).
  • Critical for making short-run production decisions.
  • Only variable costs are deemed necessary for evaluating shutdown options.

Price and Average Variable Cost

• Price:
  • Market price impacts revenue generation.
  • Influences the choice between continuing production or shutting down.
• Average Variable Cost (AVC):
  • Calculated as total variable cost divided by output quantity.
  • Essential for identifying the shutdown point.
  • If Price is less than AVC, the firm should cease operations to limit losses.
  • If Price equals AVC, the firm breaks even on variable costs, possibly continuing production.
  • If Price is greater than AVC, the firm can cover variable costs and contribute to fixed costs, indicating it should remain operational.