326 The Shut Down Decision

One of the more confusing concepts involves the firm’s decision to shut down or keep prodcuing when losing money. Perhaps the following will help:

The Firm’s Shut-Down Decision

The big decision faced by a firm that is losing money is whether to continue to operate or to shut down.

Total Revenue, Variable Cost, and the Shut-Down Decision

If a firm is losing money in the short run, would it be better to produce nothing at all or to continue operating at a loss? It depends on which choice minimizes losses.

A firm’s operating cost is the cost incurred by operating (rather than shutting down).

This is equivalent to variable cost.

The decision making rule is:

Operate if total revenue > variable cost.

Even if you are losing money, at least you can pay some of the fixed costs that will be paid in full if you shut down.

Shut down if total revenue < variable cost.

The Shut-Down Price

A firm should continue to produce as long as total revenue is greater than operating cost, or price > average variable cost.

A firm should shut down if total revenue is less than operating cost, or price < average variable cost.

The firm’s shut-down price is defined as the price at which the firm is indifferent between operating and shutting down, P = MC = AVC. The shut-down price is equal to the minimum average variable cost.

Fixed Costs and Sunk Costs

The cost of the facility is a sunk cost, a cost that the firm has already paid or committed to pay, so it cannot be recovered (often the same as fixed cost). Thus, if the firm produces nothing, it will have a loss equal to the amount of fixed costs. If the firm operates, it will receive some revenues; as long as revenues exceed operating costs, the firm is better off.

“Original document by Peter Turner licensed CC BY”