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Wize AP Microeconomics Textbook > Firms in Competitive Markets (Perfect Competition)

Shutdown Rule

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Shutdown Rule and Profit

In the short run the business should shutdown if:

Price < Average Variable Cost (AVC)\boxed{\text{Price < Average Variable Cost (AVC)}}

Why do we Ignore Fixed Costs in the Short Run?

Because a lot of fixed costs are sunk costs, which means they have already been paid and should not affect the firm's decision to stay open or shut down.
Example: Let's say you buy a restaurant and the oven costs you $10,000. This is a sunk cost (you have already paid it and cannot get it back). As long as you can pay for the food, chefs and waiters (the variable costs) at least you can survive.
  • As long as the price is greater than the AVC, the firm can afford to meet its day to day expenses and survive (even if they are not making a profit) so they will stay open. This range is also called positive output because it shows where the business is actually willing to produce some output.
  • If price is less than the AVC then firm cannot meet its day to day expenses and they must shut down. This range is also called negative output because it shows where the business is not willing to produce any output.
  • The shutdown point on a graph is the point where MC = AVC. In the diagram below this would be at an output of
    15
  • Remember that the Price = MC at profit maximization.
  • The supply curve is the upward sloping part of the
    MC
    above its intersection with
    AVC
    because that shows us all the points the business will stay open and supply the product.



Profit

  • If Price (P) = Average Total Cost (ATC) the firm will make
    zero
    economic profit (Break-Even point). In the diagram above, this occurs at an output of
    20
    and a price of
    8
  • If P > ATC the firm will earn
    positive
    economic profits. This is anywhere on the
    right
    of the break-even point.
  • If P < ATC the firm will earn
    negative
    economic profits. This is anywhere on the
    left
    of the break-even point.








Practice: Shutdown Point

In the diagram above what is the output and price associated with the shutdown point?

Practice: Break-Even Point

In the diagram above what is the output and price associated with the break-even (zero economic profit/normal profit) point?

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Example: Shutdown Rule

A perfectly competitive firm will produce output in the short run even if P<ATC because

A) as long as P > MC, it can minimize it losses.
B) as long as P > AVCmin, it can minimize it losses.
C) profits are positive.
D) fixed costs are avoidable in the short run.
E) none of the above

B
As long as price is higher than average variable costs the firm can pay for things like the food, chef, waiter so they can meet their day to day expenses and survive. By staying open they can give themselves a chance to make back some of their fixed costs (like the oven) so that's why they can minimize some of their losses.

Practice: Supply Curve and Shutdown Rule

The perfectly competitive firm’s short run supply curve is the upward-sloping part of its