The microeconomic theory of the firm provides a framework for understanding how businesses make production decisions, especially during financial difficulty. The fundamental conflict a business must resolve is whether to continue operating at a loss or to cease production entirely when total revenue falls short of total costs. A firm must determine the point at which continuing to produce would be more financially detrimental than temporarily shutting down operations.
Defining the Short Run and Fixed Costs
The short run in economics is defined as a period where at least one factor of production is fixed and cannot be easily changed. This fixed factor often relates to capital assets, such as the size of a factory or long-term equipment leases. The costs associated with these fixed inputs are called fixed costs (FC), and they must be paid regardless of the firm’s output level, even if production is zero.
Variable costs (VC) are expenses that change directly with the level of output, increasing as more units are produced and decreasing when production slows. Examples of variable costs include raw materials, hourly labor wages, and utility costs tied to machine operation. A firm’s total cost is the sum of its total fixed costs and its total variable costs.
The Goal of Loss Minimization
When a firm’s total revenue is less than its total cost, it is incurring an economic loss. The firm’s immediate goal shifts from maximizing profit to minimizing this loss. The firm must choose between producing some level of output or temporarily shutting down and producing nothing. The decision is based purely on which action results in a smaller financial loss.
If the firm chooses to produce, it applies the rule of producing where marginal revenue equals marginal cost, which corresponds to the point of minimum loss. If the firm shuts down, its total revenue drops to zero, and its loss equals its total fixed costs. The decision hinges on whether the loss from operating is smaller or larger than the loss from shutting down.
Why Variable Costs Determine Short-Term Survival
Variable costs are the metric for short-run survival because fixed costs are considered “sunk costs” that cannot be avoided. A firm has already committed to paying its fixed costs, such as rent or loan payments, regardless of its output level. Since fixed costs must be paid either way, they are irrelevant to the short-run decision of whether to produce.
The firm should only continue to produce if the revenue generated is sufficient to cover the variable costs incurred by production. If the revenue per unit (price) is less than the variable cost per unit, the firm loses money on every item it produces. Continuing production in this scenario would only add to the loss incurred from unavoidable fixed costs.
The Economic Shutdown Rule
The economic shutdown rule provides the condition under which a firm should cease production temporarily. A firm should shut down if the market price ($P$) falls below its minimum average variable cost ($AVC$). Average variable cost is calculated by dividing total variable cost by the quantity of output produced. The point where $P = AVC$ is referred to as the shutdown point.
If the price is less than $AVC$, the firm is not generating enough revenue to cover its operational expenses, such as raw materials and direct labor. Continuing to operate means the firm loses its total fixed costs plus a portion of its variable costs. By shutting down, the firm limits its loss to only its total fixed costs, minimizing financial damage.
Applying the Rule: Production Scenarios
Price is Greater Than Average Total Cost
When the market price ($P$) is greater than the firm’s average total cost ($ATC$), the firm is earning an economic profit. Since $ATC$ includes both fixed and variable costs, a price exceeding this cost per unit means the firm is profitable. In this scenario, the firm should continue to produce the output level that maximizes its profit, where marginal revenue equals marginal cost.
Price is Less Than Average Total Cost But Greater Than Average Variable Cost
This scenario describes a firm operating at an economic loss because the price is not high enough to cover all total costs. However, since the price is greater than the average variable cost ($P > AVC$), the firm covers all variable costs and generates excess revenue. This excess revenue contributes toward covering a portion of the fixed costs.
For example, if fixed costs are \$100 and operating results in a loss of \$40, the firm is covering \$60 of its fixed costs. If the firm were to shut down, its loss would be the entire \$100 in fixed costs. By continuing to produce, the firm minimizes its loss, making this the preferred short-run decision.
Price is Less Than Average Variable Cost
This is the shutdown scenario where the market price ($P$) is lower than the average variable cost ($AVC$). The firm is not generating enough revenue to pay for the raw materials and labor needed to make the product. Every unit produced increases the firm’s total loss by adding variable costs that are not recovered by revenue.
Consequently, the firm should immediately cease production to prevent the loss from exceeding its total fixed costs. The firm will temporarily halt operations, producing zero output, and wait for market conditions to improve.
Shutdown Versus Long-Run Market Exit
It is necessary to distinguish between a short-run “shutdown” and a long-run “exit” from the market. A shutdown is a temporary suspension of production, often triggered by a temporary decline in demand. The firm retains its capital assets and continues to incur fixed costs, expecting market conditions to eventually improve and allow production to resume.
An exit, conversely, is a permanent decision to leave the industry entirely, occurring in the long run when all factors of production are variable. In the long run, a firm will exit the market if the price falls below its average total cost ($P < ATC$). This indicates a persistent inability to cover all expenses.