Determining the Shutdown Point of a Firm
This continues a previous post on profit maximization. The question we want to continue with is when should a firm shutdown? Then answer is when P (price) = AVC (average variable cost).
This is the output where firms are indifferent between producing the profit-maximizing quantity (ie. loss-minimizing quantity) and shutting down operations. Take a look at this graph to help you understand the when and where.
While we’re on the topic, what is the supply curve for each firm? Looking at the graph you’ll note the MC curve. The supply curve for each firm is simply its marginal cost (MC) curve above the minimum point on the average variable cost (AVC) curve.
The supply curve for the industry is just the (horizontal) summation of each individual firm’s supply curve. Carrying on, what about the items that dictate and influence long run decision making?
Long-Run Decisions:
Forces in a competitive industry ensure that firms earn zero economic profits in the long-run.
Competitive industries will adjust in two ways: 1. Entry and exit, 2. Changes in plant size
Entry and Exit:
The prospect of persistent profit of loss causes firms to enter or exit an industry. If firms are making economic profits, other firms enter the industry. This graph shows how where there is room for new entrants in the market and how it eliminates industry profits in the long run.
If firms are making economic losses, some of the existing firms exit the industry. This entry and exit of firms influences prices, quantities, and economic profits. This graph depicts economic losses in the industry.
Important points: as new firms enter an industry, the price falls and the economic profit of each existing firm decreases. As firms leave an industry, the price rises and the economic loss of each remaining firm decreases. [See graphs above]
Changes in Plant Size: When a firm changes its plant size, it can lower its costs and increase its economic profit. Let’s see in this graph how a firm can increase its profit by increasing its plant size.
Long-Run Equilibrium: Therefore, in the long-run equilibrium for a competitive industry, all firms must be:
1. Maximizing profits (P = MR = MC)
2. Earning zero economic profits (P = SRATC)
3. Unable to increase profits by altering its scale of operations.
And that concludes our intro into profit maximization and shut down points for firms.
thanks for this, really help me alot for my econ exam
cheers
Happy to help, many more coming soon.
+1 thank you. Also helpful for my Eco exam on the 14th this month.
thanks a lot…I have an exam the day after tomorrow and all this helped me really very much…
awesome explainations! hope i can explain the graphs like you in tomorrow’s exam:)!
Thanks for this. This definitely helps! 🙂
what about the shut down point of a monopoly?
I’ll check some notes and see if there’s something. can’t think of it at the top of my head.
A bit more information is coming out on the monopoly so check the date of this comment in the archive.
The charts were hard to decipher, thanks for the commentary for the added clarity.
I don’t necessarily agree with the hard/fast conclusion that a firm should shutdown when P=AVC. I think that a company, at that point, needs to do some quick and definiate cost cutting measures to lower the AVC in the short term and work toward a longer term strategy of keeping costs low but, it’s not completely a lost cause at that point. When P < AVC (or worse yet, < AFC) is when a company should, as my Econ Prof says, "shut down, go home, and watch Oprah."
It’s not a hard fast conclusion, it’s a theory on profit maximizing firms in microeconomics.
I was having trouble understanding this as well. Thanks for the clarification. No doubt these variables have a definite bearing on the success or failure of a firm/corporation. I would think that a company would shut down before P=AVC to conserve or try to save or reduce there cost or reduce there operating expensive prior to that point.
Cheers
Thanks! I didn’t understand the shut down period so this is really helpful. Thank you!
What is the formula for calculation of total gains when saving a corporate dollar? If I save one dollar, or one product from scrap; I save at least 2, and the cost of making the third, less scrap return, plus cost saving from non scraping. What other costs advantages occur which can maximize the return? Thanks for any help. Dave
firm in the long run can operate despite the facty that there small element of fixed cost,because non firm can operate without iniatial fixed cost
why some textbooks say that in the short run, a shut down dicison is when P= average avoidable cost? Since total cost=fixed cost+ variable cost or total cost= sunk cost+ avoidable cost, I think avoidable cost and variable cost are different.
whats ATC ?? it must be AC , right ??
ATC = average total cost and captures the relation between cost per unit.