the shut-down decision

The Shut-Down Decision

The Short-Run Production Decision

• In the short-run, sometimes the firm should produce even if price falls below minimum ATC

• Why?• Total cost includes fixed cost!• Ex. Jennifer and Jason have rented a tractor

for the year, they have to pay the rent on the tractor regardless of whether they produce any tomatoes

The Short-Run Production Decision

• Since it cannot be changed in the short-run, their fixed cost is irrelevant to their decision about whether to produce or shut down in the short run

• Fixed costs don’t play a role in the decision whether to produce in the short run, other costs – variable costs – do matter

The Short-Run Production Decision

• Need to analyze the optimal production decision into eh short run to determine if a company should keep producing

• Two cases to consider:1. When market price is below minimum

average variable cost2. When the market price is greater than or

equal to minimum average variable cost

The Short-Run Individual Supply Curve

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$1816141210

MC

ATCAVC

CB

A

E

Minimum average variable cost

Short-run individual supply curve

Shut-down price

Price, cost of bushel

Quantity of tomatoes (bushels)

When the market price equals or exceeds Jennifer and Jason’s shutdown

price of $10, the minimum average variable cost (A), they will produce the output quantity at which marginal cost

is equal to price

any price equal to or above the minimum average variable cost, the short-run individual supply curve is the firm’s marginal cost

curve

When market price falls below minimum average variable cost, the firm ceases operation in the

short run

1. When market price is below minimum average variable cost

• When market price is below minimum AVC, the price the firm receives per unit is covering its variable cost per unit

• The firm should cease production because no level of output at which the firm’s TR covers its variable cost

• It still incurs a fixed cost in the short run, but no longer incurs any variable costs

1. When market price is below minimum average variable cost

• Shut-down price is when a firm will cease production in the short run if the market price falls below the shut-down price which is equal to the minimum average variable cost

• When the price is greater than the minimum average variable cost, the firm should continue producing in the short run

1. When market price is below minimum average variable cost

• For Jennifer and Jason,• If the market price of tomatoes is $18

per bushel, Jennifer and Jason should product at E which equals 5 bushels

• Since E is above C, Jennifer and Jason’s farm will be profitable, they will generate a per-bushel profit of $18.00-14.40 = 3.60 when the market price is $18

1. When market price is below minimum average variable cost

• What if the market price lies between the shut-down price and the break-even price (between minimum average variable cost and minimum average total cost)

• Jennifer and Jason = $10-$14• If $12 is the price, the farm is not

profitable since the market price is now below minimum average total cost

1. When market price is below minimum average variable cost

• But if it is not covering its total cost per unit, it is covering its variable cost per unit

• If a firm shuts down, it would incur no variable cost but would incur the full fixed cost

• So in the end, if a price falls between minimum average total cost and minimum average variable cost, the firm is better producing some output in the short run– Can cover its variable cost per unit and some of its

fixed costs

2. When the market price is greater than or equal to minimum average variable cost

• When this occurs, the firm is indifferent in producing 3 units or 0 units

• In our notes, we are assuming that the firm does produce output when price is equal to shut-down price

2. When the market price is greater than or equal to minimum average variable cost

• Short-Run individual supply curve shows how an individual producer’s profit-maximizing output quantity depends on the market price, taking fixed cost as given

2. When the market price is greater than or equal to minimum average variable cost

The upward-sloping line starting at A shows the short-run profit-maximizing output when

market price is equal to or above the shut-down price of $10 a bushel

As long as the market price is = to or above the shut-down price, the firms short-run supply curve corresponds to its marginal cost curve

The Shut-Down Decision

• Do firms really shut down permanently without going out of business?

• Yes – outdoor amusement parks

The Shut-Down Decision

The Shut-Down Decision Notes

The Short-Run Production Decision

• In the short-run, sometimes the firm should produce even if price falls below minimum ATC

• Why?

The Short-Run Production Decision

• Since it cannot be changed in the short-run, their fixed cost is irrelevant to their decision about whether to produce or shut down in the short run

• Fixed costs don’t play a role in the decision whether to produce in the short run, other costs – variable costs – do matter

The Short-Run Production Decision

• Need to analyze the optimal production decision into eh short run to determine if a company should keep producing

• Two cases to consider:

The Short-Run Individual Supply Curve

76543 3.5210

$1816141210

MC

ATCAVC

CB

A

E

Minimum average variable cost

Short-run individual supply curve

Shut-down price

Price, cost of bushel

Quantity of tomatoes (bushels)

1. When market price is below minimum average variable cost

• When market price is below minimum AVC, the price the firm receives per unit is covering its variable cost per unit

• The firm should cease production because no level of output at which the firm’s TR covers its variable cost

• It still incurs a fixed cost in the short run, but no longer incurs any variable costs

1. When market price is below minimum average variable cost

• Shut-down price is when a firm will cease production in the short run if the market price falls below the shut-down price which is equal to the minimum average variable cost

• When the price is greater than the minimum average variable cost, the firm should continue producing in the short run

1. When market price is below minimum average variable cost

• What if the market price lies between the shut-down price and the break-even price (between minimum average variable cost and minimum average total cost)

• Jennifer and Jason =

1. When market price is below minimum average variable cost

• But if it is not covering its total cost per unit, it is covering its variable cost per unit

• If a firm shuts down, it would incur no variable cost but would incur the full fixed cost

• So in the end, if a price falls between minimum average total cost and minimum average variable cost, the firm is better producing some output in the short run

2. When the market price is greater than or equal to minimum average variable cost

• When this occurs, the firm is indifferent in producing 3 units or 0 units

• In our notes, we are assuming that the firm does produce output when price is equal to shut-down price

2. When the market price is greater than or equal to minimum average variable cost

• Short-Run individual supply curve shows how an

2. When the market price is greater than or equal to minimum average variable cost

The Shut-Down Decision

• Do firms really shut down permanently without going out of business?

The Shut-Down Decision