5 Steps to a 5 AP Microeconomics, 2014-2015 Edition

122 › Step 4. Review the Knowledge You Need to Score High

Decision to Shut Down

Firms obviously do not enjoy producing at a loss and desperately hope that the market price

improves so that profits are possible. However, if firms are incurring losses, they must

decide whether it is economically rational to operate at all. The decision to shut down, or

produce zero, in the short run is sometimes the optimal strategy. To see why, consider what

happens when a firm begins to produce. When a perfectly competitive firm decides to pro-

duce any level of output greater than zero, two things happen.

1. It collects total revenue (TR) =P¥qe.


2. It incurs variable costs (TVC). Of course, the firm also incurs total fixed costs, but it
   incurs those costs anyway, regardless of the level of output.
   If the firm, by producing in the short run, can collect total revenues that at least exceed
   the total variable costs, then it continues to produce, even at a loss. However, if producing
   output incurs more variable cost than revenue collected, why bother? Shut down, hope for
   better times, and suffer losses equal to TFC. This comparison provides us a decision rule
   for shutting down in the short run:

•If TR ≥TVC, the firm produces qewhere MR =MC.

•If TR <TVC, the firm shuts down and q=0.

The Shutdown Point

We can see the shutdown point in Figure 9.5 by converting the above decision rule into a

per unit comparison. Dividing total revenue and total variable cost by qtells us to shut

down if P<AVC. This is the identical decision rule; it is just a per unit comparison of rev-

enue and variable cost:

•If P≥AVC, the firm produces qewhere MR =MC.

•If P<AVC, the firm shuts down and q=0.

In Figure 9.5, there are four prices shown:

• PH is the highest price. At qh, the firm earns enough total revenue to cover all costs.
  P>0.


• PM is the middle price. At qm, the firm’s TR exceeds TVC but only covers part of the
  TFC. P<0.


• PD is the shutdown price. At qd, the firm’s TR just covers TVC and the firm is at the
  shutdown point. If price falls any lower, the firm does not produce.


• PL is the lowest price. At q 1 , the firm’s TR cannot even cover TVC, and so the firm shuts
  down, producing q=0. P=-TFC.

MC

$

6.50 d = P = MR = AR

qe=3

One Carrot Farmer

= Loss = 3 −$14.50×($6.50 − $11.33) AT C

11.33

Quantity

Figure 9.4

“This has great

potential to be

asked on both

sections of the

exam.”

—AP Teacher

KEY IDEA

TIP

TIP

http://www.ebook3000.com