Source: Image of Shut-down Point Graph created by Kate Eskra
Hi. Welcome to Economics. This is Kate. This tutorial is called the "Shutdown Point." As always, my key terms are in red, and my examples are in green. In this tutorial, you'll be able to recognize when it is that a firm's not profitable. We'll talk about the two different options available to this unprofitable firm in the short run. You'll be able to distinguish between when a firm should shut down and operate at a loss in the short run. You'll see the shutdown point on a graph, and we'll be comparing a shutdown decision with what it means to exit.
So we know that profit equals revenues minus cost. So if a total revenue is greater than total cost, that means that the firm is making a profit. We can also look at this on a per unit basis. And we can see that when price is over and above our average total cost per unit, that's also what a profit is. In total, if total revenue is less than total cost, that's when the firm sustain a loss-- or per unit, when price is less than average total cost. If the two are equal, then the firm breaks even, and that would be where price equals average total cost. For the purposes of this tutorial, we'll be focusing here today.
So what is a loss? A loss is just simply when expenses exceed revenue. There are two different time frames that we're talking about. And really today, we're focusing mostly on the short-run. But I wanted to bring it up to you that there is a difference between short- and long-run.
So in the short-run, that's defined by at least one fixed input or cost being present. So the idea is even if the firm produces absolutely nothing, they still have to pay, for example, rent. And so in the short-run, what they're going to try to do is just minimize their loss. Whereas in the long-run, all inputs and costs become variable. So an unprofitable firm can actually opt not to re-sign their lease. They can sell off their investment, and they can get completely out of the industry. But again, let's focus on the short-run for right now.
So the first options in the short-run, if they're seeing a loss, is that they can continue to operate at a loss. And they can either maybe hope that conditions are going to turn around and improve or say, you know, what? We're going to operate at a loss right now. But in the long-run, once we can get out of that rent, that's when we'll exit the industry.
Or if things are really pretty bad-- and I'll show you what that point is-- they shut down right now. They're not exiting the industry. They still have a fixed or sunk costs that they cannot recover, and it has to be paid. So in this option right here, even if they're shutting down, they're still paying their rent, for example. OK? Maybe they're thinking about exiting the industry in the long-run and getting rid of that rent, or maybe they're thinking about reopening at a later date. But for whatever reason, sometimes this is the more profitable thing to do. And by more profitable, I mean minimizing loss.
So that's the whole idea. We need to compare these two and see what is going to minimize the loss that they're currently incurring.
So again, I mentioned this on the previous slide. But the firm still has a fixed cost regardless of what they do. And in Economics we refer to this as a sunk cost or a cost the cannot be recovered. Since they have to incur this sunk cost in either of those options, we really don't take that-- I mean, we take it into consideration, but it doesn't come in-- we're really only looking at variable costs here in the decision to shut down versus operate.
So the rule is this-- if they can make enough revenue to at least cover the cost of operating. That means that price is greater than their average variable cost. So this means they can pay for their workers. They can pay for materials. If they can cover over and above those variable expenses, then they can put some of that money towards the fixed expense that they have to pay regardless.
But if revenues won't even be enough to cover the cost of staying open, why would they stay open? They would be losing more money that way than just shutting down. So if price cannot cover these variable or operating expenses, they need to consider shutting down.
So a shutdown is defined as the factors of production no longer operating. So an example of this is that a lot of seasonal businesses actually do shut down during the off-season. It doesn't mean that they're completely out of business forever. They're just shutting down because they would make little or no revenue to justify operating in the winter, like ice cream stores and pools. Why would they pay employees to come in if they are generating no business at all? They would lose a lot more money that way. But they're so profitable once they reopen in the summer, that it's going to make up for these losses. So they're not exiting the industry, they're just shutting down during the off-season.
An exit is a different situation. This is a long-run decision where a shareholder is selling the investment in a firm. They're getting out completely. So for comparing shut down versus exit, I just wanted to recap for a second here. Shutdown is a short-run decision to minimize loss. A company would shut down if prices are not covering their average variable costs or their operating expenses. They still do have a fixed cost, but the firm's just not operating. OK? So they're not paying for labor. They're not paying for materials. They're not paying for those factors of production. They are still paying their fixed expense. An exit is a long-run decision. And this is where they're selling off all investments in the firm, and there are no more fixed costs because everything becomes variable in the long run.
Let's look at it graphically. So we know that when a firm produces where price equals average total cost that means they're covering all of their costs. This is the break even price. Anything above that, they're profitable. And that's not where we were focusing in this tutorial, but it always helps just to remember the grand scheme of things.
It's when a firm cannot cover its average variable costs-- this is the curve we're looking at in this tutorial. Because when they're incurring a loss anywhere in here, they're going to operate. Because they're covering over and above their average variable cost. But this right here is the shutdown price. Because if price came in here and it is no longer covering their average variable costs, that's when they should consider shutting down.
And that's why very often we refer to the short-run supply curve of the firm. Everything above that threshold right there. Everything above that point. Because the firm will not operate in this region of the marginal cost curve, because price is not covering average variable costs.
So in this tutorial we talked about first of all what it means for a firm to be losing money. And that's where total revenues are less than total cost. It's also where price is less than average total cost. In the short-run, the unprofitable firm can either operate at a loss or shutdown. They'll operate at a loss if they can cover their variable costs, otherwise they need to consider shutting down. And so that shutdown point is right where price equals AVC. In the long run, that's when the unprofitable firm can look at exiting the industry and getting out completely when they have no more fixed expenses.
Thank you so much for listening. Have a great day.
A shareholder sells the investment in a firm.
Expenses exceed revenue.
Factors of production no longer operate.