Lesson preview · Profit Maximization
The Shutdown Decision
~6 min · Free to read
Should a firm keep producing when it’s losing money? Sometimes yes. In the short run, fixed costs are sunk — you pay them whether you produce or not. The only question is whether revenue covers variable costs. If , the firm should keep operating (even at a loss) because revenue at least covers variable costs and contributes something toward fixed costs. If , shut down — you’re losing more by operating than by stopping.
Trap · Warning
Shutdown vs. Exit
Shutdown (short run): Stop producing temporarily. You still exist; you still pay fixed costs. Exit (long run): Leave the industry permanently. You avoid all costs, including fixed costs. The shutdown rule uses ; the exit rule uses .
The shutdown condition: if price falls below average variable cost, the firm should stop producing
Walk through the logic. If the firm shuts down, its loss equals its fixed costs () — it earns zero revenue and pays only . If the firm operates, its loss is . Operating is better when , i.e., when , which simplifies to . At that point, revenue more than covers variable costs, so the “extra” goes toward reducing the fixed-cost loss.
Worked Example
A firm has dollars, dollars at its optimal output of . The market price is 5 dollars. Should the firm produce or shut down?
Check yourself · no marks
A firm is making a loss but . Why should it keep producing in the short run?
Commit to one first. Guessing and being wrong beats reading the answer cold.
Practice · 1 / 4
A firm has dollars, dollars, and dollars. In the short run, the firm should:
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