Shut Down Conditions
Firms often face challenging decisions about whether to continue operating or to shut down, particularly during periods of financial difficulty. This chapter explains the conditions under which a firm should shut down in the short run and long run. Using simple language and real-world examples, this topic is crucial for students preparing for a level economics tuition as it provides both theoretical and practical insights.
Understanding Key Concepts: AR and AVC
Break down two key terms:
Average Revenue (AR): This refers to the revenue a firm earns per unit of output sold. It is calculated by dividing total revenue (TR) by the quantity of goods sold (Q).
AR=TR/QAverage Variable Cost (AVC): This is the cost of producing each unit of output, focusing on variable costs like wages and raw materials. It is calculated as:
AVC=TVC/Q
Simply put, AR is the revenue per unit, and AVC is the production cost per unit. When AR falls below AVC, the firm incurs a loss on every unit produced, making operations unsustainable.
The Shutdown Condition: AR < AVC
In the short run, a firm should shut down if AR < AVC. Why? Because if the revenue earned per unit is less than the cost of producing each unit, the firm is losing money for every unit it sells.
Illustrative Example
Imagine a small bakery that sells cakes for $10 each (AR). If the variable cost of making one cake (ingredients, labor, electricity) rises to $12 (AVC), the bakery loses $2 per cake. In this situation, the bakery should temporarily shut down, as continuing to produce would worsen its financial losses.
Diagrammatic Analysis
A diagram is an essential tool for analyzing the shutdown condition. Follow these steps to create and interpret it:
Axes:
The vertical axis represents Price/Cost.
The horizontal axis represents Quantity.
Curves:
Plot the AR curve (a horizontal line in perfect competition, as the firm is a price taker).
Plot the AVC curve (typically U-shaped).
Shutdown Point:
Highlight the region where the AR curve lies below the AVC curve. This is the shutdown condition.
Real-World Example
In 2020, airlines like Delta Air Lines temporarily grounded certain routes during the pandemic. Ticket revenues (AR) dropped below the variable costs of operating flights (AVC), including fuel, crew wages, and airport fees. Continuing operations on those routes would have led to deeper losses, prompting a temporary shutdown.
Short-Run vs. Long-Run Shutdown Decisions
Short Run: A firm may continue operating as long as AR ≥ AVC, even if it incurs a total loss, because fixed costs (e.g., rent, machinery) must be paid regardless of production.
Long Run: If the firm’s losses persist and it cannot cover both variable and fixed costs, it will shut down permanently.
For example, Toys "R" Us eventually shut down after years of struggling to compete in the retail market. Despite efforts to stay open, the company could not generate enough revenue to cover its fixed and variable costs.
Factors Influencing Shutdown Decisions
Several factors influence a firm's decision to shut down:
1.External Factors:
Economic downturns can reduce consumer demand, pushing AR below AVC.
Rising input costs, such as raw materials, can increase AVC.
2. Internal Factors:
Inefficient operations may lead to higher variable costs.
Poor pricing strategies can reduce AR.
3. Government Intervention:
Subsidies or support can help firms temporarily stay afloat during crises. For example, many small businesses in Singapore received subsidies during the COVID-19 pandemic to cover labor costs.
Real-World Examples of Shutdowns
Retail Industry:
Stores like Gap and Forever 21 shut down multiple outlets due to falling revenues and rising variable costs such as rent and wages.
Airlines:
India’s Jet Airways suspended operations in 2019 when ticket revenues (AR) failed to cover rising operational costs (AVC).
Seasonal Businesses:
Ice cream parlors in colder regions often shut down during winter because AR is too low to sustain even variable costs.
Conclusion
The decision to shut down is critical for firms facing financial challenges. The rule is simple: If AR < AVC, the firm should temporarily shut down to avoid deepening its losses. By analyzing this condition through diagrams and real-world examples, students can appreciate how economic theory applies to real-life business decisions.
For students attending a level economics tuition in Singapore, understanding this topic can sharpen your analytical skills and improve your ability to interpret cost-revenue relationships in different industries.
Discussion Questions
"Why might a firm continue operating in the short run despite making losses?"
"Using a diagram, explain the condition under which a firm should shut down in the short run."