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Understanding the Shutdown Rule in Economics

The shutdown rule states that in the short run, a firm should continue operating if the price exceeds average variable costs. If revenue is less than total variable costs, the firm should shut down production temporarily. The rationale is that by shutting down, the firm avoids all variable costs, while fixed costs still must be paid regardless of production. So the appropriate comparison is whether revenue exceeds total variable costs, not total costs including fixed costs.

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92 views7 pages

Understanding the Shutdown Rule in Economics

The shutdown rule states that in the short run, a firm should continue operating if the price exceeds average variable costs. If revenue is less than total variable costs, the firm should shut down production temporarily. The rationale is that by shutting down, the firm avoids all variable costs, while fixed costs still must be paid regardless of production. So the appropriate comparison is whether revenue exceeds total variable costs, not total costs including fixed costs.

Uploaded by

Mark So
Copyright
© © All Rights Reserved
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SHUTDOWN RULE

Shut down
• In economics, a firm will shutdown production when
the revenue received from the sale of the goods or
services produced cannot even cover the variable
costs of production.
• In that situation, the firm will experience a higher loss
when it produces, compared to not producing at all.
• Technically, shutdown occurs if marginal revenue is
below average variable cost at the profit-maximizing
output. Producing anything would not generate returns
significant enough to offset any fixed cost and part of
the variable cost. By not producing, the firm loses only
the fixed cost.
• The goal of a firm is to maximize profits or
minimize losses. The firm can achieve this
goal by following two rules.
– First, the firm should operate where MR = MC.
– Second, the firm should shutdown rather than
operate if it can reduce losses by doing so.
The Shutdown Rule
• In the short run, a firm operating at a loss TR <
TC (revenue less than total cost) or P < ATC
(price less than unit cost)] must decide
whether to continue to operate or temporarily
shutdown.
• Conventionally stated the shutdown rule is “in
the short run a firm should continue to
operate if price exceeds average variable
costs.”
• Restated, the rule is to produce in the short
run and a firm must earn sufficient revenue to
cover its variable costs.
• The rationale for the rule is straightforward.
By shutting down a firm avoids all variable
costs.
• However, the firm must still pay fixed costs.
Because fixed cost must be paid regardless of
whether a firm operates, they should not be
considered in deciding whether to produce or
shutdown.
• Thus, in determining whether to shut down, a
firm should compare total revenue to total
variable costs (VC) rather than total costs (FC
+ VC).
• If the revenue the firm is receiving is greater
than its total variable cost TR > VC, then the
firm is covering all variable cost plus there is
additional revenue (“contribution”), which can
be applied to fixed costs.
• (The size of the fixed costs is irrelevant as it is
a sunk cost.)
• On the other hand, if VC > TR then the firm is
not even covering its production costs and it
should immediately shut down.

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