When a firm has to shut down? Is it equivalent to exiting the market?
The evolution of the concept and the steps for perfect competition became conducted with a perfect market, uniqueness of equilibrium, and stationary of conditions (Stigler, 1957). Here, the ultimate goal of a business firm is to generate profit. Every business houses, manufacturing companies, or production houses want to exchange goods and services for the money, and in the process, they want to increase the revenue and achieve higher profit. Generally a firm has to shut down when this target cannot be achieved in the given circumstances. It is natural to shut down if the firm is operating in loss or the price is lesser than the cost. According to Guell (2015), "A business needs to make at least normal profit in the long run to justify remaining in an industry but in the short run a firm will produce as long as price per unit > or equal to average variable cost (AR = AVC). This is called the shutdown price in a competitive market.”
For instance, a seasonal business as Christmas tree farmers may shut down entire business until next winter arrives. By doing so, they can eliminate variable cost while fixed cost remain constant.
Now, I would like to define the shutting point trough graphical representation.
Figure: Profit, Loss, & Shutdown point for business firm
In the above graph, the marginal cost (MC) curve can be divided into three zones, based on where it is crossed by the average cost (AC) and average variable cost (AVC) curves. The point where MC crosses AC is called the zero-profit point. If the firm is operating at a level of output where the market price is at a level higher than the zero-profit point, then price will be greater than average cost and the firm is earning profits. If the price is exactly at the zero-profit point, then the firm is making zero profits. If price falls in the zone between the shutdown point and the zero-profit point, then the firm is making losses but will continue to operate in the short run, since it is covering its variable costs. However, if price falls below the price at the shutdown point, then the firm will shut down immediately, since it is not even covering its variable costs.
There may be some other case as well where a government may encourage firms that produce particular products to operate for reasons of national defence or national pride. In these cases public policy may be used to subsidize the firms that would find it necessary to shut down in a free market economy (Reynolds, 2011).
Guell, Robert C. (2015). Issues in Economics Today , 7th edition- 2015 ISBN: 978-0078021817
Reynolds, R. L. (2011). Basic Microeconomics.
Stigler, G. J. (1957). Perfect competition, historically contemplated. Journal of political economy, 65 (1), 1-17.
A firm has to focus on both outputs and revenue to be successful in a market where a firm should have to find a level of output that maximizes profit. For this, a firm has to set marginal revenue (MR) equals marginal cost (MC) (Felder, 1990).
In contrary, there occurs an economic shutdown in a firm if marginal revenue is below average variable cost at the profit-maximizing output. Similarly, if the average variable cost (AVC) exceed the price at all output rates then the company will shut down in the short run. In other words, If the variable cost is greater than the revenue being made (VC>R) then the firm is not even covering production costs and it should be shut down. The output level at which price equals the AVC is called the shutdown point.
Furthermore, if the revenue from the sale of goods produced cannot cover the variable cost of a production then a firm has to implement a production shutdown. In today’s business the production shut down is temporary but when there is an improvement on the condition of the market as of the fall in production cost or increase in the price of the product then the firm can again resume its production. However, if the shutdown period becomes extended for a period of time then the firm should have to decide whether to continue or level the production of business.
We can elaborate the concept of shutdown point of a firm through the given picture:
Felder, J. (1990). Content Articles in Economics The Profit-Maximizing Firm: Old Wine in New Bottles. Journal of Economic Education, 21 (2), 17.
Guell, R. C. (2012). Issues in Economic Today (Sixth ed.). New York: McGraw-Hill.