8.6 : Shut Down Point

A decision to shut down means that the firm is temporarily suspending production. The firm should continue production as long as it can cover its total variable costs and still make a partial contribution to its fixed cost obligations. This situation will occur as long as the average revenue per unit sold is greater than the average variable cost at the quantity of production that maximizes profits, q*.

However, if the average variable cost exceeds the average revenue at q*, then the firm will be better off simply shutting down, laying off its workers, and not producing any output. There is no advantage to incurring additional uncompensated costs that are in excess of the firm's existing fixed cost obligations.

Average Variable Cost (AVC) Consideration: The firm first examines whether the market price covers the average variable cost (AVC) of production when producing at q*.

Comparison with Market Price:

• If market price > AVC, the firm continues production to receive total revenues that will cover total variable costs. This minimize losses by allowing the firm to make a partial payment on its fixed cost obligations.
• If market price < AVC, continuing production would increase losses beyond its fixed cost obligations. This means that shutting down production minimizes the firm's potential losses.

Shut Down Point: The shutdown point is precisely the quantity where the market price equals the firm's AVC. Producing at lower quantities simply exacerbates total losses.

Consider a bakery in a perfectly competitive market. If the price of a loaf of bread drops so low that revenue from sales doesn't cover the costs of flour, labor, and other variable costs incurred to produce the bread, the bakery hits its shutdown point. Continuing to bake and sell bread under these conditions would result in losses greater than just bearing the fixed costs it is obligated to pay regardless of its level of output. Fixed costs include things like rent for the bakery building, which must be paid regardless of the level of production.

The shutdown point doesn't mean the bakery has to close forever. It's a temporary step until market conditions improve, and the bakery can again cover its variable costs and start contributing to fixed costs.