Shut-Down Conditions

Idea

A firm earning subnormal profit must decide whether to keep producing or shut down. The decision differs between the short run and the long run, because the two periods differ in which costs are unavoidable.

Mechanism

• Short run. Fixed cost is sunk — it is lost whether or not the firm produces. So the firm compares total revenue with variable cost only:

  • If $TR > TVC$, the firm continues. Revenue covers all variable cost and leaves a surplus that recoups part of the unavoidable fixed cost, so producing loses less than shutting down would.

  • If $TR < TVC$, the firm shuts down. Continuing would lose the whole fixed cost plus the shortfall of revenue against variable cost; shutting down loses only the fixed cost.

  The boundary is therefore $TR = TVC$: a firm produces in the short run as long as it covers its variable cost. Shutting down here is a temporary suspension, not exit — the firm may resume.

• Long run. All factors, and hence all costs, are variable — there is no fixed cost to be sunk. The firm shuts down permanently and leaves the industry whenever total revenue is less than total cost ($TR < TC$), i.e. whenever it cannot at least earn normal profit.

Considerations

The short-run rule turns entirely on the sunk nature of fixed cost: a firm rationally keeps producing at a loss provided it covers variable cost, because doing so limits the loss to less than the fixed cost it would forfeit anyway. The contrast with the long-run rule — where the benchmark rises to total cost — is the standard way to distinguish a temporary downturn from a decision to exit. (The diagrammatic depiction of these conditions is outside the 9570 syllabus; the reasoning is required in prose.)