Short Run Shutdown Decision - Video Tutorials & Practice Problems

Short Run Shutdown Decision

All right. So, we saw how there could be situations where a firm could be losing money in perfect competition. Now, let's see when they're gonna decide to shut down. Alright. So firm might shut down due to the current market conditions, right? The market price might be too low for them to make a profit or their costs might be too high in the current settings. Right? There's gonna be some reason why they don't want to produce anymore. Okay. And I want to make a quick distinction between a firm shut down and a firm exit. Okay, When a firm shuts down, Okay? So shutting down means they're gonna produce no output temporarily. Okay, temporarily. There we go, temporarily. Um So it's gonna be a short run, shut down. Okay. They shut down in the short run. Right? Remember short run and long run we're gonna dive into that here a little more. So when a firm exits, when we talk about exiting, they're gonna produce no output forever. Right there, done in this market, they're not gonna they're like wheat, that's not for me anymore. I can't make money there. So that's in the long run that a firm might exit the market entirely. Right? So, remember when we talked about the short run and the long run, in the short run, there's fixed costs, Right? That was the definition of the short run, is that there's some cost that we have fixed and we have to pay them, no matter what. Right? So when we think about a shutdown decision when we're gonna shut down, we're gonna have to pay those fixed costs anyways. So, the relevant costs, when we think about shutting down are the variable costs, right? Because those fixed costs, whether we produce units or if we don't produce units, those fixed costs are gonna be there, right? Those in the short run, the fixed costs must remain fixed cost, right? They're gonna be there no matter what, And this brings up the idea of a sunk cost, you might have heard this before. So sunk cost is a cost that cannot be recovered. Okay? So, in this case, it could be something like what we're dealing with here, right? Maybe you paid uh some amount to rent a factory or something, right? You might have paid to rent the factory and whether you produce units or you don't produce units, you're gonna have to you've already paid that amount, right? You're not gonna get that money back, you've paid the rent for that factory, it can't be recovered. Right? So this idea of some cost, it's this idea of like no refunds, right? If you if you can't get a refund on money you spent, let's say you buy a ticket to a concert, usually ticketmaster him you with that non refundable ticket, right? Once you buy it, you can't you can't send it back, you can't get a refund for it, even if the concert hasn't happened yet. Right? So there's no refunds, it's a sunk cost or something, like a contractual commitment, right? So let's say you signed a lease, right? When you sign a lease to rent the apartment you're living in. Well, you're you can't get out of that lease, right? You're stuck in the lease for a year. You're gonna have to live there for at least that time. That cost is sunk, right? You even even even the least payments you haven't made yet. Right? The rent that you're gonna pay next month, there's no way out of it, right? You're gonna have to pay that cost. You can't recover, it sunk cost. Okay? So now that we've kind of set up the playing field here for the shutdown, let's go ahead in the next video. Let's see an example of a situation where a firm might want to shut down. All right, let's do that now.

Short Run Shutdown Decision (continued)

All right, so let's continue with this example and let's see where we might shut down in the short run. Okay, So we've got a farmer paid $1000 to rent a field for the season seeds cost $200 should the farmer produce this season? All right, so We want to see whether they're gonna shut down, shut down or not. Right. The only thing left is how much money are they gonna make from the seeds? From the crop? From the seeds? Right. So we've got two scenarios here, we've got a revenue of 500 and a revenue of 100. Okay? So notice the first thing we've got here this $1000 to rent the field. He already paid it, right? The farmer already paid it. It's a sunk cost, right? He's not gonna be able to get that money back, no matter what, whether he goes ahead and buys the seeds and produces a crop, or he just lets the field sit there. Either way he's out that $1000. Okay, so let's start here in this left hand side where we've got revenue of $500 right? So now when if if he chooses to plant the seeds, he's gonna get revenue of $500 from the crop. Okay? So first scenario he doesn't produce anything, right? No production. Well in that case he's gonna lose the $1000 right, He's gonna have minus 1000 from the field that he rented and didn't produce anything. Now let's say he does produce. Right, so he's now in the first case, right, he didn't spend the $200 on seeds. Now he is gonna spend the 200 on seeds and sell them. Uh right, so let's go ahead and see what happens first. Let's think about the revenue. He's gonna have total revenue of 500, right? Just like we see above the revenue from the sale of the seeds are 500. But what are his total costs this time? Well, he's got the 1000 for the field and the 200 for the seeds, right? He's got 1200 In in total cost now. So before his total costs were just 1000 for the field. Now he's got extra cost for the seeds. And now let's see what happens to his prophet, right? His profit well or is lost. Right? We're gonna put losses in parentheses like this. A loss like a negative number. Could be in parentheses. So his profit, right? It's gonna be his total revenue minus his total cost. 500 minus total cost of 1200. Well, that leaves him with a loss of 700 right? Negative 700 is his loss in this case. So what's the best scenario for him? He can either not produce and lose $1000 or he can produce and he'll only lose 700. Right? There's no it's still a lose lose for him, right? There's no way for him to make profit, but at least he can lose less money. Right? So for for him in this scenario, the best scenario is to produce, right? He's gonna produce and have a loss of 700. Right? Now, let's think of this other side on the other side, the revenue from sales are only 100 right before they were 500. Now, the revenue from the sale of the seeds is only 100. So again, he's got the first decision, right? Should he produce, Well, if he doesn't produce, he's only gonna lose 1000 right? Negative 1000 would be uh the loss just from the field. Now, let's say he decides to produce, right, well, now he's gonna have total revenue equal to 100 right? In this case, he only gets 100 from the seed sales and then he's gonna have total costs. Well, he's got the 1000 for the field and the 200 for the seeds. Again, He's got 1200 in total costs. So, what's his profit in this case? Now, his profit is gonna be the 100 in revenue minus the 1200 costs. Well, now he's got negative 1100 right? He's lost even more money by producing this time. And that should make sense to you, right? The seeds cost him 200. It only brought in 100 right? That was a loss, right? He spent more on the seeds than he was able to get from the crop. So here we go, we have a scenario where he's not gonna want to produce, right? There's gonna be no production in this case is his best scenario and he's gonna lose 1000. Right? That better? He's gonna lose 1000 instead of 1100. Right? So it's in his best interest to not produce when that revenue is low? So, let's think about what's happening in this case. Right. In one case the price was above the variable cost, right? The variable cost was the seeds. If we want to produce, we need to spend money on seeds. Right? So, the variable costs as we produce more and more, we're gonna spend more on seeds. Right? In this case it's simple. It's either seeds or no seeds. So, those variable costs are what's important here. All right. And what we're gonna see is that the condition for shutting down is if the price falls below the minimum of the average variable cost curve. Alright, So, we're bringing another curve into the mix here, right? We've dealt with the marginal revenue and the marginal cost to find the profit maximizing quantity. We dealt with the average total cost curve. When were we use the price and the average total cost to calculate our profit or our loss. And now we're gonna use the average variable cost curve to find out where we're gonna shut down Right? If we find that the price is below that variable cost curve, then we're gonna shut down. Ok. So, that makes sense, right? If we can't cover those variable costs of producing, that means that as we produce more and more, our costs are higher. Those variable costs of producing more are higher than the money we bring in. So there's no reason to produce if those variable costs are higher than the price, right? We're gonna be spending more and more per unit. So let's do one last thing in this video. Let's kind of summarize this information in the green box. Oh, and by the way, sorry, I overlooked this, the shutdown point, we're gonna call that minimum point on the average variable cost. That is the shutdown point. Okay, So it's that very last amount of price where we would still produce and anything below that, we're not going to write. So as we saw, we're gonna shut down here in this first box. If the revenues, right, those total revenues are less than the variable costs, Right? So just like we saw in that second example where the revenues were 100 The variable costs were 200. We shut down. Right, we didn't produce in that case. So you shut down if the revenue, total revenue is less than variable cost. Now, let's do a little algebra to rearrange this formula. Let me get out of the way. So I'm not blocking that box. Alright, So let's go ahead and divide both sides by Q. Right, So we're gonna have total revenue divided by Q is less than variable costs divided by Q. Right? So what happens when we divide by Q. Right? We're talking about average, right? We're taking the average revenue and the average variable cost. So if you recall average revenue, well, average revenue is just price, right? We discussed that in the revenue video, average revenue is equal to price. So the left hand side of this equation is price and the right hand side of the equation. Well, that's average variable costs, average variable cost, Right? So if the price is less than average variable cost, then we will shut down. Okay? So let's go ahead. We'll pause right here and go on to the next video. We're going to see all this information on a graph and see where we're gonna shut down. All right, let's do that now.

Short Run Shutdown Decision on the Graph

Alright, cool. Now let's check out this graph where we've got um are marginal cost curve? We've got an average total cost curve. And then now we've added the average variable cost curve. Right? So now we're talking about average variable costs as well, when we're talking about shutdown and I want to make a quick point here, this bullet, we're only gonna talk about average variable cost um in this section, in perfect competition, average variable cost, the only time it comes up is in the short run shutdown decisions. Okay, So this is the only time you have to think about average variable cost is when we're dealing with short run shutdown. Okay. Other than that average variable cost isn't gonna come up. So that should help you kind of zone in when we're gonna use this. Okay, So, I've got these cost curves on the graph. Let's go ahead and set some different prices, Right? If we put a high price, a low price, let's see what happens. Okay, so, first price I'm gonna set here, I'm gonna put a price up here. I'm gonna call it the high price price high. Right? And at that high price, remember in perfect competition, that price is our marginal revenue, always our average revenue. Right? But that marginal revenue, because we want to see where the marginal revenue and marginal cost curve cross, Right? That's where we're gonna produce. So let's go ahead and draw in our demand curve right there, right? We've got the horizontal demand for a firm imperfect competition. So at this high price, what's going on here, we're gonna have this marginal cost and marginal revenue, right? The price is our marginal revenue curve crossing right there, That is gonna be the quantity we want to produce. And now what's what's going on in this case, there's two things we want to know first are we gonna shut down? So in this case, notice that our price is above our average variable cost, Right? And that's what we see over here, price, an average variable cost. What's the relationship? Well, if the average variable cost is uh excuse me if the price is less than the average variable costs, we would shut down, but that's not what we see here, right? The price is higher, We're able to cover those variable costs. So we are going to produce in this case. So the first question, are we gonna produce? Yeah. Second question, are we gonna make a profit? Right, So we know we're gonna produce right there. And when we want to check if we're gonna make a profit, we gotta see if we're covering our average total cost, so that goes to this curve right here, and we see that the price is greater than the average total cost. So the money we're bringing in is more than the money we're spending. We are making a profit there, right? So at that high price we do make a profit and we do produce. Alright, So now let's try some sort of medium price here. Okay, I'm gonna erase this stuff. Whoops. I'll leave the the price in there, huh? Okay. And I'll erase this stuff so that we can do another example here. Alright, let's go ahead and pick a medium price. So I'm gonna pick something around here. Price medium and again, this is also our marginal revenue in this case. Right? So we've got our flat demand curve, supposed to be flat. Mine's a little not so flat, but take it as flat. And we're gonna say that this is where we would produce, right? This is gonna be that profit maximizing quantity or loss minimizing quantity. Right? So what about in this case? What's going on 1st? We want to discuss should we produce and we produce, Right? If we can cover our variable costs and that's what's happening here, right? The price is greater than the average variable cost here. So we should produce. Right? We should produce. But notice our average total cost. We're not making a profit though. Right? Notice in this case we've got our price right there, but our average total cost is above right? Our average total costs are higher than our price. So that means that we have a loss in this case, right? We're gonna have a loss, but we are gonna produce. Right. So this is this is a key key point here is that we still produce but we're losing money. Right? So we're above that average variable cost curve, but below the average total cost. All right. Last one. I want to talk about right here, let's pick this real low price down here. Price low. Right. So something way down there and remember that is our marginal revenue curve again. So, here, this actually brings up a kind of an interesting point, right? We're crossing our marginal cost curve twice, Right? And whenever this happens, you wanna you wanna pick the point where the marginal cost is increasing. Okay, you never pick that this this point right here, where the marginal cost is still decreasing over here. That's not where we want to pick because we're still lowering our cost if we produce more. So there's still benefits to producing more and more. So, the point where we actually want to produce would be here if we produce. Right? This would be the point where we would want to produce if we're producing. Okay, So now let's let's think about shall we produce? Well, what what's happening in this case, the price is less than average variable cost, right? It's below the average variable cost curve. Right here, this being average variable cost at that quantity? Well, we're not gonna produce. Right? And are we going to make a profit or loss? We're gonna lose money equal to our fixed costs, right? Our fixed costs, since we're not producing we still have our fixed costs to cover, and that is going to be our loss. Alright. So in this case, um we don't produce when we are below that average variable cost curve. And I just want to make one more I guess. Quick note right here. I'm gonna erase this. If we had a price right here, that is our shutdown point right there. Right. The minimum of the abc. Okay. So I'm just gonna erase that and go back. I just wanted to point out that shutdown point. All right. But let's leave it like that. Alright, cool. Let's go ahead and move. Move on. Well, before we move on, I just want to note that all this information is summarized right here. Everything we went over, right? So, should we produce these are kind of the questions we've been asking so far? Should we produce? Well, that has to do with average variable cost. And then if we are producing, where do we produce? Well, it's always going to be at that marginal revenue equals marginal cost. Right. And then the last thing are we making profit? Well, that's when we look at our average total cost. Right? If we're covering our average total cost, we make profit. If not, we have a loss. Alright, let's go ahead and move on to the next video. Now

The price for a pair of edible underpants is $50. In the short-run, the firm should: 

• A. Shut down because price is less than average total cost.
• B. Shut down because it cannot make a profit.
• C. Produce one unit because, at this output, marginal revenue equals marginal cost.
• D. Produce four units because, at this output, the loss is minimized.

The price for a pair of edible underpants is $50. In the short-run, the firm's total revenue is: 

• A. $0
• B. $50
• C. $200
• D. None of the above

The price for a pair of edible underpants is $50. In the short-run, the firm's profit (or loss) is: 

• A. $200 profit
• B. $40 loss
• C. $100 loss
• D. Break-even

The firm shuts down at any price below: 

• A. P1
• B. P2
• C. P3
• D. P4

What is the least amount of output, assuming the firm does not shut down? 

• A. 5 units
• B. 8 units
• C. 10 units
• D. 11 units

If the price falls from P4 to P3, then output will decrease by

• A. 0 units
• B. 1 units
• C. 2 units
• D. 3 units