Questions: Shutdown and Breakeven Decisions

Question 1

A firm's price is $8, its AVC is $6, and its ATC is $10. What should the firm do in the short run?

• A. Shut down, because the firm is earning negative economic profit
• B. Continue operating, because it covers variable costs and contributes something toward fixed costs
• C. Shut down, because the firm cannot cover its average total cost
• D. Continue operating only if it can raise its price above ATC

Answer: (B)

P ($8) > AVC ($6), so the firm covers its variable costs and earns $2 per unit toward fixed costs. Even though P < ATC means the firm is losing money, it loses less by operating than by shutting down. If it shuts down, it still loses all its fixed costs with zero revenue — a larger loss. The shutdown rule is P < AVC, not P < ATC.

Question 2

In the short run, a firm with P < ATC but P > AVC is best described as:

• A. At breakeven — it covers all costs and earns zero economic profit
• B. Operating at a loss but producing, because variable costs are covered
• C. Indifferent between operating and shutting down
• D. Violating the profit-maximization condition by continuing to produce

Answer: (B)

This is the 'operating loss' zone — between the shutdown point (P = AVC) and breakeven (P = ATC). The firm is losing money but should still produce because it covers variable costs and contributes something toward fixed costs. Fixed costs are sunk and will be lost regardless, so the operating loss is smaller than the shutdown loss. Only at P = ATC does the firm break even (zero economic profit).

Question 3

A firm should shut down in the short run whenever its economic profit is negative.

• T. True
• F. False

Answer: False

This is the most common misconception about shutdown decisions. A firm with negative profit should still operate as long as P ≥ AVC. Fixed costs are sunk in the short run — they cannot be recovered by shutting down. If the firm operates, it covers variable costs and offsets some fixed costs, making the loss smaller than if it simply produced nothing. The shutdown rule is P < AVC, not 'profit < 0.'

Question 4

In the long run, the shutdown condition changes from P < AVC to P < LRAC because there are no fixed costs in the long run.

• T. True
• F. False

Answer: True

In the long run, a firm can exit the industry and recover all resources for alternative uses — no costs are sunk. Any cost that isn't covered is a genuine avoidable loss. The long-run exit condition is therefore P < LRAC (long-run average cost). The short-run condition P < AVC exists only because fixed costs are already committed; in the long run that asymmetry disappears.

Question 5

Explain why fixed costs are irrelevant to the short-run shutdown decision.

Model answer: Fixed costs are sunk in the short run — already committed and unavoidable whether the firm produces or not. If the firm shuts down, it loses all its fixed costs with zero revenue. If it operates, it pays fixed costs plus variable costs but also earns revenue. As long as revenue exceeds variable costs (P > AVC), operating produces a smaller total loss than shutting down. Since fixed costs are identical in both scenarios, they cancel out of the comparison and have no bearing on the decision.

The sunk cost principle applies directly: a cost that is identical across all choices should be ignored when making that choice. The shutdown comparison reduces to: does operating revenue exceed variable costs? Fixed costs appear on both sides of the comparison and cancel. What determines the outcome is solely whether P ≥ AVC.