Firm’s Shut-Down Point

At shut-down point one very important question arises i.e. will a firm take an exit as soon as it incurs a loss? The answer will be in the negative.  No doubt the aim of the firm is to maximize profit and when it incurs a loss it must try to minimize its loss.  This implies that a firm should remain in production at least as long as its loss is minimized.  To understand the shut-down point of the firm we shall have to reconsider the cost structure.  When the average revenue is below the average cost then the firm is not enjoying profit but is incurring a loss.  But the average cost itself is made up of average fixed cost and average variable cost.  Now, as long as the average revenue of the firm can cover its variable cost then the firm will continue to remain in production with the hope that it will be able to minimize its loss.  But if the revenue is not enough to cover even its variable cost then the firm must take an honorable exit.  It must shut-down at this stage and hence such a situation is called the shut-down point of the firm.

We can very conveniently elucidate the shut-down point graphically.  Let us assume that the average revenue, marginal revenue, average and marginal cost curves are given.  E is the original point of equilibrium of the firm where AR = MR = ­↑ MC = Min AC.

Let the new price be OP1 represented by AR1 = MR1.  The new equilibrium point is S and the new equilibrium output is OM1.  At this level of output the average cost is M1L and average revenue is M1S.  The cost exceeds revenue and thus LS indicates the loss.  At this stage we consider the average variable cost curve.  Let us suppose that AVC is the average variable cost curve.  At point S, the AR just covers AVC.  This is the maximum possible loss a firm can bear.  If the price is even slightly lower than OP1 say OPthen the average revenue will not be able to cover even the average variable cost and thus the firm will have no option left but to take an exit.  Hence point S may be considered to be the shut-down point of the firm.  It is therefore clear that under condition of loss, the firm tries to minimize its loss and thus continues to remain in production as long as the revenue can cover at least its variable cost.  But even if the variable cost is not covered then the firm has to shut-down.

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