Question

Auto Parts, Inc. is medium-sized company that manufactures auto parts in Buffalo, New York. The company currently loses $30,000 per month. The owner of the company is evaluating whether she should shut down the factory. She thinks that the factory should continue to operate until the economic environment improves and buyer for the factory can be identified. The logic of the owner is that her company has already invested millions of dollars in the factory over the years. The monthly fixed costs for the factory are $40,000. The CEO of Auto Parts, Inc. thinks the factory should be shut down because most the monthly fixed costs ($40,000/month) are sunk costs. Do you agree with the owner or the CEO? Explain the logic of your argument, including a numerical demonstration.

Can someone please explain who is correct and also provide a numerical demonstration showing this?

Answer 1

The owner of the auto manufacturing company is wrong because the factory should continue to operate in the short run as long as the company is able to cover its variable costs because the fixed costs are sunk costs in the short run so the company only looks at its variable cost and the shutdown condition is when the P=minimum of AVC. Since the fixed cost is $40000 and the company is losing $30000 so this means that the company is able to recover all of its variable cost and some of its fixed cost too so, the company should continue to operate in the short run.

In this case as the company is losing 30000 so the company is covering 40000-30000=10000 of its fixed costs.

Now in case the company shuts down then it will be making a loss which is equal to its fixed cost + the amount it is able to recover so the total loss would be 40000+10000=50000 which is more than its losses of 30000 if it keeps operating.