Question

Explain, in your own words, difference between a firm shutting down and a firm exiting an industry. Please provide an example showing why a firm might operate in short run despite making losses. You are welcome to provide an actual example of a firm losing money for a while before shutting down. (No Handwriting please)

Answer 1

There is a difference in shutting down the operations but remaining in the industry and finally leaving the industry. The difference lies in the time period. in the short run when most of the inputs are fixed in nature, any company operating under losses may not find it feasible to leave the industry but it can shut down its operation to prevent the losses. It takes time to sell of the assets and leave the industry and this happens in the long run when the losses are continued for a longer period of time so that the company is not able to recover even its variable cost.

Therefore, a company decides to shut down its operations in the short run when it is not able to recover its variable cost but it decides to remain in the industry. In the long run however due to persistent losses, it leaves the industry by selling of the assets.

A typical firm might operate in the short run even when the price it receives brings economic losses. This can happen when the form is able to recover all its variable cost. For this condition the prices should be at least equal to the minimum variable cost. It may not be operating in the short run when the price falls below this level. Take for example, a price of $5 per unit and a minimum average variable cost of $3 per unit with average total cost of $8 per unit.

The firm is making economic losses because price is less than average total cost, but it is able to recover its average variable cost which is less than the price. So the firm will decide to continue its operations even when there are losses.

Production will be continued till the price is $3 per unit. In case the price falls below this level, the firm will shutdown but remain in the industry as the time period is short run. It will leave the industry only in the long run.