Question

If a firm starts losing money due to increase in competitive market pressure and the business outlook remains grim, then should it always shut down to stop further losses? Explain the answer in detail. What condition must be true for the firm to be always forced to shut down in the short run?

Answer 1

Answer : In competitive market the firm's shutdown point is that point where price is equal to average variable cost. This means that when price is equal to average variable cost then the firm can shutdown it's production or can continue it's production. It is totally depends on producer. But if the price is less than the average variable cost then the firm should shutdown it's production. Because when price of less than the average variable cost then firm's total revenue does not cover the firm's total variable cost. In this situation the firm face extreme loss in short-run. Hence in short run if price is less than the average variable cost then the firm should shutdown it's production. But if the price is less than average total cost but greater than average variable cost then the firm should continue it's production although the firm faces loss in short-run. Because when price is greater than average variable cost then the firm's total revenue is able to cover the total variable cost.

When price = average variable cost then this condition force the firm to shutdown it's production in short run.