Question

Explain: “The short-run rule for operating or shutting down is P > AVC, operate; P < AVC, shut down. The long-run rule for continuing in business or exiting the industry is P ≥ ATC, continue; P < ATC, exit.”   In your answer discuss what reasons why a firm would operate not covering their ATC in the short-run and what factors may convince them this is not the best strategy in the long-run. Also consider if they are losing $$ in the short run what factors are they hoping may change to put them in a better position in the long run

Answer 1

Note that the firms experience two types of cost in the short run. One is called the variable cost, which is basically the cost that varies according to the level of output produced.

The other is the fixed cost. This is the cost which has to be borne irrespective of the number of output produced (i.e.. whether it continues its operation or stops, it doesn't matter----they have to incur this cost)

SHORT RUN:

When P>AVC, the firms will operate in the short run. Only when P<AVC, they will decide to shut down.

EXPLANATION:

The firm has to bear the fixed cost of production irrespective of whether they decide to operate or not.

When P>AVC, the firm will be in a position to cover the variable costs and only a part of the fixed cost. If they didn't operate, they would incur the entire fixed cost amount. So it's rational for the firm to still continue production and operate when P>AVC

Now when P<AVC, if the firm operates, the firm is not in a position to cover even the entire variable costs, let alone the fixed costs . So, it's rational for the firm to shut down production whereby they will only lose on the fixed cost amount and there will be no variable costs.

LONG RUN:

In the long run, remember nothing is fixed as all the factors can be changed. So there is no instance of fixed cost in the long run.

So the ATC consists only of variable costs.

When P>=ATC, the firms will operate in the long run. Only when P<ATC, they will decide to shut down.

EXPLANATION:

If the firm is able to cover the average total costs (which now consists only of variable costs), then it makes sense to continue operation. However, if they can't do so, then the firm is better off to shut down.

If the firm can be in a position to use cost effective inputs such that they enjoy economics of scale, then it might put them in a better position in the long run. This helps them to earn higher profits per unit of output as the marginal costs have fallen.

Hope this helps!!