Answer to Question #177786 in Microeconomics for Elliot Bansah

Question

Explain why a perfectly competitive firm will not shut down in a short run when it is making losses. Illustrate your answer with an appropriate diagram.

Answer 1

Let's assume that at certain market price $P_1$the firm's profit maximizing quantity is $Q_1$. The firm may decide don't shut down in a short run when it is making losses if the firm's average variable cost curve lies below its marginal revenue curve (the flat dashed line denoting the price level $P_1$). It means that the firm can cover its variable costs. The losses of the firm depicted by the dashed rectangle area in the diagram. Therefore, as we can see from the diagram, the firm will not shut down in the short run despite the losses, because it receives enough revenue to cover its variable costs.