Answer to Question #57374 in Microeconomics for Dylan Nyamande

Question

Should a firm in perfect competition shut down its business if it suffers losses?

Answer 1

The answer is in loss minimization. It is a comparison of the loss incurred from producing with the loss incurred from not producing.
There are 2 choices for firm that suffers from losses in the short run (P<ATC):
-Continue to run => Loss A=(P–ATC)*Q;
-Shut down => Loss B=-FC (sunk cost).
P – price, ATC – average total costs, Q – total output, FC – fixed costs, AVC – average variable costs.
So decision depends on the magnitudes of Loss A and Loss B:
1. P>AVC => Loss A>Loss B – firm should continue to run;
2. P<AVC => Loss A<Loss B – firm should shut down;
3. P=AVC => Loss A=Loss B – firm is indifferent between still running and shut down.
So, one condition when firm should shut down is when price is less than average variable costs. It is correct for short-run period. For long-run period condition P<ATC is enough for firm not to run.