Question

What is the difference between a firm's shutdown point in the short run and in the long run? Why are firms willing to accept losses in the short run but not in the long run?

Short answer

A firm's shutdown point in the short run is when it cannot cover its variable costs, while in the long run, it is when the firm cannot cover both the fixed and variable costs. Firms accept losses in the short run if they can cover their variable costs, to minimize losses, as fixed costs are already incurred. However, in the long run, since all costs become variable, firms will shut down if they cannot cover all costs to avoid further losses.

Step-by-step solution

Define Short Run and Long Run in Economics

In economics, the short run refers to the period during which at least one input, like capital or plant size, is fixed, while other inputs like labor could be varied. In contrast, the long run is a period sufficient for all inputs including plant size or capital investment, to be varied and no inputs are fixed.

Define Firm's Shutdown Points

A firm's shutdown point in the short run is when the price falls below the minimum average variable cost, while in the long run, a firm will shut down if it cannot cover all its costs, both fixed and variable. It is because in the short run, fixed costs have already been incurred and cannot be recovered, while variable costs can still be minimized by reducing output. In the long run, however, as all costs become variable, if the firm cannot cover all its costs, it will choose to shut down.

Reasons for Accepting Losses in the Short run

Firms are willing to accept losses in the short run because they have already incurred the fixed costs regardless of the level of production. They will continue to operate as long as they can cover their variable costs and contribute something towards fixed costs. This is to minimize losses rather than stopping production completely, which would result in a larger loss equal to the total fixed costs.

Implications for the Long run

However, in the long run, firms would not be willing to run at a loss because there are no fixed costs, and all costs are variable. Firms can change all inputs to respond to economic losses. Therefore, if a firm cannot cover its entire costs in the long run, it will choose to shut down and avoid further loss.

Key concepts

Short Run vs Long Run in Economics

In economics, the concepts of short run and long run are crucial for understanding how firms make decisions about production and whether to remain in the market.

The short run is characterized by the presence of both fixed and variable costs. During this period, certain factors of production, such as capital equipment or factory space, remain unchanged regardless of output levels. To put it simply, no matter how much a company produces, the rent for the factory or the cost of machinery does not change in the short run. However, variable costs, such as labor or raw materials, can be adjusted according to the production levels.

In contrast, the long run is a time frame where a firm has the flexibility to modify all production factors, including those that are fixed in the short run. This means that a business has the ability to make bigger changes like expanding its factory, purchasing new machinery, or changing technology altogether. There are no fixed costs in the long run because all costs can be modified or avoided by changing production levels or exiting the market entirely.

Minimum Average Variable Cost

The concept of minimum average variable cost (AVC) plays a pivotal role in a firm's decision-making process.

Essentially, AVC is calculated by dividing total variable costs by the quantity of output produced. It shows the lowest cost at which a firm is able to produce each unit of output when considering only variable costs. This does not include fixed costs, which, as we learned, are costs that do not change with the level of output in the short run.

Understanding the Shutdown Point

If a firm's market price falls below this minimum AVC, the firm is unable to cover even the variable costs of production. This is recognized as the shutdown point in the short run. Producing anything below this point would lead to greater losses than simply bearing the fixed costs without producing anything. Therefore, at minimum AVC, the firm is covering its variable costs and contributing something towards the fixed costs, even if it's running at an overall loss.

Fixed and Variable Costs

Every firm incurs costs while producing goods or providing services. Understanding the nature of each cost is essential for financial management and strategic planning.

Fixed costs are expenses that do not change with the level of output. They are unavoidable in the short term and include things like leases, insurance, and salaries of permanent staff. Even if a company doesn't produce anything, these costs still need to be paid.

On the other hand, variable costs are costs that vary depending on the company's production volume. They include items like raw materials, utilities, or hourly wages. The more a company produces, the higher the variable costs will be. It is this distinction that is central to making short-run production decisions, as managing these costs effectively can determine whether a firm stays operational or shuts down when faced with market price fluctuations.