Question

The decision to shut down is made in _____. a) both the short run and the long run b) neither the short run nor the long run c) the long run d) the short run

Short answer

The decision to shut down is made in both the short run and the long run. In the short run, a firm will decide to shut down if the revenue it generates is less than its variable costs, and in the long run, if its total revenue is less than its total costs. Therefore, the correct answer is a) both the short run and the long run.

Step-by-step solution

Understand the short run and the long run

In economics, the short run and the long run are two different time periods used to analyze production decisions. In the short run, at least one input (usually capital) is fixed, meaning that the firm cannot change it. In the long run, all inputs are variable, meaning that the firm can adjust all of them to achieve the desired level of production.

Decision to shut down in the short run

In the short run, a firm will decide to shut down if the revenue it generates is less than its variable costs. When the variable costs are higher than the revenue, the firm is not able to cover the costs associated with producing the good. This happens when the market price of the product is lower than the average variable cost of production.

Decision to shut down in the long run

In the long run, a firm will choose to shut down if its total revenue is less than its total costs. The firm will continue to operate as long as its total revenue is equal to or greater than its total costs, including both fixed and variable costs. If the price is not high enough to cover the average total cost of production, the firm will eventually decide to exit the market. Now let's examine the given options: a) both the short run and the long run: This option says that the decision to shut down is made in both the short run and the long run, which seems to be true based on the explanation above. b) neither the short run nor the long run: This option is not true because it is clear from the explanation above that the decision to shut down is related to both the short run and the long run. c) the long run: This option is partially true because the decision to shut down is made in the long run, but it is also made in the short run. d) the short run: This option is also partially true because the decision to shut down is made in the short run, but it is also made in the long run. Based on the analysis, the correct answer is:

Correct Answer

a) both the short run and the long run

Key concepts

Short Run vs Long Run Economics

Understanding the distinction between the short run and long run in economics is fundamental when discussing production and shutdown decisions. In the short run, certain inputs like machinery or the size of a factory are considered fixed. Firms can't expand or reduce these capital inputs immediately, leading to limitations on adjusting production levels.

In contrast, the long run allows firms to modify all inputs. They can invest in more equipment, technology, or resources, opening up the possibility for scaling production up or down to meet market demands. Therefore, the decisions a firm makes in each period can significantly differ due to these underlying constraints or freedoms.

Relevance to Shutdown Decisions

In both timeframes, a firm must assess its cost structures critically and decide whether continuing operations is financially viable. In the short run, it's about covering variable costs, while in the long run, the sustainability of the business model itself is questioned, checking if the firm can cover total costs which include both fixed and variable components.

Variable Costs and Shutdown

A key factor in the shutdown decision for a firm in the short run is its variable costs. Variable costs change with the level of output, examples include raw materials, hourly wages, and utility costs directly associated with production.

If the revenue from selling goods falls below these variable costs, the firm would lose less money by halting production than by continuing to produce. It's crucial to note that fixed costs, like rent or salaries, have to be paid whether the firm produces anything or not. The inability to cover just the variable costs is the tipping point for short-run shutdowns.

Short-Run Shutdown Rule

Simply put, if the price of the product is below the average variable cost (AVC) at the best output level, a firm should shut down in the short run. This strategy minimizes the loss to just the fixed costs, avoiding additional variable costs that would lead to greater losses.

Average Total Cost

The average total cost (ATC) is a critical concept when analyzing long-run economic decisions. It encompasses the average fixed cost (AFC) and average variable cost (AVC) per unit of output. The ATC gives a clear picture of what it costs on average to produce one unit of output when all costs are considered.

When prices fall below ATC, a firm's total revenue does not cover total costs, leading to losses. Successful business operation and survival in the long run depend on the ability to sell products at a price that at least covers the ATC.

Long-Run Shutdown Considerations

Long-run decisions are more about the firm's structural viability. If a firm consistently faces a market price below ATC, it might have to exit the industry or undergo significant restructuring to lower costs. Unlike the short run, where fixed costs are 'sunk', in the long run, all costs become variable and therefore avoidable, making the ATC a beacon for shutdown or continuity decisions.