Determining the Shutdown Point of a Firm

This continues a previous post on profit maximization. The question we want to continue with is when should a firm shutdown? Then answer is when P (price) = AVC (average variable cost).

This is the output where firms are indifferent between producing the profit-maximizing quantity (ie. loss-minimizing quantity) and shutting down operations. Take a look at this graph to help you understand the when and where.

While we’re on the topic, what is the supply curve for each firm? Looking at the graph you’ll note the MC curve. The supply curve for each firm is simply its marginal cost (MC) curve above the minimum point on the average variable cost (AVC) curve.

The supply curve for the industry is just the (horizontal) summation of each individual firm’s supply curve. Carrying on, what about the items that dictate and influence long run decision making?

Long-Run Decisions:

Forces in a competitive industry ensure that firms earn zero economic profits in the long-run.

Competitive industries will adjust in two ways: 1. Entry and exit, 2. Changes in plant size

Entry and Exit:

The prospect of persistent profit of loss causes firms to enter or exit an industry. If firms are making economic profits, other firms enter the industry. This graph shows how where there is room for new entrants in the market and how it eliminates industry profits in the long run.

If firms are making economic losses, some of the existing firms exit the industry. This entry and exit of firms influences prices, quantities, and economic profits. This graph depicts economic losses in the industry.

Important points: as new firms enter an industry, the price falls and the economic profit of each existing firm decreases. As firms leave an industry, the price rises and the economic loss of each remaining firm decreases. [See graphs above]

Changes in Plant Size: When a firm changes its plant size, it can lower its costs and increase its economic profit. Let’s see in this graph how a firm can increase its profit by increasing its plant size.

Long-Run Equilibrium: Therefore, in the long-run equilibrium for a competitive industry, all firms must be:

1. Maximizing profits (P = MR = MC)
2. Earning zero economic profits (P = SRATC)
3. Unable to increase profits by altering its scale of operations.

And that concludes our intro into profit maximization and shut down points for firms.