Microeconomics Profit Maximization: Shutdown Point

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.

Shutdown point



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.

Economic profits

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.

Economic losses

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.
firm 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.

Both comments and pings are currently closed.

21 Responses to “Microeconomics Profit Maximization: Shutdown Point”

  1. The viewer’s Flash player sends a request to the server that specifies a start
    time, an HTTP request that inserts some time parameter in
    to the requesting URL’s “query string. This lesson should also apply to any music device, whether a stereo, MP3 player, CD player or streaming music site. Could this are the form of movie you need to see about the big screen.

  2. chinnu says:

    whats ATC ?? it must be AC , right ??

  3. Kate says:

    why some textbooks say that in the short run, a shut down dicison is when P= average avoidable cost? Since total cost=fixed cost+ variable cost or total cost= sunk cost+ avoidable cost, I think avoidable cost and variable cost are different.

  4. pean george says:

    firm in the long run can operate despite the facty that there small element of fixed cost,because non firm can operate without iniatial fixed cost

  5. Dave Hancock says:

    What is the formula for calculation of total gains when saving a corporate dollar? If I save one dollar, or one product from scrap; I save at least 2, and the cost of making the third, less scrap return, plus cost saving from non scraping. What other costs advantages occur which can maximize the return? Thanks for any help. Dave

  6. Patty says:

    Thanks! I didn’t understand the shut down period so this is really helpful. Thank you!

  7. John says:

    I was having trouble understanding this as well. Thanks for the clarification. No doubt these variables have a definite bearing on the success or failure of a firm/corporation. I would think that a company would shut down before P=AVC to conserve or try to save or reduce there cost or reduce there operating expensive prior to that point.

    Cheers

  8. Barry Econ says:

    It’s not a hard fast conclusion, it’s a theory on profit maximizing firms in microeconomics.

  9. ChrisK says:

    I don’t necessarily agree with the hard/fast conclusion that a firm should shutdown when P=AVC. I think that a company, at that point, needs to do some quick and definiate cost cutting measures to lower the AVC in the short term and work toward a longer term strategy of keeping costs low but, it’s not completely a lost cause at that point. When P < AVC (or worse yet, < AFC) is when a company should, as my Econ Prof says, "shut down, go home, and watch Oprah."

  10. JMG says:

    The charts were hard to decipher, thanks for the commentary for the added clarity.

  11. barry econ says:

    A bit more information is coming out on the monopoly so check the date of this comment in the archive.

  12. barry econ says:

    I’ll check some notes and see if there’s something. can’t think of it at the top of my head.

  13. luke says:

    what about the shut down point of a monopoly?

  14. The Wabbster says:

    Thanks for this. This definitely helps! :)

  15. Elli says:

    awesome explainations! hope i can explain the graphs like you in tomorrow’s exam:)!

  16. Natia says:

    thanks a lot…I have an exam the day after tomorrow and all this helped me really very much…

  17. Andrew says:

    +1 thank you. Also helpful for my Eco exam on the 14th this month.

  18. barry econ says:

    Happy to help, many more coming soon.

  19. steven says:

    thanks for this, really help me alot for my econ exam

    cheers