A firm making a loss (Profit and Loss on the Graph) has a choice: keep producing, or shut down for now. The answer depends on which costs it would still have to pay.
Key idea
In the short run, a firm shut down still pays its fixed costs, so its loss is $FC$. It should keep producing as long as the price covers average variable cost ($P \ge \min AVC$), even at a loss. It should shut down if $P < \min AVC$. The shutdown price is the minimum of AVC; the break-even price is the minimum of ATC.
Why it works
Rent and loan payments are due whether the doors are open or not. Producing is worth it if the revenue at least covers the extra costs of producing, the variable costs, because anything left over helps pay the fixed costs. If price is below AVC, every unit made loses money on top of the fixed costs, so closing loses less. That's why a competitive firm's short-run supply curve is its MC curve above the minimum of AVC.
Worked example: Keep going at a loss
A firm's fixed cost is \$100. At its best output it would earn \$300 in revenue and pay \$260 in variable costs. Should it produce?
- If it produces: profit $= \$300 - \$260 - \$100 = -\$60$.
- If it shuts down: profit $= -\$100$ (it still pays the fixed cost).
- A \$60 loss beats a \$100 loss. Revenue covers variable cost, with \$40 toward fixed cost.
Answer: Produce: lose \$60 instead of \$100.
Worked example: Time to close
A firm's AVC is at least \$12 at every output, and the price falls to \$10. What should it do in the short run?
- At \$10, every unit sells for less than its average variable cost.
- Producing adds to the loss on top of fixed costs, so the firm should shut down and lose only its fixed cost.
Answer: Shut down until the price recovers.
Common mistake
Thinking a firm should shut down as soon as it makes a loss. In the short run it pays its fixed costs either way. Check: compare the loss from producing with the fixed cost. Produce whenever the loss is smaller, which is when $P \ge AVC$.
In the long run there are no fixed costs: leases end, equipment can be sold. A firm that expects losses to continue leaves the industry, which is the subject of the next lesson.