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The Shut-Down Decision. The Short-Run Production Decision In the short-run, sometimes the firm should produce even if price falls below minimum ATC In.

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Presentation on theme: "The Shut-Down Decision. The Short-Run Production Decision In the short-run, sometimes the firm should produce even if price falls below minimum ATC In."— Presentation transcript:

1 The Shut-Down Decision

2 The Short-Run Production Decision In the short-run, sometimes the firm should produce even if price falls below minimum ATC In the short-run, sometimes the firm should produce even if price falls below minimum ATC Why? Why? Total cost includes fixed cost! Total cost includes fixed cost! Ex. Jennifer and Jason have rented a tractor for the year, they have to pay the rent on the tractor regardless of whether they produce any tomatoes Ex. Jennifer and Jason have rented a tractor for the year, they have to pay the rent on the tractor regardless of whether they produce any tomatoes

3 The Short-Run Production Decision Since it cannot be changed in the short-run, their fixed cost is irrelevant to their decision about whether to produce or shut down in the short run Since it cannot be changed in the short-run, their fixed cost is irrelevant to their decision about whether to produce or shut down in the short run Fixed costs dont play a role in the decision whether to produce in the short run, other costs – variable costs – do matter Fixed costs dont play a role in the decision whether to produce in the short run, other costs – variable costs – do matter

4 The Short-Run Production Decision Need to analyze the optimal production decision into eh short run to determine if a company should keep producing Need to analyze the optimal production decision into eh short run to determine if a company should keep producing Two cases to consider: Two cases to consider: 1.When market price is below minimum average variable cost 2.When the market price is greater than or equal to minimum average variable cost

5 The Short-Run Individual Supply Curve $ MC ATC AVC C B A E Minimum average variable cost Short-run individual supply curve Shut-down price Price, cost of bushel Quantity of tomatoes (bushels) When the market price equals or exceeds Jennifer and Jasons shutdown price of $10, the minimum average variable cost (A), they will produce the output quantity at which marginal cost is equal to price any price equal to or above the minimum average variable cost, the short-run individual supply curve is the firms marginal cost curve When market price falls below minimum average variable cost, the firm ceases operation in the short run

6 1. When market price is below minimum average variable cost When market price is below minimum AVC, the price the firm receives per unit is covering its variable cost per unit When market price is below minimum AVC, the price the firm receives per unit is covering its variable cost per unit The firm should cease production because no level of output at which the firms TR covers its variable cost The firm should cease production because no level of output at which the firms TR covers its variable cost It still incurs a fixed cost in the short run, but no longer incurs any variable costs It still incurs a fixed cost in the short run, but no longer incurs any variable costs

7 1. When market price is below minimum average variable cost Shut-down price is when a firm will cease production in the short run if the market price falls below the shut-down price which is equal to the minimum average variable cost Shut-down price is when a firm will cease production in the short run if the market price falls below the shut-down price which is equal to the minimum average variable cost When the price is greater than the minimum average variable cost, the firm should continue producing in the short run When the price is greater than the minimum average variable cost, the firm should continue producing in the short run

8 1. When market price is below minimum average variable cost For Jennifer and Jason, For Jennifer and Jason, If the market price of tomatoes is $18 per bushel, Jennifer and Jason should product at E which equals 5 bushels If the market price of tomatoes is $18 per bushel, Jennifer and Jason should product at E which equals 5 bushels Since E is above C, Jennifer and Jasons farm will be profitable, they will generate a per-bushel profit of $ = 3.60 when the market price is $18 Since E is above C, Jennifer and Jasons farm will be profitable, they will generate a per-bushel profit of $ = 3.60 when the market price is $18

9 1. When market price is below minimum average variable cost What if the market price lies between the shut-down price and the break-even price (between minimum average variable cost and minimum average total cost) What if the market price lies between the shut-down price and the break-even price (between minimum average variable cost and minimum average total cost) Jennifer and Jason = $10-$14 Jennifer and Jason = $10-$14 If $12 is the price, the farm is not profitable since the market price is now below minimum average total cost If $12 is the price, the farm is not profitable since the market price is now below minimum average total cost

10 1. When market price is below minimum average variable cost But if it is not covering its total cost per unit, it is covering its variable cost per unit But if it is not covering its total cost per unit, it is covering its variable cost per unit If a firm shuts down, it would incur no variable cost but would incur the full fixed cost If a firm shuts down, it would incur no variable cost but would incur the full fixed cost So in the end, if a price falls between minimum average total cost and minimum average variable cost, the firm is better producing some output in the short run So in the end, if a price falls between minimum average total cost and minimum average variable cost, the firm is better producing some output in the short run – Can cover its variable cost per unit and some of its fixed costs

11 2. When the market price is greater than or equal to minimum average variable cost When this occurs, the firm is indifferent in producing 3 units or 0 units When this occurs, the firm is indifferent in producing 3 units or 0 units In our notes, we are assuming that the firm does produce output when price is equal to shut-down price In our notes, we are assuming that the firm does produce output when price is equal to shut-down price

12 2. When the market price is greater than or equal to minimum average variable cost Short-Run individual supply curve shows how an individual producers profit- maximizing output quantity depends on the market price, taking fixed cost as given Short-Run individual supply curve shows how an individual producers profit- maximizing output quantity depends on the market price, taking fixed cost as given

13 2. When the market price is greater than or equal to minimum average variable cost The upward-sloping line starting at A shows the short-run profit-maximizing output when market price is equal to or above the shut-down price of $10 a bushel As long as the market price is = to or above the shut-down price, the firms short-run supply curve corresponds to its marginal cost curve

14 The Shut-Down Decision Do firms really shut down permanently without going out of business? Do firms really shut down permanently without going out of business? Yes – outdoor amusement parks Yes – outdoor amusement parks

15 The Shut-Down Decision

16 The Shut-Down Decision Notes

17 The Short-Run Production Decision In the short-run, sometimes the firm should produce even if price falls below minimum ATC In the short-run, sometimes the firm should produce even if price falls below minimum ATC Why? Why?

18 The Short-Run Production Decision Since it cannot be changed in the short-run, their fixed cost is irrelevant to their decision about whether to produce or shut down in the short run Since it cannot be changed in the short-run, their fixed cost is irrelevant to their decision about whether to produce or shut down in the short run Fixed costs dont play a role in the decision whether to produce in the short run, other costs – variable costs – do matter Fixed costs dont play a role in the decision whether to produce in the short run, other costs – variable costs – do matter

19 The Short-Run Production Decision Need to analyze the optimal production decision into eh short run to determine if a company should keep producing Need to analyze the optimal production decision into eh short run to determine if a company should keep producing Two cases to consider: Two cases to consider:

20 The Short-Run Individual Supply Curve $ MC ATC AVC C B A E Minimum average variable cost Short-run individual supply curve Shut-down price Price, cost of bushel Quantity of tomatoes (bushels)

21 1. When market price is below minimum average variable cost When market price is below minimum AVC, the price the firm receives per unit is covering its variable cost per unit When market price is below minimum AVC, the price the firm receives per unit is covering its variable cost per unit The firm should cease production because no level of output at which the firms TR covers its variable cost The firm should cease production because no level of output at which the firms TR covers its variable cost It still incurs a fixed cost in the short run, but no longer incurs any variable costs It still incurs a fixed cost in the short run, but no longer incurs any variable costs

22 1. When market price is below minimum average variable cost Shut-down price is when a firm will cease production in the short run if the market price falls below the shut-down price which is equal to the minimum average variable cost Shut-down price is when a firm will cease production in the short run if the market price falls below the shut-down price which is equal to the minimum average variable cost When the price is greater than the minimum average variable cost, the firm should continue producing in the short run When the price is greater than the minimum average variable cost, the firm should continue producing in the short run

23 1. When market price is below minimum average variable cost What if the market price lies between the shut-down price and the break-even price (between minimum average variable cost and minimum average total cost) What if the market price lies between the shut-down price and the break-even price (between minimum average variable cost and minimum average total cost) Jennifer and Jason = Jennifer and Jason =

24 1. When market price is below minimum average variable cost But if it is not covering its total cost per unit, it is covering its variable cost per unit But if it is not covering its total cost per unit, it is covering its variable cost per unit If a firm shuts down, it would incur no variable cost but would incur the full fixed cost If a firm shuts down, it would incur no variable cost but would incur the full fixed cost So in the end, if a price falls between minimum average total cost and minimum average variable cost, the firm is better producing some output in the short run So in the end, if a price falls between minimum average total cost and minimum average variable cost, the firm is better producing some output in the short run

25 2. When the market price is greater than or equal to minimum average variable cost When this occurs, the firm is indifferent in producing 3 units or 0 units When this occurs, the firm is indifferent in producing 3 units or 0 units In our notes, we are assuming that the firm does produce output when price is equal to shut-down price In our notes, we are assuming that the firm does produce output when price is equal to shut-down price

26 2. When the market price is greater than or equal to minimum average variable cost Short-Run individual supply curve shows how an Short-Run individual supply curve shows how an

27 2. When the market price is greater than or equal to minimum average variable cost

28 The Shut-Down Decision Do firms really shut down permanently without going out of business? Do firms really shut down permanently without going out of business?

29 The Shut-Down Decision


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