Principles of Microeconomics / Unit 17 MIC 1623 worked example, 60 to 90 seconds
Sample Question Five: The Shutdown Test
The idea
A firm losing money in the short run compares price with average variable cost at its best quantity. If price covers average variable cost, producing pays some of the fixed cost and the loss is smaller than shutting down; produce. If price is below average variable cost, every unit adds to the loss; shut down and lose only the fixed cost. Compute average variable cost as variable cost over quantity, compare with price, and state the loss under each choice to prove the answer.
In practice
Worked example: at its best quantity of ten units a firm's total cost is one hundred ten, of which thirty is fixed, so variable cost is eighty and average variable cost eight dollars. At a price of nine, revenue is ninety: producing loses twenty, shutting down loses thirty; produce. At a price of seven, revenue is seventy: producing loses forty, shutting down loses thirty; shut down. The exam's question gives a price below average variable cost, and the key is shut down in the short run.
Where people slip
The test is average variable cost, not average total cost; a firm below total cost but above variable cost stays open at a loss. And shutting down is not exiting; the firm still owns its fixed inputs and pays for them, which is why the loss is the fixed cost and not zero.
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