Let’s face it – most students dread studying Micro-Economics. I confess I was one such student many years ago.
In particular, many students find the topic on the Production and Cost of Firms difficult to understand and relate to.
There is the Total Cost (TC), Average Cost (AC), Fixed Cost (FC), Variable Cost (VC), Marginal Cost (MC), Marginal Revenue (MR)…not to mention various monstrous cocktails of these terms, Average Fixed Cost (AFC), Average Variable Cost (AVC) etc.
The list goes on! Not surprisingly, by the time students get to the Shut-Down Condition theory for Firms, they have already “shut down” themselves.
My job today is to simplify and demystify this abstract-looking theory. So do read on!
The Shut-Down Condition in 3 sentences.
Ready? Here goes:
If P < AVC < AC, shut down in the short-run.
If AVC < P < AC, operate in the short-run, shut-down in the long-run.
If AVC < AC < P, operate in the long-run.
And That’s It!
To be clear:
- “P” is Price
- “AVC” is Average Variable Cost
- “AC” is Average (Total) Cost
All I did was to express the theory in a single Inequality statement with 3 variables, and swop the position of “P” from left to right for each condition.
This is a much neater representation and something I teach my students to avoid unnecessary memory-work for their exams.
If at this stage, you start to wonder if it is a little too “simple” to be true, your gut feel is right. And that’s because the slightly trickier part is the explanation behind these theoretical conditions.
And that’s exactly what I will be covering next.
But remember, AVC is always before AC in these Inequality Statements.
Because in theory, there is no such thing as AC < AVC, which states that the Average Cost is less than the Average Variable Cost.
Looking at a usual cost formula we are familiar with, we see that:
Average Cost = Average Variable Cost + Average Fixed Cost
Having AC < AVC would therefore imply that Average Fixed Cost is negative, which is not possible in this theoretical framework. So don’t make this mistake in the exams!
De-mystifying the Shut-Down Conditions in 4 quick paragraphs.
Before we analyse proper, we must note the following assumptions:
- The objective of a firm is assumed to be profit-maximising, or when making losses, loss-minimising.
- Fixed cost is taken to be sunk cost in the short-run and is therefore not a considering factor in the short-run.
In the first scenario, when P < AVC < AC, the firm should shut-down immediately because the per-unit revenue is exceeded by the marginal cost in producing a unit of good. The loss in that case is then minimised to only the fixed cost.
In the second scenario, when AVC < P < AC, the per-unit revenue exceeds the marginal cost in producing that unit of good. Hence the firm should operate in the short-run to cover some of its fixed cost, and the resultant loss would be less than the fixed cost.
It is very straightforward in the third scenario, when AVC < AC < P. The firm should operate in the long-run as it is profitable even taking fixed cost into account (i.e. total cost).
And there you have it! A simple explanation that I teach my students to great effect.
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