Short on time? This page is the recap. For explanations, the cost-curve graph and worked examples, use the full study guide.
Recap
- Short run: some inputs are fixed, so TFC must be paid even at zero output. The choice is produce or shut down.
- Fixed costs are paid either way, so they do not affect the shutdown decision.
- Long run: all inputs and costs are variable. The choice is stay, enter or exit.
- Firms respond to economic profit (implicit costs included), not accounting profit.
- Without barriers to entry or exit, firms enter markets with economic profit and exit markets with expected economic losses.
Key relationships
| Relationship | How to use it |
|---|---|
| Produce if TR ≥ TVC, or P ≥ AVC | test at the MR = MC output |
| Result if shut down = −TFC | the benchmark for any loss |
| Loss while producing = TFC − (TR − TVC) | smaller than TFC whenever TR > TVC |
| Shutdown price = minimum AVC | below it, produce nothing |
| Break-even price = minimum ATC | below it, the firm makes an economic loss |
| Price at best output | Short run | Long run (if expected to last) |
|---|---|---|
| P > ATC | produce, economic profit | new firms enter (if no barriers) |
| P = ATC | produce, normal profit | no entry or exit |
| AVC ≤ P < ATC | produce at a loss | firms exit |
| P < AVC | shut down, loss = TFC | firms exit |
Assumptions behind the model
- The firm chooses output by MR = MC before testing whether to produce.
- In the short run, fixed costs cannot be avoided; in the long run, they can.
- Entry and exit happen only when there are no significant barriers.
Mistakes to avoid
- Shutting down whenever there is a loss (P < ATC). The short-run test is P < AVC.
- Including fixed cost in the shutdown comparison.
- Saying a firm that shuts down has zero costs.
- Treating shutdown and exit as the same thing.
- Using accounting profit to predict entry or exit.
- Forgetting that barriers to entry can stop new firms arriving.
Quick self-check
- TR = $900, TVC = $700, TFC = $500. Produce or shut down, and what is the result? (Produce: −$300, better than −$500.)
- Minimum AVC is $12 and minimum ATC is $18. The price is $15. What happens in the short run and the long run? (Short run: produce at a loss. Long run: exit if the price is expected to stay at $15.)
- Why can’t a firm “shut down” in the long run? (In the long run it has no fixed costs, so producing nothing means leaving the market: that is exit.)
Next: practice questions.