Short-Run Production and Long-Run Entry or Exit Decisions: Study Guide (Microeconomics 3.6)

Two different time periods, two different decisions

In Topic 3.5 you found the best output: where MR = MC. That output can still make a loss. This topic asks what a firm does next, and the answer depends on the time period.

• Short run: at least one input is fixed, such as a building lease, a machine or a loan. The firm must pay its total fixed cost (TFC) even if it produces nothing. Its choice is produce (positive output) or shut down (zero output). A firm that shuts down is still in the market. It can start again later.
• Long run: every input can be changed, so all costs are variable. The lease can end, the machines can be sold. Now the firm can exit the market completely, and new firms can enter.

	Shut down	Exit
Time period	short run	long run
Output	zero, for now	zero, for good
Fixed costs	still paid	no longer paid
What the firm compares	TR with TVC (or P with AVC)	TR with TC (or P with ATC), including implicit costs

The short-run decision: produce or shut down

A firm that shuts down still pays its fixed costs. It earns no revenue and pays no variable costs. So:

Result if the firm shuts down = −TFC (a loss equal to its fixed cost)

If it produces at its best output (MR = MC), its result is TR − TVC − TFC. Compare the two:

• Producing is better when TR − TVC − TFC > −TFC, which is when TR > TVC.
• Shutting down is better when TR < TVC.

Fixed cost appears on both sides, so it cancels out. It must be paid either way, so it should not affect the decision. This is the key idea of the topic.

Dividing by quantity gives the same rule per unit. TR ÷ Q is the price (for a firm that sells every unit at one price) and TVC ÷ Q is average variable cost:

• Produce if P ≥ AVC at the best output.
• Shut down if P < AVC at every output.

If P exactly equals AVC, the firm loses its fixed cost either way, so it is indifferent.

Why producing at a loss can make sense

When TR > TVC, the firm covers all its variable costs and has money left over. That leftover, TR − TVC, pays part of the fixed cost. The loss is then smaller than TFC. Shutting down would throw that contribution away.

Loss while producing = TFC − (TR − TVC)

Three cases on a cost-curve graph

For a firm that takes the market price, MR = P. It finds its best output where MC crosses the price line, then compares the price with ATC and AVC at that output:

Price at the best output	Result	Short-run decision
P > ATC (P₁)	economic profit	produce
P = ATC (at B)	zero economic profit (normal profit)	produce
AVC < P < ATC (P₂)	economic loss, smaller than TFC	produce: minimizes the loss
P = AVC (at S)	loss equal to TFC either way	indifferent
P < AVC (P₃)	producing would lose more than TFC	shut down: loss = TFC

Two prices have names:

• Break-even price = minimum ATC (point B). Below it, the firm makes an economic loss.
• Shutdown price = minimum AVC (point S). Below it, the firm shuts down.

Point S is always below and to the left of point B. ATC = AVC + AFC and AFC is always positive, so ATC is above AVC at every output. At S, MC equals AVC but is still below ATC, so ATC is still falling there and reaches its minimum at a larger output.

Worked example 1: one firm, four prices

Question. Ashgrove Mushrooms, a fictional farm, sells crates of mushrooms at the market price. It cannot change the price. Its fixed cost (rent on growing sheds) is $60 per day.

Crates per day (Q)	0	1	2	3	4	5	6	7	8
TVC ($)	0	26	46	63	80	100	126	161	208
MC ($)	–	26	20	17	17	20	26	35	47
AVC ($)	–	26	23	21	20	20	21	23	26
ATC ($)	–	86	53	41	35	32	31	31.57	33.50

(a) Find the shutdown price and the break-even price. (b) For prices of $40, $24 and $17, find the best output, the profit or loss, and the short-run decision. (c) What happens at a price of $20?

(a) Minimum AVC is $20 (at 4 or 5 crates), so the shutdown price is $20. Minimum ATC is $31 (at 6 crates), so the break-even price is $31.

(b)

Price $40. MC is at or below $40 up to the 7th crate ($35); the 8th crate’s MC is $47. Best output = 7 crates. TR = 40 × 7 = $280; TC = $60 + $161 = $221. Profit = $59. Produce.

Price $24.

1. MC is below $24 for crates 2 to 5 ($20, $17, $17, $20); the 6th crate’s MC is $26 > $24. Best output = 5 crates.
2. TR = 24 × 5 = $120; TVC = $100; TC = $160. Result = −$40.
3. TR ($120) > TVC ($100), so produce. The extra $20 pays part of the fixed cost.
4. Check per unit: P = $24 is above AVC = $20 but below ATC = $32. Loss = (32 − 24) × 5 = $40.
5. Shutting down would lose the full $60. Producing saves $20.

(The 1st crate’s MC of $26 is above $24, but MC is still falling there. Looking only at the first crate would be a mistake: the totals show that 5 crates is best.)

Price $17. At every output, TR is less than TVC. For example, at 4 crates TR = $68 but TVC = $80. Producing any quantity would lose more than $60, and the smallest loss from producing is $69 (1 crate). Shut down: loss = $60. P = $17 is below the minimum AVC of $20.

(c) At $20, the best the farm can do by producing (4 or 5 crates) is TR = TVC, so its loss is $60, the same as if it shut down. The farm is indifferent. This is exactly the shutdown point.

Interpretation. A falling price first turns profit into loss (below $31), but the farm keeps producing. Only when the price drops below $20 does it stop, because only then does it fail to cover the cost of the crates themselves.

The long-run decision: enter or exit

In the long run the sheds’ lease ends and the machines can be sold, so there are no fixed costs. A firm can avoid all its costs by leaving. Now it compares total revenue with total cost, including implicit costs (the normal return the owner could earn elsewhere, Topic 3.4).

• Expected economic profit (P > ATC): resources earn more here than in their next-best use. If nothing blocks them, new firms enter.
• Expected economic loss (P < ATC): the owners could earn more elsewhere. Firms exit when they can, such as when a lease ends.
• Zero economic profit (P = ATC): owners earn a normal profit. No one has a reason to enter or leave.

Two conditions matter:

1. Economic, not accounting, profit drives the decision. A firm with a positive accounting profit may still exit if its owner can earn more elsewhere.
2. Entry needs low barriers. If a licence, a patent or very high start-up costs block new firms, economic profit can last. Without barriers, profit attracts entry until it disappears. You will see how entry and exit move the market price in Topic 3.7.

Worked example 2: a kayak business through the short run and long run

Question. Tidewell Kayak Hire, a fictional firm, rents kayaks for one season. Figures are per year.

• Total revenue: $120,000
• Explicit variable costs (guides’ wages, repairs, fuel for the support boat): $70,000
• Explicit fixed costs (boathouse lease and insurance, paid for the season whatever happens): $40,000
• Implicit cost: the owner has tied $140,000 of her own savings up in kayaks, which could earn $14,000 a year elsewhere. The kayaks cannot be sold during the season.

(a) Calculate accounting profit and economic profit. (b) Should Tidewell operate this season or shut down? What is its result each way? (c) If these figures are expected to continue, what should it do when the lease ends? (d) A new marina brings more visitors. Revenue rises to $150,000 and variable costs to $82,000. What is the new economic profit, and how might other firms respond?

(a)

1. Accounting profit = $120,000 − $70,000 − $40,000 = $10,000.
2. Economic profit = $10,000 − $14,000 = −$4,000, an economic loss.

(b)

1. TR ($120,000) > TVC ($70,000), so operate.
2. Operating: result = −$4,000.
3. Shutting down: the lease, insurance and tied-up savings still cost $40,000 + $14,000 = $54,000, so result = −$54,000.
4. Operating loses $50,000 less, because revenue covers the variable costs and $50,000 of the fixed costs.

(c) When the lease ends, every cost becomes avoidable. Total revenue ($120,000) is below total economic cost ($124,000). The owner could sell the kayaks and earn more from her money elsewhere, so Tidewell should exit if the loss is expected to continue. The positive accounting profit does not change this.

(d) Accounting profit = $150,000 − $82,000 − $40,000 = $28,000. Economic profit = $28,000 − $14,000 = $14,000. Resources now earn more here than elsewhere, so new kayak firms have a reason to enter, as long as nothing blocks them. If the council allows only one boathouse licence on the beach, entry is blocked and Tidewell may keep its economic profit.

Check. In (b), the difference between the two results ($50,000) equals TR − TVC, as the rule predicts.

Common misconceptions

• “A firm making a loss should shut down.” Not in the short run if P ≥ AVC (TR ≥ TVC). Shutting down saves only variable costs.
• “Shut down if price is below ATC.” Below ATC means a loss; it does not mean shut down. The short-run test uses AVC.
• “Shutting down means the firm has no costs.” It still pays TFC. Only exit, in the long run, ends fixed costs.
• “Shutdown and exit are the same.” Shutdown is temporary and short run; exit is permanent and long run.
• “Positive accounting profit means a firm will stay.” Firms respond to economic profit. Implicit costs count.
• “Economic profit always attracts new firms.” Only when there are no significant barriers to entry.
• “Fixed costs should be included when deciding whether to produce.” In the short run they are paid either way, so they cancel out.

Where this leads

Topic 3.7 puts the pieces together for a perfectly competitive market: how entry and exit move the market price until firms earn zero economic profit in the long run. Read Topic 3.7: perfect competition. First, test yourself with the practice questions, then use the revision notes and the checklist. For the MR = MC rule used here, see Topic 3.5: profit maximization.