Shutdown and Break Even Decision ?

Shutdown and Break Even Decision

Firms can’t endure a loss forever. The decision to shutdown involves a comparison between short run (SR) sunk costs and variable costs.

Sunk costs are costs that cannot be escaped in the SR. For example, a restaurant owner has signed a one-year lease on a building. Sunk costs remain even if the firm’s output falls to zero.

If the firm shuts down TR = 0 and TVC = 0, but the TFC (or sunk costs) remain. Sometimes it is better to remain in operation until the sunk costs expire.

There are two rules that govern the shutdown decision. Note: these rules hold for all firms and not just perfectly competitive firms.

Rule 1: if TR > TC then the firm earns positive profits and should remain open in the SR and the LR.

Rule 2: the firm should operate in the SR if TR > TVC, but should plan to close in the LR if TR

Proof:

Loss if the firm stays in business = TC – TR

Loss if the firm shuts down = TFC = TC – TVC

So the firm should keep operating in the SR if:

TC – TR < TC – TVC

or           TR > TVC.

Reference:

Principles of Economics, N.Gregory Mankiw, 7th edition.