Example: Shut down point

The following example of two firms that produce cold drinks in a perfectly competitive market illustrates why it is in the interest of a firm to continue its production even if it makes a loss:

Given that the price of a cold drink is R5 and that each firm produces a 1 000 cold drinks, their total revenue (TR) – that is, the price times the quantity (P x Q) – is R5 000. Both firms face the same fixed cost of R2 000.

Their variable costs, however, differ. In the case of firm 1, the variable cost (VC) is R4 000, while for firm 2, it is R5 500. The reason for the difference in the variable costs might be that firm 1 is more efficient in using its resources than firm 2. The total cost of production (TC) for firm 1 to produce 1 000 cold drinks is therefore R2 000 (the fixed cost) + R4 000 (the variable cost) = R6 000; and for firm 2, it is R2 000 (fixed cost) + R5 500 (variable cost) = R7 500. In both cases, the total revenue is smaller than the total cost, and both firms make a loss. The total loss for firm 1 is R5 000 – R6 000 = -R1 000, while for firm 2, it is R5 000 – R7 500 = -R2 500.

Table: The shutdown point

Firm 1 Firm 2
Total revenue (TR) R5 000 R5 000
Fixed cost (FC)
Variable cost (VC)
Total cost (TC)		  

 

- R6 000

R2 000
+ R4 000
R6 000

  

 

- R7 500

R2 000
+ R5 500
R7 500
Total loss if it stays in business -R1 000   -R2 500  
Total loss if it shuts down -R2 000   -R2 000  

Should both firms shut down their production? Not necessarily, let's see why:

Looking at firm 1, how much would it lose if it shuts down its production?

Think again

Think again

Correct. By shutting down its production, it would lose its revenue of R5 000, but it would also avoid the variable cost of R4 000. However, it must still pay its fixed cost of R2 000. By shutting down its operations, it would therefore lose R2 000. The choice for firm 1 is either to continue with its production and lose R1 000 or shut down and lose R2 000. Which choice do you think the firm should make?

Looking at firm 2, how much would it lose if it shut down its production?

Think again

Think again

Correct. By shutting down its production, it would lose its revenue of R5 000, but it would also avoid its variable cost of R5 500. However, it must still pay its fixed cost of R2 000. The choice for firm 2 is therefore to continue its production and lose R2 500 or shut down its business and lose R2 000. What choice do you think the firm should make?

In the case of firm 1, it should keep on producing since it would only lose R1 000 as opposed to R2 000, while firm 2 should shut down its business because by doing so it would only lose R2 000. If it decides to keep the business open, it would lose R2 500. In this case, we say that firms are minimising their losses.