After you have worked through this section of the learning unit, you should be able to:
- identify and describe the shutdown point with the aid of a diagram
When should a firm considering shutting down its production? The first warning lights for a firm to consider shutting down its production is when the total revenue (TR) the firm receives for its product is less than the total cost of production (TC).
However, making a loss is not a sufficient enough reason for a firm to shut down its production in the short run. To understand why it might be in the interest of a firm to continue production even if it makes a loss, we need to revisit the difference between fixed and variable costs.
Table: Fixed costs and variable costs
|Fixed costs (FC)||Variable costs (VC)|
|§ The costs that remain constant irrespective of the level of output that is produced. Even if the level of production of a firm is zero, it must still pay its fixed costs.
§ As the firm increases production, the fixed costs do not increase but remain the same.
§ Examples of fixed costs are the cost associated with the maintenance of a building, factory or equipment and the rent that must be paid even if it shuts down its operations.
§ Fixed costs are also known as sunk, unavoidable, overhead or indirect costs.
|§ The costs that change with the level of output. They represent the cost of the variable inputs. As more of a good or service is produced, the variable costs increase.
§ Include payments for raw materials, power, labour services, water, etc.
§ Are also called direct costs, prime costs or avoidable costs.
§ These are the costs that the firm can avoid if it shuts down its operations.
§ In the long run, all inputs are variable, a firm can build another factory or sell the one it has.
Fixed cost is only fixed in the short run. In the long run a firm can cancel the rental agreement for the factory.