Micro CHAPTER 3.6:

CHAPTER SUMMARY

Firms operate because they want to make money. If operating is causing them to lose money, it makes more sense for them to shut down the business in the short-run. We figure out whether a business should do this using the shut-down rule. The shut-down rule states that, if MR >= AVC at the point where MR = MC, the business should continue operating. However, if MR < AVC at the point where MR = MC, the business should shut down in the short-run.

In the chart on the left, you can see that the AVC (average variable cost) at the profit maximization point is $7, while the marginal revenue/selling price is only $5. In this case, the business is better off shutting down operations and just paying its short-run fixed costs, because it is losing money from its operations (revenue - variable costs).

However, as you can see in the chart on the right, if the AVC is less than the MR at the profit maximization point, but ATC is greater than MR at the same point, the business should continue to operate in the short-run. This is because, in the short run, the business has to pay the fixed costs whether it operates or not, so it should only look at the variable costs when deciding whether to operate in the short-run.

As we have said before, in the long run, all costs are variable, so in the long-run, ATC = AVC. That means that a business can use the same logic as in the short-run to make a decision about whether to operate. If the long-run AVC (which is equal to the ATC in the long run) is higher than the MR (selling price) at the profit maximization point, the business should exit the market (permanently shut down its operations).

Other firms can also use this information to decide whether to enter a market. If outsiders see that firms are earning a long-run economic profit, then we expect more firms to enter the market. We expect that this would increase supply, causing all firms' MR to fall, until it reaches the level of normal profit.

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