In a perfectly competitive market, firms operate under specific conditions that influence their behaviour, particularly in the short run when profits may fall. One important concept to understand is the shut down price—the minimum market price at which a firm will choose to continue operating in the short run. If the market price falls below this level, the firm will temporarily cease production rather than continue to incur greater losses.

Perfect competition assumes that all firms are price takers, meaning they accept the market price as given and cannot influence it through their own output decisions. In the short run, some costs—known as fixed costs—must be paid regardless of whether the firm produces or not. These include costs such as rent, insurance, or depreciation on capital equipment. In contrast, variable costs—such as wages for hourly workers or the cost of raw materials—only arise when output is actually produced. A firm facing a loss in the short run must decide whether it is better to continue producing and covering some of its fixed costs or to shut down and avoid incurring any variable costs.

The key to this decision lies in comparing the market price (P) with the firm's average variable cost (AVC). If the market price is equal to or greater than AVC, the firm is able to cover its variable costs and contribute something—however small—toward its fixed costs. In this case, the firm will remain in operation in the short run, even if it is making an overall loss. However, if the market price falls below AVC, the firm cannot even cover its variable costs. Producing at this price would increase the firm’s losses beyond what it would lose by simply shutting down and paying only its fixed costs. Therefore, the shut down price is the price at which P = AVC. At any price below this, the rational choice for a firm is to shut down production in the short run.

This concept is best illustrated using a cost and revenue diagram for a perfectly competitive firm. The diagram features a horizontal demand curve at the market price, which also represents marginal revenue (MR) and average revenue (AR) for the firm. The firm’s marginal cost (MC) curve slopes upward, intersecting the average variable cost (AVC) and average total cost (ATC) curves at their minimum points. The shut down point occurs where the price line touches the minimum point of the AVC curve. At this point, the firm is indifferent between producing and shutting down because it is exactly covering its variable costs. If the price were to fall below this point, the firm would incur higher losses by producing than by ceasing production altogether.