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Discussion on: Is firm shutting down equivalent to exiting the market?

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ujjwal_poudel

The evolution of the concept and the steps for perfect competition became conducted with a perfect market, uniqueness of equilibrium, and stationary of conditions (Stigler, 1957). Here, the ultimate goal of a business firm is to generate profit. Every business houses, manufacturing companies, or production houses want to exchange goods and services for the money, and in the process, they want to increase the revenue and achieve higher profit. Generally a firm has to shut down when this target cannot be achieved in the given circumstances. It is natural to shut down if the firm is operating in loss or the price is lesser than the cost. According to Guell (2015), "A business needs to make at least normal profit in the long run to justify remaining in an industry but in the short run a firm will produce as long as price per unit > or equal to average variable cost (AR = AVC). This is called the shutdown price in a competitive market.”

For instance, a seasonal business as Christmas tree farmers may shut down entire business until next winter arrives. By doing so, they can eliminate variable cost while fixed cost remain constant.

Now, I would like to define the shutting point trough graphical representation.

In the above graph, the marginal cost (MC) curve can be divided into three zones, based on where it is crossed by the average cost (AC) and average variable cost (AVC) curves. The point where MC crosses AC is called the zero-profit point. If the firm is operating at a level of output where the market price is at a level higher than the zero-profit point, then price will be greater than average cost and the firm is earning profits. If the price is exactly at the zero-profit point, then the firm is making zero profits. If price falls in the zone between the shutdown point and the zero-profit point, then the firm is making losses but will continue to operate in the short run, since it is covering its variable costs. However, if price falls below the price at the shutdown point, then the firm will shut down immediately, since it is not even covering its variable costs.

There may be some other case as well where a government may encourage firms that produce particular products to operate for reasons of national defence or national pride. In these cases public policy may be used to subsidize the firms that would find it necessary to shut down in a free market economy (Reynolds, 2011).

References

Guell, Robert C. (2015). Issues in Economics Today , 7th edition- 2015 ISBN: 978-0078021817

Reynolds, R. L. (2011). Basic Microeconomics.

Stigler, G. J. (1957). Perfect competition, historically contemplated. Journal of political economy, 65 (1), 1-17.