Question

Explain why a firm shuts down in the long run when a loss-making firm can cover its variable costs in the short run but cannot cover its total costs in the long run.

Answer 1

In the short run, a competitive firm will shutdown if it's revenue is less than AVC. As long as the AVC is covered, the firm will continue to operate. The supply curve in the short run will be above AVC. A firm will continue to produce as long as it covers the fixed cost.

In the long run all costs are variable. So the firm has to cover the variable costs plus the opportunity cost which is the average total costs. P= MC= Minimum average cost.The firm will make zero-profit in the long run.