Question

When the oil price drops below $40 per barrel, a large number of US shale oil companies will shut down temporarily and some may close down for good. Apply the production cost functions to explaining the firm’s shut-down and exit decisions in the oil market. Be specific about the relationship between firms’ cost structure and their shut-down and exit sequence. Which type of firm is the first to shut down?

Answer 1

Over the short run firms tend to produce as long as firm is able to recover the average variable cost (AVC). And over the long run, firm would continue to produce as long as it is able to recover the Average Total Cost (ATC).

Since here oil price has declined significantly, thus it might be that firms are even able to recover the average variable cost here. thus, firms have shut down their production facility and these firms can start their production only if price becomes at least equal to the average variable cost.

The inefficient firms are first to leave the industry.