Question

1)

A) If a firm operates at a loss, the loss is equal to TC - TR. If the firm shuts down instead, its loss is equal to FC. Given this, show that price must exceed AVC for the firm to operate at a loss and not shut down. (2points)

B) Explain why shutting down and going out-of-business (exiting the market) are different concepts. (2points)

Answer 1

(A)

Total cost (TC) = Total variable cost (TVC) + FC

When firm has a loss,

Loss = TC - TR = TVC + FC - TR

When firm shuts down, TVC = TR = 0, so

Loss = FC

Therefore, when firm has a loss but continues to operate, it makes a loss.

TVC + FC - TR < FC.

TVC - TR < 0

TVC < TR

(AVC x Q) < (Price x Q)

AVC < Price

(B)

Shutting down is a short-run concept. A firm shuts down when it not only makes losses but also faces a price that is lower than its AVC, so it cannot cover its variable costs with revenue. On the other hand, exiting the market is a long-run concept. In the long run, fixed costs do not exist. Therefore if in long run the firm cannot make a profit at any output level, the firm exits.