Question

What is the rationale for a firm under perfect competition to i) shut down? and to ii) exit? Defend your answer with an example

Answer 1

I) A firm will shut down when the price falls below the minimum Average variable costs as the firm will only produce when it is able to recover its variable costs of running the business on day to day basis because it has to pay for employees and labor costs. When it is unable to recover its variable costs, it shuts down the production in the short run

II) A firm will exit the market when it is unable to recover its total costs. Total costs include both variable and fixed costs and in the long run, all the costs are variable so when the firm is unable to recover its total costs in the long run, it will incur a loss and it is better to exit the market than to keep operating and making losses.