Question

2.   Describe the short-run shut down decision for a firm in a perfectly competitive market. In economics, what is the difference between the short-run and the long-run?

Answer 1

In the short-run, a firm in a perfectly competitive market should shut down when its total revenue is not able to recover the total variable cost i.e. the average variable cost is higher the marginal revenue i.e. the price. In such a case, the firm loses more money by continuing production. Therefore, in a perfectly competitive market, the shutdown condition is that Marginal Revenue (MR) < Average Variable Cost (AVC).

The difference between the short-run and long-run is that in the short-run only the variable inputs, like labor can be changed. Therefore, a firm cannot increase its production potential in the short-run as fixed inputs cannot be changed in the short-run. However, in the long-run, all inputs (including fixed inputs like plants and machinery) can be changed. Therefore, a firm can increase its production potential in the long-run.