The shutdown rule: keep going, close for now, or leave
Learning goals
After this page, you can:
- Compare the loss from operating with the loss from shutting down (the fixed cost), and state the rule: operate if P ≥ min AVC, even at a loss; shut down if P < min AVC.
- Tell a short-run shutdown (temporary, fixed costs still paid) from a long-run exit (permanent), and place a price in one of three zones.
- Explain why a firm’s short-run supply curve is its MC curve above min AVC, and why a change in fixed cost moves the break-even price but not the shutdown price.
The idea
In spring 2020 the oil price collapsed. Shale producers went well by well and asked one question: does today’s price still pay for lifting the next barrel? Where it did not, they closed the well and waited. The money spent drilling was gone either way. The land lease was paid either way. Some producers left the industry only later, when prices stayed too low to cover all their costs.
That story holds the whole rule. Let’s take it apart.
Two kinds of cost. A fixed cost is paid even if you produce nothing this season: a lease, a loan payment, insurance. A variable cost goes away when you stop: fuel, seed, hourly labor, ingredients. In the short run you cannot escape the fixed cost. You can only choose whether to also pay the variable cost.
Compare two losses, not “profit vs. loss”. A firm that is losing money has two options.
- Operate. Loss = total cost − revenue.
- Shut down for now. Revenue is zero and variable cost is zero. Loss = the fixed cost.
Pick the smaller loss. A loss alone is never the reason to stop. The question is whether operating loses less than closing.
The rule in one line. Operating beats closing when revenue covers the variable cost. Per unit, that means the price covers average variable cost (AVC), variable cost divided by output. Every dollar of price above AVC helps pay the fixed cost, which you owe anyway. So: operate if P ≥ min AVC. Shut down if P < min AVC. The lowest point of the AVC curve is called the shutdown price.
For a company you can use totals instead: keep operating while revenue ≥ variable cost.
Three zones. The lowest point of ATC is the break-even price. At that price profit is zero. Now every price falls into one of three zones.
- P < min AVC — shut down now. Revenue does not even cover variable cost.
- min AVC ≤ P < min ATC — operate at a loss. Revenue covers variable cost and part of the fixed cost. Stay open in the short run. If this lasts, plan to leave.
- P ≥ min ATC — operate at a profit.
Shutdown is not exit. A shutdown is temporary. You stop producing, but you keep the farm, the store or the well, and you keep paying the fixed costs. Think of a beach café that closes for the winter, an airline that drops a route until spring, or an oil well that is capped. Exit is permanent. You end the leases, sell the equipment and leave the industry. That is a long-run decision. In the long run no cost is fixed — leases end and loans get paid off. So in the long run the firm needs the price to cover all its costs: P ≥ min ATC. If the price is stuck below ATC with no recovery in sight, exit is the right call.
The supply curve falls out of the rule. A price taker produces where P = MC. That is true at every price, as long as the price is at or above min AVC. Below that, it produces nothing. So the firm’s short-run supply curve is its MC curve above min AVC, and zero below it. Slide the price down in the tool below and watch the dot jump to zero at the shutdown price.
Fixed costs move only one threshold. Suppose the landlord raises the lease. That is a fixed cost. AVC does not change, so the shutdown price does not change either. ATC rises, so the break-even price goes up. A higher fixed cost makes the business less attractive in the long run. It changes nothing about this season’s decision to operate.
Using the rule on a real company. Real firms rarely publish AVC. You will estimate it from a cost split, like the one you built in Week 3. Your numbers are at today’s volume, not at the lowest point of the curve. That is fine for a rough call. Say clearly what you had to assume.
Loss if you operate = TC − P × q · Loss if you shut down = FC
Shut down if P < min AVC (totals: revenue < variable cost) · Operate at a loss if min AVC ≤ P < min ATC · Profit if P ≥ min ATC
Short-run supply = MC above min AVC; zero below it.
Try it
Part A: trace the supply curve. Same Cedar Ridge farm as the last page. Lowest AVC is $4.00; lowest ATC is $7.50.
- Start at $8.50 and slide the price down slowly. Watch the trail of dots. That trail is the supply curve.
- Find the price where the dot jumps to zero. Compare the two losses in the readout just above and just below it.
- Set the price to $6.50. Which zone are you in? What is the best choice?
Part B: judge a real decision. Built for the exit or closing decision your company made. The Lab uses the same rule with a wheat farm.
- Read the verdict for the fictional flour line already filled in.
- Press Use my numbers (or type your segment’s revenue and costs). Write what you had to assume.
- Press Export PNG and paste the picture into your Playbook page.
Worked example
Problem. Cedar Ridge farm: fixed cost $20 thousand; lowest AVC $4.00 (at 4 thousand bushels); lowest ATC $7.50 (at 8 thousand). What should it do at $8.50, $6.50 and $3.50?
Step 1. $8.50 — green zone. The price is above min ATC. Grow 9 thousand bushels. Profit = +$8.0 thousand.
Step 2. $6.50 — amber zone. Grow 7 thousand. Revenue = 6.50 × 7 = $45.5 thousand. Variable cost = $33 thousand. Revenue covers all the variable cost and $12.5 thousand of the $20 thousand fixed cost. Operate: −$7.5 thousand. Shut down: −$20 thousand. Operate.
Step 3. $3.50 — red zone. The best it can do while operating is 4 thousand bushels. Revenue = $14 thousand; total cost = $36 thousand; profit = −$22 thousand. Shut down: −$20 thousand. Shut down for the season, and keep the land.
Step 4. The supply schedule. $3.50 → 0 · $4.00 → 4 · $5.00 → 5 · $6.50 → 7 · $8.50 → 9 thousand bushels.
Step 5. A company version. A fictional flour-milling line earns revenue of $12.0 million on 3.0 million bags. Variable cost is $10.2 million. Total cost is $13.5 million. Per bag: P = $4.00, AVC = $3.40, ATC = $4.50. Operate: −$1.5 million. Shut down: −$3.3 million (the fixed cost). Operate at a loss in the short run; exit in the long run if prices do not recover.
Step 6. A fixed-cost check. The farm’s lease rises by $5 thousand. The shutdown price stays $4.00. The break-even price rises from $7.50 to about $8.13 (65 ÷ 8).
Check yourself
A soybean farm pays $30,000 a year in fixed costs (land lease and equipment loan) whether it plants or not. If it plants this year, revenue will be $90,000 and variable cost $75,000. What is the best choice?
Operate while revenue covers variable cost; fixed costs are paid either way.
A wheat farm’s lowest average variable cost is $4.00 a bushel and its lowest average total cost is $7.50. This season the market price is $3.80. What should the farm do?
Price below min AVC: shut down now; leaving the industry is decided in the long run.
A farm’s lowest AVC is $4.00 (reached at 4,000 bushels) and its lowest ATC is $7.50. Its marginal cost is $5.00 at 5,000 bushels, $6.50 at 7,000 and $8.50 at 9,000. How much does it supply at prices of $3.50, $5.00, $6.50 and $8.50?
Short-run supply is the MC curve above min AVC, and zero below it.
The landlord raises a wheat farm’s yearly land lease by $5,000. The farm’s shutdown price is $4.00 a bushel before the increase. What happens to it?
Fixed costs move the break-even price (min ATC), not the shutdown price (min AVC).
A small refinery’s price has covered its average variable cost but not its average total cost for three years, and the owners expect no recovery. Its equipment lease ends next year. What is the best long-run move?
Below ATC with no recovery in sight: operate for now, exit when the fixed costs become avoidable.
Video
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