Skip to content

M06.L04 — Short-Run Supply and the Shutdown Decision

Module: Module 06 — Market Equilibrium and Perfect Competition Lesson: L04 of 05 Duration: ~30 minutes Level: Introductory Provenance: Principles of Microeconomics (Curtis and Irvine) | Khan Academy Microeconomics

Learning Objective

Determine when a firm should continue operating or shut down in the short run.

The Shutdown Rule

In the short run, firms face this critical decision:

Operate if: P ≥ AVC (covers variable costs) Shutdown if: P < AVC (can't cover basics)

Key points: - Fixed costs are irrelevant (sunk in short run) - Loss minimization ≠ shutdown decision - Applies to all market structures

Australian example: Seasonal tourism businesses - Operate in peak season (P > AVC) - Shutdown in off-season (P < AVC)

The Firm's Short-Run Supply Curve

For a price-taking firm: - Supply = MC curve above AVC - No supply below AVC (shutdown region)

Why? Because: - At P1 > ATC: Earns profit - At P2 (ATC > P > AVC): Loss but operates - At P3 < AVC: Shuts down

Worked Example

Australian Airline During COVID

  1. Pre-pandemic:
  2. P = $200/ticket
  3. AVC = $150
  4. ATC = $180

  5. Clearly operates (P > ATC)

  6. During travel bans:

  7. P drops to $100
  8. AVC = $120 (reduced flights)

  9. Decision: Shutdown (P < AVC)

  10. Recovery phase:

  11. P = $130
  12. AVC = $110
  13. Operates at loss (P > AVC)

Common Misconception

"Firms should shutdown whenever they're losing money"

Actually, firms should operate in the short run if they can cover variable costs, even if making an overall loss. This minimizes losses while waiting for better conditions.

Key Takeaways

  • Shutdown depends on variable costs, not fixed
  • Supply exists only where P ≥ AVC
  • Short-run ≠ long-run decisions
  • Real-world examples show dynamic applications

Practice

  1. Why are fixed costs irrelevant to shutdown?
  2. How would a drought affect a farm's shutdown point?
  3. What happens to industry supply if many firms shutdown?

Further Resources

Provenance: Principles of Microeconomics (Curtis and Irvine) | Khan Academy Microeconomics