(Original post by ezioaudi77)
The diagram above is a simplified version of the below diagram. In the above diagram, it assume average revenue is constant, making marginal revenue constant as well. This means there is only one line for both MR and AR, so explanation is much simpler.
In the short-run, as long as a firm can cover its variable cost, it will continue production, even if fixed costs are not covered
IF the firm shuts down, it will incur a greater
loss than if it continues production. The firm will at least make a little contribution to covering fixed costs if it continues production, but if it shuts down, all
fixed costs are lost.
So the firm stays in the industry as long as its AR is even a little greater than AVC.
But, if a firm isn't able to cover the variable cost, it will cease production. This is because all the fixed cost cannot be covered anyway, and remaining in business would yield greater losses.
So the shutdown point is when the firm earns less than its variable cost.
In the diagram, average revenue(P2
) is less than average variable costs(P3
) so it will cease production.
this is in the short run
, so the firm is only interested in covering up fixed costs. But in the long run, the firm will shutdown even if it earns less than the Total Cost. Just remember that. But if you want an explanation, see the spoiler.
A profit maximiser wants to make profits. So even if no profits are made in the short run, at least in the long run it should be able to make profits (AR-AC).But if AC>AR, i.e. abnormal losses are incurred, so there is no point in remaining in business.
To sum up,
In the short-run, the firm will shutdown if
In the long-run, the firm will shutdown if
I don't know how to simplify this further, so anyone else is welcome to do better explanation or point out any flaws in mine.