Unit 3: Short Run Shut Down Position

The standard theory of the firm assumes that a business needs to make at least normal profit in the long run to justify remaining in the industry but this is not necessarily a strict requirement for a firm in the short term. Indeed many businesses make operating losses when there is a fall in market demand causing prices to fall and revenues to dip below costs.

In industries with a high income elasticity of demand the market is likely to be sensitive to changes in the economic cycle so that firms are likely to see significant changes in profitability at various stages of the business cycle.

The Shut-Down Condition: Price and Variable Cost

In the short run the firm will continue to produce as long as total revenue covers total variable costs or put another way, so long as Price per unit > or equal to Average Variable Cost (AR = AVC). The reason for this is as follows. A business’s fixed costs must be paid regardless of the level of output. If we make an assumption these costs are sunk costs (i.e. they cannot be covered if the firm shuts down) then the loss per unit would be greater if the firm were to shut down, provided variable costs are covered.

Consider the cost and revenue curves facing a business in the short run shown in the diagram below. The market equilibrium price is P1 which means that the equilibrium output for the firm (where MR=MC) is at output Q2. The business is making an economic loss at this price (AC > P1) but the price is high enough for the business to cover all of its variable costs and also make some contribution to its fixed costs. If we assume that most of the fixed costs are lost if the firm shuts down, then the firm can justify continuing to produce in the short run, losses will be greater if they close down.

In the second example in the diagram below, the market price is so low that the firm is not covering its variable costs let alone the fixed costs. Losses can be cut if the firm shuts down some of their productive capacity.

The shut down price for a business in the short run is assumed to be the price which covers average variable cost. Therefore if price < AVC then the supplier is better off closing down a plant. We can use the concept of the shut down price to derive the competitive firm’s supply curve. The supply curve is the marginal cost curve above the shut down point


Example of the Shut-Down Price – The UK Electricity Market

Powergen announced in October 2002 that it planned to shut-down more than a quarter of its UK power stations, mothballing sufficient capacity to provide electricity for the whole of London. The company said the electricity market was “bust” after a price slump. Powergen will close the power station on the Isle of Grain in Kent and the Killingholme plant in Lincolnshire. UK electricity prices have fallen by almost 40 per cent since 1998 as a result of intense competition and the introduction of new trading arrangements, which have coincided with a decline in industry demand.

Powergen said that it was receiving between £13 and £15 per megawatt hour, compared with a cost of about £18 for gas-fired plant and costs of £40 per MWh for older, inefficient oil-fired plant. The decline in electricity prices has pushed British Energy, the nuclear generator, to the brink of insolvency, forcing the Government to grant a £650 million emergency loan facility.