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The shutdown point

The possibility that a firm may earn losses raises a question: Why can the firm not avoid losses by shutting down and not producing at all? The answer is that shutting down can reduce variable costs to zero, but in the short run, the firm has already paid for fixed costs. As a result, if the firm produces a quantity of zero, it would still make losses because it would still need to pay for its fixed costs. So, when a firm is experiencing losses, it must face a question: should it continue producing or should it shut down?

As an example, consider the situation of the Yoga Center, which has signed a contract to rent space that costs $10,000 per month. If the firm decides to operate, its marginal costs for hiring yoga teachers is $15,000 for the month. If the firm shuts down, it must still pay the rent, but it would not need to hire labor. [link] shows three possible scenarios. In the first scenario, the Yoga Center does not have any clients, and therefore does not make any revenues, in which case it faces losses of $10,000 equal to the fixed costs. In the second scenario, the Yoga Center has clients that earn the center revenues of $10,000 for the month, but ultimately experiences losses of $15,000 due to having to hire yoga instructors to cover the classes. In the third scenario, the Yoga Center earns revenues of $20,000 for the month, but experiences losses of $5,000.

In all three cases, the Yoga Center loses money. In all three cases, when the rental contract expires in the long run, assuming revenues do not improve, the firm should exit this business. In the short run, though, the decision varies depending on the level of losses and whether the firm can cover its variable costs. In scenario 1, the center does not have any revenues, so hiring yoga teachers would increase variable costs and losses, so it should shut down and only incur its fixed costs. In scenario 2, the center’s losses are greater because it does not make enough revenue to offset the increased variable costs plus fixed costs, so it should shut down immediately. If price is below the minimum average variable cost, the firm must shut down. In contrast, in scenario 3 the revenue that the center can earn is high enough that the losses diminish when it remains open, so the center should remain open in the short run.

Should the yoga center shut down now or later?
Scenario 1
If the center shuts down now, revenues are zero but it will not incur any variable costs and would only need to pay fixed costs of $10,000.
profit = total revenue–(fixed costs + variable cost)           = 0 –$10,000           = –$10,000
Scenario 2
The center earns revenues of $10,000, and variable costs are $15,000. The center should shut down now.
profit = total revenue   (fixed costs + variable cost)           = $10,000   ($10,000 + $15,000)           = –$15,000
Scenario 3
The center earns revenues of $20,000, and variable costs are $15,000. The center should continue in business.
profit = total revenue   (fixed costs + variable cost)           = $20,000   ($10,000 + $15,000)           = –$5,000

Questions & Answers

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what is production?
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Production is basically the creation of goods and services to satisfy human wants
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Want is a desire to have something while choice is the ability to select or choose a perticular good or services you desire to have at a perticular point in time.
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Substitute are goods that can replace another good but complements goods that can be combined together
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opportunity cost reffered to as alternative foregone when choice is made
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Source:  OpenStax, Principles of economics. OpenStax CNX. Sep 19, 2014 Download for free at http://legacy.cnx.org/content/col11613/1.11
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