which of the following best illustrates deciding how to produce a specific product? This is a topic that many people are looking for. unusual-travel-destinations.com is a channel providing useful information about learning, life, digital marketing and online courses …. it will help you have an overview and solid multi-faceted knowledge . Today, unusual-travel-destinations.com would like to introduce to you The "Shut-down Rule" – When should a firm shut down in the face of economic losses? . Following along are instructions in the video below:
“In today s lesson. We re going to look at a perfectly competitive firm and and a perfectly competitive market and ask the question when should a firm shut down than stayin in the market. So in a previous lesson. We showed that in order for a perfectly competitive firm to maximize its economic profits.
It should always produce at the level of output at which its marginal revenue equals its marginal cost for an explanation on this concept. Make sure you ve watched that previous video lesson in another lesson. Previously we showed that in the long run. A firm in a perfectly competitive market will earn only normal profits in other words it will earn zero economic profits.
We can see that this firm in our graph on the right is only breaking even at the current level of output and the current price determined in the market for this firm s product. This firm is not earning any economic profits. But it is earning a normal profit meaning that the owner of this firm is perfectly happy to remain in the market since it s not only covering all of its explicit costs. But it s also earning a little bit of profit for the owner so on our graph there is no economic profit illustrated now in this video.
What we re going to determine is when would a firm such as this choose to shut down and close its business rather than remaining in the market at all clearly what would happen if the demand for this firms good increased was that it would go from breaking even to earning economic profits a firm earning economic profits clearly does not want to leave the market rather once it wants to continue to earn those profits. So we re not even going to bother to show what would happen if demand for this product increased. What we ll look at instead is what will happen if demand for this firm s product decreases. Because that s what s going to cause the price that the firm can sell this product for to fall.
And may lead this firm to leave the market in the long run. So let s look at a graph on the left. We are assuming that this firm is one of a thousand firms selling an identical product to the other 999 firms. And that the price for this firms product is determined by the demand and supply for the good in the market.
What would happen if the demand for the product that this firm is selling decreased let s show the effect of a decrease in demand for this firm s product in a graph on the left. Let s assume that demand falls from d to d. 1. The good is less popular among consumers now or a cheaper substitute came along perhaps the incomes of consumers fell any one of those things could have caused the demand for this product to decrease in our graph this product now becomes less scarce therefore.
The equilibrium price in the market decreases. We ll call this p1 now since individual firms in this market are price takers this decrease in the equilibrium price shifts. The individual firm s marginal revenue and demand curve downwards. So we can draw a new marginal revenue and demand.
Curve below. The original marginal revenue and demand. Curve m. R.
And demand for the individual firms. Output has decreased due to the fact that there is less overall demand for this product. In the market. As a whole.
So. Call. This. New curve m.
R. 1. And demand. 1.
So looking at our graph on the right. We can see that the firm has a lower demand for its individual product since it is one of a thousand firms in this market. And there is less demand for the overall output in the market as a whole now what will the individual firm. Do is demand for its product falls in order to maintain its profit maximizing level of output.
The firm must produce where the marginal revenue equals the marginal cost so we can see that the marginal revenue has fallen and we have moved down into the left along this firms marginal cost curve. Therefore. The new profit maximizing point m r. Equals.
Mc. Is at a lower level of output. So we ll draw a dotted line down here and we will record we ll acknowledge that this firm. A profit maximizer will have to produce where mr.
Equals mc. Which is at a lower level of output. Now let s examine the effect that this fallen demand had on this firms profits actually before the demand decreased. The firm was earning no economic profits now the firm is in even worse shape the firm is now earning economic losses.
So if we continue our dotted line up to the average total cost curve and over to the price and cost axis. We can now see that this firms average total cost at a quantity of q1 is greater than the price it can sell its product for the average revenue. If average total cost is greater than average revenue or price by definition this firm is earning economic losses. So we re going to shade the area that represents the economic losses that this firm is earning the yellow rectangle represents.
The losses earned by the firm resulting from the decrease in demand for its product among consumers in the market. So the question then is should this firm shut down should this firm continue to produce the goods its producing or should it shut down. Now you may say it s an easy answer to that the firm is earning losses. Why would it want to continue to produce this good.
Well. The question. Then is if the firm shuts down what does the firm lose and how does the losses of shutting down compared to the losses. The firm is earning if it stays in the market and continues to produce to answer that question we need to examine the firm s fixed costs.
Why do we examine fixed costs the fixed costs of firm faces are those which it must pay regardless of its level of output. This may include the rent of the firm owes to its landlord. If it is renting factory space for example. This includes the interest that the firm must pay on capital that it acquired before it ever started producing in the first place.
These are costs that must be paid whether the firm s producing a million units or zero units in other words. If a firm shuts down it still must pay its fixed costs. That s right if the firm shuts down it loses its fixed costs. This would be a loss to the firm.
If the firm would have shut down the landlord does not care. Whether you are producing a million widgets or zero widgets. The bank does not care how demand for your product has been affected. It wants to be paid back for the capital that it lent you so where on this graph can we show the firm s total fixed costs.
That s the question. We re going to we re going to compare total fixed costs to total losses of remaining open. If the firm shuts down it loses all of those fixed costs that it must pay regardless of its level of output. If it remains in operation it loses what it s losing the average revenue minus the average total cost.
Which is negative in this case. So let s look at a graph and examine where on this graph we can find the area representing total fixed cost well also in a previous lesson. We explained that at any level of output. Let s just choose a random point out here.
We ll call this q. X. At. Q.
X. If we wanted to know. The firm s average fixed costs. We could just find the difference between its average variable costs.
Which are right there and its average total costs so at any level of output. The difference between a tc. And avc is the average fixed cost now if we know the average. Anything we can pretty easily determine the total of that thing if we can find the average fixed cost that the firm experience is at a quantity of q1 and we multiply the average fixed cost by the quantity q1.
We can show on this graph. The area representing the total fixed costs. So let s do that we have at q1. An average fixed cost of atc that s we ve already labeled atc right here minus avc.
So if we go up to the average variable. Cost curve and draw a dotted line over this is the firm s average variable. Cost you ll recall that average fixed cost equals average total cost minus average variable cost. So that s simply the difference between the atc and the avc that is our average fixed cost.
So now that we ve we know the area of average fixed cost. We can very easily find the area representing the total fixed cost and that is simply the yellow rectangle. Which is the firm s total losses. Plus.
An additional area represented by the blue rectangle so in our graph. Here. The blue plus. The yellow represents the total fixed costs so that entire rectangle blue and yellow together.
Represents total fixed costs. The total fixed cost is what the firm will lose if it shuts down in the short run. Because it will still have to pay those costs. So should this firm shut down.
That s the question. We re trying to answer here clearly. This firm should not shut down demand is still high enough that its total losses. It will experience if it continues to produce its good are less than its total fixed costs.
Which it will lose if it stops producing this good. We have just shown an example of where a firm should not shut down. It should continue to produce this good in the short run and hope that other firms shut down and that demand for its individual product increases allowing this room to go back to a break even level of output. So we have just shown that this firm is not yet in a situation.
Where it should shut down. It is in a loss minimizing position. It is minimizing its losses by producing at the mc equals. Mr.
Point so what would have to happen for a firm to actually have to shut down we re going to clean up our graph here and show one more shift in demand that would result in a situation. In which the firm would be better off shutting down here. We are back at our original equilibrium in the market and the firm diagram next. We re going to illustrate a situation in which demand decreases by more than it did in our previous illustration therefore.
The marginal revenue demand as seen by the individual firm is too low for it to continue to operate in the shore. So we ll start with a decrease in demand in our graph on the left this time. We re going to show demand decreasing by quite a bit more than we did before let s say this product has become really really unfashionable. I usually use the example of cosette walkmans.
The portable cassette players that we all used to carry around when we were little kids. But nobody seems to carry around anymore whatsoever. Lots of companies made cassette walkmans back in the 1980s and 90s. But today.
You can t find them anywhere. This is because they ve simply been replaced by cd players and mp3 players so as demand for cassette walkmans. Fell eventually. It became so low that the price of these things was really really low.
So we ve got a new demand curve really far to the left hardly anybody demands walkmans anymore. This means. The price is going to be very low for them in the market. We got a new price of p1 and of course since the producers of these products are in a competitive market.
They face a horizontal a perfectly elastic demand curve determined by the equilibrium price in the market. So the individual producers will face a very low price resulting from this significant decrease in the demand among consumers of the good. So we ve got a new demand curve for the individual firms product called mr1 equals demand as you can see we re in a tricky situation here because according to the profit maximization rule firms should produce where marginal revenue equals marginal cost. But what if marginal revenue is lower than marginal cost all we can say is that the firm would probably want to produce where marginal cost is lowest.
Which is right here. So let s say a firm chooses to produce at that level at a quantity of q1 and it will face an average total cost that is as we can see significantly higher than the price of the product. The firm s total economic loss in this case is atc minus ar or price times. Quantity the yellow rectangle now represents the area of economic losses.
The firm will experience if it continues to produce its product. The firm at its best possible level of output is earning very very large economic losses. But are they large enough to necessitate. Shutting down to make it in this firms best interest to actually close its doors and get out of the market to answer that question we should again compare the firm s total losses to its total fixed costs and once again.
We can determine total fixed costs by finding the difference between a tc. And a vc that gives us our average fixed cost and multiplying that by the quantity that gives us an area of total fixed cost equal to the green rectangle. The firm s total fixed costs are equal to the green rectangle. This is what the firm will forgo if it shuts down and will still have to pay its rent.
And it will still have to pay the interest on its capital if it shuts down. However as we can see the total fixed cost in this case is now less than the total loss. The firm would experience if it continued to operate. So the green rectangle represents total fixed cost and as we can see that is less than the total loss of operating.
This firm should shut down this is the shut down rule in fact. If the total fixed cost is less than the total loss. The firm should shut down this ladies and gentlemen is the shutdown rule. A firm can continue to operate as long as its total fixed cost is greater than the total loss that it is experiencing when producing at its profit maximizing quantity.
However if the total loss experienced by remaining in the market exceeds. The total fixed cost then the firm can minimize its losses by shutting down paying the fixed costs that it still owes rather than continuing to operate and going into further and further debt by doing so it would make no sense for sony or any company to continue to produce walkmans in the year 2012. There is just not enough demand for walkmans yet the fixed costs of maintaining a in factory. Are too high in fact.
I remember reading recently that sony shut down its last factory producing portable cassette players in the last year or two why did it do this clearly the global demand for such products was lower than it needed to be in order to cover the firm s variable costs. The firm was better off shutting down those factories and giving up the fixed costs that were involved in the production of affordable cassette. Players. So that wraps up our lesson on what we call the shutdown rule.
If a firm is earning losses that exceed its total fixed cost of production. The firm can minimize its total losses by shutting down in the short run as some firms shut down. The supply of the good will decrease in the market causing the price to rise allowing other firms to break even once again in the long run. But as we can see here using our walkman example.
Some goods just don t get produced anymore. That wraps up this lesson on the shutdown rule. When you combine this with our two other lessons on the profit maximization rule. And the lesson on short run and long run in perfect competition.
You ve got a pretty good idea of how perfectly competitive firms interact and how they make decisions in both the short run in the long run thanks for watching. And we ll see you soon ” ..
Thank you for watching all the articles on the topic The "Shut-down Rule" – When should a firm shut down in the face of economic losses? . All shares of unusual-travel-destinations.com are very good. We hope you are satisfied with the article. For any questions, please leave a comment below. Hopefully you guys support our website even more.
This lesson illustrates two situations in which a firm in a perfectly competitive market is earning economic losses. In one case, the losses are less than the firm s total fixed costs. In another, the firm s losses exceed its fixed costs, meaning the firm is better off shutting down.
Want to learn more about economics, or just be ready for an upcoming quiz, test or end of year exam? Jason Welker is available for tutoring, IB internal assessment and extended essay support, and other services to support economics students and teachers. Learn more here! http://econclassroom.com/?page_id=5870
theory of the firm, microeconomics, perfect competition, shut-down rule, cost minimization, profit maximization, AP Microeconomics, IB Economics