Revision on the shut down price and deriving the supply curve
This revision note is for Unit 5 (A2 micro) and looks at when businesses might decide to close
down production or take products out of a market in the short and the long run. The key concepts
to understand here are:
Normal profit
Sub-normal profit
Expectations
Sunk costs
Shut-down price
Marginal cost
Consider the two diagrams below:
Left hand diagram: The firm is profit-maximizing at output Q1 and is making super-normal profits
because P1>C1. An outward shift in demand would cause an expansion of supply assuming the
business is aiming to increase total profits.
Right hand diagram: A different situation is shown here – costs are higher and demand is much
lower. At the profit maximizing output (where MC=MR) i.e. output Q2, the firm is making a
sizeable loss (P2<C2). Not only that, the price is insufficient even to cover the variable costs of
production (see that P2 < AVC). The firm might decide that, in this situation, it would be better
not to produce an output at all i.e. shut down production – in this case we assume that the fixed
costs are lose (they are independent of output).
Cost
Revenue
Cost
Revenue
MC
MC
AC
AC
C2
P1
AVC
AVC
C1
P2
AR
AR
MR
MR
Q1
Output
Q2
Output
This then brings in the idea of the shut-down price which is said to occur whenever price <
average variable cost (P<AVC). For a firm to justify continuing production in the short run it
needs to sell at a price that at least covers the variable costs of production.
In the long run a minimum of normal profit is needed to remain in a market for a particular
product. This occurs when P=AC (i.e. the price covers both fixed and variable costs).
The shut down price can be shown for a firm in a perfectly competitive market – in this situation
we see the effects of a fall in market demand which drives the price below average variable cost.
Market Demand and Supply
Individual Firm’s Costs and Revenues
Price (P)
Price (P)
MC (Supply)
Market
Supply
P1
P1
AR = MR
AC
AC2
P2
AR2 (Demand) =
MR2
MD1
MD2
Q1
Industry
Output (Q)
Q2
Output (Q)
Deriving the supply curve
The supply curve for a firm operating in a competitive market is the marginal cost curve for a
business for prices above the shut down point
Higher prices ► expansion of supply
Lower prices ► contraction of supply
Rise in variable cost ► inward shift of supply
Fall in variable costs ► outward shift of supply
The concept of the shut down price is often criticized!
Why should businesses close or shut down production simply because price falls below the
average variable costs in the short run or because price < average cost in the long run?
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•
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Some firms might be pricing below cost as a loss-leading strategy to gain market share
Prices may fall temporarily below cost in a recession or because of volatility in world
commodity markets
There are costs in exiting a market as well as entering a market – these should be
considered too!
These are all valid criticisms and useful for evaluation purposes – let us look briefly at exit costs
including sunk costs
Sunk costs cannot be recovered if a business decides to leave an industry. Examples include:
Capital inputs that are specific to an industry and which have little or no resale value.
Money spent on advertising, marketing and research and development projects which cannot be
carried forward into another market or industry.
When sunk costs are high, a market becomes less contestable. High sunk costs act as a barrier to
entry of new firms because they risk making huge losses if they decide to leave a market. In
contrast, markets such as fast-food restaurants, sandwich bars, hairdressing salons and local
antiques markets have low sunk costs so the barriers to exit are low.
Costs associated with leaving a market or dropping a product from your range:
1. Asset-write-offs – e.g. the expense associated with writing-off items of plant and
machinery and unsold stocks
2. Closure costs including redundancy costs, contract contingencies with suppliers and the
penalty costs from ending leasing arrangements for property
3. The loss of business reputation and goodwill - a decision to leave a market can
seriously affect goodwill among previous customers, not least those who have bought a
product which is then withdrawn and for which replacement parts become difficult or
impossible to obtain.
4. A market downturn may be perceived as temporary and could be overcome when the
business cycle turns and economic conditions become more favourable
Plant shut downs are usually the result of strategic decisions taken by businesses to relocate
production in the face of changing market demand, differences in costs from country to country
and also in the wake of changes in exchange rates and tax regimes.
Good examples of shut-down decisions / product withdrawals
Boeing shuts down production of the C-16 (2006)
Toshiba shuts down production of high definition DVD players (2008)
Soymor temporarily shuts down production at its bio-diesel plant (2008)
Scottish dairy farmers leave the industry (2007) (video clip) see also farming tradition under
threat
Rolls-Royce closes plant on Merseyside (Feb 2008)
Mortgage lenders withdraw 100% mortgages (April 2008)
Shut down of Welsh brick-making plant (March 2008)