So long as the firm makes at least normal profit, it is worthwhile staying in business. If
making less than normal profit – a lower return than achievable in an alternative investment
– the firm should close down. However, closing down cannot be undertaken
immediately and in the short run the firm may continue production so long as revenue
earned helps pay the burden of fixed costs. In the meantime the firm should plan its closure
and in the long run leave the industry.
In the short-run period we can identify a shut-down price, representing the minimum
price at which the firm continues to produce despite making a loss. This is
illustrated in Figure 5.16.
For simplicity of exposition we assume in Figure 5.16 the firm to be faced with a perfectly
elastic demand curve. (We will see in Chapter 7 that this corresponds to a firm in
perfect competition, where each firm has no individual control over price and is
assumed to take the market price.) With a perfectly elastic demand curve the firm can
sell extra units without lowering price. The demand curve (average revenue curve) is
therefore also a marginal revenue curve, as selling an extra unit increases total revenue at
a constant rate equal to price. Figure 5.16 shows a series of such demand curves and also
includes a short-run average total cost curve (SRAC), a variable cost curve (SRAVC) and
a corresponding marginal cost curve (SRMC).
With demand curve D5, and a price of P5, the firm equates MC to MR and sells Q5. At
Q5, average revenue (equals price) is greater than average total cost (ATC) and the firm
earns abnormal profit. If demand falls and the demand curve shifts downwards to D4,
then, with a price of P4, the firm again equates MC to MR and decreases output to Q4.