ATC now equals average revenue and the firm makes normal profit. Imagine the
demand falls again to D2 and a price of P2. Equating MC to MR results in Q2 and average
revenue now equals AVC, with total revenue (P2 multiplied by Q2) just sufficient to
cover total variable costs (AVC multiplied by Q2). As total cost (TC) equals total variable
cost (TVC) plus total fixed cost (TFC), the firm makes a loss equal to TFC. Revenue is
now only sufficient to cover variable costs.
As we assume the firm remains in the industry, in the short run it is faced with one of
two choices: to produce and make either a profit or loss, or not produce and incur a loss
equal to fixed costs.We can now see from Figure 5.16 that with demand curve D2, a price of
P2 and an output of Q2, the firm is indifferent to producing or not producing as in either
case the firm makes a loss equal to fixed costs. However, if price fell below P2, for example
to P1 and an output of Q1, average revenue is now less than AVC and revenue from sales
does not even cover variable costs. Losses would be in excess of fixed costs if the firm were
to produce. It is therefore better to cease production and incur a loss of only fixed costs.
P2 is therefore defined as the shut-down price. This is the minimum price the firm
would accept to produce in the short run. If price fell below P2, the firm should cease
production in the short run and incur a loss equal to fixed cost. With price between P2
and P4, for example at P3 with the demand curve D3 in Figure 5.16, then although the
firm makes a loss, the revenue earned more than pays the burden of fixed costs (i.e. TR is
greater than TVC). However, with prices below P4, the firm makes less than normal
profit and would cease production and leave the industry in the long run. The above
relationships are summarised in Table 5.5.