Introduction

There is another way of explaining the shutdown rule, that is, by comparing the price of the product (P), which is also the average revenue (AR), with the average variable cost of production (AVC). Remember:

$$\text{Average Variable cost} = {\text{Total variable cost} \over \text {Quantity produced}}$$

In the above example, the average variable cost to produce 1 000 cold drinks for firm 1 is R4 000 ÷ 1 000 = R4 per cold drink, while for firm 2 it is R5 500 ÷ 1 000 = R5,50.

As long as the price (and average revenue) is greater than the average variable cost, it is in the interest of the firm to continue production. This is the case for firm 1 where the average revenue is R5 and the average variable cost is R5.

P = AR > AVC keep on producing

If the price is lower than the average variable cost, the firm should shut down its business. This is the case for firm 1, where the average revenue is R5 and the average variable cost is R5,50.

P = AR < AVC to shut down production

The following diagram provides a summary of the shutdown rule for the firm:

In terms of a diagram, it can be represented graphically as follows:

The shutdown point for the firm is where P = AR = AVC. At a point below the shutdown point, the average revenue is smaller than the average variable cost and the firm should shut down its production.

Activity

Indicate whether the firm should continue production or shut down.

Its average revenue is R12, while its average variable cost is R15.

Think again

Correct. Shut down. Since its average revenue is smaller than its average variable cost, it should shut down.

Its average revenue is R10, its average cost is R12 and its average variable cost is R8.

Correct. Since its average revenue is greater than its average variable cost, it should continue with production. The firm has some revenue left to pay some of the fixed costs.

Think again

Its total revenue is less than its total variable cost.

Think again

Correct. It should shut down. If total revenue (area 0-P1-A-Q) is less than total variable cost (area 0-P2-A-Q), it implies that average revenue is less than average cost.

The price is greater than the average variable cost.

Correct. It should continue. The price is equal to average revenue, and if average revenue is greater than average variable cost, the firm should continue with production.

Think again

Use the diagram to complete the following sentence:

The breakeven point is represented by point _____ and the shutdown point by point ______.

Click to Show Answer

The breakeven point is represented by point A and the shutdown point by point B.