Real-World Examples of Firms Using the Shutdown Rule (P < AVC)

📚 Quick Study Guide

• 📉 The Shutdown Rule: A firm should cease production in the short run if the market price ($P$) falls below its average variable costs ($AVC$).
• 🧮 Formula: Shutdown if $P < AVC$. Keep operating if $P \geq AVC$.
• ⏱️ Timeframe: This rule applies in the short run when fixed costs are unavoidable.
• ⚠️ Rationale: By shutting down, the firm minimizes its losses to only its fixed costs. Continuing to operate would mean covering fixed costs PLUS a portion of the variable costs at a loss.
• 🏢 Examples: Consider a restaurant during off-season or a small manufacturing plant facing a temporary drop in demand.

🧪 Practice Quiz

1. Which of the following conditions would MOST likely cause a firm to consider shutting down in the short run?
   1. A) Price is greater than average total cost.
   2. B) Price is equal to average total cost.
   3. C) Price is less than average variable cost.
   4. D) Price is equal to average fixed cost.
2. A small bakery is experiencing a temporary decrease in customers due to road construction. Their daily revenue barely covers the cost of ingredients and hourly wages. Which cost should they PRIMARILY consider when deciding whether to shut down temporarily?
   1. A) Fixed costs like rent and equipment leases.
   2. B) Variable costs like ingredients and labor.
   3. C) Total costs, including both fixed and variable.
   4. D) Marginal costs of production.
3. A farmer is deciding whether to harvest their current crop. The market price for the crop has fallen significantly due to oversupply. According to the shutdown rule, what should the farmer do if the price is less than the average variable cost of harvesting?
   1. A) Harvest the crop to cover at least some of the fixed costs.
   2. B) Harvest only part of the crop to reduce losses.
   3. C) Not harvest the crop and minimize losses to fixed costs.
   4. D) Harvest the crop and store it until the price increases.
4. A tech startup is burning through cash. Their revenue covers some, but not all, of their operating expenses. Which of the following factors is MOST critical in determining if they should shut down?
   1. A) The amount of venture capital they have remaining.
   2. B) The difference between price and average fixed cost.
   3. C) The difference between price and average variable cost.
   4. D) The market capitalization of the company.
5. A concert venue is hosting fewer events due to seasonal changes. If the revenue from ticket sales is lower than the cost of paying hourly staff and utilities, what action should the venue consider based on the shutdown rule?
   1. A) Increase ticket prices to cover all costs.
   2. B) Continue hosting events to maintain brand recognition.
   3. C) Temporarily close the venue until demand increases.
   4. D) Reduce fixed costs by selling assets.
6. An oil drilling company is facing low oil prices. Their variable costs include labor, electricity, and chemicals needed for extraction. When should they consider shutting down an oil well?
   1. A) When the price of oil is less than the average total cost of extraction.
   2. B) When the price of oil is equal to the average fixed cost of extraction.
   3. C) When the price of oil is less than the average variable cost of extraction.
   4. D) When the price of oil is equal to the marginal cost of extraction.
7. A software company offers a subscription-based service. If the monthly subscription revenue falls below the cost of server maintenance and customer support, the company should:
   1. A) Increase marketing spending to acquire more customers.
   2. B) Shut down the service if the revenue is less than average variable costs.
   3. C) Continue operating, assuming fixed costs are already sunk.
   4. D) Reduce fixed costs by laying off employees.