Explain the factors a profit-maximising firm will take into account when deciding whether to shut down or to carry on operating, both in the short run and in the long run

AQA A-Level Economics Paper 1 June 2019

Explain the factors a profit-maximising firm will take into account when deciding whether to shut down or to carry on operating, both in the short run and in the long run. (15 marks)

In the short-run, at least one factor of production is fixed, such as rent for a specific factory or office. Then, in the short-run, a firm would choose to shut down if average revenue is lower than average variable cost (AR < AVC). We can assume, a profit maximising firm has two choices to choose from; to continue to operate or to shut down. Also, we could assume that a firm would never be able to recover its fixed costs (such as rent) even if a firm chooses to shut down. Then, they would not take its fixed costs into account regardless of whether they shut down or continue to operate. If they shut down, the fixed costs are not recoverable. If they continue to operate, they will aim to make average revenue that exceeds their average variable costs. If they do this, they can pay money towards their fixed costs, which will eventually be cleared, and everything they produce after that would return a supernormal profit (assuming that average revenue is still higher than average variable cost).

For example, if a firm is making AR: £1000, AVC: £500 and AFC: £600, it would choose not to shut down. This is because, if it chooses to shut down, it will have wasted £600 on fixed costs. However, if it continues to operate at the chosen quantity, it would make a loss of £100 per unit. And so, since the business is covering variable costs, the firm is better off staying in business.

Secondly, in the long-run, a firm would choose to shut down only if they fail to make normal profits. Normal profit is when average revenue equals average cost. Average costs in economics factors in explicit costs such as raw materials and also implicit costs such as opportunity costs. Opportunity cost is the value of the next best alternative. For example, if a business owner's next best alternative was to accept a job with a £30,000 salary, that would be the opportunity cost of running the business, and hence an implicit cost. Then imagine, explicit costs such as raw materials cost £20,000. Then the business should make a revenue of at least £50,000 for the business owner to be motivated to operate in the long run. Hence, the long run condition for shut down is only if average revenue is lower than average costs and the business fails to make supernormal profit.