Home > Economics FAQs Blogs > Is the point at which AVC equals P the shutdown point?
This question pertains to topics in Microeconomics, such as Firm Behaviour and Costs of Production.
Average Variable Cost (AVC): Average variable cost is the total variable cost per unit of output. Variable costs are those costs that vary with the level of output, such as costs of raw materials or hourly wages.
Price (P): Price refers to the amount a customer pays for a product or service.Shutdown Point: The shutdown point is the level of production where the price of a good or service equals the minimum point on the average variable cost curve. At this point, the firm is just covering its variable costs and is indifferent between producing and shutting down.
In the short run,
a firm's decision to produce or not is influenced by the comparison of the price it receives for its goods and the average variable cost of production. If the price is less than AVC, the f
irm will not cover its variable costs by producing and selling its goods. Thus, it will minimise its losses by ceasing production, leading to a shutdown.
When the price equals the average variable cost (P=AVC), it is known as the shutdown point. At this point, the firm is just covering its variable costs, but it is not contributing anything towards its fixed costs. While it doesn't make any profit, it doesn't make any loss either, from the variable cost point of view.
However, the firm would still incur fixed costs, regardless of whether it produces or not. In this case, a rational firm would still choose to operate in the short run to minimise the losses (since stopping production would mean making losses equal to fixed costs).
Covid-19 and the Hospitality Industry: During the COVID-19 pandemic, many restaurants found themselves at the shutdown point. With social distancing measures in place, their capacity was severely reduced. As a result, the price they could charge per meal (due to decreased demand) was just covering the variable costs of raw materials and wages, but not the fixed costs like rent or loans. Yet, many chose to continue operating to minimise overall losses.
Oil Industry: During periods of low oil prices, some oil producers may find themselves at or near the shutdown point. The price they receive for their oil may just cover the variable costs of extracting the oil, but not the fixed costs associated with maintaining the oil fields. Despite this, they often continue production to avoid a total loss equal to their fixed costs.
The shutdown point is when the price a firm receives for its good equals its average variable cost (P=AVC). At this point, the firm is only covering its variable costs and is indifferent between producing and shutting down. However, considering the presence of fixed costs, a rational firm will still choose to operate in the short run at the shutdown point to minimise overall losses. Real-world examples include the hospitality industry during the COVID-19 pandemic and oil producers during periods of low oil prices.
