Should a firm shut down immediately if it is making losses?

• A. Only if fixed costs are high
• B. Yes
• C. Only if price falls further
• D. No

Answer: (D)

In the short run, a firm decides whether to shut down by comparing price to average variable cost. If the revenue from selling output covers variable costs (price is at least as high as average variable cost), the firm should keep producing because it reduces losses by contributing to fixed costs rather than paying them all without earning any revenue. Fixed costs are sunk in the short run, so continuing to operate minimizes total losses as long as you’re covering variable costs. Only if the price falls below average variable cost should the firm shut down, since then producing would incur losses larger than just paying fixed costs. So, even with losses, not shutting down immediately is the better choice as long as price covers variable costs. In the long run, persistent losses might lead to exiting the market, but not in the immediate shutdown decision.