What is the lowest price that the firm will continue to operate at in the short run (i.e. what is the shut down price)?
The correct answer and explanation is:
The shut-down price is the lowest price at which a firm will continue to operate in the short run. It is determined by the firm’s average variable cost (AVC). If the market price falls below the AVC, the firm will choose to shut down because it would not be able to cover its variable costs. In the short run, the firm has fixed costs that must be paid even if it stops producing, but if the price is below AVC, the firm is losing more by producing than it would by shutting down temporarily.
To explain further, a firm has both fixed and variable costs. Fixed costs do not change with the level of output (e.g., rent, machinery), while variable costs change with output (e.g., labor, raw materials). In the short run, a firm can cover its fixed costs even if it doesn’t produce, but it needs to cover its variable costs to stay operational.
If the price is above the AVC but below the average total cost (ATC), the firm will continue producing in the short run, even though it may not be making a profit. The firm covers its variable costs and contributes toward fixed costs. However, if the price falls below the AVC, the firm cannot cover its variable costs and will minimize its losses by shutting down production temporarily.
The shut-down price is the price level at which the firm’s total revenue equals its variable costs. If the firm continues to operate at a price below this point, it would incur a loss greater than its fixed costs, as it wouldn’t be able to cover even the variable costs of production. Therefore, the shut-down price is the minimum price at which the firm can cover its variable costs, and anything below this would lead to a shutdown.