Posted by Sally on .
You’ve been hired by an unprofitable firm to determine whether it should shut down its unprofitable operation.
The firm currently uses 70 workers to produce 300 units of output per day. The daily wage (per worker) is $100, and the price of the firm’s output is $30. Although you don’t know the firm’s fixed cost, you know that it is high enough that the firm’s total costs exceed its total revenue. Should the firm continue to operate at a loss?
I would think not.
Consider the choices facing an unprofitable (and perfectly competitive) firm. The firm currently produces 100 units per day and sells them at a price of $22 each. At the current output quantity, the total cost is $3,000 per day, the variable cost is $2,500 per day, and the marginal cost is $45.
a. Evaluate the following statement from the firm's accountant: "Given our current production level, our variable cost ($2,500) exceeds our total revenue ($2,200). We should shut down our production facility."
I would say that I would agree the accountant if the price, like it is here, is less than the variable cost then shut down.
We generally say that if revenue exceeds variable costs, then the firm should continue to produce IN THE SHORT RUN, even if there is a loss.
In a) it depends what the fixed costs are. If they are sunk costs, with no hope of recovery (no scrap value), then definately continue to produce. If the fixed costs stop being costs if the firm shuts down, (e.g., rent) then perhaps the firm should shut down, especially if there is no positive expected changes in the market.