Shut Down Point

 Under perfect competition, a firm is a price taker i.e. the price is given to the firm. In the market, the price is determined by the forces of demand and supply.

Given the price the firm can maximize supernormal profits, break even, minimise losses or shut down.

Thus, shut down point occurs when the price is so low that it cannot pay the fixed costs. The losses are incurred and are equal to fixed costs.

The price covers the AVC. There are two shut down situations as:

1. When the firm decides to shut down.

2. When the firm actually shuts down.

1st Case: When the Firm Decides to Shut Down

This situation occurs when the price line passes through the minimum point of the AVC curve. It is shown in figure 13. In this diagram, we see that at price OP, equilibrium is at point E where MR = MC. The slope of MC is greater than zero. The firm sells OX units of output.

The loss in this situation is calculated as:

Loss per unit

= Cost per unit – Revenue per unit

= CX – EX = CE

Total Losses

= Loss per unit X Equilibrium Output

= CE X OX

= Shaded Rectangle (ACEP)

= Fixed Costs

Thus the firm decides to shut down at this point.

2nd Case: When the Firm Actually Shuts Down:

The prices below OP, the firm shuts down as losses are more than the fixed costs. The firms will not be able to cover even AVC. This fact is clear from figure 14.

In figure 14, when price falls to OP, below the shut down point, Equilibrium takes place at point E. Losses which are incurred are equal to BE per point.

Total Losses= Total Rectangle (ABEP)

= Shaded Rectangle ABCD + rectangle DCEP

= TFC + some part of TVC.

Since, losses are more than TFC, the firm shuts down its unit.