AP® Microeconomics review sheet from Aim for Five (aimforfive.com/micro/units/3/3-6)
Unit 3 · Topic 3.6
3.6 Firms’ Short-Run Decisions to Produce and Long-Run Decisions to Enter or Exit a Market
A firm losing money in the short run should keep producing if price covers average variable cost, because the extra revenue helps pay its fixed costs. If price falls below the minimum of AVC, it should shut down and lose only its fixed costs. In the long run, firms enter markets with economic profit and exit markets with economic losses.
Key terms
- shutdown rule
- average variable cost
- fixed cost
- entry
- exit
- barriers to entry
The short-run shutdown rule
In the short run, a firm has to pay its fixed costs whether it produces or not. So the question isn't 'am I losing money?' but 'do I lose less by producing or by shutting down?'
If the firm shuts down, it loses exactly its fixed cost. If it produces, it earns revenue and pays variable costs too. Producing is better whenever total revenue covers total variable cost (TR ≥ TVC), which is the same as price covering average variable cost (P ≥ AVC). Any revenue above variable cost goes toward paying the fixed cost.
Shutdown rule: shut down in the short run if P < minimum AVC. Otherwise, produce where MR = MC, even if that means a loss.
Why fixed costs drop out of the decision
Fixed costs are already committed for the short run, so they're the same whether the firm produces or shuts down. That makes them irrelevant to the choice, just like the sunk costs in topic 1.6. What matters is whether producing brings in more than it adds to cost.
Take a firm with $60 of fixed cost that can sell 4 units for $160 in total, with variable costs of $120. Producing earns $160 − $120 = $40 above its variable costs, which pays off part of the $60 fixed cost. Its loss is $20 if it produces and $60 if it doesn't, so it produces. If revenue fell below variable cost, every unit made would deepen the loss, and shutting down would be better.
Comparing price with costs
| Price compared with costs | Short-run outcome | Long-run response |
|---|---|---|
| P > ATC at the best output | Economic profit | New firms enter |
| P = minimum ATC (break-even point) | Zero economic profit (normal profit) | No entry or exit |
| Minimum AVC ≤ P < ATC | Loss smaller than fixed cost; keep producing | Some firms exit |
| P < minimum AVC (below the shutdown point) | Shut down; loss = fixed cost | Firms exit |
The firm's short-run supply curve
A perfectly competitive firm produces where P = MC, as long as P is at least minimum AVC. So at each price, the MC curve tells you how much the firm supplies. That means the firm's short-run supply curve is the part of its MC curve above the minimum of AVC. Below that price, it supplies nothing. Add up all firms' supply curves and you get the market supply curve.
Long-run entry and exit
In the long run there are no fixed costs, so a firm stays only if price covers average total cost. If firms are making economic losses, some leave the industry; if they're making economic profit, new firms enter. This works only when there are no barriers to entry, things like patents, licenses or huge start-up costs that keep new firms out.
Entry and exit change market supply, which moves the market price. That process is the heart of perfect competition in topic 3.7.
Worked examples
Try each one yourself first, then open the solution.
- Example 1Calculator allowed
Producing at a loss
A perfectly competitive firm has fixed cost $60 and total cost for 0–6 units of $60, $100, $130, $150, $180, $230, $300. The market price falls to $40. How much should the firm produce in the short run, and what is its profit or loss? Should it shut down?
Show the solutionHide the solution
- Step 1: MR = P = $40. MC for units 1–6: $40, $30, $20, $30, $50, $70. Make every unit with MC ≤ $40: units 1–4. Stop before unit 5 ($50).
- Step 2: At 4 units: TR = $40 × 4 = $160; TC = $180; loss = $20.
- Step 3: Minimum AVC is $30, and $40 > $30, so price covers AVC. TR ($160) is more than VC ($120), so $40 goes toward the $60 fixed cost.
- Step 4: If it shut down, it would lose the whole $60 fixed cost. Losing $20 is better.
Answer: Produce 4 units for a loss of $20; don't shut down, since shutting down would lose $60.
- Example 2Calculator allowed
When to shut down (classic trap)
Now the market price falls to $25. What should the firm do in the short run? What will happen in the long run?
Show the solutionHide the solution
- Step 1: Minimum AVC is $30. Since $25 < $30, price doesn't cover variable cost at any output.
- Step 2: Check the best it could do by producing: at 1 or 3 units it loses $75 (for example, at 3 units TR = $75 and TC = $150). That is worse than the $60 loss from shutting down.
- Step 3: So the firm shuts down: output 0, loss = $60 (its fixed cost).
- Step 4: In the long run, with price below ATC, firms like this exit the industry.
- Step 5: The trap: some students compare price with ATC for the short-run decision. In the short run, compare price with AVC.
Answer: Shut down in the short run (loss = $60 fixed cost); in the long run, exit the industry.
Common mistakes
- Shutting down whenever there's a loss. In the short run, keep producing if P ≥ minimum AVC.
- Using ATC instead of AVC for the short-run shutdown decision. ATC matters for the long-run exit decision.
- Saying a shut-down firm's loss is zero. In the short run it still pays its fixed costs.
- Forgetting that the firm's short-run supply curve is only the part of MC above minimum AVC.
On the exam
- Free-response questions often give a price between minimum AVC and minimum ATC and ask whether the firm should keep producing; answer yes and explain that TR covers TVC with some left over for fixed costs.
- Expect questions on the long-run response: losses lead to exit, profits lead to entry, and both stop at zero economic profit.
Connected topics
Videos
Check yourself
4 questions on 3.6 Firms’ Short-Run Decisions to Produce and Long-Run Decisions to Enter or Exit a Market. Pick an answer to see if you got it, and why.
| Output (units) | Total cost |
|---|---|
| 0 | $40 |
| 1 | $70 |
| 2 | $90 |
| 3 | $105 |
| 4 | $125 |
| 5 | $155 |
| 6 | $195 |
| 7 | $245 |
Hypothetical short-run costs for a perfectly competitive firm
Suppose the market price is $25. Which of the following should the firm do in the short run?
Below what price should this firm shut down in the short run?
If the market price is $18, how much will the firm lose in the short run if it makes the best choice?
A perfectly competitive firm is producing 100 units, where price equals marginal cost. The price is $8, average variable cost is $6 and average total cost is $10. In the short run, the firm should
0 of 4 answered