10.5 Exit or Shutdown point

Firms in a competitive industry have freedom to enter or exit. With the presence of Super Normal profits, outside firms start entering the industry. If, however, some firms are suffering Sub Normal profits or losses, they will not take the decision to withdraw from the market immediately in the short run. They will prefer to wait and find out whether market conditions improve to their advantage. If they continue to make losses even in the long run the firms will have ultimately to leave the industry. This decision is governed by the behavior of the firm’s Average Variable Cost curve (AVC). So long as market price is above AVC the firm will cover all its variable costs and the same fixed costs as well. If the price falls below AVC the firm will have to close down and to stop productive activity. This is because variable cost is current expenditure which a firm must expect to cover at market price. If it is unable to cover fixed costs the firm can wait and hope to cover them in the long run.

In Figure 37 when price is as high as P the firm makes normal profits. If the price falls to P₁ then the firm still covers all its variable costs plus part of the fixed costs. If the price further falls to P2 the firm cannot cover even its variable costs. It is then advisable that the firm should close down. Therefore Shutdown point for a firm is one where price is just equal to its Average Variable Cost or below AVC.