Question

Consider you are a Chief Manager of a firm that is operating in a market where any firm can enter or exit without any barrier. At present, your competitors are in crises and your firm too is facing losses. But you firmly decided to remain in the market and not to shut-down your business. Explain, what the economic rule constitute for your decision ‘not to shut-down’.Also explain how you would overcome the short-run losses in long-run, and what kinds of economies you could achieve in future if you decide to stay in the business?   

Answer 1

As a Chief Manager, I would like to make a cost vs benefit comparative analysis and try to find out whether the benefits outweigh the cost or is the other way round.

The economic rule that governs whether a firm should shut down its operation or continue its production is following:

- If P > AVC, then the firm can continue doing business.

- If P < AVC, then the firm should shut-down its operations

Where AVC = average variable cost

So, I will decide not to shut down iff P > AVC, in this case, the firm will make losses but can bear its fixed cost of production.

In the long-run, if I continue to do business, the firm will create enough reputation in the market and will act as a deterrent for other firms to enter into the market. The firm will enjoy some kind of monopoly power and will try to overcomes the short run losses by charging more price to the consumers.

If I decide to stay, then the firm can attain Natural Monopoly in the market. The average cost will continue to fall with increase in the level of production.