Question

Auto Parts, Inc. is medium-sized company that manufactures auto parts in Buffalo, New York. The company currently loses $30,000 per month. The owner of the company is evaluating whether she should shut down the factory. She thinks that the factory should continue to operate until the economic environment improves and buyer for the factory can be identified. The logic of the owner is that her company has already invested millions of dollars in the factory over the years. The monthly fixed costs for the factory are $40,000. The CEO of Auto Parts, Inc. thinks the factory should be shut down because most the monthly fixed costs ($40,000/month) are sunk costs. Do you agree with the owner or the CEO? Explain the logic of your argument, including a numerical demonstration.

Answer 1

The owner is wrong in her logic because the factory should continue to operate in the short run as long as the company is able to cover its variable costs. Since the fixed cost is $40000 and the company is losing $30000 so this means that the company is able to recover its variable cost and some of its fixed cost too so, the company should continue to operate in the short run and exit in the long run only.