Monday, December 22, 2008

Happy Holidays: We're Shutting Down

One of the ideas that I address in 06E:001 (Prin. of Micro) is the issue of when does it make sense for a firm to shut-down, which is different than exiting in economics. By shutting down, the firm is making a short term (or short-run) decision that it is better not to produce and temporarily stop its operations than to keep producing, where exiting can be thought of as "going out of business", a permanent (or long-run) decision. With the recession upon us, we are seeing some rather large firms shutting down.

Typically, Chrysler does not operate from December 24th to January 5th, but this year is adding an additional two weeks due to the recession. Likewise Ford and General Motors are shutting down for longer than normal due to the economic downturn. Now we have word that some of the largest US tech firms are shutting down due to the economic downturn.

So when does it make sense for a firm to shut-down? Typically firms shut-down when the average revenues (or price) is less than the average production costs (or average variable costs). When this happens, the firm incurs greater amounts of losses than if it does not produce at all, which economists call fixed costs. Thus it comes down to the following decision: Which would you rather lose; $100 by producing or $50 by not producing? For me, I would rather lose neither, but if forced to answer, I would rather lose $50. Thus if the loss of shutting down ($50 in my simple example) is a smaller loss than the loss of continuing operations and producing ($100 in my example) then the firm rationally shuts down such as we are seeing in the automobile and technology industries.

UPDATE: Honda shut down UK plants for four months at the beginning of 2009.
UPDATE: Toyota to shut down US plant in 2010.

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