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Question:

Why do perfectly competitive, loss-making firms that have (AC>AVC>AR) shutdown but

Firms that have (AC>AR>AVC) not shutdown?

-Both of these types of firms are making a loss. How is it significant that the latter type's AVC is less than AR ? How does that affect whether it shuts down ?**

These two graphs are for the two types of firms in perfectly competitive markets:

  • Loss-making firms where their AC > AR & AVC > AR that shutdown diagram1
  • Loss-making firms where their AC > AR & AVC < AR that don't shutdown. diagram2
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  • $\begingroup$ Your inequalities need to be fixed, I think for the firms that shut down AC>AVC>AR, and for the firms that don't shut down AC>AR>AVC. Can you please fix it for future clarity. Your graphs are fine. $\endgroup$ – Regio Apr 22 at 3:30
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$AVC<AR$ means, without considering fixed cost, the firm is making a profit of $AR-AVC>0$ per unit of output. Compare the two options: keep producing vs shutdown:

  • Keep producing: $\text{Avg Profit}=\underbrace{AR-AVC}_{>0}-AFC$
  • Shutdown: $\text{Avg Profit}=0-AFC$

Since $AVC<AR$, staying in production is better since the revenues can be used to offset part of the fixed costs already incurred.


$AVC>AR$ means, without considering fixed costs, the firm is making a loss of $AR-AVC<0$ per unit of output. Compare the two options: keep producing vs shutdown:

  • Keep producing: $\text{Avg Profit}=\underbrace{AR-AVC}_{<0}-AFC$
  • Shutdown: $\text{Avg Profit}=0-AFC$

Since $AVC>AR$, shutting down leads to a smaller loss than staying in production.

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