Why do some perfectly competitive, loss-making firms shutdown and others don't?

Question

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
• Loss-making firms where their AC > AR & AVC < AR that don't shutdown.

Answer 1

$AVC<AR$ 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.