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2.8 The Shutdown Rule

You may recall earlier in this chapter that, before deciding to disregard the $6000 nonrefundable down payment (to hold the option to operate the ice cream business) as a relevant economic cost, the total cost of operating the business under a plan to sell 36,000 ice cream bars at a price of $1.50 per item would have exceeded the expected revenue. Even after further analysis indicated that the students could improve profit by planning to sell 30,000 ice cream bars at a price of $1.80 each, if the $6000 deposit had not been a sunk cost, there would have been no planned production level and associated price on the demand curve that would have resulted in positive economic profit. So the students would have determined the ice cream venture to be not quite viable if they had known prior to making the deposit that they could instead each have a summer corporate internship. However, having committed the $6000 deposit already, they will gain going forward by proceeding to run the ice cream bar business.

A similar situation can occur in ongoing business concerns. A struggling business may appear to generate insufficient revenue to cover costs yet continue to operate, at least for a while. Such a practice may be rational when a sizeable portion of the fixed costs in the near term are effectively sunk, and the revenue generated is enough to offset the remaining fixed costs and variable costs that are still not firmly committed.

Earlier in the chapter, we cited one condition for reaching a breakeven production level where revenue would equal or exceed costs as the point where average cost per unit is equal to the price. However, if some of the costs are already sunk, these should be disregarded in determining the relevant average cost. In a circumstance where a business regards all fixed costs as effectively sunk for the next production period, this condition becomes a statement of a principle known as the shutdown ruleWhen all fixed costs are regarded as sunk for the next production period, a firm should continue to operate only as long as the selling price per unit is at least as large as the average variable cost per unit.: If the selling price per unit is at least as large as the average variable cost per unit, the firm should continue to operate for at least a while; otherwise, the firm would be better to shut down operations immediately.

Two observations about the shutdown rule are in order: In a circumstance where a firm’s revenue is sufficient to meet variable costs but not total costs (including the sunk costs), although the firm may operate for a period of time because the additional revenue generated will cover the additional costs, eventually the fixed costs will need to be refreshed and those will be relevant economic costs prior to commitment to continue operating beyond the near term. If a business does not see circumstances changing whereby revenue will be getting better or costs will be going down, although it may be a net gain to operate for some additional time, such a firm should eventually decide to close down its business.

Sometimes, it is appropriate to shut down a business for a period of time, but not to close the business permanently. This may happen if temporary unfavorable circumstances mean even uncommitted costs cannot be covered by revenue in the near term, but the business expects favorable conditions to resume later. An example of this would be the owner of an oil drilling operation. If crude oil prices drop very low, the operator may be unable to cover variable costs and it would be best to shut down until petroleum prices climb back and operations will be profitable again. In other cases, the opportunity cost of resources may be temporarily high, so the economic profit is negative even if the accounting profit would be positive. An example would be a farmer selling his water rights for the upcoming season because he is offered more for the water rights than he could net using the water and farming.