Find where a firm would break even and where it would shut down
The idea
A firm breaks even where total revenue equals total cost, which in per-unit terms means price equals average total cost. Below that it is making a loss, but a loss does not automatically mean it should stop producing. In the short run, fixed costs are already committed, so the firm should keep operating as long as price covers average variable cost — every unit then contributes something toward the fixed costs it would owe anyway. Below average variable cost it should shut down. In the long run all costs are avoidable, so price must cover average total cost or the firm exits.
Formulas
Economic profit
economic profit = total revenue − total economic cost
- total revenue
- price × quantity sold
- total economic cost
- accounting costs plus the opportunity cost of the owner's capital and labour
Zero economic profit is a normal return, not a failure — the owners are earning exactly what their capital could earn elsewhere. A firm breaks even where revenue covers total cost, and in the short run keeps producing as long as price covers average variable cost.
A practice question
At the breakeven point, what is the relationship between price and cost?
- Price equals average total cost — correct
- Price equals average variable costWhy not: That is the short-run shutdown point, below which producing adds nothing toward fixed costs.
- Price equals marginal cost onlyWhy not: Marginal cost governs how much to produce. Breaking even is about covering the full cost per unit.
Breaking even means total revenue covers total cost, which per unit is price equal to average total cost. Economic profit is then zero.
A harder one
A firm's price is below average total cost but above average variable cost in the short run. What should it do?
- Shut down immediatelyWhy not: Shutting down loses the contribution each unit makes toward fixed costs that must be paid either way.
- Keep producing for now — correct
- Raise price to average total costWhy not: A price is set by the market, not chosen to cover a cost. Raising it would simply lose the sales.
Each unit contributes toward committed fixed costs. Those are owed whether or not the firm produces, so any contribution above variable cost reduces the loss; shutting down would mean bearing the whole fixed cost with no offset.
The hardest tier
Why does the shutdown rule differ between the short run and the long run?
- Because prices are fixed in the short runWhy not: Prices move in both horizons. What changes is which costs the firm is still committed to.
- Because variable costs disappear in the long runWhy not: Variable costs remain; it is the fixed costs that stop being fixed once commitments come up for renewal.
- Because all costs become avoidable — correct
In the long run price must therefore cover average total cost. The short-run rule exists only because fixed costs are sunk: given time, leases end and equipment is not replaced, so every cost is escapable and a firm that cannot cover all of them leaves the industry.
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