You might be tempted to say that if a firm is unprofitable because the market price is below its minimum average total cost, it shouldn’t produce any output. In the short run, however, this conclusion isn’t right.

In the short run, sometimes the firm should produce even if price falls below minimum average total cost. The reason is that total cost includes fixed cost—cost that does not depend on the amount of output produced and can only be altered in the long run.

In the short run, fixed cost must still be paid, regardless of whether or not a firm produces. For example, if Noelle rents a refrigerated truck for the year, she has to pay the rent on the truck regardless of whether she produces any trees. Since it cannot be changed in the short run, her fixed cost is irrelevant to her decision about whether to produce or shut down in the short run.

Although fixed cost should play no role in the decision about whether to produce in the short run, other costs—variable costs—do matter. An example of variable costs is the wages of workers who must be hired to help with planting and harvesting. Variable costs can be saved by not producing; so they should play a role in determining whether or not to produce in the short run.

Let’s turn to Figure 12-4: it shows both the short-run average total cost curve, ATC, and the short-run average variable cost curve, AVC, drawn from the information in Table 12-3. Recall that the difference between the two curves—the vertical distance between them—represents average fixed cost, the fixed cost per unit of output, FC/Q.

Because the marginal cost curve has a “swoosh” shape—falling at first before rising—the short-run average variable cost curve is U-shaped: the initial fall in marginal cost causes average variable cost to fall as well, before rising marginal cost eventually pulls it up again. The short-run average variable cost curve reaches its minimum value of $10 at point A, at an output of 30 trees.

We are now prepared to fully analyze the optimal production decision in the short run. We need to consider two cases:

When the market price is below minimum average variable cost, the price the firm receives per unit is not covering its variable cost per unit. A firm in this situation should cease production immediately. Why? Because there is no level of output at which the firm’s total revenue covers its variable costs—the costs it can avoid by not operating.

In this case the firm maximizes its profits by not producing at all—by, in effect, minimizing its losses. It will still incur a fixed cost in the short run, but it will no longer incur any variable cost. This means that the minimum average variable cost is equal to the shut-down price, the price at which the firm ceases production in the short run. In the example of Noelle’s tree farm, she will cease production in the short run by laying off workers and halting all planting and harvesting of trees.

When price is greater than minimum average variable cost, however, the firm should produce in the short run. In this case, the firm maximizes profit—or minimizes loss—by choosing the output quantity at which its marginal cost is equal to the market price. For example, if the market price of each tree is $18, Noelle should produce at point E in Figure 12-4, corresponding to an output of 50 trees. Note that point C in Figure 12-4 corresponds to the farm’s break-even price of $14 per tree. Since E lies above C, Noelle’s farm will be profitable; she will generate a per-tree profit of $18.00 − $14.40 = $3.60 when the market price is $18.

But what if the market price lies between the shut-down price and the break-even price—that is, between minimum average variable cost and minimum average total cost? In the case of Noelle’s farm, this corresponds to prices anywhere between $10 and $14—say, a market price of $12. At $12, Noelle’s farm is not profitable; since the market price is below minimum average total cost, the farm is losing the difference between price and average total cost per unit produced.

Yet even if it isn’t covering its total cost per unit, it is covering its variable cost per unit and some—but not all—of the fixed cost per unit. If a firm in this situation shuts down, it would incur no variable cost but would incur the full fixed cost. As a result, shutting down generates an even greater loss than continuing to operate.

This means that whenever price lies between minimum average total cost and minimum average variable cost, the firm is better off producing some output in the short run. The reason is that by producing, it can cover its variable cost per unit and at least some of its fixed cost, even though it is incurring a loss. In this case, the firm maximizes profit—that is, minimizes loss—by choosing the quantity of output at which its marginal cost is equal to the market price. So if Noelle faces a market price of $12 per tree, her profit-maximizing output is given by point B in Figure 12-4, corresponding to an output of 35 trees.

It’s worth noting that the decision to produce when the firm is covering its variable costs but not all of its fixed cost is similar to the decision to ignore sunk costs. You may recall from Chapter 9 that a sunk cost is a cost that has already been incurred and cannot be recouped; and because it cannot be changed, it should have no effect on any current decision.

In the short-run production decision, fixed cost is, in effect, like a sunk cost—it has been spent, and it can’t be recovered in the short run. This comparison also illustrates why variable cost does indeed matter in the short run: it can be avoided by not producing.

And what happens if market price is exactly equal to the shut-down price, minimum average variable cost? In this instance, the firm is indifferent between producing 30 units or 0 units. As we’ll see shortly, this is an important point when looking at the behavior of an industry as a whole. For the sake of clarity, we’ll assume that the firm, although indifferent, does indeed produce output when price is equal to the shut-down price.

Putting everything together, we can now draw the short-run individual supply curve of Noelle’s farm, the red line in Figure 12-4; it shows how the profit-maximizing quantity of output in the short run depends on the price. As you can see, the curve is in two segments. The upward-sloping red segment starting at point A shows the short-run profit-maximizing output when market price is equal to or above the shut-down price of $10 per tree.

As long as the market price is equal to or above the shut-down price, Noelle produces the quantity of output at which marginal cost is equal to the market price. That is, at market prices equal to or above the shut-down price, the firm’s short-run supply curve corresponds to its marginal cost curve. But at any market price below minimum average variable cost—in this case, $10 per tree—the firm shuts down and output drops to zero in the short run. This corresponds to the vertical segment of the curve that lies on top of the vertical axis.

Do firms really shut down temporarily without going out of business? Yes. In fact, in some businesses temporary shut-downs are routine. The most common examples are industries in which demand is highly seasonal, like outdoor amusement parks in climates with cold winters. Such parks would have to offer very low prices to entice customers during the colder months—prices so low that the owners would not cover their variable costs (principally wages and electricity). The wiser choice economically is to shut down until warm weather brings enough customers who are willing to pay a higher price.