The Shutdown Rule

A restaurant can be losing money every night and still rationally open tomorrow. Here's why: rent on the building is already owed whether the doors open or not. That's a sunk fixed cost in the short run. The only real choice left is whether running the kitchen tonight adds more revenue than it adds in variable costs like food and hourly wages. If it does, staying open chips away at the loss instead of eating the fixed cost in full.

The mechanism is a direct comparison: price versus average variable cost, AVC. If price is at least AVC, every unit sold covers its own variable cost and throws some extra money at the fixed cost bill, shrinking the loss. If price falls below AVC, each unit actually costs more in variable inputs than it brings in, so producing makes the loss worse than just shutting down and losing only the fixed cost. Fixed cost never enters this comparison because it's paid either way — it cannot be avoided by shutting down, so it cannot change which choice is better.

This connects directly to the firm's cost curves from earlier in the unit. The shutdown price is exactly the minimum point of the AVC curve, which is also where AVC crosses marginal cost. Below that point, a competitive firm exits production in the short run; above it, the firm produces where price equals marginal cost. Once a lease expires, fixed cost becomes avoidable too, so the comparison upgrades to price versus average total cost, ATC — the long-run exit decision.