What is the Shut Down Rule?
In: Economics
If a company is spending more money to make something than they can sell it for, then they need to stop producing the thing because they’re losing money every time they produce it.
To briefly restate the shutdown rule, to frame the answer:
>”In the short run a firm should continue to operate if price equals or exceeds average variable costs.”
Additionally, the goal of any firm is to maximize profit, or to minimize loss.
Now, what does this mean?
Well, you have two types of costs:
* Fixed costs, or overhead: this represents costs that don’t change for you no matter how much you produce. This would be lease payments for your building, subscription costs for payroll/security/what have you. Things that you’ll pay no matter how much you make, no matter if you make anything at all.
* Variable costs: As the name implies, these costs vary depending on what you do. Your raw materials, your labor, the power to run your machines: these costs go up and down as your production does.
Recap: You’re always going to incur the fixed costs. But the less you produce, the less you incur in variable costs.
If you can sell things for more than the variable costs are to make them, you should do this, *even if you’re still losing money*, because that reduces the amount of money you lose from the fixed costs.
Conversely, if you can’t sell any product for enough to recoup even the variable costs, don’t produce anything, because those losses add to the amount you’re losing from fixed costs.
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