Shut Down Price (Chain of Analysis)

In the short run, a business will continue to supply products as long as their revenues at least cover variable costs. Revenue = AR x Q.

Variable costs are costs that vary directly with output such as raw materials, component parts and employees paid an hourly wage.

Providing that price per unit (AR) > average variable cost (AVC), then a contributionis being made to cover some fixed (overhead) cost

As a result the firm would be better off continuing production if we assume that fixed costs are lost if a shut-down decision is made.

But, if there is a fall in demand and price drops below AVC, then a firm might decide to shut-down production to minimise their losses.

This is because not enough revenue is being generated and total losses suffered would be higher if production continued.