January 2021, Section C, Question 9, International Advanced Level Unit 3:
Business behaviour, WEC13/01
The short-run shut down point occurs where average revenue is equal to
average variable costs (point A on the figure below), whereas the long-run
shutdown point is where average revenue is equal to average costs (point
B).
In the short run, a firm may not necessarily shut down if its costs of
production are greater than its revenues. This is because, even if average
total costs (ATCs) exceed average revenues (ARs), as long as average
variable costs (AVCs) of production are still being covered by revenue, the
firm may opt to continue operations. This is illustrated in the figure above,
where a firm generating AR at or above point A (where AR = AVC) may
continue operating despite making a loss of P1.A.D.C1. This is because,
theory suggests that as long as AR exceeds AVC, the firm can still
contribute towards covering some of its fixed costs. Consequently, it is
economically advantageous, and less costly, for the firm to persist with
production, considering that shutting-down would incur the loss of all fixed
costs. However, if AR falls below P1, potentially due to reduced demand, a
firm may choose to shut down in the short term, as they would be
, incapable of covering their AVCs. Thus, total losses suffered would be
greater than if production had just stopped. As such, in the short term, a
firm’s decision to shut down hinges on its ability to cover AVCs with
revenue, with a firm potentially choosing to cease operations if AVCs
surpass ARs.
Nonetheless, a firm may not always shut down in the short term, even
when its ARs fall below AVCs, as these losses may be incurred as part of a
strategic move within a predatory pricing strategy aimed at eliminating
competitors and establishing market dominance. This is notably
exemplified by Uber’s strategy to enter the Indian ride-hailing industry,
where it deliberately set prices below not only its own AVCs, but also
below those of competitors like “Ola”, as illustrated by the price level P2.
part of a predatory pricing strategy used to eliminate competition and
gain a dominant market position. This was a strategy pursued by Uber
when it attempted to break into the Indian ride-hailing industry, where it
purposely priced its services below the average costs of production
incurred by not only itself, but other firms, like Ola, at P2 in the figure
below. Despite generating massive losses of C2.X.Y.P2 and operating
below the short-run shut-down point, Uber did not shut down. This is
because, the use of predatory pricing is often seen as a temporary
strategy used to attract customers from other firms, thus driving out
competition and increasing their own market share. Through this, Uber
was able to gain a significant foothold in the market, enabling them to
raise prices once established to recoup their losses. As such, despite
earning average revenues lower than AVCs in the short-run, firms may not
always shut down if this is a part of a longer-term strategy to gain
dominance in the market.
Business behaviour, WEC13/01
The short-run shut down point occurs where average revenue is equal to
average variable costs (point A on the figure below), whereas the long-run
shutdown point is where average revenue is equal to average costs (point
B).
In the short run, a firm may not necessarily shut down if its costs of
production are greater than its revenues. This is because, even if average
total costs (ATCs) exceed average revenues (ARs), as long as average
variable costs (AVCs) of production are still being covered by revenue, the
firm may opt to continue operations. This is illustrated in the figure above,
where a firm generating AR at or above point A (where AR = AVC) may
continue operating despite making a loss of P1.A.D.C1. This is because,
theory suggests that as long as AR exceeds AVC, the firm can still
contribute towards covering some of its fixed costs. Consequently, it is
economically advantageous, and less costly, for the firm to persist with
production, considering that shutting-down would incur the loss of all fixed
costs. However, if AR falls below P1, potentially due to reduced demand, a
firm may choose to shut down in the short term, as they would be
, incapable of covering their AVCs. Thus, total losses suffered would be
greater than if production had just stopped. As such, in the short term, a
firm’s decision to shut down hinges on its ability to cover AVCs with
revenue, with a firm potentially choosing to cease operations if AVCs
surpass ARs.
Nonetheless, a firm may not always shut down in the short term, even
when its ARs fall below AVCs, as these losses may be incurred as part of a
strategic move within a predatory pricing strategy aimed at eliminating
competitors and establishing market dominance. This is notably
exemplified by Uber’s strategy to enter the Indian ride-hailing industry,
where it deliberately set prices below not only its own AVCs, but also
below those of competitors like “Ola”, as illustrated by the price level P2.
part of a predatory pricing strategy used to eliminate competition and
gain a dominant market position. This was a strategy pursued by Uber
when it attempted to break into the Indian ride-hailing industry, where it
purposely priced its services below the average costs of production
incurred by not only itself, but other firms, like Ola, at P2 in the figure
below. Despite generating massive losses of C2.X.Y.P2 and operating
below the short-run shut-down point, Uber did not shut down. This is
because, the use of predatory pricing is often seen as a temporary
strategy used to attract customers from other firms, thus driving out
competition and increasing their own market share. Through this, Uber
was able to gain a significant foothold in the market, enabling them to
raise prices once established to recoup their losses. As such, despite
earning average revenues lower than AVCs in the short-run, firms may not
always shut down if this is a part of a longer-term strategy to gain
dominance in the market.
