In the short run, though, the decision varies depending on the level of losses and whether the firm can cover its variable costs. In all three cases, when the rental contract expires in the long run, assuming revenues do not improve, the firm should exit this business. In all three cases, the Yoga Center loses money.
In the third scenario, the Yoga Center earns revenues of $20,000 for the month, but experiences losses of $5,000. In the second scenario, the Yoga Center has clients that earn the center revenues of $12,000 for the month, but ultimately experiences losses of $13,000 due to having to hire yoga instructors to cover the classes. In the first scenario, the Yoga Center does not have any clients, and therefore does not make any revenues, in which case it faces losses of $10,000 equal to the fixed costs.
If the firm shuts down, it must still pay the rent, but it would not need to hire labor. If the firm decides to operate, its marginal costs for hiring yoga teachers is $15,000 for the month. Therefore when a firm is experiencing losses, it must face a question: should it continue producing or should it shut down?Īs an example, consider the situation of the Yoga Center, which has signed a contract to rent space that costs $10,000 per month. As a result, if the firm produces a quantity of zero, it would still make losses because it would still need to pay for its fixed costs.
The possibility that a firm may earn losses raises a question: why can the firm not avoid losses by shutting down and not producing at all? The answer is that shutting down can reduce variable costs to zero, but in the short run, the firm has already committed to pay its fixed costs.
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