Why a firm making a loss can still be right to keep producing.
The oil refinery at Grangemouth stopped processing crude oil on 29 April 2025. Its owner, Petroineos, said it had been losing about $500,000 a day. The workforce was cut from 475 to 75, and the site became an import terminal for fuel refined elsewhere.
A firm making a loss does not always close the same day. When is it right to keep going, and when should it stop?
Source: Hydrocarbon Processing (April 2025).
A factory loses money every week. Its rent is fixed for the next year whatever it does.
Its sales still cover the wages and materials it uses each week. Should it stop production now?
The rent has to be paid either way. If sales cover wages and materials with something left over, that surplus pays part of the rent. Closing would leave the whole rent as a loss, so in the short run it is better to keep producing.
Start with the assumptions. The firm is a price taker, so its AR = MR is a horizontal line at the market price. In the short run its fixed costs, like a lease on its site, must be paid even if it produces nothing. In the long run every cost is variable, so it can leave and pay nothing. Draw the costs in exam order: MC, then AVC and ATC, each cut by the rising part of MC at its lowest point.
Teacher tip: Draw ATC above AVC with the gap closing as output rises. The gap is average fixed cost, which shrinks as the fixed cost is spread over more units. So the lowest point of ATC sits to the right of the lowest point of AVC, and MC passes through both.
At price P2 the firm produces where MC = MR, at q2. The price is below ATC, so it makes a loss: the shaded box. Should it shut down? Compare two losses. If it shuts down, it still pays all its fixed costs. If it produces, it pays its fixed costs too, but its revenue might cover some of them.
Check: A firm with fixed costs of £5,000 a week shuts down. Its revenue and variable costs fall to zero. What is its loss for the week?
Fixed costs must be paid even at zero output, so a firm that shuts down in the short run loses all of them.
At q2 the price is above AVC. Each unit sold covers its own variable cost with something left over: the green box, which goes towards the fixed costs. So the loss from producing is smaller than the loss from shutting down. The firm keeps producing in the short run.
Check: A firm’s fixed costs are £5,000 a week. If it produces, its revenue is £12,000 and its variable costs are £9,000. In the short run it should:
Producing: £12,000 − £9,000 − £5,000 = −£2,000. Shutting down: −£5,000. Producing loses less.
Now the price falls to P3, below the lowest point of AVC. The firm cannot even cover its variable costs: every unit it makes adds to its loss. It should stop producing straight away. So the short-run shutdown point is the lowest point of AVC. At exactly that price, producing and shutting down lose the same.
In the long run the firm must cover all its costs, including normal profit, or its owners will put their money elsewhere. So the long-run shutdown point is the lowest point of ATC, the break-even point. If the price stays below it, the firm leaves the industry once its fixed commitments end, as Grangemouth’s owners did with refining. Do not mix the two points up: P = AVC decides whether to produce in the short run; P = ATC is break-even, where the firm makes normal profit. A firm that hangs on hopes others leave first, cutting market supply and pushing the price back up.
Check: In the long run, a firm stays in an industry only if the price covers at least:
In the long run nothing is fixed, so the firm needs to cover all its costs, including normal profit: price at least equal to ATC.
Put the short-run rule together with MC = price and you can work out how much the firm supplies at any price.
Check: The market price is £6. The firm’s AVC is lowest at £5, its ATC is lowest at £7, and MC = £6 at 400 units. In the short run it supplies:
The price is above the lowest point of AVC, so the firm keeps producing, and it produces where MC = price: 400 units.
For a firm in perfect competition this gives its short-run supply curve: the part of MC above the lowest point of AVC. At any price above that, it supplies the output where MC = price. Below it, it supplies nothing.
They put it at the lowest point of ATC. In the short run fixed costs must be paid whether the firm produces or not, so it keeps going as long as the price covers AVC. The short-run shutdown point is the lowest point of AVC. The lowest point of ATC is the long-run point.
Explain why a firm making a loss may continue to produce in the short run, but not in the long run.
In the short run a firm has fixed costs, such as rent or a lease, that it must pay whether it produces or not. If it shuts down, its loss is equal to those fixed costs.
[Diagram: MC, AVC and ATC, with MC through the lowest points of both. Price P2 between the lowest points of AVC and ATC, output where MC = P2, loss box; short-run shutdown point at the lowest point of AVC and long-run shutdown point at the lowest point of ATC.]
If the price is below ATC but above AVC, each unit sold covers its own variable cost and leaves something over towards the fixed costs. The loss from producing is therefore smaller than the loss from shutting down, so the firm keeps producing where MC = MR. Only if the price falls below the lowest point of AVC, the short-run shutdown point, should it stop at once, because then every unit adds to its loss.
In the long run all costs are variable. The firm can end its lease and avoid every cost by leaving. It will only stay if the price covers its average total cost, including normal profit, so the long-run shutdown point is the lowest point of ATC.
Source: Hydrocarbon Processing (April 2025). Diagrams drawn with Rough.js and perfect-freehand, both MIT licensed. Your answers are saved only on this device.