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Economic Losses in the Short Run

2 March, 2015 - 12:11

In the short run, a firm has one or more inputs whose quantities are fixed. That means that in the short run the firm cannot leave its industry. Even if it cannot cover all of its costs, including both its variable and fixed costs, going entirely out of business is not an option in the short run. The firm may close its doors, but it must continue to pay its fixed costs. It is forced to accept an economic loss, the amount by which its total cost exceeds its total revenue.

Suppose, for example, that a manufacturer has signed a 1-year lease on some equipment. It must make payments for this equipment during the term of its lease, whether it produces anything or not. During the period of the lease, the payments represent a fixed cost for the firm.

A firm that is experiencing economic losses—whose economic profits have become negative—in the short run may either continue to produce or shut down its operations, reducing its output to zero.It will choose the option that minimizes its losses. The crucial test of whether to operate or shut down lies in the relationship between price and average variable cost.