Question

1. At a recent board meeting, the president and the CEO got into a heated argument about whether to shut-down the firm’s plant in Dhaka Division. The CEO thinks that the organization’s business fits the competitive market definition relatively well. The plant currently incurs losses of Taka 60 million and the Fixed cost is Taka 70 million. The president of the firm argued that the plant should continue to operate, at least until a buyer is found for the production facility. The president’s argument was based on the fixed cost. The CEO exploded over this point, blaming the president for considering the fixed costs in making shutdown decision. According to the CEO, “everyone knows fixed costs do not matter!”. Should the plant be closed or continue to operate at a loss in the short run? How would you explain to the incorrect party that he or she is wrong?

What would be your opinion if the following situation prevails: The firm is currently earning-short-run profits but the industry is in increasing cost industry and it is experiencing an increase in its product demand. In the long run, what do you expect will happen to: firm’s cost of production, the price it can charge and the profits it can make?

Answer 1

a.     The plant in Dhaka should continue to be operated because the firm loses only 60M per month if the plant is operated; but would lose 70M if the plant is shut down. We can deduce that total revenue exceeds variable costs by 10M. This 10M can be applied toward fixed costs so the firm loses only TFC – 10M, which in this case is 70M – 10M = 60M Thus, the President is correct in recommending that the firm continue to operate the Dhaka plant in the short run.

b.     While it is true that the level of fixed costs do not, in any way, influence the shut down (or output) decision, TFC does represent the loss to the firm of shutting down operations. If the manager makes the correct shutdown decision by comparing P to AVC, the loss from producing will be less than TFC. The president's statement implies that P>AVC. Even if TFC were higher than 70M the firm still loses 10M less when it produces where MR = MC than when it shuts down.