Shutdown Decisions – The Role of Variable and Fixed Costs

George Orlov, Cornell University-Endowed Colleges, Douglas McKee, Cornell University
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Summary

Students will discuss full and partial shutdown decisions in a context of a small business (bagel shop) which, with the advent of cold weather, considers closing its patio, keeping it open and putting up heating lamps, or closing altogether for the months of November through March. The exercise starts with a conceptual-level discussion and continues with a (relatively simple) calculation which differs from most standard textbook problems.

Context for Use

● The activity is appropriate for both Principles and Intermediate microeconomics.
● Students should have studied fixed and variables costs, as well as firm shut down and exit decisions.
● This activity should be suitable for discussion in any class size.
● The activity will likely take around 25 minutes.

Overview

In this activity students will examine the decisions of a small bagel shop which, faced with the onset of colder weather, is choosing whether to shut down its patio, maintaining indoor seating only. The exercise consists of two parts. In the first part, students will talk about the shutdown on a conceptual level – it is meant to bring some "real-world" thinking into the group discussion. It gets students thinking conceptually about what constitutes fixed, variable, and sunk costs for a small business.

The second part gives the students numerical examples of the firm's cost structure and demand curve. Students will then compute the optimal choice of the entrepreneur.

Expected Student Learning Outcomes

This exercise pursues two learning goals. Students will:
(1) Recognize the relationship between short-run and long-run costs.
(2) Solve for a firm's shut down and exit prices.

Information Given to Students

PART 1:

Consider an entrepreneur running a bagel shop that opened in May and had a successful six months. The business consists of a building which houses the kitchen and storage area, as well as several tables and a bar with a few chairs, and a covered patio with more tables. The business faces strong competition in the form of other cafés in town, most of which have larger indoor sitting areas. With the approach of winter the entrepreneur has to decide whether she wants to install heating lamps on the patio to make it comfortable in the cold months, close the patio and keep only the building area operating, or completely shut down the business from November to late March. Finally, the entrepreneur has the option of completely closing down the sandwich shop and selling the building.


Rank the following options based on the likelihood of them being chosen (from most to least likely). Prepare to defend your ordering with well-organized arguments regarding potential costs and revenues.


A. Operate fully with the addition of multiple heating lamps on the patio.
B. Partially shut down, closing the covered patio.
C. Fully shut down until late March.
D. Close down the store.

PART 2:

Now, consider the numbers that the entrepreneur faces. The shop requires two employees, each of whom is paid $2,500 monthly. Equipment costs $1,000 monthly to maintain if it is in use. The building for the shop costs $3,050 monthly to maintain. These costs are incurred independently of the location being open or closed. The patio which contains 7 tables (out of 10 in the shop) costs nothing to maintain in the warmer months but would cost $1000 monthly (for heat lamps) from November to March.

The monthly demand for sandwiches is Q = 6,000-200P+60T , where P is price per sandwich and T is the number of tables available in the shop. Ingredients for each sandwich cost $6 and the market price for sandwiches in town has settled at $8.

Based on these numbers, what is the optimal strategy (from the list above) for the entrepreneur managing the sandwich shop?


Student Handout for "Shutdown Decisions – The Role of Variable and Fixed Costs" (Microsoft Word 2007 (.docx) 18kB Sep16 19)
Instructor Solutions for "Shutdown Decisions – The Role of Variable and Fixed Costs" (Acrobat (PDF) 55kB Aug26 19)

Teaching Notes and Tips

● What prefatory remarks should set up the application exercise? – The activity can be run as a two-part exercise. First have the students discuss the conceptual aspect. Here they are more likely to draw not only on the theory they learned but also on real world knowledge (some might even do a web search on the cost of running a heating lamp in winter). The second part has an actual calculation. It is not difficult, but it points to a partial shutdown of facilities for the winter.

● Does facilitating the teamwork require any special action? – No, beyond the usual circulation and making sure that the groups are actively discussing the problem at hand.

● What kinds of follow-up questions are recommended for facilitating the debriefing conversation among team reporters? In particular, how might the instructor get teams to evaluate which answer is the best, provide the analytical support for the team answers, identify what information would enable an economist to decide between alternative answers? – In the first part of the activity, it would be good to have the students organize their reasons for each of the answers they might choose into columns of fixed costs, variable costs, sunk costs, and revenues. Encouraging students to be clear about what assumptions they are making to arrive at their decision is essential.

● What points should be emphasized in the instructor's summary remarks to conclude the exercise? – We often talk about scaling production down, depending on the price or marginal cost changes, but we rarely talk about concrete aspects of cost reduction, such as partial shutdown of the facilities. In a way this is a very "visible" cost reduction (in many college towns with a colder winter or seasonal reduction in demand you would be able to point out venues closing patios instead of maintaining outdoor seating). This can segue into a short discussion of how economic models may evolve depending on what important aspects of an agent's behavior you are trying to model.

Assessment

Numbers can be changed in the second part of the exercise to deliver outcomes other than the partial shutdown of the facilities. Consider the following options: (1) Building maintenance $2,500; (2) Employee salaries are $3,000. These numbers would result in different shutdown/operation decisions, either separately or in combination.

References and Resources

N/A