WHY DO FIRMS STAY IN BUSINESS EVEN IF THEY ARE MAKING A LOSS?

If you are a regular news watcher, you will be familiar with the idea of businesses reporting their profits (or loss) for past periods. One intriguing result of such reports is that some firms will report a loss for the past period or sometimes consecutive periods, but will still not shut down rather than incur loss. I think its worth pointing out what we mean by a loss; A loss in business is a negative profit, a situation where a business spends more than it earns (expenses are greater than revenues), which means the extra expenses is financed from some where else, perhaps from savings or a loan.

So why don’t businesses just shut down when they are making a loss and make zero profits rather than operating at a loss? One obvious answer might be prospective profits; that firms operate believing that the loss is for short-term and that the future is bright, however a seconds thought will tell you that if this was the case, then all firms in same industry will pretty much stay operating if they are making a loss, but this is not the case, In fact even firms in same industry quit at different time periods if they continue incurring losses.

It turns out that Variable costs are the determinants of exit decisions for firms. Costs in business are divided into two; fixed and variable costs. Fixed costs are costs that are fixed, regardless of the level of production, e.g. rent, which you pay whether you produce a single unit or nothing, Variable costs are costs that directly vary with output, e.g. wages and raw materials cost, this costs changes as the level of output changes.

When firms make decisions about whether to stay in business or shut-down, they only consider their variable cost’s and ignore the fixed costs. Here is why you see some firms making a loss but still stay in business in the short-run; If a firm is making a loss, but it’s profits are more than it’s variable cost’s, then the firm is better off operating at that loss level than shutting down, on the other hand if a firm is making a loss that it’s profits are less than it’s variable cost, then the firm is better-off by totally shutting down. The technique behind the analysis here is the fact that firms have to pay the fixed cost in the short run regardless of either they produce or shut down, so if they shutdown their business in the short-run they make a loss equal to their fixed cost, now if they are making a profit that is more than their variable cost, then they can pay the difference towards reducing their fixed cost (which they would have to pay for in full otherwise). Here is the trick, firms pay their fixed cost regardless of whether they produce or not, so it makes business sense when ever a business is making a profit more than its variable cost to stay operating in order to minimise lost.

The idea of firm decision making is better explained with an example; consider a Sole trader who operates’s a convenient store in downtown New York with the following costs;

One year property lease @ $2000/month

Wages of two employees @ $1500/month each

If the traders monthly revenues are $4000

Then the Traders monthly profit/loss statement will be as follows:

Total Revenue	4000
Minus Expenses:
Variable Costs:
Wages employee A	1500
Wages employee B	1500
Profit Before Fixed Cost	1000
Less Fixed Cost:
Rent	2000
Net Profit:	-1000

Now this trader is definitely making a monthly loss of $1000, the interesting question is should s/he shut down? And the answer is no! The trader should operate at a loss of $1000 in the short run. If he chose to shut down, here is what is going to happen, he will be  paying the rent of $2000 because this is fixed regardless of whether he sell or not, remember he signed a one year lease contract, normally businesses pay their rent in advance. However the firm should just shut down anytime the revenue goes below $3000, because his profit won’t even cover his variable cost, it’s left to the reader to change the total revenue to any amount less than $3000 and observe what happen to the profit/loss at that level. At any level of total revenue less than $3000 the trader will be making a loss more than his rent of $2000/ month, hence it’s better for him to stop trading and only pay the rent in the short run than incur a cost more than $2000 when he could do better.

It’s due to this reason that you see that some firms leave the industry so quick once loss hits whiles others in same industry continue operating while still making a loss. The nature of a firms cost determines when to exit the business and this is at any point where profit is less than variable cost.

I have be talking about short-term all along this article, but what do I actually mean by short-term? In economics short term is referred to as the time period within which at least one input of production is fixed and cannot be changed (In order words no specific time period attached to it). These is a very important definition with regards to firms exit decisions, because once all inputs are variable and can be changed, then it doesn’t make any sense for a firm to  operate a business at a continuous loss. Let’s revisit our previous sole trader example, if this guy can re-transfer his Lease (re-rent) to a third party, then it is no more a fixed cost and then he will be better off by just shutting down and make zero profits, however in general we don’t expect such processes to be very immediate, hence the name short-term.

If firms are making a loss, but their revenue is greater than their Variable cost, they will continue to operate until they can get rid of their fixed cost, this take different times for different firms, since every firm have different cost structures, that’s why we witness the shut down of Blockbuster  happened so quick when sales dwindle. 

“An Economist is a man who states the obvious in terms of the incomprehensible”

Alfred A Knopf.