Market Power

Musings by an academic economist on the power of markets and the power over markets.

Monday, March 07, 2005

Wither the Shut-Down Condition?

When economists teach the theory of production decisions, we run into the case where a firm may shut down in the short run. In this theory, the firm does not leave the market altogether. Instead, the firm finds that its price is "too low" to allow it to generate enough revenue to cover its variable costs. Since it minimizes losses by shutting down, it decides to not produce. Normally, when I teach the shut down condition, I teach it from the standpoint of a falling price with costs held constant, but it certainly could result from increasing costs at each level of production.

How often does this happen in the business world? Usually when people think of a firm shutting down, they think of the firm completely quitting business. But how often do firms stop production for a short period of time because of short-term price and cost considerations?

Several years ago, aluminum manufacturers shut down their operations because they found that their opportunity cost of using electricity that they had bought under favorable long-term contracts was too high relative to the price of their output. California was in the midst of its electricity crisis, and needed electricity. So, instead of using the electricity to manufacture aluminum, some aluminum companies sold the electricty to California. See here. A quote from the article:

Similarly, aluminum companies are collecting about $1.7 billion this year by not making aluminum. Companies like Alcoa have earned profits that delight Wall Street, while keeping about 10,000 workers on their payroll, by reselling hydropower that they bought in the mid-1990's under a cheap long-term contract.
The shut down condition at work.