When will a perfectly competitive firm shut down?

To answer to this question, it is crucial that the students understand the difference between variable and fixed costs.Variable costs relate directly to the level of production and are dependent on it. When production (quantity produced) rises, variable costs rise too and vice versa. When the firm produces 0 units of output, variable costs will equal 0. A classic example of variable costs are electricity bills. The higher the level of production the higher the bills will be.Fixed costs do not rely on the quantity produced and hence are independent of the level of production. A good example of fixed cost is the rent a company is paying. For instance, no matter if a can manufacturer produces 0 or 10 or 20 cans a day, the fixed cost will always be the same and independent of the quantity produced.Having drawn the line between the two types of costs, we can easily answer to the original question. Why would a firm shut down? The answer is that it is no longer making a profit. But does this mean that whenever a firm is making a loss, it will have to shut down? The answer is no. Even when firms are making a loss, they still need to minimize their losses and shutting down might not always be the best option, cause shutting down cannot guarantee that the firm is following a loss-minimizing strategy.Why is that? Let’s look at two different scenarios. Scenario A, where the firm’s revenues from production cover all variable costs and part of the fixed costs and scenario B, where the firm’s revenues from production cover only part of the variable costs and none of the fixed costs.Is, under scenario A, shutting down the loss minimizing option for the firm? The answer is no, and the reason is that while the firm is making a loss when producing, the loss would be greater if it ceased production. The firm’s loss from producing is only the part of the fixed costs that are not covered by the revenues. In the case the firm shut down, the loss would be all its fixed costs, not part of them, because fixed costs must be remunerated even if the firm does not produce.To the contrary, shutting down, under scenario B, appears to be a wise choice. If the firm shuts down, then the loss will be equal to the entire fixed cost, whereas if it doesn’t, the loss will equal the entire fixed cost and the part of the variable cost that is not covered by the revenues.To summarize the above, losses generated by a firm do not necessarily lead to the shut down of the firm. It depends on the scenario under which the firm operates.