•    We know that a firm has to incur fixed cost in the short run even if it stops production altogether.

• If a firm choose to close down and stop producing the losses would be equal to its fixed cost.

• Since total costs is the addition of total fixed cost and total variable cost, when price drops so low that, the revenues are insufficient to meet variable costs, the firm can avoid these costs by stop producing.

• When a firm produces no output to minimise its loss, but retains the capital that would allow it resume production later, it is said to be in shut down situation.

• Since fixed cost must be paid even if the firm produces nothing, the shut – down results in a loss that equals to the firm’s fixed cost.

• Therefore, before taking any decisions regarding production, the firm has to compare the losses in the two situations – losses in a situation of shut – down  and losses when the firm continues to produce.

• If the losses in production are less than or equal to the losses in shut – down, the firm decides to produce.

• This means that the firm will produce output only if the price (P) or the average revenue (AR) covers at least the average variable cost (AVC)  or we can say that the price will be equal or greater than average variable cost. Because in that case losses in the product would be equal to or less than losses in case of shut – down. 

• If the price equals average variable cost (AVC) ,it means that the firm is covering only variable cost and not able to cover fixed cost. Thus, the losses in both situation, shut – down or production – would be the same i.e., equals to the fixed cost.

• If the price is more than AVC, then the firm would cover entire variable cost and a part of fixed cost. Here the losses in the production is less then the losses in shut – down. Therefore the firm would like to produce.

•  Therefore the first rule or condition is –  “In short run, a firm should produce if and only if  (P > AVC or P = AVC)”

     2. A Rule that is necessary for Profit Maximisation  :

• When the first rule is satisfied, then the firm has to decide as to how much should it produce.

• The firm would produce that amount of output which maximises its profits.

• Profit maximisation output would be the one which equates marginal revenue with marginal cost. 

• So the second rule wold be –  “A necessary condition for a profit maximising firm is that the marginal revenue (MR)  should be equal to marginal cost (MC).”

• If a firm finds that the cost of producing one more unit (MC)  is less than the additional revenue earned by selling that unit (MR)    

• If the firm finds that the cost of producing one more unit is more than the additional revenue earned by selling that unit i.e., MC > MR . it means, that this additional unit produced reduces profits. So, the firm can increase its profits by producing less.

• Equality between marginal cost and marginal revenue not always indicate profit maximisation but some times it indicates minimisation of profit also.

• So the third rule is – “when marginal cost and marginal revenue equates, to ensure profit maximisation, rather than profit minimisation, marginal cost should be less than marginal revenue at slightly lower level of output and marginal cost exceeds marginal revenue for slightly higher level of output.”

• Given figure shows the diagrammatic illustration of MR and MC approach.

• In the figure, MR curve is marginal revenue curve and MC is marginal cost curve.

•  The curve MC cuts curve MR at two points, therefore, MC = MR at two level of output OQ0  and. OQ1.

• Output  OQ0 is minimum profit position up to OQ0 level of output, the firm is incurring losses.

• Point R is break even point at which level MR = MC.

• Beyond  OQ0  level the firm is earning profit  since     MR > MC. Therefore, the firm will not stop producing at OQ0 level, as it is profitable for the firm to produce up to  OQ1  level of output.

•  Thus, point R where MC cuts MR from above , can not be the point of equilibrium.

• On the other hand, output OQ1 level is profit maximising output since any change in output in either direction would reduce profit.

• For the output just below OQ1 level  MC < MR , so profit can be increased by increasing output towards OQ1.

• Similarly, for the output above OQ1 level, MC > MR , therefore profit can only be increased by reducing output towards OQ1 level.

• Thus, point K, corresponding to the OQ1 level of output is the point of equilibrium.

• It can be concluded that MC curve should intersect MR curve from below, so that MC is less than MR to the left of equilibrium point and MC is greater than MR to the right of equilibrium point where the profit is maximum.