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An illustrative example of the decision-making process for a company facing negative economic profit, using the analogy of a homeowner's budget. The concept of covering fixed and variable expenses, and the importance of evaluating the social costs of bankruptcy or leaving an unwieldy situation.
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In this example, we are going to examine the decision of a company to either continue operation even though they are making negative economic profit or shut down their production. In order to illustrate this concept, we will use an example of whether you should abandon your home since this situation may be easier to understand. Letโs assume your monthly budget is as follows: Monthly Budget 1 In this situation, your wages are equal to your total expenses (Total Revenue = Total Costs). In this situation, it is obvious that you would continue to live in your current home. Now, letโs assume your hours at your job get cut back. Here is the effect on your budget. Monthly Budget 2 We can see from the above budget that your income is less than your total expenses (Total Revenue > Total Cost). So you have to decide on whether or not you should abandon your home. There are two kinds of expenses, fixed and variable. Since your income at least pays your fixed expenses (mortgage/rent) you decide that you would lose more by leaving the home since you are still obligated to pay your mortgage. Specifically, you can cover your mortgage and at least some of your variable expenses. So you start to look for ways to cut your variable expenses. You may start eating at home more rather than going out. You may decide to cut back on cable or get rid of your home phone. You
also may decide to cut back on your electricity usage. You make some changes to your variable expenses and you adjust your budget. Monthly Budget 3 As a result of your cuts, you are still paying more in expenses that you are earning, but you are better off than before. You decide to stay in your home because you can at least pay the mortgage (fixed expense). If you did decide to leave, not only would you have to still pay the mortgage, but you would also have to pay rent at the new apartment. So you would lose more if you left the house than if you stayed and hoped things got better. Now, letโs assume your hours at work got cut again. This time, it was a big cut. Monthly Budget 4 Now you have a real decision to make. Now your income is less than your fixed expenses. So not only can you not pay your variable expenses, but now you cannot pay your fixed expenses as well. You may have some time until they come and kick you out. So you may stick it out for a few months in hopes that something will change. At this point, you may have to consider leaving. You may have to decide to move in with your parents. You are still obligated to pay your mortgage but at least by living with your parents, you will not have to pay rent somewhere else (unless you have my parents).