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Analyzing the Decision to Continue Operations: A Homeowner's Perspective - Prof. Justin D., Study notes of Economics

Virginia Commonwealth University (VCU)Economics
Prof. Justin D. White

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.

Typology: Study notes

2009/2010

Uploaded on 12/09/2010

mikechen168
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Should๎˜ƒYou๎˜ƒStay๎˜ƒor๎˜ƒShould๎˜ƒYou๎˜ƒGo?๎˜ƒ
In๎˜ƒthis๎˜ƒexample,๎˜ƒwe๎˜ƒare๎˜ƒgoing๎˜ƒto๎˜ƒexamine๎˜ƒthe๎˜ƒdecision๎˜ƒof๎˜ƒa๎˜ƒcompany๎˜ƒto๎˜ƒeither๎˜ƒcontinue๎˜ƒoperation๎˜ƒeven๎˜ƒ
though๎˜ƒthey๎˜ƒare๎˜ƒmaking๎˜ƒnegative๎˜ƒeconomic๎˜ƒprofit๎˜ƒor๎˜ƒshut๎˜ƒdown๎˜ƒtheir๎˜ƒproduction.๎˜ƒ๎˜ƒIn๎˜ƒorder๎˜ƒto๎˜ƒillustrate๎˜ƒ
this๎˜ƒconcept,๎˜ƒwe๎˜ƒwill๎˜ƒuse๎˜ƒan๎˜ƒexample๎˜ƒof๎˜ƒwhether๎˜ƒyou๎˜ƒshould๎˜ƒabandon๎˜ƒyour๎˜ƒhome๎˜ƒsince๎˜ƒthis๎˜ƒsituation๎˜ƒmay๎˜ƒ
be๎˜ƒeasier๎˜ƒto๎˜ƒunderstand.๎˜ƒ๎˜ƒLetโ€™s๎˜ƒassume๎˜ƒyour๎˜ƒmonthly๎˜ƒbudget๎˜ƒis๎˜ƒas๎˜ƒfollows:๎˜ƒ
๎˜ƒ
Monthly๎˜ƒBudget๎˜ƒ1๎˜ƒ
In๎˜ƒthis๎˜ƒsituation,๎˜ƒyour๎˜ƒwages๎˜ƒare๎˜ƒequal๎˜ƒto๎˜ƒyour๎˜ƒtotal๎˜ƒexpenses๎˜ƒ(Total๎˜ƒRevenue๎˜ƒ=๎˜ƒTotal๎˜ƒCosts).๎˜ƒ๎˜ƒIn๎˜ƒthis๎˜ƒ
situation,๎˜ƒit๎˜ƒis๎˜ƒobvious๎˜ƒthat๎˜ƒyou๎˜ƒwould๎˜ƒcontinue๎˜ƒto๎˜ƒlive๎˜ƒin๎˜ƒyour๎˜ƒcurrent๎˜ƒhome.๎˜ƒ๎˜ƒNow,๎˜ƒletโ€™s๎˜ƒassume๎˜ƒyour๎˜ƒ
hours๎˜ƒat๎˜ƒyour๎˜ƒjob๎˜ƒget๎˜ƒcut๎˜ƒback.๎˜ƒ๎˜ƒHere๎˜ƒis๎˜ƒthe๎˜ƒeffect๎˜ƒon๎˜ƒyour๎˜ƒbudget.๎˜ƒ
๎˜ƒ
Monthly๎˜ƒBudget๎˜ƒ2๎˜ƒ
We๎˜ƒcan๎˜ƒsee๎˜ƒfrom๎˜ƒthe๎˜ƒabove๎˜ƒbudget๎˜ƒthat๎˜ƒyour๎˜ƒincome๎˜ƒis๎˜ƒless๎˜ƒthan๎˜ƒyour๎˜ƒtotal๎˜ƒexpenses๎˜ƒ(Total๎˜ƒRevenue๎˜ƒ>๎˜ƒ
Total๎˜ƒCost).๎˜ƒ๎˜ƒSo๎˜ƒyou๎˜ƒhave๎˜ƒto๎˜ƒdecide๎˜ƒon๎˜ƒwhether๎˜ƒor๎˜ƒnot๎˜ƒyou๎˜ƒshould๎˜ƒabandon๎˜ƒyour๎˜ƒhome.๎˜ƒ๎˜ƒThere๎˜ƒare๎˜ƒtwo๎˜ƒ
kinds๎˜ƒof๎˜ƒexpenses,๎˜ƒfixed๎˜ƒand๎˜ƒvariable.๎˜ƒ๎˜ƒSince๎˜ƒyour๎˜ƒincome๎˜ƒat๎˜ƒleast๎˜ƒpays๎˜ƒyour๎˜ƒfixed๎˜ƒexpenses๎˜ƒ
(mortgage/rent)๎˜ƒyou๎˜ƒdecide๎˜ƒthat๎˜ƒyou๎˜ƒwould๎˜ƒlose๎˜ƒmore๎˜ƒby๎˜ƒleaving๎˜ƒthe๎˜ƒhome๎˜ƒsince๎˜ƒyou๎˜ƒare๎˜ƒstill๎˜ƒobligated๎˜ƒ
to๎˜ƒpay๎˜ƒyour๎˜ƒmortgage.๎˜ƒ๎˜ƒSpecifically,๎˜ƒyou๎˜ƒcan๎˜ƒcover๎˜ƒyour๎˜ƒmortgage๎˜ƒand๎˜ƒat๎˜ƒleast๎˜ƒsome๎˜ƒof๎˜ƒyour๎˜ƒvariable๎˜ƒ
expenses.๎˜ƒ๎˜ƒSo๎˜ƒyou๎˜ƒstart๎˜ƒto๎˜ƒlook๎˜ƒfor๎˜ƒways๎˜ƒto๎˜ƒcut๎˜ƒyour๎˜ƒvariable๎˜ƒexpenses.๎˜ƒ๎˜ƒYou๎˜ƒmay๎˜ƒstart๎˜ƒeating๎˜ƒat๎˜ƒhome๎˜ƒ
more๎˜ƒrather๎˜ƒthan๎˜ƒgoing๎˜ƒout.๎˜ƒ๎˜ƒYou๎˜ƒmay๎˜ƒdecide๎˜ƒto๎˜ƒcut๎˜ƒback๎˜ƒon๎˜ƒcable๎˜ƒor๎˜ƒget๎˜ƒrid๎˜ƒof๎˜ƒyour๎˜ƒhome๎˜ƒphone.๎˜ƒ๎˜ƒYou๎˜ƒ
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Download Analyzing the Decision to Continue Operations: A Homeowner's Perspective - Prof. Justin D. and more Study notes Economics in PDF only on Docsity!

Should You Stay or Should You Go?

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. Letโ€™s 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, letโ€™s 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, letโ€™s 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).