Shut Down Decisions Under Perfect Competition:  

A perfectly competitive firm is considered to have shut down, if it ceases production temporarily but keeps fixed capital. A firm has exit the industry when it has made a permanent decision to leave the industry. The decision to temporarily shut down a firm depends on a few factors. We know that ATC = AVC + AFC. So the Average Fixed Cost (AFC) is the vertical distance between average variable cost and average total cost.

Supposing a perfectly competitive firm shuts down, its total revenue becomes zero, and its total cost equals the fixed cost. So the firm should continue producing its product, as long as it covers its variable costs. This way, total revenue is greater than total variable cost, because losses are then less than TFC. Basically, shut down when P (AR = MR) < AVC, to minimize the losses and so the firm's short-run supply curve equals the Marginal Cost curve above AVC. The firm therefore produces where profit equals marginal cost.

Another way to put this is that sunk costs are sunk. Fixed costs are sunk, and therefore cannot be recovered by shutting down in the short run. The decision to continue producing depends on revenues and variable costs. If average revenue is greater than average variable cost, then the firm should continue to produce. It is rational to continue producing, so long as AVC < P < ATC.

A firm should leave the industry when revenue is less than cost of operating in the long run. In other words, exit if total revenue is less than total cost (P < ATC). In competitive markets, a firm will make zero economic profits in the long run. If companies are making more than zero economic profits, it will encourage other firms to enter the industry to share in these profits. In other words, enter if total revenue is greater than total cost (P > AC). If firms are making zero economic profits, there is no entry and no exit, which is a long run condition.