Final answer:
The price below which a firm will shut down is dictated by its variable costs. This shutdown decision is made when the price is less than the average variable cost, leading to a scenario where the loss from continuing operation exceeds that from ceasing production. Fixed costs, being sunk costs, do not influence the decision to shut down.
Step-by-step explanation:
The critical price below which a firm will shut down depends on the firm's variable costs. In a short-run scenario, a firm encounters both fixed costs, which are incurred before production starts and are considered sunk costs, and variable costs, which are incurred during the production process. When the price of a product falls below the Average Variable Cost (AVC), the firm is not able to earn sufficient revenue to cover these variable costs. At this point, it will suffer less loss by shutting down and not producing any output because it would only have to bear the fixed costs, which are sunk costs, as opposed to bearing both variable and fixed costs if it continued to operate.
Fixed costs do not influence the shutdown decision, because they will be incurred whether or not the firm is in operation. Thus, a firm will continue to operate as long as it can cover its variable costs with the revenues obtained from production. If the firm cannot cover its variable costs, it is economically viable to cease production, minimizing the loss to just the fixed costs. This decision is also guided by the relationship between Marginal Cost (MC) and AVC, where the firm will shut down if the price reaches a level at or below the shutdown point where MC crosses AVC.