A firm with fixed costs starts each month standing at the bottom of a deep financial hole. The depth of that "money pit" is equal to the dollar value of all the payments that the firm is legally obligated to make even if it is producing nothing. These fixed costs include contractually guaranteed salaries, interest payments on loans, and equipment rental fees that are locked in by long-term contracts. As the firm stands at the bottom of this fixed-cost financial hole and stares upward looking for a way out, it has to ask itself the following question: Will producing output make the hole even deeper? Naturally, the firm hopes that producing output will generate positive cash flows that will offset its fixed costs and start filling in the hole. If those positive flows are large enough, they may completely offset the firm's fixed costs, fill up the hole, and allow the firm to break even. And if they are just a bit larger, they will not only fill up the hole but also accumulate a nice little pile of profits above ground. But those are just the firm's hopes. The firm's reality may be quite unpleasant. In particular, the firm may be facing a situation in which producing output would make its financial situation worse rather than better. As explained in this chapter, if the firm's price falls too low, then producing output will yield cash flows that are negative rather than positive because revenues will be less than variable costs. If that happens, producing output will lose money for the firm so that the firm would be better off shutting down production rather than producing output. By shutting down, it will lose only its fixed costs. By shutting down, its financial hole won't get even deeper. A crucial thing to understand, however, is that the low prices that cause firms to shut down production are often temporaryso that shutdowns are also often temporary. Just because a firm shuts down at a given moment to prevent its financial hole from getting any deeper does not mean that the firm will go out of business forever. On the contrary, many industries are characterized by firms that regularly switch production on and off depending upon the market price they can get for their output and, consequently, whether producing output will generate positive or negative cash flows. Oil production is a good example. Different wells have different variable production costs. If the price of oil drops below a given well's variable costs, then it would be better to halt production on that well and just lose the value of its fixed costs rather than pumping oil whose variable cost exceeds the revenue that it generates when sold. Seasonal resorts are another good example of turning production on and off depending on the price. The demand for hotel rooms near ski resorts in Quebec, for instance, is much higher during the winter ski season than it is during the summer. As a result, the market price of hotel rooms falls so low during the summer that many inns and resorts close during the warmer months. They have all sorts of fixed costs, but it makes more sense for them to shut down rather than remain open because operating in the summer would cost more in variable costs than it would generate in revenues. It is better to lose only their fixed costs. Similarly, mills in northwestern Ontario experience temporary shutdowns due to fluctuating demand for pulp, paper, and lumber. Numerous other examples of temporary shutdowns occur during recessions, the occasional economy-wide economic slowdowns during which demand declines for nearly all goods and services. The 2008-2009 recession in Canada, for instance, saw many manufacturing companies temporarily shut down and "mothball" their production facilities. The recession witnessed the mothballing of electric generating plants, factories that make fibre optic cable, automobile factories, and chemical plants. Many other firms also shut down production to wait out the recessionso many, in fact, that there was a mini-boom for consulting firms that specialized in helping firms mothball their factories (the main problem being how to properly store idle machinery so that it will work again when it is eventually brought back into service). Firms that mothball factories or equipment during a recession do so expecting to eventually turn them back on. But the lengths of recessions vary, as do the specific circumstances of individual firms. So while many firms shut down in the short run with the expectation of reopening as soon as their particular business conditions improve, sometimes their business conditions do not improve. Sometimes the only way to terminate fixed costs is to terminate the firm.

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