- [Instructor] We've spent
several videos already
talking about graphs like you see here.
This is the graph for a particular firm.
Maybe it's making donuts
so it's in the donut industry.
And we can see how the marginal cost
relates to the average variable cost
and average total cost.
We go into some depth several videos ago
but we see that trend that marginal cost
can trend down initially
because as quantity increases
each incremental unit could benefit
from things like specialization.
And then the marginal cost,
the cost of each incremental unit
as a function of quantity, could go up
because of things like coordination costs.
And then we've also seen
how that relates to average variable cost,
that while marginal cost
is below average variable cost,
every incremental unit is going
to bring down the average variable cost.
But then when marginal cost
crosses average variable cost,
well, now every incremental unit
is going to bring up the
average variable cost.
And the same thing happens
once it crosses the average total cost.
And of course the difference
between, for any give quantity
between the average total cost
and the average variable cost,
that is the average fixed cost.
Now, with that out of the way
we're going to think about how this firm
would react under different
market conditions.
We're going to assume that it's
in a very competitive, or we could say
a perfectly competitive market,
and so it is a price taker.
And so let's first imagine
what would be a positive scenario
for this firm?
Let's imagine the price up here.
So let's call this P sub-one
and in the previous video we already said
it would be rational for
a profit-maximizing firm
to produce at a quantity
where the marginal cost
and the marginal revenue meet.
If we're talking about
a competitive market,
then this price right over here
is not going to be a function
of the firm's quantity,
so that's why it's horizontal,
and it would be the same thing
as the marginal revenue.
So, in this situation, at P sub-one,
the firm would produce Q sub-one,
and this is a good situation for the firm,
because the price that it's getting
is higher than its average total cost.
And so there is going to be
a nice amount of profit for this firm.
The profit is going to be the price
minus the average total
cost at that quantity
times the actual quantity.
So, because P one is greater
than the average total cost,
we have a situation where
the firm is profitable.
Firm is profitable.
It would want to stay in the market.
But because you have a profitable firm
in this market and you're likely to have
many profitable firms in that market,
it will probably attract entrance.
Attract,
attract entrance.
Other people might say,
hey, I want to make just as much money
as this donut company right over here,
then this firm, and so you'll probably
have more and more
entrance into the market,
which will probably reduce the prices.
Now, they could reduce the prices
until you get to a price that looks
something like this.
So I will call that P sub-two.
Now, a profit-maximizing firm
in this world would keep producing
until the marginal cost is equal
to the marginal revenue,
which in this case is the price.
And so this would be,
my lines aren't completely straight there,
but you get the idea.
So that's Q sub-two.
Now, in this situation, P sub-two
is equal to the average total cost
so the firm is breakeven.
It's not running at a loss or a profit.
So it is breakeven.
And so here the firm is neutral
about whether in the long run
it stays in the market
or it exits the market.
But you're no longer
likely attracting entrance.
So no longer
attracting,
attracting entrance.
But it does make sense for the firm
to keep operating at this situation
even in the long run,
because it is at least breakeven.
Now let's imagine another scenario.
Let's imagine this price level.
So for whatever reason the market price
gets to that as we've talked about.
A rational firm would be producing
at Q sub-three.
And at P sub-three right over here
there's some interesting things.
Because P sub-three is less
than your average total cost,
your firm is running at a loss.
It's running at a loss here.
So running, so firm,
firm not profitable.
Not profitable.
Now, you might say,
well, what is this firm likely to do?
Would it just shut down?
Well, in the short run it would not
make sense for this firm to shut down,
because the price that it's getting
is still higher than its
average variable cost.
In the short run, the fixed cost,
they've already been spent.
So, you might as well get as much
incremental profit on
the margin as you can.
And so as long as the price is higher
than the average variable cost,
well, outside of their fixed cost
they're still making some money
to make up those fixed costs.
So you have two things going on.
So, they would stay operating
in the short run, stay operating,
operating in the short run,
short run.
But what would this
firm do in the long run?
Well, in the long run it makes no sense
to have a, to be in a market
where you can't make a profit.
So in the long run it will exit.
So, it will exit
in the long run.
And in general, the terminology
when people are talking about "well,
"do you start or stop in the short run,"
they usually talk about "do you either
"shut down or operate in the short run?"
And in the long run we say hey,
are you going to sell your factories,
or somehow dismantle them,
or are you gonna build new factories?
That's all about exiting
or entering the industry.
And of course, you have another
even worse scenario for this firm,
which might be down here,
where you have price sub-four.
Here, in theory, this is where
we intersect the marginal cost curve,
Q sub-four.
Now here it makes no sense
for the company to operate at all.
So, because P sub-four is less
than the average total cost,
you would want to exit in the long run,
exit in long run, exit the market.
Well, you wouldn't even
wait for that long,
wait to sell your factories.
Because P sub-four is less
than your average variable cost,
you would also just shut down,
shut down,
in the short run.
So, a big picture.
From a firm's point of view,
you obviously want to be at P one
where you make a profit,
but you might attract entrance.
At P sub-two, you as a firm
in the long run are neutral
versus exiting the market
or entering the market,
or other people entering the market.
You're at breakeven.
At P sub-three, in the long run,
you'd want to exit because
you're not profitable,
if the prices stay at P sub-three.
Your price is below
your average total cost
at the rational quantity to produce,
so in the long run you would exit.
But because P sub-three is greater
than your average variable cost
at the rational quantity,
you would stay operating in the short run.
And then, the last scenario, of course,
is P sub-four where the price gets so low
that just doesn't make sense
to even operate another moment.
