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Understanding the long term supply curve in terms of economic profit. Created by Sal Khan.
Video transcript
Voiceover: We've now thought a lot about the orange juice market, at least at a firm-specific level within the last few videos. We talked about what our average total costs and average variable costs and marginal costs are, if we are running an orange juice making business. Now let's think about what happens at the market level. We're going to go back to some of what we've thought about in the past in terms of just supply and demand curves. This is the orange juice, orange juice market, and let's just draw some supply and demand curves right over here. This is going to be, this is going to be the price per gallon, price per gallon, and let's say that this right over here is $1. This right over here is 50 cents, and this is 0, and let's say that this is the quantity, quantity, quantity in gallons per week, and gallons per week. We're going to talk about the entire orange juice market, so this is going to be in millions of gallons per week. Millions of gallons per week, per week. That is, let's say this is 1, 2, 3, 4, 5, and 6. Let's just say, and I'm going to simplify it relative to what we saw in the last video. Let's just say that the supply curve for the orange juice market, and I'll be careful this time. This is the near-term supply curve, or the short-term supply curve, looks like, looks something like this. that is the supply curve. This is the entire market. These are all of the orange juice producers. So to get them to produce even that first gallon, it looks like they need about 20 cents for that first gallon, and then each incremental gallon, they need more and more money. The marginal cost of that incremental gallon and for the market as a whole is going higher and higher and higher. They have to get oranges from futher away and transport them further and further. This right over here is the supply curve, or you could view it as the marginal cost, marginal cost curve. Now let's just draw an arbitrary demand curve here. The demand curve, let's say it looks something like this. Let's say that's our current demand, that is our current demand curve, and then what I'm going to add to this is I'm going to add the price at which firms, the suppliers of the orange juice make are neutral with returns to economic profit, or when economic profit is equal to 0. Let's say right over here, which happens to be our current equilibrium price, this is the price, so 50 cents per gallon, this is the price at which economic profit is 0. so I'll just write economic profit is equal to 0. I want to remind you, economic profit being 0 does not mean that the accounting profit is 0. People could be making money at this price, it just says that they're neutral whether or not they should be doing this business. That the amount of money that they're making is roughly comparable to their opportunity cost to be doing other things. When I say economic profit is 0, sometimes that's called the normal profit, when economic profit is 0. This is the price at which people are neutral between shutting down and starting up their business. If you have positive economic profit, that means that more people will want to go into this market and if you have negative economic profit, that means that people are going to want to essentially use up their fixed expenses, their equipment and any labor contracts they might have and then go out of business. This is where, this is that point right over there. Now let's think of a couple of scenarios. Let's say a research paper comes out and in that research paper, for whatever reason, we don't know if it was well-done research. It says oranges are bad for you, for whatever reason. When the research paper comes out and says oranges are bad for you, what happens to demand? Well, at any given price, demand will go down. At any given price, demand will go down, and the new demand curve might look something like this. Now, in the near term, we have a new equilibrium price, and we have a new equilibrium quanitity. This was the old equilibrium price, the way I set that up, it just happened to be the price at which economic profit is 0, and this was our old equilibrium quantity, a little over 3 million gallons a week. Now we have a new, lower equilibrium price. We have a new lower equilibrium price. I don't know, this looks about 40 cents per gallon, and we have a new lower equilibrium quantity. Now, what happens at this price? Obviously in the near term, people are willing to produce there because that's where their marginal cost is, so, as we saw in multiple videos that someone's willing to produce when the price is equal to their marginal cost, or they're willing to produce a quantity up to when their marginal cost is equal to the marginal revenue, or the price that they're going to get. But, I just said that they need to be getting 50 cents a gallon in order to make an economic profit. Now if they get, I don't know, this looks like about 40 cents a gallon, they're going to be having an economic loss. So no profit. No profit there. If there's no profit there, it really doesn't make sense for them to continue, or at least it doesn't make sense for all of them to continue in that business. What's going to happen is that over time, it will make sense for them in the near term to produce, to use up, they've already put in their cost for their equipment and maybe labor contracts and whatever else. But over time, when prices are this low, as people use up their equipment, there's no incentive for them to buy new equipment. As the labor contracts expire, there's no incentive for them to renew the labor contract. As those things expire, they're just going to shut down the business. So as they shut down the business, as they shut down the business, two things will happen. Quantity produced in the market will go down, and the price will go up. We will essentially move along this curve until we get to this point. That's the point, once the price is at 50 cents a gallon again, then people are neutral now. They're not going to shut down their firms. We're going to get to this new equilibrium price and equilibrium quantity in the long term, in the long term. Now let's think of another situation. Instead of a newspaper report saying that oranges are bad, let's say a newspaper report comes out saying oranges are very good. They make you live longer. They are the best thing that you can have. Well, then, at any given price, you're going to have more demand, and so you'd have a demand curve that looks something like that. Then, you'd have a higher equilibrium quantity, and a higher equilibrium price. And, people are going to be making, since the price is higher, than the price at which the economic profit is 0, people are going to be making very positive economic profits, which means that there's a strong incentive, that people are neutral between shutting down the business or starting up the business. At that point, a lot of people are strongly motivated to enter into the business. What's going to happen is, more and more people are going to get more and more equipment, hire more and more people, and as they do that, quantity is going to go up, and the price is going to go down. And so, over the long term, you're going to shift back to this line. Once the price gets down to that, then there's no reason for more people to enter. They're kind of neutral about it. What you see happening is in the short term, you would look at where the demand curve intersects with the short-term supply curve, but in the long term, you care where it intersects with this kind of horizontal line, which is the price at which economic profit is 0. That's why you will hear, and this is kind of a more precise way of thinking about it than we've done in the previous videos, this horizontal line right over here, you could view this as the long run, the long run, long run supply curve, long run supply curve. That says look, pretty much whatever we will always produce over the long run, we will always produce whatever supply is kind of necessary, given that people are neutral when it comes to economic profit. You go down here, yes, people will try to use up their fixed costs, but once they used up their fixed costs, no incentive for them to stay in business, then some of them go out of business. Price goes up, quantity goes down. You get back to the long run supply curve, where that intersects with the demand curve, or if the opposite happens. A lot of economic profit, a lot of entrance into the market, price goes down, supply goes up. You get back to the long run supply curve. I guess you could say, you could go back to where the new demand curve is intersecting the long run supply curve.