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Main content
Current time:0:00Total duration:7:40
PRD‑2 (EU)
PRD‑2.A (LO)
PRD‑2.A.1 (EK)
PRD‑2.A.2 (EK)

Video transcript

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 doughnuts so it's in the donut industry and we can see how the marginal cost relates to the average variable cost in average total cost we go into some depth several videos ago but we see that trend that marginal costs 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 the 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 costs 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 given 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 a previous video we already said it would be rational for profit maximizing firm to produce at a quantity where the marginal cost and the marginal revenue is meat and if we're talking about a competitive market then the 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 a the same thing as the marginal revenue so in this situation at P sub 1 the firm would produce Q sub 1 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 farm the profit is going to be the price minus the average total cost at that quantity times the actual quantity so because p1 is greater than the average total cost u 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 doughnut 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 2 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 2 now in this situation P sub 2 is equal to the average total cost so the firm is breakeven it's not running at a loss or 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 a tracking 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 break even 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 3 and at P sub 3 right over here there's some interesting things because P sub 3 is less than your average total cost ferm 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 what is this firm likely to do what it 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 costs 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 then in the long run we're stuck hey who are you going to sell your factories or or somehow dismantle them or you're going to 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 4 here in theory this is where we intersect the marginal cost curve Q sub 4 now here it makes no sense for the company to operate at all so because P sub 4 is less than the average total cost you would want to exit in the long run exit in long run exit the market but you wouldn't even wait for that long wait to sell your factories because C piece of 4 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 p1 where you make a profit but you might attract entrance at P sub to you as a firm in the long run our neutral versus exiting the market or entering the market or other people entering the market you're at break-even at P sub 3 in the long run you'd want to exit because you're not profitable if the prices stay at P sub 3 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 3 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 4 where the price gets so low that just doesn't make sense to even operate another moment