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Shutting down or exiting industry based on price

AP.MICRO:
PRD‑2 (EU)
,
PRD‑2.A (LO)
,
PRD‑2.A.1 (EK)
,
PRD‑2.A.2 (EK)
A firm shut's down temporarily when it can't cover its variable cost, but it exits the industry for good when it's economic profits are negative. In this video, learn more about how to use a graph of cost curves to determine when a firm shuts down, enters an industry, or exits an industry.

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  • blobby green style avatar for user nicklaus.millican
    Why would price levels below average variable cost lead to immediate shutdown? Doesn't the firm stand to offset fixed costs by continuing to produce?
    (4 votes)
    Default Khan Academy avatar avatar for user
    • leafers ultimate style avatar for user Cedric
      Imagine if you bought a food truck, then realized it was going to cost you $7 for the ingredients for each burger, and the market price was $5. Making each burger would be a $2 loss, so you would not produce at all. This is a situation where average variable costs are greater than price.
      (5 votes)
  • starky seedling style avatar for user JJ
    Do any of these points change depending on if it's a competitive market or a monopoly?
    (1 vote)
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  • boggle blue style avatar for user Bryan
    How could it be possible for a firm's MR for every unit of output to be higher than it's MC (basically, for every incremental unit of output the firm is making more revenue than it cost them), but the firm's total revenue is still lower than the total variable cost?

    They earned a profit on every incremental unit of output, so shouldn't the total revenue be greater than total variable cost?

    Also, does the AVC curve not have to start off at the same place as the MC curve, since for the first unit of output, they are the same?
    (1 vote)
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    • sneak peak yellow style avatar for user Dr. Yesimkhan Seidikarim
      For the first unit AVC doesn't equal to MC, because MC is incremental, while the AVC is the average.
      So, for example, a jump from 10,000$ to 10,400 as 40 more quantities produced from 100 would result in 10$ MC, while the AVC = 10400/140.
      Because the MR which is also AR(average revenue)price is simply lower than of ATC, if you sell toy for 100$, but on average it costs to you produce it 140, then your Total Revenue will be less than Total cost
      (1 vote)

Video transcript

- [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 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 costs, 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 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 a profit-maximizing firm to produce at a quantity where the marginal cost and the marginal revenue is meet. And 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 entrants. Other people might say, hey, I wanna make just as much money as this donut company right over here, than this firm, and so you'll probably have more and more entrants 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 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 break-even. It's not running at a loss or a profit. So it is break-even 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 entrants, so no longer attracting, attracting entrants. 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-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 then in the long-run, where it's like, hey, are you going to sell your factories or somehow dismantle them or are you 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-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 but 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 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 entrants. 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 wanna 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 it just doesn't make sense to even operate another moment.