Shutting down or exiting industry based on price | AP Microeconomics | Khan Academy

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. 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.

Then the marginal cost, the cost of each incremental unit as a function of quantity, could go up because of things like coordination costs. We've also seen how that relates to average variable costs. 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. The same thing happens once it crosses the average total cost.

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 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. So it is a price taker.

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 1. 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 met. 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. It would be the same thing as the marginal revenue.

In this situation at p sub 1, the firm would produce q sub 1. 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. Since p1 is greater than the average total cost, we have a situation where the firm is profitable. The 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 want to make just as much money as this donut company right over here." Thus, 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 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. 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 break-even. It's not running at a loss or a profit, so it is break-even.

Here, the firm is neutral about whether in the long run it stays in the market or it exits the market. You're no longer likely attracting entrants. 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. 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 are some interesting things because p sub 3 is less than your average total cost; your firm is running at a loss. It's running at a loss here, so the firm is not profitable. 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 costs have already been spent, so you might as well get as much incremental profit on the margin as you can. 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: they would stay operating in the short run.

But what would this firm do in the long run? Well, in the long run, it makes no sense to be in a market where you can't make a profit. So in the long run, it will exit; it will exit in the long run. In general, the terminology when people are talking about whether you start or stop in the short run, they usually talk about do you either shut down or operate in the short run.

Then in the long run, 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. 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. Because p sub 4 is less than the average total cost, you would want to exit in the long run. Exit in the long run means to exit the market, but you wouldn't even wait that long to sell your factories because p sub 4 is less than your average variable cost; you would also just shut down in the short run.

So 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 entrants at p sub 2. As a firm in the long run, you are neutral versus exiting the market or entering the market or other people entering the market. 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. Then the last scenario, of course, is p sub 4 where the price gets so low that it just doesn't make sense to even operate another moment.