0:00:01.416,0:00:03.205 ♪ [music] ♪ 0:00:09.076,0:00:11.394 - [Alex] Now that we know [br]how to find the profit 0:00:11.394,0:00:13.805 maximization point, [br]we're going to show 0:00:13.805,0:00:18.706 the amount of profit on the diagram [br]using the average cost curve. 0:00:23.516,0:00:25.398 So as I said in the last lecture, 0:00:25.398,0:00:27.928 average cost is the cost [br]per unit of output. 0:00:28.295,0:00:32.792 That is, average cost is[br]total cost divided by Q. 0:00:33.140,0:00:36.041 Now remember also [br]that total cost can be broken down 0:00:36.041,0:00:38.842 into fixed costs plus [br]variable costs. 0:00:39.219,0:00:42.681 So we can also write average cost[br]in a slightly longer format. 0:00:42.681,0:00:45.507 Average cost is equal [br]to fixed cost divided by Q 0:00:45.507,0:00:49.588 plus the variable cost divided [br]by Q, the units of output. 0:00:50.194,0:00:53.702 That's a little bit useful [br]because we're able to see, 0:00:53.702,0:00:57.188 get some intuition, for the shape [br]of a typical average cost curve. 0:00:57.557,0:01:02.324 Notice that the fixed costs [br]don't change with Q. 0:01:02.456,0:01:04.261 That's why they're fixed. 0:01:04.261,0:01:07.312 So when Q is small -- this number, 0:01:07.312,0:01:09.143 suppose fixed cost is 100, 0:01:09.143,0:01:12.292 and Q is small -- then this number [br]is going to be big 0:01:12.292,0:01:14.431 like 100 divided by 1. 9:59:59.000,9:59:59.000 As Q gets larger, however,[br]this number -- 9:59:59.000,9:59:59.000 fixed cost divided by Q -- [br]is going to get smaller, 9:59:59.000,9:59:59.000 So when Q is 10, this number [br]100 divided by 10 becomes 10. 9:59:59.000,9:59:59.000 So it goes from 100,[br]and it goes down, down, down, down, 9:59:59.000,9:59:59.000 get's lower and lower and lower[br]all the time as you divide 9:59:59.000,9:59:59.000 by a bigger quantity. 9:59:59.000,9:59:59.000 On the other hand, the variable [br]costs increase with quantity. 9:59:59.000,9:59:59.000 Moreover, what we saw [br]with the marginal cost curve 9:59:59.000,9:59:59.000 is that at some point,[br]your variable costs are going 9:59:59.000,9:59:59.000 to increase faster than quantity. 9:59:59.000,9:59:59.000 So what's going to happen is [br]that this number at some point -- 9:59:59.000,9:59:59.000 variable cost divided by quantity --[br]is going to get bigger 9:59:59.000,9:59:59.000 and bigger and bigger. 9:59:59.000,9:59:59.000 So you have two things, one force [br]is driving average cost down. 9:59:59.000,9:59:59.000 That's going to be particularly [br]strong at the beginning. 9:59:59.000,9:59:59.000 Eventually, however, [br]the second force here is going 9:59:59.000,9:59:59.000 to drive average cost up. 9:59:59.000,9:59:59.000 So that's going to be our typical [br]shape of an average cost curve -- 9:59:59.000,9:59:59.000 falling, reaches a minimum,[br]and then rising. 9:59:59.000,9:59:59.000 So let's draw it like that. 9:59:59.000,9:59:59.000 Okay, here's our typical[br]marginal cost curve, 9:59:59.000,9:59:59.000 and here is our marginal [br]revenue curve, equal to price. 9:59:59.000,9:59:59.000 We know that the profit maximizing [br]point is where marginal revenue 9:59:59.000,9:59:59.000 is equal to marginal cost. 9:59:59.000,9:59:59.000 Here is our average cost curve [br]and notice it has the shape 9:59:59.000,9:59:59.000 which I described --[br]it starts off high, it falls, 9:59:59.000,9:59:59.000 reaches a minimum, [br]and then goes right back up again. 9:59:59.000,9:59:59.000 Couple of other points to notice[br]is that the minimum point, 9:59:59.000,9:59:59.000 the marginal cost curve goes [br]through the minimum point 9:59:59.000,9:59:59.000 of the average cost curve. 9:59:59.000,9:59:59.000 Now that's just a mathematical fact, [br]but let me give you some intuition. 9:59:59.000,9:59:59.000 Instead of cost I want [br]to talk about average grade 9:59:59.000,9:59:59.000 and marginal grade. 9:59:59.000,9:59:59.000 So suppose that your [br]average grade is 80%. 9:59:59.000,9:59:59.000 You're doing really pretty good,[br]but then on your next test 9:59:59.000,9:59:59.000 you only get 60% -- lower. 9:59:59.000,9:59:59.000 What is that going to do [br]to your average? 9:59:59.000,9:59:59.000 Well, it's going to drive [br]your average down. 9:59:59.000,9:59:59.000 Indeed whenever your marginal [br]is below your average, 9:59:59.000,9:59:59.000 the average must be falling. 9:59:59.000,9:59:59.000 On the other hand, suppose [br]that you're getting 80%, 9:59:59.000,9:59:59.000 and on your next test you get 90%. 9:59:59.000,9:59:59.000 Great, but what does [br]that do to your average? 9:59:59.000,9:59:59.000 It drives your average up. 9:59:59.000,9:59:59.000 Indeed whenever your marginal[br]is above the average, 9:59:59.000,9:59:59.000 the average must be rising. 9:59:59.000,9:59:59.000 Now suppose what happens [br]when you're getting let's say 80%, 9:59:59.000,9:59:59.000 and on your next test,[br]you also get 80%. 9:59:59.000,9:59:59.000 Well then your marginal is equal [br]to your average grade, 9:59:59.000,9:59:59.000 and your average grade is flat -- [br]it doesn't change, it's flat. 9:59:59.000,9:59:59.000 But what is true for average [br]and marginal grades is also true 9:59:59.000,9:59:59.000 for average cost and marginal cost. 9:59:59.000,9:59:59.000 Whenever the marginal cost is [br]below the average, 9:59:59.000,9:59:59.000 the average is falling. 9:59:59.000,9:59:59.000 Whenever the marginal cost is [br]above the average, 9:59:59.000,9:59:59.000 the average is rising. 9:59:59.000,9:59:59.000 And where marginal is [br]just equal to average, 9:59:59.000,9:59:59.000 the average is flat. 9:59:59.000,9:59:59.000 In other words, we are [br]at the minimum point 9:59:59.000,9:59:59.000 of the average cost curve. 9:59:59.000,9:59:59.000 Okay, now I said we could use [br]the average cost curve 9:59:59.000,9:59:59.000 to figure out profit -- [br]show profit on the diagram. 9:59:59.000,9:59:59.000 We can do that with just [br]a little bit of rearranging. 9:59:59.000,9:59:59.000 Remember that profit is equal [br]to total revenue minus total cost 9:59:59.000,9:59:59.000 and total revenue is [br]price times quantity -- P times Q. 9:59:59.000,9:59:59.000 We also know [br]that average cost is equal 9:59:59.000,9:59:59.000 to total cost divided by quantity. 9:59:59.000,9:59:59.000 Let's just rearrange that [br]to tell us that total cost is equal 9:59:59.000,9:59:59.000 to average cost times quantity. 9:59:59.000,9:59:59.000 So just take this one [br]and multiply both sides by Q. 9:59:59.000,9:59:59.000 Let's now make these substitutions [br]into our profit equation. 9:59:59.000,9:59:59.000 If we do that, then profit is equal [br]to total revenue -- 9:59:59.000,9:59:59.000 price times quantity --[br]minus total cost -- 9:59:59.000,9:59:59.000 average cost times quantity. 9:59:59.000,9:59:59.000 Now let's take Q out [br]of both parts of this equation, 9:59:59.000,9:59:59.000 and we find that profit [br]can also be written as price 9:59:59.000,9:59:59.000 minus average cost, [br]all of that times quantity. 9:59:59.000,9:59:59.000 That's nice because we can find 9:59:59.000,9:59:59.000 all of these elements [br]on our diagram. 9:59:59.000,9:59:59.000 Here's the price. 9:59:59.000,9:59:59.000 Here's the average cost[br]at the profit maximizing quantity. 9:59:59.000,9:59:59.000 Let's just show that. [br]There's the price. 9:59:59.000,9:59:59.000 There's the average cost [br]at the profit maximizing quantity. 9:59:59.000,9:59:59.000 So profit at the profit [br]maximizing quantity is 9:59:59.000,9:59:59.000 this green area right here -- 9:59:59.000,9:59:59.000 price minus average cost [br]times quantity. 9:59:59.000,9:59:59.000 So now we have a nice way [br]of showing in a diagram 9:59:59.000,9:59:59.000 exactly how much profit is. 9:59:59.000,9:59:59.000 Let's use this tool some more. 9:59:59.000,9:59:59.000 Here's another example [br]of the average cost curve in action. 9:59:59.000,9:59:59.000 Remember, I said that profit [br]maximization doesn't necessarily 9:59:59.000,9:59:59.000 mean the firm is making [br]a positive profit. 9:59:59.000,9:59:59.000 Sometimes the best you can do [br]is to minimize your losses. 9:59:59.000,9:59:59.000 You may have to take a loss. 9:59:59.000,9:59:59.000 For example, suppose [br]that the price is below $17. 9:59:59.000,9:59:59.000 That is, here's the market price, [br]which is equal to the firm's 9:59:59.000,9:59:59.000 marginal revenue curve. 9:59:59.000,9:59:59.000 How does the firm profit maximize? 9:59:59.000,9:59:59.000 It chooses the quantity [br]where marginal revenue is 9:59:59.000,9:59:59.000 equal to marginal cost. 9:59:59.000,9:59:59.000 In that case, this quantity is one. 9:59:59.000,9:59:59.000 Now what's the profit [br]for the firm? 9:59:59.000,9:59:59.000 Well, as usual we measure [br]profit as price minus 9:59:59.000,9:59:59.000 average cost times quantity. 9:59:59.000,9:59:59.000 But notice that price is [br]below the average cost 9:59:59.000,9:59:59.000 at the profit maximizing [br]quantity of one. 9:59:59.000,9:59:59.000 Since price is below average cost, [br]this is a loss. 9:59:59.000,9:59:59.000 It's a negative quantity. 9:59:59.000,9:59:59.000 It is a loss. In fact, notice [br]that the breakeven price is $17, 9:59:59.000,9:59:59.000 which is the minimum [br]of the average cost curve. 9:59:59.000,9:59:59.000 In order to make a profit, [br]the firm at least has to meet 9:59:59.000,9:59:59.000 the minimum of its [br]average cost curve. 9:59:59.000,9:59:59.000 So at any price below $17,[br]we'll be profit maximizing 9:59:59.000,9:59:59.000 at a point where price is equal[br]to marginal cost, 9:59:59.000,9:59:59.000 and notice that all of these [br]prices are below average cost. 9:59:59.000,9:59:59.000 So all of this area down here, 9:59:59.000,9:59:59.000 even the profit maximizing [br]quantity, will mean a loss. 9:59:59.000,9:59:59.000 On the other hand, once we get [br]above $17, above the minimum 9:59:59.000,9:59:59.000 of the average cost curve, then we [br]can price equal to marginal cost. 9:59:59.000,9:59:59.000 We can chose the quantities such [br]the price is equal to marginal cost. 9:59:59.000,9:59:59.000 That price will be above average [br]cost, so we'll be taking a profit. 9:59:59.000,9:59:59.000 Therefore, $17, the minimum[br]of the average cost curve, 9:59:59.000,9:59:59.000 is the breakeven point. 9:59:59.000,9:59:59.000 If the price is less [br]than the minimum 9:59:59.000,9:59:59.000 of the average cost curve, [br]we're going to be taking a loss. 9:59:59.000,9:59:59.000 If the price is bigger [br]than the minimum 9:59:59.000,9:59:59.000 of the average cost curve, [br]then we can make a profit. 9:59:59.000,9:59:59.000 So when should a firm enter [br]or exit an industry? 9:59:59.000,9:59:59.000 In the long run, the firms will [br]enter when price 9:59:59.000,9:59:59.000 is above average cost. 9:59:59.000,9:59:59.000 If price is somewhere [br]above the average cost curve 9:59:59.000,9:59:59.000 then the firm can make [br]a profit by entering 9:59:59.000,9:59:59.000 and that's what firms want to do. 9:59:59.000,9:59:59.000 They want to find profit, [br]so they will want to enter 9:59:59.000,9:59:59.000 wherever a profit is possible. 9:59:59.000,9:59:59.000 Firms will exit the industry [br]when the price is below 9:59:59.000,9:59:59.000 the average cost curve. 9:59:59.000,9:59:59.000 Then they're going [br]to be taking a loss, 9:59:59.000,9:59:59.000 and they're going to want to exit. 9:59:59.000,9:59:59.000 Finally, when the price is [br]equal to the minimum 9:59:59.000,9:59:59.000 of the average cost --[br]it's just equal to the bottom 9:59:59.000,9:59:59.000 of the average cost curve, [br]profits are zero, 9:59:59.000,9:59:59.000 and there's no incentive 9:59:59.000,9:59:59.000 to either exit [br]or enter the industry. 9:59:59.000,9:59:59.000 Now you might ask, [br]why would firms remain 9:59:59.000,9:59:59.000 in an industry if profits are zero? 9:59:59.000,9:59:59.000 Zero profits, this is just [br]a matter of terminology, 9:59:59.000,9:59:59.000 means that at the market price [br]the firm is covering all 9:59:59.000,9:59:59.000 of its costs, including enough [br]to pay labor and capital, 9:59:59.000,9:59:59.000 their ordinary opportunity cost. 9:59:59.000,9:59:59.000 So zero profits means [br]everyone is being paid enough 9:59:59.000,9:59:59.000 to make them satisfied. 9:59:59.000,9:59:59.000 Zero profits, in other words,[br]is what normal people mean 9:59:59.000,9:59:59.000 by normal profits. 9:59:59.000,9:59:59.000 So when an economist [br]says zero profits 9:59:59.000,9:59:59.000 just substitute normal profits. 9:59:59.000,9:59:59.000 One more point [br]about entry and exit. [br] 9:59:59.000,9:59:59.000 It doesn't always make sense [br]to exit an industry immediately 9:59:59.000,9:59:59.000 when price falls [br]below average cost. 9:59:59.000,9:59:59.000 Or to enter immediately [br]when price is above average cost. 9:59:59.000,9:59:59.000 Why not? Well, there are [br]also entry and exit costs. 9:59:59.000,9:59:59.000 For example, suppose [br]that that the price of oil is 9:59:59.000,9:59:59.000 currently above the average [br]cost of pumping oil, 9:59:59.000,9:59:59.000 if you've already got a well. [br]Should you enter the industry? 9:59:59.000,9:59:59.000 Well, maybe not necessarily. 9:59:59.000,9:59:59.000 Because entry requires you [br]to drill an oil well, 9:59:59.000,9:59:59.000 and drilling an oil well is [br]a sunk cost -- literally in this case. 9:59:59.000,9:59:59.000 A sunk cost is a cost that once [br]incurred can never be recovered. 9:59:59.000,9:59:59.000 So if you enter the industry [br]and drill the oil well, 9:59:59.000,9:59:59.000 you don't get that money back [br]when you later exit the industry. 9:59:59.000,9:59:59.000 What this means is you[br]don't want to enter 9:59:59.000,9:59:59.000 unless you expect [br]the price of oil to stay 9:59:59.000,9:59:59.000 above the minimum [br]of the average cost curve 9:59:59.000,9:59:59.000 long enough so that you can [br]also recover your entry costs. 9:59:59.000,9:59:59.000 So just because the price goes[br]above the average cost a little bit, 9:59:59.000,9:59:59.000 you don't immediately [br]want to jump into that industry. 9:59:59.000,9:59:59.000 You have to expect that [br]that price is going to stay 9:59:59.000,9:59:59.000 above average cost [br]long enough for you 9:59:59.000,9:59:59.000 to recover your entry costs. 9:59:59.000,9:59:59.000 For the same reasons, [br]if there are exit costs, 9:59:59.000,9:59:59.000 for example, if you have [br]to shutter up the well 9:59:59.000,9:59:59.000 or fill the well with cement [br]when you exit the industry 9:59:59.000,9:59:59.000 as you do in the United States, [br]then when price falls 9:59:59.000,9:59:59.000 below average cost, [br]it may be best to weather 9:59:59.000,9:59:59.000 the storm at least [br]for sometime before you exit. 9:59:59.000,9:59:59.000 Only if you expect the price [br]of oil to stay below your minimum 9:59:59.000,9:59:59.000 of average cost [br]for an extended period of time 9:59:59.000,9:59:59.000 will you want to exit the industry. 9:59:59.000,9:59:59.000 After all, if the price of oil falls [br]below the average cost 9:59:59.000,9:59:59.000 just for a little bit, [br]and then it goes back up, 9:59:59.000,9:59:59.000 the lifetime profits can [br]still be possible. 9:59:59.000,9:59:59.000 So, entry and exit could be [br]quite complicated 9:59:59.000,9:59:59.000 because you've got [br]to be thinking 9:59:59.000,9:59:59.000 about the lifetime profits,[br]not just your immediate profits. 9:59:59.000,9:59:59.000 However, the bottom line[br]is pretty simple. 9:59:59.000,9:59:59.000 Firms seek profits[br]and they want to avoid losses. 9:59:59.000,9:59:59.000 As a result, firms will enter [br]industries when the price is above 9:59:59.000,9:59:59.000 the average cost[br]and they can make a profit, 9:59:59.000,9:59:59.000 and they will exit when the price [br]is below the average cost. 9:59:59.000,9:59:59.000 Thanks. 9:59:59.000,9:59:59.000 - [Narrator] If you want to test [br]yourself, click, "Practice Questions." 9:59:59.000,9:59:59.000 Or, if you're ready to move on,[br]just click, "Next Video." 9:59:59.000,9:59:59.000 ♪ [music] ♪