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.

0:01:14.981,0:01:17.991
As Q gets larger, however,[br]this number --

0:01:17.991,0:01:20.412
fixed cost divided by Q -- [br]is going to get smaller,

0:01:20.412,0:01:25.320
So when Q is 10, this number [br]100 divided by 10 becomes 10.

0:01:25.674,0:01:29.099
So it goes from 100,[br]and it goes down, down, down, down,

0:01:29.099,0:01:31.812
get's lower and lower and lower[br]all the time as you divide

0:01:31.812,0:01:33.489
by a bigger quantity.

0:01:33.626,0:01:38.154
On the other hand, the variable [br]costs increase with quantity.

0:01:38.154,0:01:41.774
Moreover, what we saw [br]with the marginal cost curve

0:01:41.774,0:01:44.925
is that at some point,[br]your variable costs are going

0:01:44.925,0:01:47.397
to increase faster than quantity.

0:01:47.397,0:01:50.676
So what's going to happen is [br]that this number at some point --

0:01:50.676,0:01:52.857
variable cost divided by quantity --[br]is going to get bigger

0:01:52.857,0:01:54.196
and bigger and bigger.

0:01:54.241,0:01:58.824
So you have two things, one force [br]is driving average cost down.

0:01:59.412,0:02:02.365
That's going to be particularly [br]strong at the beginning.

0:02:03.123,0:02:06.784
Eventually, however, [br]the second force here is going

0:02:06.784,0:02:09.404
to drive average cost up.

0:02:09.562,0:02:12.191
So that's going to be our typical [br]shape of an average cost curve --

0:02:12.191,0:02:14.554
falling, reaches a minimum,[br]and then rising.

0:02:14.666,0:02:16.241
So let's draw it like that.

0:02:16.452,0:02:18.790
Okay, here's our typical[br]marginal cost curve,

0:02:19.082,0:02:22.366
and here is our marginal [br]revenue curve, equal to price.

0:02:22.676,0:02:26.405
We know that the profit maximizing [br]point is where marginal revenue

0:02:26.405,0:02:28.006
is equal to marginal cost.

0:02:28.216,0:02:31.699
Here is our average cost curve,[br]and notice it has the shape

0:02:31.699,0:02:35.157
which I described --[br]it starts off high, it falls,

0:02:35.157,0:02:37.656
reaches a minimum, [br]and then goes right back up again.

0:02:37.815,0:02:42.644
Couple of other points to notice[br]is that the minimum point,

0:02:42.644,0:02:46.396
the marginal cost curve goes [br]through the minimum point

0:02:46.396,0:02:48.415
of the average cost curve.

0:02:48.415,0:02:52.046
Now that's just a mathematical fact, [br]but let me give you some intuition.

0:02:52.046,0:02:54.958
Instead of cost, I want [br]to talk about average grade

0:02:54.958,0:02:56.867
and marginal grade.

0:02:57.143,0:03:01.545
So suppose that your [br]average grade is 80%.

0:03:01.545,0:03:05.034
You're doing really pretty good,[br]but then on your next test

0:03:05.034,0:03:08.165
you only get 60% -- lower.

0:03:08.165,0:03:10.568
What is that going to do [br]to your average?

0:03:10.568,0:03:13.464
Well, it's going to drive [br]your average down.

0:03:13.464,0:03:18.045
Indeed whenever your marginal [br]is below your average,

0:03:18.045,0:03:20.395
the average must be falling.

0:03:20.395,0:03:24.326
On the other hand, suppose [br]that you're getting 80%,

0:03:24.326,0:03:26.944
and on your next test you get 90%.

0:03:26.944,0:03:29.534
Great, but what does [br]that do to your average?

0:03:29.534,0:03:31.948
It drives your average up.

0:03:31.948,0:03:35.846
Indeed whenever your marginal[br]is above the average,

0:03:35.846,0:03:37.776
the average must be rising.

0:03:37.776,0:03:41.486
Now suppose what happens [br]when you're getting let's say 80%,

0:03:41.486,0:03:45.347
and on your next test,[br]you also get 80%.

0:03:45.347,0:03:49.319
Well then your marginal is equal [br]to your average grade,

0:03:49.319,0:03:54.465
and your average grade is flat -- [br]it doesn't change, it's flat.

0:03:54.465,0:03:58.197
But what is true for average [br]and marginal grades is also true

0:03:58.197,0:04:00.666
for average cost and marginal cost.

0:04:00.791,0:04:06.868
Whenever the marginal cost is [br]below the average,

0:04:06.868,0:04:08.698
the average is falling.

0:04:08.698,0:04:11.867
Whenever the marginal cost is [br]above the average,

0:04:11.867,0:04:13.623
the average is rising.

0:04:13.623,0:04:16.857
And where marginal is [br]just equal to average,

0:04:16.857,0:04:18.386
the average is flat.

0:04:18.448,0:04:21.084
In other words, we are [br]at the minimum point

0:04:21.084,0:04:22.966
of the average cost curve.

0:04:23.818,0:04:26.738
Okay, now I said we could use [br]the average cost curve

0:04:26.747,0:04:29.378
to figure out profit -- [br]show profit on the diagram.

0:04:29.477,0:04:32.522
We can do that with just [br]a little bit of rearranging.

0:04:32.522,0:04:35.976
Remember that profit is equal [br]to total revenue minus total cost

0:04:35.976,0:04:39.574
and total revenue is [br]price times quantity -- P times Q.

0:04:39.574,0:04:42.114
We also know [br]that average cost is equal

0:04:42.114,0:04:44.804
to total cost divided by quantity.

0:04:44.804,0:04:48.834
Let's just rearrange that [br]to tell us that total cost is equal

0:04:48.834,0:04:51.293
to average cost times quantity.

0:04:51.293,0:04:54.404
So just take this one [br]and multiply both sides by Q.

0:04:54.783,0:04:59.744
Let's now make these substitutions [br]into our profit equation.

0:04:59.814,0:05:03.896
If we do that, then profit is equal [br]to total revenue --

0:05:03.896,0:05:06.442
price times quantity --[br]minus total cost --

0:05:06.442,0:05:08.215
average cost times quantity.

0:05:08.323,0:05:12.285
Now let's take Q out [br]of both parts of this equation,

0:05:12.285,0:05:16.604
and we find that profit [br]can also be written as price

0:05:16.604,0:05:19.982
minus average cost, [br]all of that times quantity.

0:05:20.593,0:05:22.604
That's nice because we can find

0:05:22.604,0:05:26.316
all of these elements [br]on our diagram.

0:05:26.783,0:05:28.336
Here's the price.

0:05:28.336,0:05:32.414
Here's the average cost[br]at the profit maximizing quantity.

0:05:32.874,0:05:35.125
Let's just show that. [br]There's the price.

0:05:35.544,0:05:40.094
There's the average cost [br]at the profit maximizing quantity.

0:05:40.094,0:05:44.144
So profit at the profit [br]maximizing quantity is

0:05:44.144,0:05:47.404
this green area right here --

0:05:47.742,0:05:52.041
price minus average cost [br]times quantity.

0:05:52.041,0:05:54.696
So now we have a nice way [br]of showing in a diagram

0:05:54.696,0:05:57.237
exactly how much profit is.

0:05:57.746,0:05:59.662
Let's use this tool some more.

0:06:00.291,0:06:03.146
Here's another example [br]of the average cost curve in action.

0:06:03.169,0:06:06.669
Remember, I said that profit [br]maximization doesn't necessarily

0:06:06.669,0:06:09.241
mean the firm is making [br]a positive profit.

0:06:09.539,0:06:12.889
Sometimes the best you can do [br]is to minimize your losses.

0:06:12.889,0:06:14.768
You may have to take a loss.

0:06:14.768,0:06:18.919
For example, suppose [br]that the price is below $17.

0:06:18.919,0:06:22.169
That is, here's the market price, [br]which is equal to the firm's

0:06:22.169,0:06:23.789
marginal revenue curve.

0:06:24.099,0:06:26.133
How does the firm profit maximize?

0:06:26.133,0:06:28.848
It chooses the quantity [br]where marginal revenue is

0:06:28.848,0:06:30.640
equal to marginal cost.

0:06:30.640,0:06:33.172
In that case, this quantity is one.

0:06:33.172,0:06:35.056
Now what's the profit [br]for the firm?

0:06:35.056,0:06:39.971
Well, as usual we measure [br]profit as price minus

0:06:39.971,0:06:42.791
average cost times quantity.

0:06:42.791,0:06:46.820
But notice that price is [br]below the average cost

0:06:46.820,0:06:50.769
at the profit maximizing [br]quantity of one.

0:06:50.769,0:06:55.970
Since price is below average cost, [br]this is a loss.

0:06:55.970,0:06:57.700
It's a negative quantity.

0:06:57.700,0:07:05.877
It is a loss. In fact, notice [br]that the breakeven price is $17,

0:07:05.877,0:07:09.430
which is the minimum [br]of the average cost curve.

0:07:09.430,0:07:14.242
In order to make a profit, [br]the firm at least has to meet

0:07:14.242,0:07:17.430
the minimum of its [br]average cost curve.

0:07:17.430,0:07:21.332
So at any price below $17,[br]we'll be profit maximizing

0:07:21.332,0:07:24.101
at a point where price is equal[br]to marginal cost,

0:07:24.101,0:07:28.711
and notice that all of these [br]prices are below average cost.

0:07:28.711,0:07:30.853
So all of this area down here,

0:07:30.853,0:07:35.738
even the profit maximizing [br]quantity, will mean a loss.

0:07:36.281,0:07:40.929
On the other hand, once we get [br]above $17, above the minimum

0:07:40.929,0:07:45.561
of the average cost curve, then we [br]can price equal to marginal cost.

0:07:45.561,0:07:49.271
We can choose the quantities such [br]the price is equal to marginal cost.

0:07:49.334,0:07:54.055
That price will be above average [br]cost, so we'll be taking a profit.

0:07:54.525,0:07:59.224
Therefore, $17, the minimum[br]of the average cost curve,

0:07:59.224,0:08:01.216
is the breakeven point.

0:08:01.563,0:08:04.027
If the price is less [br]than the minimum

0:08:04.027,0:08:07.277
of the average cost curve, [br]we're going to be taking a loss.

0:08:07.372,0:08:09.344
If the price is bigger [br]than the minimum

0:08:09.344,0:08:12.244
of the average cost curve, [br]then we can make a profit.

0:08:12.982,0:08:15.784
So when should a firm enter [br]or exit an industry?

0:08:15.854,0:08:19.322
In the long run, the firms will [br]enter when price

0:08:19.322,0:08:21.189
is above average cost.

0:08:21.189,0:08:23.989
If price is somewhere [br]above the average cost curve

0:08:23.989,0:08:26.258
then the firm can make [br]a profit by entering,

0:08:26.258,0:08:27.928
and that's what firms want to do.

0:08:27.969,0:08:30.251
They want to find profit, [br]so they will want to enter

0:08:30.251,0:08:32.010
wherever a profit is possible.

0:08:32.010,0:08:35.640
Firms will exit the industry [br]when the price is below

0:08:35.640,0:08:37.229
the average cost curve.

0:08:37.229,0:08:38.550
Then they're going [br]to be taking a loss,

0:08:38.550,0:08:40.269
and they're going to want to exit.

0:08:40.364,0:08:44.171
Finally, when the price is [br]equal to the minimum

0:08:44.228,0:08:46.930
of the average cost --[br]it's just equal to the bottom

0:08:46.930,0:08:49.758
of the average cost curve, [br]profits are zero,

0:08:49.758,0:08:51.277
and there's no incentive

0:08:51.277,0:08:54.029
to either exit [br]or enter the industry.

0:08:54.163,0:08:56.519
Now you might ask, [br]why would firms remain

0:08:56.519,0:08:59.413
in an industry if profits are zero?

0:08:59.413,0:09:03.403
Zero profits, this is just [br]a matter of terminology,

0:09:03.403,0:09:07.013
means that at the market price [br]the firm is covering all

0:09:07.013,0:09:10.871
of its costs, including enough [br]to pay labor and capital,

0:09:10.871,0:09:13.134
their ordinary opportunity cost.

0:09:13.494,0:09:17.652
So zero profits means [br]everyone is being paid

0:09:17.652,0:09:19.573
enough to make them satisfied.

0:09:19.715,0:09:23.514
Zero profits, in other words,[br]is what normal people mean

0:09:23.514,0:09:25.496
by normal profits.

0:09:25.496,0:09:27.708
So when an economist [br]says zero profits

0:09:27.708,0:09:30.084
just substitute normal profits.

0:09:30.344,0:09:32.824
One more point [br]about entry and exit.

0:09:32.974,0:09:36.876
It doesn't always make sense [br]to exit an industry immediately

0:09:36.938,0:09:38.997
when price falls [br]below average cost,

0:09:39.208,0:09:43.127
or to enter immediately [br]when price is above average cost.

0:09:43.247,0:09:47.916
Why not? Well, there are [br]also entry and exit costs.

0:09:48.279,0:09:50.717
For example, suppose [br]that that the price of oil is

0:09:50.717,0:09:55.369
currently above the average [br]cost of pumping oil --

0:09:55.369,0:09:59.011
if you've already got a well,[br]should you enter the industry?

0:09:59.269,0:10:01.248
Well, maybe not necessarily.

0:10:01.266,0:10:04.776
Because entry requires you [br]to drill an oil well,

0:10:04.776,0:10:09.037
and drilling an oil well is [br]a sunk cost -- literally in this case.

0:10:09.037,0:10:14.438
A sunk cost is a cost that once [br]incurred can never be recovered.

0:10:14.741,0:10:17.849
So if you enter the industry [br]and drill the oil well,

0:10:17.849,0:10:21.548
you don't get that money back [br]when you later exit the industry.

0:10:22.368,0:10:24.930
What this means is you[br]don't want to enter

0:10:24.930,0:10:30.286
unless you expect [br]the price of oil to stay

0:10:30.286,0:10:33.658
above the minimum [br]of the average cost curve

0:10:33.658,0:10:38.828
long enough so that you can [br]also recover your entry costs.

0:10:39.435,0:10:43.530
So just because the price goes[br]above the average cost a little bit,

0:10:43.530,0:10:46.498
you don't immediately [br]want to jump into that industry.

0:10:46.786,0:10:50.040
You have to expect that [br]that price is going to stay

0:10:50.040,0:10:53.958
above average cost [br]long enough for you

0:10:53.958,0:10:56.039
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] ♪