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- [Alex] Now that we know [br]how to find the profit

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maximization point, [br]we're going to show

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the amount of profit on the diagram [br]using the average cost curve.

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So as I said in the last lecture,

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average cost is the cost [br]per unit of output.

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That is, average cost is[br]total cost divided by Q.

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Now remember also [br]that total cost can be broken down

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into fixed costs plus [br]variable costs.

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So we can also write average cost[br]in a slightly longer format.

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Average cost is equal [br]to fixed cost divided by Q

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plus the variable cost divided [br]by Q, the units of output.

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That's a little bit useful [br]because we're able to see,

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get some intuition, for the shape [br]of a typical average cost curve.

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Notice that the fixed costs [br]don't change with Q.

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That's why they're fixed.

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So when Q is small, this number, [br]suppose fixed cost is a hundred

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and Q is small, [br]then this number is going to be big

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like 100 divided by 1.

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fixed cost divided Q - is going to get[br]smaller, so when Q is 10 this number 100

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divided by 10 becomes 10. So it goes from[br]100 and it goes down, down, down, down,

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get's lower and lower and lower all the[br]time as you divide by a bigger

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quantity. On the other hand, the variable[br]costs increase with quantity. Moreover,

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what we saw with the marginal cost curve[br]is that at some point your variable costs

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are going to increase faster than[br]quantity. So what's going to happen is

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that this number at some point - variable[br]cost divided by quantity - is going to get

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bigger and bigger and bigger. So you have[br]two things one force is driving average

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cost down. That's going to be[br]particularly strong at the beginning.

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Eventually however, the second force here[br]is going to drive average cost, uh, up. So

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that's going to be our typical shape of an[br]average cost curve - falling reaches a

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minimum and then rising. So let's draw it[br]like that. Okay here's our typical

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marginal cost curve and here is our[br]marginal revenue curve equal to price. We

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know that the profit maximizing point is[br]where marginal revenue is equal to

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marginal cost. Here is our average cost[br]curve and notice it has the shape, which I

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described, it starts off high, it falls,[br]reaches a minimum, and then goes right back

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up again. Couple of other points to notice[br]is that the minimum point, the marginal

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cost curve goes through the minimum point[br]of the average cost curve. Now that's just

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a mathematical fact, but let me give you[br]some intuition. Instead of cost I want to

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talk about average grade and marginal[br]grade. So suppose that your average grade

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is 80%. You're doing really pretty good.[br]But then on your next test you only get

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60% - lower. What is that going to do to[br]your average? Well, it's going to drive

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your average down. Indeed whenever your[br]marginal is below your average, the average

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must be falling. On the other hand,[br]suppose that you're getting, uh, 80% and on

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your next test you get 90%. Great, but what[br]does that do to your average? It drives your

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average up. Indeed whenever your marginal[br]is above the average, the average must be

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rising. Now suppose what happens when[br]you're getting let's say 80%, and on your

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next test you also get 80%. Well then your[br]marginal is equal to your average grade

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and your average grade is flat - it doesn't[br]change, it's flat. But what is true for

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average and marginal grades is also true[br]for average cost and marginal cost.

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Whenever the marginal cost is below the[br]average, the average is falling. Whenever

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the marginal cost is above the average, the[br]average is rising. And where marginal is

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just equal to average, the average is flat.[br]In other words we are at the minimum point

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of the average cost curve. Okay, now I[br]said we could use the average cost curve

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to figure out profit - show profit on the[br]diagram. We can do that with just a little

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bit of rearranging. Remember that profit[br]is equal to total revenue minus total cost

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and total revenue is price times quantity -[br]P times Q. We also know that average cost

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is equal to total cost divided by[br]quantity. Let's just rearrange that to

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tell us that total cost is equal to[br]average cost times quantity. So just take

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this one and multiply both sides by Q.[br]So, let's now make these substitutions into

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our profit equation. If we do that, then[br]profit is equal to total revenue - price

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times quantity - minus total cost - average[br]cost times quantity. Now let's take Q out

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of both parts of this equation and we find[br]that profit can also be written as price

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minus average cost, all of that times[br]quantity. That's nice because we can find

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all of these elements on our diagram.[br]Here's the price. Here's the average cost

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at the profit maximizing quantity. Let's[br]just show that. There's the price. There's

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the average cost at the profit maximizing[br]quantity. So profit at the profit

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maximizing quantity is this green area[br]right here. Price minus average cost times

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quantity. So now we have a nice way of[br]showing in a diagram exactly how much

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profit is. Let's use this tool some more.[br]Here's another example of the average cost

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curve in action. Remember I said that[br]profit maximization doesn't necessarily

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mean the firm is making a positive profit.[br]Sometimes the best you can do is to

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minimize your losses. You may have to take[br]a loss. For example, suppose that the

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price is below $17. That is, here's the market[br]price, which is equal to the firm's marginal

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revenue curve. How does the firm profit[br]maximize? It chooses the quantity where

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marginal revenue is equal to marginal cost.[br]In that case, this quantity is one. Now

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what's the profit for the firm? Well, as[br]usual we measure profit as price minus

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average cost times quantity. But notice[br]that price is below the average cost at

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the profit maximizing quantity of one.[br]Since price is below average cost, this is

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a loss. It's a negative quantity. It is a[br]loss. In fact, notice that the breakeven

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price is $17, which is the minimum of the[br]average cost curve. In order to make a

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profit, the firm at least has to meet the[br]minimum of it's average cost curve. So at

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any price below $17 we'll be profit[br]maximizing at a point where price is equal

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to marginal cost, and notice that all of[br]these prices are below average cost. So

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all of this area down here, even the[br]profit maximizing quantity, will mean a

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loss. On the other hand, once we get above[br]$17, above the minimum of the average cost

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curve, then we can price equal to marginal[br]cost. We can chose the quantities such the

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price is equal to marginal cost. That price[br]will be above average cost so we'll be

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taking a profit. Therefore, $17, the minimum[br]of the average cost curve, is the

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breakeven point.[br]If the price is less than the minimum of

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the average cost curve, we're going to be[br]taking a loss. If the price is bigger than

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the minimum of the average cost curve, then[br]we can make a profit. So when should a

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firm enter or exit an industry? In the[br]long run, the firms will enter when price

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is above average cost. If price is[br]somewhere above the average cost curve

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then the firm can make a profit by[br]entering and that's what firms want to do.

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They want to find profit, so they will[br]want to enter wherever a profit is

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possible. Firms will exit the industry[br]when the price is below the average cost

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curve. Then they're going to be taking a[br]loss and they're going to want to exit. So

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finally, when the price is equal to the[br]minimum of the average cost - it's just

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equal to the bottom of the average cost[br]curve, profits are zero and there's no

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incentive to either exit or enter the[br]industry. Now you might ask, why would

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firms remain in an industry if profits are[br]zero? Zero profits, this is just a matter

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of terminology, means that at the market[br]price the firm is covering all of its

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costs including enough to pay labor and[br]capital, their ordinary opportunity cost.

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So zero profits means everyone[br]is being paid, enough to make

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them satisfied. Zero profits, in other[br]words, is what normal people mean by normal

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profits. So when an economist says zero[br]profits just substitute normal profits.

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One more point about entry and exit. It[br]doesn't always make sense to exit an

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industry immediately when price falls[br]below average cost. Or to enter immediately

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when price is above average cost. Why not?[br]Well, there are also entry and exit costs.

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For example, suppose that that the price[br]of oil is currently above the average cost

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of pumping oil, if you've already got a[br]well. Should you enter the industry? Well,

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maybe not necessarily. Because entry[br]requires you to drill an oil well, and

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drilling an oil well is a sunk cost -[br]literally in this case.

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A sunk cost is a cost that once incurred[br]can never be recovered. So if you enter

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the industry and drill the oil well, you[br]don't get that money back when you later

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exit the industry. What this means is you[br]don't want to enter unless you expect the

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price of oil to stay above the minimum of[br]the average cost curve long enough so

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that you can also recover your entry[br]costs. So just because the price goes

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above the average cost a little bit, you[br]don't immediately want to jump into that

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industry. You have to expect that that[br]price is going to stay above average cost

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long enough for you to recover your entry[br]costs. For the same reasons, if there are

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exit costs, for example, if you have to[br]shutter up the well or fill the well with

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cement when you exit the industry as you[br]do in the United States, then when price

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falls below average cost, it may be best to[br]weather the storm at least for sometime

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before you exit. Only if you expect the[br]price of oil to stay below your minimum of

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average cost for an extended period of[br]time will you want to exit the industry.

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After all, if the price of oil falls below[br]the average cost just for a little bit, and

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then it goes back up, the lifetime[br]profits can still be possible. So, entry

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and exit could be quite complicated[br]because you've got to be thinking about

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the lifetime profits, not just your[br]immediate profits. However, the bottom

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line is pretty simple. Firms seek profits[br]and they want to avoid losses. As a

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result, firms will enter industries when[br]the price is above the average cost and

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they can make a profit, and they will exit[br]when the price is below the average cost.

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Thanks.

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