Shutdown vs.

Exit
▪ Shutdown:
A short-run decision not to produce anything
because of market conditions.
▪ Exit:
A long-run decision to leave the market.
▪ A key difference:
▪ If shut down in SR, must still pay FC.
▪ If exit in LR, zero costs.

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 A Firm’s Short-run Decision to Shut Down
▪ Cost of shutting down: revenue loss = TR
▪ Benefit of shutting down: cost savings = VC
(firm must still pay FC)
▪ So, shut down if TR < VC
▪ Divide both sides by Q: TR/Q < VC/Q
▪ So, firm’s decision rule is:
Shut down if P < AVC

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 A Competitive Firm’s SR Supply Curve

The firm’s SR
supply curve is Costs
the portion of MC
its MC curve
If P > AVC, then
above AVC.
firm produces Q ATC
where P = MC.
AVC

If P < AVC, then

firm shuts down
(produces Q = 0). Q

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 The Irrelevance of Sunk Costs
▪ Sunk cost: a cost that has already been
committed and cannot be recovered
▪ Sunk costs should be irrelevant to decisions;
you must pay them regardless of your choice.
▪ FC is a sunk cost: The firm must pay its fixed
costs whether it produces or shuts down.
▪ So, FC should not matter in the decision to shut
down.

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 A Firm’s Long-Run Decision to Exit
▪ Cost of exiting the market: revenue loss = TR
▪ Benefit of exiting the market: cost savings = TC
(zero FC in the long run)
▪ So, firm exits if TR < TC
▪ Divide both sides by Q to write the firm’s
decision rule as:
Exit if P < ATC

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 A New Firm’s Decision to Enter Market
▪ In the long run, a new firm will enter the market if
it is profitable to do so: if TR > TC.
▪ Divide both sides by Q to express the firm’s
entry decision as:
Enter if P > ATC

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 The Competitive Firm’s Supply Curve

The firm’s
Costs
LR supply curve
is the portion of MC
its MC curve
above LRATC. LRATC

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 ACTIVE LEARNING 2
Identifying a firm’s profit
A competitive firm
Determine
this firm’s Costs, P
total profit. MC

Identify the P = $10 MR

area on the ATC
graph that
$6
represents
the firm’s
profit.
Q
50
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 ACTIVE LEARNING 2
Answers
A competitive firm
Costs, P
Profit per unit MC
= P – ATC
P = $10 MR
= $10 – 6
profit ATC
= $4
$6

Total profit
= (P – ATC) x Q
= $4 x 50 Q
= $200 50
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 ACTIVE LEARNING 3
Identifying a firm’s loss
Determine A competitive firm
this firm’s Costs, P
total loss, MC
assuming
AVC < $3.
ATC
Identify the
area on the $5
graph that
P = $3 MR
represents
the firm’s
Q
loss. 30
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 ACTIVE LEARNING 3
Answers
A competitive firm
Costs, P
Total loss MC
= (ATC – P) x Q
= $2 x 30 ATC
= $60
$5
loss loss per unit = $2
P = $3 MR

Q
30
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Market Supply: Assumptions
1) All existing firms and potential entrants have
identical costs.
2) Each firm’s costs do not change as other firms
enter or exit the market.
3) The number of firms in the market is
▪ fixed in the short run
(due to fixed costs)
▪ variable in the long run
(due to free entry and exit)

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 The SR Market Supply Curve
▪ As long as P ≥ AVC, each firm will produce its
profit-maximizing quantity, where MR = MC.
▪ Recall from earlier lecture:
At each price, the market quantity supplied is
the sum of quantities supplied by all firms.

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 The SR Market Supply Curve
Example: 1000 identical firms
At each P, market Qs = 1000 x (one firm’s Qs)

One firm Market

P MC P S
P3 P3

P2 P2
AVC
P1 P1
Q Q
10 20 30 (firm) (market)

10,000 20,000 30,000

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 Entry & Exit in the Long Run
▪ In the LR, the number of firms can change due
to entry & exit.
▪ If existing firms earn positive economic profit,
▪ new firms enter, SR market supply shifts right.
▪ P falls, reducing profits and slowing entry.
▪ If existing firms incur losses,
▪ some firms exit, SR market supply shifts left.
▪ P rises, reducing remaining firms’ losses.

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 The Zero-Profit Condition
▪ Long-run equilibrium:
The process of entry or exit is complete—
remaining firms earn zero economic profit.
▪ Zero economic profit occurs when P = ATC.
▪ Since firms produce where P = MR = MC,
the zero-profit condition is P = MC = ATC.
▪ Recall that MC intersects ATC at minimum ATC.
▪ Hence, in the long run, P = minimum ATC.

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Why Do Firms Stay in Business
if Profit = 0?
▪ Recall, economic profit is revenue minus all
costs, including implicit costs like the opportunity
cost of the owner’s time and money.
▪ In the zero-profit equilibrium,
▪ firms earn enough revenue to cover these costs
▪ accounting profit is positive

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 The LR Market Supply Curve
In the long run, The LR market supply
the typical firm curve is horizontal at
earns zero profit. P = minimum ATC.

One firm Market

P MC P

LRATC
P=
long-run
min. supply
ATC

Q Q
(firm) (market)
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 SR & LR Effects of an Increase in Demand
A firm begins in …but then an increase
long-run to…driving
…leadingeq’m… SR profits to zero
Over time, profits
in demandinduce entry,
raises P,…
andfirm.
profits for the restoring long-run
shifting eq’m.
S to the right, reducing P…

P One firm P Market

MC S1

S2
Profit ATC B
P2 P2
A C long-run
P1 P1 supply
D2
D1
Q Q
(firm) Q1 Q 2 Q3 (market)
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 Why the LR Supply Curve Might Slope Upward

▪ The LR market supply curve is horizontal if

1) all firms have identical costs, and
2) costs do not change as other firms enter or
exit the market.
▪ If either of these assumptions is not true,
then LR supply curve slopes upward.

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 1) Firms Have Different Costs
▪ As P rises, firms with lower costs enter the market
before those with higher costs.
▪ Further increases in P make it worthwhile
for higher-cost firms to enter the market,
which increases market quantity supplied.
▪ Hence, LR market supply curve slopes upward.
▪ At any P,
▪ For the marginal firm,
P = minimum ATC and profit = 0.
▪ For lower-cost firms, profit > 0.
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 2) Costs Rise as Firms Enter the Market
▪ In some industries, the supply of a key input is
limited (e.g., amount of land suitable for farming
is fixed).
▪ The entry of new firms increases demand for
this input, causing its price to rise.
▪ This increases all firms’ costs.
▪ Hence, an increase in P is required to increase
the market quantity supplied, so the supply
curve is upward-sloping.

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.