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Shutting down or exiting industry based on price | APⓇ Microeconomics | Khan Academy - YouTube
Channel: Khan Academy
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we've spent several videos already
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talking about graphs like you see here
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this is the graph for a particular firm
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maybe it's making donuts so it's in the
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donut industry and we can see how the
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marginal cost relates to the average
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variable cost and average total cost we
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go into some depth several videos ago
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but we see that trend that marginal
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costs can trend down initially because
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as quantity increases each incremental
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unit could benefit from things like
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specialization and then the marginal
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cost the cost of each incremental unit
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as a function of quantity could go up
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because of things like coordination
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costs and then we've also seen how that
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relates to average variable costs that
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while marginal cost is below average
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variable cost every incremental unit is
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going to bring down the average variable
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cost but then when marginal cost crosses
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average variable cost well now every
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incremental unit is going to bring up
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the average variable cost and the same
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thing happens once it crosses the
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average total cost and of course the
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difference between for any given
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quantity between the average total cost
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and the average variable cost that is
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the average fixed cost now with that out
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of the way we're going to think about
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how this firm would react under
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different market conditions we're going
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to assume that it's in a very
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competitive or we could say a perfectly
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competitive market and so it is a price
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taker and so let's first imagine what
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would be a positive scenario for this
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firm let's imagine the price up here so
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let's call this
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p
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sub 1
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and in a previous video we already said
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it would be rational for profit
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maximizing firm to produce at a quantity
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where the marginal cost and the marginal
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revenue is meat
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and if we're talking about a competitive
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market then the this price right over
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here is not going to be a function of
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the firm's quantity so that's why it's
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horizontal and it would be
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a the same thing as the marginal revenue
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so in this situation at p sub 1 the firm
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would produce
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q sub 1.
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and this is a good situation for the
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firm because the price that it's getting
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is higher than its average total cost
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and so there is going to be a nice
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amount of profit for this farm the
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profit is going to be the price minus
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the average total cost at that quantity
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times the actual quantity so
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because p1 is greater than the average
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total cost
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you we have a situation where the firm
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is profitable
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firm
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is profitable
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it would want to stay in the market but
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because you have a profitable firm in
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this market and you're likely to have
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many profitable firms in that market it
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will probably attract entrants
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attract
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attract entrants other people might say
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hey i want to make just as much money as
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this donut company right over here than
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this firm and so you'll probably have
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more and more entrance into the market
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which will probably reduce the prices
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now they could reduce the prices until
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you get to a price that looks something
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like this so i will call that p sub 2.
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now a profit maximizing firm in this
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world would keep producing until the
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marginal cost is equal to the marginal
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revenue which in this case is the price
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and so this would be
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my lines aren't completely straight
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there but you get the idea so that's q
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sub 2.
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now in this situation p sub 2 is equal
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to the average total cost so the firm is
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break even
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it's not running at a loss or a profit
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so it is break even and so here the firm
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is neutral about whether in the long run
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it stays in the market or it exits the
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market but you're no longer likely a
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tracking entrance so no
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longer
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attracting
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attracting
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entrants
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but it does make sense for the firm to
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keep operating at this situation even in
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the long run because it is at least
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break even
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now let's imagine another scenario let's
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imagine
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this price level
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so for whatever reason the market price
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gets to that as we've talked about a
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rational firm would be producing at q
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sub 3
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and at p sub 3 right over here there's
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some interesting things because p sub 3
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is less than your average total cost
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your firm is running at a loss
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it's running at a loss here
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so running so firm
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firm
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not profitable
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not profitable now you might say well
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what what is this firm likely to do
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would it would it just shut down well in
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the short run it would not make sense
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for this firm to shut down because the
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price that it's getting is still higher
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than its average variable cost in the
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short run the fixed costs they've
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already been spent so you might as well
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get as much incremental profit on the
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margin as you can and so as long as the
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price is higher than the average
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variable cost well outside of their
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fixed cost they're still making some
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money to make up those fixed costs
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so you have two things going on so they
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would stay operating in the short run
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stay
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operating
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operating
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in the short run
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short run
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but what would this firm do in the long
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run well in the long run it makes no
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sense to have a
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to be in a market where you can't make a
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profit so in the long run it will exit
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so it will exit
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in
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the
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long
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run
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and in general the terminology when
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people are talking about well do you
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start or stop in the short run they
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usually talk about do you either shut
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down or operate in the short run and
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then in the long run where it's like hey
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do are you going to sell your factories
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or or or
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somehow dismantle them or you're going
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to build new factories that's all about
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exiting or entering the industry
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and of course you have another even
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worse scenario for this firm which might
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be down here
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where you have price sub 4.
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here in theory this is where we
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intersect the marginal cost curve q sub
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4.
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now here it makes no sense for the
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company to operate at all so because p
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sub 4 is less than the average total
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cost
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you would want to exit
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in the long run exit in long run exit
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the market
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but you wouldn't even wait for that long
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wait to sell your factories because c p
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sub 4 is less than your average variable
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cost you would also just shut down
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shut down
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in
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the
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short
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run
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so big picture from a firm's point of
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view you obviously want to be at p1
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where you make a profit but you might
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attract entrance
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at p sub 2 you as a firm in the long run
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are neutral versus exiting the market or
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entering the market or other people
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entering the market you're at break even
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at p sub 3
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in
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the long run you'd want to exit because
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you're not profitable if the prices stay
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at p sub 3 your price is below your
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average total cost at the rational
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quantity to produce so in the long run
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you would exit
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but because p sub 3
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is greater than your average variable
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cost at the rational quantity you would
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stay operating in the short run and then
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the last scenario of course is p sub 4
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where the price gets so low that just
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doesn't make sense to even operate
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another moment
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