Understanding long-run exit decisions in a market involves analyzing cost curves, price levels, and profit outcomes. The key cost curves to consider are marginal cost (MC), average total cost (ATC), and average variable cost (AVC). The price levels, denoted as P1 through P5, help illustrate different scenarios for short-run and long-run production decisions.
Starting with a high price level, P1, which is above both AVC and ATC, firms will produce in the short run since they can cover their average variable costs. In this scenario, they also earn a profit because the price exceeds the average total cost. The profit can be calculated as the area of the rectangle formed by the difference between price and ATC multiplied by the quantity produced.
At the next price level, P2, where the price equals the minimum of the ATC curve, firms will still produce in the short run as they cover their AVC. However, since the price equals ATC, they earn zero economic profit. This situation highlights the distinction between accounting profit and economic profit, where the latter accounts for opportunity costs, leading to a situation where firms may continue to operate without making a profit.
For price level P3, which lies between AVC and ATC, firms will produce in the short run because the price is above AVC. However, they incur a loss in the long run since the price does not cover ATC. This loss is represented by the area between the price and ATC, indicating that firms will eventually exit the market if this condition persists.
At price level P4, which touches the minimum of the AVC curve, firms will produce in the short run as they cover their AVC, but they will not cover their ATC, leading to losses in the long run. This situation reflects a point of indifference for firms, as they may choose to produce to minimize losses but will ultimately exit if conditions do not improve.
Finally, at price level P5, which is below both AVC and ATC, firms will not produce in the short run or long run, as they cannot cover their variable costs. This scenario illustrates a clear exit decision, as continued operation would lead to unsustainable losses.
In summary, the relationship between price, average total cost, and average variable cost is crucial in determining whether firms will produce in the short run and whether they can sustain operations in the long run. Understanding these dynamics helps clarify the conditions under which firms will enter or exit a market.