Long Run Entry and Exit Decision - Online Tutor, Practice Problems & Exam Prep

In the long run, firms exit the market if they cannot cover their average total costs, leading to economic losses. Unlike the short run, where only variable costs are considered, all costs are relevant in the long run. A firm will produce if the price exceeds average variable costs, but if the price falls below average total costs, it will exit the market. The decision to enter or exit hinges on the relationship between price and average total cost, emphasizing the importance of understanding market dynamics and cost structures.

Long Run Exit/Enter Decision

Alright, so we've discussed the short-run shutdown, now let's talk about the long-run exit from the market. A firm will exit the market if it cannot earn a profit, right? If there's no way for it to make any money, there's no reason for it to be in business in this sector. So, it's going to exit the market entirely if it cannot earn a profit. We're going to see firms entering and exiting a market.

Okay, so like before, just to recap, we're going to say 'shuts down'. A firm shutting down, well, that's temporary. They're temporarily not going to produce, right? So that's a short-term thing. They might produce again in the future if they shut down, but if they exit, they're done. They're going to produce no output forever. This is the long run. If there's no way for them to make money in the long run, then they're just going to exit; they're not going to have anything to do with this market.

Okay, so when we were talking about a short-run decision, we only considered the variable costs, right? Because those fixed costs were going to remain fixed costs. Now, when we talk about a long-run exit decision, all costs are relevant. This includes the fixed costs and the variable costs. Well, when I say fixed costs, in the long run, there are no fixed costs. That was our definition of the long run: enough time has passed that our fixed costs, we can change them. So if we had some sort of lease that we were signed up to and we had to rent this factory for so long, well in the long run, that lease is going to end, right? And we no longer have to rent this factory, so all our costs in this long run are variable costs. Those fixed costs from the short run, well now we can change them. We can decide whether or not we want to keep them.

So what we're getting at here is that there are no fixed costs in the long run. That's exactly the point here. All of our costs are variable costs, and we can choose more thoroughly whether we want to produce in this market.

Okay, so let's go ahead, in the next video, we're going to do a similar example to what we did in the short-run shutdown decision. Let's see what happens with the long-run exit decision, alright? Let's do that in the next video.

Long Run Exit/Enter Decision (continued)

Alright, so now let's do a similar example, but now we're in the long run. Notice how our terminology has changed here a little bit. A farmer is considering whether he should continue to rent a field for the upcoming season at a price of $1,000, right? So in this case, he doesn't have the field rented already. When we talked about the short run, he had already paid for the field and he was going to have it no matter what for the season, right? So in this case, he can decide whether or not he wants to pay for the field, right? The seeds still cost $200 here, and we have to decide whether or not the farmer should produce, right? So in the first case, we see that revenues from sales are $500 just like last time, and we're going to see what happens when revenues are $100 as well. Okay, so in this case, if they don't produce, right? Before when he didn't produce, he had to eat the cost of the field, right? That $1,000 for the field, he had already paid it. There was nothing he could do about it. But now in this case, he hasn't paid for the field yet, right? He's deciding whether or not he wants to rent it. So, if he doesn't produce, he doesn't have to pay for the field, and he has zero profit but zero loss as well, right? Now, what if he does decide to produce? If he does decide, he's going to have to pay for the field, right? Well, first revenue, right? If he does produce, he's going to bring in 500 in revenue, but now his total cost, he's going to have to pay for the field. Right? He's going to have to pay the $1,000 for the field and $200 for the seeds. Total cost of $1,200, right? This is similar to what we saw before, and his profit is going to be that $500 minus the $1,200, and he's going to lose $700 in this case, right? Last time when we were talking about the short run, this was the better option, right? Because he was losing less money than if he paid for the field and didn't produce, but now he doesn't even have to pay for the field. So the best scenario in this case is no production, no loss, right? He's going to have no loss, no profit either, but he's not going to lose money, right? This was a losing venture, he can finally get out, and this is his chance to exit the market.

Alright, what about if we have lower revenue? Well, you can imagine this is going to be an even worse case, right?

So if he doesn't produce, again 0, right? He's not going to have any profit or loss. He doesn't have to pay for the fields. He doesn’t have to pay for the seeds. He doesn’t bring in any money. So he's got 0 there.

Now, what if he does produce? Well, his revenue will be the $100 from the sales, and his total cost, well, he's going to have to pay for the field, $1,000, and he's going to have to pay $200 for the seeds. So, he's got $1,200 in total costs there. His profit, or rather his loss, is going to be $100 minus $1,200, which is a negative $1,100, right? Revenue minus cost there, negative $1,100. Okay. So again, his best case scenario is no production here. He shouldn't produce again, and that is because he couldn't cover his costs, right? So now notice what happened is that all of our costs are relevant, right? We were able to get out of paying for the field as well. So what we're going to see in this long-run decision is that we're going to shut down when the price falls below the minimum, and this time it's not the Average Variable Cost (AVC); it's the Average Total Cost (ATC), right? Because all the costs are relevant and we can get out of say renting the field in this case, right?

So they don't have a name for this like they did in the short run; they had the shutdown point for that minimum point on the AVC. Well, they don’t really have a name like that; it’s the entry-exit point, right. Any point below that, we are going to exit the market entirely, okay. So this is a long-run decision if our long-run Average Total Cost (ATC) is greater than our price, right? We can't cover those costs in the long run. There's just no way for us to make money. So let's go ahead and finish up right now, as we saw that we're going to exit, right if our total revenue, the money we’re bringing in, can't cover our total cost in the long run, right. Total revenue less than total cost, we’re out of here, we exit. So let's do the same thing and divide, right? Total revenue divided by q, right? We’re going to find the average of each and total cost divided by q, and what was our average revenue? Just like last time, right? Average revenue is just price, as we discovered in our revenue video, so our left side of the equation becomes price, and we're going to exit if that price is less than our Average Total Cost (ATC), right. And just here behind me, I'll move to the side. We're going to enter the opposite, right? If the price is greater than Average Total Cost (ATC), right? If that price is greater than Average Total Cost, firms are going to see, hey, we can make money here. Let's go ahead and join this market. We're going to see the implications of this entering and exiting of the market in other videos, but for now, what we see is that for long-run decisions, it’s that Average Total Cost curve that matters again, right? So Average Variable Cost curve doesn't matter for the long-run decision. We want to see the Average Total Cost, okay? So let’s go ahead and pause right here and in the next video, let’s discuss all of these points on the graph, alright? Let’s discuss what can happen at different price levels. Cool? Alright, let’s do that now.

Long Run Exit/Enter Decision on the Graph

Alright, so let's go ahead and see this long-run exit decision on the graph. Alright, so we've got our cost curves there, marginal cost, average total cost, and average variable cost, right? And now I want to set different price levels and see what's going to happen in the short run, the long run, and what happens with profit as well. Okay. So let's start here with a high price. We'll call this p1. We're going to go p1 through p5. So let's start with a high price, something way up here. P1, somewhere along there. Okay. And remember that that price level to the firm, that is the demand curve, right? They have to sell at that price set by the market and that is going to be their average revenue as well as their marginal revenue, right? So that marginal revenue curve we just drew touches the marginal cost where our profit is maximized or loss is minimized right there, right? That's the important point. Marginal revenue equals marginal cost. So let's ask a few questions. Should we produce in the short run at this price? Well, remember, in the short run, we have to cover our average variable cost and you can see that our price is greater than our average variable cost at that price, right? The average variable costs are down there, prices up there. So yes, we will produce in the short run because our price is greater than average variable cost and the same thing with average total cost right. The price is greater than average total cost right there, so we will produce in the long run as well. Okay so those are the conditions for short-run production and long-run production. Now what about whether we're going to make a profit? So how do we see if we're going to make a profit? Well, that's if our price is greater than average total cost, right? So this kind of goes with that long-run decision which makes sense. In the long run, we're going to exit the market if we can't make a profit, right? So it's the same kind of idea is does our price cover our average total cost? And yes, we just saw that with long-run production. Price is greater than average total cost. So don't draw this in because I'm going to erase it but this would be the profit right here, right? This box right here, price minus average total cost times the quantity. Alright. So let me just get that out of there, so we can continue to the next price level. Alright, so yes we earn a profit there, okay? So let's go on to the next price level.

In this price, I want to touch the very minimum of the ATC curve. Okay? So that's going to be right let me try that again a little bit. Alright. Something like that, right? So it's a flat demand curve touching the very minimum of ATC. So that that is our marginal revenue curve. It touches marginal cost right here. So let's think about short-run production first. So are we covering our average variable costs in this case? And yes we are, right? Average variable costs are way down there. Our price level is above it. So yes, in the short run, we will produce, right? How about in the long run? Well in the long run, our price is equal to our average total cost, right? So in this case, they are equal to each other. So it's not less, it's we're at that minimum point and yes, yes, we are going to produce there, right? Where the price is equal to average total cost, it's not less than average total cost yet, right? The average total cost isn't exceeding our price, so we're still going to produce. However, if you notice since our price is touching our average total cost, we can't make a box there for our profit or our loss, right? So here where the price equals average total cost, well there's no profit right? So at p2, we have 0 profit right? So they are going to produce but they're going to have no profit. And you might say why are they even going to bother producing and go through all this trouble? Well you have to remember that when we're talking about economics, we talk about economic profit and when we defined economic profit, we discussed that economic profit includes opportunity costs, right? So some non-monetary opportunity costs, things that you didn't have to spend money on, but they were still opportunity costs so say like you know a foregone salary that the owner of the firm instead of buying a farm and producing wheat, they could have been a chemical engineer and been making some money, right? So these opportunity costs, they're not included in an accounting profit, right? So when we think about an accounting profit, they are still making money in that sense, but the economic profit when we consider these other opportunity costs, well that's when it goes to 0. Okay? So whenever we talk about profit in this class, you have to remember that we're always talking about this economic profit and accounting profit is always going to be a little higher, right? So here we have those opportunity costs as well-being accounted for. Okay, so let's go on to a third price level.

Here’s what students ask on this topic:

What is the difference between short run and long run exit decisions in microeconomics?

In microeconomics, the short run and long run exit decisions differ primarily in the costs considered. In the short run, firms focus on covering their average variable costs (AVC) because fixed costs are already incurred and cannot be changed. If the price falls below AVC, the firm will shut down temporarily. In the long run, all costs are variable, and firms will exit the market if they cannot cover their average total costs (ATC). This means that if the price is less than ATC, the firm will exit the market permanently, as it cannot sustain economic losses indefinitely.

How do firms decide to enter or exit a market in the long run?

Firms decide to enter or exit a market in the long run based on the relationship between the market price and their average total costs (ATC). If the market price is greater than the ATC, firms will enter the market because they can earn a profit. Conversely, if the market price is less than the ATC, firms will exit the market because they cannot cover their costs and will incur economic losses. This decision hinges on the ability to sustain profitability over time, considering all variable costs.

Why are all costs considered variable in the long run?

In the long run, all costs are considered variable because firms have enough time to adjust all inputs and resources. Unlike the short run, where some costs are fixed (e.g., lease agreements, equipment), the long run allows firms to renegotiate leases, purchase or sell equipment, and adjust labor and other inputs. This flexibility means that firms can change their cost structures entirely, making all costs variable and relevant for long-term decision-making.

What happens if a firm's price is equal to its average total cost in the long run?

If a firm's price is equal to its average total cost (ATC) in the long run, the firm will break even, earning zero economic profit. This means that the firm's total revenue covers all its costs, including opportunity costs. While the firm does not make an economic profit, it also does not incur a loss. In this scenario, the firm will continue to operate in the market, as it is covering all its costs, but it will not attract new firms to enter the market due to the lack of economic profit.

How do opportunity costs affect long run exit decisions?

Opportunity costs play a crucial role in long run exit decisions because they represent the potential benefits a firm foregoes by choosing one alternative over another. In the long run, firms must cover not only their explicit costs but also their implicit costs, which include opportunity costs. If a firm's total revenue does not cover these opportunity costs, it will consider exiting the market. This ensures that resources are allocated to their most efficient use, where they can generate the highest possible return.