now that we understand profit maximization for a competitive firm we can go back to another key characteristic of competitive markets free entry and exit free entry and exit again means that competitive firms don't face barriers to entry or exit when we think about how a firm will make the decision about entry or exit it's going to be a function of profitability that is do our revenues cover our cost of production how the firm responds to this motivation will be dependent on whether we're in the short run or in the long run a couple of terms the term shutdown for a firm refers to a short run decision a short run decision not to produce anything because of certain market conditions in other words this just means that the firm is temporarily stopping production temporarily not producing and selling goods this doesn't mean that the firm won't come back in a few months or a few years exit on the other hand is a long-term decision this is the firm completely exiting the market completely leaving the market because they're no longer profitable so how do they make these decisions well let's begin in the short run in the short run the firm compares their revenues to their cost of production in the short run if the price that they receive for their product exceeds their average total cost they continue to produce recall our equation profit is equal to price minus the average total cost of production times the quantity therefore if the price that they receive is greater than that average total cost regardless of the quantity they produce they're making a positive profit and the firm remains in the market and continues to produce however for the short run the firm faces two types of cost variable cost and fixed cost when we think of the difference between variable cost and fixed cost we remember that variable costs are ones that we only incur if we produce fixed cost we incur regardless so in looking at the profit maximization for the competitive firm if the price that the competitive firm is able to charge exceeds the variable cost of production that means that they can cover all of the additional costs from producing plus some of the fixed costs that they're going to incur regardless of whether they choose to produce or not now if this price is less than the average total cost they're not going to make any money they're going to earn a negative profit but they're still better off by choosing to produce than completely shutting down however if their price falls below their average variable cost that means the revenue that they receive isn't going to be enough to cover the variable cost of production that means that the total revenue isn't enough to cover the additional cost that they incur by producing anything and that's the point when the firm makes the decision in the short run to shut down they still earn a negative profit because they're still incurring what those fixed costs but they incur a smaller loss than they would if they chose to continue to produce the key determinant here is are the revenues enough to cover our cost and if not what types of cost am i able to cover let's look at this graphically here we see that we've got our typical cost curves average variable average total and marginal cost and i've drawn in three separate demand curves d1 2 and 3. let's begin with d3 we're going to follow our step-by-step profit maximization to determine exactly what the firm is going to do at a price point of d3 where our price level is p3 the firm is going to maximize profit by equating that d to our marginal cost because remember your demand curve is also your marginal revenue curve so there i'm setting marginal revenue equal to marginal cost to get my profit maximizing quantity q3 at a quantity of q3 the price that i receive is greater than both my average total cost and my average variable cost therefore this is the place where the firm will continue to produce in the short run because it's covering all of its costs its average total cost and then by default of course its average variable let's consider demand curve d3 or d2 excuse me at d2 remember this is also their marginal revenue curve and their price point p2 where that demand curve intersects the marginal cost curve gives us the quantity that maximizes profit for that demand curve this quantity also shows us that we're above our average variable cost but we're not above our average total cost in other words this firm is losing money how much well remember your formula is price minus average total cost times quantity so if your price is p2 and your average total cost for the quantity is here then that means your firm is losing this much there is your loss for this particular firm the question is is that loss enough to shut the firm down the answer is no because the price of p2 is greater than the average variable cost meaning that by producing q2 units i'm incurring additional costs my variable cost to produce but i'm able to cover all of those plus some of my fixed costs i'm better off than if i chose to produce nothing at all finally let's look at d1 at d1 now we look at of course marginal revenue for that firm price of p1 marginal revenue equals marginal cost here occurs at this intersection giving us a quantity of q1 this quantity my average variable cost is above my price level and my average total cost is above my price level for this firm they're going to choose to produce nothing at all they're going to shut down why because there's no way they can even cover their variable cost of production they're better off shutting down than producing anything at this point because they would lose even more money by continuing to produce as opposed to shutting down what about the long run the long run is essentially the same decision but recall that all costs become variable in the long run that is our average total cost curve reflects all the costs that we face so the decision is a little more direct if the price that we receive is greater than our average total cost then we continue to produce in the long run and earn positive profit if the price is equal to the average total cost then we continue to produce while earning zero economic profit remember zero economic profit incorporates both implicit and explicit costs finally price is less than average total cost is when we exit the market exiting the market implies that we're completely leaving the market as a result of the losses that we're incurring that is in the long run we can't just simply float our fixed cost why because those fixed costs have become variables our contracts have become due and we have to have enough revenue to pay all of our cost we can't sustain economic losses for an extended period of time or in the long run so for the competitive firm in the long run we only have our average total cost curve but the same decision holds when we look at our d1 we can see that again for our marginal revenue curve and a price point of p1 we get our profit maximizing quantity but that profit maximizing quantity is going to lead to an economic loss that is we equate our marginal revenue and our marginal cost to get that profit maximizing quantity and use the average total cost of that quantity to determine the economic loss that is we would be earning negative economic profit if we chose to produce at that quantity q1 however when we look at the demand curve d2 we see that of course we see that this becomes also our marginal revenue curve or our price point p2 equating marginal revenue and marginal cost we get a profit maximizing quantity q2 at that quantity our average total cost is at that intersection point tracking it over we see that now this shaded area represents the profit or the positive profit that we will earn when we consider this long run decision this idea of free entry and exit is solely being determined by the fact that we have either gains or losses in our market so why the key difference between the short run and the long run remember from our cost module that variable cost and fixed cost are represented by that short run in the long run in the fix in the short run fixed costs are fixed we can't undo them we can't change them they're what we call sunk cost they're ones that we've already committed to pay and we can't get out of those contracts so we make this decision in the short run a little bit differently because we want to minimize our losses if possible we want to do the best that we can in all cases profit maximization isn't always about earning a positive profit profit maximization can also mean loss minimization in other words we want to minimize our losses if we can by only focusing on the ability to cover our variable cost in the short run and be able to come or cover some of our fixed cost we may be in a better situation than just by completely leaving the market in its entirety