[MUSIC] In this module we are going to move on to the essence of our analysis, as we examine pricing and production rules under perfect competition. Let's start with this question, given a market structure of perfect competition, what kind of conduct with respect to pricing can we expect? That is, what do you think the price will wind being equal to? [MUSIC] Well, the answer is captured in this key equation. So emblazon it into your brain because it is a keeper. Price equals marginal revenue equals marginal cost. Let me repeat that. Price equals marginal revenue equals marginal cost. Our task now is to prove this key equation. And the first part, price equals marginal revenue, is really easy to do. [MUSIC] In fact, we have already proved the P = MR rule in our early discussion. Recall that we observed that the profit maximizing perfectly competitive firm will be the price taker in the marketplace. And therefore faces a horizontal or a perfectly elastic demand curve. So in that case, the firm's marginal revenue must be equal to price. [MUSIC] Now having proved that P = MR under perfect competition, let's go to the harder task, which is to show that profits are maximized when the firm sets marginal revenue to marginal cost. This, in fact, is a key equation called the profit maximizing rule, MR = MC. Let's demonstrate this profit maximizing rule with the help of first a table and then with a graph. Here's the table and a quick refresher exercise to perform. Please go through each of the columns and remind yourself of the definition of each. That's an excellent review of the last lesson. After you do that review, then see if you can fill in the empty boxes in the columns for marginal revenue, marginal cost, and total profit. Where total profit is simply total revenue- total cost. So please pause the presentation now to do this. And it is well worth doing. [MUSIC] So does your table look like this? If not, please check your work. If so, let's try answering this question by looking at the table and applying our marginal revenue equals marginal cost, MR = MC rule. Here's the question. At what price and quantity will profits be maximized? Please pause now to think this through. [MUSIC] The answer here is a price of $35 and a quantity of 8 units. And this observation leads us to our proof of the profit maximizing rule. In particular, if you increase output from 7 to 8 units, the marginal cost is only $30. Because that is less than the marginal revenue you would earn, it does make sense to do that. However, if you further increase output from 8 to 9 units, that has a marginal cost of $40, which is more that the marginal revenue of $35. Clearly that's not the way to maximize profits. Therefore, 8 units is the profit maximizing output just as our MR = MC rule indicated it would be. Now, here I'm going to share with your perhaps the most important key point of this entire lesson. The MR = MC rule is not just an accurate guide to maximizing profits under perfect competition. This profit maximizing rule applies in all other cases as well. But here's the big difference. In the other cases, for example, monopoly or oligopoly, while profits will be maximized where MR = MC, price will not be equal to marginal revenue as it is in the perfect competition case. [MUSIC] Now here is another really key point of this lesson. And one that we can extract from our table of price and output data. If the profit-maximizing firm always sets its output at a level where marginal cost equals marginal revenue, then it must be true that a firm's marginal cost curve must also be its supply curve. Wow, think about that. If the profit-maximizing firm always sets its output at a level where marginal cost equals marginal revenue, then it must be true that a firm's marginal cost curve must also be its supply curve. This is how this situation looks, graphically, using the data from our previous table. Please study this figure carefully now for a few minutes as you think about this question. How would you calculate the firm's profit simply by looking at the graph? Here are some options. So please, pause the presentation now and see if you can figure it out. [MUSIC] Did you get it right? Profits are measured by the rectangle A, B, C, and D. There's one way to think about this result, total revenue is simple price times quantity or the big rectangle ADGF. Do you see that in the figure? As for the total cost that you must subtract from total revenues to get profits, this is simply the average total cost or ATC times the quantity sold. This yields the rectangle BCGF. Of course, subtracting the rectangle BCGF from ADGF gives us the green profit box, ABCD. [MUSIC] Okay, to finish up this part of the module, let's look at a very clever and helpful key concept known as the shutdown rule. The idea here is that it may not always make sense to shut down a business, even if it is losing money in the short run. We can demonstrate that with this figure. Here we have a situation where the firm's average total cost curve or ATC is actually above the price equals marginal revenue line. But the average variable cost curve ABC is actually below the price equals marginal revenue line. Do you see that? Take a minute to determine the profit or loss rectangle in this situation. And please pause now to do so. [MUSIC] Well, in this case, the firm suffers a loss equal to the rectangle ABED. Its totally revenues equal only DEFG but total costs equal ABGF. Got it? Now here's a harder question. Given the firm's loss, should it close its doors and go out of business? If not, why not? And note, this is an important question that has very real world implications for businesses. And if you can answer riddles like these, it will show that you are building up your business skills and economics. So please, pause the presentation again to think about this. [MUSIC] So here is perhaps the surprising answer. You definitely should stay in business, at least in the short run, even in the face of these negative profits. Why might you do this? Well, here's the intuition first. You may be in an industry that is highly cyclical. Where cyclical means your business is highly sensitive to fluctuations of the business cycle. The economy expands and your business booms. The economy goes into a recession and your business suffers. And the economy recovers from that recession and so does your business. We will learn more about such fluctuations in the business cycle and how to strategically manage such fluctuations in our companion macroeconomics course. But the idea is this, if your firm can ride out the rough economic patch where prices are depressed in a recession, you can then once again generate positive profits once prices firm up during an economic expansion. In the meantime, you stay in business even if you are earning negative economic profits, so long as you are able to help pay for your fixed costs through the revenues you generate. That is the essence of the shutdown rule, which is also known as the shutdown condition or close down rule. Technically the shutdown point for your firm only comes at the point where revenues just cover variable costs or where losses are equal to fixed costs. However, if price falls below the level where revenues are equal to variable costs, the firm will minimize its losses by shutting down. The thing you have to remember here to really wrap your head around the shutdown rule is that a firm must still cover its contractual commitments, even when it produces nothing. That means in the short run the firm must still pay fixed costs such as rent, interest on bank loans, and salaries to key management personnel. [MUSIC] Okay, here's a quick numerical example to complete our discussion of the shutdown rule. Suppose the firm in our example has fixed costs of $40. However, the rectangle of loss only equals $20. Clearly, it is better off to continue to operate in the short run because losses are minimized. Put another way, would you rather lose $40 by shutting down or $20 by staying in business? In fact, there are lots of industries sensitive to macroeconomic fluctuations that go through cycles of large short run losses without shutting down. Knowing what you know about the shutdown rule, which type of industry is likely to incur such losses? An industry with low fixed costs like coffee shops and dry cleaners, or a capital-intensive industry with high fixed cost like automobiles and the airlines? [MUSIC] The answer, it's the capital-intensive industry. Intuitively, we should see that the higher the firm's fixed cost, the more it has to lose by shutting down. Got it? [MUSIC] Now, here's a really tough question to end this module. In light of the shutdown rule, how must we change our definition of the firm's supply curve as it relates to marginal cost? [MUSIC] Well, the firm's marginal cost curve is still the supply curve, but this is true only for that portion of the marginal cost curve that lies above the AVC. If you got that question right, go to the head of our digital classroom. And that's it for this module. In our next module of this lesson, we need to address the issue of just how long a firm can afford to lose money. And that will take us into our analysis of long run equilibrium. So when you are ready, onto module five. [MUSIC]