Source: Image of Breakeven Point graph created by Kate Eskra, Image of Short-Run Profit graph created by Kate Eskra, Image of Firm Entry in Long-Run graph created by Kate Eskra, Image of Short-Run Loss graph created by Kate Eskra, Image of Firm Exit in Long-Run graph created by Kate Eskra
Hi. Welcome to Economics. This is Kate. Is tutorial is on the breakeven point. As always, my examples are going to be in green, and my key terms will be in red.
In this tutorial you'll understand that firms will break even when total revenue equals total cost. And on a graph, you'll see that as where price equals average total cost.
We'll talk about why a perfectly competitive firm will always earn zero economic profit in the long run and what that means. We'll talk about what a zero economic profit actually means to the firm.
So we know that profit equals revenues minus cost. So if our revenues are greater than all of our costs, then the firm makes a profit. If our revenues are less than our costs, then the firm sustains a loss. If total revenue equals total cost, then the firm breaks even. And this is where we're focusing today.
So here's a graph for you. This is price and quantity. Here's our marginal revenue, which is also our demand curve, and it's also price for a perfect competitor. And that's the example I'm going to use today is let's say an apple farmer.
So the first thing we is we find the profit maximizing quantity. And we know that we do that by equating marginal revenue and marginal cost. So our eye goes right here to find our equilibrium quantity or quantity that will maximize our profit or minimize our loss. This is the best-case situation. That's the quantity that they will always produce.
Now we need an average total cost curve to compare it to the price to see if the firm's making a profit or loss. And here, I drew it so that our price is exactly right where our average total costs are. So that means that on average the price they're receiving is exactly the same as the cost to produce each unit. That's the breakeven situation. This is zero profit. They're basically just covering costs.
So breakeven is a situation where there is no profit or loss. Now we need to talk about what's going to happen in the short-run versus the long-run. So remember, the short-run is a point in which a firm cannot adjust output and expenses and preparation to minimize cost per unit. Something is fixed in the short-run that they can't really do much about. There are more constraints in the short-run.
Let's actually look at a short-run profit situation. So notice that I drew average total cost down here this time. Again, marginal revenue equals marginal cost here.
And this apple farmer is going to maximize his profit by producing $10. The price he receives is $20. Remember he's a price taker. That's why the demand curve is straight across, and it's the same as marginal revenue is price.
So you can see that the price he receives, at $20, is up above his cost per unit, which is $18. His total revenue is greater than total cost, and his price is greater than average total cost. This is looking at it per unit. This is looking at it in total. It doesn't matter which way you look at it, it will result in the same thing.
So here's the situation, in the short-run, it is possible for perfect competitors to make a profit. But it's perfect competition because there are no barriers to entry. There's no barriers to entry. Other firms are going to see, oh, those apple farmers are making profits. I think I'll get it on that profit opportunity.
So now what's going to happen? Well, now that more people have joined the industry, that's more competition. Remember whenever the industry supply curve shifts to the right and there's more competition market price falls. We like more competition as consumers, right? It means prices fall.
Well look at the impact though on our farmer. The price now that he has to take-- he's a price taker-- fell. He has to take a lower price now. I'm showing you that it fell down to $18.
And remember, that's where our average total cost curve is now going to come in, right around $18. So our economic profits are going to disappear. The price will fall basically until firms are breaking even where price equals average total cost.
The long-run then is a point in which the firm can adjust output and expenses to minimize cost per unit. So the long-run, that's where firms can enter, firms can exit.
Let's look at the short-run loss situation. In the short-run, this firm is experiencing a loss. He's producing where mr equals mc. Notice that cost is now above. So price is less than average total cost. And he's losing $5 per unit.
There's no barriers to exit. So some of these farmers are probably going to decide, you know what, this isn't worth it. In the long-run, I'm going to exit the industry.
Now that there's less competition in the industry, the market price rises. Economic losses are going to disappear, and price will end up rising until firms are breaking even where price equals average total cost again.
So let's talk about what this means, this zero economic profit. Economic profit, remember, is total revenue minus total costs. And in economics, those include explicit cause and implicit or opportunity costs.
So a lot of the time I get the question, why would a firm ever continue to operate in the long-run if they're earning zero economic profit? Because remember in the long-run I just said that perfectly competitive firms earn zero economic profit in the long-run. Why would they ever do that?
Well remember that this includes them covering their opportunity cost. So zero economic profit or breaking even in economics means that they still may very well be earning an accounting profit. For example our apple farmer, he's earning enough returns that they're the same as his next best alternative. Or let's say he gave up doing something else.
He's making at least that much, nothing over and above it. He's not making an economic profit, which means he's not doing better than what he has given up. But he's not doing worse either. He's not earning economic losses. So it's just enough to keep our apple farmer in this industry.
And that's long-run equilibrium for perfect competition simply because where there are profits, there's no barriers to entry. So firms will enter. Where there are losses being seen, some firms are going to exit. And that's why it's not equilibrium yet, because there's change occurring.
But keep in mind this is really a theoretical concept because markets change rapidly all the time. There's always new advertisements or products being recalled because of something. Things extraneous to what we have just been looking at in these simplified models happen all the time. And so is equilibrium ever completely able to be reached? Maybe, maybe not. So just keep in mind that we're talking about this as a theoretical concept.
Finally, I want you to understand that profits are sustainable in other industries. In less competitive industries than perfect competition there are barriers to entry. So an example I'm giving you here is if the airline industry is making huge profits, there are such barriers to entry. That's so expensive to get into that market. It's not going to be possible next month for a large amount of producers to suddenly enter to compete with them and lower price.
So because of that, the less competitive the industry, usually because there are more barriers to entry, the more capable of these kinds of firms are going to be of seeing profits into the long-run.
So in this tutorial we talked about how firms breakeven when total revenue equals total cost. But if we look at it on a per unit basis-- on a graph we look at where price equals average total cost-- perfectly competitive firms are the ones who earn zero economic profit in the long-run, because short-run profit causes entry into the industry. And short-run losses cause exit out of the industry.
Imperfectly competitive firms can keep sustaining those profits in the long-run because of barriers to entry. And finally, keep in mind that zero economic profit does not necessarily mean zero accounting profit, because it means that we are, in fact, covering our opportunity costs or what was given up.
Thank you so much for listening. Have a great day.
A situation where there is no profit or loss.
Total revenue calculated minus explicit costs and opportunity costs.
A point in which a firm can adjust output and expenses to minimize cost per unit.
A point in which a firm cannot adjust output and expenses in preparation to minimize cost per unit.