Chapter 6: Perfectly Competitive Supply

1
Chapter 6 Perfectly Competitive Supply

• Derive a supply curve
• Opportunity cost
• The principle of increasing opportunity cost
• Sellers reservation price
• Cost-Benefit principle
• Marginal benefit vs. marginal cost

2
Individuals Supply Curve

• An example
• Opportunity cost of Harry's time
• Wash dishes for 6 per hour is his baseline
• Recycling aluminum cans is the alternative
• Harry earns 2 per can
• How much labor should Harry supply to each
  activity?
• Harry should work at recycling as long as he is
  earning at least 6 per hour

3
Harrys Supply Curve
Recycling Services
Additional Number of Cans Found
600
400
300
200
100
Hours per Day Total Number of Containers Found
0 0
1 600
2 1,000
3 1,300
4 1,500
5 1,600
4
Harrys Supply Curve
Recycling Services
Hours per Day Additional Number of Cans Found Revenue from Additional Cans
1 600 12.00
2 400 8.00
3 300 6.00
4 200 4.00
5 100 2.00

• Harry's rule is to collect cans if the return in
  an hour is the same as washing dishes
• The opportunity cost of collecting cans in an
  hour is the revenue given up from washing dishes
  - 6
• Therefore, Harry should spend 3 hours in
  recycling cans.

5
Harrys Supply Curve

• Reservation Price Per Can

• What is the lowest deposit per can that would get
  Harry to recycle for an hour?
• What price makes his wage at recycling equal to
  his opportunity cost?
• 1st hour price is 1
• 2nd hour is 1.5
• 3rd hour is 2
• 4th hour is 3
• 5th hour is 6

Hours per Day Additional Number of Cans Found
1 600
2 400
3 300
4 200
5 100
6
Harrys Supply Curve
Reservation Price () Number of Cans (00s)
1 6
1.5 10
2 13
3 15
6 16
7
Individual and Market Supply Curves
Harrys Supply Curve
Barrys Supply Curve
Market Supply Curve
0
Recycled cans (00s of cans/day)
Recycled cans (00s of cans/day)
Recycled cans (00s of cans/day)
8
Profit Maximization

• Economists assume firms seek to maximize profits
• Corresponds to buyers' maximizing utility
• Profit is total revenue minus total cost
• Both explicit and implicit costs are included in
  total cost

9
Perfectly Competitive Firm
10
Perfectly Competitive Firm's Demand

• Market supply and market demand set the price
• Buyers and sellers takes price (P) as given
• Perfectly competitive firm can sell all it wants
  to sell at the market price
• Since the supplier is small, its output decision
  will not change market price
• Each firm must decide how much to supply (Q)

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Perfectly Competitive Firm's Demand
12
Profit Maximization An Example

• In the example, the model has a single product
  and two inputs, labor and capital
• Capital is fixed, labor is variable
• Determine the profit maximizing level of output
  for a perfectly competitive bottle manufacturer
• Capacity of the bottle-making machine is fixed

13
Law of Diminishing Return
The Law of Diminishing ReturnsWith all inputs
except one fixed, additional units of the
variable input yield ever smaller amounts of
additional output
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Law of Diminishing Return

• At low levels of production, the law of
  diminishing returns may not hold
• Similar to the increase in a buyer's marginal
  utility from a second unit
• As with marginal utility, marginal product
  eventually diminishes
• Lower marginal products are often caused by
  congestion
• Workers per machine
• Information flows

15
Cost Concepts

• A fixed factor of production is an input whose
  quantity cannot be changed in the short run
• Fixed cost (FC) is the sum of all payments for
  fixed inputs
• A variable factor of production is an input whose
  quantity can be changed in the short run
• Variable cost (VC) is the sum of all payments for
  variable inputs
• Total cost (TC) is the sum of all payments for
  inputs
• Marginal cost (MC) is the change in total cost
  divided by the change in output

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Profit Maximization - Data
Workers Bottles per Day
0 0
1 80
2 200
3 260
4 300
5 330
6 350
7 362
Fixed Costs (/day)
40
40
40
40
40
40
40
40
Variable Cost (/day)
0
12
24
36
48
60
72
84
Total Cost (/day)
40
52
64
76
88
100
112
124
Marginal Cost (/bottle)
0.15
0.10
0.20
0.30
0.40
0.60
1.00
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Profit Maximization

• Profit Total revenue Total cost
• Since Total cost Fixed cost Variable cost
• Profit Total revenue Variable cost Fixed
  cost
• The firm must know about both revenues and costs
  in order to maximize profits
• Increase output if marginal benefit is at least
  as great as marginal cost
• Decrease output if marginal benefit is less than
  marginal cost

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Profit Maximization

• Firms maximize their profit when marginal benefit
  equals marginal cost
• In a perfectly competitive market, marginal
  benefit is simply the market price, which is a
  constant
• Fixed costs do not affect the marginal cost,
  since the change in fixed costs is zero.

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ATC, AVC, and MC

• Average values are the total divided by quantity
• Average variable cost (AVC) is
• AVC VC / Q
• Average total cost (ATC) is
• ATC TC / Q
• Marginal cost (MC)
• MC ?TC/?Q

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Cost Structure
Workers per day Bottles per day Variable Cost (/day) AVC ( per unit) Total Cost ATC ( per unit)
0 0 0 40
1 80 12 0.15 52 0.65
2 200 24 0.12 64 0.32
3 260 36 0.135 76 0.292
Marginal Cost (/unit)
0.15
0.10
0.20
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Cost Structure A graph
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Profit Maximization A graph

• Market price is 0.20 per bottle
• Produce where the marginal benefit of selling a
  bottle (price) equals the marginal cost
• 260 bottles per day

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Profit Maximization A graph
24
Production Loss A graph
25
Shut Down Decision

• Firms can make losses in the short run
• Some firms continue to operate
• Some firms shut down
• If the firm shuts down in the short run, it loses
  all of its fixed costs
• The firm should shut down if revenue is less than
  variable cost P x Q lt VC for all levels of Q
• The firm should continue its business if revenue
  is at least larger than variable cost.

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Shut Down A graph
MC
ATC
AVC
Cost (/bottle)
Price
Output (bottles/day)
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"Law" of Supply

• Short-run marginal cost curves have a positive
  slope
• Higher prices generally increase quantity
  supplied
• In the long run, all inputs are variable
• Long-run supply curves can be flat, upward
  sloping, or downward sloping
• The perfectly competitive firm's supply curve is
  its marginal cost curve
• At every quantity on the market supply curve,
  price is equal to the seller's marginal cost of
  production
• Applies in both the short run and the long run

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Increases in Supply
29
Producer Surplus

• Producer surplus is the difference between the
  market price and the seller's reservation price
• Reservation price is on the supply curve
• Producer surplus is the area above the supply
  curve and below the market price