Perfectly Competitive Supply: The Cost Side of The Market: MB MC

Perfectly Competitive Supply: The Cost Side of The Market
MB
MC
MB MC
Learning Objectives
1.
2.
3.
4.
5.
Explain how opportunity cost is related to the supply curve Individual supply curves (firms)and market supply curve (industrys) Profit maximization and Economic profit Some important Production and cost concepts Characteristics of perfectly competitive markets
Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 2
MB MC
Thinking About Supply: The Importance of Opportunity Cost
Harry is trying to decide on how to divide his time between washing dishes for $6/hour and collecting soft drink containers which may be redeemed at 2 cents each. Earnings aside, Harry is indifferent between the two tasks. Harrys opportunity cost of one hour of recycling is the $6/hr that he could have earned washing dishes.
Chapter 6: Perfectly Competitive Supply Slide 3
MB MC
Harrys Productivity at Recycling

Total number of containers found (Total Product) Additional number of containers found (Marginal Product)
Search time (hours/day) (input)
0 1 2 3 4 5
0 600 1,000 1,300 1,500 1,600
600
400 300
200
100
Chapter 6: Perfectly Competitive Supply
Slide 4
MB MC
Harry should recycle for the 1st three hours everyday and then do dishwashing. Why? Apply the costbenefit principle: MC = $6 MB = MRP (marginal revenue product) 1 hour MB = (600)(.02) = $12; MB>MC, so continue recycling 2nd hour MB = (400)(0.2) = $8; MB>MC; continue recycling 3rd hour MB = (300)(0.2) = $6; MB=MC; optimal reached; stop right here, dont recycle any more
MB MC
What is the lowest redemption price that would induce Harry to recycle 1 hour/day? He needs to earn at leas $6 and his MP=600 containers. So he needs to be able to make at least 1 cent per container to break even with dishwashing. So Harrys Reservation Price (as a seller of recycled containers) for the first 600 containers is 1 cent.
Slide 6
MB MC
MB=MRP=pxMP must equal $6, where p=redemption price of recycled containers Reservation Price
1 hour recycling = p(600) = $6; p = 1 cent 2 hours recycling = p(400) = $6; p = 1.5 cents 3 hours recycling = p(300) = $6; p = 2 cents 4 hours recycling = p(200) = $6; p = 3 cents 5 hours recycling = p(100) = $6; p = 6 cents
Graph these prices with quantity

MB MC
An Individual Supply Curve for Recycling Services

Harrys Supply Curve
Deposit (cents/can)
3 2
1.5
1
6 10 Recycled cans (100s of cans/day)

13
16
15
Slide 8
MB MC
Barrys Supply Curve
We introduce a second individual, Barry, with an identical supply curve as Harry. The market supply curve is the horizontal sum of all individual supply curves in the market.
Slide 9
MB MC
Supply Curves of Two Individuals

Harrys Supply Curve
Deposit (cents/can)
Barrys Supply Curve

6
3 2
Deposit (cents/can) 1.5
3 2
1.5
10
13
16
Recycled cans (100s of cans/day)

15
10
13
16

Slide 10
15
MB MC
The Market Supply Curve for Recycling Services

Market Supply Curve
Deposit (cents/can) 1.5
3 2
=
12
20
26
32
30
Slide 11
MB MC
The Market Supply Curve with 1,000 Identical Sellers

Market Supply Curve
Deposit (cents/can) 6
3 2
1.5
1
6 10 13 Recycled cans (100,000s of cans/day)

16
15
Slide 12
MB MC
Individual and Market Supply
Individual (firm) supply curves are upward sloping because of the principle of increasing OC (as shown by the diminishing MP in Harrys case). Market (industry) supply curves are upward sloping for an additional reason that suppliers differ in their OCs; when redemption price is low suppliers with low OC supply the good; as redemption price increases, suppliers with higher OC join in. If Harrys OC rises to $8, his RP for the 1st 600 containers will rise to 1.33 cents.
MB MC
Some Important Production Concepts
Factor of production An input used in the production of a good or service Short run A period of time sufficiently short that at least some of the firms factors of production are fixed Fixed factor of production An input whose quantity cannot be altered in the short run like heavy machinery, land, etc Variable factor of production An input whose quantity can be altered even in the short run like labor, etc. Long run - period of time long enough such that all factors of production are variable.
MB MC
Example: Glass Bottles

Consider a small company that makes glass bottles For simplicity, assume silica is free Two factors of production Labor (variable) Capital (fixed) oA bottle-making machine
Slide 15
MB MC
Employment and Output for a Glass Bottle Maker

Total Product (bottles/day) Marginal Product (bottles/L)
Employees/day
0 1 2
0 80 200
-80 120
3
4 5
260
300 330
60
40 30
6
7
350
362
20
12
Slide 16
MB MC
Law of Diminishing Returns
Law of Diminishing (marginal) Returns to an Input states:

that as more of a variable input is combined with fixed amounts of other inputs, the total product (total output) will eventually increase at a decreasing rate (i.e., the MP will eventually decline). It says that when some factors of production are fixed, increased production of the good even at the same rate eventually requires ever-larger increases in the variable factor.
Slide 17
MB MC
Some Important Cost Concepts
Fixed cost The sum of all payments made to a firms fixed factors of production Assume: the cost of the bottle making machine is $40/day (fixed cost). Variable cost The sum of all payments made to the firms variable factors of production The cost of labor is $12/worker (variable cost).
Slide 18
MB MC
Total Cost (TC) is also the sum total of Total Fixed Cost (TFC) and Total Variable Cost (TVC)
TC = TFC + TVC
TC/Q = TFC/Q + TVC/Q, where Q=Total Output

Therefore, ATC = AFC + AVC,

Where, ATC = Average Total Cost; AFC = Average Fixed Cost; and, AVC = Average variable Cost.
Slide 19
MB MC
Marginal Cost (MC) is the change in total cost resulting from a one-unit rise in the level of output, holding everything else constant. Marginal Cost =
DTC DQ
DTFC
=
DTVC
+
DQ
DQ
Therefore, MC = MVC as MFC=0
Slide 20
MB MC
Fixed, Variable, and Total Costs of Bottle Production

Bottles per day Fixed cost ($/day) Variable cost ($/day) Total cost ($/day) Marginal cost ($/bottle)
Employees per day
0 1 2 3
0 80 200 260
40 40 40 40
0 12 24 36
40 52 64 76 0.15 0.10 0.20
4
5 6
300
330 350
40
40 40
48
60 72
88
100 112
0.30
0.40 0.60 1.00
362
40
84
124
Slide 21
MB MC
Average Variable Cost and Average Total Cost of Bottle Production

Variable cost ($/day) Average variable cost ($/unit of output) Total cost ($/day) Average total cost ($/unit of output) Marginal cost ($/bottle)
Employees per day
Bottles per day
0 1 2
0 80 200
0 12 24 0.150 0.120
40 52 64 0.650 0.320 0.15 0.10 0.20 0.30 0.40 0.60
3
4 5 6 7
260
300 330 350 362
36
48 60 72 84
0.138
0.160 0.182 0.206 0.232
76
88 100 112 124
0.292
0.293 0.303 0.320 0.343
1.00
Slide 22
MB MC
Some Important Revenue Concepts
Total revenue = PxQ Assume: bottles sell for $0.35 each. So if 100 bottles are sold, TR=$35. Average Revenue = (PxQ)/Q = P Average Revenue always equals price it is an identity; AR is just another name for P. So the AR per bottle is $0.35. Marginal revenue = Change in TR divided by change in Q. When P is constant, MR=P; when P is rising, MR>P and when price is falling MR<P.
MB MC
The Goal of Profit-Maximization
Although firms may have other goals, most of the time private firms are in business because they want to maximize Total Profit. Total Profit = TR TC
TR = PxQ TC = Money Costs (explicit) + Opportunity Costs (implicit) In Economics, Total Profit is called Economic Profit
Economic Profit is in general not equal to Accounting Profit.

MB MC
Economic Profit
Goofy, the owner of a small business makes profit of $35,000 a year. He could also have earned $35,000 working as a consultant for a software firm. Goofys accounting profit is $35,000.
Goofys Economic Profit = $0.
We will see that firms make zero economic profits in many markets.
Slide 25
MB MC
Maximum Profit
To maximize total profit (P), one needs to set marginal profit to zero.
Marginal Profit
DP DQ
DTR
=
DTC
-
DQ
DQ
So, Marginal P = MR MC Marginal P = 0 implies, MR = MC

MB MC
Output, Revenue, Costs, and Profit

Employees per day Output (bottles/day) Total revenue ($/day) Total cost ($/day) Profit ($/day)
0 1 2 3 4 5 6 7
0 80 200 260 300 330 350 362
0 28 70 91 105
MB = .35
40
-40
52 MC = .15 -24 64 MC = .10 76 MC = .20 88 MC = .30 6 15 17 15.50 10.50 2.70
MB = .35
MB = .35 MB = .35
115.50 MB = .35 100 MC = .40 122.50 MB = .35 112 MC = .60 126.70 MB = .35 124 MC = 1.00
Assume bottles sell for $0.35; This is the firms MR

Slide 27
MB MC
Perfectly Competitive Markets: Characteristics
1.
2.
3.
4.
Numerous buyers and sellers small market share so that no individual agent can affect the price; buyers and sellers are price takers. Homogeneous (standardized) product difficult to satisfy in reality; buyers are willing to switch to the seller offering the lowest price Mobile productive resources (freedom of entry and exit) Sellers can move with labor, capital, and other productive resources to the most profitable activity Buyers and sellers are well informed buyers know all relevant opportunities available to them
Chapter 4: Elasticity
Slide 28
MB MC
Demand curve faced by the firm
The individual firm takes the price as given. Individual agents are price takers. The firm can sell any amount of the product at given prices. The firm faces a perfectly elastic horizontal demand curve.
29
7/21/2013
Sudeshna C. Bandyopadhy
Firms demand curve graphical representation

P
S P
d: MR=AR
P* P*
Industry
Firm
30 7/21/2013 Sudeshna C. Bandyopadhy
MB MC
Firms Short-run Equilibrium

The firm maximizes profits. In the short-run, no new firms enter the industry and no existing firms leave the industry. The firm maximizes profit by setting MR=MC.
31
7/21/2013
MB MC
Graph of firms short-run equilibrium with profit

P MC
ATC d: MR=AR
E P* 1 ATC*
2
q
32
Firm
q*
7/21/2013
MB MC
Graph of a firms short-run equilibrium with loss

P MC ATC
ATC* 2 P* E d: MR=AR
Firm
q*
q
MB MC
Break Even Analysis

P ATC
Break Even when: Economic profit = 0. TR = TC. Min ATC (Point B).
MC
Min ATC
B d: MR=AR E
P*
Firm
q*
34
7/21/2013
MB MC
Shut Down Analysis
Julias monthly mortgage and other fixed costs are $750 per month. If she rents to Paul, there will be additional costs (electricity, water etc. and depreciation) of $210 per month.
Paul offers $215 per month. Should Julia rent?

MB MC
Shut Down Analysis

Say TR=$500, TVC=300 and TFC=400. If the firm remains in business, loss is $200. If the firm shuts down, loss is $400. If TR>TVC, stay in business. If TR<TVC, shut down.
36
7/21/2013
MB MC
Shut Down Analysis

If P>AVC, stay in business. If P<AVC, shut down. If P=AVC, indifferent between shutting down and staying open. Shut down point: Minimum point on the AVC curve.
MB MC
Shut Down Point

P MC ATC
Shut Down when: TR<TVC. P < AVC. Shut Down Point: Min AVC: S.
AVC
P*
S d: MR=AR
Firm
q*
38
7/21/2013
MB MC
Firms Supply Curve

P MC ATC
A firms supply curve is its MC curve, above the shut down point, S.
AVC
P*
S d: MR=AR
Firm
q*
39
7/21/2013
MB MC
The 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; so long-run supply curves can be flat, upward sloping, or downward sloping The perfectly competitive firm's supply curve is its marginal cost curve - applies in both the short run and the long run
MB MC
Economic Naturalist
When recycling is left to private market forces, why are many more aluminum beverage containers recycled than glass ones? Aluminum containers can be easily processed for scrap aluminum and so fetch high redemption prices. Glass containers have limited resale value because raw materials needed to produce glass are very cheap.
MB MC
Externalities and Recycling
Recycling is an activity with positive externalities. So in a market determined private equilibrium too little will be recycled. There is an equilibrium amount of litter that is likely to be greater than zero. This is because of scarcity and OC of resources used in getting rid of litter.
Slide 42
MB MC
The Supply Curve of Container Recycling Services for Burlington, Vermont

Market supply curve of glass container recycling services
6
60,000 citizens would collectively pay 6 cents for each container which equals marginal benefit Redemptions price
The local government pays 6 cents/contai ner. The optimal quantity of containers is 16,000/day where MC(.06) = MB
(cents/container)
3 2 1.5 1
10
13
15 16
Number of containers recycled (1,000s of containers/day)

Slide 43
MB MC
Applying the Theory of Supply
Will all containers be removed from the environment at $0.06/container? No. Why is the optimal amount of removal 16,000/day? Because of the underlying cost benefit numbers; proceeding beyond 16,000 is wasteful. Will private individuals choose to remove 16,000 containers/day? No, because anyone that pays for litter removal bears the full cost but only a fraction of the benefit (6 cents/60,000) = 0.0001 cent per person.
MB MC
Supply and Producer Surplus
Producer Surplus
The amount by which price exceeds the sellers reservation price
Slide 45
MB MC
The Supply and Demand in the Market for Milk

Producer surplus is the difference between $2 and the reservation price at each quantity Producer surplus = (1/2)(4,000 gallons/day)($2/gallon) = $4,000/day D
.50
Equilibrium P = $2 & Q = 4,000

S
3.00
Price ($/gallon)
2.50
2.00 1.50 1.00
10
11
12
Quantity (1,000s of gallons/day)
Slide 46
MB MC
Producer Surplus in the Market for Milk
3.00
Price ($/gallon)
2.50
2.00 1.50 1.00 Producer surplus = $4,000/day
D
.50
10
11
12
Quantity (1,000s of gallons/day)
Slide 47
End of Chapter
MB MC

Perfectly Competitive Supply: The Cost Side of The Market: MB MC

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Perfectly Competitive Supply: The Cost Side of The Market

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Thinking About Supply: The Importance of Opportunity Cost

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Harrys Productivity at Recycling

Search time (hours/day) (input)

0 600 1,000 1,300 1,500 1,600

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 6: Perfectly Competitive Supply

Thinking About Supply: The Importance of Opportunity Cost

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Thinking About Supply: The Importance of Opportunity Cost

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 6: Perfectly Competitive Supply

Thinking About Supply: The Importance of Opportunity Cost

Graph these prices with quantity

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

An Individual Supply Curve for Recycling Services

6 10 Recycled cans (100s of cans/day)

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Barrys Supply Curve

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 6: Perfectly Competitive Supply

Supply Curves of Two Individuals

Barrys Supply Curve

Deposit (cents/can) 1.5

Recycled cans (100s of cans/day)

Recycled cans (100s of cans/day)

Chapter 6: Perfectly Competitive Supply

The Market Supply Curve for Recycling Services

Recycled cans (100s of cans/day)

Chapter 6: Perfectly Competitive Supply

The Market Supply Curve with 1,000 Identical Sellers

6 10 13 Recycled cans (100,000s of cans/day)

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Individual and Market Supply

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Some Important Production Concepts

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Example: Glass Bottles

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 6: Perfectly Competitive Supply

Employment and Output for a Glass Bottle Maker

Chapter 6: Perfectly Competitive Supply

Law of Diminishing Returns

Law of Diminishing (marginal) Returns to an Input states:

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 6: Perfectly Competitive Supply

Some Important Cost Concepts

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 6: Perfectly Competitive Supply

Some Important Cost Concepts

TC/Q = TFC/Q + TVC/Q, where Q=Total Output

Therefore, ATC = AFC + AVC,

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 6: Perfectly Competitive Supply

Some Important Cost Concepts

Therefore, MC = MVC as MFC=0

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 6: Perfectly Competitive Supply

Fixed, Variable, and Total Costs of Bottle Production

Employees per day

40 52 64 76 0.15 0.10 0.20