1

Chapter 6: Perfectly Competitive Supply

• Derive a supply curve

– Opportunity cost The principle of increasing opportunity cost

– Seller’s reservation price

– Cost-Benefit principle Marginal benefit vs. marginal cost

2

Individual’s 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

Harry’s Supply Curve

Recycling Services

Hours per Day

Total Number of Containers Found

0 0

1 600

2 1,000

3 1,300

4 1,500

5 1,600

Additional Number of Cans

Found

600

400

300

200

100

4

Harry’s Supply Curve

Recycling Services

Hours per DayAdditional Number of

Cans FoundRevenue 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

Harry’s Supply Curve

Reservation Price Per Can

Hours per Day

Additional Number of Cans

Found

1 600

2 400

3 300

4 200

5 100

• 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¢

6

Harry’s Supply Curve

Reservation Price (¢)

Number of Cans (00s)

1 61.5 102 133 156 16

Recycled cans(100s of cans/day)

Dep

osit

(cen

ts/c

an)

6 10 13 16

6

3

2

1

7

Individual and Market Supply Curves

Recycled cans (00s of cans/day)

Recycled cans (00s of cans/day)

Recycled cans (00s of cans/day)

016

6

16

6

32

6

6

1

6

1

12

1

13

3

2

1513

3

2

1526

3

2

30

Harry’s Supply Curve Barry’s Supply Curve Market Supply Curve

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)

11

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 Returns

With all inputs except one fixed,

additional units of the variable input yield

ever smaller amounts of additional output

14

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

16

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

17

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

18

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.

19

ATC, AVC, and MC

• Average values are the total divided by quantity– Average variable cost (AVC) is

AVC = VC / Q

– Average total cost (ATC) isATC = TC / Q

• Marginal cost (MC)– MC = ΔTC/ΔQ

20

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

21

Cost Structure – A graph

22

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

23

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 < VC for all levels of Q;

The firm should continue its business if revenue is at least larger than variable cost.

26

Shut Down – A graph

MCATC

AVC

Price

Output (bottles/day)

Co

st (

$/b

ott

l e)

27

"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

28

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