06_01

PRICE

QUANTITY SUPPLIED

Supply curve

Imagine that you are the owner and CEO of a very small firm

• You have a plot of land (already paid for)

• You can hire workers to help you – More workers, more output– Of course, you must pay the workers

• Many other firms are in the market too

• Your decision is how much to produce– You look at the price and then decide

Assumption about the firm’s behavior

• General economic principle– People

– make purposeful choices

– with limited resources

• When applied to the behavior of firms – Firms

– maximize profits

– subject to a production function relating output to inputs

Profits = total revenue - total costs

• Total revenue– Price times quantity

– P x Q

• Total costs– cost of everything used

to produce the product, including opportunity costs

– economic profits rather than accounting profits

Key assumption of competition:

The firm is a price taker

Finding Total Revenue (T6.1)

QuantityProduced

Price = 35Dollars

Price = 70dollars

Price=100dollars

0 0 0 01 35 70 1002 70 140 2003 105 210 3004 140 280 4005 175 350 500

6

Finding Total Costs

• Start with the firm’s production function– Relates firm’s output (shoes, CDs, pumpkins)

to the firm’s inputs (labor)

• Marginal product of labor

• Diminishing returns to labor– marginal product of labor decreases with more

labor input

06_03

Higher marginalproduct of labor

Lower marginalproduct of labor

1

0

2

3

4

5

6

10 20 30

QUANTITY OF PUMPKINSPRODUCED (CRATES)

HOURS OF WORK

06_02T

Quantity Hours of Variable Costs FixedProduced Labor at $10 Wage Costs Total Costs(crates) Input (dollars) (dollars) (dollars)

0 0 0 50 501 2 20 50 702 5 50 50 1003 10 100 50 1504 18 180 50 2305 30 300 50 350

From Total Costs to Marginal Cost (T6.3)

Quantity Total Costs(dollars)

Marginal Cost(dollars)

0 50 --1 70 202 100 303 150 504 230 805 350 120

06_04

100

200

300

400

1 2 3 4 50CRATES OF PUMPKINS

DOLLARS

Total costs

06_05

20

40

60

80

100

120

1 2 3 4 50

DOLLARS

Marginal cost

CRATES OF PUMPKINS

Now, use profit maximization to derive the supply curve

• Plot marginal costs for the firm

• Consider different prices

• Find the quantity supplied at each price

• The result is the supply curve

An Important Conclusion: MC = P

• The firm chooses a quantity to produce such that the marginal cost (MC) equals the price (P)

• When I see a supply curve, I think of the marginal cost to firms

• The supply curve slopes upward because marginal cost is increasing

06_08

Slope = = Marginal costTotal costs

Quantity

Maximum profits Total costs

100

100

200

100

300

400

Maximum profits

1 2 3 4 50

1 2 3 4 50

QUANTITY PRODUCED

QUANTITY PRODUCED

DOLLARS

Total revenue

Profits

DOLLARS

Producer Surplus

• Producer surplus is the area above the supply curve and below the price

• What is the difference between producer surplus and profits? profits = producer surplus minus fixed costs

Market Supply Curve

• Consider all firms in the market

• Add up quantity supplied by all firms at each price to get market supply

• Add horizontally

06_09

20

40

60

80

100

120

0 1 2 3 4 5 6 7 8 9 10

Market supply curve

QUANTITY SUPPLIED

IN MARKET (CRATES)

QUANTITY SUPPLIEDBY YOU (CRATES)

QUANTITY SUPPLIEDBY FRED (CRATES)

20

40

60

80

100

120

0 1 2 3 4 5

Your supply curve

20

40

60

80

100

120

0 1 2 3 4 5

PRICE(DOLLARS)

PRICE(DOLLARS)

PRICE(DOLLARS)

Fred's supply curve