Jennings2e PPT Ch06

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Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics 2e by Frank, Jennings and OlekalnsSlides prepared by Jayanath Ananda, La Trobe University

Chapter 6

Perfectly competitive supply: the cost side of the

market

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Learning Objectives

• State the law of supply• Describe how a firm in a perfectly competitive market

decides how much to supply at each price• Apply the profit-maximising rule• Explain the relationship between the law of

diminishing returns and SR cost curves

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Learning Objectives (contd.)

• Construct a market supply curve from individual supply curves

• Use theory of supply to predict the firm behaviour• Define and calculate producer surplus and

analyse welfare effects

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Outline• The opportunity cost• Individual and market supply curves• Perfectly competitive markets• Profit maximisation• Demand curve for a firm in perfect competition• Law of diminishing returns• Costs curves in the short run• Law of supply• Producer surplus

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The opportunity cost

• Example: How much time should Harry spend recycling soft drink containers?

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• Harry is choosing between washing dishes for $6/hour and collecting containers at 2 cents each

• Opportunity cost of collecting cans is $6/hour

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• Applying the cost-benefit principle:– 1 hour collecting cans = (600)(.02) = $12– Benefit ($12) > Opportunity cost ($6)– 2nd hour benefit ($8) > Opportunity cost ($6)– 3rd hour benefit ($6) = Opportunity cost ($6)

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The opportunity cost• Question:

– What is the lowest refund that would induce Harry to spend at least 1 hour/day recycling?

• Solution:– 600 containers x 1 cent = $6 = opportunity cost of

washing dishes

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The opportunity cost• Harry’s additional earnings from searching the additional hour will be

6$Qp

)( Qp

• The smallest refund that will lead Harry to search another hour must satisfy the equation:

= 400p(400)= $6p = 1.5 cents ($0.015)

ΔQ

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Harry’s individual supply curve for recycling services

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Individual and market supply curves

• The quantity that corresponds to a given price on the market supply curve is the sum of the quantities supplied at that price by all individual sellers

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Market supply curve for recycling services

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Market supply curve• Horizontal summation of individual supply curves• Upward sloping• Reasons for upward-sloped supply curve:

– costs tend to rise with expanded production– each individual exploits his most attractive

opportunities first – different potential sellers face different opportunity

costs

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Supply in perfectly competitive markets

• Profit defined:

The total revenue a firm receives from the sale of its product minus all costs – explicit and implicit – incurred in producing it

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Profit maximisation

• Profit maximising firm defined:

A firm whose primary goal is to maximise the difference between its total revenues and total costs, or profit

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Perfectly competitive markets

• Perfectly competitive market defined:A market in which no individual supplier has any influence on the market price of the product

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Perfectly competitive markets

• Price taker defined:

A firm that has no influence over the price at which it sells its product

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Characteristics of perfectly competitive markets

1. All firms sell the same standardised product

2. The market has many buyers and sellers each of which buys or sells only a small fraction of the total quantity exchanged

3. Sellers are able to enter and leave a market as they like

4. Buyers and sellers are well informed

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Market supply and demand for wheat

The market demand and supply curves interest to determine the market price of wheat

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Demand curve for a firm in perfect competition

The individual farmer’s Di is perfectly elastic at the market price

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Production in the short run

• Factor of production:

An input used in the production of a good or service

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• Short run:A period of time sufficiently short that at least one of the firm’s factors of production are fixed

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• Long run:A period of time of sufficient length that all the firm’s factors of production are variable

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Law of diminishing returns• In the short run, when at lest one factor of

production is fixed, successive increases in the input of a variable factor eventually yield smaller and smaller increments in output.

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Concepts of production

• Fixed factor production

An input whose quantity does not change as the output, produced in a given period of time, changes

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Concepts of production

• Variable factor productionAn input whose quantity varies as the output, produced in a given period of time, changes

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Production in the short run• Bottle-maker example:• Assume

– A company makes glass bottles– Two factors of production

Labour (variable) Capital (fixed)

• A bottle-making machine

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Employment and output for a glass bottle maker

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Costs in the short run

• Fixed cost

The sum of all payments made to the firm’s fixed factors of production

• Variable cost

The sum of all payments made to the firm’s variable factors of production

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Costs in the short run

• Total cost

The sum of all payments made to the firm’s fixed and variable factors of production

• Marginal cost

The change in total cost divided by the corresponding change in output

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Costs of bottle production

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Choosing output to maximise profit

• How much will a profit-maximising perfectly competitive firm choose to produce when faced with a horizontal demand curve and when the law of diminishing returns holds?– If bottles sell for $0.35 each, how many bottles should

the company described in Table 6.2 produce each day?

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Output, revenue, costs and profits of bottle production

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Firm’s shut down condition• When producing at a loss, a firm must cover its variable cost to

minimise losses

• The firm’s SR shut down rule:

If P x Q < VC for every single level of Q

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Average costs

• Average variable cost (AVC):Variable cost divided by total output

• Average total cost (ATC):

Total cost divided by total output

QVC

AVC

QTC

ATC

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Average costs

• A firm should shut down and produce nothing in the short run when P x Q < VC for all levels of Q, or

P < minimum value of AVC

• Profits = TR – TC or (P x Q) - (ATC x Q)To be profitable: P > ATC

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AVC and ATC of bottle production

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The short run MC, AVC and ATC

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The profit-maximisation rule: P=MC

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Showing profit graphically

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Firm making a loss in the SR

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The law of supply• The perfectly competitive firm’s supply curve is its

marginal cost curve• Every quantity of output along the market supply

curve represents the summation of all the quantities individual sellers offer at the corresponding price

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The profit-maximising rule summarised• Produce the level of output for which P = MC,

provided that P>AVC• If P<AVC at all levels of output, shut down and

produce nothing• Firm’s SR supply curve is the portion of its MC lies

above its AVC curve• In the LR a firm will leave the market if P<ATC at

all levels of output

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Determinants of supply revisited

• Technology• Input prices• Expectations• Changes in prices of other products• The number of suppliers

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Applying the theory of supply• What is the socially optimal amount of recycling of

glass containers?– Will all containers be removed from the environment at

$0.06/container?– Why is the optimal amount of removal 16 000/day?– Will private individuals choose to remove 16 000

containers/day?

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Supply of container recycling services for Burnside, SA

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Supply and producer surplus

• Producer surplusThe difference between the amount actually received by the seller of a good and the seller’s reservation price

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Producer surplus in the market for fish

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The effect on the market for wheat of weed infestation

Jennings2e PPT Ch06

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