MBMC Perfectly Competitive Supply: The Cost Side of The Market Part II.

MB MC

Perfectly Competitive Supply: The Cost Side of The Market

Part II

MB MC

Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.

Quiz

Which of the following is a variable factor of production on a local farm over the next month?A. The pesticides and fertilizersB. The landC. The barnD. The machineryE. All of the above

MB MC


Quiz

Which of the following is a variable factor of production on a local farm over the 10 years?A. The pesticides and fertilizersB. The landC. The cowsD. The machineryE. All of the above

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Chapter 6: Perfectly Competitive Supply Slide 4

Concepts of production

Fixed factor of production An input whose quantity cannot be altered in the

short run (defines short run) e.g. a farmers barns, machinery, land; in ground

oil and pumps; saw mills and fishing boats; unionized workers personal skills

Variable factor of production An input whose quantity can be altered in the short

run e.g. raw material inputs, temporary workers

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Profit-Maximizing Firms in Perfectly Competitive Markets

AssumeAn oil company produces barrels of oilTwo factors of production

Labor (variable)Capital (fixed)

An oil well

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Employment and Output for an oil producer

Total number of employees per day Total number of barrels per day

0 0

1 8

2 20

3 26

4 30

5 33

6 35

7 36.2

ObservationOutput gains from each additional worker begins to diminish with the third employee

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Employment and Output for an oil producer

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Law of Diminishing ReturnsA property of the relationship between the

amount of a good or service produced and the amount of a variable factor required to produce it

It says that when some factors of production are fixed, increased production of the good eventually requires ever-larger increases in the variable factor

DIFFERENT CONCEPT THAN ECONOMIES OF SCALE

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Some Important Cost ConceptsAssume

The cost of the oil wells is $500/day and it is a fixed cost (e.g. the payment on the loans taken to purchase the well).

Fixed costThe sum of all payments made to a firm’s fixed

factors of production

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Some Important Cost ConceptsAssume

The cost of labor is $150/worker/day and is a variable cost.

Workers can be hired or fired at will

Variable costThe sum of all payments made to the firm’s

variable factors of production

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Some Important Cost Concepts

Total CostFixed cost + variable cost

Marginal CostMeasures how total cost changes with a

change in output

What’s the impact of fixed costs on MC?

Output

TC

MC

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Fixed, Variable, and Total Costs of Oil Production

Employeesper day

Barrelsper day

Fixed cost($/day)

Variable cost($/day)

Total cost($/day)

Marginal cost($/barrel)

What costs are conspicuously absent?

0 0 500 0 500

1 8 500 150 650 18.75

2 20 500 300 800 12.5

3 26 500 450 950 25

4 30 500 600 1100 37.5

5 33 500 750 1250 50

6 35 500 900 1400 75

7 36.2 500 1050 1550 125

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Fixed, Variable, and Total Costs of Oil Production

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What are the benefits of production?

Total benefit = total revenue Total revenue = barrels sold x price So what is marginal benefit? Barrels sell for $80 each Profit = TR – TC When do you think profit is maximized?

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80 18.75

80 12.5

80 25

80 37.5

80 50

80 75

80 125


Output, Revenue, Costs, and Profit

Employeesper day

Output(barrels/day)

Total revenue($/day)

Profit($/day)

Total cost($/day)

What will happen to the profit maximizing output if price falls to $40?

0 0 0 500 -500

1 8 640 650 -10

2 20 1600 800 800

3 26 1820 950 1130

4 30 2100 1100 1300

5 33 2310 1250 1390

6 35 2450 1400 1400

7 36.2 2534 1550 1346

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What will happen to the profit maximizing output if price falls to $40?

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Employeesper day

Output(barrels/day)


Profit($/day)

Total cost($/day)

What will happen to the profit maximizing output if:(a) employees receive a wage of $75/day; (b) fixed costs are $650?

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40 18.75

40 12.5

40 25

40 37.5

40 50

40 75

40 125

0 0 0 500 -500

1 8 320 650 -330

2 20 800 800 0

3 26 1040 950 90

4 30 1200 1100 100

5 33 1320 1250 70

6 35 1400 1400 0

7 36.2 1448 1550 -102

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Employeesper day

Output(barrels/day)


Profit($/day)

Total cost($/day)

Wages drop to $75/day (fixed costs $500)

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40 9.375

40 6.25

40 12.5

40 18.75

40 25

40 37.5

40 62.5

0 0 0 500 -500

1 8 320 575 -255

2 20 800 650 150

3 26 1040 725 315

4 30 1200 800 400

5 33 1320 875 445

6 35 1400 950 450

7 36.2 1448 1025 423

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Employeesper day

Output(barrels/day)


Profit($/day)

Total cost($/day)

Fixed costs are $650 (wages at $150/day). Profits are negative, but producer can cover some of fixed costs.

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40 18.75

40 12.5

40 25

40 37.5

40 50

40 75

40 125

0 0 0 650 -650

1 8 320 800 -480

2 20 800 950 -150

3 26 1040 1100 -60

4 30 1200 1250 -50

5 33 1320 1400 -80

6 35 1400 1550 -150

7 36.2 1448 1700 -252

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When will a firm shut down?

When producing at a loss, a firm must cover its variable cost to minimize losses.Short-run shutdown condition

QVCPxQ of levels all for

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Average Variable Cost

Variable cost divided by total output

Q

VC

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Short-run shutdown condition

Determined by AVC

AVCP of valueminimum

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Average Total Cost

Total cost divided by total output

Q

TC

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Long Run Shutdown condition

Determined by ATC Profits = TR – TC or (P x Q) - (ATC x Q) To be profitable: P > ATC Long run Shutdown condition P < ATC

for all Q

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Price = Marginal Cost: The Perfectly Competitive Firm’s Profit-Maximizing Supply Rule

Output (barrels/day)

Co

st (

$/b

arre

l)

Price = 80

•Less than 35 barrels/day P > MC and output should be increased•More than 35 barrels/day P < MC and output should be decreased

Total revenue

Total cost

profit

•Price = $80/barrel•P > MC at 35 barrels/day•ATC =$40 /barrel•P > ATC by $40/barrel•Profit = 35 x $40 = $1400/day

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Co

st (

$/b

arre

l)

Price = $40

•Less than 30 barrels/day P > MC and output should be increased•More than 30 barrels/day P < MC and output should be decreased

Total revenueTotal cost

profit

•Price = $40/barrel•P> MC at 30 barrels/day•ATC =~ $36.7/barrel•P > ATC by $3.3/barrel•Profit = 350x $3.3 = $100/day

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Co

st (

$/b

arre

l)

Price = 20

Producer continues to produce at negative profit. Covers variable costs plus some of fixed costs.

Total revenue

Total cost

Profit (negative)

•Price = $20/barrel•P = MC at 20 barrels/day•ATC = $40/barrel•P < ATC by $20/barrel•Profit = -$20 x 20 = -400//day

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If a firm continues to produce even though it has a negative profit, it is safe to assume that:

A. TC<TRB. Price > average variable costC. Price > average total costD. MC > PriceE. The firm will close down in the short run

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The Law of SupplyThe perfectly competitive firm’s supply

curve is its marginal cost curveMC curve upward sloping in short run (law

of diminishing marginal returns), but not necessarily in long run

Market output is sum of individual outputs, i.e. the sum of how much each supplier will supply at the given price.

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The Law of Supply

At every point along the market supply curve, price measures what it would cost producers to expand production by one unit.

RecallDemand measures the benefit side of the

marketSupply measures the cost side of the

market

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Determinants of Supply

Technology Input prices

e.g. labor in China Number of suppliers

e.g. trade with China Expectations

e.g. rising or falling prices Changes in prices of other products

i.e. opportunity costs Subsidies, implicit and explicit

e.g. the energy sector and the new clean air laws

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Determinants of Supply

What about the oil????

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Supply and Producer Surplus

Producer SurplusThe amount by which price exceeds the

seller’s reservation price

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The Supply and Demand in the Market for Milk

Quantity (1,000s of gallons/day)

Pri

ce (

$/g

allo

n)

1

.50

1.00

1.50

2.00

2.50

3.00

2 3 4 5 6 7 8 9 10 11 120

S

D

•Equilibrium P = $2 & Q = 4,000

•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

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Producer Surplus in the Market for Milk

Quantity (1,000s of gallons/day)

Pri

ce (

$/g

allo

n)

1

.50

1.00

1.50

2.00

2.50

3.00

2 3 4 5 6 7 8 9 10 11 120

Producer surplus= $4,000/day

S

D

MBMC Perfectly Competitive Supply: The Cost Side of The Market Part II.

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