Chapter 5 – Product Market Supply zThis chapter examines the major causes of how much firms will supply of a specific good (under perfect competition), given the price of the good, the price of inputs (e.g. energy, and other causes that we will cover. zIt also explains how we distinguish between individual and market supply, and goes further into the individual producer’s production decision.

Price and Quantity Supplied: Direction of Change zRecall – the good’s own price (P) is a cause of quantity supplied of that good (Q S ). P   Q S . zWe’ll examine why in more detail.

Marginal Cost zMarginal Cost (MC) – the change in total cost that a firm experiences as a result of increasing the quantity or output of the good it’s producing (Q). zFormula: MC =  (Total Cost)/  Q.

Properties of Marginal Cost (MC) zMC > 0. Q   (Total Cost)  zComes from production function (relationship how inputs combine to produce output).

The Law of Diminishing Returns and Marginal Cost zThe Law of Diminishing Returns (LDR) necessarily implies increasing Marginal Cost. zIn other words, beginning at the point of LDR,  MC/  Q > 0. zLDR  Total Cost increases at an increasing rate. It becomes more successively more expensive for the firm to produce the additional good.

Marginal Cost and the Production Decision zDownward sloping part of MC curve: firm wouldn’t consider stopping production there. zUpward sloping part of MC curve: individual firm evaluates the marginal benefit versus the marginal cost (MC) of producing the additional good.

Marginal Benefit to Production (Perfect Competition) zMarginal Benefit of producing the additional good = price that the good sells for in the market (P). zPerfect Competition  P is given to the individual producer.

The Production Decision zIndividual producer evaluates the marginal benefit (P) versus the marginal cost (MC) of producing the additional unit. zIf P > MC, produce it and consider producing the next additional unit. zIf P < MC, do not produce and in fact consider decreasing output. zIf P = MC, produce the additional unit and stop there (first order condition).

The Supply Curve is the Marginal Cost Curve (LDR) zGiven price, the individual producer will increase production until P = MC. zIncrease in price (P) implies that the producer will move up its MC curve, and increase the quantity supplied (Q S ).

Individual Versus Market Supply zThe Market Supply for any good is obtained by summing up the individual supplies for all the producers of this good. zExample – consider the supply of pizzas. zSuppose the producers consist of two firms, the Varsity and Cosmos.

Supply of Pizzas Price ($) Varsity + Cosmos = Market

Individual Firm’s Supply and Market Supply: Causes zPrice of Good (P), P   Q S . zPrice of Inputs (P INPUT ), P INPUT   Q S . -- Labor (Wage Rate) -- Materials (e.g. Energy) -- Capital Stock zTechnology (Tech), Tech   Q S . zRegulatory Environment (Reg), Reg   Q S . zNumber of Producers (entry and exit) (Market Supply only)

Supply: Graphical Description zGraph supply against the own price (P), upward sloping. zChanges in causes other than P, described as shifts of supply curve. zChanges that enhance supply shift the supply curve rightward. zChanges that hinder supply shift the supply curve leftward.

Example 1: Technology Under Perfect Competition zSuppose that industries which produce calculators discover a more efficient way to make them (cheaper computer chips). zTechnology   Q S . zIncrease in Technology increases Supply, described by rightward shift of supply curve. zAs a result, P* , Q* .

Example 2 -- The Effect of Increased Regulation zSuppose that government passes increased regulations on worker safety and workman’s compensation for all businesses. zRegulation   Q S . zThis change decreases the market quantity supplied, described by leftward shift of Supply curve. zAs a result, P* , Q* . zTradeoff – business performance versus worker protections.

Example 3 -- Entry and Exit in Perfect Competition zHighly Favorable Markets  new firms enter  Market Supply increases (shifts rightward)  P* . zHighly Unfavorable Markets  firms exit  Market Supply decreases (shifts leftward)  P* .