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

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

Additional Number of Cans Found Total Number of Containers Found Harry’s Supply Curve Recycling Services Additional Number of Cans Found 600 400 300 200 100 Hours per Day Total Number of Containers Found 1 600 2 1,000 3 1,300 4 1,500 5 1,600

Additional Number of Cans Found Revenue from Additional Cans Harry’s Supply Curve Recycling Services Hours per Day Additional Number of Cans Found Revenue 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.

Additional Number of Cans Found Harry’s Supply Curve Reservation Price Per Can 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¢ Hours per Day Additional Number of Cans Found 1 600 2 400 3 300 4 200 5 100

Harry’s Supply Curve Reservation Price (¢) Number of Cans (00s) 1 6 Recycled cans (100s of cans/day) Deposit (cents/can) 6 10 13 16 3 2 1 Reservation Price (¢) Number of Cans (00s) 1 6 1.5 10 2 13 3 15 16

Individual and Market Supply Curves Harry’s Supply Curve Barry’s Supply Curve Market Supply Curve 16 6 32 13 3 2 15 26 30 6 1 12 Recycled cans (00s of cans/day) Recycled cans (00s of cans/day) Recycled cans (00s of cans/day)

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

Perfectly Competitive Firm

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)

Perfectly Competitive Firm's Demand

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

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

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

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

Profit Maximization - Data Workers Bottles per Day 1 80 2 200 3 260 4 300 5 330 6 350 7 362 Fixed Costs ($/day) $40 40 Variable Cost ($/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

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

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.

ATC, AVC, and MC Marginal cost (MC) Average values are the total divided by quantity Average variable cost (AVC) is AVC = VC / Q Average total cost (ATC) is ATC = TC / Q Marginal cost (MC) MC = ΔTC/ΔQ

Marginal Cost ($/unit) Cost Structure Workers per day Bottles per day Variable Cost ($/day) AVC ($ per unit) Total Cost ATC ($ per unit) 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

Cost Structure – A graph

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

Profit Maximization – A graph

Production Loss – A graph

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.

Shut Down – A graph MC ATC AVC Cost ($/bottle) Price Output (bottles/day)

"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

Increases in Supply

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