155184410 06 perfectly competitive supply

8/9/2019 155184410 06 Perfectly Competitive Supply

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Perfectly Competitive

Supply: The CostSide of The Market


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Copyright c 2007 by The McGraw-HillCompanies, Inc. All rights reserved.

Chapter 4: Elasticity Slide 2

Learning Objectives

1.

Explain how opportunity cost is related to thesupply curve

2. Individual supply curves (firm’s)and market supplycurve (industry’s)

3. Profit maximization and Economic profit4. Some important Production and cost concepts

5. Characteristics of perfectly competitive markets


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Chapter 6: Perfectly Competitive Supply Slide 3

Thinking About Supply: TheImportance of Opportunity Cost

Harry is trying to decide on how to divide histime between washing dishes for $6/hourand collecting soft drink containers whichmay be redeemed at 2 cents each.

Earnings aside, Harry is indifferent betweenthe two tasks.

Harry’s opportunity cost of one hour ofrecycling is the $6/hr that he could haveearned washing dishes.


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Harry’s Productivity at Recycling

Search time(hours/day)

(input)

0 0

1 600

2 1,000

3 1,300

4 1,500

5 1,600

Total number ofcontainers found(Total Product)

Additional number ofcontainers found

(Marginal Product)

600

400

300

200

100


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Harry should recycle for the 1st three hours everydayand then do dishwashing. Why? Apply the cost-benefit principle:

MC = $6

MB = MRP (marginal revenue product) 1 hour MB = (600)(.02) = $12; MB>MC, so continue

recycling

2nd hour MB = (400)(0.2) = $8; MB>MC; continuerecycling

3rd hour MB = (300)(0.2) = $6; MB=MC; optimalreached; stop right here, don’t recycle any more


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What is the lowest redemption price that wouldinduce Harry to recycle 1 hour/day?

He needs to earn at leas $6 and his MP=600containers. So he needs to be able to make at

least 1 cent per container to break even withdishwashing.

So Harry’s Reservation Price (as a seller of

recycled containers) for the first 600 containers is 1cent.


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MB=MRP=pxMP must equal $6, wherep=redemption price of recycled containers

Reservation Price

1 hour recycling = p(600) = $6; p = 1 cent 2 hours recycling = p(400) = $6; p = 1.5 cents

3 hours recycling = p(300) = $6; p = 2 cents

4 hours recycling = p(200) = $6; p = 3 cents 5 hours recycling = p(100) = $6; p = 6 cents

Graph these prices with quantity


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An Individual SupplyCurve for Recycling Services

Recycled cans

(100s of cans/day)

D e p o s i t ( c e n t s / c a n )

0 6 10 13 16

6

3

2

1

1.5

15

Harry’s Supply Curve


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Barry’s Supply Curve

We introduce a second individual, Barry, withan identical supply curve as Harry.

The market supply curve is the horizontal

sum of all individual supply curves in themarket.


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Supply Curves of Two Individuals

Recycled cans

(100s of cans/day)

Recycled cans

(100s of cans/day)

D e p o s i t ( c e

n t s / c a n )

+

+

D e p o s i t ( c e n t s / c a n )

6 10 13 16

6

3

2

1

0

1.5

15

Harry’s Supply Curve

6 10 13 16

6

3

2

1

0

1.5

15

Barry’s Supply Curve


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Recycled cans

(100s of cans/day)

D e p o s i t

( c e n t s / c a n )

12 20 26 32

6

3

2

1

0

1.5

30

=

=

The Market Supply Curvefor Recycling Services

Market Supply Curve


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The Market Supply Curvewith 1,000 Identical Sellers

Recycled cans

(100,000s of cans/day)

D e p o s i t

( c e n t s / c a n )

6 10 13 16

6

3

2

1

0

1.5

15

Market Supply Curve


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Individual and Market Supply

Individual (firm) supply curves are upward slopingbecause of the principle of increasing OC (asshown by the diminishing MP in Harry’s case).

Market (industry) supply curves are upward slopingfor an additional reason – that suppliers differ intheir OCs; when redemption price is low supplierswith low OC supply the good; as redemption price

increases, suppliers with higher OC join in.

If Harry’s OC rises to $8, his RP for the 1st 600containers will rise to 1.33 cents.


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Some Important Production Concepts

Factor of production

An input used in the production of a good or service

Short run

A period of time sufficiently short that at least some of thefirm’s factors of production are fixed

Fixed factor of production

An input whose quantity cannot be altered in the shortrun – like heavy machinery, land, etc

Variable factor of production

An input whose quantity can be altered even in the shortrun – like labor, etc.

Long run - period of time long enough such that all factors

of production are variable.


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Example: Glass Bottles

Consider a small company that makes glass bottles

For simplicity, assume silica is free

Two factors of production

Labor (variable)

Capital (fixed)

o A bottle-making machine


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Employment and Outputfor a Glass Bottle Maker

Employees/day Total Product (bottles/day) Marginal Product (bottles/L)

0 0 --

1 80 80

2 200 120

3 260 60

4 300 40

5 330 306 350 20

7 362 12


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Law of Diminishing Returns

Law of Diminishing (marginal) Returns to anInput states:

that as more of a variable input is combined withfixed amounts of other inputs, the total product(total output) will eventually increase at adecreasing rate (i.e., the MP will eventuallydecline).

It says that when some factors of production arefixed, increased production of the good even atthe same rate eventually requires ever-largerincreases in the variable factor.


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Some Important Cost Concepts

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

factors of production

Assume: the cost of the bottle making

machine is $40/day (fixed cost).

Variable cost

The sum of all payments made to the firms

variable factors of productionThe cost of labor is $12/worker (variable cost).


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Total Cost (TC) is also the sum total of Total Fixed Cost(TFC) and Total Variable Cost (TVC)

TC = TFC + TVC

TC/Q = TFC/Q + TVC/Q, where Q=Total Output

Therefore, ATC = AFC + AVC,

Where, ATC = Average Total Cost;

AFC = Average Fixed Cost; and,

AVC = Average variable Cost.


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Marginal Cost (MC) is the change in total costresulting from a one-unit rise in the level of output,holding everything else constant.

Therefore, MC = MVC as MFC=0

MarginalCost

=

DTC

DQ =

DTFC

DQ +

DTVC

DQ


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Fixed, Variable, and TotalCosts of Bottle Production

0 0 40 0 40

1 80 40 12 52

2 200 40 24 64

3 260 40 36 76

4 300 40 48 88

5 330 40 60 1006 350 40 72 112

7 362 40 84 124

Employeesper day

Bottlesper day

Fixed cost($/day)

Variable cost($/day)

Total cost($/day)

Marginal cost($/bottle)

0.15

0.10

0.20

0.30

0.400.60

1.00


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Average Variable Cost andAverage Total Cost of Bottle Production

Employees

per day

0 0 0 40

1 80 12 0.150 52 0.650

2 200 24 0.120 64 0.320

3 260 36 0.138 76 0.292

4 300 48 0.160 88 0.293

5 330 60 0.182 100 0.303

6 350 72 0.206 112 0.320

7 362 84 0.232 124 0.343

Bottles

per day

Variable

cost

($/day)

Averagevariable cost

($/unit ofoutput)

Total

cost

($/day)

Averagetotal cost

($/unit ofoutput)

0.15

0.10

0.20

0.30

0.40

0.60

1.00

Marginal

cost

($/bottle)


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Some Important Revenue Concepts

Total revenue = PxQ

Assume: bottles sell for $0.35 each. So if 100bottles are sold, TR=$35.

Average Revenue = (PxQ)/Q = P

Average Revenue always equals price – it is anidentity; AR is just another name for P. So the

AR per bottle is $0.35.

Marginal revenue = Change in TR divided bychange in Q.

When P is constant, MR=P; when P is rising,MR>P and when price is falling MR


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The Goal of Profit-Maximization

Although firms may have other goals, most of thetime private firms are in business because theywant to maximize Total Profit.

Total Profit = TR – TC

TR = PxQ

TC = Money Costs (explicit) + Opportunity Costs(implicit)

In Economics, Total Profit is called Economic Profit

Economic Profit is in general not equal to AccountingProfit.


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Economic Profit

Goofy, the owner of a small business makes profitof $35,000 a year. He could also have earned$35,000 working as a consultant for a software firm.

Goofy’s accounting profit is $35,000.

Goofy’s Economic Profit = $0.

We will see that firms make zero economic profits

in many markets.


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Maximum Profit

To maximize total profit (P ), one needs to setmarginal profit to zero.

So, Marginal P = MR – MC

Marginal P = 0 implies, MR = MC

MarginalProfit

=

DP

DQ =

DTR

DQ -

DTC

DQ


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Output, Revenue, Costs, and Profit

0 0 0 40 -40

1 80 28 52 -24

2 200 70 64 6

3 260 91 76 15

4 300 105 88 17

5 330 115.50 100 15.50

6 350 122.50 112 10.50

7 362 126.70 124 2.70

Employees

per day

Output

(bottles/day)

Total revenue

($/day)

Profit

($/day)

Total cost

($/day)

MB = .35

MB = .35

MB = .35

MB = .35

MB = .35

MB = .35

MB = .35

MC = .15

MC = .10

MC = .20

MC = .30

MC = .40

MC = .60

MC = 1.00

Assume bottles sell for $0.35; This is the firm’s MR

Perfectly Competitive Markets:


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Chapter 4: Elasticity Slide 28

Perfectly Competitive Markets:Characteristics

1. Numerous buyers and sellers

small market share so that no individual agent can affectthe price; buyers and sellers are price takers.

2. Homogeneous (standardized) product

difficult to satisfy in reality; buyers are willing to switch tothe seller offering the lowest price

3. Mobile productive resources (freedom of entry and exit)

Sellers can move with labor, capital, and otherproductive resources to the most profitable activity

4. Buyers and sellers are well informed

buyers know all relevant opportunities available to them


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7/21/2013 Sudeshna C.Band o adh

29

Demand curve faced by the firm

The individual firm takes the price as given.Individual agents are price takers.

The firm can sell any amount of the product

at given prices.

The firm faces a perfectly elastic horizontal

demand curve.

Fi ’ d d hi l


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30

Firm’s demand curve – graphicalrepresentation

D

Q

E

P

S

Industry

P

qFirm

d: MR=ARP* P*


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31

Firm’s Short-run Equilibrium

The firm maximizes profits.

In the short-run, no new firms enter the

industry and no existing firms leave theindustry.

The firm maximizes profit by settingMR=MC.

MB MC G h f fi ’ h t ilib i


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32

Graph of firm’s short-run equilibriumwith profit

Firm

P

q

d: MR=AR

P*

MC

q*

ATC

ATC*

E

1

2

MB MC G h f fi ’ h t


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33

Graph of a firm’s short-runequilibrium with loss

P

qFirm

d: MR=AR

P*

MC

q*

ATC

ATC*

1

2

E

MB MC


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34

Break Even Analysis

Break Evenwhen:

Economic

profit = 0. TR = TC.

Min ATC

(Point B).

P

qFirm

d: MR=ARP*

MC

q*

ATC

Min ATC

E

B

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35

Shut Down Analysis

Julia’s monthly mortgage and other fixedcosts are $750 per month.

If she rents to Paul, there will be additionalcosts (electricity, water etc. anddepreciation) of $210 per month.

Paul offers $215 per month. Should Juliarent?

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36

Shut Down Analysis

Say TR=$500, TVC=300 and TFC=400.

If the firm remains in business, loss is

$200. If the firm shuts down, loss is $400. If TR>TVC, stay in business.

If TR


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37

Shut Down Analysis

If P>AVC, stay in business.

If P


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38

Shut Down Point

Shut Downwhen:

TR


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39

Firm’s Supply Curve

A firm’ssupply

curve is itsMC curve,above theshut downpoint, S.

P

qFirm

d: MR=AR

P*

MC

q*

ATC

AVC

S

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The Law of Supply

Short-run marginal cost curves have a positiveslope

Higher prices generally increase quantitysupplied

In the long run, all inputs are variable; so long-runsupply curves can be flat, upward sloping, ordownward sloping

The perfectly competitive firm's supply curve is itsmarginal cost curve - applies in both the short runand the long run

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Economic Naturalist

When recycling is left to private marketforces, why are many more aluminumbeverage containers recycled than glassones?

Aluminum containers can be easilyprocessed for scrap aluminum and so fetchhigh redemption prices. Glass containers

have limited resale value because rawmaterials needed to produce glass are verycheap.

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Externalities and Recycling

Recycling is an activity with positiveexternalities. So in a market determinedprivate equilibrium too little will be recycled.

There is an equilibrium amount of litter that islikely to be greater than zero. This isbecause of scarcity and OC of resourcesused in getting rid of litter.

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The Supply Curve of Container


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The Supply Curve of ContainerRecycling Services for Burlington, Vermont

Number of containers recycled

(1,000s of containers/day)

R e d e m p t i o n s p

r i c e

( c e n t s / c o n t a i n

e r )

6 10 13 16

6

3

2

1

1.5

15

Market supply curve of glass

container recycling services

•60,000 citizens would

collectively pay 6cents for eachcontainer whichequals marginal

benefit

•The localgovernmentpays 6cents/container. Theoptimalquantity of

containers is16,000/daywhere MC (.06) = MB

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Applying the Theory of Supply

Will all containers be removed from theenvironment at $0.06/container? No.

Why is the optimal amount of removal 16,000/day?

Because of the underlying cost benefit numbers;

proceeding beyond 16,000 is wasteful.

Will private individuals choose to remove 16,000containers/day?

No, because anyone that pays for litter removalbears the full cost but only a fraction of thebenefit (6 cents/60,000) = 0.0001 cent perperson.

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S l d P d S l


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Supply and Producer Surplus

Producer Surplus

The amount by which price exceeds theseller’s reservation price

MB MC The Supply and


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The Supply andDemand in the Market for Milk

Quantity (1,000s of gallons/day)

P r i c e ( $ / g a

l l o 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

•EquilibriumP =

$2 &Q =

4,000•Producer surplus is thedifference between $2and the reservationprice at each quantity

•Producer surplus =

(1/2)(4,000gallons/day)($2/gallon)= $4,000/day

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Producer Surplus in the Market for Milk

Quantity (1,000s of gallons/day)

P r i c e ( $ / g a

l l o 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


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End of

Chapter

155184410 06 perfectly competitive supply

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