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Perfectly Competitive
Supply: The CostSide of The Market
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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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Chapter 6: Perfectly Competitive Supply Slide 4
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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Chapter 6: Perfectly Competitive Supply Slide 5
Thinking About Supply: TheImportance of Opportunity Cost
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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Chapter 6: Perfectly Competitive Supply Slide 6
Thinking About Supply: TheImportance of Opportunity Cost
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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Chapter 6: Perfectly Competitive Supply Slide 7
Thinking About Supply: TheImportance of Opportunity Cost
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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Chapter 6: Perfectly Competitive Supply Slide 8
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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Chapter 6: Perfectly Competitive Supply Slide 9
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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Chapter 6: Perfectly Competitive Supply Slide 10
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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Chapter 6: Perfectly Competitive Supply Slide 11
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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Chapter 6: Perfectly Competitive Supply Slide 12
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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Chapter 6: Perfectly Competitive Supply Slide 13
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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Chapter 6: Perfectly Competitive Supply Slide 14
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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Chapter 6: Perfectly Competitive Supply Slide 15
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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Chapter 6: Perfectly Competitive Supply Slide 16
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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Chapter 6: Perfectly Competitive Supply Slide 17
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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Chapter 6: Perfectly Competitive Supply Slide 18
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 $12/worker (variable cost).
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Chapter 6: Perfectly Competitive Supply Slide 19
Some Important Cost Concepts
Total Cost (TC) is also the sum total of Total Fixed Cost(TFC) and Total Variable Cost (TVC)
TC = TFC + TVC
TC/Q = TFC/Q + TVC/Q, where Q=Total Output
Therefore, ATC = AFC + AVC,
Where, ATC = Average Total Cost;
AFC = Average Fixed Cost; and,
AVC = Average variable Cost.
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Chapter 6: Perfectly Competitive Supply Slide 20
Some Important Cost Concepts
Marginal Cost (MC) is the change in total costresulting from a one-unit rise in the level of output,holding everything else constant.
Therefore, MC = MVC as MFC=0
MarginalCost
=
DTC
DQ =
DTFC
DQ +
DTVC
DQ
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Chapter 6: Perfectly Competitive Supply Slide 21
Fixed, Variable, and TotalCosts of Bottle Production
0 0 40 0 40
1 80 40 12 52
2 200 40 24 64
3 260 40 36 76
4 300 40 48 88
5 330 40 60 1006 350 40 72 112
7 362 40 84 124
Employeesper day
Bottlesper day
Fixed cost($/day)
Variable cost($/day)
Total cost($/day)
Marginal cost($/bottle)
0.15
0.10
0.20
0.30
0.400.60
1.00
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Chapter 6: Perfectly Competitive Supply Slide 22
Average Variable Cost andAverage Total Cost of Bottle Production
Employees
per day
0 0 0 40
1 80 12 0.150 52 0.650
2 200 24 0.120 64 0.320
3 260 36 0.138 76 0.292
4 300 48 0.160 88 0.293
5 330 60 0.182 100 0.303
6 350 72 0.206 112 0.320
7 362 84 0.232 124 0.343
Bottles
per day
Variable
cost
($/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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Chapter 6: Perfectly Competitive Supply Slide 23
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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Chapter 6: Perfectly Competitive Supply Slide 24
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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Chapter 6: Perfectly Competitive Supply Slide 25
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 = $0.
We will see that firms make zero economic profits
in many markets.
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Chapter 6: Perfectly Competitive Supply Slide 26
Maximum Profit
To maximize total profit (P ), one needs to setmarginal profit to zero.
So, Marginal P = MR – MC
Marginal P = 0 implies, MR = MC
MarginalProfit
=
DP
DQ =
DTR
DQ -
DTC
DQ
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Chapter 6: Perfectly Competitive Supply Slide 27
Output, Revenue, Costs, and Profit
0 0 0 40 -40
1 80 28 52 -24
2 200 70 64 6
3 260 91 76 15
4 300 105 88 17
5 330 115.50 100 15.50
6 350 122.50 112 10.50
7 362 126.70 124 2.70
Employees
per day
Output
(bottles/day)
Total revenue
($/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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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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Firm’s demand curve – graphicalrepresentation
D
Q
E
P
S
Industry
P
qFirm
d: MR=ARP* P*
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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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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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Graph of a firm’s short-runequilibrium with loss
P
qFirm
d: MR=AR
P*
MC
q*
ATC
ATC*
1
2
E
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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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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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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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Shut Down Analysis
If P>AVC, stay in business.
If P
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Shut Down Point
Shut Downwhen:
TR
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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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Chapter 6: Perfectly Competitive Supply Slide 40
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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Chapter 6: Perfectly Competitive Supply Slide 41
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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Chapter 6: Perfectly Competitive Supply Slide 42
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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Chapter 6: Perfectly Competitive Supply Slide 43
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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Chapter 6: Perfectly Competitive Supply Slide 44
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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Chapter 6: Perfectly Competitive Supply Slide 45
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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Chapter 6: Perfectly Competitive Supply Slide 46
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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Chapter 6: Perfectly Competitive Supply Slide 47
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