Chapter 6

Perfectly competitive supply: the cost side of the market

Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics 2e by Frank, Jennings and Olekalns Slides prepared by Jayanath Ananda, La Trobe University

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Learning Objectives
State the law of supply Describe how a firm in a perfectly competitive market decides how much to supply at each price Apply the profit-maximising rule Explain the relationship between the law of diminishing returns and SR cost curves

Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics 2e by Frank, Jennings and Olekalns Slides prepared by Jayanath Ananda, La Trobe University

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Learning Objectives (contd.)

Construct a market supply curve from individual supply curves Use theory of supply to predict the firm behaviour Define and calculate producer surplus and analyse welfare effects

Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics 2e by Frank, Jennings and Olekalns Slides prepared by Jayanath Ananda, La Trobe University

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Outline
The opportunity cost Individual and market supply curves Perfectly competitive markets Profit maximisation Demand curve for a firm in perfect competition Law of diminishing returns Costs curves in the short run Law of supply Producer surplus

Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics 2e by Frank, Jennings and Olekalns Slides prepared by Jayanath Ananda, La Trobe University

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The opportunity cost

Example: How much time should Harry spend recycling soft drink containers?

Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics 2e by Frank, Jennings and Olekalns Slides prepared by Jayanath Ananda, La Trobe University

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The opportunity cost

Harry is choosing between washing dishes for $6/hour and collecting containers at 2 cents each Opportunity cost of collecting cans is $6/hour

Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics 2e by Frank, Jennings and Olekalns Slides prepared by Jayanath Ananda, La Trobe University

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The opportunity cost

Applying the cost-benefit principle:
1 hour collecting cans = (600)(.02) = $12 Benefit ($12) > Opportunity cost ($6) 2nd hour benefit ($8) > Opportunity cost ($6) 3rd hour benefit ($6) = Opportunity cost ($6)

Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics 2e by Frank, Jennings and Olekalns Slides prepared by Jayanath Ananda, La Trobe University

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The opportunity cost

Question:
What is the lowest refund that would induce Harry to spend at least 1 hour/day recycling?

Solution:
600 containers x 1 cent = $6 = opportunity cost of washing dishes

Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics 2e by Frank, Jennings and Olekalns Slides prepared by Jayanath Ananda, La Trobe University

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The opportunity cost

Harrys additional earnings from searching the additional hour will be p (Q) The smallest refund that will lead Harry to search another hour must satisfy the equation:

pQ $6
= 400 p(400) = $6 p = 1.5 cents ($0.015)

Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics 2e by Frank, Jennings and Olekalns Slides prepared by Jayanath Ananda, La Trobe University

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Harrys individual supply curve for recycling services

Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics 2e by Frank, Jennings and Olekalns Slides prepared by Jayanath Ananda, La Trobe University

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Individual and market supply curves

The quantity that corresponds to a given price on the market supply curve is the sum of the quantities supplied at that price by all individual sellers

Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics 2e by Frank, Jennings and Olekalns Slides prepared by Jayanath Ananda, La Trobe University

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Market supply curve for recycling services

Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics 2e by Frank, Jennings and Olekalns Slides prepared by Jayanath Ananda, La Trobe University

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Market supply curve

Horizontal summation of individual supply curves Upward sloping Reasons for upward-sloped supply curve:
costs tend to rise with expanded production each individual exploits his most attractive opportunities first different potential sellers face different opportunity costs

Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics 2e by Frank, Jennings and Olekalns Slides prepared by Jayanath Ananda, La Trobe University

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Supply in perfectly competitive markets

Profit defined:
The total revenue a firm receives from the sale of its product minus all costs explicit and implicit incurred in producing it

Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics 2e by Frank, Jennings and Olekalns Slides prepared by Jayanath Ananda, La Trobe University

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Profit maximisation
Profit maximising firm defined:
A firm whose primary goal is to maximise the difference between its total revenues and total costs, or profit

Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics 2e by Frank, Jennings and Olekalns Slides prepared by Jayanath Ananda, La Trobe University

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Perfectly competitive markets

Perfectly competitive market defined:
A market in which no individual supplier has any influence on the market price of the product

Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics 2e by Frank, Jennings and Olekalns Slides prepared by Jayanath Ananda, La Trobe University

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Perfectly competitive markets

Price taker defined:
A firm that has no influence over the price at which it sells its product

Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics 2e by Frank, Jennings and Olekalns Slides prepared by Jayanath Ananda, La Trobe University

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Characteristics of perfectly competitive markets

1. All firms sell the same standardised product 2. The market has many buyers and sellers each of which buys or sells only a small fraction of the total quantity exchanged 3. Sellers are able to enter and leave a market as they like 4. Buyers and sellers are well informed

Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics 2e by Frank, Jennings and Olekalns Slides prepared by Jayanath Ananda, La Trobe University

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Market supply and demand for wheat

The market demand and supply curves interest to determine the market price of wheat
Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics 2e by Frank, Jennings and Olekalns Slides prepared by Jayanath Ananda, La Trobe University

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Demand curve for a firm in perfect competition

The individual farmers Di is perfectly elastic at the market price

Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics 2e by Frank, Jennings and Olekalns Slides prepared by Jayanath Ananda, La Trobe University

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Production in the short run

Factor of production:
An input used in the production of a good or service

Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics 2e by Frank, Jennings and Olekalns Slides prepared by Jayanath Ananda, La Trobe University

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Production in the short run

Short run:
A period of time sufficiently short that at least one of the firms factors of production are fixed

Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics 2e by Frank, Jennings and Olekalns Slides prepared by Jayanath Ananda, La Trobe University

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Production in the short run

Long run:
A period of time of sufficient length that all the firms factors of production are variable

Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics 2e by Frank, Jennings and Olekalns Slides prepared by Jayanath Ananda, La Trobe University

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Law of diminishing returns

In the short run, when at lest one factor of production is fixed, successive increases in the input of a variable factor eventually yield smaller and smaller increments in output.

Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics 2e by Frank, Jennings and Olekalns Slides prepared by Jayanath Ananda, La Trobe University

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Concepts of production
Fixed factor production An input whose quantity does not change as the output, produced in a given period of time, changes

Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics 2e by Frank, Jennings and Olekalns Slides prepared by Jayanath Ananda, La Trobe University

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Concepts of production
Variable factor production
An input whose quantity varies as the output, produced in a given period of time, changes

Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics 2e by Frank, Jennings and Olekalns Slides prepared by Jayanath Ananda, La Trobe University

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Production in the short run

Bottle-maker example: Assume
A company makes glass bottles Two factors of production
Labour (variable) Capital (fixed)

A bottle-making machine

Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics 2e by Frank, Jennings and Olekalns Slides prepared by Jayanath Ananda, La Trobe University

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Employment and output for a glass bottle maker

Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics 2e by Frank, Jennings and Olekalns Slides prepared by Jayanath Ananda, La Trobe University

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Costs in the short run

Fixed cost
The sum of all payments made to the firms fixed factors of production

Variable cost
The sum of all payments made to the firms variable factors of production

Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics 2e by Frank, Jennings and Olekalns Slides prepared by Jayanath Ananda, La Trobe University

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Costs in the short run

Total cost
The sum of all payments made to the firms fixed and variable factors of production

Marginal cost
The change in total cost divided by the corresponding change in output

Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics 2e by Frank, Jennings and Olekalns Slides prepared by Jayanath Ananda, La Trobe University

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Costs of bottle production

Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics 2e by Frank, Jennings and Olekalns Slides prepared by Jayanath Ananda, La Trobe University

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Choosing output to maximise profit

How much will a profit-maximising perfectly competitive firm choose to produce when faced with a horizontal demand curve and when the law of diminishing returns holds?
If bottles sell for $0.35 each, how many bottles should the company described in Table 6.2 produce each day?

Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics 2e by Frank, Jennings and Olekalns Slides prepared by Jayanath Ananda, La Trobe University

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Output, revenue, costs and profits of bottle production

Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics 2e by Frank, Jennings and Olekalns Slides prepared by Jayanath Ananda, La Trobe University

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Firms shut down condition

When producing at a loss, a firm must cover its variable cost to minimise losses The firms SR shut down rule:

If P x Q < VC for every single level of Q

Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics 2e by Frank, Jennings and Olekalns Slides prepared by Jayanath Ananda, La Trobe University

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Average costs
Average variable cost (AVC):
Variable cost divided by total output

VC AVC Q
Average total cost (ATC): Total cost divided by total output

TC ATC Q
Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics 2e by Frank, Jennings and Olekalns Slides prepared by Jayanath Ananda, La Trobe University

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Average costs
A firm should shut down and produce nothing in the short run when P x Q < VC for all levels of Q, or P < minimum value of AVC
Profits = TR TC or (P x Q) - (ATC x Q) To be profitable: P > ATC

Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics 2e by Frank, Jennings and Olekalns Slides prepared by Jayanath Ananda, La Trobe University

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AVC and ATC of bottle production

Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics 2e by Frank, Jennings and Olekalns Slides prepared by Jayanath Ananda, La Trobe University

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The short run MC, AVC and ATC

Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics 2e by Frank, Jennings and Olekalns Slides prepared by Jayanath Ananda, La Trobe University

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The profit-maximisation rule: P=MC

Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics 2e by Frank, Jennings and Olekalns Slides prepared by Jayanath Ananda, La Trobe University

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Showing profit graphically

Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics 2e by Frank, Jennings and Olekalns Slides prepared by Jayanath Ananda, La Trobe University

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Firm making a loss in the SR

Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics 2e by Frank, Jennings and Olekalns Slides prepared by Jayanath Ananda, La Trobe University

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The law of supply

The perfectly competitive firms supply curve is its marginal cost curve Every quantity of output along the market supply curve represents the summation of all the quantities individual sellers offer at the corresponding price

Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics 2e by Frank, Jennings and Olekalns Slides prepared by Jayanath Ananda, La Trobe University

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The profit-maximising rule summarised

Produce the level of output for which P = MC, provided that P>AVC If P<AVC at all levels of output, shut down and produce nothing Firms SR supply curve is the portion of its MC lies above its AVC curve In the LR a firm will leave the market if P<ATC at all levels of output

Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics 2e by Frank, Jennings and Olekalns Slides prepared by Jayanath Ananda, La Trobe University

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Determinants of supply revisited

Technology Input prices Expectations Changes in prices of other products The number of suppliers

Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics 2e by Frank, Jennings and Olekalns Slides prepared by Jayanath Ananda, La Trobe University

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Applying the theory of supply

What is the socially optimal amount of recycling of glass containers?
Will all containers be removed from the environment at $0.06/container? Why is the optimal amount of removal 16 000/day? Will private individuals choose to remove 16 000 containers/day?

Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics 2e by Frank, Jennings and Olekalns Slides prepared by Jayanath Ananda, La Trobe University

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Supply of container recycling services for Burnside, SA

Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics 2e by Frank, Jennings and Olekalns Slides prepared by Jayanath Ananda, La Trobe University

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Supply and producer surplus

Producer surplus
The difference between the amount actually received by the seller of a good and the sellers reservation price

Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics 2e by Frank, Jennings and Olekalns Slides prepared by Jayanath Ananda, La Trobe University

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Producer surplus in the market for fish

Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics 2e by Frank, Jennings and Olekalns Slides prepared by Jayanath Ananda, La Trobe University

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The effect on the market for wheat of weed infestation

Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics 2e by Frank, Jennings and Olekalns Slides prepared by Jayanath Ananda, La Trobe University

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