1

Perfectly Competitive Supply:

The Cost Side of the Market

Perfectly Competitive Supply:

The Cost Side of the Market

2

Buyers and SellersBuyers and Sellers

Buyers“Should I buy another unit?”Answer: If the marginal benefit exceeds

the marginal costSellers

“Should I sell another unit?Answer: If the marginal revenue exceeds

the marginal cost of making it

3

Upward-Sloping Supply Curves

Upward-Sloping Supply Curves

The Low-Hanging Fruit PrincipleSuppliers first use the resources easiest-to-

find So, the price of the output must go up in

order to compensate for using harder-to-find resources

I.E., costs tend to rise when producers expand production in the short-run (some inputs are fixed in the short-run)

4

Fig. 6.1An Individual Supply Curve for

Recycling Services

Fig. 6.1An Individual Supply Curve for

Recycling Services

5

Fig. 6.2The Market Supply Curve for

Recycling Services

Fig. 6.2The Market Supply Curve for

Recycling Services

6

Profit MaximizationProfit MaximizationProfit

The difference between the total revenue it receives from the sale of its product minus all costs, explicit and implicit

Note: this includes opportunity cost, and is therefore different than profit in a traditional accounting sense

Profit-maximizing firmA firm whose primary goal is to maximize profits

7

Types of MarketsTypes of Markets

One firm = 2-12 firms many firms many, many firms

Monopoly Oligopoly Monopolistic Perfect

Competition Competition

8

Firm Decisions to Max Profit

Firm Decisions to Max Profit

What to produce (what market)?How much to produce?What inputs to use?What price to charge?

9

Perfect CompetitionPerfect CompetitionPerfectly Competitive Market

A market in which no individual supplier has significant influence on the market price of the product

Many firms all selling the same product. Product is “standardized”

A Price taker is a firm thatHas no influence over the price at which it sells its

productSells only a fraction of the market outputCan sell as much output as it wishes

10

Perfectly Competitive Firm Perfectly Competitive Firm

Given that there are many firms all selling the exact same product, what does the demand curve for any one firm’s good look like?

11

Fig. 6.4The Demand Curve Facing Perfectly

Competitive Firm

Fig. 6.4The Demand Curve Facing Perfectly

Competitive Firm

12

Production in the Short RunProduction in the Short Run

Factors of ProductionAn input used in the production of a good or

service

Short RunA period of time sufficiently short that at least

some of the firm’s factors of production are fixed

Long RunA period of time of sufficient length that all the

firm’s factors of production are variable

13

Law of Diminishing ReturnsLaw of Diminishing Returns

Fixed factor of productionAn input whose quantity cannot be altered in the

short run. E.g. square footage of factory spaceVariable factor of production

An input whose quantity can be altered in the short run. E.g. labor

Law of Diminishing ReturnsIf one factor is variable and all others are fixed: the

increased production of the good eventually requires ever larger increases in the variable factor

14

Law of Diminishing Marginal Returns

Law of Diminishing Marginal Returns

Q

Labor

MPL

Point of diminishing marginal returns

15

Implications for Marginal Costs

Implications for Marginal Costs

Since productivity (MPL) typically first increases and then decreases (at the point of DMR), what will marginal costs do?

When productivity is rising, marginal costs should be falling.

When productivity is falling, marginal costs should be rising.

Unit costs measures are inversely related to productivity measures

16

Choosing OutputChoosing Output

How much to produce?The goal is to maximize profit

Profit = TR – TCA perfectly competitive firm chooses to

produce the output level where profit is maximized

Cost-Benefit Principle A firm should increase output if marginal

benefit (revenue) exceeds the marginal cost

17

Choosing OutputChoosing Output

Cost-Benefit PrincipleIncrease output if marginal benefit exceeds the

marginal cost

For a perfectly competitive firmMarginal benefit = marginal revenue = price

Cost-Benefit Principle for a Price TakerKeep expanding as long as the price of the

product is greater than marginal costChoose the output where P = MC

18

Profit Maximizing ConditionProfit Maximizing Condition

Profit = TR – TCMax Profit with respect to Qd Profit / dQ = (dTR/ dQ) – (dTC/dQ) = 0 therefore maximum profit occurs where MR

= MC

19

Shut Down?Shut Down?

Perfectly competitive firms should produce where MR (P) = MC, unless price is very low

If total revenue falls below variable cost, the best the firm could do is shut down in the short run

20

Fig. 6.5The Firm’s Marginal Cost of Production

Fig. 6.5The Firm’s Marginal Cost of Production

21

Fig. 6.6Price = Marginal Cost: The Perfectly Competitive Firm’s Profit-Maximizing

Supply Rule

Fig. 6.6Price = Marginal Cost: The Perfectly Competitive Firm’s Profit-Maximizing

Supply Rule

22

Perfectly Competitive Firm’s Supply CurvePerfectly Competitive Firm’s Supply Curve

The perfectly competitive firm’s supply curve is itsMarginal cost curve

At every point along a market supply curvePrice measures what it would cost

producers to expand production by one unit

23

Profit MaximizationProfit Maximization

P

ATC

MC

Q* Quantity

10 = P* D = MR

ATC = Total Cost / Q so, TC = ATC x Q

P > ATC means profit > 0

8

100

24

Suppose Price Falls to Min ATC

Suppose Price Falls to Min ATC

P

ATC

MC

Q* Quantity

7 = P* D = MR

P = ATC means profit = 0

25

Suppose Price Falls below Min ATC

Suppose Price Falls below Min ATC

P

ATC

MC

Q* Quantity

7 = P* D = MR

P < ATC means profit < 0

26

Producer SurplusProducer Surplus

Producer Surplus (PS) is the difference between the firm’s minimum willingness to accept (MC) and what they actually accept (P), summed over all units produced.

27

Producer Surplus and Supply

Producer Surplus and Supply

Graphically then, PS is the area below the price line and above the supply curve, up to Q*

Here, PS = $100

=½(base)(height)

= ½(20)(10)

20 Quantity

P

30

10PS

S

D

28

exercisesexercises

A profit maximizing perfectly competitive firm must decide:

A. only on what price to charge, taking output as fixed. B. both what price to charge and how much to produce. C. only on how much to produce, taking price as fixed. D. only on which industry to join, taking price and output as fixed. E. only on how much revenue it wishes to collect.

29

exercisesexercises

To produce 150 units of output, the firm must use 3 employee-hours. To produce 300 units of output the firm must use 8 employee-hours. Apparently, the firm is:

A. more profitable. B. experiencing diminishing marginal returns. C. in the long run. D. not using any fixed factors of production. E. failing to profit maximize.

30

exercisesexercises Which of the following factors of production is likely to be fixed

in the short run? A. The location of the firm.

B. The number of employee-hours. C. The amount of electricity consumed. D. The amount of paper used. E. The amount of RAM installed in the network server.

When the marginal return to the variable factor of production is diminishing, the marginal cost curve is

A. upward sloping. B. convex. C. parallel to the vertical axis. D. downward sloping. E. concave.