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MB MC
Perfectly Competitive Supply: The Cost Side of The Market
Part II
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Quiz
Which of the following is a variable factor of production on a local farm over the next month?A. The pesticides and fertilizersB. The landC. The barnD. The machineryE. All of the above
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Quiz
Which of the following is a variable factor of production on a local farm over the 10 years?A. The pesticides and fertilizersB. The landC. The cowsD. The machineryE. All of the above
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 6: Perfectly Competitive Supply Slide 4
Concepts of production
Fixed factor of production An input whose quantity cannot be altered in the
short run (defines short run) e.g. a farmers barns, machinery, land; in ground
oil and pumps; saw mills and fishing boats; unionized workers personal skills
Variable factor of production An input whose quantity can be altered in the short
run e.g. raw material inputs, temporary workers
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 6: Perfectly Competitive Supply Slide 5
Profit-Maximizing Firms in Perfectly Competitive Markets
AssumeAn oil company produces barrels of oilTwo factors of production
Labor (variable)Capital (fixed)
An oil well
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 6: Perfectly Competitive Supply Slide 6
Employment and Output for an oil producer
Total number of employees per day Total number of barrels per day
0 0
1 8
2 20
3 26
4 30
5 33
6 35
7 36.2
ObservationOutput gains from each additional worker begins to diminish with the third employee
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 6: Perfectly Competitive Supply Slide 7
Employment and Output for an oil producer
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 6: Perfectly Competitive Supply Slide 8
Profit-Maximizing Firms in Perfectly Competitive Markets
Law of Diminishing ReturnsA property of the relationship between the
amount of a good or service produced and the amount of a variable factor required to produce it
It says that when some factors of production are fixed, increased production of the good eventually requires ever-larger increases in the variable factor
DIFFERENT CONCEPT THAN ECONOMIES OF SCALE
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 6: Perfectly Competitive Supply Slide 9
Profit-Maximizing Firms in Perfectly Competitive Markets
Some Important Cost ConceptsAssume
The cost of the oil wells is $500/day and it is a fixed cost (e.g. the payment on the loans taken to purchase the well).
Fixed costThe sum of all payments made to a firm’s fixed
factors of production
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 6: Perfectly Competitive Supply Slide 10
Profit-Maximizing Firms in Perfectly Competitive Markets
Some Important Cost ConceptsAssume
The cost of labor is $150/worker/day and is a variable cost.
Workers can be hired or fired at will
Variable costThe sum of all payments made to the firm’s
variable factors of production
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 6: Perfectly Competitive Supply Slide 11
Some Important Cost Concepts
Total CostFixed cost + variable cost
Marginal CostMeasures how total cost changes with a
change in output
What’s the impact of fixed costs on MC?
Output
TC
MC
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 6: Perfectly Competitive Supply Slide 12
Fixed, Variable, and Total Costs of Oil Production
Employeesper day
Barrelsper day
Fixed cost($/day)
Variable cost($/day)
Total cost($/day)
Marginal cost($/barrel)
What costs are conspicuously absent?
0 0 500 0 500
1 8 500 150 650 18.75
2 20 500 300 800 12.5
3 26 500 450 950 25
4 30 500 600 1100 37.5
5 33 500 750 1250 50
6 35 500 900 1400 75
7 36.2 500 1050 1550 125
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 6: Perfectly Competitive Supply Slide 13
Fixed, Variable, and Total Costs of Oil Production
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 6: Perfectly Competitive Supply Slide 14
What are the benefits of production?
Total benefit = total revenue Total revenue = barrels sold x price So what is marginal benefit? Barrels sell for $80 each Profit = TR – TC When do you think profit is maximized?
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
MB MC
80 18.75
80 12.5
80 25
80 37.5
80 50
80 75
80 125
Chapter 6: Perfectly Competitive Supply Slide 15
Output, Revenue, Costs, and Profit
Employeesper day
Output(barrels/day)
Total revenue($/day)
Profit($/day)
Total cost($/day)
What will happen to the profit maximizing output if price falls to $40?
0 0 0 500 -500
1 8 640 650 -10
2 20 1600 800 800
3 26 1820 950 1130
4 30 2100 1100 1300
5 33 2310 1250 1390
6 35 2450 1400 1400
7 36.2 2534 1550 1346
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 6: Perfectly Competitive Supply Slide 16
Output, Revenue, Costs, and Profit
What will happen to the profit maximizing output if price falls to $40?
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 6: Perfectly Competitive Supply Slide 17
Output, Revenue, Costs, and Profit
Employeesper day
Output(barrels/day)
Total revenue($/day)
Profit($/day)
Total cost($/day)
What will happen to the profit maximizing output if:(a) employees receive a wage of $75/day; (b) fixed costs are $650?
MB MC
40 18.75
40 12.5
40 25
40 37.5
40 50
40 75
40 125
0 0 0 500 -500
1 8 320 650 -330
2 20 800 800 0
3 26 1040 950 90
4 30 1200 1100 100
5 33 1320 1250 70
6 35 1400 1400 0
7 36.2 1448 1550 -102
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 6: Perfectly Competitive Supply Slide 18
Output, Revenue, Costs, and Profit
Employeesper day
Output(barrels/day)
Total revenue($/day)
Profit($/day)
Total cost($/day)
Wages drop to $75/day (fixed costs $500)
MB MC
40 9.375
40 6.25
40 12.5
40 18.75
40 25
40 37.5
40 62.5
0 0 0 500 -500
1 8 320 575 -255
2 20 800 650 150
3 26 1040 725 315
4 30 1200 800 400
5 33 1320 875 445
6 35 1400 950 450
7 36.2 1448 1025 423
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 6: Perfectly Competitive Supply Slide 19
Output, Revenue, Costs, and Profit
Employeesper day
Output(barrels/day)
Total revenue($/day)
Profit($/day)
Total cost($/day)
Fixed costs are $650 (wages at $150/day). Profits are negative, but producer can cover some of fixed costs.
MB MC
40 18.75
40 12.5
40 25
40 37.5
40 50
40 75
40 125
0 0 0 650 -650
1 8 320 800 -480
2 20 800 950 -150
3 26 1040 1100 -60
4 30 1200 1250 -50
5 33 1320 1400 -80
6 35 1400 1550 -150
7 36.2 1448 1700 -252
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 6: Perfectly Competitive Supply Slide 20
When will a firm shut down?
When producing at a loss, a firm must cover its variable cost to minimize losses.Short-run shutdown condition
QVCPxQ of levels all for
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 6: Perfectly Competitive Supply Slide 21
Average Variable Cost
Variable cost divided by total output
Q
VC
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 6: Perfectly Competitive Supply Slide 22
Short-run shutdown condition
Determined by AVC
AVCP of valueminimum
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 6: Perfectly Competitive Supply Slide 23
Average Total Cost
Total cost divided by total output
Q
TC
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 6: Perfectly Competitive Supply Slide 24
Long Run Shutdown condition
Determined by ATC Profits = TR – TC or (P x Q) - (ATC x Q) To be profitable: P > ATC Long run Shutdown condition P < ATC
for all Q
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 6: Perfectly Competitive Supply Slide 25
Price = Marginal Cost: The Perfectly Competitive Firm’s Profit-Maximizing Supply Rule
Output (barrels/day)
Co
st (
$/b
arre
l)
Price = 80
•Less than 35 barrels/day P > MC and output should be increased•More than 35 barrels/day P < MC and output should be decreased
Total revenue
Total cost
profit
•Price = $80/barrel•P > MC at 35 barrels/day•ATC =$40 /barrel•P > ATC by $40/barrel•Profit = 35 x $40 = $1400/day
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 6: Perfectly Competitive Supply Slide 26
Price = Marginal Cost: The Perfectly Competitive Firm’s Profit-Maximizing Supply Rule
Output (barrels/day)
Co
st (
$/b
arre
l)
Price = $40
•Less than 30 barrels/day P > MC and output should be increased•More than 30 barrels/day P < MC and output should be decreased
Total revenueTotal cost
profit
•Price = $40/barrel•P> MC at 30 barrels/day•ATC =~ $36.7/barrel•P > ATC by $3.3/barrel•Profit = 350x $3.3 = $100/day
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 6: Perfectly Competitive Supply Slide 27
Price = Marginal Cost: The Perfectly Competitive Firm’s Profit-Maximizing Supply Rule
Output (barrels/day)
Co
st (
$/b
arre
l)
Price = 20
Producer continues to produce at negative profit. Covers variable costs plus some of fixed costs.
Total revenue
Total cost
Profit (negative)
•Price = $20/barrel•P = MC at 20 barrels/day•ATC = $40/barrel•P < ATC by $20/barrel•Profit = -$20 x 20 = -400//day
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
If a firm continues to produce even though it has a negative profit, it is safe to assume that:
A. TC<TRB. Price > average variable costC. Price > average total costD. MC > PriceE. The firm will close down in the short run
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 6: Perfectly Competitive Supply Slide 29
Profit-Maximizing Firms in Perfectly Competitive Markets
The Law of SupplyThe perfectly competitive firm’s supply
curve is its marginal cost curveMC curve upward sloping in short run (law
of diminishing marginal returns), but not necessarily in long run
Market output is sum of individual outputs, i.e. the sum of how much each supplier will supply at the given price.
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 6: Perfectly Competitive Supply Slide 30
The Law of Supply
At every point along the market supply curve, price measures what it would cost producers to expand production by one unit.
RecallDemand measures the benefit side of the
marketSupply measures the cost side of the
market
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 6: Perfectly Competitive Supply Slide 31
Determinants of Supply
Technology Input prices
e.g. labor in China Number of suppliers
e.g. trade with China Expectations
e.g. rising or falling prices Changes in prices of other products
i.e. opportunity costs Subsidies, implicit and explicit
e.g. the energy sector and the new clean air laws
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 6: Perfectly Competitive Supply Slide 32
Determinants of Supply
What about the oil????
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 6: Perfectly Competitive Supply Slide 33
Supply and Producer Surplus
Producer SurplusThe amount by which price exceeds the
seller’s reservation price
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 6: Perfectly Competitive Supply Slide 34
The Supply and Demand in the Market for Milk
Quantity (1,000s of gallons/day)
Pri
ce (
$/g
allo
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
•Equilibrium P = $2 & Q = 4,000
•Producer surplus is the difference between $2 and the reservation price at each quantity
•Producer surplus = (1/2)(4,000 gallons/day)($2/gallon) = $4,000/day
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 6: Perfectly Competitive Supply Slide 35
Producer Surplus in the Market for Milk
Quantity (1,000s of gallons/day)
Pri
ce (
$/g
allo
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