1 Frank & Bernanke 3 rd edition, 2007 Ch. 6: Ch. 6: Perfectly Competitive Supply: The Cost Side of The Market

2 Importance of Opportunity Cost If today it takes the same number of orchestra members to play a Brahms symphony as it did 100 years ago, why are they paid five times as much? If today it takes the same number of orchestra members to play a Brahms symphony as it did 100 years ago, why are they paid five times as much? If it still takes 20 minutes to get a haircut just like a hundred years ago why the barber pa id so much more? And why do barbers in the US get paid more than barbers in Bulgaria? If it still takes 20 minutes to get a haircut just like a hundred years ago why the barber pa id so much more? And why do barbers in the US get paid more than barbers in Bulgaria? If it takes 8 hours to assemble car today compared to more than 50 hours 40 years ago shoud the worker be paid more? If it takes 8 hours to assemble car today compared to more than 50 hours 40 years ago shoud the worker be paid more?

3 The Importance of Opportunity Cost Harry is choosing between washing dishes for $6/hour and collecting containers at 2 cents each. Harry is choosing between washing dishes for $6/hour and collecting containers at 2 cents each. Opportunity cost of collecting cans is $6/hour. Opportunity cost of collecting cans is $6/hour. How much time should Harry spend recycling soft drink containers? How much time should Harry spend recycling soft drink containers?

4 Example Search time (hours/day) ,000 31,300 41,500 51,600 Total number of containers found Additional number of containers found

5 Costs and Benefits 1 hour collecting cans = (600)(.02) = $12 1 hour collecting cans = (600)(.02) = $12 Benefit ($12) > Opportunity Cost ($6) Benefit ($12) > Opportunity Cost ($6) 2nd hour benefit ($8) > Opportunity Cost ($6) 2nd hour benefit ($8) > Opportunity Cost ($6) 3rd hour benefit ($6) = Opportunity Cost ($6) 3rd hour benefit ($6) = Opportunity Cost ($6)

6 Opportunity Cost What should the price of recycled cans be to make Harry indifferent between washing dishes for one hour or collecting cans? What should the price of recycled cans be to make Harry indifferent between washing dishes for one hour or collecting cans? What should the price of recycled cans be to make Harry indifferent between collecting cans for two hours or washing dishes ? What should the price of recycled cans be to make Harry indifferent between collecting cans for two hours or washing dishes ?

7 Reservation Price 1 hour recycling = p(600) = $6 = 1 cent 2 hours recycling = p(400) = $6 = 1.5 cents 3 hours recycling = p(300) = $6 = 2 cents 4 hours recycling = p(200) = $6 = 3 cents 5 hours recycling = p(100) = $6 = 6 cents

8 An Individual Supply Curve for Recycling Services Recycled cans (100s of cans/day) Deposit (cents/can) Harry’s Supply Curve

9 The Market Supply Curve for Recycling Services Recycled cans (100s of cans/day) Recycled cans (100s of cans/day) Deposit (cents/can) Harry’s Supply Curve Barry’s Supply Curve

10 Recycled cans (100s of cans/day) Deposit (cents/can) = The Market Supply Curve for Recycling Services Market Supply Curve

11 The Market Supply Curve with 1,000 Identical Sellers Recycled cans (100,000s of cans/day) Deposit (cents/can) Market Supply Curve

12 Typical Test Question Why is the supply curve upward sloping?

13 Perfectly Competitive Market A market in which no individual supplier has significant influence on the market price of the product. A market in which no individual supplier has significant influence on the market price of the product. A firm that has no influence over the price at which it sells its product is a Price Taker. A firm that has no influence over the price at which it sells its product is a Price Taker.

14 Characteristics of Perfect Competition 1.All firms sell the same standardized 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.Productive resources are mobile 4.Buyers and sellers are well informed.

15 Market Supply and Demand P0P0 Q0Q0 S D Market Quantity (units/month) Price ($/unit) Market supply and demand

16 The Demand Curve Facing a Perfectly Competitive Firm DiDi P0P0 Price ($/unit) Individual Firm’s Quantity (units/month) Individual firm demand

17 Perfectly Competitive Firm A firm facing a horizontal demand curve will always sell one additional unit it produces at the ongoing market price. A firm facing a horizontal demand curve will always sell one additional unit it produces at the ongoing market price. The firm’s demand curve is the same as the price of its product. The firm’s demand curve is the same as the price of its product. Marginal Revenue for this firm will be equal to Price. Marginal Revenue for this firm will be equal to Price.

18 Profit Maximizing Firms are thought to behave as if maximizing their profits. Firms are thought to behave as if maximizing their profits. Profits = Total Revenue – All explicit and implicit costs Profits = Total Revenue – All explicit and implicit costs TR = PQ TR = PQ Profit maximizing rule: MB = MC Profit maximizing rule: MB = MC If benefit is revenue then MB=MR. If benefit is revenue then MB=MR. We have to figure out the costs. We have to figure out the costs.

19 Factors of Production Fixed factor of production Fixed factor of production An input whose quantity cannot be altered in the short run An input whose quantity cannot be altered in the short run Variable factor of production Variable factor of production An input whose quantity can be altered in the short run An input whose quantity can be altered in the short run

20 Law of Diminishing Returns When some factors of production are fixed, increased production of the good eventually requires ever-larger increases in the variable factor When some factors of production are fixed, increased production of the good eventually requires ever-larger increases in the variable factor

21 Employment and Output for a Glass Bottle Maker Total number of employees per day Total number of bottles per day Observation Output gains from each additional worker begins to diminish with the third employee

22 Costs The cost of labor is $12/worker and is a variable cost. The cost of labor is $12/worker and is a variable cost. The cost of the bottle making machine is $40/day and it is a fixed cost. The cost of the bottle making machine is $40/day and it is a fixed cost.

23 Fixed, Variable, and Total Costs of Bottle Production Employees per day Bottles per day Fixed cost ($/day) Variable cost ($/day) Total cost ($/day) Marginal cost ($/bottle)

24 Definitions Total Cost Total Cost Fixed Cost + Variable Cost Fixed Cost + Variable Cost Marginal Cost Marginal Cost Measures how total cost changes with a change in output Measures how total cost changes with a change in output

25 Output, Revenue, Costs, and Profit Employees per day Output (bottles/day) Total revenue ($/day) Profit ($/day) Total cost ($/day) MB =.35 MC =.15 MC =.10 MC =.20 MC =.30 MC =.40 MC =.60 MC = 1.00 What will happen to the profit maximizing output if: (a) employees receive a wage of $6/day; (b) fixed costs are $45?

26 Average Variable Cost and Average Total Cost of Bottle Production Employees per day Bottles per day Variable cost ($/day) Average variable cost ($/unit of output) Total cost ($/day) Average total cost ($/unit of output) Marginal cost ($/bottle)

27 Profits Profits = TR – TC or (P x Q) - (ATC x Q) Profits = TR – TC or (P x Q) - (ATC x Q) To be profitable: P > ATC To be profitable: P > ATC

28 Firm’s Shutdown Condition When producing at a loss, a firm must cover its variable cost to minimize losses. When producing at a loss, a firm must cover its variable cost to minimize losses. Short-run shutdown condition Short-run shutdown condition P < minimum level of AVC

Upward-sloping MC corresponds to diminishing returns MC = AVC & ATC at their minimum points MC The Marginal, Average Variable, and Average Total Cost Curves for a Bottle Manufacturer Cost ($/bottle) 0.05 Output (bottles/day) ATC AVC

30 Price = Marginal Cost: The Perfectly Competitive Firm’s Profit-Maximizing Supply Rule Output (bottles/day) Cost ($/bottle) Price Less than 260 bottles/day P > MC and output should be increased More than 260 bottles/day P < MC and output should be decreased Profit maximizing output: P = MC MC ATC AVC

Price = MC at 260 bottles/day ATC =.12/bottle TR = (.20)(260) = $52/day TC = (.12)(26) = $31.20/day Profit = $52 - $31.20 = $20.80/day Price Price = Marginal Cost: The Perfectly Competitive Firm’s Profit-Maximizing Supply Rule Output (bottles/day) Cost ($/bottle) MC ATC AVC

Price =.08/bottle P = MC at 180 bottles/day ATC =.10/bottle P < ATC by.02/bottle Profit = -.02 x 180 = -3.60//day 180 Price 0.08 A Negative Profit Output (bottles/day) Cost ($/bottle) MC ATC AVC

33 The Law of Supply The perfectly competitive firm’s supply curve is its marginal cost curve The perfectly competitive firm’s supply curve is its marginal cost curve Every quantity of output along the market supply represents the summation of all the quantities individual sellers offer at the corresponding price Every quantity of output along the market supply represents the summation of all the quantities individual sellers offer at the corresponding price At every point along the market supply curve, price measures what it would cost producers to expand production by one unit. At every point along the market supply curve, price measures what it would cost producers to expand production by one unit.

34 Determinants of Supply Technology Technology Input prices Input prices Number of suppliers Number of suppliers Expectations Expectations Changes in prices of other products Changes in prices of other products

35 The Supply Curve of Container Recycling Services for Burlington, Vermont Number of containers recycled (1,000s of containers/day) Redemptions price (cents/container) Market supply curve of glass container recycling services 60,000 citizens would pay 6 cents times 16,000 ($960) which equals the tax (1.6 cents/day/person) The local government pays 6 cents/container (MB)

36 Applying the Theory of Supply Will all containers be removed from the environment at $0.06/container? Will all containers be removed from the environment at $0.06/container? Why is the optimal amount of removal 16,000/day? Why is the optimal amount of removal 16,000/day? Will private individuals choose to remove 16,000 containers/day? Will private individuals choose to remove 16,000 containers/day?

37 Producer Surplus The amount by which price exceeds the seller’s reservation price The amount by which price exceeds the seller’s reservation price

38 The Supply and Demand in the Market for Milk Quantity (1,000s of gallons/day) Price ($/gallon) 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