Perfectly Competitive Supply: The Cost Side of The Market Part II

Quiz Which of the following is a variable factor of production on a local farm over the next month? The pesticides and fertilizers The land The barn The machinery All of the above

Concepts of production Fixed factor of production An input whose quantity cannot be altered in the 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 Chapter 6: Perfectly Competitive Supply

Quiz Which of the following is a variable factor of production on a local farm over the 10 years? The pesticides and fertilizers The land The cows The machinery All of the above

Profit-Maximizing Firms in Perfectly Competitive Markets Assume An oil company produces barrels of oil Two factors of production Labor (variable) Capital (fixed) An oil well Chapter 6: Perfectly Competitive Supply

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 Observation Output gains from each additional worker begins to diminish with the third employee Chapter 6: Perfectly Competitive Supply

Employment and Output for an oil producer Chapter 6: Perfectly Competitive Supply

Profit-Maximizing Firms in Perfectly Competitive Markets Law of Diminishing Returns A 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 Chapter 6: Perfectly Competitive Supply

Profit-Maximizing Firms in Perfectly Competitive Markets Some Important Cost Concepts Assume 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 cost The sum of all payments made to a firm’s fixed factors of production Chapter 6: Perfectly Competitive Supply

Profit-Maximizing Firms in Perfectly Competitive Markets Some Important Cost Concepts Assume The cost of labor is $150/worker/day and is a variable cost. Workers can be hired or fired at will Variable cost The sum of all payments made to the firm’s variable factors of production Chapter 6: Perfectly Competitive Supply

Some Important Cost Concepts Total Cost Fixed cost + variable cost Marginal Cost Measures how total cost changes with a change in output What’s the impact of fixed costs on MC? Chapter 6: Perfectly Competitive Supply

Fixed, Variable, and Total Costs of Oil Production Employees per day Barrels Fixed cost ($/day) Variable cost Total cost Marginal cost ($/barrel) 500 1 8 150 650 18.75 2 20 300 800 12.5 3 26 450 950 25 4 30 600 1100 37.5 5 33 750 1250 50 6 35 900 1400 75 7 36.2 1050 1550 125 What costs are conspicuously absent? Chapter 6: Perfectly Competitive Supply

Fixed, Variable, and Total Costs of Oil Production Chapter 6: Perfectly Competitive Supply

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? Chapter 6: Perfectly Competitive Supply

Output, Revenue, Costs, and Profit Employees per day Output (barrels/day) Total revenue ($/day) Profit Total cost MB MC 80 18.75 12.5 25 37.5 50 75 125 500 -500 1 8 640 650 -10 2 20 1600 800 3 26 1820 950 1130 4 30 2100 1100 1300 5 33 2310 1250 1390 6 35 2450 1400 7 36.2 2534 1550 1346 What will happen to the profit maximizing output if price falls to $40? Chapter 6: Perfectly Competitive Supply

Output, Revenue, Costs, and Profit What will happen to the profit maximizing output if price falls to $40? Chapter 6: Perfectly Competitive Supply

Output, Revenue, Costs, and Profit Employees per day Output (barrels/day) Total revenue ($/day) Profit Total cost MB MC 40 18.75 12.5 25 37.5 50 75 125 500 -500 1 8 320 650 -330 2 20 800 3 26 1040 950 90 4 30 1200 1100 100 5 33 1320 1250 70 6 35 1400 7 36.2 1448 1550 -102 What will happen to the profit maximizing output if: (a) employees receive a wage of $75/day; (b) fixed costs are $650? Chapter 6: Perfectly Competitive Supply

Output, Revenue, Costs, and Profit Employees per day Output (barrels/day) Total revenue ($/day) Profit Total cost MB MC 40 9.375 6.25 12.5 18.75 25 37.5 62.5 500 -500 1 8 320 575 -255 2 20 800 650 150 3 26 1040 725 315 4 30 1200 400 5 33 1320 875 445 6 35 1400 950 450 7 36.2 1448 1025 423 Wages drop to $75/day (fixed costs $500) Chapter 6: Perfectly Competitive Supply

Output, Revenue, Costs, and Profit Employees per day Output (barrels/day) Total revenue ($/day) Profit Total cost MB MC 40 18.75 12.5 25 37.5 50 75 125 650 -650 1 8 320 800 -480 2 20 950 -150 3 26 1040 1100 -60 4 30 1200 1250 -50 5 33 1320 1400 -80 6 35 1550 7 36.2 1448 1700 -252 Fixed costs are $650 (wages at $150/day). Profits are negative, but producer can cover some of fixed costs. Chapter 6: Perfectly Competitive Supply

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 Chapter 6: Perfectly Competitive Supply

Chapter 6: Perfectly Competitive Supply Average Variable Cost Variable cost divided by total output Chapter 6: Perfectly Competitive Supply

Short-run shutdown condition Determined by AVC Chapter 6: Perfectly Competitive Supply

Chapter 6: Perfectly Competitive Supply Average Total Cost Total cost divided by total output Chapter 6: Perfectly Competitive Supply

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 Chapter 6: Perfectly Competitive Supply

Chapter 6: Perfectly Competitive Supply Price = Marginal Cost: The Perfectly Competitive Firm’s Profit-Maximizing Supply Rule Price = 80 Price = $80/barrel P > MC at 35 barrels/day ATC =$40 /barrel P > ATC by $40/barrel Profit = 35 x $40 = $1400/day Total revenue profit Cost ($/barrel) Total cost Output (barrels/day) Less than 35 barrels/day P > MC and output should be increased More than 35 barrels/day P < MC and output should be decreased Chapter 6: Perfectly Competitive Supply

Chapter 6: Perfectly Competitive Supply Price = Marginal Cost: The Perfectly Competitive Firm’s Profit-Maximizing Supply Rule Price = $40/barrel P> MC at 30 barrels/day ATC =~ $36.7/barrel P > ATC by $3.3/barrel Profit = 350x $3.3 = $100/day profit Cost ($/barrel) Price = $40 Total revenue Total cost Output (barrels/day) Less than 30 barrels/day P > MC and output should be increased More than 30 barrels/day P < MC and output should be decreased Chapter 6: Perfectly Competitive Supply

Chapter 6: Perfectly Competitive Supply Price = Marginal Cost: The Perfectly Competitive Firm’s Profit-Maximizing Supply Rule Price = $20/barrel P = MC at 20 barrels/day ATC = $40/barrel P < ATC by $20/barrel Profit = -$20 x 20 = -400//day Profit (negative) Cost ($/barrel) Total cost Price = 20 Total revenue Output (barrels/day) Producer continues to produce at negative profit. Covers variable costs plus some of fixed costs. Chapter 6: Perfectly Competitive Supply

If a firm continues to produce even though it has a negative profit, it is safe to assume that: TC<TR Price > average variable cost Price > average total cost MC > Price The firm will close down in the short run

Profit-Maximizing Firms in Perfectly Competitive Markets The “Law” of Supply The perfectly competitive firm’s supply curve is its marginal cost curve MC 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. Chapter 6: Perfectly Competitive Supply

Chapter 6: Perfectly Competitive Supply 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. Recall Demand measures the benefit side of the market Supply measures the cost side of the market Chapter 6: Perfectly Competitive Supply

Determinants of Supply Technology Input prices e.g. labor in China Number of suppliers e.g. trade with China Expectations e.g. rising 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 Chapter 6: Perfectly Competitive Supply

Determinants of Supply What about the oil???? Chapter 6: Perfectly Competitive Supply

Supply and Producer Surplus The amount by which price exceeds the seller’s reservation price Chapter 6: Perfectly Competitive Supply

The Supply and Demand in the Market for Milk 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) = $4,000/day S D 3.00 2.50 Price ($/gallon) 2.00 1.50 1.00 .50 1 2 3 4 5 6 7 8 9 10 11 12 Quantity (1,000s of gallons/day) Chapter 6: Perfectly Competitive Supply

Producer Surplus in the Market for Milk Quantity (1,000s of gallons/day) Price ($/gallon) 1 .50 1.00 1.50 2.00 2.50 3.00 2 3 4 5 6 7 8 9 10 11 12 Producer surplus = $4,000/day S D Chapter 6: Perfectly Competitive Supply