More on supply Today: Supply curves, opportunity cost, perfect competition, and profit maximization

In previous lectures… …we have studied demand Today, we start supply Some concepts from demand carry over to supply Horizontal addition Surplus

Core principles, revisited It is important to think like an economist when looking at supply Opportunity cost: Important in decision making Cost-benefit analysis: Economic profit includes not only explicit costs, but also implicit costs Costs can be fixed or variable Some firms may operate at a loss in the short run MB = MC rule (except under shutdown condition)

Today Idea of perfect competition Very little or no market power by any firm Individual supply to market supply Opportunity costs The first steps to profit maximization

Perfect competition For all discussion until Ch. 8 (monopoly), assume that all markets are perfectly competitive, unless mentioned otherwise In perfect competition, there are many firms, each of which produces a very small percentage of the good in question

Perfect competition Each firm has no significant control over price charged under perfect competition Perfectly competitive markets do not necessarily occur when product differentiation occurs This will also be addressed in Ch. 8

Perfect competition Since each firm has no control over price, each firm is called a price taker In this example, market equilibrium is $5 Each firm can sell as much of the good it wants at $5/lb.

Perfect competition How much will each firm sell? Theory Each firm will sell the output that maximizes profits Basic idea related to theory Sell another unit if profit goes up

The steps to profit maximization Profit = Total revenue – Total cost = Total revenue – Variable Cost – Fixed Cost Opportunity costs are included in the total cost when calculating economic profit

Opportunity cost Always think “what is the best use of my time?” Assume that you have 10 hours per week for jobs Building widgets, which sell for $1 each Working at an I.V. coffee shop for $10/hr. Assume that material costs for widgets and walking costs to I.V. are negligible

Opportunity cost Should I only build widgets, since I am making positive profits for each widget produced? Maybe For each widget I build, I must work less at the coffee shop Similar logic applies to working at the coffee shop

Supply of widgets and coffee shop work How much should I work at each job? To make the most money, of course Remember that marginal analysis is important in making the most money

Widget production function Hours of widget production Total number of widgets built Additional widgets built

Why diminishing marginal productivity? Assume that widget production is labor- intensive You will pick your most productive work hour each week to be the first hour of work on widgets You use the best opportunities to be the most productive

How many widgets should I build? Again, we use marginal analysis in maximizing your earnings for your 10 hours available for work each week I should build widgets as long as: MB ≥ MC (in dollars)

How many widgets should I build? MB of 1 st hour of work: $15 MB of 2 nd hour of work: $13 MB of 3 rd hour of work: $11 MB of 4 th hour of work: $9 MC of each hour of widget building is the $10 lost in wages from working at the coffee shop

How many widgets should I build? Is MB ≥ MC? 1 st hour?  Yes, since $15 > $10 2 nd hour?  Yes, since $13 > $10 3 rd hour?  Yes, since $11 > $10 4 th hour?  No, since $9 < $10

How many widgets should I build? You should build widgets for 3 hours/week, earning $39 from widgets You should work 7 hours/week, earning $70 from work Total earnings: $109/week Marginal analysis  Maximize earnings

Deriving individual supply From previous example: If price of widgets goes up, I would want to spend more time building widgets As price goes up, quantity supplied increases If price of widgets goes down, I would want to spend less time building widgets As price goes down, quantity supplied decreases We have justified an upward-sloping supply curve

Market supply Horizontal addition from individual supply to market supply We did this already with demand

Moving on… Today, we will not start analyzing the costs necessary to analyze profit maximization We will look at this on Wednesday

Long run By definition, the long run is such that all costs are variable Analysis in the long run is easier than in the short run In the long run, profits are maximized to be either positive or at zero

Fixed costs in the short run The short run is defined such that some costs must be spent, whether or not a firm operates The costs that must be spent are fixed costs Fixed cost examples could include: Rent Capital (e.g. manufacturing equipment) Contract laborers

Simplified analysis Although there may be many fixed costs and many variable costs, we will study a simple case One fixed cost: Building rent One variable cost: Labor costs

Graphical approach? A graphical approach is best used with continuous cost functions We will start with a discrete example on Wednesday