Imagine that you are the owner and CEO of a very small firm You have a plot of land (already paid for) You can hire workers to help you –More workers, more output –Of course, you must pay the workers Many other firms are in the market too Your decision is how much to produce –You look at the price and then decide

Assumption about the firm’s behavior General economic principle –People –make purposeful choices –with limited resources When applied to the behavior of firms –Firms –maximize profits –subject to a production function relating output to inputs

Profits = total revenue - total costs Total revenue –Price times quantity –P x Q Total costs –cost of everything used to produce the product, including opportunity costs –economic profits rather than accounting profits

Key assumption of competition: The firm is a price taker

Finding Total Revenue (T6.1)

Finding Total Costs Start with the firm’s production function –Relates firm’s output (shoes, CDs, pumpkins) to the firm’s inputs (labor) Marginal product of labor Diminishing returns to labor –marginal product of labor decreases with more labor input

From Total Costs to Marginal Cost (T6.3)

Now, use profit maximization to derive the supply curve Plot marginal costs for the firm Consider different prices Find the quantity supplied at each price The result is the supply curve

An Important Conclusion: MC = P The firm chooses a quantity to produce such that the marginal cost (MC) equals the price (P) When I see a supply curve, I think of the marginal cost to firms The supply curve slopes upward because marginal cost is increasing

Producer Surplus Producer surplus is the area above the supply curve and below the price What is the difference between producer surplus and profits? profits = producer surplus minus fixed costs

Market Supply Curve Consider all firms in the market Add up quantity supplied by all firms at each price to get market supply Add horizontally