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

MBMC Copyright c 2004 by The McGraw-Hill Companies, 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 fertilizers B. The land C. The barn D. The machinery E. All of the above

MBMC Copyright c 2004 by The McGraw-Hill Companies, 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 fertilizers B. The land C. The cows D. The machinery E. All of the above

MBMC Copyright c 2004 by The McGraw-Hill Companies, 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

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 6: Perfectly Competitive Supply Slide 5 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

MBMC Copyright c 2004 by The McGraw-Hill Companies, 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 Observation Output gains from each additional worker begins to diminish with the third employee

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 6: Perfectly Competitive Supply Slide 7 Employment and Output for an oil producer

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 6: Perfectly Competitive Supply Slide 8 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

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 6: Perfectly Competitive Supply Slide 9 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

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 6: Perfectly Competitive Supply Slide 10 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

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 6: Perfectly Competitive Supply Slide 11 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?

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 6: Perfectly Competitive Supply Slide 12 Fixed, Variable, and Total Costs of Oil Production Employees per day Barrels per day Fixed cost ($/day) Variable cost ($/day) Total cost ($/day) Marginal cost ($/barrel) What costs are conspicuously absent?

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 6: Perfectly Competitive Supply Slide 13 Fixed, Variable, and Total Costs of Oil Production

MBMC Copyright c 2004 by The McGraw-Hill Companies, 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?

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. MBMC Chapter 6: Perfectly Competitive Supply Slide 15 Output, Revenue, Costs, and Profit Employees per 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?

MBMC Copyright c 2004 by The McGraw-Hill Companies, 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?

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 6: Perfectly Competitive Supply Slide 17 Output, Revenue, Costs, and Profit Employees per 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? MBMC

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 6: Perfectly Competitive Supply Slide 18 Output, Revenue, Costs, and Profit Employees per day Output (barrels/day) Total revenue ($/day) Profit ($/day) Total cost ($/day) Wages drop to $75/day (fixed costs $500) MBMC

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 6: Perfectly Competitive Supply Slide 19 Output, Revenue, Costs, and Profit Employees per 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. MBMC

MBMC Copyright c 2004 by The McGraw-Hill Companies, 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

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 6: Perfectly Competitive Supply Slide 21 Average Variable Cost Variable cost divided by total output

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 6: Perfectly Competitive Supply Slide 22 Short-run shutdown condition Determined by AVC

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 6: Perfectly Competitive Supply Slide 23 Average Total Cost Total cost divided by total output

MBMC Copyright c 2004 by The McGraw-Hill Companies, 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

MBMC Copyright c 2004 by The McGraw-Hill Companies, 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) Cost ($/barrel) 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

MBMC Copyright c 2004 by The McGraw-Hill Companies, 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) Cost ($/barrel) 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 revenue Total 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

MBMC Copyright c 2004 by The McGraw-Hill Companies, 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) Cost ($/barrel) 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

MBMC Copyright c 2004 by The McGraw-Hill Companies, 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<TR B. Price > average variable cost C. Price > average total cost D. MC > Price E. The firm will close down in the short run

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 6: Perfectly Competitive Supply Slide 29 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.

MBMC Copyright c 2004 by The McGraw-Hill Companies, 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. Recall Demand measures the benefit side of the market Supply measures the cost side of the market

MBMC Copyright c 2004 by The McGraw-Hill Companies, 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

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 6: Perfectly Competitive Supply Slide 32 Determinants of Supply What about the oil????

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 6: Perfectly Competitive Supply Slide 33 Supply and Producer Surplus Producer Surplus The amount by which price exceeds the seller’s reservation price

MBMC Copyright c 2004 by The McGraw-Hill Companies, 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) 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

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 6: Perfectly Competitive Supply Slide 35 Producer Surplus in the Market for Milk Quantity (1,000s of gallons/day) Price ($/gallon) Producer surplus = $4,000/day S D