Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 6-1 Chapter 6 Perfectly competitive supply: the cost side of the market

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 6-2 Thinking about supply: the importance of opportunity cost Example –How much time should Harry spend recycling soft-drink containers?

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 6-3 Thinking about supply: the importance of opportunity cost Harry is choosing between washing dishes for $6/hour and collecting containers at 2 cents each. Opportunity cost of collecting cans is $6/hour.

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 6-4 Example Search time (hours/day) Total number of containers found Additional number of containers found

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 6-5 Thinking about supply: the importance of opportunity cost Costs and benefits –1 hour collecting cans = (600)(.02) = $12 –Benefit ($12) > Opportunity cost ($6) –2nd hour benefit ($8) > Opportunity cost ($6) –3rd hour benefit ($6) = Opportunity cost ($6)

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 6-6 Thinking about supply: the importance of opportunity cost Question –What is the lowest redemption price that would induce Harry to recycle 1 hour/day? Solution –600 containers x 1 cent = $6 = opportunity cost of washing dishes

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 6-7 Thinking about supply: the importance of opportunity cost Reservation price

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 6-8 Thinking about supply: the importance of opportunity cost 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

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 6-9 Individual and market supply curves The relationship between the individual and market supply curves for a product is analogous to the relationship between the individual and market demand curves.

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 6-10 Harry’s individual supply curve for recycling services Recycled cans (100s of cans/day) Refund (cents/can) Harry’s supply curve

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 6-11 The market supply curve for recycling services Recycled cans (100s of cans/day) Recycled cans (100s of cans/day) Refund (cents/can) Harry’s supply curve Barry’s supply curve

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 6-12 Recycled cans (100s of cans/day) Refund (cents/can) = = The market supply curve for recycling services Market supply curve

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 6-13 The market supply curve with 1000 identical sellers Recycled cans ( s of cans/day) Refund (cents/can) Market supply curve

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 6-14 Thinking about supply: the importance of opportunity cost What do you think? –Why is the supply curve upward sloping?

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 6-15 Supply in perfectly competitive markets Profit maximisation –Profit  Total revenue - All costs (explicit & implicit)  Profit-maximising firms Goal of the firm is to maximise the difference between total revenues and total costs, i.e. to maximise the profit it earns.

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 6-16 Supply in perfectly competitive markets The perfectly competitive market –A market in which no individual supplier has any influence on the market price of the product. A price taker –A firm that has no influence over the price at which it sells its product.

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 6-17 Perfectly competitive markets The characteristics of perfect competition 1.All firms sell the same standardised product. 2.The market has many buyers and sellers, each of which buys or sells only a small fraction of the total quantity exchanged.

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 6-18 Perfectly competitive markets The characteristics of perfect competition 3.Sellers are able to enter and leave a market as they like. 4.Buyers and sellers are well informed.

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 6-19 The demand curve facing a perfectly competitive firm P0P0 Q0Q0 S D Market quantity (units/month) Price ($/unit) Market supply and demand

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 6-20 DiDi P0P0 The demand curve facing a perfectly competitive firm Price ($/unit) Individual firm’s quantity (units/month) Individual firm demand

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 6-21 Production in the short run Concepts of production –Factor of production  An input used in the production of a good or service. –Short run  A period of time sufficiently short that at least one of the firm’s factors of production are fixed. –Long run  A period of time of sufficient length that all the firm’s factors of production are variable.

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 6-22 Production in the short run Concepts of production –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. –Fixed factor of production  An input whose quantity cannot be altered in the short run. –Variable factor of production  An input whose quantity can be altered in the short run.

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 6-23 Production in the short run Assume –A company makes glass bottles. –Two factors of production  Labour (variable)  Capital (fixed) A bottle-making machine.

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 6-24 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

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 6-25 Cost in the short run Some important cost concepts –Assume  The cost of the bottle-making machine is $40 per day and it is a fixed cost. –Fixed cost  The sum of all payments made to a firm’s fixed factors of production.

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 6-26 Cost in the short run Some important cost concepts –Assume  The cost of labour is $12 per worker and is a variable cost. –Variable cost  The sum of all payments made to the firm’s variable factors of production.

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 6-27 Fixed, variable, marginal and total costs of bottle production Employees per day Bottles per day Fixed cost ($/day) Variable cost ($/day) Total cost ($/day) Marginal cost ($/bottle)

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 6-28 Costs in the short run Some important cost concepts –Total cost  Sum of fixed and variable cost of production. –Marginal cost  The changes in total cost divided by the corresponding change in output.

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 6-29 Choosing output to maximise profit Example –If a bottle sells for $0.35, how many bottles should the company described in Table 6.2 of your textbook [slide 27] produce each day?

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 6-30 Output, revenue, costs and profit of bottle production Employees per day Output (bottles/day) Total revenue ($/day) Profit ($/day) Total cost ($/day) MB =.35 MC =.15 MC =.10 MC =.20 MC =.33 MC =.44 MC =.60 MC = 1.00 What will happen to the profit-maximising output if: (a) employees receive a wage of $6/day; (b) fixed costs are $45?

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 6-31 Supply in perfectly competitive markets A note on the firm’s shutdown condition –When producing at a loss, a firm must cover its variable cost to minimise losses.  Short-run shutdown condition

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 6-32 Thinking in terms of average costs Average variable cost and average total cost –Average variable cost  Variable cost divided by total output.

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 6-33 Thinking in terms of average costs Average variable cost and average total cost –Short-run shutdown condition  A firm should shut down and produce nothing in the short run when P x Q < VC for all levels of Q, or

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 6-34 Thinking in terms of average costs Average variable cost and average total cost –Average total cost (ATC)  Total cost divided by total output

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 6-35 Thinking in terms of average costs Average variable cost and average total cost –Profits = TR – TC or (P x Q) - (ATC x Q) –To be profitable: P > ATC

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 6-36 Showing profit maximisation graphically Average variable cost (AVC), average total cost (ATC) and marginal cost (MC)

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 6-37 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)

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan Upward-sloping MC corresponds to diminishing returns MC = AVC & ATC at their minimum points MC The short-run marginal, average variable and average total cost curves for a bottle manufacturer Cost ($/bottle) 0.05 Output (bottles/day) ATC AVC

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 6-39 MC ATC AVC Price = Marginal cost: the maximum-profit condition 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 maximising output: P = MC

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan Price = MC at 260 bottles/day ATC =.12/bottle TR = (.20)(260) = $52/day TC = (.12)(26) = $31.20/day Profit = $52 - $31.20 = $20.80/day Price Price = Marginal cost: The perfectly competitive firm’s profit-maximising supply rule Output (bottles/day) Cost ($/bottle) MC ATC AVC

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 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 profit-maximising firm that is making a loss in the short run Output (bottles/day) Cost ($/bottle) MC ATC AVC

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 6-42 Supply in perfectly competitive markets The law of supply –The perfectly competitive firm’s supply curve is its marginal cost curve. –Every quantity of output along the market supply curve represents the summation of all the quantities individual sellers offer at the corresponding price.

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 6-43 Profit-maximising firms in perfectly competitive markets 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.

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 6-44 Determinants of supply revisited Determinants of supply –Technology –Input prices –Expectations –Changes in prices of other products –The number of suppliers

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 6-45 Applying the theory of supply Thinking as an economist –Why are bottle recycling rates higher in South Australia than in other states?

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 6-46 Applying the theory of supply Example –What is the socially optimal amount of recycling of glass containers?

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 6-47 The market supply curve of container recycling services for Burnside, South Australia Number of containers recycled (1000s of containers/day) Refund price (cents/container) Market supply curve of glass container recycling services citizens would pay 6 cents for each container which equals marginal benefit The local government pays 6 cents/container The optimal quantity of containers is /day where MC(.06) = marginal benefit

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 6-48 Applying the theory of supply What do you think? –Will all containers be removed from the environment at $0.06/container? –Why is the optimal amount of removal /day? –Will private individuals choose to remove containers/day?

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 6-49 Supply and producer surplus Producer surplus (or seller’s surplus) –The difference between the amount actually received by the seller of a good and the seller’s reservation price.

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 6-50 Calculating producer surplus in the market for fish Quantity (1000s of kg/day) Price ($/kg) S D Equilibrium P = $2 & Q = 4000 Producer surplus is the difference between $2 and the reservation price at each quantity. Producer surplus = (1/2)(4000 day)($2/kg) = $4000/day.

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 6-51 Producer surplus in the market for fish Quantity (1000s of kg/day) Price ($/kg) Producer surplus = $4000/day S D