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

2. 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

3. 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

4. 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

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
Chapter 6: Perfectly Competitive Supply

6. Employment and Output for an oil producer
Total number of employees per day Total number of barrels per day
1 8
3 26
4 30
5 33
6 35
Observation
Output gains from each additional worker begins to diminish with the third employee
Chapter 6: Perfectly Competitive Supply

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

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
Chapter 6: Perfectly Competitive Supply

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
Chapter 6: Perfectly Competitive Supply

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
Chapter 6: Perfectly Competitive Supply

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?
Chapter 6: Perfectly Competitive Supply

12. 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

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

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?
Chapter 6: Perfectly Competitive Supply

15. 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

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

17. 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

18. 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

19. 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

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
Chapter 6: Perfectly Competitive Supply

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

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

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

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
Chapter 6: Perfectly Competitive Supply

25. 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

26. 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

27. 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

28. 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

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.
Chapter 6: Perfectly Competitive Supply

30. 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

31. 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

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

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

34. 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

35. 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