Download L11 Producer econ 2

Perfectly Competitive
Supply: The Cost
Side of The Market
Part II
MB
MC
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Quiz

Which of the following is a variable
factor of production on a local farm over
the next month?
A.
B.
C.
D.
E.
The pesticides and fertilizers
The land
The barn
The machinery
All of the above
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
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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
Copyright c 2004 by The McGraw-Hill
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Chapter 6: Perfectly Competitive Supply
Slide 3
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Quiz

Which of the following is a variable
factor of production on a local farm over
the 10 years?
A.
B.
C.
D.
E.
The pesticides and fertilizers
The land
The cows
The machinery
All of the above
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
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Profit-Maximizing Firms in
Perfectly Competitive Markets
Assume
 An oil company produces barrels of oil
 Two factors of production
Labor (variable)
 Capital (fixed)

 An
Copyright c 2004 by The McGraw-Hill
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oil well
Chapter 6: Perfectly Competitive Supply
Slide 5
Employment and Output
for an oil producer
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Total number of employees per day
Total number of barrels per day
0
0
1
8
2
3
4
Observation
Output gains from each
additional worker begins
to diminish with the
third employee
20
26
30
5
33
6
35
7
36.2
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Chapter 6: Perfectly Competitive Supply
Slide 6
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Employment and Output
for an oil producer
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Companies, Inc. All rights reserved.
Chapter 6: Perfectly Competitive Supply
Slide 7
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
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
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Chapter 6: Perfectly Competitive Supply
Slide 8
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
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
Copyright c 2004 by The McGraw-Hill
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Chapter 6: Perfectly Competitive Supply
Slide 9
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
Profit-Maximizing Firms in
Perfectly Competitive Markets
Some Important Cost Concepts

Assume
 The
cost of labor is $150/worker/day and is a
variable cost.
 Workers can be hired or fired at will

Variable cost
 The
sum of all payments made to the firm’s
variable factors of production
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Chapter 6: Perfectly Competitive Supply
Slide 10
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Some Important Cost Concepts

Total Cost


Fixed cost + variable cost
Marginal Cost

Measures how total cost changes with a
change in output
TC
MC 
Output

What’s the impact of fixed costs on MC?
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Chapter 6: Perfectly Competitive Supply
Slide 11
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Employees
per day
Fixed, Variable, and Total
Costs of Oil Production
Barrels
per day
Fixed cost
($/day)
Variable cost
($/day)
Total cost
($/day)
0
0
500
0
500
1
8
500
150
650
2
20
500
300
800
3
26
500
450
950
4
30
500
600
1100
5
33
500
750
1250
6
35
500
900
1400
7
36.2
500
1050
1550
Marginal cost
($/barrel)
18.75
12.5
25
37.5
50
75
125
What costs are conspicuously absent?
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Chapter 6: Perfectly Competitive Supply
Slide 12
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Fixed, Variable, and Total
Costs of Oil Production
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Chapter 6: Perfectly Competitive Supply
Slide 13
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What are the benefits of production?






Total benefit = total revenue
Total revenue = barrels sold x price
So what is marginal benefit?
Barrels sell for $80 each
Profit = TR – TC
When do you think profit is maximized?
Copyright c 2004 by The McGraw-Hill
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Chapter 6: Perfectly Competitive Supply
Slide 14
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Output, Revenue, Costs, and Profit
Employees
per day
Output
(barrels/day)
Total revenue
($/day)
0
0
0
1
8
640
2
20
1600
3
26
1820
4
30
2100
5
33
2310
6
35
2450
7
36.2
2534
MB
80
80
80
80
80
80
80
Total cost
($/day)
500
650
800
950
1100
1250
1400
1550
MC
18.75
12.5
25
37.5
50
75
125
Profit
($/day)
-500
-10
800
1130
1300
1390
1400
1346
What will happen to the profit maximizing output if price falls to
Copyright c 2004 by The McGraw-Hill
Chapter 6: Perfectly Competitive Supply
Slide 15
$40?
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Inc. All rights reserved.
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Output, Revenue, Costs, and Profit
What will happen to the profit maximizing output if price falls to
Copyright c 2004 by The McGraw-Hill
Chapter 6: Perfectly Competitive Supply
Slide 16
$40?
Companies,
Inc. All rights reserved.
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Output, Revenue, Costs, and Profit
Employees
per day
Output
(barrels/day)
Total revenue
($/day)
0
0
0
1
8
320
2
20
800
3
26
1040
4
30
1200
5
33
1320
6
35
1400
7
36.2
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MB
40
40
40
40
40
40
40
Total cost
($/day)
500
650
800
950
1100
1250
1400
1550
MC
18.75
12.5
25
37.5
50
75
125
Profit
($/day)
-500
-330
0
90
100
70
0
-102
What will happen to the profit maximizing output if:
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Chapter 6: Perfectly Competitive Supply
Slide 17
(a)Inc.employees
Companies,
All rights reserved. receive a wage of $75/day; (b) fixed costs are $650?
MB MC
Output, Revenue, Costs, and Profit
Employees
per day
Output
(barrels/day)
Total revenue
($/day)
0
0
0
1
8
320
MB
40
40
Total cost
($/day)
500
575
9.375
6.25
-500
-255
2
20
800
3
26
1040
4
30
1200
5
33
1320
40
875
25
445
6
35
1400
40
950
37.5
450
7
36.2
1448
40
1025
62.5
423
40
40
650
MC
Profit
($/day)
725
800
12.5
18.75
150
315
400
Wages drop to $75/day (fixed costs $500)
Copyright c 2004 by The McGraw-Hill
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Chapter 6: Perfectly Competitive Supply
Slide 18
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Output, Revenue, Costs, and Profit
Employees
per day
Output
(barrels/day)
Total revenue
($/day)
0
0
0
1
8
320
2
20
800
3
26
1040
4
30
1200
5
33
1320
6
35
1400
7
36.2
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MB
40
40
40
40
40
40
40
Total cost
($/day)
650
800
950
1100
1250
1400
1550
1700
MC
18.75
12.5
25
37.5
50
75
125
Profit
($/day)
-650
-480
-150
-60
-50
-80
-150
-252
Fixed costs are $650 (wages at $150/day). Profits are negative, but
Copyright c 2004 by The McGraw-Hill
Chapter 6: Perfectly Competitive Supply
Slide 19
producer
can cover some
of fixed costs.
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When will a firm shut down?

When producing at a loss, a firm must
cover its variable cost to minimize
losses.

Short-run shutdown condition
PxQ  VC for all levels of Q
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Chapter 6: Perfectly Competitive Supply
Slide 20
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Average Variable Cost

Variable cost divided by total output
VC
Q
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Chapter 6: Perfectly Competitive Supply
Slide 21
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Short-run shutdown condition

Determined by AVC
P  minimum value of AVC
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Chapter 6: Perfectly Competitive Supply
Slide 22
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Average Total Cost

Total cost divided by total output
TC
Q
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Chapter 6: Perfectly Competitive Supply
Slide 23
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Long Run Shutdown condition




Determined by ATC
Profits = TR – TC or (P x Q) - (ATC x Q)
To be profitable: P > ATC
Long run Shutdown condition P < ATC
for all Q
Copyright c 2004 by The McGraw-Hill
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Chapter 6: Perfectly Competitive Supply
Slide 24
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Price = Marginal Cost: The Perfectly
Competitive Firm’s Profit-Maximizing Supply Rule
Price = 80
Cost ($/barrel)
Total revenue
profit
•Price = $80/barrel
•P > MC at 35 barrels/day
•ATC =$40 /barrel
•P > ATC by $40/barrel
•Profit = 35 x $40 = $1400/day
Total cost
Output (barrels/day)
•Less than 35 barrels/day P > MC and output should be increased
•More than 35 barrels/day P < MC and output should be decreased
Copyright c 2004 by The McGraw-Hill
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Chapter 6: Perfectly Competitive Supply
Slide 25
Cost ($/barrel)
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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
Price = $40
Total revenue
Total cost
Output (barrels/day)
•Less than 30 barrels/day P > MC and output should be increased
•More than 30 barrels/day P < MC and output should be decreased
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 6: Perfectly Competitive Supply
Slide 26
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Price = Marginal Cost: The Perfectly
Competitive Firm’s Profit-Maximizing Supply Rule
Cost ($/barrel)
•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)
Total cost
Price = 20
Total revenue
Output (barrels/day)
Producer continues to produce at negative profit.
Covers variable costs plus some of fixed costs.
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 6: Perfectly Competitive Supply
Slide 27
MB MC
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

Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
MB MC

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.

Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 6: Perfectly Competitive Supply
Slide 29
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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 c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 6: Perfectly Competitive Supply
Slide 30
MB MC
Determinants of Supply


Technology
Input prices


Number of suppliers


e.g. rising prices
Changes in prices of other products


e.g. trade with China
Expectations


e.g. labor in China
i.e. opportunity costs
Subsidies, implicit and explicit

e.g. the energy sector and the new clean air laws
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Chapter 6: Perfectly Competitive Supply
Slide 31
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Determinants of Supply
What
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about the oil????
Chapter 6: Perfectly Competitive Supply
Slide 32
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Supply and Producer Surplus

Producer Surplus

The amount by which price exceeds the
seller’s reservation price
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 6: Perfectly Competitive Supply
Slide 33
The Supply and
Demand in the Market for Milk
MB MC
•Equilibrium P = $2 & Q = 4,000
S
3.00
Price ($/gallon)
•Producer surplus is the difference
between $2 and the reservation
price at each quantity
•Producer surplus =
(1/2)(4,000 gallons/day)($2/gallon)
= $4,000/day
2.50
2.00
1.50
1.00
D
.50
0
1
2
3
4
5
6
7
8
9
10
11
12
Quantity (1,000s of gallons/day)
Copyright c 2004 by The McGraw-Hill
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Chapter 6: Perfectly Competitive Supply
Slide 34
MB MC
Producer Surplus in the Market for Milk
S
Price ($/gallon)
3.00
2.50
2.00
Producer surplus
= $4,000/day
1.50
1.00
D
.50
0
1
2
3
4
5
6
7
8
9
10
11
12
Quantity (1,000s of gallons/day)
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 6: Perfectly Competitive Supply
Slide 35