Download Principles of Microeconomics

Perfectly Competitive Supply:
The Cost Side of The Market
1
Profit-Maximizing Firms and Perfectly
Competitive Markets
 A profit-maximizing firm is one whose primary goal
is to maximize profit, i.e. total revenue minus total cost.
 A perfectly competitive market is one in which no
individual supplier has any influence on the market
price of the good.
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Characteristics of Perfectly Competitive Market
 Homogeneous product
 Many buyers and sellers, each of which buys or
sells only a small fraction of the total quantity
exchanged
 Buyer and sellers are well-informed
 Rapid dissemination of accurate information at low
cost
 Free entry and exit into the market
 Productive resources are mobile
Profit-Maximizing Firms and Perfectly
Competitive Markets
 A price taker is a firm that has no influence over the
price of the product that it sells.
Laundry
Art reproduction
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Factors of production
 Factors of production are inputs used in the
production of a good or service.
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Fixed factor of production
 A fixed factor of production is an input whose
quantity cannot be altered in the short run.
 A typical fixed factor is capital
E.g., buildings or plants
Example: Transmission tower
for a student radio station.
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Variable factor of production
 A variable factor of production is an input whose
quantity can be altered in the short run.
 A typical variable factor is labor
E.g., workers or raw materials or plants
Example: Music library
for a student radio station.
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Total Product and Marginal Product
Total Product (TP)
The quantity of output produced by the firm in a
given period of time.
The total output is related to the input level of the
fixed and variable factors of production
 Marginal Product (MP)
The increase in total product due to hiring of one
additional unit of the variable factor (assuming quantities
of other factors are constant)
The Law of Diminishing Returns
Total no. of
Total no. of
employees/day
bats/Day
(TP)
Additional
no. of
bats/day
(MP)
0
0
1
40
40
2
100
60
3
130
30
4
150
20
5
165
15
6
175
10
7
181
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Note that output gains
begin to diminish
with the third
employee.
Economists refer to this
pattern as the law of
diminishing
returns, and it
always refers to
situations in which
the quantities of all
other factors are
fixed.
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Short Run and Long Run
Short Run (SR)
A period of time over which at least
one factor is fixed.
Long Run (LR)
A period of time over which all
factors are variable.
Example: Louisville Slugger uses two inputs
labor (e.g., woodworkers)…
and
capital (e.g., lathes, tools, buildings)
A lathe is a tool which spins a block of material to perform
various operations such as cutting, sanding, knurling, or
deformation with tools that are applied to the workpiece to
create an object which has symmetry about an axis of
rotation.
… to transform raw materials (e.g., lumber)
…into finished output (baseball bats).
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Fixed Cost
 Suppose the lease payment for the Louisville Slugger’s
lathe and factory is $80 per day.
 This payment is a fixed cost (since it does not depend
on the number of bats per day the firm makes)
FC = rK
r: Price of renting a unit of capital service (rental rate)
K: No. of unit of the capital service
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Variable Cost
 The company’s payment to its employees is called
variable cost, because unlike the fixed cost, it varies
with the number of bats the company produces.
VC = wL
w: Price of hiring a unit of labor service (wage rate)
L: No. of unit of labor service
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Total Cost
 The firm’s total cost is the sum of its fixed and
variable costs:
Total cost = Fixed Cost + Variable Cost
TC = FC + VC
TC = rK + wL
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Marginal Cost
 The firm’s marginal cost is the change in total cost
divided by the corresponding change in output.
MC = DTC/DQ
MC = DVC/DQ
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Example: Louisville Slugger
 If Louisville slugger pays a fixed cost of $80 per day,
and to each employee a wage of $24/day, calculate the
company’s output, variable cost, total cost and marginal
cost for each level of employment.
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Example: Louisville Slugger
Employees
per day
Bats per
day
Fixed Cost
($ per day)
Variable
Cost ($/day)
Total Cost
($/day)
Marginal Cost
($/bat)
0
0
80
0
80
1
40
80
24
104
0.6 (=24/40)
2
100
80
48
128
0.4(=24/60)
3
130
80
72
152
0.8(=24/30)
4
150
80
96
176
1.2(=24/20)
5
165
80
120
200
1.6(=24/15)
6
175
80
144
224
2.4(=24/10)
7
181
80
168
248
4.0(=24/6)
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Choosing Output to Maximize Profit
 If a company’s goal is to maximize its profit, it should
continue to expand its output as long as the marginal
benefit from expanding is at least as great as the
marginal cost.
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Example: Louisville Slugger (Continued)
 Suppose the wholesale price of each bat (net of lumber
and other materials costs) is $2.50.
 How many bats should Louisville Slugger produce?
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Example: Louisville Slugger (Continued)
 If we compare this marginal benefit ($2.50 per bat) with the marginal
cost entries shown in table, we see that the firm should keep
expanding until it reaches 175 bats per day (6 employees per day).
Employees
per day
Bats per day
Fixed Cost
($ per day)
Variable
Cost ($/day)
Total Cost
($/day)
Marginal
Cost ($/bat)
0
0
80
0
80
1
40
80
24
104
0.6
2
100
80
48
128
0.4
3
130
80
72
152
0.8
4
150
80
96
176
1.2
5
165
80
120
200
1.6
6
175
80
144
224
2.4
7
181
80
168
248
4.0
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Example: Louisville Slugger (Continued)
 To confirm that the cost-benefit principle thus applied identifies
the profit-maximizing number of bottles to produce, we can
calculate profit levels directly:
Employees per
day
Output
(bats/day)
Total revenue
($/day)
Total cost
($/day)
Profit
($/day)
0
0
0
80
-80
1
40
100
104
-4
2
100
250
128
122
3
130
325
152
173
4
150
375
176
199
5
165
412.50
200
212.50
6
175
437.50
224
213.50
7
181
452.50
248
204.50
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Choosing Output to Maximize Profit
 According to the law of diminishing returns, marginal
cost increases as the firm expands production.
 The firm's best option is to keep expanding output as
long as marginal cost is less than price, i.e. marginal
benefit of production.
 In equilibrium, the profit maximizing output level for a
perfectly competitive firm:
P = MC
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Caveat: Production at a loss when P=MC
 If the company's fixed cost was more than $213.50 per day (say,
$300/day), it would have made a loss at every possible level of
output.
Employees per
day
Output
(bats/day)
Total revenue
($/day)
Total cost
($/day)
Profit
($/day)
0
0
0
300
-300
1
40
100
324
-224
2
100
250
348
-98
3
130
325
372
-47
4
150
375
396
-21
5
165
412.50
420
-7.5
6
175
437.50
444
-6.5
7
181
452.50
468
-15.6
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Choosing Output to Maximize Profit in the SR
 In the short run (SR), the fixed cost is unavoidable and
does not affect the output decision in the SR.
 As the firm’s fixed cost is a sunk cost, the firm’s best
bet would have been to continue producing 175 bats
per day, because a smaller loss is better than a larger
one.
 If a firm continues to face the same situation in the
long run (LR), it would be better for the firm to get out
of the bat business completely as soon as its equipment
lease is expired.
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Shut-Down Condition in the Short Run
 It might seem that a firm that can sell as many output
as it wishes at a constant market price would always do
best in the short run by producing and selling the
output level for which price equals marginal cost.
 But there is an exception to this rule.
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Shut-Down Condition in the Short Run
 Suppose, for example, that the market price of the
firm’s product falls so low that its revenue from sales is
smaller than its variable cost at all possible levels of
output.
 The firm should shut down its production
 By shutting down, it will suffer a loss equal to its fixed cost.
 By continuing production, it would suffer an even larger loss
(than its fixed cost).
Shutdown Condition:
 Shut down production if total revenue is less than
variable costs.
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Choosing Output to Maximize Profit in the LR
Average total cost:
ATC = TC/Q.
Profit = total revenue – total cost
= PxQ – ATCxQ
= (P – ATC) Q
A firm is profitable only if the price of its product price
(P) exceeds its ATC.
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A Graphical Approach to Profit-Maximization
Properties of the cost curves:
 The upward sloping portion
of the marginal cost curve
(MC) corresponds to the
region of diminishing returns.
 The marginal cost curve
must intersect both the
average variable cost curve
(AVC) and the average total
cost curve (ATC) at their
respective minimum points.
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Modified Louisville Slugger Example
 For the bat-maker whose cost curves are shown in the
next slide, find the profit-maximizing output level if bats
sell for $0.80 each.
 How much profit will this firm earn?
 What is the lowest price at which this firm would
continue to operate in the short run?
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Modified Louisville Slugger Example
 The cost-benefit
principle tells us that
MC
this firm should
ATC
continue to expand as
AVC
long as price is at least
as great as marginal
cost.
Price
 If the firm follows this
rule it will produce 130
bats per day, the
quantity at which price
and marginal cost are
equal.
$/bat
1.40
1.32
1.20
1.00
0.80
0.60
0.48
0.40
0.28
80 100
130
150
Bats/day
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Modified Louisville Slugger Example
$/bat
1.40
1.32
1.20
1.00
MB 0.80
0.60
0.48
MC 0.40
0.28
 Suppose that the firm
had sold any amount
MC
less than 130—say, only
ATC
100 bats per day.
AVC
 Its benefit from
expanding output by
one bat would then be
Price
the bat's market price,
80 cents.
 The cost of expanding
output by one bat is
equal (by definition) to
the firm’s marginal cost,
Bats/day
80 100 130
which at 100 bats per
150
day is only 40 cents.
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Modified Louisville Slugger Example
$/bat
1.40
1.32
1.20
1.00
MB 0.80
0.60
0.48
MC 0.40
0.28
 So by selling the 101st
bat for 80 cents and
MC
producing it for an extra
ATC
cost of only 40 cents,
AVC
the firm will increase its
profit by 80 – 40 = 40
cents per day.
Price
 In a similar way, we can
show that for any
quantity less than the
level at which price
equals marginal cost,
the seller can boost
Bats/day
80 100 130
profit by expanding
150
production.
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Modified Louisville Slugger Example
$/bat
1.40
MC 1.32
1.20
1.00
MB 0.80
0.60
0.48
0.40
0.28
 Conversely, suppose that
the firm were currently
MC
selling more than 130
ATC
bats per day—say, 150—
AVC
at a price of 80 cents
each.
 Marginal cost at an output
Price
of 150 is 1.32 per bat. If
the firm then contracted
its output by one bat per
day, it would cut its costs
by 1.32 cents while losing
only 80 cents in revenue.
Bats/day
80 100 130
As a result, its profit
150
would grow by 52 cents
per day.
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Modified Louisville Slugger Example
 The same arguments can be made regarding any
quantities that differ from 130.
 Thus, if the firm were selling fewer than 130 bats per
day, it could earn more profit by expanding; and that if
it were selling more than 130, it could earn more by
contracting.
 So at a market price of 80 cents per bat, the seller
maximizes its profit by selling 130 units per week, the
quantity for which price and marginal cost are exactly
the same.
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Modified Louisville Slugger Example
Total revenue = PxQ
= ($0.80/bat)x(130 bats/day)
= $104 per day.
Total cost = ATCxQ
= $0.48/bat x 130 bats/day
= $62.40/day
So the firm’s profit is $41.60/day.
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Modified Louisville Slugger Example
 Profit is equal to (P – ATC)xQ, which is equal to the
area of the shaded rectangle.
MC
$/bat
ATC
AVC
0.80
Price
Profit = $41.60/day
0.48
130
Bats/day
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End
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