Download Chapter 6

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
6-1
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
6-2
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
6-3
Example
Search time
(hours/day)
0
Total number of
containers found
Additional number of
containers found
0
600
1
2
600
1000
3
1300
4
1500
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
400
300
200
100
6-4
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
6-5
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
6-6
Thinking about supply: the importance of
opportunity cost
• Reservation price
pQ   $6
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
6-7
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
6-8
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
6-9
Harry’s individual supply curve for recycling
services
Refund (cents/can)
Harry’s supply curve
6
3
2
1.5
1
0
6
10
Recycled cans
(100s of cans/day)
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
13
16
15
6-10
The market supply curve for recycling
services
Barry’s supply curve
6
+
3
2
1.5
Refund (cents/can)
Refund (cents/can)
Harry’s supply curve
6
3
2
1.5
1
0
1
6
10
Recycled cans
(100s of cans/day)
13
16
15
+
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
0
6
10
Recycled cans
(100s of cans/day)
13
16
15
6-11
The market supply curve for recycling
services
=
Refund (cents/can)
Market supply curve
6
3
2
1.5
1
=
0
12
20
26
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
32
Recycled cans
(100s of cans/day)
30
6-12
The market supply curve with 1000 identical
sellers
Refund (cents/can)
Market supply curve
6
3
2
1.5
1
0
6
10
13
Recycled cans
(100 000s of cans/day)
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
16
15
6-13
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
6-14
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
6-15
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
6-16
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
6-17
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
6-18
The demand curve facing a perfectly
competitive firm
Price ($/unit)
Market supply and demand
S
P0
D
Q0
Market quantity
(units/month)
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
Price ($/unit)
Individual firm demand
P0
Di
Individual firm’s quantity
(units/month)
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
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
6-21
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
6-22
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
6-23
Employment and output for a glass-bottle
maker
Total number of employees per day
Total number of bottles per day
0
0
1
80
2
3
4
Observation
Output gains from each
additional worker begins
to diminish with the
third employee
200
260
300
5
330
6
350
7
362
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
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
6-25
Cost in the short run
• Some important cost concepts
– Assume
 The cost of labour is $12 per worker and is a variable cost.
– Variable cost
 The sum of all payments made to the firm’s variable factors of
production.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
6-26
Fixed, variable, marginal and total costs of
bottle production
Employees
per day
Bottles
per day
Fixed cost
($/day)
Variable cost
($/day)
0
0
40
0
40
1
80
40
12
52
0.15
2
200
40
24
64
0.10
3
260
40
36
76
0.20
4
300
40
48
88
0.33
5
330
40
60
100
0.40
6
350
40
72
112
0.60
7
362
40
84
124
1.00
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
Total cost
($/day)
Marginal cost
($/bottle)
6-27
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.
TC
MC 
Output
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
6-28
Choosing output to maximise profit
• Example
– If a bottle sells for $0.35, how many bottles should the
company described in Table 6.2 of your textbook [slide 27]
produce each day?
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
6-29
Output, revenue, costs and profit of bottle
production
Employees
per day
Output
(bottles/day)
Total revenue
($/day)
Total cost
($/day)
Profit
($/day)
0
0
0
40
-40
1
80
28
MB = .35
52 MC = .15 -24
2
200
70
MB = .35
64 MC = .10
3
260
91
MB = .35
76 MC = .20 15
4
300
105
MB = .35
88 MC = .33 17
5
330
115.50 MB = .35 100 MC = .44 15.50
6
350
122.50 MB = .35 112 MC = .60 10.50
7
362
126.70 MB = .35 124 MC = 1.00
6
2.70
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
6-30
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
PxQ  VC for every level of Q
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
Thinking in terms of average costs
• Average variable cost and average total cost
– Average variable cost
 Variable cost divided by total output.
VC
Q
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
– 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
P  minimum value of AVC
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
6-33
Thinking in terms of average costs
• Average variable cost and average total cost
– Average total cost (ATC)
 Total cost divided by total output
TC
Q
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
– 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
6-35
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
6-36
Average variable cost and
average total cost of bottle production
Employees Bottles
per day
per day
Variable
cost
($/day)
Average
variable cost
($/unit of
output)
Total
cost
($/day)
Average
total cost
($/unit of
output)
Marginal
cost
($/bottle)
0
0
0
40
1
80
12
0.150
52
0.650
0.15
2
200
24
0.120
64
0.320
0.10
3
260
36
0.138
76
0.292
0.20
4
300
48
0.160
88
0.293
0.33
5
330
60
0.182
100
0.303
0.40
6
350
72
0.206
112
0.320
0.60
7
362
84
0.232
124
0.343
1.00
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
Cost ($/bottle)
The short-run marginal, average variable and average
total cost curves for a bottle manufacturer
Upward-sloping MC
corresponds to
diminishing returns
0.65
0.60
0.55
0.50
0.45
0.40
0.35
0.30
0.25
0.20
0.15
0.10
0.05
ATC
AVC
80
MC = AVC & ATC
at their minimum
points
MC
200
260 300
362
330 350
Output (bottles/day)
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
6-38
Price = Marginal cost: the maximum-profit
condition supply rule
Cost ($/bottle)
0.35
0.33
0.30
0.25
MC
Profit maximising
output: P = MC
0.20
ATC
AVC
Price
0.15
0.12
0.10
0.07
160 200
260 300
Output (bottles/day)
•Less than 260 bottles/day P > MC and output should be increased.
•More than 260 bottles/day P < MC and output should be decreased.
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
Cost ($/bottle)
Price = Marginal cost: The perfectly
competitive firm’s profit-maximising supply rule
•Price = MC at 260 bottles/day
•ATC = .12/bottle
•TR = (.20)(260) = $52/day
•TC = (.12)(26) = $31.20/day
•Profit = $52 - $31.20 = $20.80/day
MC
ATC
AVC
Price
0.20
0.12
260
Output (bottles/day)
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
6-40
A profit-maximising firm that is making a
loss in the short run
MC
ATC
AVC
Cost ($/bottle)
• Price = .08/bottle
• P = MC at 180 bottles/day
• ATC = .10/bottle
• P < ATC by .02/bottle
• Profit = -.02 x 180 = -3.60/day
0.10
0.08
Price
180
Output (bottles/day)
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
6-41
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
6-42
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
6-43
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
6-44
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
6-45
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
6-46
The market supply curve of container
recycling services for Burnside, South Australia
(cents/container)
Refund price
• 60 000 citizens would pay 6
cents for each container
which equals marginal benefit
Market supply curve of glass
container recycling services
6
3
2
1.5
1
• The local government pays 6
cents/container
• The optimal quantity of containers
is 16 000/day where
MC(.06) = marginal benefit
6
10
13
15 16
Number of containers recycled
(1000s of 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
6-47
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 16 000/day?
– Will private individuals choose to remove 16 000
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
6-48
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
6-49
Calculating producer surplus in the market
for fish
• Equilibrium P = $2 & Q = 4000
S
Price ($/kg)
3.00
• Producer surplus is the difference
between $2 and the reservation price
at each quantity.
• Producer surplus =
(1/2)(4000 day)($2/kg) = $4000/day.
2.50
2.00
1.50
1.00
D
.50
0
1
2
3
4
5
6
7
8
9
10
11
12
Quantity (1000s of kg/day)
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings
Slides prepared by Nahid Khan
6-50
Producer surplus in the market for fish
S
Price ($/kg)
3.00
2.50
2.00
Producer surplus
= $4000/day
1.50
1.00
D
.50
0
1
2
3
4
5
6
7
8
9
10
11
12
Quantity (1000s of kg/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