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Chapter 6: Perfectly Competitive Supply
• Derive a supply curve
– Opportunity cost
 The principle of increasing opportunity cost
– Seller’s reservation price
– Cost-Benefit principle
 Marginal benefit vs. marginal cost
1
Individual’s Supply Curve
• An example
– Opportunity cost of Harry's time
• Wash dishes for $6 per hour is his baseline
• Recycling aluminum cans is the alternative
– Harry earns 2¢ per can
– How much labor should Harry supply to each
activity?
• Harry should work at recycling as long as he is
earning at least $6 per hour
2
Harry’s Supply Curve
Recycling Services
Hours per
Day
Total Number of
Containers Found
0
0
1
600
2
1,000
3
1,300
4
1,500
5
1,600
Additional
Number of Cans
Found
600
400
300
200
100
3
Harry’s Supply Curve
Recycling Services
Hours per Day
Additional Number of
Cans Found
Revenue from
Additional Cans
1
600
$12.00
2
400
$8.00
3
300
$6.00
4
200
$4.00
5
100
$2.00
 Harry's rule is to collect cans if the return in an hour is the same as
washing dishes;
 The opportunity cost of collecting cans in an hour is the revenue given
up from washing dishes - $6;
 Therefore, Harry should spend 3 hours in recycling cans.
4
Harry’s Supply Curve
Reservation Price Per Can
• What is the lowest deposit per
can that would get Harry to
recycle for an hour?
• What price makes his wage at
recycling equal to his
opportunity cost?
1st hour price is 1¢
2nd hour is 1.5¢
3rd hour is 2¢
4th hour is 3¢
5th hour is 6¢
Hours
per Day
Additional
Number of Cans
Found
1
600
2
400
3
300
4
200
5
100
5
Reservation
Price (¢)
Number of
Cans (00s)
1
1.5
2
3
6
6
10
13
15
16
Deposit (cents/can)
Harry’s Supply Curve
6
3
2
1
6
10 13 16
Recycled cans
(100s of cans/day)
6
Individual and Market Supply Curves
Harry’s Supply Curve
Barry’s Supply Curve
Market Supply Curve
6
6
6
3
3
3
2
2
2
1
1
1
13 16
15
Recycled cans
(00s of cans/day)
6
16
15
Recycled cans
(00s of cans/day)
6
13
0
12
26
Recycled cans
(00s of cans/day)
32
30
7
Profit Maximization
• Economists assume firms seek to maximize
profits
– Corresponds to buyers' maximizing utility
• Profit is total revenue minus total cost
– Both explicit and implicit costs are included in
total cost
8
Perfectly Competitive Firm
9
Perfectly Competitive Firm's Demand
• Market supply and market demand set the
price
– Buyers and sellers takes price (P) as given
• Perfectly competitive firm can sell all it
wants to sell at the market price
– Since the supplier is small, its output decision
will not change market price
– Each firm must decide how much to supply (Q)
10
Perfectly Competitive Firm's Demand
11
Profit Maximization – An Example
• In the example, the model has a single
product and two inputs, labor and capital
– Capital is fixed, labor is variable
• Determine the profit maximizing level of
output for a perfectly competitive bottle
manufacturer
• Capacity of the bottle-making machine is fixed
12
Law of Diminishing Return
The Law of Diminishing Returns
With all inputs except one fixed,
additional units of the variable input yield
ever smaller amounts of additional output
13
Law of Diminishing Return
• At low levels of production, the law of diminishing
returns may not hold
– Similar to the increase in a buyer's marginal utility from
a second unit
• As with marginal utility, marginal product
eventually diminishes
– Lower marginal products are often caused by
congestion
• Workers per machine
• Information flows
14
Cost Concepts
• A fixed factor of production is an input whose quantity
cannot be changed in the short run
– Fixed cost (FC) is the sum of all payments for fixed
inputs
• A variable factor of production is an input whose quantity
can be changed in the short run
– Variable cost (VC) is the sum of all payments for
variable inputs
• Total cost (TC) is the sum of all payments for inputs
• Marginal cost (MC) is the change in total cost divided by
the change in output
15
Profit Maximization - Data
Workers
Bottles
per Day
Fixed
Costs
($/day)
Variable
Cost
($/day)
Total
Cost
($/day)
0
0
$40
$0
$40
1
80
40
12
52
2
200
40
24
64
3
260
40
36
76
4
300
40
48
88
5
330
40
60
100
6
350
40
72
112
7
362
40
84
124
Marginal
Cost
($/bottle)
$0.15
0.10
0.20
0.30
0.40
0.60
1.00
16
Profit Maximization
Profit = Total revenue – Total cost
• Since Total cost = Fixed cost + Variable cost
Profit = Total revenue – Variable cost – Fixed cost
• The firm must know about both revenues and
costs in order to maximize profits
– Increase output if marginal benefit is at least as great
as marginal cost
– Decrease output if marginal benefit is less than
marginal cost
17
Profit Maximization
• Firms maximize their profit when marginal benefit equals
marginal cost;
• In a perfectly competitive market, marginal benefit is
simply the market price, which is a constant;
• Fixed costs do not affect the marginal cost, since the
change in fixed costs is zero.
18
ATC, AVC, and MC
• Average values are the total divided by quantity
– Average variable cost (AVC) is
AVC = VC / Q
– Average total cost (ATC) is
ATC = TC / Q
• Marginal cost (MC)
– MC = ΔTC/ΔQ
19
Cost Structure
Worker
Bottles
s per
per day
day
Variabl
e Cost
($/day)
AVC ($
per
unit)
Total
Cost
ATC ($
per
unit)
40
Margin
al Cost
($/unit)
0
0
0
1
80
12
0.15
52
0.65
0.10
2
200
24
0.12
64
0.32
0.20
3
260
36
0.135
76
0.292
0.15
20
Cost Structure – A graph
21
Profit Maximization – A graph
• Market price is $0.20 per bottle
– Produce where the marginal benefit of selling a bottle (price)
equals the marginal cost
• 260 bottles per day
22
Profit Maximization – A graph
23
Production Loss – A graph
24
Shut Down Decision
• Firms can make losses in the short run
– Some firms continue to operate
– Some firms shut down
 If the firm shuts down in the short run, it loses all of its
fixed costs;
 The firm should shut down if revenue is less than
variable cost: P x Q < VC for all levels of Q;
 The firm should continue its business if revenue is at
least larger than variable cost.
25
Shut Down – A graph
MC
ATC
AVC
Price
Output (bottles/day)
26
"Law" of Supply
• Short-run marginal cost curves have a positive
slope
– Higher prices generally increase quantity supplied
• In the long run, all inputs are variable
– Long-run supply curves can be flat, upward sloping, or
downward sloping
• The perfectly competitive firm's supply curve is its
marginal cost curve
– At every quantity on the market supply curve, price is
equal to the seller's marginal cost of production
– Applies in both the short run and the long run
27
Increases in Supply
28
Producer Surplus
• Producer surplus is the difference between the market
price and the seller's reservation price
• Reservation price is on the supply curve
• Producer surplus is the area above the supply curve and
below the
market price
29