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Frank & Bernanke
rd
3 edition, 2007
Ch. 6: Perfectly Competitive Supply:
The Cost Side of The Market
1
Importance of Opportunity Cost



If today it takes the same number of orchestra
members to play a Brahms symphony as it did
100 years ago, why are they paid five times as
much?
If it still takes 20 minutes to get a haircut just like
a hundred years ago why the barber pa id so
much more? And why do barbers in the US get
paid more than barbers in Bulgaria?
If it takes 8 hours to assemble car today
compared to more than 50 hours 40 years ago
shoud the worker be paid more?
2
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.
 How much time should Harry spend
recycling soft drink containers?

3
Example
Search time
(hours/day)
0
1
Total number of
containers found
0
600
Additional number of
containers found
600
400
300
2
1,000
200
3
1,300
4
1,500
100
4
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)
5
Opportunity Cost
What should the price of recycled cans be
to make Harry indifferent between washing
dishes for one hour or collecting cans?
 What should the price of recycled cans be
to make Harry indifferent between
collecting cans for two hours or washing
dishes ?

6
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) = $6 = 6
cents
7
An Individual Supply
Curve for Recycling Services
Deposit (cents/can)
Harry’s Supply Curve
6
3
2
1.5
1
0
6
10
Recycled cans
(100s of cans/day)
13
16
15
8
The Market Supply Curve
for Recycling Services
Barry’s Supply Curve
6
+
3
2
1.5
Deposit (cents/can)
Deposit (cents/can)
Harry’s Supply Curve
6
3
2
1.5
1
0
1
6
10
13
Recycled cans
(100s of cans/day)
16
15
0
6
10
Recycled cans
(100s of cans/day)
13
16
15
9
The Market Supply Curve
for Recycling Services
=
Deposit (cents/can)
Market Supply Curve
6
3
2
1.5
1
0
12
20
26
32
Recycled cans
(100s of cans/day)
30
10
The Market Supply Curve
with 1,000 Identical Sellers
Deposit (cents/can)
Market Supply Curve
6
3
2
1.5
1
0
6
10
13
Recycled cans
(100,000s of cans/day)
16
15
11
Typical Test Question
Why is the supply curve upward sloping?
12
Perfectly Competitive Market
A market in which no individual supplier
has significant influence on the market
price of the product.
 A firm that has no influence over the price
at which it sells its product is a Price Taker.

13
Characteristics of Perfect
Competition
1. All firms sell the same standardized
product.
2. The market has many buyers and
sellers, each of which buys or sells only
a small fraction of the total quantity
exchanged.
3. Productive resources are mobile
4. Buyers and sellers are well informed.
14
Market Supply and Demand
Price ($/unit)
Market supply and demand
S
P0
D
Q0
Market Quantity
(units/month)
15
The Demand Curve Facing
a Perfectly Competitive Firm
Price ($/unit)
Individual firm demand
P0
Di
Individual Firm’s Quantity
(units/month)
16
Perfectly Competitive Firm
A firm facing a horizontal demand curve
will always sell one additional unit it
produces at the ongoing market price.
 The firm’s demand curve is the same as
the price of its product.
 Marginal Revenue for this firm will be
equal to Price.

17
Profit Maximizing
Firms are thought to behave as if
maximizing their profits.
 Profits = Total Revenue – All explicit and
implicit costs
 TR = PQ
 Profit maximizing rule: MB = MC
 If benefit is revenue then MB=MR.
 We have to figure out the costs.

18
Factors of Production

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
19
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
20
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
21
Costs
The cost of labor is $12/worker and is a
variable cost.
 The cost of the bottle making machine is
$40/day and it is a fixed cost.

22
Fixed, Variable, and Total
Costs of Bottle Production
Employees
per day
0
1
2
3
4
5
6
7
Bottles
per day
0
80
200
260
300
330
350
362
Fixed cost
($/day)
40
40
40
40
40
40
40
40
Variable cost
($/day)
0
12
24
36
48
60
72
84
Total cost
($/day)
Marginal cost
($/bottle)
40
52
64
76
88
100
112
124
0.15
0.10
0.20
0.30
0.40
0.60
1.00
23
Definitions

Total Cost


Fixed Cost + Variable Cost
Marginal Cost

Measures how total cost changes with a
change in output
TC
MC 
Output
24
Output, Revenue, Costs, and
Profit
Employees
per day
Output
(bottles/day)
Total revenue
($/day)
Total cost
($/day)
0
0
0
1
80
28
MB = .35
52 MC = .15 -24
2
200
70
MB = .35
64 MC = .10
6
3
260
91
MB = .35
76 MC = .20
15
4
300
105
MB = .35
88 MC = .30
17
5
330
115.50 MB = .35 100 MC = .40
15.50
6
350
122.50 MB = .35 112 MC = .60
10.50
7
362
126.70 MB = .35 124 MC = 1.00
2.70
40
Profit
($/day)
-40
What will happen to the profit maximizing output if:
(a) employees receive a wage of $6/day; (b) fixed costs are $45?
25
Average Variable Cost and
Average Total Cost of Bottle Production
Average
variable cost
($/unit of
output)
Bottles
per day
Variable
cost
($/day)
0
0
0
1
80
12
0.150
52
0.650
2
200
24
0.120
64
0.320
3
260
36
0.138
76
0.292
4
300
48
0.160
88
0.293
5
330
60
0.182
100
0.303
6
350
72
0.206
112
0.320
7
362
84
0.232
124
0.343
Employees
per day
Total
cost
($/day)
Average
total cost
($/unit of
output)
40
Marginal
cost
($/bottle)
0.15
0.10
0.20
0.30
0.40
0.60
1.00
26
Profits
Profits = TR – TC or (P x Q) - (ATC x Q)
 To be profitable: P > ATC

27
Firm’s Shutdown Condition

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
P < minimum level of AVC
28
Cost ($/bottle)
The Marginal, Average Variable, and Average
Total Cost Curves for a Bottle Manufacturer
Upward-sloping MC
corresponds to
diminishing returns
0.65
0.60
0.55
0.50
0.45
0.40
0.35
0.30
0.25
0.20
0.15
0.10
0.05
ATC
AVC
80
MC = AVC & ATC
at their minimum
points
MC
200
260 300
362
330 350
Output (bottles/day)
29
Price = Marginal Cost: The Perfectly
Competitive Firm’s Profit-Maximizing Supply Rule
Cost ($/bottle)
0.35
0.33
0.30
0.25
0.20
MC
Profit maximizing
output: P = MC
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
30
Cost ($/bottle)
Price = Marginal Cost: The Perfectly
Competitive Firm’s Profit-Maximizing 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 = $20.80/day
MC
ATC
AVC
Price
0.20
0.12
260
Output (bottles/day)
31
A Negative Profit
MC
ATC
AVC
Cost ($/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)
32
The Law of Supply



The perfectly competitive firm’s supply curve is
its marginal cost curve
Every quantity of output along the market supply
represents the summation of all the quantities
individual sellers offer at the corresponding price
At every point along the market supply curve,
price measures what it would cost producers to
expand production by one unit.
33
Determinants of Supply
Technology
 Input prices
 Number of suppliers
 Expectations
 Changes in prices of other products

34
The Supply Curve of Container
Recycling Services for Burlington, Vermont
Market supply curve of glass
container recycling services
6
(cents/container)
Redemptions price
•60,000 citizens would
pay 6 cents times
16,000 ($960) which
equals the tax (1.6
cents/day/person)
•The local government
pays 6 cents/container
(MB)
3
2
1.5
1
6
10
13
15 16
Number of containers recycled
(1,000s of containers/day)
35
Applying the Theory of Supply
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?

36
Producer Surplus

The amount by which price exceeds the
seller’s reservation price
37
The Supply and
Demand in the Market for Milk
•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)
38