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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