Principles of Microeconomics

1
Perfectly Competitive Supply The Cost Side of
The Market
2
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.

3
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

4
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
5
Factors of production

• Factors of production are inputs used in the
  production of a good or service.

6
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.
7
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.
8
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)

9
The Law of Diminishing Returns
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.
Total no. of employees/day Total no. of 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 6
10
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.

11
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).
12
Fixed Cost

• Suppose the lease payment for the Louisville
  Sluggers 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

13
Variable Cost

• The companys 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

14
Total Cost

• The firms total cost is the sum of its fixed and
  variable costs
• Total cost Fixed Cost Variable Cost
• TC FC VC
• TC rK wL

15
Marginal Cost

• The firms marginal cost is the change in total
  cost divided by the corresponding change in
  output.
• MC DTC/DQ
• MC DVC/DQ

16
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 companys output, variable cost,
  total cost and marginal cost for each level of
  employment.

17
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)
18
Choosing Output to Maximize Profit

• If a companys 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.

19
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?

20
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
21
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
22
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

23
Caveat Production at a loss when PMC

• 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
24
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 firms fixed cost is a sunk cost, the
  firms 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.

25
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.

26
Shut-Down Condition in the Short Run

• Suppose, for example, that the market price of
  the firms 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.

27
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.

28
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.

29
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?

30
Modified Louisville Slugger Example

• The cost-benefit principle tells us that this
  firm should continue to expand as long as price
  is at least as great as marginal cost.
• If the firm follows this rule it will produce 130
  bats per day, the quantity at which price and
  marginal cost are equal.

31
Modified Louisville Slugger Example

• Suppose that the firm had sold any amount less
  than 130say, only 100 bats per day.
• Its benefit from expanding output by one bat
  would then be the bat's market price, 80 cents.
• The cost of expanding output by one bat is equal
  (by definition) to the firms marginal cost,
  which at 100 bats per day is only 40 cents.

MB
MC
32
Modified Louisville Slugger Example

• So by selling the 101st bat for 80 cents and
  producing it for an extra cost of only 40 cents,
  the firm will increase its profit by 80 40 40
  cents per day.
• 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 profit
  by expanding production.

MB
MC
33
Modified Louisville Slugger Example

• Conversely, suppose that the firm were currently
  selling more than 130 bats per daysay, 150at a
  price of 80 cents each.
• Marginal cost at an output 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. As
  a result, its profit would grow by 52 cents per
  day.

MC
MB
34
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.

35
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 firms profit is 41.60/day.

36
Modified Louisville Slugger Example

• Profit is equal to (P ATC)xQ, which is equal to
  the area of the shaded rectangle.

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End