Chapter 6 Perfectly Competitive Supply: The cost side of the market

1
Chapter 6 Perfectly Competitive SupplyThe cost
side of the market
Even-numbered Qs. and 3 94 additional
questions
2

• Profit-maximizing firm
• - Goal is to maximize profit,
• - Profit Total Revenue Total Cost
• - Total costs include explicit and implicit
  costs
• Perfectly Competitive Market
• - Firms in this market make many decisions but
  one thing they do not decide is the price at
  which to sell their output
• - Firms in perfect competition are said to be
  price taker
• - Price taker a firm that cannot influence the
  price of a good or service
• - At the market price, individual firm can sell
  as much or as little quantity as it wishes
• - Individual firms demand curve is perfectly
  elastic

3

• Five conditions of Perfectly competitive market
• All firms are price-taker
• 2) All firms sell the same standardized product
  to many buyers
• - buyers are able to switch from one seller to
  another if the price of the good is lower
• - substitution goods are available
• 3) The market has many buyers and sellers, they
  have a relatively small market share of the total
  quantity exchanged
• - individuals decision will have no impact on
  the market price
• Productive resources are mobile
• - free to enter or exit the market
• Buyers and sellers are well informed about
  product being sold and the prices charged by each
  firm
• - Buyers are able to seek for the lowest price
• - Sellers are able to seek for the most-profit
  earning opportunities

4

• Factors of Production
• - inputs used in production
• - it can be variable or fixed
• Variable factor of production
• - input can be varied in the short run
• - i.e. labor firms can increase production
  simply by having labors working overtime in a
  short notice
• Fixed factor of production
• - input cannot be varied in the short run
• - i.e. machinery, a factory it takes time to
  install a new equipment, train labors to use it
  and it takes time to plan and build a new factory

5

• Short run vs. Long run
• Short run
• - at least one input is fixed and the other
  inputs are variable
• - it is impossible to add another factory or
  install a machine in a short period of time
• Long run
• - all inputs are variable
• - it is sufficient to add another factory or
  install a machine in a long period of time
• The short run and long run distinction varies
  from one industry to another

6

• Law of Diminishing Returns
• - as adding more variable inputs, the marginal
  production grows, (increasing marginal returns)
  but beyond some point, the marginal production
  starts to diminish (decreasing marginal returns)
• - it only applies to the short run, at least one
  input is fixed and the other inputs can be varied
• Marginal Product the change in total product/the
  change in variable input
• - i.e., a firm hires some additional labors in
  the car production and the amount of machinery
  stays the same, then, the used of the machine
  would be overcrowded. The marginal productivity
  grows only for the first few units of labors,
  then it starts to diminish. Therefore, marginal
  productivity actually decreases

7

• Marginal Cost the change in total cost (total
  variable cost)/the change in quantity
• - MC at first decreases sharply, it reaches a
  min. point, then again, starts to increase
• - This reflects the fact that VC, or TC
  increases by a decreasing amount and then TC
  increases by an increasing amount
• - The shape of the MC curve is a consequence of
  the Law of Diminishing Return

MC
MC
Law of diminishing returns
Quantity
8

• Law of Diminishing Returns
• it only applies to the short run, at least one
  input is fixed and the other inputs can be varied
• In the Short run, MC curve is U-shape
• in the Long run, MC curve is horizontal
• in the long run, all inputs are variable. The
  firm can often double its production by simply
  doubling the amount of each input they use
• Thus, cost is proportional to output
• Therefore, MC in the long run is horizontal, not
  upward sloping

9

• For a perfectly competitive firm, it chooses to
  produce at a point where PMC
• If P gt MC Firm can increase its profit by
  increasing output
• If P lt MC Firm can increase its profit by
  decreasing output

Firms earn profit P gt ATC where Q is at optimal level of output
Firms suffer loss P lt ATC where Q is at optimal level of output
Firms break-even, TR TC, earning zero Economic profit P ATC where Q is at optimal level of output
Firms shutdown point P min. AVC
Firms should shutdown P lt min. AVC, loss fixed cost
10
To Summarize

• If P gt ATC gt min. AVC
• Firms earn profit and stay in the market
• If ATC gt P gt min. AVC
• Firms suffer loss but continue to operate
• If ATC gt min. AVC gt P
• Firms should shutdown and loss equals to its
  fixed cost

11
Additional Question 1

• Q1) Which of the following is NOT true of a
  perfectly competitive firm?
• It faces a perfectly elastic demand curve.
• It is unable to influence the market price of the
  good it sells.
• It seeks to maximize revenue.
• Relative to the size of the market, the firm is
  small.
• The firms only decision is how much output to
  produce.

Ans C
12

• (A) is correct. Each firm in a perfectly
  competitive market is facing a horizontal demand
  for its products.
• The demand is perfectly elastic because firms are
  selling homogeneous goods. It is very easy for
  the customers to find substitutes.
• Note that the MARKET DEMAND is not horizontal.
  Only the demand for individual firms products is
  perfectly elastic.

13

• (B) and (D) are the features of a perfectly
  competitive market.
• In a perfectly competitive market, there is a
  huge number of firms and each firm is of a
  minuscule size (compared to the whole market)
• Because each firm is so small, none of its action
  can influence the market. The firm will suffer if
  it deviates from the market price. There will
  not be any effect on the market price if the firm
  varies its output level.
• Therefore, (B) and (D) are true.

14

• (E) is also true. Indeed, when each firm is
  facing a given market price, what it can do is to
  determine how much output it is going to supply.
• The decision on output is made based on the
  firms cost function.
• A rational economic agent will always aim at
  maximising profits.

15

• Is maximizing profit the same as minimizing cost?
• What is the output level at which cost of
  production is minimized?
• Zero output !!
• Thus maximizing profit is not the same as
  minimizing cost!!

16

• As mentioned just now, firms always aim at
  maximising PROFITS.
• However, it does not mean that they aim at
  maximising REVENUE. (Profit is the difference
  between revenue and costs)
• i.e. Firms can maximize TR by increasing the
  production, but the expenses incurred in order to
  earn more may be more than the actual earnings.
• Therefore, (C) is the only option that is NOT
  true.

17
Additional Question 2

• Q2) The Law of Diminishing Marginal Returns
• Is a Long Run concept.
• Applies only to small and medium sized firms.
• Is a Short and Long Run concept.
• Applies only to large firms.
• Is a short run concept.

Ans E
18

• The Law of Diminishing Marginal Returns states
  that
• In a production where there are fixed and
  variable factors,
• when more variable factors are added, additional
  output yielded by each marginal unit of input
  drops eventually.

19

• Does the Law of Diminishing Marginal Returns have
  anything to do with firm size?
• NO!
• LDMR holds whenever a firm has both fixed and
  variable factors of production, regardless of
  size.
• Firms of any size can be using (or not using)
  both fixed and variable factor input.
• Hence, (B) and (D) can be eliminated because they
  are wrong.

20

• (A), (C) and (E) are all about Long / Short Run.
• What is Short Run? What is Long Run?

Short Run Long Run
Fixed Factor ? ?
Variable Factor ? ?
Yes
No
Yes
Yes
21

• Recall that LDMR describes a situation at which
  both fixed and variable factors are in used.
• So is it referring to Long Run or Short Run?
• Short Run
• Therefore, the answer is (E).

22
Additional Question 3

• Q3) Suppose a firm is collecting 1999 in Total
  Revenue and the Total Cost of its fixed factors
  of production falls from 500 to 400. One can
  speculate that the firm will
• Expand output.
• Lower Price.
• Earn greater profits or smaller losses.
• Contract output.
• Earn smaller profits or great losses.

Ans C
23

• First of all, how are production decisions made
  by firms in economics?
• Firms make production decisions based on a
  universal rule MCMR
• For a price taker, its marginal revenue is always
  equal to the price (MRP)
• Therefore, the firm only has to determine its
  output level. The optimal level of output is
  where MC MR.

24

• Now that the fixed cost of production has
  decreased.
• Is the Marginal Cost (MC) schedule affected by
  any means?
• NO!
• So would the previous Q determined by MCMR be
  affected?
• NO!

25

• Therefore, (A) and (D) can be eliminated as they
  are the wrong answers.
• Output level is not affected by a change in fixed
  costs.
• This is because a change in fixed costs has no
  effect on marginal cost of output.

26

• How about option (B)?
• Since we are talking about Perfect Competition
  (Price Taker)
• Does the firm have any say on its price?
• No!
• Therefore, (B) is also not the answer.

27

• That leaves us with options (C) and (D).
• Recall that Profit Revenue Costs
• Now that (Fixed) Costs have dropped
• What happens to Profit?
• Increases!
• Hence (C) is the correct answer.

28
Chapter 6 Problem 2

• A price-taking firm makes air conditioners. The
  market price of one of their new air conditioners
  is 120. Its total cost information is given in
  the table below
• How many air conditioners should the firm
  produce per day if its goal is to maximize its
  profit?

Air conditioners per day Total cost ( per day)
1 100
2 150
3 220
4 310
5 405
6 510
7 650
8 800
29

• To decide how many air conditioners should
  produce in order to maximize its profit, we can
• Apply the cost-benefit principle ,or,
• Calculate the profit levels and choose the
  production level that gives the largest profit

30

• Method 1
• The cost benefit principle, we know that firm
  should continue to produce an additional unit of
  goods as long as the additional benefit to
  produce the good is at least as great as the
  additional cost to produce the same good.
• That is, MB gt MC
• At the market price of 120 for one air
  conditioner, perfectly competitive firm can sell
  as many air conditioners as they wish in order to
  maximize its profit.
• The MB from selling an additional air
  conditioner is 120.

31

• To calculate the MC
• By comparing the MB (120) and the MC, the
  optimal output for this firm to produce is 6 air
  conditioners per day.
• The MC of each of the first 6 air conditioners
  produced each day is 105, which is less than the
  MB of 120. MB (120) gt MC (105)

Air conditioners/day Total Cost (/day) MC (/day)
1 100 100
2 150 50
3 220 70
4 310 90
5 405 95
6 510 105
7 650 140
8 800 150
32

• Method 2) Calculate the profit
• Profit TR TC
• In order to maximize its profit, this firm should
  produce 6 air conditioners per day, since it
  yields the largest profit among the others,
  210/day.
• Same result as by applying the cost-benefit
  principle.

Air conditioners/day Total Cost (/day) Total Revenue (/day) Profit (/day)
1 100 120 20
2 150 240 90
3 220 360 140
4 310 480 170
5 405 600 195
6 510 720 210
7 650 840 190
8 800 960 160
33
Chapter 6, Problem 3

• The Paducah Slugger Company makes baseball bats
  out of lumber supplied to it by Acme Sporting
  Goods, which pays Paducah 10 for each finished
  bat. Paducahs only factors of production are
  lathe operators and a small building with a
  lathe. The number of bats per day it produces
  depends on the number of employee-hours per day,
  as shown in the table below.

of bats per day of employee-hours per day
0 0
5 1
10 2
15 4
20 7
25 11
30 16
35 22
34

• a) If the wage is 15 per hour and Paducahs
  daily fixed cost for the lathe and building is
  60, what is the profit-maximizing quantity of
  bats?

Quantity (bats/day) Total Revenue (/day) Total labor cost (hours X wage) Total cost (labor cost fixed cost) Profit (/day) (revenue cost)
0 0 0 15 0 0 60 60 -60
5 50 1 15 15 15 60 75 -25
10 100 2 15 30 30 60 90 10
15 150 4 15 60 60 60 120 30
20 200 7 15 105 105 60 165 35
25 250 11 15 165 165 60 225 25
30 300 16 15 240 240 60 300 0
35 350 22 15 330 330 60 390 -40
35

• b) If the firms fixed cost decreases from 60
  to 30, what is the profit maximizing quantity of
  bats?
• Decrease in fixed cost will increase the profits
  across different quantities of bats by the same
  amount (30)

Quantity (bats/day) Total Revenue (/day) Total labor cost (hours X wage) Total cost (labor cost fixed cost) Profit (/day) (revenue cost)
0 0 0 15 0 0 30 30 -30
5 50 1 15 15 15 30 45 5
10 100 2 15 30 30 30 60 40
15 150 4 15 60 60 30 90 60
20 200 7 15 105 105 30 135 65
25 250 11 15 165 165 30 195 55
30 300 16 15 240 240 30 270 30
35 350 22 15 330 330 30 360 -10
36
Chapter 6 Problem 4

• In the preceding problem (3), how would
  Paducahs profit-maximizing level of output be
  affected if the government imposed a tax of 10
  per day on the company? (Hint Think of this
  tax as equivalent to a 10 increase in fixed
  cost.) What would Paducahs profit-maximizing
  level of output be if the government imposed a
  tax of 2 per bat? (Hint Think of this tax as
  a 2-per-bat increase in the firms marginal
  cost.) Why do these two taxes have such
  different effects?

37

• Fixed cost
• Cost on all fixed Factor of Production, ex.,
  lease payment on machines, buildings
• Not depends on firms output
• A sunk cost
• Variable cost
• Cost on all variable Factor of Production, e.g.,
  labor cost, input cost
• Depends on firms output
• Varied with number of products that firm produces

38

• Government imposed a tax of 10 per day (increase
  in fixed cost)
• Will this tax affected the optimal level of
  output?
• Will this tax affected the cost of production?
• A tax of 10 per day would decrease its profit by
  10 per day at every level of output.
• The profit-maximizing level of output would still
  be 20 bats per day (from Q3)
• This tax does not depends on the output, like a
  fixed cost or a sunk cost.
• If Fixed cost changes, MB and MC will not be
  affected
• That is, this tax does not change the marginal
  cost, and hence, does not change the
  profit-maximizing level of output if the firm
  continues to produce.

39
Government imposed a tax of 10 per day
Quantity (bats/day) Total Revenue (/day) Total labor cost (hours X wage) Total cost (labor cost fixed cost) Profit (/day) (revenue cost)
0 0 0 15 0 0 60 10 70 -70
5 50 1 15 15 15 60 10 85 -35
10 100 2 15 30 30 60 10 100 0
15 150 4 15 60 60 60 10130 20
20 200 7 15 105 105 60 10 175 25
25 250 11 15 165 165 60 10 235 15
30 300 16 15 240 240 60 10 310 -10
35 350 22 15 330 330 60 10 400 -50

• Tax of 10 decreases its profit by 10 per day
  at every level of output.
• Its profit-maximizing output level is still at
  20 bats per day.
• Fixed cost is independent of output

40

• Government imposed a tax of 2 per bat (increase
  in marginal cost)
• Will this tax affected the optimal level of
  output?
• Will this tax affected the cost of production?
• A tax of 2 per bat would increase its cost of
  production.
• On every bat produces, additional 2/bat has to
  be added towards the production cost.
• The marginal cost increases.
• The profit-maximizing level of output would
  decrease
• This tax depends on the output

41
Government imposed a tax of 2 per bat
Quantity (bats/day) Total Revenue (/day) Total labor cost (hours X wage) 2 per bat Total cost (labor cost fixed cost) Profit (/day) (revenue cost)
0 0 0 15 20 0 0 60 60 -60
5 50 1 15 25 25 25 60 85 -35
10 100 2 15 210 50 50 60 110 -10
15 150 4 15 215 90 90 60 150 0
20 200 7 15 220 145 145 60 205 -5
25 250 11 15 225 215 215 60 275 -25
30 300 16 15 230 300 300 60 360 -60
35 350 22 15 235 400 400 60 460 -110

• Tax of 2 per bat, the profit-maximizing output
  level falls to 15 bats per day, with profit 0.
• Variable cost depends on output.

42

• With Tax of 10 per day (increase in fixed cost)
• Profit-maximizing level of output stays the same
• With Tax of 2 per bat (increase firms MC)
• Profit-maximizing level of output falls
• The different effects are due to the nature of
  the Factor of Production.

43
What if

• government imposed a tax of 20 per bat (think of
  this tax as equivalent to increase in marginal
  cost.)
• TR lt VC for all level of Q.
• If this firm continues to operate, it would
  suffer an even greater loss.
• This firms should shutdown and loss equals to the
  fixed cost, 60.

Bats (per day) Total Revenue (/day) Total Variable cost (/day) Fixed Cost (/day) Total Cost (/Day) Profit (/day)
0 0 0 20(0)0 60 60 -60
5 50 15 20(5)115 60 175 -125
10 100 30 20(10)230 60 290 -190
15 150 60 20(15)360 60 420 -270
20 200 105 20(20)505 60 565 -365
25 250 165 20(25) 665 60 725 -475
30 300 240 20(30) 840 60 900 -600
35 350 330 20(35) 1030 60 1090 -740
44
Chapter 6 Problem 6

• Calculate daily producer surplus for the market
  for pizza whose demand and supply curves are
  shown in the graph.

Price (/slice)
S
6
3
D
0
12
Quantity (1,000s of slices/day)
24
45

• Producer Surplus
• The economic surplus received by sellers.
• If the price exceeds MC, the firm receives a
  producer surplus.
• It is the difference between price that sellers
  receive (market price) and the lowest price that
  the sellers are willing to sell (reservation
  price or marginal cost).
• To calculate producer surplus
• The area below the market price and above the
  supply curve.

46
Price (/slice)

• Producer surplus
• The area of the shaded triangle
• (3/slice) (12,000 slices/day) (1/2) 18,000
  slices /day

S
6
3
D
0
24
12
Quantity 1000s slice per day
47
Chapter 6 Problem 8

• For the pizza seller whose marginal, average
  variable, and average total cost curves are shown
  in the accompanying diagram, what is the
  profit-maximizing level of output and how much
  profit will this producer earn if the price of
  pizza is 0.80 per slice?

MC
ATC

• Price (/slice)

AVC
1.03
0.80
0
360
Quantity (slices/day)
48

• Assume it is a perfectly competitive market
• Firms are price taker
• It is a profit-maximizing firm
• Goal is to maximize the amount of profit it earns
• The optimal level of output that maximizes
  profit, when, P MC
• Firms earn profit when,
• P gt ATC where Q is at optimal level of output
• Firms Short-run shutdown condition
• P lt Min. AVC

49

• This firm is suffering a lost
• P lt ATC
• Will this firm shutdown in the short-run?
• NO. P gt min. AVC
• What is the profit-maximizing output?
• Profit-maximizing output, is the point where P
  MC.
• This firm will sell 360 slices per day to
  maximize its profit.
• How much profit will this firm earns if price of
  pizza is 0.80 per slice?
• Profit TR TC
• TR P x Q, TC ATC x Q
• Profit P x Q ATC x Q
• Profit ( P ATC )Q
• (0.80 - 1.03)(360 slices)
• - 82.8/day (loss)

50
MC
ATC

• Price (/slice)

AVC
1.03
Loss
0.80
0
360
Quantity (slices/day)
51
Chapter 6, Problem 9

• For the pizza seller whole marginal, average
  variable, and average total cost curves are shown
  in the accompanying diagram, what is the
  profit-maximizing level of output and how much
  profit will this producer earn if the price of
  pizza is 0.50 per slice?

MC
ATC
Price (/slice)
AVC
1.18
0.68
0.50
0
Quantity (slices/day)
260
52

• The firm shutdown point is at P 0.68 per slice
  (where P AVC)
• The firm should shutdown at any point below 0.68
• If a slice of pizza is sold for only 0.50, the
  firm will definitely not produce any pizza and
  shut down
• Because price is less than the minimum value of
  AVC, this producer will shut down in the short
  run.

53

• If the firm shuts down, there will be no
  (average) variable cost
• By shutting down the plant, the firm will have a
  negative profit that is exactly equal to the
  fixed cost
• Fixed cost Total cost variable cost
• Total cost
• ATC Q
• 1.18 / slice 260 slices 306.80 / day
• Variable cost
• AVC Q
• 0.68 / slice 260 slices 176.80 / day

54

• Fixed cost 306.80/day - 176.80/day 130/day
• Thus, by shutting down the plant in the short
  run, the firm will loss 130 a day
• In other words, the firm earns a profit of -130
  per day if the price for a slice of pizza is just
  0.50

55
Chapter 6 Problem 10

• For the pizza seller whose marginal, average
  variable, and average total cost curves are shown
  in the accompanying diagram (who is the same
  seller as in problem 9), what is the
  profit-maximizing level of output and how much
  profit will this producer earn if the price of
  pizza is 1.18 per slice?

56
MC
ATC
AVC

• Price (/slice)

1.18 0.77 0.68 0.50
0
435
260
Quantity (slices/day)
This firm will sell 435 slices per day to
maximize its profit.
57

• This firm is making profit
• P gt ATC
• The profit-maximizing output is 435 slices if
  price of pizza is 1.18 per slice
• Total profit
• Profit TR TC
• TR P x Q
• TC ATC x Q
• Profit (P - ATC) x Q

58
MC
ATC
AVC

• Price (/slice)

1.18 0.77 0.68 0.50
?
0
435
260
Quantity (slices/day)
This firm will sell 435 slices per day to
maximize its profit.
59

• ATC at the profit-maximizing level of output
• Recall, TC FC VC
• At the optimal level of output, 435 slices, AVC
  equals to 0.77 per slice
• VC AVC x Q
• VC 0.77 x 435 slices
• VC 334.95
• Recall from Q9, the firms FC 130 per day
• Total cost
• 130 334.95 464.95

60

• Total profit at price of 1.18 per slice and
  output 435 slices
• Profit TR TC
• TR P x Q
• 1.18 x 435 slices
• 513.3
• Profit 513.3/day - 464.95/day 48.35

61
Additional Question 4
According to the graph below, if market price of
sweater is 20. What is the profit-maximizing
output? How much profit will this firm make?
What should be the shutdown point for this firm?
MC
ATC
AVC

• Price (/sweater)

20
17
15
0
5
6
8
Quantity (sweater/day)
62

• At price 20, the profit-maximizing output is 8
  sweaters per day
• At price 20, P MC ATC
• This is the firms breakeven point, total revenue
  equals total cost
• It earns zero economic profit
• Economic profit Total Revenue Explicit Costs
  Implicit Costs
• (More on Chapter 8)

63

• Shutdown point the output and price at which
  the firm just covers its total variable cost.
  Firm is indifferent between continuing operations
  and shutting down.
• P MC min. AVC
• At price 17, P min. AVC,
• Both price and AVC equal 17, the firm just
  covers its TVC
• The firm is indifferent on staying or shutting
  down
• At the shutdown point, firm usually incurs loss.
  How could it be able to cover its TVC?
• As long as the Unit Contribution Margin equals to
  zero, this is the firms shutdown point.
• Unit Contribution Margin Unit Revenue (Unit
  Price) Unit Variable Cost (AVC)

64

• Any point below the shutdown point, the firm
  should shutdown.
• At price 15, P lt min. AVC,
• Firms cannot even cover its TVC
• It should shutdown and the loss equals to fixed
  cost
• Therefore, the shutdown point is at 17
• Any price below 17, the firm should shutdown

65
MC
ATC
AVC
Breakeven Point

• Price (/sweater)

20
Shutdown Point
17
15
0
5
6
8
Quantity (sweater/day)
66

• End of Chapter 6