Chapter 6 Perfectly Competitive Supply:

The cost side of the market

Even-numbered Qs. and #3 #94 additional questions

• 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 firm’s demand curve is perfectly elastic

• Five conditions of Perfectly competitive market:1) 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- individual’s decision will have no impact on the market price

4) Productive resources are mobile- free to enter or exit the market

5) 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

• 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

• 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

• 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

• 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

Quantity

MC

Law of diminishing returns

• 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

• For a perfectly competitive firm, it chooses to produce at a point where P=MC

• If P > MC: Firm can increase its profit by increasing output• If P < MC: Firm can increase its profit by decreasing output

Firms earn profit P > ATC where Q is at optimal level of output

Firms suffer loss P < 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 < min. AVC, loss = fixed cost

To Summarize:

• If P > ATC > min. AVCFirms earn profit and stay in the market

• If ATC > P > min. AVCFirms suffer loss but continue to operate

• If ATC > min. AVC > PFirms should shutdown and loss equals to its fixed cost

Q1) Which of the following is NOT true of a perfectly competitive firm?

A) It faces a perfectly elastic demand curve.B) It is unable to influence the market price of the good it

sells.C) It seeks to maximize revenue.D) Relative to the size of the market, the firm is small.E) The firm’s only decision is how much output to produce.

Additional Question #1

Ans: C

• (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.

• (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.

• (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 firm’s cost function.

• A rational economic agent will always aim at maximising profits.

• 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!!

• 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.

Q2)The Law of Diminishing Marginal Returns…

A) Is a Long Run concept.B) Applies only to small and medium sized firms.C) Is a Short and Long Run concept.D) Applies only to large firms.E) Is a short run concept.

Additional Question #2

Ans: E

• 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.

• 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.

• (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

Yes Yes

No

• 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).

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…

A) Expand output.B) Lower Price.C) Earn greater profits or smaller losses.D) Contract output.E) Earn smaller profits or great losses.

Additional Question #3

Ans: C

• First of all, how are production decisions made by firms in economics?

• Firms make production decisions based on a universal rule: MC=MR

• For a price taker, its marginal revenue is always equal to the price (MR=P)

• Therefore, the firm only has to determine its output level. The optimal level of output is where MC = MR.

• 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 MC=MR be affected?

• NO!

• 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.

• 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.

• 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.

Chapter 6 Problem 2A 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

To decide how many air conditioners should produce in order to maximize its profit, we can

1) Apply the cost-benefit principle ,or,2) Calculate the profit levels and choose the production level

that gives the largest profit

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 > 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.

• 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) > 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

• 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

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. Paducah’s 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

a) If the wage is $15 per hour and Paducah’s 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

b) If the firm’s 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

Chapter 6 Problem 4

In the preceding problem (3), how would Paducah’s 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 Paducah’s 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 firm’s marginal cost.) Why do these two taxes have such different effects?

Fixed cost: • Cost on all fixed Factor of Production, ex., lease payment on

machines, buildings• Not depends on firm’s output• A sunk cost

Variable cost:• Cost on all variable Factor of Production, e.g., labor cost,

input cost• Depends on firm’s output• Varied with number of products that firm produces

• 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.

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

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 +10=$130 $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

• 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

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

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 + 2*0= $0 0 + 60 =$60 -$60

5 50 1 *15 + 2*5= $25 25 + 60 =$85 -$35

10 100 2 *15 +2*10= $50 50 + 60 =$110 -$10

15 150 4 *15 + 2*15= $90 90 + 60 =$150 $0

20 200 7 * 15 +2*20= $145 145 + 60 =$205 -$5

25 250 11 *15 +2*25= $215 215 + 60 =$275 -$25

30 300 16 *15 +2^30= $300 300 + 60 =$360 -$60

35 350 22 *15 +2*35= $400 400 + 60 =$460 -$110

• 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 firm’s MC)• Profit-maximizing level of output falls

• The different effects are due to the nature of the Factor of Production.

• government imposed a tax of $20 per bat (think of this tax as equivalent to increase in marginal cost.)

TR < 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

What if…

Chapter 6 Problem 6

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

12

Price ($/slice)

Quantity (1,000s of slices/day)

3

6

0 24

S

D

• 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.

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

Price ($/slice)

6

240

3

Quantity 1000s slice per day

12

S

D

Chapter 6 Problem 8For 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?

Pri

ce (

$/s

lice)

Quantity (slices/day)

MC

ATC

AVC

360

1.03

0.80

0

• 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 > ATC where Q is at optimal level of output

• Firm’s Short-run shutdown condition:P < Min. AVC

• This firm is suffering a lost:• P < ATC• Will this firm shutdown in the short-run?• NO. P > 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 it’s 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)

Pri

ce (

$/s

lice)

Quantity (slices/day)

MC

ATC

AVC

360

1.03

0.80

0

Loss

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?

Quantity (slices/day)

Pric

e ($

/slic

e)

0

ATCAVC

MC

260

0.500.68

1.18

• 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.

• 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

• 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

Chapter 6 Problem 10For 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?

Pri

ce (

$/s

lice)

Quantity (slices/day)

MCATC

AVC

435

1.180.770.680.50

2600

This firm will sell 435 slices per day to maximize it’s profit.

• This firm is making profit:• P > 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

Pri

ce (

$/s

lice)

Quantity (slices/day)

MCATC

AVC

435

1.18

0.770.68

0.50

2600

This firm will sell 435 slices per day to maximize it’s profit.

?

• 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 QVC = $0.77 x 435 slicesVC = $334.95

• Recall from Q9, the firm’s FC = $130 per day

• Total cost:• $130 + $334.95 = $464.95

• 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

Pri

ce

($/s

weate

r)

Quantity (sweater/day)

MCATC

AVC

8

$20

0

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?

Additional Question #4

1715

5 6

• At price $20, the profit-maximizing output is 8 sweaters per day

• At price $20, P = MC = ATC

• This is the firm’s breakeven point, total revenue equals total cost

• It earns zero economic profit

• Economic profit = Total Revenue – Explicit Costs – Implicit Costs(More on Chapter 8…)

• 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 firm’s shutdown point.

• Unit Contribution Margin = Unit Revenue (Unit Price) – Unit Variable Cost (AVC)

• Any point below the shutdown point, the firm should shutdown.

• At price $15, P < 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

Pri

ce

($/s

weate

r)

Quantity (sweater/day)

MCATC

AVC

8

$20

0

Breakeven Point

Shutdown Point1715

5 6

End of Chapter 6