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

Chapter 6 Perfectly Competitive Supply: The cost side of the market. Even-numbered Qs. and #3 #9 4 additional questions. Profit-maximizing firm - Goal is to maximize profit, - Profit = Total Revenue – Total Cost - Total costs include explicit and implicit costs

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

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  1. Chapter 6 Perfectly Competitive Supply:The 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 firm’s 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 - individual’s 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 P=MC • If P > MC: Firm can increase its profit by increasing output • If P < MC: Firm can increase its profit by decreasing output

  10. To Summarize: • If P > ATC > min. AVC Firms earn profit and stay in the market • If ATC > P > min. AVC Firms suffer loss but continue to operate • If ATC > min. AVC > 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 firm’s 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 firm’s 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? 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: 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.

  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 MC=MR 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?

  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 > 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) > MC ($105)

  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.

  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. 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.

  34. 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?

  35. 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)

  36. 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?

  37. 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

  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 • 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

  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 • 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 firm’s 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 < 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.

  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 24 Quantity (1,000s of slices/day)

  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) S 6 Producer surplus: The area of the shaded triangle: ($3/slice) (12,000 slices/day) (1/2) = $18,000 slices /day 3 D 0 12 24 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 > ATCwhere Q is at optimal level of output • Firm’s Short-run shutdown condition: P < Min. AVC

  49. 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)

  50. MC Price ($/slice) ATC AVC 1.03 Loss 0.80 0 360 Quantity (slices/day)

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