Perfectly Competitive Supply: The Cost Side of The Market

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.

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 Slugger’s 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 company’s 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 firm’s 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 firm’s 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 company’s output, variable cost, total cost and marginal cost for each level of employment.

17. Example: Louisville Slugger

18. Choosing Output to Maximize Profit • If a company’s 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).

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:

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 P=MC • 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.

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 firm’s fixed cost is a sunk cost, the firm’s 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 firm’s 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 130—say, 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 firm’s 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 day—say, 150—at 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 firm’s profit is $41.60/day.

36. Profit is equal to (P – ATC)xQ, which is equal to the area of the shaded rectangle. Modified Louisville Slugger Example

37. End