Chapter 5 - Perfectly competitive supply. In our discussion of supply and demand in part 1, we asked you simply to assume the law of demand, which says that demand curves are downward-sloping. In chapter 5 we will see that this law is a simple consequence of the fact that people spend their limited incomes in rational ways.
Chapter 5: Perfectly Competitive Supply Identify the firm's demand curve, and explain its derivation Describe how the firm employs fixed and variable inputs to produce output Determine why price equals marginal cost at the profit-maximizing output level Construct the industry supply curve from the supply curves of individual firms Define and calculate price elasticity of supply Define and calculate producer surplus McGrawHill/Irwin Copyright © 2011 by The McGrawHill Companies, Inc. All rights reserved Perfectly Competitive Firms 52 Perfectly Competitive Market • Market supply and market demand set the price – Buyers and sellers take price (P) as given • Perfectly competitive firm can sell all it wants at the market price – Since the firm is small, its output decision will not change market price – Each firm must decide how much to supply (Q) • Imperfectly competitive firms have some control over price – Some similarities to perfectly competitive firms 53 Perfectly Competitive Firm's Demand 54 Production Ideas • Production converts inputs into outputs – Many different ways to produce the same product – Technology is a recipe for production • A factor of production is an input used in the production of a good or a service – Examples are land, labor, capital, and entrepreneurship • The short run is the period of time when at least one of the firm's factors of production is fixed • The long run is the period of time in which all inputs are variable 55 Production in the Short Run • A perfectly competitive firm has to decide how much to produce • The firm produces a single product (glass bottles) using two inputs (workers and a bottlemaking machine) – Labor is a variable factor – it can be changed in the short run – Bottle-making machine is a fixed factor – it cannot be changed in the short run • Determine the profit maximizing level of output 56 Law of Diminishing Returns • At low levels of production, the law of diminishing returns may not hold – Gains from specialization • Diminishing returns eventually sets in and is often caused by congestion • Only so many people can fit into the office • Only one worker can use the machine at a time When some factors of production are fixed, increased production of the good eventually requires ever larger increases in the variable factor 57 Cost Concepts • Fixed cost is the sum of all payments for fixed inputs – The $40 per day for the bottle machine – Often referred to as the capital cost • Variable cost is the sum of all payments for variable inputs – The total labor cost – Wage rate of $10 per hour • Total cost is the sum of all payments for all inputs – Fixed cost plus variable cost 58 Find the Output Level that Maximizes Profit Profit = total revenue – total cost • Since Total cost = fixed cost + variable cost – Profit = Total revenue – variable cost – fixed cost • The firm must know about both revenues and costs in order to maximize profits – Increase output if marginal benefit is at least as great and marginal cost – Decrease output if marginal benefit is greater than marginal cost 59 The Seller’s Supply Rule • The profit maximizing quantity does not depend on fixed cost • A firm should increase output only if the extra benefit exceeds the extra cost (cost-benefit principle) • The extra benefit is the price • The extra cost is the marginal cost – the amount by which total cost increases when production rises • The competitive firm produces where price equals marginal cost • When diminishing returns apply, marginal cost rises as production increases 510 The Firm’s Shut-Down Condition • Firms can suffer losses in the short run – Some firms continue to operate – Some firms shut down • When should the firm shut down in the short run? • If revenue from sales is less than its variable cost when price equals marginal cost • The firm will suffer a loss equal to fixed cost • If it remains open it will suffer an even larger loss because variable costs are greater than total revenue 511 "Law" of Supply • Short-run marginal cost curves have a positive slope – Higher prices generally increase quantity supplied • In the long run, all inputs are variable – Long-run supply curves can be flat, upward sloping, or downward sloping • The perfectly competitive firm's supply curve is its marginal cost curve – At every quantity on the market supply curve, price is equal to the seller's marginal cost of production – Applies in both the short run and the long run 512 Increases in Supply 513 Price Elasticity of Supply • Price elasticity of supply is defined as the percentage change in quantity supplied from a percent change in price Price elasticity of supply = Price elasticity of supply = P Q ΔQ / Q ΔP / P x slope 514 Determinants of Price Elasticity of Supply 515 Supply Opportunity Cost Pr Su o d u rp ce lu r s Individual Supply Curve ProfitMaximizing Quantity Market Supply Curve Market Equilibrium Price Supply Determinants Market Demand Curve 516 ... percent change in price Price elasticity of supply = Price elasticity of supply = P Q ΔQ / Q ΔP / P x slope 5 14 Determinants of Price Elasticity of Supply 5 15 Supply Opportunity Cost Pr Su o d u... run – Bottle-making machine is a fixed factor – it cannot be changed in the short run • Determine the profit maximizing level of output 5 6 Law of Diminishing Returns • At low levels of production,... the seller's marginal cost of production – Applies in both the short run and the long run 5 12 Increases in Supply 5 13 Price Elasticity of Supply • Price elasticity of supply is defined as the