Chapter 6

Perfectly competitive supply: the cost side of the market

6.1 Thinking about supply: the important of opportunity cost

- The supply curve for a good or service is rooted in the individual’s choice of whether to
produce it, and that choice is guided by the logic of the cost-benefit principle.
- We can find the supply curve by plotting the reservation prices at different quantities.
- When the container refund increases, it becomes more attractive to abandon alternative
pursuits to spend more time searching for soft drink containers.
- The prices at which individuals offer goods and services for sale depend, in turn, on the
opportunity cost of the resources required to produce them.

Individual and market supply curves

- The quantity that corresponds to any given point on the market supply curve is the sum
of the quantities supplies at that price by all individual sellers in the market.
- To generate the market supply curve from the individual supply curves, we add the
individual supply curves horizontally.

6.2 Supply in perfectly competitive markets

- Profits – the total revenue a firm receives from the sale of its product minus all costs –
explicit and implicit – incurred in producing it.

Profit maximization
- Profit-maximising firm – a firm whose primary goal is to maximize the difference
between its total revenues and total costs, or profit.
- Maximum profit when price=marginal cost

Perfectly competitive markets

- Perfect competitive market – a market in which no individual supplier has any influence
on the market price of the product.
- The supply curves that economists use in standard supply and demand theory are based
on the assumption that goods are sold by profit-maximising firms in perfectly
competitive markets.
- Price taker – a firm that has no influence over the price at which it sells its products.
Perfectly competitive firms.
- Four characteristics of markets that are perfectly competitive;
Ø All firms sell the same standardized product.
Ø The market has many buyers and sellers, each of which buys or sells only a small
 fraction of the total quantity exchanged.
Ø Sellers are able to enter and leave a market as they like. This requires that
productive resources be mobile.
Ø Buyers and sellers are well informed. They must be aware of the relevant
opportunities available to them.
- Imperfectly competitive firm – a firm that has at least some control over the market
price of its product.
- Like Microsoft, that have at least some ability to vary their own prices.

The demand curve facing a perfectly competitive firm

- The challenge confronting the perfectly competitive firm is to choose its output level so
that it makes as much profit as it can at that price.

Production in the short run

- Factor of production – an input used in the production of a good or service.
- Short run – a period of time sufficiently short that at least one of the firm’s factors of
production are fixed.
- Long run – a period of time of sufficient length that all the firm’s factors of production
are variable.
- Law of diminishing returns – in the short run, when at least one factor of production is
fixed, successive increases in the input of a variable factor eventually yield smaller and
smaller increments in output. Equivalently, when some factors of production are fixed,
increased production of the good eventually requires ever-larger increases in the
variable factor.
- Fixed factor of production – an input whose quantity does not change as the output of a
particular good or service produced in a given period of time, changes.
- Variable factor of production – an input whose quantity varies as the output of a
particular good or service produced in a given period of time, changes.

Costs in the short run

- Fixed cost – the sum of all payments made to the firm’s fixed factors of production.
- Variable cost – the sum of all payments made to the firm’s variable factors of production.
- Total cost – the sum of all payments made to the firm’s fixed and variable factors of
production.
- Fixed cost is the sunk cost for the duration of the lease.
- Marginal cost is defined as the change in total cost divided by the corresponding change
in output.

A note on the firm’s shutdown condition

- When the market price of a firm’s product falls so that its revenue from sales is less than
its variable cost at all possible levels of output, the firm should then cease production for
the time being.
- By shutting down, it will suffer a loss equal to its fixed costs.
- The short-run shutdown rule says that the firm should shut down in the short run if P X
 Q is less than VC for every level of Q.

Thinking in terms of average costs

- If P X Q < VC for all levels of Q, then P < VC / Q for all levels of Q.
- VC / Q is average variable cost.
- Average variable cost (AVC) – variable cost divided by total output.
- Short-run shutdown condition – a firm should shut down and produce nothing in the
short run when P X Q < VC, or when P < minimum value of AVC.
- Average total cost (ATC) – total cost divided by total output.
- ATC is pulled down by spreading the overheads and behaviour of the average variable
cost. Then the law of diminishing returns sets in, and the AFC is not strong enough to
offset the law of diminishing return (i.e. from AVC)
- Profit= (P X Q) – (ATC X Q)
- A firm can thus be profitable only if the price of its product price exceeds its ATC for
some level of output.

Showing profit maximisation graphically

- The upward-sloping portion of the MC curve corresponds to the region of diminishing
returns.
- The MC curve cuts both the AVC and ATC curves at their minimum points, and that the
vertical distance between the AVC and ATC gets smaller as output rises.

-
- Average fixed cost (AFC) – fixed cost divided by total output.

Profit=marginal cost: the maximum-profit condition

- If P is greater than MC, the firm can increase its profit by expanding production and sales.
- If P is less than MC, the firm can increase its profits by producing and selling less output.
- Profit is maximized when P=MC.
- The firm’s profit is the difference between its total revenue and its total cost.
- Profit is equal to (P-ATC) X Q, which is equal to the area of the shaded triangle.
- When price is less than ATC, but above minimum AVC, at the profit maximizing quantity,
the firm experiences a loss, which is equal to the area of the shaded triangle, (ATC-P) X Q.
Ø The company should still operate at this price in the short run.

Law of supply
- The law of supply says that producers offer more of a product for sale when its price
rises.
- Because supply curves are essentially marginal cost curves, and because of the law of
diminishing returns, marginal cost curves are upward-shaping in the short run.
- For every price-quantity pair along the market supply curve, the price will be equal to
each seller’s marginal cost of production.
- At every point along a market supply curve, price measures what it would cost producers
to expand production by one unit.

6.3 Determinants of supply revisited

Technology
- The most important determinant of production cost is technology.
- The only technological changes that rational producers will adopt are those that will
reduce their cost of production.

Input prices
- The price of crude oil may fluctuate, and the resulting shifts in supply will cause the price
of the product to exhibit corresponding fluctuations.

Expectations
- Expectations about future price movements can affect how much sellers choose to offer
in the current market.

Changes in prices of other products

- Most important after technology is variation in the prices of other goods and services
that sellers might produce.

The number of suppliers

- The preceding four factors affect market supply indirectly, since market supply is the
horizontal aggregation of individual supply curves.
- Rise in no. of suppliers= shift of curve to right.
6.4 Applying the theory of supply
Smart for one, dumb for the group
- We should recycle the number of containers for which the marginal cost of recycling is
equal to marginal benefit
- The theory of supply can be used to predict how sellers will respond to changes in a
good’s price and to other factors that determine supply.
- If the incentives that an individual supplier of an activity faces do not reflect the benefits
of that activity to society or the group, private decisions will not be socially optimal.

6.5 Supply and producer surplus

- Producer surplus / seller’s surplus – the difference between the amount actually
received by the seller of a good and the seller’s reservation price.

Calculating producer surplus

- Producer surplus in a market is calculated in an analogous way as the area bounded
above by the market price and bounded below by the market supply curve.
- Producer surplus is the cumulative sum of the difference between the market price and
these reservation prices.
- A shift of the supply curve to left will reduce economic surplus.
- Measuring changes in producer surplus can help government decision makers
understand how changes in the market conditions affect the welfare of sellers.