More on supply Today: Supply curves, opportunity cost, perfect competition, and profit maximization
In previous lectures… • …we have studied demand • Today, we start supply • Some concepts from demand carry over to supply • Horizontal addition • Surplus
Other supply concepts • It is important to think like an economist when looking at supply • Opportunity cost is important in decision making • Economic profit includes not only explicit costs, but also implicit costs • Costs can be fixed or variable • Some firms may operate at a loss in the short run • MB = MC rule (except under shutdown condition)
Today • Idea of perfect competition • Very little or no market power by any firm • Individual supply to market supply • Opportunity costs • The first steps to profit maximization
Perfect competition • For all discussion until Ch. 10 (monopoly), assume that all markets are perfectly competitive, unless mentioned otherwise • In perfect competition, there are many firms, each of which produces a very small percentage of the good in question
Perfect competition • Each firm has no significant control over price charged under perfect competition • Perfectly competitive markets do not necessarily occur when product differentiation occurs • This will also be addressed in Ch. 10
Perfect competition • Since each firm has no control over price, each firm is called a price taker • In this example, market equilibrium is $5 • Each firm can sell as much of the good it wants at $5/lb.
Perfect competition • How much will each firm sell? • Theory: Each firm will sell the output that maximizes profits
The steps to profit maximization • Profit = Total revenue – Total cost = Total revenue – Variable Cost – Fixed Cost • Opportunity costs are included in the total cost when calculating economic profit
Opportunity cost • Always think “what is the best use of my time?” • Assume that you have 10 hours per week for jobs • Building widgets, which sell for $1 each • Working at an I.V. coffee shop for $10/hr. • Assume that material costs for widgets and walking costs to I.V. are negligible
Opportunity cost • Should I only build widgets, since I am making positive profits for each widget produced? • Maybe • For each widget I build, I must work less at the coffee shop • Similar logic applies to working at the coffee shop
Supply of widgets and coffee shop work • How much should I work at each job? • To make the most money, of course • Remember that marginal analysis is important in making the most money
Widget production function
Why diminishing marginal productivity? • Assume that widget production is labor-intensive • You will pick your most productive work hour each week to be the first hour of work on widgets • You use the best opportunities to be the most productive
How many widgets should I build? • Again, we use marginal analysis in maximizing your earnings for your 10 hours available for work each week • I should build widgets as long as: MB ≥ MC (in dollars)
How many widgets should I build? • MB of 1st hour of work: $15 • MB of 2nd hour of work: $13 • MB of 3rd hour of work: $11 • MB of 4th hour of work: $9 • MC of each hour of widget building is the $10 lost in wages from working at the coffee shop
How many widgets should I build? • Is MB ≥ MC? • 1st hour? Yes, since $15 > $10 • 2nd hour? Yes, since $13 > $10 • 3rd hour? Yes, since $11 > $10 • 4th hour? No, since $9 < $10
How many widgets should I build? • You should build widgets for 3 hours/week, earning $39 from widgets • You should work 7 hours/week, earning $70 from work • Total earnings: $109/week • Marginal analysis Maximize earnings
Deriving individual supply • From previous example: • If price of widgets goes up, I would want to spend more time building widgets • If price of widgets goes down, I would want to spend less time building widgets • As price goes up, quantity supplied increases • We have justified an upward-sloping supply curve
Market supply • Horizontal addition from individual supply to market supply • We did this already with demand
Moving on… • Today, we will not start analyzing the costs necessary to analyze profit maximization • We will look at this on Friday
Long run • By definition, the long run is such that all costs are variable • Analysis in the long run is easier than in the short run • In the long run, profits are maximized to be either positive or at zero
Fixed costs in the short run • The short run is defined such that some costs must be spent, whether or not a firm operates • Short run cost examples could include: • Rent • Capital (e.g. manufacturing equipment) • Contract laborers
Simplified analysis • Although there may be many fixed costs and many variable costs, we will study a simple case • One fixed cost: Building rent • One variable cost: Labor costs
Graphical approach? • A graphical approach is best used with continuous cost functions • We will start with a discrete example on Friday
