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Principles of Microeconomics, 1st Canadian Edition

Robert H. Frank, Cornell University
Ben S. Bernanke, Princeton University
Lars Osberg, Dalhousie University
Melvin Cross, Dalhousie University
Brian MacLean, Laurentian University

Perfectly Competitive Supply: The Cost Side of the Market

Cyberlecture

This chapter introduces you to perfectly competitive markets and how firms in that market maximize profits. You will also discover the basis of the market supply curve and learn about price elasticity of supply.

What is a perfectly competitive market?
A perfectly competitive market consists of many small firms each producing a similar good for sale and profit. Four conditions sufficient to produce a perfectly competitive market are:

many buyers and many sellers
– each buyer and seller is small relative to the size of the entire market
one good of constant quality is produced
all buyers and sellers know the cost and quality of the product
factors of production can enter and exit the market at low cost

What does the perfectly competitive firm's demand curve look like?
The perfectly competitive firm faces a perfectly elastic demand curve. Since it cannot alter its own price, it is called a price taker.

the firm can sell as much as it can produce at the going price
the going price is determined in the market of all buyers and sellers

The perfectly competitive firm chooses its output to maximize its profit.

What is the difference between the short run and the long run?
Economists measure time with reference to the flexibility of the production process.

short run: that length of time when the quantity of at least one input cannot be changed
– may be two days or two years, depending upon the nature of the production process
long run: that length of time when the quantities of all inputs can be changed
– factories can be enlarged or rebuilt
– machinery can be installed or replaced

Since the quantity of all inputs cannot be changed instantaneously, all firms operate on a day-to-day basis in the short run. They keep an eye on the long run, however, for planning purposes.

What is a production function?
A production function tells a firm how much output it can produce, using its current technology, with varying amounts of inputs. For our purposes, we are going to assume that all inputs except labour are fixed in the short run. Therefore a production function tells us how much total output a firm can produce, using its current technology, with varying amounts of labour (L).

Total output is shown below.

Employment and Output for a Glass-Bottle Maker
(1)
Total number of
employees/day (2)
Total number of
bottles/day (3)
Marginal
product (4)
Average product
(2)÷(1)
0 0
90
1 90
110 90
2 200
60 100
3 260
40 87
4 300
38 75
5 338
33 68
6 371
29 62
7 400
57
11 500
45
16 600
38
22 700 32

What are average product and marginal product?
Marginal product (MP) tells us how much additional output will be produced because of the addition of one more unit of labour. Marginal product is shown below. Average product (AP) tells us how much, on average, each unit of labour produces. Average product is shown below.

Average and marginal product both increase and then decrease as additional labour is added to the production process.
Marginal product eventually decreases because more labour applied to a fixed amount of capital causes crowding and less efficient work. Therefore, less additional output is produced as more labour is added. This is referred to as the law of eventually diminishing returns. Note that marginal product can even be negative if crowding is severe.

How are marginal and average values related?
Marginal values lead average values. If a marginal value is less than the average, the average will fall. If a marginal value is greater than the average, the average will rise. Experiment with your grade point average, and what will happen when you add the grades you earn in additional courses.

How much should the perfectly competitive firm produce?
Marginal revenue (MR) is the additional revenue that is earned from the sale of one more unit of output (Q). In this case, marginal revenue is how much total revenue increases when the firm produces and sells an extra unit of output.
Marginal cost (MC) is the additional cost that is incurred by the production of one more unit of output (Q). In this case, marginal cost is how much total cost increases when the firm produces an extra unit of output.

The perfectly competitive firm should continue to increase its output if and only if the marginal revenue (or price) received from selling that output exceeds the marginal cost of producing the output. The firm will then be maximizing profit.

Practice Activity 1
Try answering some questions about perfect competition output and profit.

What is the Law of Supply?
The Law of Supply says that, in the short run, a firm will offer more for sale if the price of its product rises. The firm's marginal cost curve rises as diminishing returns set in. The firm's marginal cost curve is its supply curve.
The market supply curve is the horizontal summation of all the firms' supply curves.

How do diminishing returns affect short run costs?
When marginal product declines with diminishing returns, marginal cost increases. The opposite holds as well: when marginal product increases, marginal cost decreases. Recall that marginal cost is the additional cost incurred by the production of one extra unit of output.

MC = DTC/DQ

Total variable cost (TVC) is the total cost of the firm's variable factors of production at each level of output. Average variable cost (AVC) is total variable cost divided by output.

AVC = TVC/Q

When average product declines because marginal product is pulling it down, average variable cost increases. And when average product increases because marginal product is pulling it up, average variable cost decreases.

Total fixed cost (TFC) is the firm's short-run capital cost. TFC is not affected by diminishing returns since it exists regardless of the level of production. Average fixed cost (AFC) is total fixed cost divided by output.

AFC = TFC/Q

Average total cost (ATC) is the sum of average fixed cost and average variable cost.

ATC = AFC + AVC

Average fixed cost diminishes as output increases. Both average variable cost and average total cost are u-shaped due to the effect of diminishing returns. Marginal cost intersects both average variable cost and average total cost at the minimum points.

Visit Human Resources Canada's student website, Canlearn Interactive, at http://www.canlearn.ca/English/fin/financial2.html. Click on Student Financial Planner and answer the questions about your future plans for post-secondary education. The planner will summarize what your plans will cost, and provide you with both fixed and variable costs to ponder.

Practice Activity 2
Try answering some questions about output and cost.

When should the perfectly competitive firm shut down?
The firm should shut down when the total revenue earned from the profit-maximizing level of output is less than the firm's total variable cost. The firm must pay its fixed costs in any event. If it also has to pay variable costs that are not covered by revenue, then the firm is losing more money than it needs to lose.
The firm's short-run shut-down point can also be expressed in terms of price: when price falls below minimum average variable cost, the firm should shut down.
The firm shuts down when price is below minimum average variable cost. Thus the firm produces when price is above minimum average variable cost. Therefore the firm's short run supply curve is its marginal cost curve above minimum average variable cost.

Even large companies find they have to shut down on occasion if they find their profits falling. Go to http://news.bbc.co.uk/hi/english/business/newsid_1101000/1101500.stm to read about the General Motors' plant shutdowns in 2001.

How is the firm's profit determined?
Profit is total revenue less total cost. Total revenue (TR) is price × quantity for all the output that the firm produces and sells.
Average profit is total profit divided by output, or average revenue (AR) less average total cost. To find total profit from average profit, multiply by output as shown in the figure below.

What changes supply?
Recall from Chapter 4 that five determinants will shift the supply curve.

Technology: A technological change will shift the market supply curve to the right.
Input prices: An increase in input prices will shift the market supply curve to the left. A decrease in input prices will shift the supply curve to the right.
Number of suppliers: An increase in the number of firms in the market will shift the supply curve to the right. A decrease in the number of firms in the market will shift the supply curve to the left.
Expectations: If firms expect the price of their product to increase in the future, the supply of the product on the market today will decrease and the supply curve will shift to the left. If firms expect the price of their product to decrease in the future, the supply of the product on the market today will increase and the supply curve will shift to the right.
Prices of other products: If the price of other products that the firm could produce increases, firms will switch to that product and the supply curve of the product they were producing will shift to the left. If the price of other products that the firm could produce decreases, firms will produce less of the other products and more of the product whose price has not fallen. Its supply curve will shift to the right.

Economic Naturalist
Why does the price of electronic instruments continue to fall even as the demand for them increases?

What is elasticity of supply?
Price elasticity of supply measures the relative changes in quantity supplied when price changes.

Price elasticity of supply = (DQ/Q)
(DP/P)

Price elasticity of supply is analogous to price elasticity of demand from Chapter 5. Thus price elasticity of supply can also be expressed using the slope of the supply curve.

price elasticity of supply = æ P
Q ö æ DQ
DP ö
è ø è ø

Price elasticity of supply is always positive.

when price rises (+), quantity supplied increases too (+)
when price falls (-), quantity supplied falls too (-)

When a supply curve passes through the origin, its price elasticity will always equal one.

However when a supply curve does not pass through the origin, its price elasticity will change at every point, as is the case with demand elasticity.

Perfectly inelastic supply occurs when quantity supplied does not change if price changes. The value of perfectly inelastic supply is zero. A perfectly inelastic supply curve is vertical.

Perfectly elastic supply occurs when quantity supplied disappears if price changes. The value of perfectly elastic supply is infinite. A perfectly elastic supply curve is horizontal.

What are the determinants of price elasticity of supply?
The main determinant of the price elasticity of supply is how easily factors of production can be obtained. The more easily they can be acquired, the more elastic will be supply.

flexibility of inputs
– if inputs can be easily adapted to other uses, supply will be more elastic
mobility of inputs
– if inputs can be easily moved from location to location, supply will be more elastic
ability to produce substitute inputs
– if substitute inputs can be easily used, supply will be more elastic
time
– the longer the time frame, the longer firms have to increase or change inputs, and the more elastic will be supply

Understanding Questions
Do I understand this chapter? As a check to your understanding of the material in this chapter, you should be able to answer our questions.

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