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

Core principles, revisited It is important to think like an economist

when looking at supply Opportunity cost: Important in decision

making Cost-benefit analysis: 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. 8 (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. 8

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

Basic idea related to theory Sell another unit if profit goes up

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

Hours of widget production

Total number of widgets built

Additional widgets built

0 0

15

1 15

13

2 28

11

3 39

9

4 48

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

As price goes up, quantity supplied increases If price of widgets goes down, I would want

to spend less time building widgets As price goes down, quantity supplied decreases

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 Wednesday

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 The costs that must be spent are fixed costs

Fixed 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 Wednesday