Supply Side--LecturesSupply Side--Lectures

Rebecca Tuttle BaldwinRebecca Tuttle Baldwin

BCC--MicroBCC--Micro

Reminder for our simple model Reminder for our simple model

• Supply side means firms in final goods/service market

• We will use corporate structure

• Supply ( Price & Quantity relationship) reflects the quantity of the good firm willing & able to produce at various prices.

Perfectly Competitive MarketPerfectly Competitive Market

• Many buyers

• Many sellers

• Ease of entry/exit (no barriers)

• Perfect information

• Homogeneous good

ProfitProfit

• Defined as the residual after subtracting all costs to necessary factors of production from gross revenues.

• TR-TC

• All firms are profit maximizers, not revenue or sales

Result for our individual firmResult for our individual firm

• No market power--it will be a price TAKER

How does Total Revenue (TR) depend on How does Total Revenue (TR) depend on

Quantity (Q)?Quantity (Q)? • = Price times Quantity (PxQ)

• focus on one product’s production at a time

• relatively straightforward (comes from demand)

CostsCosts

• capture opportunity costs of factors

• only true costs are opportunity cost

• needed for calculation of “economic” profit, to distinguish from “accounting profit”

• can be broken down or sorted into fixed/variable or implicit/explicit

Time Needs to be brought into our Time Needs to be brought into our modelmodel

• Short-run (production decision)– Relevant decision is what Q to produce at?

• Long-run (investment decision)– Whether to enter/exit market– In the Long-Run ALL COSTS ARE VARIABLE

(FC=0)

Production FunctionProduction Function

• Links quantity of input to output levels• Marginal Product of labor is defined at the

incremental increase in production from one more unit of labor, also called Marginal Physical Product (MPP)

• Already know marginal concept

MPPMPP

• Expect it to decline as we add more workers

• Why?

• When evaluating, we are holding other factors constant

Marginal CostsMarginal Costs

• Change in Total Costs due to one unit change in Quantity produced

• =change in TC/change in Q

• can graph MC on $/Q

Review ExampleReview Example

– Economan has been infected by the free enterprise bug and set up a firm on extraterrestrial affairs. The rent for the building is $4000, cost of two secretaries is $40,000 and the cost of electricity and gas comes to $5000. There is a great demand for his information and his total revenues amount to $100,000. He has turned down the $50,000 salary he could have made from the Friendly Space Agency and he lost the interest of $4000 he made last year because now his funds are tied up in the business

Profit?Profit?

– Explicit Costs ($4000+$40,000+5,000)=49K– Implicit Costs ($54K)– TR=$100K– Economic Profit -3K

Supply Curve for Ind. FirmSupply Curve for Ind. Firm

– Firm is a price-taker– Profit Max Rule then P=MC– so the P represents the minimum amount they

would be willing to accept to produce that quantity for sale (our definition of Supply curve)

– Market curve-aggregate across firms

DeterminantsDeterminants

• Because the Marginal Cost curve is the supply curve, anything that changes MC will shift curve.

• Technology, expectations, factor markets

Producer SurplusProducer Surplus

• difference between price and the marginal cost.

• below market price and above supply curve for market

Competitive Market ModelCompetitive Market Model

• Demand curve is summation of individual demand curves, which are based on the MB of additional consumption

• Market supply is aggregated across all firms, and their individual supply curve comes from their MC curve (in S-R)

Model driven to equilibriumModel driven to equilibrium

• With enough time to adjust, in the absence of shifts, this market will reach an equilibrium, regardless of where it started

• Once price and Q established within market, now we can use the price to answer output and consumption for each individual player.

Imperfect InformationImperfect Information

• Consumer only has information on his/her own tastes, WTP

• Individual firm only knows its own MC structure

• Still works fairly well as a predictor

Why do we like competitive markets?Why do we like competitive markets?

• Leads to an efficient outcome

• responsive

• adaptable

• captures society’s relative rankings

EfficiencyEfficiency

• Use the least amount of resources to produce a given level of output

• For a given level of inputs, yield the most output

• With voluntary transactions, no one can be made better off without making someone else worse off (Pareto efficiency or optimal)

Conditions for EfficiencyConditions for Efficiency

• MB=MC for last

• MC equal for all producers

• MB equal across consumers

• Quantity is not the same

Efficient SolutionEfficient Solution

• Not unique outcome

• Depends on initial income distributions

• PROPERTY RIGHTS

• Income inequality (issue of fairness)

Market Equilibrium and the Market Equilibrium and the

Firm’s Demand Curve in Perfect CompetitionFirm’s Demand Curve in Perfect Competition

Market Equilibrium and the Market Equilibrium and the

Firm’s Demand Curve in Perfect CompetitionFirm’s Demand Curve in Perfect Competition

Bushels ofwheat per day

$5

0 1,200,000

S

D

Pri

ce p

er b

ush

el

(a) Market Equilibrium

Pri

ce p

er b

ush

el

$5

0 Bushels ofwheat per day

d

5 10 15

(b) Firm’s Demand

Short-Run Short-Run Profit Profit

MaximizationMaximization

Short-Run Short-Run Profit Profit

MaximizationMaximization

$60

48

15

0

Total cost Total revenue ( $5 × q )

Maximum economicprofit $12

Bushels of wheat per day 5 7 10 12 15

To

tal

do

lla

rs

(a) Total Revenue Minus Total Cost

$5

4

0 15

Marginal cost

Average total cost

d Marginal revenue average revenue

e

a

Profit

Bushels of wheat per day 12 10 5

Do

lla

rs p

er

un

it

(b) Marginal Cost Equals Marginal Revenue

Minimizing Minimizing Short-Run Short-Run

Losses Losses

Minimizing Minimizing Short-Run Short-Run

Losses Losses

$4.00

3.00 2.50

0 5 10 15

Marginal cost

Average total cost

d Marginal revenue average revenue

Average variable cost

eLoss

Bushels of wheat per day

Do

lla

rs p

er

bu

sh

el

(b) Marginal Cost Equals Marginal Revenue

$40

30

15

0 5 10 15

Total cost

Total revenue( $3 × q )

Minimum economicloss = $10

Bushels of wheat per day

(a) Total Cost and Total Revenue

To

tal

do

lla

rs

Summary of Short-Run Summary of Short-Run Output Decisions Output Decisions

Summary of Short-Run Summary of Short-Run Output Decisions Output Decisions

Do

lla

rs p

er

un

it

0

q1 Quantity per period

d1

Average total cost

Average variable cost

4

1

Marginal cost

p1

Shutdownpoint

2

q2

p2 d

2

q3

3p

3 d

3

Break-evenpoint

q4

p4 d

4

q5

p5

5d

5

Aggregating Individual Aggregating Individual Supply to Form Market Supply Supply to Form Market Supply

Aggregating Individual Aggregating Individual Supply to Form Market Supply Supply to Form Market Supply

Pri

ce p

er

un

it

p'

p

0 10 20

(a) Firm A

SA

Quantity per period

p'

p

0 30 60

(d) Industry, or market, supply

Quantity per period

(b) Firm B (c) Firm C

p'

p

0 10 20

p'

p

0 10 20

SCSB

Quantity per period

Quantity per period

SAS

BS

C S

Relationship Between Relationship Between Short-Run Profit Maximization and Short-Run Profit Maximization and

Market Equilibrium Market Equilibrium

Relationship Between Relationship Between Short-Run Profit Maximization and Short-Run Profit Maximization and

Market Equilibrium Market Equilibrium

Do

llars

per

un

it

$5 4

0 5 10 12 Bushels of wheatper day

Bushels of wheatper day

(a) Firm

d

Pri

ce p

er u

nit

$5

0 1,200,000

(b) Industry, or market

D

ATCAVC

Profit

MC = SMC = s

Long Run Equilibrium Long Run Equilibrium for the Firm and the Industryfor the Firm and the Industry

Long Run Equilibrium Long Run Equilibrium for the Firm and the Industryfor the Firm and the Industry

p

0

d

Quantity per period

MC

ATC

e

LRAC

q

Do

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per

un

it

p

0

Q Quantity per period

Pri

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er u

nit

S

D

(a) Firm (b) Industry, or market

Long-Run Adjustment Long-Run Adjustment to an Increase in Demandto an Increase in Demand

Long-Run Adjustment Long-Run Adjustment to an Increase in Demandto an Increase in Demand

0

ATC

MC

LRAC

Quantityper period

(a) Firm

0

D

a

Qa Quantity

per period

(b) Industry, or Market

p

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d'

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Profitp'

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p' b

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Long-Run Adjustment Long-Run Adjustment to a Decrease in Demandto a Decrease in Demand

Long-Run Adjustment Long-Run Adjustment to a Decrease in Demandto a Decrease in Demand

p

p"

0

d

MC

ATC

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LRAC

Quantityper period

(a) Firm

0

S

Quantityper period

Qa

(b) Industry, or Market

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ap

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q"

d"

Lossp"

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Exhibit 12: An Increasing-Cost IndustryExhibit 12: An Increasing-Cost IndustryExhibit 12: An Increasing-Cost IndustryExhibit 12: An Increasing-Cost Industry

p a

0

d a

ATC

MC

a

Quantityper period

(a) Firm

pa

0

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D

a

QaQuantity

per period

(b) Industry, or Market

Do

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b bp b d

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Consumer Surplus and Consumer Surplus and Producer Surplus for a Competitive Producer Surplus for a Competitive

Market in the Short RunMarket in the Short Run

Consumer Surplus and Consumer Surplus and Producer Surplus for a Competitive Producer Surplus for a Competitive

Market in the Short RunMarket in the Short RunD

olla

rs p

er u

nit

$10

6 5

0 100,000 120,000 200,000

Producer surplus

Consumer surplus

D

S

m

e

Quantity per period

General Profit Max RuleGeneral Profit Max Rule

• MR=MC

• Marginal Revenue (MR) is change in Total Revenue (TR)/ change in Q

• MR adds to incremental profit and MC takes away from it

But in our Perfectly Competitive WorldBut in our Perfectly Competitive World

• P= MR for an individual firm

• so special case, the rule becomes P=MC