More on supply
Today: Supply curves, opportunity
cost, perfect competition, and profit
maximization
In previous lectures…
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…we have studied demand
Today, we start supply
Some concepts from demand carry over
to supply
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Horizontal addition
Surplus
Core principles, revisited
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It is important to think like an economist
when looking at supply
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Opportunity cost: Important in decision making
Cost-benefit analysis: Economic profit includes
not only explicit costs, but also implicit costs
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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
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Idea of perfect competition
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Very little or no market power by any firm
Individual supply to market supply
Opportunity costs
The first steps to profit maximization
Perfect competition
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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
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Each firm has no significant control over
price charged under perfect competition
Perfectly competitive markets do not
necessarily occur when product
differentiation occurs
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This will also be addressed in Ch. 8
Perfect competition
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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
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How much will each firm sell?
Theory
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Each firm will sell the output that
maximizes profits
Basic idea related to theory
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Sell another unit if profit goes up
The steps to profit
maximization
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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
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Always think “what is the best use of
my time?”
Assume that you have 10 hours per
week for jobs
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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
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Should I only build widgets, since I am
making positive profits for each widget
produced?
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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
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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
0
0
Additional widgets
built
15
1
15
13
2
28
11
3
39
9
4
48
Why diminishing marginal
productivity?
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Assume that widget production is laborintensive
You will pick your most productive work
hour each week to be the first hour of
work on widgets
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You use the best opportunities to be the
most productive
How many widgets should I
build?
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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?
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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?
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Is MB ≥ MC?
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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?
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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
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From previous example:
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If price of widgets goes up, I would want to spend
more time building widgets
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If price of widgets goes down, I would want to
spend less time building widgets
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As price goes up, quantity supplied increases
As price goes down, quantity supplied decreases
We have justified an upward-sloping supply curve
Market supply
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Horizontal addition from individual
supply to market supply
We did this already with demand
Moving on…
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Today, we will not start analyzing the
costs necessary to analyze profit
maximization
We will look at this on Wednesday
Long run
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By definition, the long run is such that
all costs are variable
Analysis in the long run is easier than in
the short run
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In the long run, profits are maximized to
be either positive or at zero
Fixed costs in the short run
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The short run is defined such that some costs
must be spent, whether or not a firm
operates
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The costs that must be spent are fixed costs
Fixed cost examples could include:
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Rent
Capital (e.g. manufacturing equipment)
Contract laborers
Simplified analysis
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Although there may be many fixed costs
and many variable costs, we will study a
simple case
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One fixed cost: Building rent
One variable cost: Labor costs
Graphical approach?
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A graphical
approach is best
used with
continuous cost
functions
We will start with a
discrete example on
Wednesday