1LECTURE 6
Topic 4.
Perfectly Competitive Supply
)
ECON1010
Introductory Microeconomics
Q1. The elasticity of demand can be found knowing:
a. only how high the price is.
b. the quantity demanded and the price only.
c. the slope of the demand curve only.
d. mostly whether the product or service is a substitute
or complement.
Last lecture feedback
e. the price, quantity demanded, and slope of the
demand curve.
Q2. If a point on the demand curve in the elastic region sees
an increase in the price, this new price and quantity will be:
Last lecture feedback
b. relatively more elastic
a. more inelastic
c. inelastic
d. less elastic.
e. none of the above
Plan of Lecture 6.
First half
Analysing production costs
Lecture 6 ECON1010 4
Second Half
Profit maximising in Perfectly Competitive
Markets
An understanding of production costs and
assessing their impact in making decisions.
Lecture 6 ECON1010 5
Overview:
Using marginal analysis to help make decisions
to maximise profits in competitive markets.
Consider a Business Case.
You are the new owner of a local pizza shop.
6
Questions.
1. What price do you charge per pizza?
2. Can you cover the costs involved?
3. How many pizzas need to be sold to
maximize profit (not just maximise revenue)?
4. How can economic analysis help?
Lecture 6 ECON1010
2Differing Competition and Differing Demand
Quantity
(units)
Price
($/unit)
Increasing pricing power,
more inelastic demand
Perfectly Competitive
0
Monopolistic
Monopoly
Oligopoly
Perfectly Competitive Market Features.
a. Many buyers and many sellers (small in
size). No one buyer or seller is able to dictate price.
c. Products are homogeneous (identical with no
ability to differentiate, all perfect substitutes).
d. Resources are perfectly mobile (no transport
costs, able to freely enter and leave).
b. Easy entry and exist into the industry (no
barriers or large exit costs).
e. Perfect knowledge and information (both
buyers and sellers) about others in the industry.
9
Perfectly Competitive Market Features.
- looks more like an idealised abstraction!
- firms become price takers in a perfectly
competitive market.
- the “invisible hand” and industry forces
result in supply and demand reaching a
market clearing point.
- each individual firm supplies what it can, at
the price dictated by the market, to
maximise its own profit.
10
Recall (from Lecture 3):
Market supply is the sum of all individual
suppliers.
At a given price, the market quantity supplied is
the sum of all individual quantities able to be
supplied by each firm at that price.
Lecture 6 ECON1010
Perfectly Competitive Market Features.
11
0 Quantity
(‘000 pizzas)
Price
($/pizza)
Mkt
Price
Market
(industry)
Smarket
Dmarket
Mkt
Price
0 Quantity
(pizzas)
Price
($/pizza)
Firm = price taker
Sfirm
Dfirm
Definitions
(understanding production levels, costs to a firm)
Lecture 6 ECON1010
Short run.
12
That time period when some inputs are fixed
(eg: capital) and some inputs can change.
Long run.
That time period when all inputs can
change, including technology and physical
size of the operations.
3Employment and output of pizzas
(in the short run)
Total employees per day Total of Pizzas per day MPL
0 0
1 80
2 200
3 260
4 300
5 330
6 350
7 362
Observation
Output gains from
each additional worker
begins to diminish with
the third worker
(Law of Diminishing
Returns)
0
80
120
60
40
30
20
12
13Lecture 6 ECON1010
Definitions.
Total Fixed Costs (TFC, in $).
14
Costs that remain constant as output either
increases or decreases. eg: rent, insurance.
Total Variable Costs (TVC, in $).
Costs that vary as the output increases or
decreases. eg: topping ingredients, casual wages
(note: buying “in bulk” can reduce the cost/unit)
Lecture 6 ECON1010
Definitions
(understanding production levels, costs to a firm)
Total Costs (TC, in $).
15
Includes all the costs a firm uses in its production.
Average Total Costs (ATC, in $/unit).
The total cost of producing output quantity Q
(units), divided by the total output quantity.
ATC =
TC = TFC + TVC
Definitions.
Average Fixed Costs (AFC, in $/unit).
16
Average Variable Costs (AVC, in $/unit).
Total fixed costs of producing output quantity Q
(units), divided by the total output quantity.
AFC =
Total variable costs of producing output quantity Q
(units), divided by the total output quantity.
AVC =
Definitions.
Marginal Cost (MC, in $/unit).
17
The change in total cost to a firm to produce one
more unit of a good or service.
MC =
Note the units are $/unit, and one extra unit of output
can be a very large number. eg: what is the additional
cost to make one more space shuttle launch? Could be
8 billion dollars for the 10th launch compared to 3
billion dollars for the 2nd launch. Why?
Doing the Calculations.
Lecture 6 ECON1010
You are thinking of buying a gourmet
pizzeria, in an up market trendy suburb, to
add to the pizza stores you already manage.
18
Using historical data from your other stores,
plus survey information in the local area on
demand for your pizzas, you collect the
following data for what you believe relate to
daily sales at your new store.
4Lecture 6 ECON1010 19
Quantity
(pizzas)
Total Fixed Cost
TFC ($)
Total Variable Cost
TVC ($)
0 120 0
10 120 20
20 120 30
30 120 50
40 120 80
50 120 130
60 120 230
70 120 380
80 120 690
Costs and sales data at new store (measured) Note:
Assumptions made in analysing this case are:
Lecture 6 ECON1010 20
1. The operations are occurring in the short
run (the shop size, number of pizza ovens is
fixed and not able to be changed in the near
future).
2. The larger quantity of pizzas can be made
only by employing more casual staff (a high
variable cost component thus being wages).
Quantity
(pizzas)
TFC
($)
TVC
($)
TC
($)
AFC
($/pizza)
AVC
($/pizza)
ATC
($/pizza)
MC
($/pizza)
0 120 0 120 - - - -
10 120 20 140 12 2 14 2
20 120 30 150 6 1.5 7.5 1
30 120 50 170 4 1.7 5.7 2
40 120 80 200 3 2 5 3
50 120 130 250 2.4 2.6 5 5
60 120 230 350 2 3.8 5.83 10
70 120 380 500 1.7 5.4 7.1 15
80 120 690 810 1.5 8.6 10.1 31
Calculated Cost data
A B+CCB C/AB/A
Measured Cost data
Note: if TFC = constant, MC results only from an increase in TVC
0
2
4
6
8
10
12
14
C
o
st
(
$
/p
iz
z
a
)
Quantity (pizzas)
Average Fixed Costs (AFC) and
Average Variable Costs (AVC)
AFC
AVC
10 3020 40 6050 70 80
0
2
4
6
8
10
12
14
16
C
o
st
(
$
/p
iz
z
a
)
Quantity (pizzas)
Average Total Cost
ATC = AFC + AVC
AFC
AVC
AFC
AVC
ATC
10 3020 40 6050 70 80 0
2
4
6
8
10
12
14
16
C
o
st
s
($
/
p
iz
za
)
Quantity (pizzas)
Combined Cost Curves
MC
AFC
AVC
ATC
10 3020 40 50
50
100
200
300
400
500
600
700
800
900
0 10 20 30 40 50 60 70 80 90
T
C
(
$
)
Quantity (pizzas)
Graphical understanding of
ATC and MC
70
(70, 500)
500
10(60, 350)
150
ATC = 500/70
= $7.14 per pizza
MC = 150/10
= $15 per pizza
Total Cost
Curve, TC
Costs are one thing, but what about Profit?
Lecture 6 ECON1010 26
1. Profit = Revenue ─ Expenses
2. Revenue = price * quantity
3. Price depends on many things
(elasticity of demand, differentiation, substitutes etc.,
and the type of Market Structure)
4. For simplicity at this stage, consider a
Perfectly Competitive Market.
What is the supply curve for a firm, ?
Focus on the Marginal Cost
27
1. The operations are taking place in the short
run (the shop size and number of pizza ovens
is fixed and not able to be changed in the near
future).
2. A larger quantity of pizzas can only be made
by employing more casual staff and using
more ingredients (high variable cost
components), and not by having more ovens.
Sfirm
Lecture 6 ECON1010 28
Quantity
(pizzas)
TC
($)
MC
($/pizza)
0 12 -
1 14 2
2 15 1
3 17 2
4 20 3
5 25 5
6 35 10
7 50 15
8 81 31
Calculating the supply curve for a Firm.
NEW revised COST TABLE
For making the 4th pizza,
MC =
= 3 $/pizza
MC =
Question:
If the increase in total cost to make the 4th pizza
is $3, and assuming the selling price dictated by
the market is $10 per pizza, would you make the
4th pizza if you are looking to maximise profit?
Lecture 6 ECON1010 29
Answer:
Need to think about incremental revenues from
selling one extra pizza as well as incremental total
cost of making the extra pizza.
If price obtained from selling one extra pizza
is $10 (Marginal Revenue), and the increase
in total cost (Marginal cost) to make the 4th
pizza is $3, then:
30
there must be an incremental increase to total
profit, since extra revenue is more than the extra
cost, so:
the firm should make the 4th pizza if the aim
is to maximise profit.
Answer (cont):
6MC for the firm = Supply curve for firm
31
The firm should continue to make the next
pizza up until the point where the selling
price (MR) equals the extra total cost to make
that next pizza (MC).
The MC curve is the supply curve
for an individual firm.
Quantity
(pizzas)
MC
($/pizza)
0 -
1 2
2 1
3 2
4 3
5 5
6 10
7 15
8 31
Calculating the supply curve for a firm.
0
2
4
6
8
10
12
14
16
0 1 2 3 4 5 6 7 8
Demand = Price = $10/pizza
MC
Quantity (pizzas)
P
ri
c
e
,
M
C
(
$
/p
iz
z
a
)
Note: Profit is not found from this diagram! When P > MC, a positive
contribution to profit will be made at that level of output. Profit is
found using Revenue - Total cost.
0
2
4
6
8
10
12
14
16
0 1 2 3 4 5 6 7 8
MR
= $10 MR
= $10
MR
= $10 MR
= $10
MR
= $10
MR
= $10
Price = MR = Demand = $10/pizza
MC
P
ri
c
e
,
M
C
(
$
/p
iz
z
a
)
Quantity (pizzas)
Price and MC with Pizzas sold
(for a competitive firm)
Back to the Gourmet Pizza shop! Profit
maximising number of pizzas (at $10 each)?
Quantity Price Revenue Total Cost Profit Profit Incr MC MR
(pizzas) ($/pizza) ($) ($) ($) ($/pizza) ($/pizza) ($/pizza)
0 10 0 120 -120
10 10 100 140 -40 8 2 10
20 10 200 150 50 9 1 10
30 10 300 170 130 8 2 10
40 10 400 200 200 7 3 10
50 10 500 250 250 5 5 10
60 10 600 350 250 0 10 10
70 10 700 500 200 -5 15 10
80 10 800 810 -10 -21 31 10
0
100
200
300
400
500
600
700
800
900
0 10 20 30 40 50 60 70 80 90
R
ev
en
u
e,
T
C
(
$
)
Quantity (pizzas)
Graphical understanding for profit
maximising quantity when MR = MC
MC = 100/10 = $10
per pizza = tangent
slope to TC curve
MR = 800/80 = $10
per pizza = tangent
slope to Revenue line
MR = MC
at 60 pizzas
Profit =
Revenue – Total Cost
(60,600)
M
a
x
P
ro
fi
t
$
2
5
0
(60, 350)
Total Cost
Curve, TC
(50, 250)
$
1
3
0 $
2
0
0 $
2
5
0
$
5
0
$
2
0
0
The RULE for profit maximising output
level for a firm in a Competitive Market
Continue to produce output up until where
Price = Marginal Cost
P = MC
Note: For a competitive firm, P = MR when
demand is horizontal (perfectly elastic). Hence,
the rule MR = MC can also used to find the profit
maximising output. This is the general rule used
later in other markets).
7Lecture 6 ECON1010 37
Calculating the Maximum Profit Graphically
When P = MC, the profit maximising
output is 60 pizzas (assuming a selling price
of $10 / pizza).
Profit = Revenue – Total Expenses
Using the cost curves of ATC, AVC, MC, a
graphical solution technique can be used
to find the maximum profit. 0
2
4
6
8
10
12
14
16
P
, A
T
C
, A
V
C
,
M
C
(
$
/p
iz
za
)
Quantity (pizzas)
Maximum Profit
(graphical solution)
AVC
ATC
5.8
10
MC
3
Profit = Revenue – total costs
= 10*60 – 5.83*60
= $250
Total Costs = ATC * Q
= 5.83 * 60
= $350
10 3020 40 6050 70 80
Lecture 6 ECON1010 39
Once new players enter the industry
profits are competed away
Quantity
(pizzas)
TFC
($)
TVC
($)
TC
($)
AFC
($/pizza)
AVC
($/pizza)
ATC
($/pizza)
MC
($/pizza)
0 120 0 120 - - - -
10 120 20 140 12 2 14 2
20 120 30 150 6 1.5 7.5 1
30 120 50 170 4 1.7 5.7 2
40 120 80 200 3 2 5 3
50 120 130 250 2.4 2.6 5 5
60 120 230 350 2 3.8 5.83 10
70 120 380 500 1.7 5.4 7.1 15
80 120 690 810 1.5 8.6 10.1 31
Calculated Cost data
A B+CCB C/AB/A
Measured Cost data
0
2
4
6
8
10
12
14
16
P
, A
T
C
, A
V
C
,
M
C
(
$
/p
iz
za
)
Quantity (pizzas)
No economic profit when
Price = Minimum of ATC
AVC
ATC
10
MC
P=MC =5
10 3020 40 6050 70 80
Making zero economic profit
When P = MC = $5 per pizza,
ATC also = $5 per pizza
Revenue = $5/pizza * 50 pizzas = $250
Total cost = ATC * Q
= $5 per pizza * 50 pizzas = $250.
Profit = Revenue – Total Cost
= 250 – 250
= $0
42
80
2
4
6
8
10
12
14
16
P
,
A
T
C
,
A
V
C
,
M
C
(
$
/p
iz
za
)
Quantity (pizzas)
Loss Minimising
(graphical solution)
AVC
ATC
ATC = 5
Price = 3
MC
AVC = 2
10 3020 40 6050 70 80
Lecture 6 ECON1010 44
Loss Minimising Analysis
Minimise any losses when AVC < P < ATC
by
producing an output at the point where P = MC
All of the variable costs will able to be paid
under these conditions, and any losses will be
minimised.
Only part of the fixed costs will able to be paid,
not all. Will a business be able to survive? For
how long?
Loss Minimising Analysis
(explained diagrammatically)
AFC=$3
AVC = $2
Part of the Fixed Costs
covered by revenue when
AVC < Price < ATC
Price
= $3
A
T
C
=
$
5
p
er
p
iz
za
Q = 0 Q = 40
$1
Part of the Fixed Costs
NOT covered by revenue
when AVC < Price < ATC
Loss margin =
$5 - $3 = $2 per pizza, so Economic Loss = 2*40 = $80 Lecture 6 ECON1010 46
Shut Down and Leave
(unable to cover all the variable costs)
When the price is set by the market to be less
than the minimum point of the AVC curve,
the pizza shop should close (can’t cover any of
the fixed costs, or even things like wages!)
Resources will need to be used elsewhere.
Shutdown condition when
Price < minimum AVC
0
2
4
6
8
10
12
14
16
10 20 30 40 50 60 70 80
P
, A
T
C
, A
V
C
,
M
C
(
$
/p
iz
za
)
Quantity (pizzas)
Shutdown Operations
(graphical solution)
AVC
ATC
MC
AVC = 1.5 = Price
6.5
1.5
Lecture 6 ECON1010 48
The Shutdown Point when P < min AVC
(can’t pay the variable costs, including wages)
AFC=
$5/pizza
Price = $1.50/pizza
= Minimum AVC
None of the Fixed
Costs are covered by
revenue when
Price = Minimum AVC
A
T
C
=
$
6
.5
0
/p
iz
za
Total Variable
Cost = $37.5
Q = 0 pizzas Q = 25 pizzas
9Conclusions.
▪ Perfectly competitive markets provide useful insights
into understanding business behaviour.
▪ Competitive pressures and consumer preferences
constantly change and force producers to come up
with new products and services at lowest cost.
▪ Firms that initially profit are typically followed by
entry and exit of other firms from an industry as
technology and consumers’ needs change.
Lecture 6 ECON1010 49
Next Lecture
▪ Lecture 7
“The Quest for Profit”.
Lecture 6 ECON1010 50