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Chapter 5: Production and Cost: The Supply Side of the Market in the Short run 1.

Market structures (Types) 2 Perfect Competition (Ideal) 3. Short run vs. Long run 4. Law of diminishing productivity in the short run One firms output supply rule: Produce each unit for which P MC 5. The firms family of short-run cost curves 6. The short-run shut-down point for a firmPerfect

Competition (Ideal Market)


Most markets in the real world are not competitive. Perfect competition is an ideal form of market that serves as a benchmark for real-world (imperfect) markets; allows us to see how and where an imperfectly competitive market breaks down and fails to allocate resources efficiently. 11 Perfect competition implies price-taking behaviour by individual agents. Price-taking behaviour, in turn, requires 4 assumptions. A failure of any one or more of these assumptions results in imperfect markets.

Market Structures (Types)


Characteristics 1.No of firms: 2. Product Differentiation 3. Entry barriers 4.Perfect information Perfect competition Many, Many No, (identical product) No (free entry and exit) Yes (symmetric) Imperfect competition 1, 2, few, many Yes (similar products) Yes (costly entry exit) No (asymmetric)

2. Price-taking behaviour in a Competitive Market

P
MC

P
D S

P
d P=2 S D 30 Competitive market (millions) d = MU

P=2

MR

One firm (hundreds)

10 One Buyer (tens)

A Competitive Firm (Short run)

How many units of output should a firm produce?


P = Price per unit MR = Marginal revenue MC = Marginal Cost For a price-taking firm MR = P P

P=2

P =2 =MR

1 2 3

Profit maximizing output supply rule (C-B Principle)

If , P > MC Produce each unit for which P > MC P = MC Stop here (last unit).

MC =

Wage Rate W $20 = = = $2 M arg inal Pr oductivity of Labour MP 10

Derive firms short-run supply curve in 3 Steps


Step 1: Study the short-run relationship between inputs and output (Techonological). Law of diminishing MP. Capital is fixed at K = 10 units. Labour L is the variable input ________________________________________________ Units of Units of Total Marginal Average Labour Capital Product Product Product Q Q M =P A = P (L) ( K ) (Q) L L ________________________________________________ 0 10 0 *** *** 1 10 12 12 12 2 10 28 16 14 3 10 48 20 16 4 10 65 17 16.2 5 10 76 11 15.2 6 10 84 8 14 7 10 88 4 12.6 8 10 90 2 11.2 ________________________________________________

The Shape of AP and MP curves (L) and their relationship


AP, MP 20 16 AP MP
3 4

Step 2: Determine Costs of output Use the market prices of inputs to determine the firms total costs of
production . Suppose, PL = $16 and PK = $10

Definitions Total Cost = Total Fixed Cost + Total Variable Cost


TC = TFC + TVC
(1)

T F C = PK K = 100

(2)

AFC =

TFC 100 = Q Q

(3)

TVC = PL L = 16 L

(4)

AVC =

TVC 16 L 16 = = Q Q APL

(5)

MC =

PL 16 = MPL MPL

(6)

Shapes of Short-run Cost Curves Shape of AFC Curve


AFC = T FC 100 = Q Q

AFC

AFC Q

Shape of AVC curve

AVC
AVC = 16 APL

ATC = AFC + AVC ATC AFC ATC AVC

AVC Q

Shape of MC Curve

MC
MC = 16 MPL

Step 3: Find the best output at each price (Supply curve) The Family of Short-run Cost Curves
Costs $

MC

ATC
6.55 4.60 AVCmin = 3.50 3.00

AVC

c b a

P2 P1

P3

60 75

90

Q Quantity

Step 3: A firms Short-run output Supply Curve Price 6.55 4.60 3.00 Price Supply curve Quantity Supplied 90 75 60

Quantity A competitive firm Shut Down Point (short run)


Costs $
MC

ATC AVC
6.55 4.67 3.50 AVC

c a

= 3.00 min

60 75

90

Q Quantity

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