Chapter 6

Perfectly Competitive
Supply:
The cost side of the
market
Even-numbered Qs. and #3 #9
4 additional questions

 Profit-maximizing firm
- Goal is to maximize profit,
- Profit = Total Revenue Total Cost
- Total costs include explicit and implicit costs

Perfectly Competitive Market

- Firms in this market make many decisions; but one thing
they do not decide is the price at which to sell their output
- Firms in perfect competition are said to be price taker
- Price taker a firm that cannot influence the price of a
good or service
- At the market price, individual firm can sell as much or as
little quantity as it wishes
- Individual firms demand curve is perfectly elastic

 Five conditions of Perfectly competitive market:

1) All firms are price-taker
2) All firms sell the same standardized product to many buyers
- buyers are able to switch from one seller to another if the price of
the good is lower
- substitution goods are available
3) The market has many buyers and sellers, they have a relatively small
market share of the total quantity exchanged
- individuals decision will have no impact on the market price
4) Productive resources are mobile
- free to enter or exit the market
5) Buyers and sellers are well informed about product being sold and the
prices charged by each firm
- Buyers are able to seek for the lowest price
- Sellers are able to seek for the most-profit earning opportunities

 Factors of Production:
- inputs used in production
- it can be variable or fixed
Variable factor of production
- input can be varied in the short run
- i.e. labor firms can increase production simply by having
labors working overtime in a short notice

Fixed factor of production

- input cannot be varied in the short run
- i.e. machinery, a factory it takes time to install a new
equipment, train labors to use it; and it takes time to plan
and build a new factory

 Short run vs. Long run

Short run
- at least one input is fixed and the other inputs are
variable
- it is impossible to add another factory or install a
machine in a short period of time
Long run
- all inputs are variable
- it is sufficient to add another factory or install a
machine in a long period of time
The short run and long run distinction varies from
one industry to another

 Law of Diminishing Returns

- as adding more variable inputs, the marginal production

grows, (increasing marginal returns); but beyond some
point, the marginal production starts to diminish
(decreasing marginal returns)
- it only applies to the short run, at least one input is fixed
and the other inputs can be varied

Marginal Product: the change in total product/the change in

variable input

- i.e., a firm hires some additional labors in the car

production and the amount of machinery stays the same,
then, the used of the machine would be overcrowded. The
marginal productivity grows only for the first few units of
labors, then it starts to diminish. Therefore, marginal
productivity actually decreases

 Marginal Cost: the change in total cost (total variable

cost)/the change in quantity

- MC at first decreases sharply, it reaches a min. point, then

again, starts to increase
- This reflects the fact that VC, or TC increases by a
decreasing amount and then TC increases by an increasing
amount
- The shape of the MC curve is a consequence of the Law of
Diminishing Return
MC
MC

Law of diminishing returns

Quantity

 Law of Diminishing Returns

it only applies to the short run, at least one input
is fixed and the other inputs can be varied
In the Short run, MC curve is U-shape
in the Long run, MC curve is horizontal
in the long run, all inputs are variable. The firm
can often double its production by simply doubling
the amount of each input they use
Thus, cost is proportional to output
Therefore, MC in the long run is horizontal, not
upward sloping

 For a perfectly competitive firm, it chooses to

produce at a point where P=MC
If P > MC: Firm can increase its profit by increasing
output
If P < MC: Firm can increase its profit by decreasing
output
Firms earn profit

P > ATC

where Q is at optimal

level of output

Firms suffer loss

P < ATC

where Q is at optimal

level of output

Firms break-even, TR =
Firms
shutdown
TC, earning
zero point
Firms
should
shutdown
Economic
profit

P = ATC where Q is at optimal

P = min. AVC
level of output

P < min. AVC, loss =

fixed cost

To Summarize:

If P > ATC > min. AVC

Firms earn profit and stay in the market

If ATC > P > min. AVC

Firms suffer loss but continue to operate

If ATC > min. AVC > P

Firms should shutdown and loss equals to its fixed cost

Additional Question #1
Q1) Which of the following is NOT true of a perfectly
competitive firm?
A) It faces a perfectly elastic demand curve.
B) It is unable to influence the market price of the
good it sells.
C) It seeks to maximize revenue.
D) Relative to the size of the market, the firm is
small.
E) The firms only decision is how much output to
Ans:produce.
C

 (A) is correct. Each firm in a perfectly competitive

market is facing a horizontal demand for its
products.
The demand is perfectly elastic because firms are
selling homogeneous goods. It is very easy for
the customers to find substitutes.
Note that the MARKET DEMAND is not horizontal.
Only the demand for individual firms products is
perfectly elastic.

 (B) and (D) are the features of a perfectly

competitive market.
In a perfectly competitive market, there is a huge
number of firms and each firm is of a minuscule
size (compared to the whole market)
Because each firm is so small, none of its action
can influence the market. The firm will suffer if it
deviates from the market price. There will not be
any effect on the market price if the firm varies its
output level.
Therefore, (B) and (D) are true.

 (E) is also true. Indeed, when each firm is facing

a given market price, what it can do is to
determine how much output it is going to supply.
The decision on output is made based on the
firms cost function.
A rational economic agent will always aim at
maximising profits.

 Is maximizing profit the same as minimizing

cost?
What is the output level at which cost of
production is minimized?
Zero output !!
Thus maximizing profit is not the same as
minimizing cost!!

 As mentioned just now, firms always aim at

maximising PROFITS.
However, it does not mean that they aim at
maximising REVENUE. (Profit is the difference
between revenue and costs)
i.e. Firms can maximize TR by increasing the
production, but the expenses incurred in order to
earn more may be more than the actual earnings.

Therefore, (C) is the only option that is NOT true.

Additional Question #2
Q2) The Law of Diminishing Marginal
Returns
A) Is a Long Run concept.
B) Applies only to small and medium sized
firms.
C) Is a Short and Long Run concept.
D) Applies only to large firms.
E) Ans:
Is aE short run concept.

 The Law of Diminishing Marginal Returns states

that
In a production where there are fixed and variable
factors,
when more variable factors are added, additional
output yielded by each marginal unit of input
drops eventually.

 Does the Law of Diminishing Marginal Returns

have anything to do with firm size?
NO!
LDMR holds whenever a firm has both fixed and
variable factors of production, regardless of size.
Firms of any size can be using (or not using) both
fixed and variable factor input.
Hence, (B) and (D) can be eliminated because
they are wrong.

 (A), (C) and (E) are all about Long / Short Run.
What is Short Run? What is Long Run?

Short Run

Long Run

Fixed Factor

Yes
?

?No

Variable Factor

?
Yes

?Yes

 Recall that LDMR describes a situation at which

both fixed and variable factors are in used.
So is it referring to Long Run or Short Run?
Short Run
Therefore, the answer is (E).

Additional Question #3
Q3) Suppose a firm is collecting $1999 in Total
Revenue and the Total Cost of its fixed factors of
production falls from $500 to $400. One can
speculate that the firm will
A)
B)
C)
D)
E)

Expand output.
Lower Price.
Earn greater profits or smaller losses.
Contract output.
Earn smaller profits or great losses.
Ans: C

 First of all, how are production decisions made by

firms in economics?
Firms make production decisions based on a
universal rule: MC=MR
For a price taker, its marginal revenue is always
equal to the price (MR=P)
Therefore, the firm only has to determine its
output level. The optimal level of output is where
MC = MR.

 Now that the fixed cost of production has

decreased.
Is the Marginal Cost (MC) schedule affected by
any means?
NO!
So would the previous Q determined by MC=MR
be affected?
NO!

 Therefore, (A) and (D) can be eliminated as they

are the wrong answers.
Output level is not affected by a change in fixed
costs.
This is because a change in fixed costs has no
effect on marginal cost of output.

 How about option (B)?

Since we are talking about Perfect Competition
(Price Taker)
Does the firm have any say on its price?
No!
Therefore, (B) is also not the answer.

 That leaves us with options (C) and (D).

Recall that Profit = Revenue Costs
Now that (Fixed) Costs have dropped
What happens to Profit?
Increases!
Hence (C) is the correct answer.

Chapter 6 Problem 2
A price-taking firm makes air conditioners. The
market price of one of their new air conditioners
is $120. Its total cost information is given in the
table below:
Air conditioners per
day

Total cost ($ per day)

100

150

220

310

405

510

650

800

How many air conditioners should the firm

produce per day if its goal is to maximize its

To decide how many air conditioners should produce in order

to maximize its profit, we can
1) Apply the cost-benefit principle ,or,
2) Calculate the profit levels and choose the production level
that gives the largest profit

Method 1:
The cost benefit principle, we know that firm should
continue to produce an additional unit of goods as long as
the additional benefit to produce the good is at least as
great as the additional cost to produce the same good.
That is, MB > MC
At the market price of $120 for one air conditioner,
perfectly competitive firm can sell as many air conditioners
as they wish in order to maximize its profit.
The MB from selling an additional air conditioner is $120.

 To calculate the MC:

Air
conditioners/day

Total Cost
($/day)

MC ($/day)

100

100

150

50

220

70

310

90

405

95

510

105

650

140

800

150

By comparing the MB ($120) and the MC, the optimal output

for this firm to produce is 6 air conditioners per day.
The MC of each of the first 6 air conditioners produced each
day is $105, which is less than the MB of $120. MB ($120) >
MC ($105)

Method 2) Calculate the profit:

Profit = TR TC

Air
conditioners/
day

Total Cost
($/day)

Total
Revenue
($/day)

Profit
($/day)

100

120

20

150

240

90

220

360

140

310

480

170

405

600

195

510

720

210

650

840

190

800

960

160

In order to maximize its profit, this firm should produce 6 air

conditioners per day, since it yields the largest profit among
the others, $210/day.
Same result as by applying the cost-benefit principle.

Chapter 6, Problem 3
The Paducah Slugger Company makes baseball bats out of
lumber supplied to it by Acme Sporting Goods, which pays
Paducah $10 for each finished bat. Paducahs only factors of
production are lathe operators and a small building with a
lathe. The number of bats per day it produces depends on the
number of employee-hours per day, as shown in the table
below.
# of bats per day
# of employee-hours per day
0

10

15

20

25

11

30

16

35

22

a) If the wage is $15 per hour and Paducahs daily

fixed cost for the lathe and building is $60, what
is the profit-maximizing quantity of bats?
Quantity
(bats/day)

Total
Revenue
($/day)

Total labor cost

(hours X wage)

Total cost
(labor cost +
fixed cost)

Profit ($/day)
(revenue
cost)

0 *15 = $0

0 + 60 =$60

-$60

50

1 *15 = $15

15 + 60 =$75

-$25

10

100

2 *15 = $30

30 + 60 =$90

$10

15

150

4 *15 = $60

60 + 60 =$120

$30

20

200

7 * 15 = $105

105 + 60 =$165

$35

25

250

11 *15 = $165

165 + 60 =$225

$25

30

300

16 *15 = $240

240 + 60 =$300

$0

35

350

22 *15 = $330

330 + 60 =$390

-$40

b) If the firms fixed cost decreases from $60 to $30,

what is the profit maximizing quantity of bats?
Decrease in fixed cost will increase the profits across
different quantities of bats by the same amount ($30)
Quantity
(bats/day)

Total
Revenue
($/day)

Total labor
cost (hours X
wage)

Total cost
(labor cost +
fixed cost)

Profit
($/day)
(revenue
cost)

0 *15 = $0

0 + 30 =$30

-$30

50

1 *15 = $15

15 + 30 =$45

$5

10

100

2 *15 = $30

30 + 30 =$60

$40

15

150

4 *15 = $60

60 + 30 =$90

$60

20

200

7 * 15 = $105

105 + 30 =$135

$65

25

250

11 *15 = $165

165 + 30 =$195

$55

30

300

16 *15 = $240

240 + 30 =$270

$30

35

350

22 *15 = $330

330 + 30 =$360

-$10

Chapter 6 Problem 4
In the preceding problem (3), how would Paducahs profitmaximizing level of output be affected if the government
imposed a tax of $10 per day on the company? (Hint:
Think of this tax as equivalent to a $10 increase in fixed
cost.) What would Paducahs profit-maximizing level of
output be if the government imposed a tax of $2 per bat?
(Hint: Think of this tax as a $2-per-bat increase in the firms
marginal cost.) Why do these two taxes have such different
effects?

Fixed cost:
Cost on all fixed Factor of Production, ex., lease payment on
machines, buildings
Not depends on firms output
A sunk cost
Variable cost:
Cost on all variable Factor of Production, e.g., labor cost,
input cost
Depends on firms output
Varied with number of products that firm produces

Government imposed a tax of $10 per day (increase

in fixed cost)

Will this tax affected the optimal level of output?

Will this tax affected the cost of production?

A tax of $10 per day would decrease its profit by $10 per
day at every level of output.
The profit-maximizing level of output would still be 20 bats
per day (from Q3)
This tax does not depends on the output, like a fixed cost or
a sunk cost.
If Fixed cost changes, MB and MC will not be affected
That is, this tax does not change the marginal cost, and
hence, does not change the profit-maximizing level of
output if the firm continues to produce.

Government imposed a tax of $10 per day

Quantity
(bats/day)

Total
Revenue
($/day)

Total labor cost

(hours X wage)

Total cost (labor

cost + fixed
cost)

Profit ($/day)
(revenue
cost)

0 *15 = $0

0 + 60 +10 =$70

-$70

50

1 *15 = $15

15 + 60 +10 =$85

-$35

10

100

2 *15 = $30

30 + 60 +10
=$100

$0

15

150

4 *15 = $60

60 + 60 +10=$130

$20

20

200

7 * 15 = $105

105 + 60 +10
=$175

$25

25

250

11 *15 = $165

165 + 60 +10
=$235

$15

30

300

16 *15 = $240

240 + 60 +10
=$310

$-10

35

350

22 *15 = $330

330 + 60 +10
=$400

-$50

Tax of $10 decreases its profit by $10 per day at every level of
output.
Its profit-maximizing output level is still at 20 bats per day.
Fixed cost is independent of output

Government imposed a tax of $2 per bat (increase in

marginal cost)

Will this tax affected the optimal level of output?

Will this tax affected the cost of production?

A tax of $2 per bat would increase its cost of production.

On every bat produces, additional $2/bat has to be added
towards the production cost.
The marginal cost increases.
The profit-maximizing level of output would decrease
This tax depends on the output

Government imposed a tax of $2 per bat

Quantity
(bats/day)

Total
Revenue
($/day)

Total labor cost

(hours X wage) + $2
per bat

Total cost (labor

cost + fixed cost)

Profit ($/day)
(revenue cost)

0 *15 + 2*0= $0

0 + 60 =$60

-$60

50

1 *15 + 2*5= $25

25 + 60 =$85

-$35

10

100

2 *15 +2*10= $50

50 + 60 =$110

-$10

15

150

4 *15 + 2*15= $90

90 + 60 =$150

$0

20

200

7 * 15 +2*20= $145

145 + 60 =$205

-$5

25

250

11 *15 +2*25= $215

215 + 60 =$275

-$25

30

300

16 *15 +2^30= $300

300 + 60 =$360

-$60

35

350

22 *15 +2*35= $400

400 + 60 =$460

-$110

Tax of $2 per bat, the profit-maximizing output level falls to

15 bats per day, with profit = $0.
Variable cost depends on output.

With Tax of $10 per day (increase in fixed cost)

Profit-maximizing level of output stays the same

With Tax of $2 per bat (increase firms MC)

Profit-maximizing level of output falls

The different effects are due to the nature of the Factor of

Production.

What if
government imposed a tax of $20 per bat (think of this tax as
equivalent to increase in marginal cost.)
Bats
(per day)

Total
Revenue
($/day)

Total Variable
cost
($/day)

Fixed
Cost
($/day)

Total Cost
($/Day)

Profit
($/day)

0 +20(0)=0

60

60

-60

50

15 +20(5)=115

60

175

-125

10

100

30 +20(10)=230

60

290

-190

15

150

60 +20(15)=360

60

420

-270

20

200

105
+20(20)=505

60

565

-365

25

250

165 + 20(25) =
665

60

725

-475

30

300

240 + 20(30) =
840

60

900

-600

35

350

330 + 20(35) =
of Q. 1030

60

1090

-740

TR < VC for all level

If this firm continues to operate, it would suffer an even greater
loss.
This firms should shutdown and loss equals to the fixed cost, $60.

Chapter 6 Problem 6
Calculate daily producer surplus for the market
for pizza whose demand and supply curves are
shown in the graph.
Price
($/slice)

D
12

2
4

Quantity (1,000s
of slices/day)

 Producer Surplus:
The economic surplus received by sellers.
If the price exceeds MC, the firm receives a producer surplus.
It is the difference between price that sellers receive (market
price) and the lowest price that the sellers are willing to sell
(reservation price or marginal cost).
To calculate producer surplus:
The area below the market price and above the supply
curve.

Price
($/slice)

D
0

12

2
4

Quantity 1000s
slice
per day

Producer surplus:
The area of the shaded triangle:
($3/slice) (12,000 slices/day) (1/2) = $18,000
slices /day

Chapter 6 Problem 8
For the pizza seller whose marginal, average
variable, and average total cost curves are shown
in the accompanying diagram, what is the profitmaximizing level of output and how much profit
will this producer earn if the price
MCof pizza is
$0.80 per slice?
Price ($/slice)

ATC

AVC
1.03
0.80

360

Quantity (slices/day)

Assume it is a perfectly competitive market

Firms are price taker
It is a profit-maximizing firm
Goal is to maximize the amount of profit it earns

The optimal level of output that maximizes profit, when,

P = MC
Firms earn profit when,
P > ATC where Q is at optimal level of output
Firms Short-run shutdown condition:
P < Min. AVC

This firm is suffering a lost:

P < ATC
Will this firm shutdown in the short-run?
NO. P > min. AVC

What is the profit-maximizing output?

Profit-maximizing output, is the point where P = MC.
This firm will sell 360 slices per day to maximize its profit.
How much profit will this firm earns if price of pizza is $0.80
per slice?
Profit = TR TC
TR = P x Q, TC = ATC x Q
Profit = P x Q ATC x Q
Profit = ( P ATC )Q
= ($0.80 - $1.03)(360 slices)
= - $82.8/day (loss)

MC

Price ($/slice)

ATC
AVC
1.03
Loss
0.80

360
Quantity (slices/day)

Chapter 6, Problem 9

Price ($/slice)

For the pizza seller whole marginal, average

variable, and average total cost curves are shown
in the accompanying diagram, what is the profitmaximizing level of output and how much profit
will this producer earn if the price of pizza is
MC
$0.50 per slice?
ATC
AVC

1.18
0.68
0.50
0

260

Quantity (slices/day)

 The firm shutdown point is at P = $0.68 per slice

(where P = AVC)
The firm should shutdown at any point below
$0.68
If a slice of pizza is sold for only $0.50, the firm
will definitely not produce any pizza and shut
down
Because price is less than the minimum value of
AVC, this producer will shut down in the short run.

 If the firm shuts down, there will be no (average)

variable cost
By shutting down the plant, the firm will have a
negative profit that is exactly equal to the fixed
cost
Fixed cost = Total cost variable cost
Total cost
ATC * Q
$1.18 / slice * 260 slices = $306.80 / day

Variable cost
AVC * Q
$0.68 / slice * 260 slices = $176.80 / day

 Fixed cost = $306.80/day - $176.80/day

=$130/day
Thus, by shutting down the plant in the short run,
the firm will loss $130 a day
In other words, the firm earns a profit of -$130
per day if the price for a slice of pizza is just
$0.50

Chapter 6 Problem 10
For the pizza seller whose marginal, average variable, and
average total cost curves are shown in the accompanying
diagram (who is the same seller as in problem 9), what is
the profit-maximizing level of output and how much profit
will this producer earn if the price of pizza is $1.18 per
slice?

Price ($/slice)

MC

ATC

AVC

1.18
0.77
0.68
0.50

260

435

Quantity (slices/day)
This firm will sell 435 slices per day to maximize its profit.

 This firm is making profit:

P > ATC
The profit-maximizing output is 435 slices if price
of pizza is $1.18 per slice

Total profit:
Profit = TR TC
TR = P x Q
TC = ATC x Q
Profit = (P - ATC) x Q

ATC

AVC

Price ($/slice)

MC

1.18

0.77
0.68
0.50

260

435

Quantity (slices/day)
This firm will sell 435 slices per day to maximize its profit.

 ATC at the profit-maximizing level of output:

Recall, TC = FC + VC
At the optimal level of output, 435 slices, AVC equals
to $0.77 per slice
VC = AVC x Q
VC = $0.77 x 435 slices
VC = $334.95
Recall from Q9, the firms FC = $130 per day
Total cost:
$130 + $334.95 = $464.95

 Total profit at price of $1.18 per slice and output 435

slices:
Profit = TR TC
TR = P x Q
= $1.18 x 435 slices
= $513.3
Profit = $513.3/day - $464.95/day = $48.35

Additional Question #4
According to the graph below, if market price of sweater is
$20. What is the profit-maximizing output? How much
profit will this firm make? What should be the shutdown
MC
point for this firm?
ATC

Price
($/sweater)

AVC

$20
17
15
0

Quantity (sweater/day)

 At price $20, the profit-maximizing output is 8

sweaters per day
At price $20, P = MC = ATC
This is the firms breakeven point, total revenue
equals total cost
It earns zero economic profit

Economic profit = Total Revenue Explicit Costs Implicit Costs

(More on Chapter 8)

Shutdown point: the output and price at which the firm just covers its total
variable cost. Firm is indifferent between continuing operations and shutting
down.
P = MC = min. AVC

At price $17, P = min. AVC,

Both price and AVC equal $17, the firm just covers its TVC
The firm is indifferent on staying or shutting down

At the shutdown point, firm usually incurs loss. How could it be able to cover
its TVC?
As long as the Unit Contribution Margin equals to zero, this is the firms
shutdown point.
Unit Contribution Margin = Unit Revenue (Unit Price) Unit Variable Cost
(AVC)

Any point below the shutdown point, the firm

should shutdown.

At price $15, P < min. AVC,

Firms cannot even cover its TVC
It should shutdown and the loss equals to fixed
cost

Therefore, the shutdown point is at $17

Any price below $17, the firm should shutdown

MC

ATC

Price
($/sweater)

AVC
Breakeven Point

$20
Shutdown Point

17
15
0

Quantity (sweater/day)

End of Chapter 6