Perfectly Competitive Supply: the Cost Side of the Market
The law of supply states that an increase in price results in an increase in quantity supplied, ceteris paribus. The supply curve has an increasing slope because suppliers exploit their most attractive opportunities first, i.e. the principle of increasing opportunity cost.
Production Time Periods
- Short run: period of time sufficiently short that at least one factor remains fixed but long enough to change some variable factors, although existing fixed factors can be used more
- Long run: period of time of sufficient length to vary all factors, e. no fixed factors
Factors of Production in Short Run
- Variable factors of production: an input that changes in the short as the output of a particular good or service produced in a given time period changes, g. labour
- Fixed factors of production: an input that does not change as the output of a particular good or service produced in a given time period changes, even if output is zero
The law of diminishing return states that in the short run when at least one factor is fixed, successive increase in input of a variable factor eventually makes less and less of a difference to output. This is due to the eventual overcrowding or overusing of a fixed factor. This means that increase production of a good eventually requires larger and larger increase in input of a variable factor.
Production Costs
- Average Fixed Cost (AFC)
AFC is the total fixed cost divided by the total output quantity. The AFC decreases with quantity as the fixed cost spread among a greater quantity of outputs.
AFC = TFC
and
lim AFC = 0
Q®¥
Ø Average Variable Cost (AVC)
AVC is the total variable cost divided by the total output quantity. The AVC decreases initially due to specialisation, but increases afterwards as the law of diminishing return takes place.
AVC = TVC
and
lim AVC = ¥
Q®¥
Ø Average Total Cost (ATC)
ATC is the sum of all variable and fixed costs divided by the total output quantity. Equivalently, it is the sum of average total cost and average variable cost. ATC approaches AVC as quantity increases because the AFC is becoming smaller due to spreading.
ATC = TC = AFC + AVC and Q
lim ATC = AVC
Q®¥
Ø Marginal Cost (MC)
MC is the cost of producing an extra unit of output. Marginal cost decreases initially because due to specialisation, output is increasing greater than the increase in costs. However, it then increases due to diminishing returns. It corresponds to the increasing slope of supply curves:
Change in Total Cost DP
Marginal Cost = Change in Quantity = DQ = m
Short-Run Shutdown Rule:
A firm should consider shutting down production in the long run when the price of the good is less than the minimum value of its average variable cost, i.e. revenue is less than variable cost
P * Q < VC
P < VC
Q
i.e. P < AVC
Shutdown Rule and Profit
Profit is given by revenue minus total costs such that a firm is profitable if its price is greater than its average total cost. Thus, a firm should shut down if price is less than average total cost
Profit = (P ´ Q) - (Q ´ ATC ) = Q (P - ATC )
Profitable IF P > ATC
When the curves of MC, ATC and AVC are graphed together, the marginal cost curve must intersect the average total cost curve (ATC) and the average variable cost curve (AVC) at their respective minimum points
Maximum-Profit Condition
For a firm to maximise their profit, they should supply at a quantity such that the price (P) at that quantity is equal to the marginal cost, assuming output and employment can be varied continuously. Graphically, it is where y = P intersects the marginal cost curve.
Therefore, for a firm in a market where:
- P < MC then INCREASING output INCREASES profit
P > MC then DECREASING output INCREASES profit
Measuring Profit
Profit can be measured graphically, it is the region bound between the rectangle formed by the price and the rectangle formed by the ATC
