Chapter 6 Perfectly competitive supply: the cost side of the

market
Answers to review questions
1

The principle of increasing opportunity cost, also known as the low-hanging-fruit

principle, says that the least costly options should be exploited first, with more costly
options taken up only after the least costly ones have been exhausted. At low prices,
only those with low opportunity costs of producing a product would find it worthwhile
to offer it for sale. As prices rise, others with higher opportunity cost could profitably
enter the market. This positive relationship between a products price and the quantity
supplied is shown by an upward-sloping supply curve.

Bus fares are determined by the interaction of the market demand for bus rides and the
market supply of bus rides. In a perfectly competitive market, each individual
travellers demand is so small compared to the size of the market that no single
individuals decision has an effect on market demand or on the equilibrium price of a
bus ride. Individual bus travellers are price-takers. Similarly, an individual apple
growers decision about how much to supply at each price has no effect on total market
supply or on the price of a kilo of apples. Individual apple growers are also price-takers
in the market for apples.

To build, or even rent, a new factory often takes years, certainly many months. By
contrast, additional production workers can be hired in days, or at most weeks. The
factory is far more likely to be a fixed factor over the next two months.

Explaining economic concepts to someone else is a very effective way of checking your
own understanding. The law of diminishing returns refers to the fact that, when some
factor is fixed, successive units of a variable factor eventually yield smaller and smaller
increments in output. The flip side of this is that increasing output will eventually
require ever-larger increases in the amount of the variable factor. Adding more labour to
a machine, or more fertiliser to a field, will both eventually result in diminishing
returns.

The U-shape of the short-run AVC curve reflects the law of eventually diminishing
returns. When the average productivity of the variable factor rises, AVC will fall. When
average productivity of the variable factor falls, AVC will rise. AVC reaches its
minimum and has its turning point at the level of output where average returns to the
variable factor begin to diminish. Since ATC at any level of output is the sum of AVC
and AFC, the u-shape of ATC also reflects the law of diminishing returns. The AVC
reaches a minimum at a level of output that is less than the level of output where ATC
reaches a minimum, since AFC declines as output gets larger.

False. An exception to the price equals marginal cost rule occurs when market price is
so low that total revenue is less than variable cost, or price is less than AVC, when price
equals marginal cost. In this case, profit maximisation involves shutting down and
producing nothing; the loss incurred is then equal to total fixed costs alone.

Plastic surgeons can switch between supplying surgical and reconstructive procedures.
An increase in the price of cosmetic surgery means that the opportunity cost of
performing reconstructive procedures is higher. Plastic surgeons reservation price for
supplying reconstructive procedures will therefore increase and the supply curve of
these procedures will shift to the left.

To calculate producer surplus, we need to know the reservation price of sellers at every
level of output. The vertical interpretation of the supply curve tells us marginal cost at
every level of output, and marginal cost is the reservation price of sellers.

Answers to problems
1

If the price of a fossil is less than $6, Jo should devote all her time to photography because when the price is, say, $5 per fossil, an hour spent looking for
fossils will give her 5($5) = $25, or $2 less than shed earn doing photography. If
the price of fossils is $6, Jo should spend one hour searching, which will supply
five fossils and earn Jo revenue of $30; that is, $3 more than she would earn from
photography. However, an additional hour would yield only four additional
fossils or $24 additional revenue, so Jo should not spend any further time looking
for fossils. If the price of fossils rises to $7, however, the additional hour
gathering fossils would yield an additional $28; gathering fossils during that hour
would then be the best choice, and Jo would therefore supply nine fossils per day.
Using this reasoning, we can derive Jos pricequantity supplied relationship for
fossils as follows:

Price of fossils ($)

Number of fossils supplied per day

05

7, 8

913

12

1426

14

27+

15

If we plot these points, we get Jos daily supply curve for fossils:

Price($/fossil)
27

14
9
7
6
5

9 12 15
14

Numberoffossils

The marginal cost of each of the first six air conditioners produced each day is less than
$120, but the marginal cost of the seventh air conditioner is $140. So the company
should produce six air conditioners per day to maximise its profit.
Air conditioners/day

Total cost

Marginal cost

($/day)

($/air conditioner)
100

100
50

150
70

220
90

310
95

405
105

510
140

650
150

800

b
4

As indicated by the entries in the last column of the table below, the profit-maximising
quantity of bats for the Big Hitter Company is 20 per day, which yields a daily profit of
$35.
Quantit
y

Total
revenue

Total labour
cost

Total cost

Profit

(bats/da
y)

($/day)

($/day)

($/day)

($/day)

60

-60

50

15

75

-25

10

100

30

90

10

15

150

60

120

30

20

200

105

165

35

25

250

165

225

25

30

300

240

300

35

350

330

390

-40

The profit-maximising quantity of bats for the Big Hitter Company is again 20
per day, but now profit is $65, or $30 more than before.

A tax of $10 per day would decrease the Big Hitter Companys profit by $10 per day at
every level of output, but the company would still maximise its profit by producing 20
bats per day. A tax that is independent of output does not change marginal cost, and
hence does not change the profit-maximising level of output.
However, a tax of $2 per bat has exactly the same effect as any other $2 increase in the
marginal cost of making each bat. As we see in the last column of the table below, the
companys profit-maximising level of output now falls to 15 bats per day. At that level
it earns exactly 0 profit, but at any other level of output it would sustain a loss.

Quantity

Total revenue

(bats/day)

($/day)

Total labour
cost

Total cost

Profit

($/day)

($/day)

($/day)
0

60

60

50

15

85

35

10

100

30

110

10

15

150

60

150

20

200

105

205

25

250

165

275

25

30

300

240

360

60

35

350

330

460

110

The market supply curve (right) is the horizontal summation of the supply curves of the
individual market participants (left and centre).

P=2Q1

P=2+Q
2

Q
1

Q
2

Horizontal summation means holding price fixed and adding the corresponding
quantities. For example, at a price of $4 per unit, a total of 2 + 2 = 4 units will be
supplied. If you want to derive the market supply curve algebraically, rewrite each
individual supply curve with quantity as the dependent variable and add. Pay careful

attention to the region for which the supply curves dont overlap (here, the region P<2).
From P = 2Q1, get Q1 = P/2; from P = 2 + Q2, get Q2 = P 2.
For the region P<2, the market supply is the same as Firm 1s supply:
Q = P/2, or P = 2Q
For P>2 we add Q1 + Q2 to get Q = P/2 + (P 2), which reduces to Q = (3P/2) 2.
Rewriting this, we have P = (4/3) + (2/3)Q for P>2.
Expressed algebraically, the market supply curve is thus:
P = 2Q for P<2
and P = (4/3) + (2/3)Q for P>2
6

The equation for the demand curve is P = 6 .25Q.

The equation for the supply curve is P = .25Q.

Producer surplus is the area of the shaded triangle:

($3 12 000)/2 = $18 000/day
Price
($ per slice)
6
Supply

3
Demand
12

Quantity
24 (1000s of slices per day)

This firm will sell 570 slices per day, the quantity for which P = MC. Its profit will be:
(P ATC) Q = ($2.50/slice $1.40/slice) (570 slices/day) = $627/day.

MC

$/slice

ATC
AVC

2.50

1.40

slices/day

570

This firm will sell 360 slices per day, the quantity for which P = MC. Its profit will be:
(P ATC) Q, or
($0.80/slice $1.03/slice) (360 slices/day) = $82.80/day.
MC

$/slice

ATC
AVC

1.03
0.80

360

slices/day

Because price is less than the minimum value of AVC, this producer will shut down in
the short run. They will thus experience a loss equal to their fixed cost. Fixed cost is the
difference between total cost and total variable cost.
For Q = 260 slices/day, we know both ATC and AVC, so for that output level we can
calculate:
TC = (260 slices/day)($1.18/slice) = $306.80/day
VC = (260 slices/day)($0.68/slice) = $176.80/day.

So fixed cost is $306.80/day $176.80/day = $130/day.

This producers profit is thus $130/day.
MC

$/slice

ATC
AVC

1.18
0.68
0.50

260

10

slices/day

This producer will sell 435 slices per day, the quantity for which P = MC. Their total
revenue will therefore be:
P Q = ($1.18/slice) (435 slices/day) = $513.30/day.
Their variable cost is:
AVC Q = ($0.77/slice)(435 slices/day) = $334.95/day.
To this we add their fixed cost of $130/day to obtain:
TC = $464.95/day (calculated using the method shown in problem 9).
This producers profit is therefore $513.30/day $464.95/day = $48.35/day.

MC

$/slice

ATC
AVC

1.18
0.77
0.68
0.50

260

435

slices/day