Short-Run Supply and Perfect Competition: Principles of Microeconomics Study Notes

Perfect Competition

Key Features of Perfectly Competitive Markets

Perfect competition is a foundational concept in microeconomics, describing a market structure with specific characteristics that lead to efficient outcomes.

• Many buyers and sellers: No individual buyer or seller is large enough to influence the market price.

• Price takers: All firms and consumers accept the market price as given; they cannot set prices themselves.

• Homogenous goods: The products offered by different firms are identical, so consumers have no preference for one seller over another.

• Free entry and exit: Firms can freely enter or leave the market without barriers.

• Consumer behavior: If firms charge different prices, consumers will always buy from the cheapest source.

Example: Agricultural markets, such as wheat or corn, often approximate perfect competition.

Basics of Supply

Objects of Supply in Perfect Competition

Supply in microeconomics refers to the relationship between the price of a good and the quantity that producers are willing to offer for sale.

• Quantity supplied: The amount a firm chooses to supply at a given price.

• Supply schedule: A table showing the quantity supplied at different fixed prices.

• Supply curve: A graphical representation of the supply schedule, showing the relationship between price and quantity supplied.

Example: If the market price of shoes increases, a shoe manufacturer will supply more shoes.

Supply Curves and Supply Functions

The supply function mathematically relates price to quantity supplied. The supply curve is the graphical representation of this function.

• Supply function: $q = S(p)$, where $q$ is quantity supplied and $p$ is price.

• Example supply function: $q = -1 + p$

• Supply curve: Plots price ($p$) on the vertical axis and quantity supplied ($q$) on the horizontal axis.

Example: If $p = 5$, then $q = -1 + 5 = 4$ units supplied.

Willingness to Accept and Marginal Cost

The minimum price a seller is willing to accept for an additional unit (the willingness to accept, WTA) is closely related to the marginal cost (MC) of production.

• Willingness to accept (WTA): The lowest price at which a seller will sell the $q^{th}$ unit.

• Marginal cost (MC): The cost of producing one more unit of output.

• On the supply curve, WTA at quantity $q$ equals the MC of the $q^{th}$ unit.

Example: If WTA = 3 at $q = 2$, the marginal cost of producing the second unit is $3.

The Law of Supply

The law of supply states that, all else equal, the quantity supplied of a good rises when the price of the good rises.

• Positive relationship: Price and quantity supplied move in the same direction.

• Supply curve slope: Upward sloping due to increasing marginal cost.

Example: As the price of oil increases, oil producers are willing to supply more barrels.

Profit Maximization and the Supply Decision

The Firm’s Decision-Making Process

Firms in perfectly competitive markets make several key decisions to maximize profits:

• What to produce?

• How to produce it?

• What price to charge? (In perfect competition, this is determined by the market.)

• How much to produce and sell?

Profit and Revenue

Profit is the difference between total revenue and total costs.

• Total Revenue (TR): $TR(q) = p \times q$

• Average Revenue (AR): $AR(q) = \frac{TR(q)}{q} = p$

• Marginal Revenue (MR): $MR(q) = \frac{dTR(q)}{dq} = p$ (in perfect competition)

• Profit: $\pi(q) = TR(q) - TC(q)$

Example: If a firm sells 10 units at $5 each,$TR = 5 \times 10 = 50$.

Factors of Production and Costs

Firms use various inputs, called factors of production, to produce goods and services. These factors can be classified as variable or fixed in the short run.

• Variable factors: Inputs that can be changed quickly (e.g., labor, raw materials).

• Fixed factors: Inputs that take a long time to change (e.g., factory buildings, oil tankers).

• Variable costs: Costs associated with variable factors; change with output.

• Fixed costs: Costs associated with fixed factors; do not change with output in the short run.

Example: For an oil company, crude oil reserves are a fixed factor, while labor and fuel are variable factors.

The Short Run vs. The Long Run

The distinction between the short run and the long run is based on the flexibility of factors of production.

• Short run: At least one factor of production is fixed.

• Long run: All factors of production are variable.

• In the short run, only variable costs matter for supply decisions; fixed costs are considered sunk costs.

Example: An oil tanker (fixed cost) cannot be changed quickly, but the amount of oil extracted (variable cost) can be adjusted.

Marginal Cost and Average Variable Cost

Marginal cost (MC) and average variable cost (AVC) are key concepts for understanding a firm's supply decision in the short run.

• Marginal Cost (MC): $MC(q) = \text{Cost of making the } q^{th} \text{ unit}$

• Total Variable Cost (VC): $VC(q) = \sum_{x=1}^{q} MC(x)$

• Average Variable Cost (AVC): $AVC(q) = \frac{VC(q)}{q}$

Example: If $MC(1) = 2$, $MC(2) = 3$, then $VC(2) = 2 + 3 = 5$, $AVC(2) = 5/2 = 2.5$.

Profit Maximization in the Short Run

In perfect competition, the profit-maximizing output is found where marginal revenue equals marginal cost.

• Profit maximization rule: Set $MR(q) = MC(q)$

• Since $MR = p$ in perfect competition, set $p = MC(q)$

• If $p < \min AVC$, the firm should shut down in the short run.

• If $p \geq \min AVC$, produce the quantity where $p = MC(q)$.

Example: If the minimum AVC is $3 and the market price is $5, the firm produces where$MC(q) = 5$.

Market Supply

From Individual to Market Supply

The market supply curve is the horizontal sum of all individual firms' supply curves at each price level.

• Market supply: At each price, add up the quantities supplied by all firms.

• As price increases, more firms (including higher-cost producers) enter the market.

Example: If Firm 1 supplies 10 units and Firm 2 supplies 15 units at $p = 20$, the market supply is 25 units at that price.

Application: Oil Markets

Oil markets are often used as real-world examples of supply in competitive markets.

• Homogenous product: Oil is largely identical regardless of producer.

• Price-taking behavior: Individual oil producers cannot influence the world price.

• Cost differences: Different sources of oil (onshore, offshore, shale) have different extraction costs, affecting their supply curves.

• Market supply curve: As price rises, more expensive sources of oil become profitable and enter the market supply.

Example: At low prices, only low-cost onshore oil is supplied; as price increases, offshore and shale oil enter the market.

Environmental and Macroeconomic Considerations

Oil markets have significant impacts on the environment and the global economy.

• Environmental impact: Oil extraction and consumption contribute to global emissions.

• Macroeconomic effects: Oil price shocks can cause recessions, as seen in the 1973 OPEC embargo.

Example: A sudden increase in oil prices can lead to higher production costs across the economy, reducing output and employment.

Summary Table: Key Cost Concepts

Concept	Definition	Formula
Total Revenue (TR)	Total income from sales	$TR(q) = p \times q$
Average Revenue (AR)	Revenue per unit sold	$AR(q) = \frac{TR(q)}{q} = p$
Marginal Revenue (MR)	Change in revenue from selling one more unit	$MR(q) = \frac{dTR(q)}{dq} = p$
Total Cost (TC)	Total cost of production	$TC(q) = FC + VC(q)$
Variable Cost (VC)	Cost that varies with output	$VC(q) = \sum_{x=1}^{q} MC(x)$
Average Variable Cost (AVC)	Variable cost per unit	$AVC(q) = \frac{VC(q)}{q}$
Marginal Cost (MC)	Cost of producing one more unit	$MC(q) = \frac{dTC(q)}{dq}$