ECON1101 Lecture Notes - Lecture 2: Perfect Competition, Externality, Marginal Cost
ECON Notes
Part II Perfect Competitive Markets
2.0 Introduction
• Market: is the set of all the consumers and suppliers who are willing to buy and sell that
good or service, has reached equilibrium when the price and the quantity sold of a given
good are stable
• Market equilibrium: occurs when the price and the quantity sold of a given good is stable,
i.e. when the price is such that the quantity consumers demand is equal to the quantity
supplied
• Characteristics of perfectly competitive markets
o Consumers and suppliers are price takers:
▪ Suppliers and consumers are willing/able to affect the market price
o Homogenous goods
▪ All suppliers sell exactly9 the same product
o No externality
▪ Externality: is a cost (or benefit) that is incurred by someone who is not
involved in the production or consumption of a certain good
▪ In a market with no externalities, all production costs and benefits are
incurred by the supplier
▪ Similarly, all the consumption costs and benefits are incurred by the
consumer of the good
o Goods are excludable and rival
▪ Suppliers can prevent consumers from consuming a certain good
(excludability), once consumed, that good becomes unavailable to other
consumers (rivalry)
o Full information
o Free entry and exit to the market
• External cost: an external cost is a cost incurred by someone who is not involved in the
production/consumption of a given good
• External benefit: an external benefit is a benefit accrued to someone who is not involved in
the production/consumption of a given good
2.1 Supply Curve for an individual
• Marginal benefit: the marginal benefit of producing a certain unit of a given good is the extra
benefit accrued by producing that unit
• Marginal cost: of producing a certain unit of a given good is the extra cost of producing that
unit (relevant cost is the opportunity cost)
• Cost-benefit principle: states that an action should be taken if the marginal benefit is greater
than the marginal cost
• Economic surplus: is the difference between the marginal benefit and the marginal cost of
taking that action
• Supply curve: the supply curve represents the relationship between the price of a good or
service and the quantity supplied of that good or service
• Law of supply: describes the tendency for a producer to offer more of a certain good or
service when the price of that good or service increases
• Horizontal interpretation of the supply curve: Start from a certain price and find the
associated quantity on the supply curve. The quantity you found indicates how many units
the producer is willing to supply at that price.
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• Vertical Interpretation (of the Supply Curve): Start form a certain quantity (say 2 units) and
find the associated price on the supply curve. The price you found indicates the minimum
amount of money the producer is willing to accept to offer the marginal unit (in our example
the marginal unit would be the 2nd unit).
2.2 How to Derive the Supply Curve for a Firm
• Sunk cost: is a cost that once paid cannot be recovered
• Fixed cost: is a cost associated with a fixed factor of production (cost associated with it does
not vary with the quantity produced)
• Short run: denotes a period of time during which at least one factor of production is fixed
(sunk cost)
• Variable factor of production: the cost associated with the production varies with the
number of units produced
• Variable cost: a cost associated with a variable factor of production
• Long run: denotes a period of time during which all factors of production are variable
• In the short run, the entrepreneur should shut down production if πʳᵒᵈᶸᶜᶤᵒⁿ< – FC, otherwise
should hire the optimal number of workers and continue operations
• I the log u, the etepeeu should eit the idust if πʳᵒᵈᶸᶜᶤᵒⁿ<0, otherwise should
hire the optimal number of workers and continue operations
• If πʳᵒᵈᶸᶜᶤᵒⁿ=0 the entrepreneur is indifferent between exiting and continuing operations
2.3 From a discrete to a continuous model
• In the previous section we considered a model where the entrepreneur could only hire
workers in whole numbers
• If labour supply was much more flexible would be a smooth curve
o Provides quick hint on how many units of the good the entrepreneur should produce
(expand the quantity produced until the price line – marginal revenue – intersects
the marginal cost curve)
o Whether the entrepreneur should shut down (if the price is line is below the
minimum point on the average variable cost curve – shut down condition in the
short run – or the average total costs curve – shut down condition in the long run)
• Other aspects of the productive problem we are considering
o The supply curve for a firm can be derived by changing the price and observe the
variation in quantity produced
▪ In context: the supply curve is equal to the marginal cost curve for those
values of the MC that are higher than the minimum AVC (in the short run)
and higher than the minimum ATC (in the long run)
▪ The entrepreneur will not produce anything if the price is below these
points, in the short and long run respectively
o The MC curve eventually increases with the quantity produced i.e. production
process is subject to increasing marginal costs
o The MC curve cuts the AVC + ATC curve at their minimum points
▪ Marginal costs are the extra cost associated with the production of an extra
unit
▪ If the extra cost is smaller than the average cost, the average decreases
▪ If the extra cost is higher than the average cost, the average increases
▪ Remains constant only if the marginal cost is equal to the average cost
▪ Hence the AVC curve and the ATC curve decrease initially as the MC curve is
below them until the MC curve intersects, and they begin to increase
o As an entrepreneur moves into the long run the AVC curve would become identical
to the ATC curve as all costs become variable
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• What causes shifts along the supply curve
1. Technology: increases efficiency and therefore production
2. Input prices: changes in these prices will affect the productive capacity of a
firm/industry, reflected in the supply
3. Expectations: expected future prices changes will make suppliers adjust their
behavior to advantage (or shield themselves) from the new opportunities
4. Changes in pricing for other products: if a seller is producing two or more goods, a
surge in demand for one product will cause a shift of factors to the higher
demanded good
5. Number of suppliers: the higher the number of suppliers entering a market, the
larger the right shift in the curve
2.4 Price Elasticy of supply
• Price elasticy of supply: denotes the % change in the quantity supplied resulting from a very
small % change in price
• Elasticityᴬ= (∆Q / Qᴬ) / (∆P / Pᴬ) or Elasticityᴬ= (∆Q / Qᴬ) * (1/slope)
o Where the term slope indicates the gradient of the supply curve
• The law of supply states that supply curves tend to be upward sloping, and hence elasticity
must be positive
• Supply is said to be:
o Elastic if the elasticity is greater than 1
o Unit elastic if the elasticity of supply is equal to 1
o Inelastic if the elasticity of supply is less than 1
2.5 Determinants of Price Elasticy of supply
• What affects the willingness of sellers to adjust their productive decisions after a price
change:
o Availability of raw materials: larger availability, more elastic supply
o Factors mobility: more mobile the factors of production the higher the elasticity
o Inventories/excess capacity: the larger the amount of inventories and excess
capacity, the higher the elasticity
o Time horizon: the longer the time horizon, the higher the elasticity tends to be
3.1 Demand Curve for an Individual
• Utility: denotes the satisfaction that an individual derives from consuming a given good or
taking a certain action, measured in utils per unit of time
o Decreasing marginal utility: implies that the utility from consuming an extra unit of a
given good decreases with the no. of units that have been previously consumed
• Substitution/income effect
o Substitution effect captures the change in the quantity demanded of a given good
following a change in its relative price
o Income effect: captures the changes in the quantity demanded of a given good
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o For a normal good, a decrease (respectively increase) in income reduces
(respectively increases) the quantity consumed
▪ E.g. normal good = expensive wine, the richer you are the more you buy
▪ E.g. inferior good = fast food, the richer you are the less you consume
o The opposite applies in the case of an inferior good: a decrease (respectively
increase) in income increases (respectively decreases) the quantity consumed
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Document Summary
The price you found indicates the minimum amount of money the producer is willing to accept to offer the marginal unit (in our example the marginal unit would be the 2nd unit). Long run: denotes a period of time during which all factors of production are variable. In the short run, the entrepreneur should shut down production if (cid:2269) (cid:2270) < fc, otherwise should hire the optimal number of workers and continue operations. I(cid:374) the lo(cid:374)g (cid:396)u(cid:374), the e(cid:374)t(cid:396)ep(cid:396)e(cid:374)eu(cid:396) should e(cid:454)it the i(cid:374)dust(cid:396)(cid:455) if (cid:2269) (cid:2270) <0, otherwise should hire the optimal number of workers and continue operations. If (cid:2269) (cid:2270) =0 the entrepreneur is indifferent between exiting and continuing operations. 2. 3 from a discrete to a continuous model. In the previous section we considered a model where the entrepreneur could only hire workers in whole numbers. If the extra cost is smaller than the average cost, the average decreases. Inelastic if the elasticity of supply is less than 1.
