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5.0 Product Market Supply
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5.1.1Economists argued for years about
the shape of the supply line1817- David Ricardo – Principles of a
Political Economy – argues supply was perfectly elastic – a horizontal line
Whatever the cost of production was determined the supply, and therefore the price
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In the 1870s,Jevons/Menger/Walras all argued
Ricardo had it all wrongThey said the level of supply was fixed
by the quantity available in the market
This implies a vertical or perfectly inelastic supply line
They said that where demand intersects this line, that will be the price
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5.1.2Alfred Marshall – Principles of
EconomicsSaid that these two analyses were just
special cases of a larger possible setHe called Ricardo’s case the long run
condition – when the entire scale of production has time to fully adjust
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He called the Jevons/Menger /Walras
caseThe market period condition – an
immediate position where there is a fixed amount of something available
Marshall says there is an intermediate case between these two extremes
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The Short RunScale of production is fixed, butsome factor inputs are variableYou can make more things by adding
more of the variable factorThis implies an upward-sloping supply lineMarshall argues it is this intersection of
supply and demand that determines price
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5.1.3Diminishing marginal productivity-Holding all other factors constant, as you increase one input, you
eventually get less output from each successive unit
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Output
MP
Figure 5.1.1 - Marginal Productivity
Units of Input
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5.1.4
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Unit of labor MP for labor in candy bars
1 252 1003 2004 1805 1606 1407 1208 1109 100
10 90
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This is consistent withThe shape of the MP curveMP rises, then fallsNow, assume a unit of labor costs
$20We can calculate marginal cost
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Unit of labor MP for labor in candy bars
Marginal cost/unit of
candy in dollars1 25 .802 100 .203 200 .104 180 .115 160 .136 140 .147 120 .178 110 .189 100 .20
10 90 .22
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Since we pay a constant price for the input,
and since output rises then falls, the marginal cost of the output will
fall then riseWhen workers are most productive,
the stuff costs less per unitWhen workers get less productive,
the marginal cost begins to rise
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$
MC
Figure 5.1.2 - Marginal Cost
Units of Output
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5.1.5The upward sloping segment of the MC
curve is the firm’s supply lineHow far do we expand production as
MC keeps risingThe firm gets the market signal – the
priceThe signal says “we’re willing to pay
this much, how many will you produce?”
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FIRM MARKET
Figure 5.1.3 - Price Signal and a Firm's Response
$
p0
Q
p
D
Q
S
p0
Q0
MC,Supply Line
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The firm looks at the market price and its marginal cost curve
They can produce up to that point and still cover costs, but to produce more
means that rising costs don’t make it worthwhile
If market price adjusts upward, then they will produce more
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5.1.6Firms consider all costs they incurYou have to pay yourself, tooNormal return – the amount that
covers the opportunity cost of working for yourself
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5.1.7People who run their own business
have many skillsThey could easily work for someone
elseThe normal return might be in cash,
pride of ownership, satisfaction, or any combination, but
it must exceed the opportunity cost of working for another
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Normal returns arean essential part of any firm’s costsThey are built right into the marginal
cost curve
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5.1.8A firm’s cost structure is based upon
The prices of inputs into productionLevel of technologyThe Environment of production
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When one of the changes,it changes the level of the cost
structure, and shifts the whole MC line
Since the MC line is a firm’s supply curve, it is these variables that shift supply
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Q1s = S1 (p1 | pI, Tech.,
Env.)Where:pI is the price of inputsTech. Is the level of technologyEnv. Stands for the environment of
production
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5.1.9If an input price goes up, the whole
cost structure of the firm goes upIt costs more to produce at any
quantityThis increase in input prices will shift
the supply curve upEx. Increase in price of leather shifts
supply of gloves up
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p
Figure 5.1.4 - A Shift Up in Supply
Q
S
S'
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5.1.10If a new technique is developed that
allows production at a lower cost,the supply line will shift down
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5.1.11If the environment of production
deteriorates, supply will shift upEx. Horrible weather for farmers
ruins crops
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In each of these three cases,
What happens to the price and total revenue for the firm depends on
the own price elasticity of demand for that product
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If supply shifts upTotal revenue would increase if the
demand curve were inelasticTotal revenue would decrease if the
demand curve were elastic
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If supply shifts downTotal revenue would decrease if the
demand curve were inelasticTotal revenue would increase if the
demand curve were elastic
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5.1.12
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The market supply curveis the sum of individual firms’ supply
curves
Figure 5.1.5 - From Individual to Market Supply
Q
1
2
3
4
5
6
1 3 7542 86 9 10 11 12 13 140 15
S
Q1 3 542 60
p S
1
2
3
4
5
Q1 3 542 60
p S
1
2
3
4
5
Q1 3 542 60
p S
1
2
3
4
5
pp
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5.1.13Entry and exit of firms shifts the
market supply curveCeteris paribus, More firms, more supply at each
price level, supply shifts rightFewer firms, less supply at each
price level, supply shifts left
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5.1.14Under the nice assumptions that ensure
perfect competition,the market sets the priceFirms and households just have to deal with
it, as they have no powerThe firm faces a perfectly elastic demand
lineThe household faces a perfectly elastic
supply line
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Figure 5.1.6 - Individuals and Firms as Price Takers
p
Dp0
S
Q
FIRM
p0
p
D
S
Q
MARKET
p
D
p0S
Q
INDIVIDUAL
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FIRM MARKET
Figure 5.1.7 - The Firm and the Market
$
p0
Q
p
D
Q
S
p0
Q0
MC, S
D
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Suppose new firms enter the market
FIRM MARKET
Figure 5.1.8 - The Firm in a Changing Market - As New Firms Enter
p
p0
Q
p
D
Q
S0
p0
Q0
MC, S
D0p1
Q1
D1
p1
S1
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As market supply expands, price falls
Intersection of price and MC for the firm falls down to the left
The firm will be at a new position with a lower quantity supplied
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Suppliers and demanders are
constantly responding to the price signalUnder the nice assumptions, all these individual
behaviors lead to an incredibly efficient outcome