Chapter 6 Notes: Sellers and Incentives
6.1 Sellers in a Perfectly Competitive Market
Three defining conditions of a perfectly competitive market:
No buyer or seller is large enough to influence the market price.
Sellers produce identical goods.
There is free entry and exit in the market.
Price-taking behavior:
In perfect competition, individual firms are price-takers because each firm sells only a tiny fraction of total market output.
The market price is determined by the collective actions of all buyers and sellers; an individual firm cannot set or influence it.
Intuition and examples:
A farmer deciding to grow corn vs. soybeans does not affect world prices; if all farmers switch to corn, prices would fall for corn and rise for soybeans.
Markets like eBay illustrate entry/exit flexibility; many markets permit free entry and exit in practice.
Implications for policy and business:
Understanding seller decisions under perfect competition helps predict responses to policies (e.g., subsidies, taxes) and to entrepreneurial opportunities.
6.2 The Seller's Problem
The seller's objective:
Maximize net benefits, i.e., profits.
Three components of the seller's problem: making the goods, the cost of doing business, and the rewards of doing business.
Production function:
Relationship between inputs used and outputs produced; transformation from inputs (e.g., labor, capital) to outputs (goods/services).
Firm concept: a firm produces and sells; can be a large organization or a single person.
The Wisconsin Cheeseman as a real-life example:
Inputs: labor (to pack cheese boxes) and physical capital (equipment/buildings).
Short run vs long run:
Short run: some inputs fixed (physical capital); labor is variable.
Long run: all inputs are variable; firm can adjust size and capital.
Key terminology:
Physical capital: machines and buildings used for production.
Short run: a period in which some inputs cannot be varied (fixed inputs).
Long run: a period in which all inputs can be varied.
Fixed factor of production: input that cannot be changed in the short run.
Variable factor of production: input that can be changed in the short run.
The short-run production function and marginal product:
Exhibit 6.1 (The Cheeseman): output varies with number of workers; marginal product (MP) is the additional output from one more unit of input:
MP behavior:
MP can initially rise with the first few workers due to specialization and division of labor.
Specialization example: Subway assembly line; workers specialize in specific steps to boost productivity.
MP eventually decreases as more workers are added (Law of Diminishing Returns): with a fixed amount of capital, adding workers leads to smaller increments in output.
The last worker can even reduce total output if too many workers create congestion or get in each other’s way.
The cost of doing business: introducing cost curves
Total cost (TC) = Variable cost (VC) + Fixed cost (FC):
Variable costs: vary with output (e.g., wages for workers).
Fixed costs: do not vary with output in the short run (e.g., buildings, machinery).
The Wisconsin Cheeseman numbers (illustrative):
Workers’ daily wage = $72; 8 hours per day; VC increases by $72 per additional worker.
Fixed cost (cost of structures/machinery) = $200 per day.
Thus, VC and FC are specified for different output levels; TC is VC+FC.
Cost per unit measures:
Average total cost (ATC) =
Average variable cost (AVC) =
Average fixed cost (AFC) =
Example values (The Cheeseman at Q = 321):
Total cost (TC) = $416 → ATC =
Average variable cost (AVC) = $0.67
Average fixed cost (AFC) = $0.62
Hence,
Marginal cost (MC): the change in total cost from producing one more unit:
At Q = 321, MC = $0.63 for the 321st unit.
Relationship between MC and cost curves:
MC is below ATC and AVC when ATC and AVC are falling; MC is above them when ATC and AVC are rising. This explains why MC intersects ATC and AVC at their minimums.
Intuition example: adding a new item to a basket with average price rises the basket’s average price if the new item is priced above the current average; analogous intuition for MC crossing ATC/AVC.
The rewards of doing business: revenue concepts
Revenue (TR) = price × quantity:
In perfectly competitive markets, sellers are price-takers, so price equals marginal revenue (MR):
The “good stuff” for profits comes from comparing TR to TC.
Profit definitions
Profit (economic profit) = TR − TC
Accounting profits = TR − explicit costs (e.g., wages, materials, depreciation)
Economic profits = TR − (explicit costs + implicit costs, e.g., opportunity costs of owner’s time)
From the seller's problem to the supply curve
The MR = MC rule links market price to the MC curve to determine short-run output:
A firm’s supply curve shows the quantity supplied as a function of price.
Price elasticity of supply
Measure of how responsive quantity supplied is to price changes:
Typically positive: higher price → more quantity supplied.
Elasticities range from perfectly elastic (∞) to perfectly inelastic (0) to unit-elastic (1).
Perfectly elastic supply: a tiny price change leads to an infinite change in quantity supplied.
Unit-elastic supply: a 1% increase in price leads to a 1% increase in quantity supplied.
Determinants of supply elasticity:
Availability of inventories (extensibility to ramp up production)
Time to respond (longer time → more elastic)
Availability of labor (easier hiring) → more elastic
Shutdown and sunk costs
Shutdown: a short-run decision to stop producing for a period.
In Exhibit 6.10, a price of $0.59 may lead MR = MC to a positive output but the firm might still shut down if price cannot cover variable costs.
Sunk costs: costs that cannot be recovered once incurred (e.g., a fixed lease). Decisions in the short run should ignore sunk costs when choosing current production levels; only variable costs matter for the shutdown decision.
Producer surplus (PS)
PS measures the seller’s gain from participating in the market, analogous to consumer surplus.
Defined as the area above the MC curve and below the market price: PS = (Price − MC) integrated over the quantity sold.
PS is distinct from economic profits because PS does not account for total costs beyond MC; it only uses the MC as the relevant supply curve boundary.
6.5 From the Short Run to the Long Run
Long run is the period in which all inputs are variable, and firms can adjust the size of their plant and the mix of inputs.
In the long run, firms choose the optimal combination of labor and capital to minimize ATC for each output level.
Long-run cost curves are derived from the envelope of short-run cost curves and reflect the scale of operation.
Economies, constants, and diseconomies of scale
Economies of scale: ATC falls as output rises within a certain range, due to increases in efficiency as plant size grows.
Constant returns to scale: ATC remains unchanged as output changes.
Diseconomies of scale: ATC rises as output increases beyond a certain level, possibly due to management inefficiencies or coordination problems.
Long-run vs short-run cost curves
The long-run average total cost (LRATC) curve is typically smoother and exhibits economies, constants, and diseconomies of scale as scale changes.
Long-run supply and exit rules
If the market price is below the minimum of the LRATC, firms have no incentive to stay in the industry and will exit in the long run.
Exit rule (long run): Exit if price is less than ATC or equivalently if total revenue is less than total cost.
The Cheeseman and long-run implications
In the long run, firms adjust to minimize ATC and to the level where profit is zero (economic profit = 0) in a competitive market.
6.6 From the Firm to the Market: Long-Run Competitive Equilibrium
Free entry and exit in the long run
With identical firms and constant input costs, free entry and exit push profits toward zero in long-run equilibrium.
Entry increases market supply, lowering price; exit decreases market supply, raising price.
Process of entry
Suppose price is above a firm’s minimum LRATC; new firms enter seeking profits.
Entry shifts market supply to the right, lowering price until it reaches the minimum LRATC; at that price, economic profits are zero, and no further entry occurs.
If the price remains above the minimum LRATC, additional firms enter until the price falls to the minimum LRATC.
Process of exit
If demand falls or costs rise, price can fall below LRATC; firms exit, shifting supply left and increasing price until it returns to the minimum LRATC.
Long-run equilibrium in a perfectly competitive industry
The long-run industry supply curve is horizontal at the level of the long-run minimum ATC.
Economic profits are zero in long-run equilibrium because entry/exit adjust supply to drive price to the LRATC minimum.
Accounting profits and economic profits diverge: zero economic profits do not imply zero accounting profits; owners are earning their opportunity costs in the economy.
Important caveats
The zero-profit result assumes identical firms with constant input costs. Heterogeneous firms or different cost structures can yield positive economic profits for some firms in long-run equilibrium; this is discussed further in the appendix.
Subsidies (brief note)
Subsidy: a payment or tax break used as an incentive for an agent to engage in an activity. Subsidies can affect firm behavior and may alter the long-run equilibrium by changing effective costs or the market price.
Summary of Core Points
Sellers optimize by solving the seller's problem on the margin: produce up to the point where MC = MR.
Short-run and long-run supply curves reflect a seller's willingness to sell at various prices; MC is central to determining supply.
Producer surplus is the area between the market price and the MC curve; it captures sellers' gains from trade beyond variable costs.
Free entry and exit in a perfectly competitive market drive long-run profits to zero, with price equaling the minimum of the long-run average total cost.
Economic profits account for both explicit and implicit costs, whereas accounting profits consider only explicit costs.
Understanding these rules helps explain both everyday business decisions and the likely effects of public policies, including subsidies and taxes.
Key Terms
firm: a business entity that produces and sells goods or services
production: the transformation of inputs into outputs
physical capital: machines and buildings used in production
short run: a period during which some inputs are fixed
long run: a period during which all inputs can be varied
fixed factor of production: an input that cannot be changed in the short run
variable factor of production: an input that can be changed in the short run
marginal product (MP): the change in output from adding one more unit of input
specialization: concentrating input use on a specific task to increase productivity
Law of Diminishing Returns: beyond a point, successive increases in inputs yield smaller increases in output
cost of production: total cost of inputs to produce a given output level
total cost (TC): VC + FC
variable cost (VC): costs that vary with output
fixed cost (FC): costs that do not vary with output in the short run
average total cost (ATC):
average variable cost (AVC):
average fixed cost (AFC):
marginal cost (MC):
revenue (TR):
marginal revenue (MR):
profits: economic profits = TR − (explicit costs + implicit costs); accounting profits = TR − explicit costs
price elasticity of supply:
shutdown: a short-run decision to not produce for a period
sunk costs: costs that cannot be recovered once incurred; should not affect current decisions
producer surplus: area above the MC curve and below the market price
economies of scale: ATC falls as output increases
constant returns to scale: ATC unchanged with output
diseconomies of scale: ATC rises as output increases
free entry: no barriers to entering an industry
free exit: no barriers to exiting an industry
subsidy: a payment or tax break to incentivize an activity