Production Profit and Supply

The supply side of a market is just the reverse of the demand side. While demand is based on marginal benefit, which determines consumers' willingness to pay, supply is based on marginal cost, which determines producers' willingness to sell. In a market, supply comes from firms or producers that combine inputs to make the goods and services that consumers will buy. Economists sometimes refer to these inputs as factors of production, meaning labor, capital, and land, as well as other more specific inputs such as energy, chemicals, water, steel, wood, and seeds.

Key Concept: Opportunity cost

In the last chapter we indicated that the supply curve tends to be upward sloping: marginal cost increases with quantity. At a very general level an upward-sloping supply curve is quite intuitively based on opportunity cost. In order to produce more goods in market X, we must draw inputs away from other uses such as producing other goods in other markets. As inputs are drawn away from other uses, the marginal value of using those inputs in

Key Concept: Opportunity cost those other markets is likely to rise. The cost of inputs for producing X will depend on their opportunity cost, or the value of using them elsewhere, and this cost tends to rise as the production of X rises.

Just as consumers substitute among goods and services, firms make similar kinds of substitutions. Capital can be substituted for labor (tractors, automated machinery, or computers). Labor can be substituted for land (using more labor to tend crops as a way to get more output per acre). There may be limits to the degree of substitution: if you are producing bottled water, you are going to need water. Over long periods of time, research and development (R&D) can raise the productivity of labor or land, which makes R&D a form of capital that is substituted for labor or land. Firms also may enter or exit an industry, or expand or reduce the size of their operation, which affects supply. And since the supply of goods in each industry is just the sum of the actions of all the individual firms, we need to understand a few things about how those firms operate, how they make decisions.

Firms, Profits, and Production

Each firm in an industry will make its own decisions about combining and substituting inputs to produce output. Standard economic theory assumes that firms try to maximize profits, and in a competitive market where many firms are producing the same commodity, only the firms that can keep their costs low will survive. Low-cost firms can keep prices low to attract customers. High-cost firms will be unable to cover their costs at competitive prices. The airline industry is a visible example of this kind of competition, where extinct firms like Pan Am and TWA were unable to compete. Farms and restaurants are also industries where financial failure is common.

When economists talk about a competitive industry, they have in mind a situation where each firm is small relative to the size of the market. This means that the firm does not have any influence over the prices of products or inputs, and so it behaves as though these prices are fixed. The firm can sell all it wants at the market price for its product and buy all the inputs it wants at the going rate.

A few key concepts related to profits, entry, and exit in an industry will come in handy later on. Figure 3.1 illustrates several key ideas about the economics of a firm in a competitive industry. First, firms have two kinds of costs, fixed costs and variable costs. Fixed costs are things such as buildings, land, large equipment, or contracts with managers or other employees. These costs are independent of the level of production. Variable costs vary with the output level and include the materials and other inputs that go into the product being produced. The distinction is important for understanding why the average cost curve in figure 3.1 is different from the marginal cost curve.

Typically, we recognize that before you can produce even one unit of a commodity, you need some capital equipment, and that because of these expenses, it would be very costly to operate at a very low level of output. As output increases, average cost declines—over some range of output levels. But we also understand that at some point a firm can get too big and unwieldy, making it difficult to produce as efficiently as it did at some intermediate level. For this reason, we generally assume that average costs start to rise when a firm gets too big. The idea of the U-shaped average cost curve in figure 3.1 is that there is an optimal-size firm and that firms will do best if they can operate at the lowest average cost. Of course, that level will vary by industry and technology. The optimal-size pizza restaurant is different from the optimal-size airplane manufacturer.

Marginal cost will generally rise over the range of output levels we are interested in. The MC curve will always cross the AC curve at the minimum average cost. (If you think about it long enough, you can probably figure out why this has to be the case.)

If a firm producing TVs has costs like those in figure 3.1, and it wants to maximize profit, what will it do? The profit for a firm is just equal to the difference between revenues and costs. If the firm produces one additional TV, its marginal revenue is just P, the price of the TV. Its marginal cost is indicated by the MC curve. So as long as P > MC, the firm should increase output. If P = MC, the firm should stop. In figure 3.1, if the price were P2, the firm would produce at Q2.

If we want to be able to identify or measure the profit of the firm based on something like figure 3.1, it is useful to recognize

■ FIGURE 3.1 Profits, costs, and output for a firm producing TVs

that profits are equal to total revenue (TR) minus total cost (TC) for any output Q. Another way to measure profit is to take average revenue (P), subtract average cost (AC), and multiply this by Q. To see that these two different ways of measuring profit are the same algebraically, we need only to recognize that TR = P x Q (since price in a competitive market is both the marginal revenue and the average revenue), and also that TC/Q = AC, so AC x Q = TC. The second way to measure profit, (P - AC) x Q, can be identified by the shaded area in figure 3.1 as the profit-maximizing output Q2, when the price is P2. This is the case because A - B is equal to P - AC, and output is Q2, so that the area of the rectangle is equal to (P - AC) x Q.

What happens if the firms in the TV industry find themselves at P2? Well, the firms are making positive profits equal to (A - B) x Q2, or the shaded area. This attracts new firms; output rises, which puts downward pressure on price. As price falls, incentives for new firms to enter diminishes until, at P1, no new firms are interested in entering, and profits equal zero (MR = P = AC, so (P - AC) x Q = 0).

What happens if the firms in the TV industry find themselves at P3? Well, in that case the firms are making negative profits since (D - E) x Q3 is less than zero and equal to the striped area. This situation will discourage firms, and some are likely to leave the industry (in search of positive, or at least zero, profits); out put declines, which puts upward pressure on price. As price rises, the incentives for firms to exit the industry will diminish until, at Pj, no additional firms will be interested in leaving, and profits will once again be zero.

Taken together, all these ways that firms respond to price changes give us an industry supply curve. It may be flat or steep, and that will depend on how existing firms respond by moving along their marginal cost curves, as well as the entry or exit of firms. The industry supply curve is just the horizontal sum of all the firm supply curves, as illustrated in figure 3.2.

The central point here is that profits end up being zero because positive or negative profits will trigger the self-correcting mechanisms of entry into or exit from the industry until profits settle back to zero. But "zero profit" in this sense does not mean the company is broke. In fact, it means that the firm owner is earning just enough to be satisfied. Well, perhaps grumbling a bit, but not really willing to go elsewhere for better opportunities. Why? Well, because elsewhere, in any other competitive industry, the situation is going to be exactly the same.

We can measure the responsiveness of supply in a market the same way we measured the responsiveness of demand, with elasticities. The price elasticity of supply (PES) measures the percentage change in quantity supplied as a result of a given

Supply Response

Key DefinHion:Price elasticity of supply




0 50 100 Firm supply

0 5,000 10,000 20,000 Industry supply

0 50 100 Firm supply

0 5,000 10,000 20,000 Industry supply

■ FIGURE 3.2 Firm supply and industry supply percentage change in price. Mathematically, we can write this as PES = %AQ/%AP, where Q is the quantity supplied, P is the price, and %A is the percentage by which each changes. Unlike PED, we expect PES to be positive since the change in supply is generally in the same direction as the change in price. If the proportional change in quantity supplied is less than the proportional change in price, then PES < 1 and we call this inelastic supply. If the proportional change in quantity supplied is greater than the proportional change in price, then PES > 1 and we call this elastic supply. For PES = 1, we call that unit elastic, meaning that a 10% increase in price will lead to a 10% increase in quantity supplied.

Although supply curves shift in response to changes elsewhere in the economy, we don't frequently talk about the "cross-price elasticities of supply." We are, however, interested often in how changes in the market price of a commodity will alter the firm's demand for inputs. This is the notion of derived demand, taken up next. Another way that supply curves, which are also marginal cost curves, can shift is in response to government policies that may raise (tax) or lower (subsidize) a firm's costs. Examples of how these kinds of policies will shift the supply curve can be found in the section on market distortions.

Derived Demand

The demand for inputs by firms is very similar to the demand for goods and services by consumers. One key difference is that this demand for inputs is dependent on the demand by consumers for the goods and services being produced. Economists call this derived demand. As an illustration, let's look at the demand for labor in U.S. agriculture. Given market prices that consumers are willing to pay for food, the cost of processing and transporting, and the production technologies that farmers are using in order to minimize their costs (using land, chemicals, machinery, etc.), there will be a derived demand for farm labor like D1 in figure 3.3. For a labor supply curve like the one depicted, the labor employed will be Q1 and it will be paid a wage W1.

What if foreign suppliers are suddenly able to send more food to the U.S. market at lower cost? The demand for U.S.-produced food would decline, causing prices to fall. This would make prof its negative, and some farmers would reduce or stop production, which in turn would affect the derived demand for labor in agriculture. This change in demand for the product would cause a shift in labor demand from D1 to D2 in figure 3.3. The market for farm labor will need to find a new equilibrium, and it will do that with a decline in wages and a decline in employment to D2 and W2. A similar shift in derived demand could have occurred if farm employers were required to pay more for workers insurance. A shift of the derived demand in the opposite direction (up and to the right) might occur if labor-saving farm machinery became more expensive (so that farmers would choose to rely somewhat more on manual labor).

While we're on this topic, what might this representation of a labor market tell us about the impact of environmental regulations on the job market? First, the introduction of environmental regulations could shift the demand for labor to the left or the right. The reason for this is that labor could be a complement or a substitute to the regulations; the regulation could be labor using or labor reducing. Indeed, some evidence indicates that environmental spending by industry is labor intensive so that it actually creates additional jobs in some industries, while other evidence finds that air pollution regulations in the United States have led to modest

■ FIGURE 3.3 Derived demand for labor in agriculture

manufacturing job losses in some regions.1 Second, the graph indicates that if environmental regulations do cause the demand for workers to shift to the left, there will be market forces at work to reestablish a new equilibrium rather than leave a gap between supply and demand. True, unemployment is a persistent feature of the economy, but this unemployment exists for reasons mostly having to do with shifts in labor demand among different industries and locations, and the time it takes for workers who lose their jobs to find new ones. Overall, the evidence suggests that environmental regulations do not slow job growth, deepen recessions, or prevent an economy from achieving full employment.

Deficient Markets

In order for market allocation to be efficient, it has to allocate goods and services efficiently, but it also has to allocate inputs efficiently. The markets where derived demand for inputs meets input supply must also find that equilibrium where MB = MC. If they don't, then the allocation of inputs will be inefficient, and the net benefits from allocating inputs will not be maximized. Let's look at an example.

For a variety of reasons, markets for water do not always exist or work very well, in some cases because of legal restrictions on the transfer of water between uses or locations. Take the situation described in figure 3.4. Much more water is allocated for use A (e.g., irrigated agriculture), whereas much less water is allocated for use B (which might be municipal, residential, hydropower, or industrial use). At the margin, the value of a unit of water in use B is much higher than in use A, and this suggests that B users would be willing to pay a price well above what it would take to get A users to willingly sell. Voluntary exchange, through a market, could make both buyers and sellers better off.

For example, if a portion of the water currently available for use A (e.g., AS indicated in the figure) were transferred to the B

1See Richard D. Morgenstern, William A. Pizer, and Jhih-Shyang Shih, Journal of Environmental Economics and Management 43, no. 3 (May 2002): 412--436; and Michael Greenstone Journal of Political Economy 110, no. 6 (December 2002): 1175—1219.

■ FIGURE 3.4 Potential gains from a water market

user group, we can represent this as shifting supply SA to the left by AS and shifting supply SB to the right by the same amount. Let's assume this transfer of AS occurs as the result of a voluntary market exchange at price PM. The net benefit for A users is the shaded triangle in the right-hand panel indicating the difference between their benefits (payments from group B) and the costs (the lost marginal benefits from AS). For the B group, the net benefit is the shaded area in the left-hand panel indicating the difference between the benefit (the gain in marginal benefit from AS) and the cost (the payments to group B). Both groups see a net benefit equal to these shaded areas.

In this hypothetical example, the ratio of the marginal values before the trade occurs (PB/PA) is about 3 to 1. In reality these differences can be 20 to 1, for example, in some parts of the western United States (see box 1) where, among other things, legal restrictions or jurisdictional barriers prevent water markets from functioning efficiently. Some of the reasons for these obstacles have to do with what are called third-party effects, where small rural communities would see their economies shrink if irrigation water were sold to distant uses.

Profits and Economic Rent

When a competitive market is in equilibrium, the last consumer to enter the market is one for whom the marginal benefit is just equal to the price (the last consumer's marginal cost): MB = P. On

In the spring of 2001, the U.S. Bureau of Reclamation (BOR) announced that farmers who irrigate the 190,000-acre Klamath Reclamation Project (KRP) in southern Oregon and northern California would get no water that year from the Klamath River because of a combination of drought conditions and Endangered Species Act directives to maintain adequate instream flow and lake levels to protect coho salmon and two other species of endangered fish. That decision by the BOR prompted protests, marches, civil disobedience, and political fallout that received national attention throughout that year. Estimates of the economic damage suffered by the farmers ranged from $30 million to $40 million. Federal and state public funds spent drilling groundwater wells and compensating farmers for their losses topped $50 million.

More than half of the irrigated land in the Upper Klamath Basin, however, is outside the jurisdiction of the BOR. There are nearly 300,000 acres of privately irrigated lands upstream and outside the federal KRP, and those farmers irrigated their lands in 2001 under state law without restriction. One other key difference between the KPR acres and the non-KPR acres is that most of the very high productivity lands are in the KRP, and most of the least productive irrigable lands are outside the KRP. As a result, the marginal value of irrigation water across the different areas varies by a factor of 20!

Unresolved legal issues and history made it impossible to have a water market in 2001, although some progress has been made since. If farmers in the KRP had been able to lease water rights from non-KRP farmers (leaving more water instream in the upper portions of the watershed so that KRP farmers could divert it later on), the efficiency of the water that was available for irrigation could have been increased significantly. Would this have made much of a difference in terms of the costs of the 2001 crisis? One analysis based on some economic simulation models suggests that the costs could have been reduced from $33 million to less than $9 million.

Source: William K. Jaeger, "Conflicts over Water in the Upper Klamath Basin and the Potential Role for Market-based Allocations," Journal of Agricultural and Resource Economics 29, no. 2 (August 2004): 167-184.


The Klamath Water Crisis and the Lack of a Water Market the supply side, the last firm to produce the last unit of the commodity is also one for which the marginal benefit (the price received) is just equal to marginal cost: P = MC. It's easy to see that the firm receives no extra benefit, or profit, on this last unit produced and sold (MC = P). But it's not so obvious why profits are zero for all units produced by all the firms. This is partly because of the way that economists define profits, and this in turn is related to that fundamental idea of opportunity cost.

Here's how it works. If there are competitive markets for all the inputs that a firm uses to produce a commodity (labor, land, energy, materials, supervisors), and if the firm can make substitutions among different inputs to some extent, then we can expect the firm to be using each input up to the point where the marginal value is just equal to its price (just as consumers will consume a commodity up to the point where MB = P). If, after paying for all its inputs, the firm gets a price from the market that is above the firm's marginal cost, what do you think will happen? Other firms will see this as an opportunity for excess benefit or "profits" and will enter the market. This will increase supply and drive down the price to where, you guessed it, the price is just enough to cover the firm's costs. At that point, profits are zero. And if all firms are identical, then profits will be zero for all firms. Economists use economic profit to refer to excess benefit, something above the normal returns expected in a competitive market.

But what if all firms are not identical? What if some firms have a cost advantage that other firms don't have, for example, farmers who have the best land or restaurants that have the best location or view? After all, the situation with identical firms having identical costs and zero profits will look like a horizontal supply curve, and we generally draw supply curves to be upward sloping.

In that case those advantages will result in economic or scarcity "rents," not economic profit. Here's how economists make the distinction. If a farmer has land that is 10% more productive than that of all other farmers, he can produce 10% more wheat than everybody else with the same inputs and make more profit. But are his costs lower per ton of wheat? Economists say no, because his very special land is worth more than other farmers' land. So if we recognize this opportunity cost (he could sell or lease his productive land for more than the land used by other farmers), then his costs (for cultivating the land himself) are really higher when you include this opportunity cost. So producing 10% more leaves him right where everybody else is: zero profits. Alternatively, he could lease his land to somebody else and just sit back and enjoy the rents from his land.

This situation is depicted in figure 3.5, indicating a fixed supply of highly productive farmland. The demand for this land will raise its price/opportunity cost to P*, a level reflecting its value in farm use. In general, the value of an input will be determined by the market just like commodities, and even if the owner inherited this productive farmland, or land with a great location for a downtown restaurant, its (opportunity) cost is the economic cost to consider. When the concept of profit is viewed this way, we expect profits for all firms in competitive markets to be zero because all costs, including opportunity costs, are taken into account.

■ FIGURE 3.5 Economic rent from a scarce resource

What happens to economic rents if the supply of productive farmland is hugely abundant? (Hint: shift the vertical supply curve in the figure way out to the right.) The price falls to zero, meaning no economic rents. Anybody can just go farm some land, and as a result nobody would buy or lease it from somebody else. Michael Jordan had a highly productive resource, his basketball skills, and he earned huge economic rents (a multimillion-dollar salary). What if players with his basketball skills were hugely abundant? The price for that particular skill level could fall to zero, and they would receive no economic rents.

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    Do "markets for water" always exist environmental economics?
    8 years ago

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