3.4 Building Supply and Producer Surplus
Learning Objectives
By the end of this section, you will be able to:
- Explain quantity supplied, and the law of supply
- Understand how implicit and explicit costs are used to build a supply curve
- Calculate producer surplus given a marginal cost curve and price
- Explain the divisibility of goods
Now that we have examined demand and its determinants, let’s look at supply. For the most part, the analysis is similar. Let’s start with an example.
The Cupcake Business
When the store “Cupcakes” came to Vancouver in 2002, the cupcake industry was very different than it is today. The start-up was the only one in town and had the ability to set the price as it saw fit. Over 10 years later, the industry has changed. It is now common to see multiple cupcake shops in each city. New York even has a cupcake ATM where customers can buy cupcakes after the store closes. To understand the supply side of the market, let’s look at a cupcake business that operated in a far more competitive market model than the ones mentioned above – Alaythia Cakes. Alaythia Cakes, a small-town business that primarily sold its products at a weekly farmer’s market, was looking to bring its products to the provincial stage with distribution in grocery stores. Compared to the overall market, Alaythia Cakes was a small player, and when negotiating with brands like Save on Foods, Thrifty Foods, and Costco, it found that it had little to no power in negotiating price, since the grocery chains had access to many other cupcakes suppliers (no supplier power).
Opportunity Cost in the Real World
In Topic 2, we looked at the production possibilities of a person on an island, denominating costs in the marginal opportunity cost of an action. Let’s take that island example and apply it to a firm. While Alaythia Cakes was looking to expand, its production possibilities are limited by the owner and the capacity of the staff. The business can choose to produce and sell cookies, cupcakes, or a mix of both. Assume that:
For the first 5 cupcakes, the MC = 0.8 cookies (4 cookies/5 cupcakes)
For the second 5 cupcakes, the MC = 1.6 cookies (8 cookies/5 cupcakes)
For the third 5 cupcakes, the MC = 2.4 cookies (12 cookies/5 cupcakes)
With this information, we can derive the supply curve, but first we need to denominate the marginal cost in the correct medium of exchange – dollars. Let’s assume the current market price for cookies is $0.50 per cookie. Then, for the first 5 cupcakes, implicit costs are $0.50 x 0.8 = $0.4. All we are doing is changing the way we describe cost from ‘cookie terms’ to ‘dollar terms.’ Is this all our costs? Recall in Topic 1 that the opportunity costs of an action include all implicit and explicit costs. In this case, an explicit cost would include the actual cost of flour, eggs, etc. Let’s assume that the explicit costs of a cupcake are $0.5. This means:
MC of 1st 5 cupcakes = $0.5 (explicit) + $0.4 (implicit) = $0.9
MC of 2nd 5 cupcakes