Supply

1. Supply IMBA Managerial Economics Lecturer: Jack Wu

2. Supply

3. DRAM Industry, 1996-98 • Prices falling sharply: • Fujitsu closed Durham, UK, factory but continued production at Gresham, OR • Texas Instruments sold Richardson TX, Italy, and Singapore plants to Micron • TI shut Midland, TX plant

4. Question • Question: explain differences in strategic decisions: • why did Fujitsu close Durham? • why did it continue with Gresham? • Question: Why did Micron buy some TI plants?

5. Business Response to Price Changes • If market price falls, should business reduce production or shut down? • Correct managerial decision depends on time horizon – which inputs can be adjusted. • Focus on short run, then later consider long run; • distinction between short/long run on supply side similar to that on demand side

6. Adjustment Time • short run: time horizon within which seller cannot adjust at least one input • long run: time horizon long enough for seller to adjust all inputs

7. Short-Run Cost Analyze total cost into two categories • fixed cost – do not vary with production scale • variable cost – does vary • marginal cost = increase in total cost for production of additional unit • average (unit) cost = total cost / production rate

8. SHORT-RUN WEEKLY EXPENSES

9. ANALYSIS OF SHORT-RUN COSTS

10. Common Misconception • Capital expenditure = fixed cost • Labor = variable cost • Example: • US: workers employed “at will”. • Western Europe: strong worker protection laws • Japan: guaranteed lifetime employment • Current: temporary workers

11. Short-Run Total Cost total cost 8 variable cost 6 Cost (Thousand $) 4 2 fixed cost 0 2 4 6 8 Production rate (Thousand dozens a week)

12. DIMINISHING MARGINAL PRODUCT • Marginal product: increase in output from additional unit of input • Diminishing marginal product: marginal product reduces with each additional unit of input

13. SHORT-RUN MARGINAL, AVERAGE VARIABLE, AND AVERAGE COSTS diminishing marginal product causes marginal and average cost curves to rise 300 Cost (Cents per dozen) 250 200 marginal cost 150 average cost 100 average variable cost 50 0 2 4 6 8 Production rate (Thousand dozens a week)

14. MARGINAL REVENUE • Total revenue = price x sales quantity. • Marginal revenue: change in total revenue from selling additional unit • May be positive or negative • If price is fixed, then marginal revenue is equal to price

15. SHORT-RUN PROFIT, I

16. SHORT-RUN PROFIT, II total cost variable cost total revenue 4.793 loss = $1293 3.5 Cost/revenue (Thousand $) 0 1 5 9 Production rate (Thousand dozens a week)

17. Short-Run Decisions • Two key business decisions: • whether to continue in operation • scale of operation

18. Short-Run Production produce where marginal cost = price Cost/revenue (Cents per dozen) marginal cost average cost average variable cost 70 marginal revenue = price 5 break-even price Production rate (Thousand dozens a week)

19. Short Run Breakeven I produce if • total revenue >= variable cost, or • price >= average variable cost

20. Short Run Breakeven II • Sunk cost: cost that has been committed and cannot be avoided. • sunk costs should be ignored in making a current decision • assume, for competitive markets analysis, fixed cost = sunk cost • hence, a business should continue in production so long as its revenue covers variable cost (i.e. shut down if losses are greater than fixed cost) • or equivalently, so long as price covers average variable cost.

21. Short-Run supply curve • individual seller’s supply curve: that part of the marginal cost curve above minimum average variable cost; • minimum average variable cost -- short-run breakeven level.

22. Short-run individual supply: Input demand • Change in input price • shift in marginal cost • change in profit-maximing production

23. Long-Run Decisions • whether to enter/exit • price >= average cost • scale of operation • where marginal cost = price

24. Long-run production

25. Fujitsu • Durham, UK: long-run price < average cost (including cost of refitting) • Gresham, OR: average variable cost < short-run price < average cost

26. Why did Micron buy TI plants? • different views of long-run DRAM price • Micron could achieve greater scale economies • Why didn’t Micron buy all of TI’s plants? Possible explanation: • Micron Electronics bought TI plants -- Singapore, Italy, Richardson TX -- with lower average cost • TI closed plants with higher average cost -- Midland TX -- Micron didn’t wish to buy

27. Individual Supply • Graph of quantity that seller will supply at every possible price • follows marginal cost curve • slopes upward -- increasing marginal cost of production (or decreasing marginal return to inputs)

28. Supply Curve: Two Views • For every possible price, it shows the production/ delivery rate • For each unit of item, it shows the minimum price that the seller is willing to accept

29. Market Supply, I Graph of quantity that seller will supply at every possible price • horizontal sum of individual supply curves

30. Market supply

31. Market Supply, II • lowest cost seller defines starting point • gradually, blends in higher-cost sellers • slopes upward

32. Long-Run Supply • long run -- freedom of entry and exit • if a business earns profits • attract new entrants • increase market supply • reduce market price • if business making loss, will exit

33. Long-Run Supply Curve slope of long-run supply • gentler than short-run supply • may be flat

34. Seller Surplus • Individual seller surplus = revenue a seller gets from a product - production cost • Market seller surplus = sum of individual seller surpluses

35. INDIVIDUAL SELLER SURPLUS individual seller surplus marginal cost c b 70 marginal revenue = price d d Cost/revenue (Cents per dozen) 43 a 0 1 5 Production rate (Thousand dozens a week)

36. Bulk Order • use bulk order to extract seller surplus • Sellers use package deals, two-part tariffs to extract buyer surplus; • buyer can apply symmetric concept -- how to get most out of seller; • use bulk purchasing to capture all seller surplus -- Speedy should offer Luna a lump sum equal to area 0abd plus $1 of seller surplus to supply a bulk order of 5000 dozen eggs

37. Profit/Price Variation: Lihir Gold IPO, Oct. 1995 • Projected profit in 1999: • $52m if gold price = $400 per ounce • $76m if gold price = $450 per ounce • Why would a 12.5% increase in gold price raise profit by 46%?

38. Labor Supply • marginal cost of labor -- benefit from alternative use of time • with higher wage rate • some people work longer and harder • however, some might work less

39. Price Elasticity of Supply percentage by which quantity supplied will change if the price of the item rises by 1% • usually, positive number • supply more elastic with time

40. Price Elasticities

41. FORECASTING • Forecasting quantity supplied • Change in quantity supplied = price elasticity of supply x change in price

42. DISCUSSION QUESTION • Suppose that Jupiter System operates two call centers, one in the north and another in the south. The following table reports the total costs at the two centers for various rates of customer service.

43. DISCUSSION QUESTION: CONTINUED

44. DISCUSSION QUESTION 2: CONTINUED • To serve a total of 5000 calls per day in the cheapest way, how many calls should the company serve from the northern center and how many from the southern center? • At the service rates that you give for (a), what is the cost of the last thousand calls from the northern and the southern centers?