Managerial Economics Lecturer: Jack Wu Supply Managerial Economics Lecturer: Jack Wu

Supply Two fundamental building blocks of managerial economics: demand costs-- we discuss from two perspectives as building block for model of competitive markets -- current chapter; as basis for strategic business decisions -- Chapter 7

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

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?

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

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

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

SHORT-RUN WEEKLY EXPENSES

ANALYSIS OF SHORT-RUN COSTS

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

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

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

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 2 4 6 8 Production rate (Thousand dozens a week)

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

SHORT-RUN PROFIT, I

SHORT-RUN PROFIT, II total cost variable cost total revenue 4.097 2.8 loss = $1297 2.8 Cost/revenue (Thousand $) 1 4 9 Production rate (Thousand dozens a week)

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

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

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

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.

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.

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

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

Long-run production Profit-maximizing rule: produce where price equals marginal cost same in the long run as for the short run -- but use long-run price and long-run marginal cost Same analysis for manufacturing and services manufacturing -- production rate, eg, for auto producer, no. of automobiles per year service -- operating rate, eg, for telecoms carriers, no. of minutes per month

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

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

Graph of quantity that seller will supply at every possible price 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)

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

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

Market supply

lowest cost seller defines starting point Market Supply, II lowest cost seller defines starting point gradually, blends in higher-cost sellers slopes upward market supply begins with lowest-cost seller; each new seller comes into market supply according to for short run: its minimum average variable cost for long run: its minimum average cost

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

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

Market seller surplus = sum of individual seller surpluses Individual seller surplus = revenue a seller gets from a product - production cost Market seller surplus = sum of individual seller surpluses

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

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

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%?

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

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

Price Elasticities

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

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.

DISCUSSION QUESTION: CONTINUED Service rate Northern Southern 1000 $5000 $8000 2000 $11000 $16000 3000 $18000 $24000 4000 $26000 $32000 5000 $35000 $40000

DISCUSSION QUESTION : 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?