SUPPLY IMBA Managerial Economics Lecturer Jack Wu

SUPPLY IMBA Managerial Economics Lecturer: Jack Wu

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

Cost (Thousand $) SHORT-RUN TOTAL COST total cost 8 variable cost 6 4 2 0 fixed cost 2 4 6 8 Production rate (Thousand dozens a week)

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

SHORT-RUN PROFIT, I

SHORT-RUN PROFIT, II Cost/revenue (Thousand $) total cost variable cost total revenue 4. 097 loss = $1297 2. 8 0 1 4 9 Production rate (Thousand dozens a week)

SHORT-RUN DECISIONS Two key business decisions: • whether to continue in operation • scale of operation

Cost/revenue (Cents per dozen) SHORT-RUN PRODUCTION produce where marginal cost = price marginal cost average variable cost marginal revenue = price 70 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.

LONG-RUN DECISIONS whether q price >= average cost scale q to enter/exit of operation where marginal cost = price

Cost/revenue (Cents per dozen) LONG-RUN PRODUCTION marginal cost average cost 70 marginal revenue = price break-even price 0 3. 4 Production rate (Thousand dozens a week)

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

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

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

MARKET SUPPLY, II lowest cost seller defines starting point gradually, blends in higher-cost sellers slopes upward

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

LONG-RUN SUPPLY CURVE slope of long-run supply gentler than short-run supply may be flat

SELLER SURPLUS Individual seller surplus = revenue a seller gets from a production cost Market seller surplus = sum of individual seller surpluses

Cost/revenue (Cents per dozen) INDIVIDUAL SELLER SURPLUS individual seller surplus 70 43 0 c marginal cost b marginal revenue = price d 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 0 abd 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: $52 m if gold price = $400 per ounce $76 m 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

DISCUSSION QUESTION 1 Until 1998, there were two major American manufacturers of DRAMs – Texas Instruments (TI) and Micron Technology. Then, TI sold its factories in Avezzano (Italy), Richardson (Texas), and Singapore, and interests in two Asian joint ventures to Micron Technology. TI shut the remainder of its DRAM production facilities including one in Midland, Texas.

DISCUSSION QUESTION 1: CONTINUED Which probably had the higher average cost – the Richardson or Midland plant? Compare the effects on the world wide long-run DRAM supply of TI’s sale of the Richardson plant with its closure of the Midland factory. Explain Micron’s decision to buy TI’s plants in terms of differences between the two companies in their expectations of long-run DRAM prices.

DISCUSSION QUESTION 2 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 2: CONTINUED Service rate Northern Southern 1000 $5000 $8000 2000 $11000 $16000 3000 $18000 $24000 $26000 $32000 5000 $35000 $40000

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?