SUPPLY

DRAM INDUSTRY, 1996-98Prices 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

QUESTIONQuestion: 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 TIMEshort 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 COSTAnalyze total cost into two categoriesfixed cost – do not vary with production scale variable cost – does varymarginal cost = increase in total cost for production of additional unit average (unit) cost = total cost / production rate

Production Rent Wages Supplies Total0 $2000 $200 $0 $2200

1000 $2000 $529 $100 $26292000 $2000 $836 $200 $30363000 $2000 $1216 $300 $35164000 $2000 $1697 $400 $40975000 $2000 $2293 $500 $47936000 $2000 $3015 $600 $56157000 $2000 $3870 $700 $65708000 $2000 $4862 $800 $76629000 $2000 $5996 $900 $8896

SHORT-RUN WEEKLY EXPENSES

Production FC VC TC MC AFC AVC AC0 $2200 $0 $2200

1000 $2200 $429 $2629 $0.43 $2.2 $0.43 $2.632000 $2200 $836 $3036 $0.41 $1.1 $0.42 $1.523000 $2200 $1316 $3516 $0.48 $0.73 $0.44 $1.174000 $2200 $1897 $4097 $0.58 $0.55 $0.47 $1.025000 $2200 $2593 $4793 $0.7 $0.44 $0.52 $0.966000 $2200 $3415 $5615 $0.82 $0.37 $0.57 $0.947000 $2200 $4370 $6570 $0.95 $0.31 $0.62 $0.948000 $2200 $5462 $7662 $1.09 $0.28 $0.68 $0.969000 $2200 $6696 $8896 $1.23 $0.24 $0.74 $0.99

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

0

2

4

6

8

2 4 6 8

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

0

50

100

150

200

2 4 6 8

Cost

(C

ents

per

doze

n)

Production rate (Thousand dozens a week)

250

300

MARGINAL REVENUETotal revenue = price x sales quantity.

Marginal revenue: change in total revenue from selling additional unitMay be positive or negative

If price is fixed, then marginal revenue is equal to price

Prodn VC TC TR Profit MC MR0 $0 $2200 $0 -$2,200

1000 $429 $2629 $700 -$1,929 $0.43 $0.72000 $836 $3036 $1400 -$1,636 $0.41 $0.73000 $1316 $3516 $2100 -$1,416 $0.48 $0.74000 $1897 $4097 $2800 -$1,297 $0.58 $0.75000 $2593 $4793 $3500 -$1,293 $0.7 $0.76000 $3415 $5615 $4200 -$1,415 $0.82 $0.77000 $4370 $6570 $4900 -$1,670 $0.95 $0.78000 $5462 $7662 $5600 -$2,062 $1.09 $0.79000 $6696 $8896 $6300 -$2,596 $1.23 $0.7

SHORT-RUN PROFIT, I

0

3.5

4.793

1 5 9

Two key business decisions:• whether to continue in

operation • scale of operation

SHORT-RUN DECISIONS

70

5

marginal cost

average costaverage variable cost

marginal revenue = price

Production rate (Thousand dozens a week)

Cost

/revenue (

Cents

per

doze

n)

break-even price

SHORT RUN BREAKEVEN Iproduce 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

LONG-RUN DECISIONS

whether to enter/exitprice >= average cost

scale of operation where marginal cost = price

LONG-RUN PRODUCTION

FUJITSUDurham, 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 priceMicron 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• follows marginal cost curve• slopes upward -- increasing marginal cost of production (or decreasing marginal return to inputs)

INDIVIDUAL SUPPLY

• 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

SUPPLY CURVE: TWO VIEWS

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

MARKET SUPPLY

MARKET SUPPLY, IIlowest cost seller defines starting pointgradually, blends in higher-cost sellersslopes upward

LONG-RUN SUPPLYlong run -- freedom of entry and exit

if a business earns profitsattract 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 SURPLUSIndividual seller surplus = revenue a seller gets from a product - production costMarket seller surplus = sum of individual seller surpluses

0

43

70

1 5

bc

a

d

marginal cost

marginal revenue= price

individual seller surplus

Production rate (Thousand dozens a week)

Cost

/revenue (

Cents

per

doze

n)

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 SUPPLYmarginal cost of labor -- benefit from alternative use of time

with higher wage ratesome 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

Item Horizon Price Elasticitydistillate short run 1.57gasoline short run 1.61pork long run 0.23tobacco long run 7housing long run 1.6 - 3.7

PRICE ELASTICITIES

FORECASTINGForecasting quantity suppliedChange in quantity supplied = price elasticity of supply x change in price

DISCUSSION QUESTIONSuppose 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 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?