Supply

MGEC Session 3

DHM 1, 2020-21

1
This session
• Production (pre session async video)
• Costs (pre session async video)
• Managerial use of economies of scale and economies of scope
• Supply
• What is the supply curve and where does it come from?
• Shifts in supply curve
• Supply elasticity
• Producer surplus
• Equilibrium dynamics
• Effects of government intervention (post session async video)
• Profit maximization and the optimal pricing rule
2
References
• Production
• AWDM Ch 5: only sections on production function with one variable input, law
of diminishing marginal returns
• RP Ch 6.1 and 6.2 only

• Cost
• AWDM Ch 6: only sections on short-run cost functions, average and marginal
costs, managerial use of scale economies and managerial use of scope
economies
• RP Ch 7.1, 7.2, 7.4 (subsection on economies and diseconomies of scale only)
and 7.5
3
References
• Supply: What is the supply curve and where does it come from, shifts in
supply curve, supply elasticity, producer surplus, equilibrium dynamics of
shifts in demand and supply together, effects of government intervention
• AWDM Ch 1: only sections on supply side of market, equilibrium price, actual
price, what if demand curve shifts, what is supply curve shifts
• RP Ch 2 (all of it)

• Profit maximization condition and optimal pricing rule

• AWDM Ch 8: only sections on cost-plus pricing and can cost-plus pricing maximize
profit?
• RP Ch 10.2 (only subsection “thumb rule for pricing”)

4
Production
Slides for async video

5
First principles
The technology of production

• Firms
  produce goods and services using different factors of production:
• Broadly speaking, these are capital and labor:

• For instance, a company producing cars with a 10,000 square foot plant and a
specific amount of assembly-line labor
• It is typically possible to combine inputs in varying proportions to produce
the same level of output:
• Labor-intensive or capital-intensive (think RIL versus Shahi Exports)
• Some inputs are more easily adjusted than others:
• It takes longer to build a factory than to hire a worker
• Short run versus long run

6
Short run production
Production with one variable input, L (assume K is fixed)
Amount of Amount of Total Marginal Average
Labor(L) Capital(K) Product(q) Product () Product (
0 10 0 - -
0 10 0 - -
1 10 10 10 10
1 10 10 10 10
2 10 30 20 15
2 10 30 20 15
3 10 60 30 20
3 10 60 30 20
4 10 80 20 20
4 10 80 20 20
5 10 95 15 19
5 10 95 15 19
6 10 108 13 18
6 10 108 13 18
7 10 112 4 16
7 10 112 4 16
8 10 112 0 14
8 10 112 0 14
9 10 108 -4 12
9 10 108 -4 12
7
Average and marginal products
• Average product: output per unit of a particular input = q/L
• Marginal product: additional output produced as an input is increased
by one unit = dq/dL

• Relationship between AP and MP

• When marginal > average, average is increasing
• When marginal < average, average is decreasing
• When marginal = average, average is stationary

8
 Production

Slopes of product
with one
variable input

curves
• The total product curve in (a) shows
the output produced for different
amounts of labor input.
• The average and marginal products in
(b) can be obtained (using the data in
Table) from the total product curve.
• At point A in (a), the marginal product
is 20 because the tangent to the total
product curve has a slope of 20.
• At point B in (a) the average product of 20
labor is 20, which is the slope of the
line from the origin to B.
• The average product of labor at point C
in (a) is given by the slope of the line
0C.
9
 Production

Slopes of product
with one
variable input

curves
• To the left of point E in (b), the marginal
product is above the average product
and the average is increasing; to the
right of E, the marginal product is below
the average product and the average is
decreasing.
• As a result, E represents the point at
which the average and marginal
products are equal, when the average
product reaches its maximum. 20

• At D, when total output is maximized,

the slope of the tangent to the total
product curve is 0, as is the marginal
product.
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The mechanics of diminishing marginal
returns

• As the use of an input increases in the production process, holding other

inputs fixed, a point will eventually be reached where each successive unit
of the input adds less and less to the output, i.e., the marginal product of
the input diminishes
• Initial increases come about as extra units of labor enable division of labor
and specialization
• Think of an assembly line with each worker doing just one job
• Eventually, when there are too many workers, some of them become
ineffective and their marginal product falls
11
Costs
Slides for async video

14
Costs
• The short run product curves are mirrored in the firm's costs, and
therefore, its supply decisions

• Before we understand the cost curves, a primer on the types of costs

incurred by a firm...

15
Basic cost concepts
•• Total
  Cost (TC) is the cost of all inputs used to produce output, q:
• Total cost is fixed cost plus variable cost
• Fixed costs do not vary with output (examples?)
• Variable costs vary with output (examples?)

• Average Cost (AC) is the total cost averaged by the total output, i.e. TC

• Marginal Cost (MC) is the additional cost incurred for a unit increase
in output, i.e. MC =

16
Fixed v. variable costs

17
Fixed costs, variable costs and sunk costs
• How do we know which costs are fixed and which are variable?
• Over a very short time horizon—say, a few months—most costs are fixed. Over
such a short period, a firm is usually obligated to pay for contracted shipments of
materials.
• Over a very long time horizon—say, ten years—nearly all costs are variable.
Workers and managers can be laid off (or employment can be reduced by
attrition), and much of the machinery can be sold off or not replaced as it becomes
obsolete and is scrapped.
• Fixed vs sunk costs
• Fixed costs can be avoided if the firm shuts down a plant or goes out of business.
• Fixed costs affect the firm’s decisions looking forward, whereas sunk costs do not.

18
From production to costs
Assume wage = 100, K = 10
Amount of Labor Total Marg. Average Total Variable Average Variable
(L) Product Product Product Cost Cost
(q) ( ( (TVC) ()
0 0 - - 0 0
0
1 0
10 -
10 -
10 0
100 0
10
1
2 10
30 10
20 10
15 100
200 10
6.7
3
2 60
30 30
20 20
15 300
200 5
6.7
4
3 80
60 20
30 20
20 400
300 5
5
5
4 95
80 15
20 19
20 500
400 5.3
5
6 108 13 18 600 5.6
5 95 15 19 500 5.3
7 112 -4 16 700 6.3
6 108 13 18 600 5.6
8 112 0 14 800 7.1
7
9 112
108 -4
4 16
12 700
900 6.3
8.3
8 112 0 14 800 7.1
9 108 4 12 900 8.3
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From production to costs

AP: Average Product, MP: Marginal Product, AVC: Average Variable cost, MC: Marginal cost 20
Shapes of cost
curves
• In (a) total cost TC is the
vertical sum of fixed cost FC
and variable cost VC.

• In (b) average total cost ATC is

the sum of average variable
cost AVC and average fixed cost
AFC.

• Marginal cost MC crosses the

average variable cost and
average total cost curves at
their minimum points.
21
Relationship between MC and AC
•• Precise
  relationship between MC and AC, i.e., marginal cost and average cost:

Þ MC = AC at minimum AC
Þ If MC < AC , AC is falling
Þ If MC > AC , AC is rising

• Firms always produce in the region where MC is increasing:

• At any quantity q where MC is decreasing the firm can decrease its average cost by producing more
and therefore, this is not an efficient use of resources to be producing where MC is decreasing
• The MC of producing each successive unit is greater than the last one
Þ Each successive unit must be sold at a higher price to cover the higher cost of production
Þ Gives rise to the upward sloping supply curve!

22
Managerial use of economies of
scale and economies of scope

23
Pre-session production and cost recap
• In the short run, one or more of a firm’s inputs are fixed. Total cost can
be divided into fixed cost and variable cost.
• A firm’s marginal cost is the additional variable cost associated with each
additional unit of output.
• The average variable cost is the total variable cost divided by the number of
units of output.

• In the short run, when not all inputs are variable, the presence of
diminishing returns determines the shape of the cost curves.
• In particular, there is an inverse relationship between the marginal product of a
single variable input and the marginal cost of production.
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What about the long run? What is the
takeaway for managers in the long run?
• In the long run all inputs are variable, and managers can build any scale
or type of plant. Note: There are no fixed costs in the long run.

• Managers have lot more flexibility and there is nothing to stop a

manager from being as efficient as possible.

• Thinking about the long run requires managers to focus more on the
destination rather than the route (Game theory has a lot to say about
how managers should try to anticipate the future, second half of the
course will discuss this)
25
Economies of scale
• Economies of scale occur when
the firm’s average unit cost
decreases as output increases.

• For example, if a nursing home

provides 10,000 patient–days of
service per year, the cost per
patient–day is almost $29; if it
provides about 50,000 patient–
days of service per year, the cost
per patient–day is under $26.
26
Quantifying economies of scale
•  Economies of scale: situation in which output can be doubled for
less than a doubling of cost.
• Economies of scale are often measured in terms of a cost-output
elasticity, EC.
• EC is the percentage change in the cost of production resulting from a
1-percent increase in output:

Alternatively,
• EC is less than 1 => economies of scale
27
Managerial use of economies of scale
• Managers must understand their cost relationships to recognize
where to best exploit scale economies.

• Scale economies are not confined to plants and to the production

process; they are found in distribution, raising capital, advertising, and
most business processes.

• All managers have the opportunity to exploit scale economies in some

form, though some fail to recognize their opportunities.

28
How to spot economies of scale?
• As output increases, the firm’s average cost of producing that output is
likely to decline, at least to a point. This can happen for three reasons:
1. If the firm operates on a larger scale, workers can specialize in the activities
at which they are most productive.
2. Scale can provide flexibility. By varying the combination of inputs utilized to
produce the firm’s output, managers can organize the production process
more effectively.
3. The firm may be able to acquire some production inputs at lower cost
because it is buying them in large quantities and can therefore negotiate
better prices. The mix of inputs might change with the scale of the firm’s
operation if managers take advantage of lower-cost inputs.
29
Diseconomies of scale
• At some point, however, it is likely that the average cost of production
will begin to increase with output. There are three reasons for this
shift:
1. At least in the short run, factory space and machinery may make it
more difficult for workers to do their jobs effectively.
2. Managing a larger firm may become more complex and inefficient
as the number of tasks increases.
3. The advantages of buying in bulk may have disappeared once
certain quantities are reached. At some point, available supplies of
key inputs may be limited, pushing their costs up.
30
Production with two (or more) outputs
• Many firms produce more than one product.

• A firm is likely to enjoy production or cost advantages when it

produces two or more products.

• These advantages could result from the joint use of inputs or

production facilities, joint marketing programs, or possibly the cost
savings of a common administration.

31
Economies and diseconomies of scope
• Economies of scope: Situation in which joint output of a single firm
is greater than output that could be achieved by two different firms
when each produces a single product.

• Diseconomies of scope: Situation in which joint output of a single firm

is less than could be achieved by separate firms when each produces a
single product.

• Note: There is no direct relationship between economies of scale and

economies of scope.
32
Degree of economies of scope
• Percentage
  of cost savings resulting when two or more products are
produced jointly rather than individually can be measured by is measured by
degree of economies of scope (SC)

• If SC is positive => economies of scope

• In general, the larger the value of SC, the greater the economies of scope.

• If SC is negative => diseconomies of scope

33
Application: Corporate strategy in
conglomerates
Why do some firms organize as
conglomerates whereas others produce
in just one line of business? The latter
argue for “core competency”— doing
what they do best, whereas the former
argue for economies of scope and
diversification of risk. Those who have
disassembled conglomerates argue that
the whole is worth less than the sum of
its parts (for example, Cendent, which
was built and then dismantled by Henry
Silverman).
Those who favor conglomerates, such as
General Electric and Siemens, argue the
reverse and point to synergies of idea
generation and the ability to use
personnel across businesses. On the risk-
diversification side, critics argue that as
capital markets have become more
sophisticated, global, and liquid, fund
managers maintain that they can
diversify risk and increase returns by
purchasing securities across multiple
sectors.
Supply curve & its determinants

35
 We will derive the firm’s
individual supply curve in the
next class; for now remember

Supply (SS) curve

that firm’s can cover rising MC
only by selling the additional
unit at a higher price (see slide
on AC-MC relationship)

• Supply curve captures the

relationship between the price of a
good and the quantity supplied
• Quantity supplied is the amount of a
good that sellers/producers are willing
and able to sell

• Law of supply claims that, all other

things equal, the quantity supplied of
a good rises when the price of the
good rises.
• The supply curve is upward sloping

36
The supply curve
Tabular representation

P Q=S(P)
30 0
35 10
40 20
45 30

Q = S(P) = 2P - 60

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Factors affecting supply

38
How do the following affect the SS curve?
• Cost of raw materials rise

• Invention of new technology

that reduces firms’ costs

• If sellers expect the prices to

rise in the future

39
Supply elasticity = dQs/dP × P/Qs
• Supply elasticity is a measure of
how much the quantity supplied of
a good responds to a change in the
price (P) of that good, and is
computed as the % change in
quantity supplied (Qs) divided by
the % change in price
• Firms often have a maximum
capacity for production and so,
supply elasticity may be very high at
low levels of quantity supplied (Qs)
and very low at high levels of
quantity supplied (Qs)
40
Inelastic supply

41
Elastic supply

42
Application: elasticity of supply and durability
• Like that of most goods, the
supply of primary copper, shown
in part (a), is more elastic in the
long run.
• If price increases, firms would
like to produce more but are
limited by capacity constraints in
the short run.
• In the longer run, they can add
to capacity and produce more.
Supply elasticity and durability
• Part (b) shows supply curves for
secondary copper.
• If the price increases, there is a
greater incentive to convert scrap
copper into new supply. Initially,
therefore, secondary supply (i.e.,
supply from scrap) increases
sharply.
• But later, as the stock of scrap falls,
secondary supply contracts.
• Secondary supply is therefore less PRICE ELASTICITY OF: SHORT-RUN LONG-RUN
Primary copper supply 0.20 1.60
elastic in the long run than in the Secondary copper supply 0.43 0.31
short run. Total copper supply 0.25 1.50
Equilibrium dynamics

45
When can we use the DD-SS model? A
caveat
• We are assuming that at any given price, a given quantity will be
produced and sold.
• This assumption makes sense only if a market is at least roughly competitive.
• By this we mean that both sellers and buyers should have little market power
i.e., little ability individually to affect the market price.

• Suppose instead that supply were controlled by a single producer. If

the demand curve shifts in a particular way, it may be in the
monopolist’s interest to keep Q fixed but change P, or to keep P fixed
and change Q. (More on this in the next session.)

46
Market mechanism
• The market clears at price P0
and quantity Q0.

• At the higher price P1, a surplus

develops, so price falls.

• At the lower price P2, there is a

shortage, so price is bid up.

47
Definitions
• Equilibrium (or market clearing) price: Price that equates the quantity supplied to
the quantity demanded.

• Market mechanism: Tendency in a free market for price to change until the
market clears.

• Surplus: Situation in which the quantity supplied exceeds the quantity demanded.

• Shortage: Situation in which the quantity demanded exceeds the quantity

supplied.

48
Shifts in demand and supply curves

49
Simultaneous shifts in DD and SS curves
• Think back to the coconuts article: an increase in demand and a decrease
in supply, simultaneously

• The impact on equilibrium price and quantity is no longer straightforward,

and depends on the relative change in demand and supply

• When analyzing impact on P* and Q*, first decide which curve shifts (or do
both shift?), then think about the direction of the shift and the extent of
the shift and finally compare the new equilibrium to the old.

50
Application: Market for US college education
• The supply curve for a college
education shifted up as the costs
of equipment, maintenance, and
staffing rose.
• The demand curve shifted to the
right as a growing number of
high school graduates desired a
college education.
• As a result, both price and
enrollments rose sharply.

51
 Application THE EFFECTS OF 9/11 ON THE SUPPLY AND DEMAND FOR
NEW YORK CITY OFFICE SPACE

SUPPLY AND DEMAND FOR NEW YORK CITY OFFICE SPACE

Following 9/11 the supply curve shifted to the left, but the demand curve
also shifted to the left, so that the average rental price fell.
Effect of changes in DD and SS on Q* and
P*

53
Application: surge pricing in Uber
• Variation in demand for rides on Uber, both over time and space

• Similarly, variation in supply of rides, both over time and space

• Mismatch will cause dissatisfaction, both among riders and drivers

• Uber takes microeconomics very seriously!

• Surge pricing uses price as an instrument for matching demand and supply
• The correct surge increase will be just sufficient to match demand and supply
54
Demand for Uber spikes following sold-out
concert in NY

55
Uber driver partner supply increases to match
spike in demand

56
Vital signs of surge pricing in action on
March 21, 2015

57
Demand for Uber on NYE 2015 (no surge)

58
Completion rates - NYE 2015

59
Vital signs without surge pricing - NYE 2015

60
Unpacking what happened

61
Unpacking what happened

62
Unpacking what happened

63
Unpacking what happened

64
Producer Surplus
• Producer surplus measures the
benefit to sellers of participating in a
market.
• The area below the price and above
the supply curve measures the
producer surplus in a market.
• The height of the supply curve
measures sellers’ costs, and the
difference between the price and the
cost of production is each seller’s
producer surplus. Thus, the total area is
the sum of the producer surplus of all
sellers.
65
How price changes affect producer surplus?

66
Profit maximization and the
optimal pricing rule

67
Profit maximization using marginal analysis
• What is the objective of a firm?
• Profit maximization

• The manager's key decision is how much to produce (choose q)

• Profits are revenue less costs

π=TR - TC = P*q - TC(q)

• At what point (q) will the manager choose to produce?

68
Marginal Analysis
Profit maximization
•  Profit Maximization Condition:
= 0 MR = MC

Why?
• What should the manager do (to q) if MR > MC
• What should the manager do (to q) if MR < MC
• Profit maximizing production is always at MR = MC

69
Conventional pricing rules
• Manager appear to use heuristic of cost-plus pricing
• Cost-plus pricing is a simplistic strategy that guarantees that price is higher
than the estimated average cost.
• In this approach, a manager estimates the cost per unit of output
(based on some assumed output level) and adds a markup to include
costs that cannot be allocated to any specific product and to provide a
return on the firm’s investment.
• But does cost-plus pricing maximize profit?
• On the demand side, it doesn’t take into account price elasticity of demand
• On the supply side, it focuses on average cost, instead of marginal cost

70
Optimal pricing rule
• Recall, MR = P(1 – 1/|E|)

• Profit maximizing condition implies choosing q* such that MR = MC

=> MC(q*) = P × (1 – 1/|E|)

Þ(P* – MC*)/P* = 1/|E|

• Greater the elasticity, lower is the markup/market power

71
How can a firm use optimal pricing rule?
• Suppose Apple is about to introduce the iPhone X
• They expect their manufacturing costs to be about $350
• They are unsure of a good price, so they conduct a focus group/survey
and learn the following:
If they price iPhone X at… The probability of their target customer buying is…
$799 0.85
$899 0.75
$999 0.65
$1099 0.55
$1199 0.45

72
Optimal pricing rule in practice
Purchase
Price Markup fraction probability Elasticity |E| 1/|E|

(799-350)/799 =
$799 0.85 0.94 1.06
0.56

(899-35)/899 =
$899 0.75 1.20 0.83
0.61

(999-350)/999 =
$999 0.65 1.54 0.64
0.64

(1099-350)/1099 =
$1099 0.68 0.55 2.00 0.50

(1199-350)/1199 =
$1199 0.45 2.66 0.38
0.71

73
Recap
• After
  a point, the marginal product of a variable factor decreases
marginal cost of production increases
Supply curve is upward sloping

• Prices move to equate quantity demanded with quantity supplied

• Supply curve may shift due to changes in input costs, technology, number of
suppliers, and expectations

• Producer surplus is the net benefit to producers from transactions

• Profit maximization requires setting marginal revenue = marginal cost

74
Practice Problem 1
A survey indicated that chocolate is the most popular ice cream flavor. For each of the
following, indicate the possible effects on demand, supply, or both as well as equilibrium
price and quantity of chocolate ice cream.

a. A severe drought causes dairy farmers to reduce the number of milk-producing cattle
in their herds by a third. These dairy farmers supply cream that is used to manufacture
chocolate ice cream.
b. Latest research suggests that chocolate does, in fact, have significant health benefits.
c. The discovery of cheaper synthetic vanilla flavoring lowers the price of vanilla ice
cream.
d. New technology for mixing and freezing ice cream lowers manufacturers’ costs of
producing chocolate ice cream.

75
Practice Problem 2
Consider a market where supply and demand are given as the
following:
Demand Curve: QD = 20 - 2P
Supply Curve: QS = 2P

a. Calculate the market equilibrium price and quantity

b. Calculate the consumer surplus at equilibrium
c. Calculate the producer surplus at equilibrium

76