SUPPLY

IMBA NCCU
Managerial Economics
Lecturer: Jack Wu
CASE: 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
Production Rent Wages Supplies Total
0 $2000 $200 $0 $2200
1000 $2000 $529 $100 $2629
2000 $2000 $836 $200 $3036
3000 $2000 $1216 $300 $3516
4000 $2000 $1697 $400 $4097
5000 $2000 $2293 $500 $4793
6000 $2000 $3015 $600 $5615
7000 $2000 $3870 $700 $6570
8000 $2000 $4862 $800 $7662
9000 $2000 $5996 $900 $8896
 ANALYSIS OF SHORT-RUN COSTS

Production FC VC TC MC AFC AVC AC

0 $2200 $0 $2200
1000 $2200 $429 $2629 $0.43 $2.2 $0.43 $2.63
2000 $2200 $836 $3036 $0.41 $1.1 $0.42 $1.52
3000 $2200 $1316 $3516 $0.48 $0.73 $0.44 $1.17
4000 $2200 $1897 $4097 $0.58 $0.55 $0.47 $1.02
5000 $2200 $2593 $4793 $0.7 $0.44 $0.52 $0.96
6000 $2200 $3415 $5615 $0.82 $0.37 $0.57 $0.94
7000 $2200 $4370 $6570 $0.95 $0.31 $0.62 $0.94
8000 $2200 $5462 $7662 $1.09 $0.28 $0.68 $0.96
9000 $2200 $6696 $8896 $1.23 $0.24 $0.74 $0.99
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
Cost (Thousand $)

6 variable cost

2
fixed cost
0 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
Cost (Cents per dozen)

diminishing marginal product

300
causes marginal and average
250 cost curves to rise
200
150 marginal cost
100 average cost
50 average variable cost

0 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

Prodn VC TC TR Profit MC MR
0 $0 $2200 $0 -$2,200
1000 $429 $2629 $700 -$1,929 $0.43 $0.7
2000 $836 $3036 $1400 -$1,636 $0.41 $0.7
3000 $1316 $3516 $2100 -$1,416 $0.48 $0.7
4000 $1897 $4097 $2800 -$1,297 $0.58 $0.7
5000 $2593 $4793 $3500 -$1,293 $0.7 $0.7
6000 $3415 $5615 $4200 -$1,415 $0.82 $0.7
7000 $4370 $6570 $4900 -$1,670 $0.95 $0.7
8000 $5462 $7662 $5600 -$2,062 $1.09 $0.7
9000 $6696 $8896 $6300 -$2,596 $1.23 $0.7
 SHORT-RUN PROFIT, II
total cost

variable cost
Cost/revenue (Thousand $)

total revenue
4.793 loss =
$1293
3.5

0 1 5 9

Production rate (Thousand dozens a week)

 SHORT-RUN DECISIONS

Two key business decisions:

• whether to continue in
operation
• scale of operation
 SHORT-RUN PRODUCTION
Cost/revenue (Cents per dozen)

produce where marginal

cost = price

marginal cost
average cost
70 average variable cost
marginal revenue = price

break-even 5
price

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
LONG-RUN DECISIONS
whether to enter/exit
 price >= average cost
scale of operation
 where marginal cost = price
LONG-RUN PRODUCTION
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
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
 attractnew 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 product - production cost
 Market seller surplus = sum of individual
seller surpluses
INDIVIDUAL SELLER SURPLUS
Cost/revenue (Cents per dozen)
individual seller surplus marginal cost

c b
70
marginal revenue
= price
d
43

a
0 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%?
 PRICE ELASTICITIES

Item Horizon Price Elasticity

distillate short run 1.57
gasoline short run 1.61
pork long run 0.23
tobacco long run 7
housing long run 1.6 - 3.7
FORECASTING
 Forecasting quantity supplied
 Change in quantity supplied = price elasticity of supply x
change in price