Chapter 4 Supply

2 Bestar, Canadian furniture manufacturer Revenue (C$ mill) Restructuring costs (C$ ‘000) n.a.1,400n.a. Net earnings (C$ ‘000)

3 Bestar  How do changes in wood prices affect furniture industry?  How do Asian manufacturers affect supply of furniture in North America?  Should Bestar shut down?

4 Learning objectives  Appreciate why producers supply more at higher prices.  Appreciate how to decide, in the short run, whether to continue in business, and if so, the scale of production.  Distinguish fixed and variable costs in the short run.  Understand the concepts of marginal cost and marginal revenue.

5 Learning objectives, cont’d  Appreciate how to decide, in the long run, whether to continue in business, and if so, the scale of production.  Appreciate that, in the long run, businesses can adjust by entering or exiting the industry.  Appreciate the concept of seller surplus and apply it in purchasing.  Apply the concept of price elasticity of supply.

6 Outline  Short-run costs  Short-run individual supply  Long-run individual supply  Seller surplus  Supply elasticity  Market supply

7 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  Difference between short and long run depends on past commitments  E.g., firms have contracts with workers

8 Short-run costs  Analyze total cost into two categories  Fixed cost – the cost of inputs that does not vary with production scale  Variable cost – does vary  Total cost, C = F + V

9 Short-run costs: Expenses

10 Short-run costs: Analysis

11 Short-run costs  Common misconception  capital expenditure = fixed cost ?  labor cost = variable cost ?  worker protection laws, life-time employment

12 Short-run costs

13 Short-run costs  Marginal cost: change in total cost due to production of additional unit  Average (unit) cost: total cost divided by production rate  Algebraically,

14 Short-run costs  Marginal product: increase in output from additional unit of input  Diminishing marginal product: marginal product reduces with each additional unit of input

15 Short-run costs diminishing marginal product causes marginal and average cost curves to rise

16 Outline  Short-run costs  Short-run individual supply  Long-run individual supply  Seller surplus  Supply elasticity  Market supply

17 Short-run individual supply  Two key business decisions:  Participation: Whether to continue in business (break even)?  Extent: If continue, what scale of operation?

18 Short-run individual supply  Total revenue = price x sales quantity.  Marginal revenue: the change in total revenue from selling additional unit  May be positive or negative

19 Short-run profit

20 Short-run profit

21 Short-run individual supply

22 Short run individual supply: Break even  Sunk cost: a cost that has been committed and cannot be avoided  Not relevant to the current decision  Short-run fixed cost = sunk cost  Short-run breakeven condition: Continue to produce if  Total revenue  variable cost, or  Price  average variable cost

23 Short run individual supply  Individual supply curve: the graph showing quantity that seller will supply at every possible price

Short-run supply curve $ AC MC Output, q AVC p0p0 q0q0 AVC* AC* profit shutdown point p1p1 p2p2 the firm’s supply curve 24

Shutdown decision  A firm should produce only if the revenue from producing exceeds avoidable costs.  If all fixed cost are sunk, a firm should continue to produce if  The competitive firm’s supply curve is the portion of MC curve above the minimum AVC, the shutdown point. 25

26 Outline  Short-run costs  Short-run individual supply  Long-run individual supply  Seller surplus  Supply elasticity  Market supply

27 Long-run individual supply  Two key business decisions:  Participation: Whether to continue in business (break even)? If price  average cost  Extent: If continue, what scale of operation? Where marginal cost = price.

28 Long-run weekly expenses

Long-run costs: Analysis 29

30 Long-run production

31 Long-run individual supply  Long-run individual supply curve: 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)

32 Long-run individual supply  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

33 Bestar  Why didn’t Bestar shut down?  Short-run price  average variable cost  How could Bestar procure new financing?  Long-run price  average cost

34 Outline  Short-run costs  Short-run individual supply  Long-run individual supply  Seller surplus  Supply elasticity  Market supply

35 Seller surplus  Individual seller surplus = seller’s revenue from product – avoidable cost  In the short run, avoidable cost = variable cost  In the long run, avoidable cost = total cost

36 Individual seller surplus

37 Seller surplus: Bulk order  Sellers use package deals, two-part tariffs to extract buyer surplus  Buyer can also use bulk order to extract seller surplus  B2B e-commerce – use group buying to get better deals.

38 Why is overtime rate so high?  Overtime rate typically % higher than regular wage  Typical employment contract is bulk order of 40 hours a week  Extracts worker’s (seller) surplus  Regular wage rate reflects the worker’s average cost of labor for 40 hours a week.  Marginal cost of 41-45th hours much higher than average cost of first 40 hours

39 Outline  Short-run costs  Short-run individual supply  Long-run individual supply  Seller surplus  Supply elasticity  Market supply

40 Price elasticity of supply  Definition  usually, positive number  supply more elastic with time  Intuitive factors  capacity utilization: more unused capacity => supply more elastic  adjustment time: more time => supply more elastic

41 Price elasticities of supply ItemHorizon Price elasticity DistillateShort run1.57 GasolineShort run1.61 TobaccoLong run7.0 HousingLong run

42 Outline  Short-run costs  Short-run individual supply  Long-run individual supply  Seller surplus  Supply elasticity  Market supply

43 Market supply  Market supply curve: Graph of quantity that seller will supply at every possible price  Horizontal sum of individual supply curves

44 Market supply  Lowest cost seller defines starting point  Gradually, blends in higher-cost sellers  Slopes upward

45 Market supply

46 Market supply curve  price -- movement along curve  input prices and other factors -- shift curve

47 Market supply: Long-run  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

48 Market supply: Long-run  Slope of long-run supply  Gentler than short-run supply  May be flat

49 Key takeaways  To the extent that marginal costs increase with production, sellers will only increase production for higher prices.  In the short run, to maximize profit, shut down if total revenue is less than variable cost, otherwise, produce at the scale where marginal revenue equals marginal cost..  Fixed cost is the cost of inputs that do not change with the production rate, while, variable cost is the cost of inputs that do change with the production rate.  Marginal cost is the change in total cost due to the production of an additional unit, while marginal revenue is the change in total revenue arising from selling an additional unit.

50 Key takeaways, cont’d  In the long run, to maximize profit, shut down if total revenue is less than total cost, otherwise, produce at the scale where marginal revenue equals marginal cost.  In the long run, businesses can adjust by entering or exiting the industry.  Seller surplus is the difference between the seller's revenue from some production and the seller's avoidable cost to produce that quantity.  Managers can raise the profit from purchasing by extracting the sellers' surplus.  The price elasticity of supply is the percentage by which quantity supplied will change if price of the item rises by 1%.