Supply, Elasticity and Costs Assistant Professor Chanin Yoopetch

Learning outcomes By studying this chapter students will be able to: understand and utilize the concept of elasticity of supply identify the factors of production distinguish between fixed and variable factors of production analyse the relationship between costs and output in the short run and long run understand the reasons for economies of scale

Price elasticity of supply Elasticity of supply measures the responsiveness of supply to a change in price. This relationship may be expressed as a formula: Percentage change in quantity supplied ÷ Percentage change in price Where supply is inelastic it means that supply cannot easily be changed, whereas elastic supply is more flexible. Ways to increase supply  Expanding your factories?  Outsourcing ?

Factors affecting price elasticity of supply time period availability of stocks spare capacity flexibility of capacity / resource mobility

Factors affecting price elasticity of supply time period The longer the period of time, the easier it is for supply to be changed. Build more hotel rooms or invest in more capacity

Factors affecting price elasticity of supply availability of stocks in the warehouse, enabling supply to be flexible and more elastic However, some leisure services, such as theatres and hotels, can’t be kept in stock, so supply is inelastic in the short run

Factors affecting price elasticity of supply spare capacity Some hotels generally utilize only 90% of capacity to provide services. Some airlines have spare aircraft available for deployment Making supply more elastic

Factors affecting price elasticity of supply flexibility of capacity / resource mobility Flexibility of capacity Resources can easily be shifted from provision of one good or service to another. Flexibility of the labour force is one of the key factors. Many organizations train staff to be multiskilled to enable them to shift from one task to another. Job rotation Organizations have to deal with training several skills

Supply and costs Leisure and tourism inputs Land This includes natural resources such as minerals, and land itself. Labour This includes skilled and unskilled human effort. Capital This includes buildings, machines and tools. Enterprise This is the factor which brings together the other factors of production to produce goods and services.

Supply and costs Leisure and tourism inputs We can also categorize factors of production into; Fixed and variable factors Fixed factors  Those factors which cannot be easily varied in the short run  E.g. Actual building of hotels, airports Variable factors  Can be changed in the short run and include unskilled labour, energy and readily available raw materials

Supply The Costs of Production The Law of Supply: Firms are willing to produce and sell a greater quantity of a good when the price of a good is high, this results in a supply curve that slopes upward.

Why Study Behavior of Firms? À Gain a better understanding of the decisions made by producers. Á Study how the behavior of a firm depends on the structure of the market.

Purpose Facing The Typical Firm The economic purpose of the firm is to maximize profits! Profit: The firm’s revenues minus its costs.

An Individual Firm’s Profit: Revenue minus Cost Revenues: The amount that the firm receives for the sale of its product. (Market Price x Amount Sold)= Revenues Costs: The amount that the firm pays to buy inputs. Profit is often referred to as Producer Surplus: the amount a seller is paid minus the cost of production. A measure of the benefits to sellers.

Producer Surplus: Graphical S D PEPE QEQE Producer Surplus Production Costs

Costs of Production In general, three costs are often considered when making business strategy or supply decisions. Explicit Costs Implicit Costs Sunk Costs

Costs as Opportunity Costs The firm’s costs include Explicit Costs and Implicit Costs: Explicit Costs: costs that involve a direct money outlay for factors of production. (cost for wages,materials) Implicit Costs: costs that do not involve direct money outlay. (e.g. opportunity costs) Both can include opportunity costs. Especially, for self-employed or self-owned business; one’s time or one’s opportunity to do something else.

Costs as Opportunity Costs Economists include all opportunity costs when measuring costs. Accountants measure the explicit costs but often ignore the implicit costs. When revenues exceed both explicit and implicit costs the firm earns economic profits.

Costs as Opportunity Costs A third, not so obvious implicit cost includes sunk costs. Sunk costs are costs that have already been committed and cannot be recovered. Sunk Costs are... an opportunity cost often ignored when making decisions about business strategy Cost for market research

The Various Measures of Cost Costs of production may be divided into two specific categories: Fixed Costs: Those costs that do not vary with the amount of output produced. (Security services, full-time worker salary) Variable Costs: Those costs that do vary with the amount of output produced. (cost of flour for producing cake)

Fixed versus Variable Costs The division of costs between fixed and variable often depends on the time horizon being considered. Over a period of weeks, i.e. short-run, some costs are fixed (e.g. plant size.) Over a period of years, i.e. long-run, many fixed costs become variable costs. Allows greater ability to respond to changing circumstances in the long run.

Family of Total Costs... Total Fixed Costs (TFC)- costs that do not vary with the quantity of output produced Total Variable Costs- (TVC)- Costs that do vary with the quantity of output produced Total Costs (TC): TC = TFC + TVC

Family of Average Costs... Average Costs: Specific Cost / Output Level Average Fixed Costs (AFC)- fixed costs divided by the quantity of output Average Variable Costs (AVC)- variable costs divided by the quantity of output Average Total Costs (ATC)- total costs divided by the quantity of output

Marginal Cost: “How much does it cost to produce an additional unit of output?” Marginal Cost (MC): “The extra or additional cost of producing one more unit of output.” MC is the addition to the cost of production that must be covered by additional revenue for profit maximization

Mathematical Definitions of Costs Average Total Cost: ATC = TC / Q Marginal Cost: MC = TC / Q

Long run costs Long run Economies of scale- Economies of scale arises from increases in the size of an organization. Financial  Large firms tend to have bigger assets.  Large firms tend to get lower borrowing rates from banks?? buying and selling  Buying and selling economies arise from buying and selling in bulk.  Buying, leading to large purchase discounts  Selling, costs of advertising are spread out over a large number of sales Managerial / specialization  Large travel agency chains, comparing to a small travel agency, will have the scope for employing experts in functional areas, such as accounting, marketing, and personnel.

Long run costs Long run Economies of scale- Economies of scale arises from increases in the size of an organization. Technical  Relating to utilization of complex and expensive technology and machinery. Cost per guest per year will be relatively insignificant for large hotels when they buy an expensive accounting system software. economies of increased dimensions  Cost of buying one big bus for 50 people is cheaper than cost of buying 5 vans( also for 50 people).

Long run costs Long run Economies of scale- Economies of scale arises from increases in the size of an organization. risk-bearing  The ability of large organizations to stay viable in hard time.  Two factors  Diversified interests (demand falls in one area can be compensated for by business elsewhere.  Large organizations with more assets are able to sustain short-term losses from reserves.

Long run costs Diseconomies of scale costs  are the forces that cause larger firms to produce goods and services at increased per-unit costs.

Long run costs Two types of diseconomies of scale Internal diseconomies  For some firms, it is difficult to manage efficiently beyond a certain size and problems of control, delegation, and communications arise.  It may arise from the growth due to M&A. External diseconomies  Can result from activities in a particular area which can be from high pollution costs.  External diseconomies can be restricted by prohibiting some polluting activities and taxing others

How firms grow 1. internal growth A slow process, Firms slowly accumulate assets to grow. 2. mergers and take-overs A faster process of growth Including vertical and horizontal integration, and diversification

Vertical integration The degree to which a firm owns its upstream suppliers and its downstream buyers The concept of vertical integration can be visualized using the value chain.

Vertical Integration

Benefits of Vertical Integration Vertical integration potentially offers the following advantages: Reduce transportation costs if common ownership results in closer geographic proximity. Improve supply chain coordination. Provide more opportunities to differentiate by means of increased control over inputs. Capture upstream or downstream profit margins.

Horizontal integration Horizontal growth can be achieved by internal expansion or by external expansion through mergers and acquisitions of firms offering similar products and services. A firm may diversify by growing horizontally into unrelated businesses. Some examples of horizontal integration include:  The Standard Oil Company's acquisition of 40 refineries.  An automobile manufacturer's acquisition of a sport utility vehicle manufacturer.  A media company's ownership of radio, television, newspapers, books, and magazines.

Benefits of Horizontal Integration Economies of scale - achieved by selling more of the same product, for example, by geographic expansion. Economies of scope - achieved by sharing resources common to different products. Commonly referred to as "synergies." Increased market power (over suppliers and downstream channel members) Reduction in the cost of international trade by operating factories in foreign markets.

Social and private costs Private costs of production are those costs which an organization has to pay for its inputs. They are also known as accounting costs since they appear in an organization’s accounts. Social costs do not appear in an organization’s accounts and do not affect its profitability, although they may well affect the well-being of society at large.

Group assignment - Short and long run costs What happens to average short run costs of a hotel as occupancy falls? How will the hotel respond to a long run fall in occupancy? How do hotels benefit from economies of scale?

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