Download Short run individual supply

Chapter 4
Supply
Bestar, Canadian furniture manufacturer
2003
2004
2005
Revenue (C$ mill)
44.3
43.7
38.7
Restructuring
costs (C$ ‘000)
n.a.
1,400
n.a.
Net earnings (C$
‘000)
254
-442
174
2
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?
3
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.
4
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.
5
Outline

Short-run costs
 Short-run individual supply
 Long-run individual supply
 Seller surplus
 Supply elasticity
 Market supply
6
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
7
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
8
Short-run costs: Expenses
Table 4.1 Short-run weekly expenses
Weekly
Equipment
prodn
Rent
Salaries
lease
rate
0 $2,000
$10,000
$8,000
1,000 $2,000
$10,000
$8,000
2,000 $2,000
$10,000
$8,000
3,000 $2,000
$10,000
$8,000
4,000 $2,000
$10,000
$8,000
5,000 $2,000
$10,000
$8,000
6,000 $2,000
$10,000
$8,000
7,000 $2,000
$10,000
$8,000
8,000 $2,000
$10,000
$8,000
9,000 $2,000
$10,000
$8,000
Wages
$2,000
$5,290
$8,360
$12,160
$16,970
$22,930
$30,150
$38,700
$48,620
$59,960
Cost of
supplies
$0
$1,000
$2,000
$3,000
$4,000
$5,000
$6,000
$7,000
$8,000
$9,000
Total
$22,000
$26,290
$30,360
$35,160
$40,970
$47,930
$56,150
$65,700
$76,620
$88,960
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Short-run costs: Analysis
Table 4.2 Analysis of short-run costs
Weekly Fixed
Variable Total
prodn
cost
cost
cost
rate
0 $22,000
$0 $22,000
1,000 $22,000
$4,290 $26,290
2,000 $22,000
$8,360 $30,360
3,000 $22,000 $13,160 $35,160
4,000 $22,000 $18,970 $40,970
5,000 $22,000 $25,930 $47,930
6,000 $22,000 $34,150 $56,150
7,000 $22,000 $43,700 $65,700
8,000 $22,000 $54,620 $76,620
9,000 $22,000 $66,960 $88,960
Marginal
cost
Average
fixed cost
$4.29
$4.07
$4.80
$5.81
$6.96
$8.22
$9.55
$10.92
$12.34
$22.00
$11.00
$7.33
$5.50
$4.40
$3.67
$3.14
$2.75
$2.44
Average
variable
cost
$4.29
$4.18
$4.39
$4.74
$5.19
$5.69
$6.24
$6.83
$7.44
Average
cost
$26.29
$15.18
$11.72
$10.24
$9.59
$9.36
$9.39
$9.58
$9.88
10
Short-run costs

Common misconception
 capital expenditure = fixed cost ?
 labor

cost = variable cost ?
worker protection laws, life-time employment
11
Short-run costs
12
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,
C
q

average cost

F
q

average fixed cost

V
q

average variable cost
13
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
14
Short-run costs
diminishing marginal product
causes marginal and average
cost curves to rise
15
Outline

Short-run costs
 Short-run individual supply
 Long-run individual supply
 Seller surplus
 Supply elasticity
 Market supply
16
Short-run individual supply

Two key business decisions:
 Participation: Whether to continue in business
(break even)?
 Extent:
If continue, what scale of operation?
17
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
18
Short-run profit
Table 4.3 Short-run profit
Weekly Variable Total
prodn
cost
cost
rate
0
$0 $22,000
1,000
$4,290 $26,290
2,000
$8,360 $30,360
3,000 $13,160 $35,160
4,000 $18,970 $40,970
5,000 $25,930 $47,930
6,000 $34,150 $56,150
7,000 $43,700 $65,700
8,000 $54,620 $76,620
9,000 $66,960 $88,960
Total
revenue
Accounting
profit
$0
$7,000
$14,000
$21,000
$28,000
$35,000
$42,000
$49,000
$56,000
$63,000
($22,000)
($19,290)
($16,360)
($14,160)
($12,970)
($12,930)
($14,150)
($16,700)
($20,620)
($25,960)
Economic
profit
$0
$2,710
$5,640
$7,840
$9,030
$9,070
$7,850
$5,300
$1,380
($3,960)
Marg.
cost
$4.29
$4.07
$4.80
$5.81
$6.96
$8.22
$9.55
$10.92
$12.34
Marg.
revenue
$7.00
$7.00
$7.00
$7.00
$7.00
$7.00
$7.00
$7.00
$7.00
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Short-run profit
20
Short-run individual supply
21
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
22
Short run individual supply

Individual supply curve: the graph showing
quantity that seller will supply at every possible
price
23
Short-run supply curve
$
MC
the firm’s supply
curve
AC
p0
AVC
profit
p1
p2
AC*
AVC*
shutdown point
24
q0
Output, q
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
  TR(q)  TVC (q)  TFC  TFC
 p  AVC

The competitive firm’s supply curve is the portion
of MC curve above the minimum AVC, the
shutdown point.
25
Outline

Short-run costs
 Short-run individual supply
 Long-run individual supply
 Seller surplus
 Supply elasticity
 Market supply
26
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.
27
Long-run weekly expenses
Table 4.4 Long-run weekly expenses
Weekly
Rent
Equipt
Salaries
prodn
lease
rate
0 $1,000
$1,000
$2,500
1,000 $1,000
$1,000
$5,000
2,000 $1,000
$1,000
$7,500
3,000 $1,000
$1,000
$10,000
4,000 $1,000
$1,000
$12,500
5,000 $1,000
$1,000
$15,000
6,000 $1,000
$1,000
$17,500
7,000 $1,000
$1,000
$20,000
8,000 $1,000
$1,000
$22,500
9,000 $1,000
$1,000
$25,000
Wages
$0
$790
$2,610
$5,570
$9,760
$15,220
$22,030
$30,210
$39,820
$50,890
Cost of
supplies
$0
$1,000
$2,000
$3,000
$4,000
$5,000
$6,000
$7,000
$8,000
$9,000
Total
$4,500
$8,790
$14,110
$20,570
$28,260
$37,220
$47,530
$59,210
$72,320
$86,890
28
Long-run costs: Analysis
Table 4.5 Analysis of long-run costs
Weekly
Total
Marginal
Average
prodn
cost
cost
cost
rate
0
$4,500
1,000
$8,790
$4.29
$8.79
2,000 $14,110
$5.32
$7.06
3,000 $20,570
$6.46
$6.86
4,000 $28,260
$7.69
$7.07
5,000 $37,220
$8.96
$7.44
6,000 $47,530
$10.31
$7.92
7,000 $59,210
$11.68
$8.46
8,000 $72,320
$13.11
$9.04
9,000 $86,890
$14.57
$9.65
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Long-run production
Table 4.6 Long-run profit
Weekly
Total
Total
prodn
cost
revenue
rate
0
$4,500
$0
1,000
$8,790
$7,000
2,000
$14,110 $14,000
3,000
$20,570 $21,000
4,000
$28,260 $28,000
5,000
$37,220 $35,000
6,000
$47,530 $42,000
7,000
$59,210 $49,000
8,000
$72,320 $56,000
9,000
$86,890 $63,000
Economic
profit
($4,500)
($1,790)
($110)
$430
($260)
($2,220)
($5,530)
($10,210)
($16,320)
($23,890)
Marg.
cost
$4.29
$5.32
$6.46
$7.69
$8.96
$10.31
$11.68
$13.11
$14.57
Marg.
revenue
$7.00
$7.00
$7.00
$7.00
$7.00
$7.00
$7.00
$7.00
$7.00
30
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)
31
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
32
Bestar

Why didn’t Bestar shut down?
 Short-run price  average variable cost

How could Bestar procure new financing?
 Long-run price  average cost
33
Outline

Short-run costs
 Short-run individual supply
 Long-run individual supply
 Seller surplus
 Supply elasticity
 Market supply
34
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
35
Individual seller surplus
36
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.
37
Why is overtime rate so high?

Overtime rate typically 50-100% 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
38
Outline

Short-run costs
 Short-run individual supply
 Long-run individual supply
 Seller surplus
 Supply elasticity
 Market supply
39
Price elasticity of supply

Definition
% change in quantity supplied
% change in price
 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
40
Price elasticities of supply
Item
Horizon
Price
elasticity
Distillate
Short run
1.57
Gasoline
Short run
1.61
Tobacco
Long run
7.0
Housing
Long run
1.6-3.7
41
Outline

Short-run costs
 Short-run individual supply
 Long-run individual supply
 Seller surplus
 Supply elasticity
 Market supply
42
Market supply

Market supply curve: Graph of quantity that
seller will supply at every possible price
 Horizontal sum of individual supply curves
43
Market supply

Lowest cost seller defines starting point
 Gradually, blends in higher-cost sellers
 Slopes upward
44
Market supply
45
Market supply curve
 price
-- movement
along curve
 input
prices and other
factors -- shift curve
46
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

47
Market supply: Long-run

Slope of long-run supply
 Gentler than short-run supply
 May be flat
48
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.
49
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%.
50