SUPPLYIMBA Managerial Economics

Lecturer: Jack Wu

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

Production Rent Wages Supplies Total0 $2000 $200 $0 $2200

1000 $2000 $529 $100 $26292000 $2000 $836 $200 $30363000 $2000 $1216 $300 $35164000 $2000 $1697 $400 $40975000 $2000 $2293 $500 $47936000 $2000 $3015 $600 $56157000 $2000 $3870 $700 $65708000 $2000 $4862 $800 $76629000 $2000 $5996 $900 $8896

SHORT-RUN WEEKLY EXPENSES

Production FC VC TC MC AFC AVC AC0 $2200 $0 $2200

1000 $2200 $429 $2629 $0.43 $2.2 $0.43 $2.632000 $2200 $836 $3036 $0.41 $1.1 $0.42 $1.523000 $2200 $1316 $3516 $0.48 $0.73 $0.44 $1.174000 $2200 $1897 $4097 $0.58 $0.55 $0.47 $1.025000 $2200 $2593 $4793 $0.7 $0.44 $0.52 $0.966000 $2200 $3415 $5615 $0.82 $0.37 $0.57 $0.947000 $2200 $4370 $6570 $0.95 $0.31 $0.62 $0.948000 $2200 $5462 $7662 $1.09 $0.28 $0.68 $0.969000 $2200 $6696 $8896 $1.23 $0.24 $0.74 $0.99

ANALYSIS OF SHORT-RUN COSTS

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

0

2

4

6

8

2 4 6 8

total cost

variable cost

fixed cost

Cost

(Thousa

nd $

)

Production rate (Thousand dozens a week)

SHORT-RUN TOTAL COST

0

50

100

150

200

2 4 6 8

Cost

(C

ents

per

doze

n)

Production rate (Thousand dozens a week)

250

300

marginal cost

average cost

average variable cost

SHORT-RUN MARGINAL, AVERAGE VARIABLE, AND AVERAGE COSTS

diminishing marginal product causes marginal and average cost curves to rise

Prodn VC TC TR Profit MC MR0 $0 $2200 $0 -$2,200

1000 $429 $2629 $700 -$1,929 $0.43 $0.72000 $836 $3036 $1400 -$1,636 $0.41 $0.73000 $1316 $3516 $2100 -$1,416 $0.48 $0.74000 $1897 $4097 $2800 -$1,297 $0.58 $0.75000 $2593 $4793 $3500 -$1,293 $0.7 $0.76000 $3415 $5615 $4200 -$1,415 $0.82 $0.77000 $4370 $6570 $4900 -$1,670 $0.95 $0.78000 $5462 $7662 $5600 -$2,062 $1.09 $0.79000 $6696 $8896 $6300 -$2,596 $1.23 $0.7

SHORT-RUN PROFIT, I

0

2.8

4.097

1 4 9

total cost

total revenue

variable cost

loss =$1297

Production rate (Thousand dozens a week)

Cost

/revenue (

Thousa

nd $

)SHORT-RUN PROFIT, II

Two key business decisions:•whether to continue in

operation •scale of operation

SHORT-RUN DECISIONS

70

5

marginal cost

average costaverage variable cost

marginal revenue = price

Production rate (Thousand dozens a week)

Cost

/revenue (

Cents

per

doze

n)

break-even price

SHORT-RUN PRODUCTION

produce where marginal cost = price

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.

LONG-RUN DECISIONS

whether to enter/exit price >= average cost

scale of operation where marginal cost = price

0

70

3.4

marginal cost

average cost

marginal revenue= price

break-even price

Production rate (Thousand dozens a week)

Cost

/revenue (

Cents

per

doze

n)

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

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)

INDIVIDUAL SUPPLY

• 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

SUPPLY CURVE: TWO VIEWS

MARKET SUPPLY, I

Graph of quantity that seller will supply at every possible price horizontal sum of individual supply curves

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

attract new 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 supplymay be flat

SELLER SURPLUS

Individual seller surplus = revenue a seller gets from a product - production cost

Market seller surplus = sum of individual seller surpluses

0

43

70

1 5

bc

a

d

marginal cost

marginal revenue= price

individual seller surplus

Production rate (Thousand dozens a week)

Cost

/revenue (

Cents

per

doze

n)

d

INDIVIDUAL SELLER SURPLUS

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%?

LABOR SUPPLY

marginal cost of labor -- benefit from alternative use of time

with higher wage rate some people work longer and harder however, some might work less

PRICE ELASTICITY OF SUPPLY

percentage by which quantity supplied will change if the price of the item rises by 1% usually, positive number supply more elastic with time

Item Horizon Price Elasticitydistillate short run 1.57gasoline short run 1.61pork long run 0.23tobacco long run 7housing long run 1.6 - 3.7

PRICE ELASTICITIES

DISCUSSION QUESTION 1

Until 1998, there were two major American manufacturers of DRAMs – Texas Instruments (TI) and Micron Technology. Then, TI sold its factories in Avezzano (Italy), Richardson (Texas), and Singapore, and interests in two Asian joint ventures to Micron Technology. TI shut the remainder of its DRAM production facilities including one in Midland, Texas.

DISCUSSION QUESTION 1: CONTINUED

Which probably had the higher average cost – the Richardson or Midland plant?

Compare the effects on the world wide long-run DRAM supply of TI’s sale of the Richardson plant with its closure of the Midland factory.

Explain Micron’s decision to buy TI’s plants in terms of differences between the two companies in their expectations of long-run DRAM prices.

DISCUSSION QUESTION 2

Suppose that Jupiter System operates two call centers, one in the north and another in the south. The following table reports the total costs at the two centers for various rates of customer service.

DISCUSSION QUESTION 2: CONTINUED

Service rate Northern Southern

1000 $5000 $8000

2000 $11000 $16000

3000 $18000 $24000

4000 $26000 $32000

5000 $35000 $40000

DISCUSSION QUESTION 2: CONTINUED

To serve a total of 5000 calls per day in the cheapest way, how many calls should the company serve from the northern center and how many from the southern center?

At the service rates that you give for (a), what is the cost of the last thousand calls from the northern and the southern centers?