Supply and CostSupply and Cost

■ ■ Our objectives:Our objectives:

► ► Explain individual choices given Explain individual choices given unlimited wants in the face of limited unlimited wants in the face of limited resourcesresources

► ► Develop a theory that helps us Develop a theory that helps us understand what we observe in the understand what we observe in the world.world.

Cost—always an issue in production Cost—always an issue in production (supply).(supply).1700: Production of pots in England & 1700: Production of pots in England & China.China.Why the different technology? Think cost.Why the different technology? Think cost.

Real supply chains are complicated, so we use a simple model

Opportunity CostOpportunity Cost

■ ■ The cost of any choice The cost of any choice isis the best the best opportunity not taken (sacrificed). opportunity not taken (sacrificed). Hence we say Hence we say ““opportunity cost.opportunity cost.”” This This can only be known by the individual can only be known by the individual decision maker. Costs are subjective.decision maker. Costs are subjective.

■ ■ When we measure costs, opportunity When we measure costs, opportunity cost is the true measure, but we mostly cost is the true measure, but we mostly focus on accounting or objective costs. focus on accounting or objective costs.

Remember: Remember: Cost are Cost are nevernever fully known. fully known.

Put Theory into PracticePut Theory into Practice

““Opportunity cost is the value of the Opportunity cost is the value of the most valuable alternative that must most valuable alternative that must be forgone to undertake a given act. be forgone to undertake a given act. In decision making, we must look at In decision making, we must look at opportunity cost rather than book opportunity cost rather than book costs. That is, we must look forward costs. That is, we must look forward rather than backward.rather than backward.””

Charles G. Koch, CEO Koch Industries,Charles G. Koch, CEO Koch Industries,p. 33, p. 33, ““The Science of SuccessThe Science of Success””

The (weak) Law of Supply

■ ■ Holding other relevant factors constant, Holding other relevant factors constant, the higher (lower) the price of a good, the the higher (lower) the price of a good, the greater (smaller) will be the quantity greater (smaller) will be the quantity supplied.supplied. ▪ ▪ Like all scientific propositions, it is a Like all scientific propositions, it is a ceteris ceteris paribusparibus ( (““other things equalother things equal””) statement) statement

■ ■ Note the terminology:Note the terminology:- changes in the price of the good lead to - changes in the price of the good lead to

changes in changes in ““quantity suppliedquantity supplied””- they do not lead to changes in - they do not lead to changes in ““supplysupply””

FoundationsFoundations

■ ■ The principle of Rising Marginal CostThe principle of Rising Marginal Cost

► ► As the rate of production rises in a As the rate of production rises in a certain time period, given fixed inputs and certain time period, given fixed inputs and technology, at some point the technology, at some point the marginalmarginal cost of producing the next unit risescost of producing the next unit rises

► ► So, in a market, supply usually reflects So, in a market, supply usually reflects the marginal cost (MC) of suppliers as the marginal cost (MC) of suppliers as they evaluate their alternatives.they evaluate their alternatives.

We Are All Garbage MenWe Are All Garbage Men

Holding all else constant, the following is true if Holding all else constant, the following is true if we survey a group of possible workers:we survey a group of possible workers:

Number of VolunteersNumber of Volunteers Price OfferedPrice Offered

11 $10/hour$10/hour

22 $20/hour$20/hour

33 $50/hour$50/hour

44 $80/hour$80/hour

55 $200/hour$200/hour

Rising Marginal Cost or Rising Marginal Cost or Opportunity Cost of Opportunity Cost of SuppliersSuppliers

MARGINAL COST = SUPPLY

$ Price

1 2 3 4 5 Volunteers per time period

10

20

50

80

200

The Supply FunctionThe Supply Function

■ ■ S = f (P, I, T, etc.)S = f (P, I, T, etc.)

Price of the good itself—determines the location Price of the good itself—determines the location alongalong the supply curve the supply curve

■ ■ Other factors—determine the Other factors—determine the placementplacement of the supply curve: of the supply curve:

► ► Prices of inputs (also called Prices of inputs (also called ““factor pricesfactor prices””)) ► ► Technology (e.g, state of knowledge; regulations)Technology (e.g, state of knowledge; regulations) ► ► Other variables particular to each good, including weather Other variables particular to each good, including weather

conditions, etc.conditions, etc.

Summarize the Supply Curve

It represents the individual It represents the individual valuations of many different existing valuations of many different existing and potential suppliers in a market, and potential suppliers in a market, each making their own decision.each making their own decision.

What is best for me, as I see the What is best for me, as I see the world?world?

As I understand my opportunity As I understand my opportunity costs.costs.

A simple curve to help us sharpen A simple curve to help us sharpen our thinking about markets.our thinking about markets.

Change in PriceChange in Price

A change in the price of a good A change in the price of a good means a movement means a movement alongalong a given a given supply curve.supply curve.

Supply

Quantity/time

Price

Pa

Qa

Pb

Qb

Increase in SupplyIncrease in Supply(A Decrease in Supply Is Opposite)(A Decrease in Supply Is Opposite)

Price

Quantity

Sa

Sb

Caused by: Lower Factor Prices, Improvements in Technology; other changes that lower marginal costs of production.

Not caused byChange in price

Pa

Qa Qb

Question on SupplyQuestion on Supply

In 1998, DVD players cost almost In 1998, DVD players cost almost $1,000. Only a few were sold. $1,000. Only a few were sold.

Now DVD players cost as little as Now DVD players cost as little as $30. $30.

Why can suppliers provide them at Why can suppliers provide them at such a lower cost? such a lower cost?

What else impacted decision to What else impacted decision to supply and the demand?supply and the demand?

Opportunity Cost Opportunity Cost question:question:

Suppose average tickets to the Suppose average tickets to the Superbowl usually sell for $1,000, Superbowl usually sell for $1,000, but can be resold for about $3,000. but can be resold for about $3,000. Suppose you bought a ticket for Suppose you bought a ticket for $1,000 and can go to the game.$1,000 and can go to the game.

What is the opportunity cost of What is the opportunity cost of going to the game?going to the game?

Flat Screen TVs and Movies:Flat Screen TVs and Movies:Change in One Market Impact Change in One Market Impact AnotherAnother

Matsushita invested $1 billion+ in a new flat Matsushita invested $1 billion+ in a new flat screen TV plant. Production over 2.5 million screen TV plant. Production over 2.5 million per year.per year.

Economies of scale allows price to drop Economies of scale allows price to drop while profits increase due to lower per unit while profits increase due to lower per unit cost compared to rivals. Some rivals will die.cost compared to rivals. Some rivals will die.

Thinking about demand: Increase in Thinking about demand: Increase in bandwidth means cost of delivering movies bandwidth means cost of delivering movies to a home users falling rapidly. Value of TV to a home users falling rapidly. Value of TV changes. [Who will lose markets?] changes. [Who will lose markets?]

Costs are imperfect but are worth Costs are imperfect but are worth studying for opportunities: Where is studying for opportunities: Where is the value for the demander?the value for the demander?

Consider a CD that retails for $15.99:Consider a CD that retails for $15.99:24% ($3.83) is retail overhead.24% ($3.83) is retail overhead.

18% ($2.88) is overhead for the label18% ($2.88) is overhead for the label

15% ($2.40) is marketing15% ($2.40) is marketing

11% ($1.76) is label accounting profit11% ($1.76) is label accounting profit

10% ($1.60) is artist royalty10% ($1.60) is artist royalty

6% ($0.96) is distribution cost6% ($0.96) is distribution cost

5% ($0.80) is retail accounting profit; 5% 5% ($0.80) is retail accounting profit; 5% manufacturing;manufacturing;

5% publishing accounting royalties5% publishing accounting royalties

What does the consumer want?What does the consumer want?

Any wonder this industry is in turmoil?Any wonder this industry is in turmoil?

Book Publishing—Change?

The Associate by John Grisham, $27.95 list:$3.55, editors, graphic designer, etc.$2.83, printing costs$2.00, marketing$2.80, wholesaler$4.19, author royalties (high because star author)$12.58, retailer (45% of list); often discounted

Room for change? Typical best seller author gets 20%;Amazon offering 45-50%; if self-publish, 75%

Remember: Competition Remember: Competition (Supply) Is Increasingly (Supply) Is Increasingly GlobalGlobal

Cost of Heart Bypass Operation:Cost of Heart Bypass Operation:U.S.: $130,000 Singapore: $18,500 India: U.S.: $130,000 Singapore: $18,500 India: $10,000$10,000

Cost of a Hip Replacement:Cost of a Hip Replacement:U.S.: $43,000 Thailand: $12,000 India: U.S.: $43,000 Thailand: $12,000 India: $9,000$9,000

Number of Number of ““Medical TouristsMedical Tourists”” to to Thailand: 2000: 500,000 2010: Thailand: 2000: 500,000 2010: 2,000,000 estimated2,000,000 estimated

(33% from U.S.; 29% from China; 18% (33% from U.S.; 29% from China; 18% from Japan; 14% from England)from Japan; 14% from England)