The ShutDown Option:

1
The Shut-Down Option Short-Run Long Run
Supply Decisions

• Marginal conditions for optimal output mc (q) P
• Need to check also the shut-down option in short
  long run.
• Shut Down Decisions
• Short-run shutdown when P lt min (AVC)
• Long-run shutdown when P lt min (AC)

2
Last Sessions
Consumer Choice and Demand Production
and Costs
TOOLS
This Session Competitive Market

• Definition of perfect competition (i.e,
  competitive market).
• Supply decision in competitive markets.
• Equilibrium and Elasticity of supply
• Individual and aggregate supply curves.
• Exercises and the Alusaf Case

Next Session Competitive Market (cont.)
Exit and entry Short-run versus long-run
pricing and supply The importance of
forecasting
3
Understanding Cost (session 3)
Revenue Understanding Demand (session 2)
Profit Revenue Cost
Pricing
Monopoly Trade off b/w high P and low Q
(session 6)
Perfect Competition Supply and entry decisions
(session 4 5)
What if we can price discriminate? (i.e.,
different consumers pay different
prices) (session 9 10)
How pricing depends on demand through the
elasticities (session 7)
Strategic Competition Solving for the NE
price and quantity competition (session 12)
How timing matters Stackelberg (session 14)
Exotic topics Strategic Demand Network
externalities and Auctions. (session 15)
Tools Games Theory (session 11)
Externalities and Strategic interaction
Collusion (session 13)
4
Conditions/definitions for perfect competition

• 1. Product homogeneity.
• Free entry and exit
• a) No legal barriers
• b) No threats of retaliation by incumbents

How is de Demand curve? What is the consequence
on the supply side? Demand is perfectly Elastic ?
individual sellers are price takers.
3. Price taking behavior a) many buyers and
sellers b) each buyer/seller too small to
influence price
5
Competitive Market
Produce nearly identical goods
(homogeneous) Free entry and exit in the
market Sellers are price takers
Examples Commodity markets Aluminum (100s)
Steel (80s) Steel Mills (135 in US) Logging
(12985 in US) Agriculture in developing countries
6
The model

• Market price P determined by supplydemand.
• Consumers, given price, choose how much to buy
  demand curves d(P).
• Firms, given price, choose how much to produce
  supply curves s(P).

7
Alusafs 2 billion question
At the beginning of 1994, Alusaf was considering
building a primary aluminum smelter ? 466 ktpy ?
Located at Richards bay, a deepwater port on the
east coast of South Africa A feasibility study
for this Hillside smelter was performed two
years earlier ? But as a result of the flow of
Russian and other former eastern block
countries ? .. aluminum prices plummeted to
around 1,110 per ton Given that aluminum prices
are at historic lows would you recommend
dropping the Alusaf project?
8
This is fundamentally a simple business

• Competitive Market identical product no tech.
  differences price-
• takers
• No room for fancy marketing strategies little
  or no opportunities for
• operational improvements
• Profitability here boils down to
• price - cost

• How hard can that be?
• To assess the viability of such a major bet we
  need to understand
• What determines prices?
• Which costs are relevant to Alusafs decisions?
• What drives industry dynamics?
• For this, we need an economic model of what
  drives supply decisions
• and prices

9
Modeling Supply Decisions in Competitive Markets
Industry
Firm


s (P)
mc (q)
s (P)
P MR
P MR
d (P)
Q
q
q
q
Marginal conditions for optimal output (MR MC)
mc (q) P ? Supply curve s (P) is simply the
marginal cost curve.
10
The Supply Curve
mc(q)
ac(q)
P
avc(q)
profit
Q
11
The Supply Curve
mc(q)
In the LR FC 0 ac(q) avc(q)
ac(q)
avc(q)
loss
P
Q
12
The Short Run Supply Curve
mc(q)
s (P)
ac(q)
avc(q)
13
The Long Run Supply Curve
s (P)
mc(q)
ac(q)
14
P
d (P)
15
Lessons so far

• In Perfect competition, MR Price
• You produce where MC Price, but
• You do not produce below AC (in LR) or the AVC
  (in SR).
• Hence, the individual supply curve is that part
  of the MC curve that lies above AC.

16
Elasticity of Market Supply
Measuring responsiveness of supply to changes
in price
Arc Elasticity (calculating elasticity from two
points on supply curve)
Point Elasticity
17
A numerical example

• Consider a representative firm operating in a
  competitive market. Its total cost is given by
  TC(q) 10 2q2 and hence its marginal cost is
  MC(q) 4q. The market demand is given by Qd
  300 10P and the (short run) equilibrium market
  price is P 20. How many firms are there in the
  market at this instance?

18
Back to Alusaf Cost (per ton) Analysis
Which costs are variable and which are fixed?
19
Supply of an Incumbent Firm Constant MC

MC is vertical once capacity is reached
Min. AC LR shutdown
AC
Assuming variable cost includes all but labor,
maintenance, plant power, and GA
Min. AVC SR shutdown
AVC MC
Max. capacity
Short-run P gt MC AVC then produce at capacity

20
Industry Supply with 4 Firms

• Arrange firms by marginal cost in an ascending
  manner
• Below is a table showing the lowest 4 firms

Average
21
Short Run Supply Curve
Short Run Demand Curve
22
How does the model measure up to the data?

• In 1993, at a price of 1,110
• Actual production 19,781
• Supply model predicts 19,412
• Not bad!!
• Is that all??

• No remember that there was 950 thousand tpy of
  idled European
• capacity, most of which is low cost and would
  be operating at 1,110
• So 19,412 overstates actual production after all
• After adjusting for this idled capacity, we get
• Adjusted Supply
  18,462
• Demand 18,375

23
Irrational Capacity Incentives dont matter!
Is this the whole story? It cant be Case
says that inventories are accumulating fast,
? supply gt demand

• Explanation Irrational Capacity which stays up
  and running regardless
• of pricing
• This is mostly state-owned capacity
• To adjust for this, add to supply at 1,110 all
  state-owned capacity
• with average variable cost exceeding 1,110
• This is capacity that would not have operated
  under normal market
• incentives, but operates because decisions are
  driven by non-profit
• considerations

24
How does the model measure up?
Actual demand 18,375 At a price of 1,110
the model predicts 19,412 Deduct 950 to
adjust for idled European capacity 19,412-950
18,462 Add back 1,120 irrational capacity
18,4621,120 19,582 This is very close to
actual production 19,781 The difference
between supply and demand builds-up as excess
inventories
Question Given that Aluminum are at historical
lows, should Alusaf drop the project? Answer
depends on answering a more fundamental
question What is the relationship between
current prices and long-run profitability?
25
Aluminum in 1992 Introduction of new capacity
can lead to catastrophic collapse in prices
Short Run Demand Curve (inelastic)
New Capacity
Collapse when a) Demand highly inelastic b)
Initial equilibrium on steep segment of supply
curve
26
It All Depends on Relative Demand and Supply
Demand and supply can vary by a significant
amount but no big change in prices WHY?
Supply intersects demand on the flat segment of
the supply curve
27
Take Away Point from Alusaf

• So is there any connection between short-run and
  long-run profitability?
• The short answer is NO!!
• The long answer is
• Short-run prices and profitability averaged
  over a long time horizon do reflect long-run
  profitability of an industry. However, in any
  given period of time, short-run profitability is
  entirely determined by idiosyncratic demand and
  supply fluctuations that have little or anything
  to do with market fundamentals.
• IMPORTANT IMPLICATION It is very dangerous to
  be either overly optimistic or overly pessimistic
  about a commodity market opportunity based on
  just observing short-run trends
• Firms lose profit if they misinterpret short-run
  fluctuations and trends

28
Wrap Up

• In competitive markets firms are price takers
  produce where
• P MC. Price determined by aggregate demand
  and aggregate supply
• Firms in the industry in SR shut down if P lt
  min of AVC (AVC MC)
• Firms in the industry in LR shut down if P lt
  min of AC (AC MC)
• With increasing marginal cost
• Short run Firm supply curve is MC above minimum
  AVC
• Long run Firm supply curve is MC above minimum
  AC
• With constant marginal (and average variable)
  cost
• Short run Incumbent firms produce at capacity
  if P gt MC AVC

Caveat Keep track of irrational production
hitting the market