Last Session: Competitive Market

1
Past Sessions
Consumer Choice and Demand Production
and Costs
TOOLS
Last Session Competitive Market
Definition of perfect competition Supply
decision in competitive markets Equilibrium and
Elasticity of supply Individual and aggregate
supply curves
This Session Competitive Market (cont.)

• Exit and entry
• Short-run versus long-run pricing and supply
• The importance of forecasting

2
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)
3
Summary of last session

• 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
• Industry supply curve is (horizontal) sum of
  firm supply curves

4
Clearing out some potential confusions (I) Short
and Long Run Average Cost curve are Different
P
P
LRmc(q)
SRmc(q)
SRac(q)
LRac(q)
avc(q)
Q
Q
Short Run Supply Curve
Long Run Supply Curve
Firm supply curve is MC above minimum AVC
Firm supply curve is MC above minimum AC
5
Clearing out some potential confusions
(II) Supply of an Incumbent Firm Constant MC

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

6
Short Run Supply Curve
Short Run Demand Curve
7
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

8
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

9
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?
10
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
11
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
12
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

13
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

• Current prices are poor indicators of long-run
  profitability

14
Coming up
Different forms of Free Entry The Bagel
Industry Alusafs Entry Decision
15
Different forms of Free Entry

• Weak-form
• No legal barriers to entering the market No
  threats of retaliation by active firms
• But costs structure may be different
  (technology input prices)
• Strong-form
• Anyone can set up a firm with the same cost
  structure as any existing firm. (Entrants have
  access to the same technology and inputs)
• ? Everyone has the same cost functions (same AC,
  MC etc.)
• Alusaf case?
• Bagel Industry?

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Long Run Strong-form Free Entry and Exit
Supply0
Firms supply (MC)
Supply1
AC
P 1
P 1
P 2
P 2
Demand
ACu
q1
qu
Q1nq1
p gt 0 firms enter industry (alternatively p lt 0
firms leave industry) Long Run n ? Supply
curve shifts to the right. Price starts falling!
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Long Run Equilibrium Zero Profits
Firms supply MC


S2
AC
S1
D2
D1
PACu
q qu
Q
q

• Long-run
• Price converges to point where firms break-even,
  covering all their costs, including the
  opportunity cost of entrepreneur
• The equilibrium is achieved through entry and
  exit

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Long Run Equilibrium Strong-form Free Entry

• Equilibrium
• (a) no incentive to enter or exit market (P
  AC)
• (b) active firms maximize profit given price (P
  MC).
• Where is AC MC?
• Let ACu min. value of AC curve.
• Let qu quantity that minimizes AC.
• Entry/exit occurs until one more entrant would
  push price below ACu.
• P ACu MC Profit 0 q qu
• No. of firms n is such that aggregate demand
  supply

19
A numerical example

• Consider a perfectly competitive market, where
  each firm has access to the same technology, and
  hence faces the same cost. The Total Cost and the
  demand are given by
•  
• Find the long-run (zero profit) equilibrium
  price, quantity and number of firms.

20
Growth and Profitability A Tale of Two
Competitive Industries
One

• Bagel industry Strong form or Weak form free
  entry?
• What is the relationship between growth and
  profitability?
• Youll never make profits in an easy to enter
  market. What does this mean?
• Does strategy of enter early earn profits
  exit when rivals enter work?

21
Bagel Industry Dynamics
Firms supply
D
S
D
S
AC
P2
P1
ACu

• Short Run Demand shifts out to D due to
  growth. Price rises to P2 from P1.
• Gap between P and AC increases ? George makes
  more profits in short run.
• Long Run Others rapidly enter the market ?
  price starts falling
• Price falls quickly to minimum of AC (ACu) where
  P AC and ? 0.

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How to win in a competitive market?

• Strong-form free-entry and lack of
  differentiation imply
• In the long run firms earn zero profits
• Resources, in particular capital and
  entrepreneurs, earn their
• the opportunity cost
• Expected profits are zero actual profits may be
  positive in the short run
• because of the gyrations a competitive markets
  goes through
• Firms have no sustainable competitive advantage
• Basically, in the long-run, competitive
  industries are average!
• VerdictPretty depressing!

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Four Generic Strategies

• How can firms escape from this logic?
• Create new profit opportunities through a
  relative cost advantage
• Protect current profits and generate profits
  through differentiation
• Capture a superior market opportunity with a
  first mover advantage
• Change industry structure to reduce competition
  and entry through
• consolidation, collusion, or government
  interventions

Alusaf relative cost advantage through
government intervention
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A cost advantage achieved by a single or very
few firms

AC of a typical firm
Imagine a firm seeking a cost advantage over
others through Greater operational
effectiveness Lower input costs Better
technology If successful, this firm experiences
a drop in its AC curve, and consequently its
break-even point ? Likely to make profits even
when others dont
AC of firm With cost advantage
q
25
Alusafs Decision

• The Economics of the aluminum business is
  unattractive
• Identical product, mature technology, intense
  rivalry, etc.
• In 1992, the industrys prospects seemed
  particularly bleak
• Prices are at historical lows
• The decline in prices is the result of a
  permanent over capacity
• shock (the flow of Eastern European imports)
  that is unlikely to go
• away soon
• Why is Alusaf even considering investing in this
  business?
• Generic answer Alusaf has a cost advantage
• But Would a cost advantage mean one should
  invest regardless of what prices will be?

26
Alusafs 2 billion bet
Estimated Cost structure Power and alumina 41
of aluminum price Other raw material 143 per
ton Consumables 32 per ton Freight 40
per ton Plant power and fuel 17 per ton
(fixed in SR) Maintenance 38 per ton (fixed
in SR) Labor 68 per ton (fixed in
SR) General and administrative 32 per ton
(fixed in SR)
215 AVC MC
155 AFC
27
Alusaf A Sweet Deal in a Lousy Industry

• Alusaf obviously has a huge variable cost
  advantage over its competitors
• At a price of 1,110, its variable cost is only
• (0.41)1,110 215 670
• The marginal firm at that price has an avg.
  variable cost of 1,110
• Alusafs cash cost is about 60 670/1100 of
  that of the marginal firm!
• But Alusaf is contemplating an entry decision.
• What are the relevant costs for the entry
  decision?

Raw material, freight consumables
28
Entry Decision Price must cover AVC, AFC and
Capital Costs

• The cost of capital in per unit, annualized value
• We need to do this so that the cost of capital
  can be compared to AVC and AFC (both are
  calculated per unit per year)
• Example Capital cost is 1.6 billion for 466
  ktpy of capacity
• Cost of capital per ton of capacity is
  3,433 (1.6bn/466,000)
• Multiply the cost of capital by the rate of
  return
• At a 10 rate, the per year per ton cost of
  capital is 343
• While at 15, the per year per ton cost of
  capital is 515

Opportunity Cost (recall heuristic)
29
Price and Costs for Entry Decision
Alusaf invests If forecast of price equals or
exceeds its estimate of the AC which includes the
opportunity cost of capital AC AVC AFC
annual per unit cost of capital Given a price P
and, as an example, 15 return on capital AC
(0.41) P 215 155 515 To justify
investment, P AC, we need P 515 155
(0.41) P 215 P - (0.41) P 0.59 P 515
155 215 P (515 155 215) / 0.59
1,500
Conclusion It is not enough for Alusaf to be a
cost leader it must expect future prices around
1,500 on average to justify investment
30
Should Alusaf Invest?

• This essentially depends on the forecast of
  future prices. Forecasting is hard!!
• A complex problem simplify by breaking it up
  into smaller pieces
• Long-run without demand growth and no entry by
  competitors
• Long-run with demand growth and no entry by
  competitors
• Long-run with demand growth and with entry by
  competitors

31
Long Run Supply Curve No new entrants no demand
growth
Long-run analysis tells us that price must move
above 1,110
32
Summary No Entry and No Demand Growth

• Even if firms disregard the cost of capital,
  long run prices must
• rise above 1,110 in order to cover AFC and
  AVC
• The precise magnitude of the price increase
  depends on
• demand elasticity
• If the demand is perfectly inelastic (vertical
  demand), the
• price increases to more than 1,400.
• Carefully estimate the long run demand curve
  when making a
• recommendation

33
No new entrants demand growth
Demand growth (assuming no entry) will
relentlessly push prices upward, bringing in more
idle/marginal producers, and raising the profits
of infra-marginal producers (e.g., Alusaf ).
34
Demand growth Entry
As demand grows from D0 to D1, prices rise in
the short-run Because capacity is limited in
the medium/short-run

• As prices exceed AC, new firms have an
  incentive to enter
• Entry shifts the short-run supply curve to the
  new dotted line
• Prices drop
• When will this process stop? New firms should
  have no further incentive to enter This happens
  when the price reaches AC cost of the most
  efficient of potential entrants
• CONCLUSION prices converge to this AC in the
  long-run

35
Can We Find This Cost?

• Unfortunately, the case does not give us this
  information
• Alusafs reasoning
• From Ex. 6, average operating cost (fixed and
  variable) is 1,210
• If the incremental smelter spends 2 billion for
  466 ktpy plant, and
• expects a return of 10, the per unit
  annualized cost of capital is
• 429
• Add this to average operating cost and we may
  expect a long run
• price of 1,639 gt 1,500 (gt15 return for
  Alcoa)
• So Alcoa should invest!!

36
Does this long run price have anything to do with
reality?

• The LR price does not describe the price
• level at any give moment rather it describes
  the
• long-run trend in prices
• Trend is evident in the case of aluminum
• despite violent short-term gyrations in prices,
  
• the long run trend is fairly stable around
  1,400
• (the 1,639 scenario discussed earlier may be
• overly optimistic)
• The LR price is constant if cost conditions of
• the industry are relatively stable over time
  (this
• seems to be the case with Aluminum--the slight
• positive slope is due to inflation)
• However, an industry that undergoes
• permanent cost shifts will experience
• corresponding shifts in their LR price

37
Case Update

• Alusaf did build the Hillside plant and
  completed it on budget
• The plants official opening was on April 19,
  1996, roughly 3 years after
• the decision to go ahead was made
• The Hillside plant was considered a wild
  success
• Its operating cost matched estimates
• Actual capacity turned out to be 510 ktpy, so
  the cost of capital per ton of
• capacity turned out to be lower than expected
• This implies a price of only 1,425 to achieve a
  ROR of 15
• Aluminum prices recovered quickly from their
  1992 levels and inventories turned to normal.
  Current price 1700

38
Takeaways Framework to Analyze Commodity Markets

• Cost fundamentals determine the industry supply
  curve
• We have seen precisely how to construct various
  supply curves for
• aluminum
• Short-run price movements are determined by
  current demand and
• supply curves
• We have seen precisely how this works
• Entry decisions are determined by cost (fixed,
  variable and those that
• will become sunk) and forecasts of price trends
• Economics gives us a framework to forecast these
  trends based on
• limited available information