Microeconomics Supply Chain

Macroeconomics focus on the economy as a whole. In macro, you outline relationships between variables ( growth, employment rate, investment…).

Micro : focus on economic agents, players, and companies. Focus on how consumers and companies are behaving. In micro you look at the economy as being structured, divided in several individual markets. It is an important difference in focus : from the overall standpoint to the micro one here. For example, you will focus on markets separately : the Real Estate one, the Financial market, the consumer market, etc… That’s why competition is mainly a microeconomics issue. A micro question : what are the conditions for the Real Estate to be balanced ? When a market is balanced in microeconomics, we speak of a “partial equilibrium”. In micro you can (conceptually) move from partial equilibriums to global equilibrium by adding all partial equilibriums.

Rationality, scarcity and opportunity costs.

Rationality

In terms of social sciences : microeconomics is a social science which relies on methodological individualism. It derives from methodology, but in a specific way to look at social realities. It means that if you want to understand a social phenomenon( why a price moves up, a market changes…) you have to first understand individual behavior. By looking in how individuals are behaving, you can derive logical relationships that unable you to understand social phenomenon. It is an assumption. The key driving force explaining why prices are moving up or down, etc is individual behavior.

Another assumption of microeconomics is that people behave in a rational way. People will make decisions in an intentional way. Economic agents are rational. This is a major assumption.

Looking at micro in a historical context : appeared in the XIXth century, and developed really in the early XX. It first appeared as a new school of economics ( neo-classical school of economics) in opposition to the classical economists. They shared some concepts, but bring new ideas in strong opposition with the classical economists. Neo-classical economists shared with classicals a trust in the market. They had a very positive view of the market. They all believed that the market was a very efficient institution.

But the big difference regards to the theory of value. According to neoclassicals, the driver of value is not labor. For classical, the value of a good was driven by the amount of labor embedded into the good. The neo-classicals are at odds with this idea. They asserted that the value of a good is driven by marginal utility ( utilité marginale).

What is “utility” ?
It makes reference to the utility function. It is a function which represents individual preferences. It is not something useful or not. It is about preferences. The idea is that if you are rational, then you will tend to implement actions that would increase your satisfaction. You will maximize your utility level : make decisions which will make you happier.

The main driver of the value of something is the preferences of individuals, it is the satisfaction this value is going to bring to consumers. It is rational.

What is “marginal”?
It is the utility derived of the last unit consumed. The last factor to observe to set a price is the last unit of the good consumed, and the pleasure, the utility it brings to the consumer.

In micro we assume that marginal utility is declining : the more you consume a product, the less attractive and pleasant it is. For example, a new gadget sold : when it is a new one, very appealing, then consumers will want to
consume it. But 3 years later, it will bring less satisfaction. The last unit to be consumed is going to be less gratifying to consume. Then the price should go down, or the production, or the product should be remplaced by a new one.

A big assumption is that value is very subjective, based on preferences. The preferences, at the individual level add up to create a demand in a special market.

Scarcity

Some goods, services, etc are characterized by scarcity. The air that we breath, the oceans : there is no scarcity. There is not a scarce amount of air available. But it not the case with any other kind of goods we can think of. Scarcity is another huge assumption of microeconomics. It is an objective factor. If capital were available, there would not be a need for a market. The scarcity level can be modified.

Part 1 : The supply function

Chapter 1 : The neo-classical view of outputs

The neo-classical view of output

Y: production for a company

f : the production function, a technological relationship between production factors and the production itself

Y= f(x1,x2,…xN) (measured in physical units)

There also must be a time reference (measure over a year, a semester, a quarter…)

The short run and the long run

In the electronics industry, life cycles of products are short so products always need to be renewed while on the other hand, in the nuclear industry, products have a longer life cycle. So the big differences is really life cycles

Short term is when the production function is given but in the long term it may be possible to change it thanks to investment (to produce more: skilled investment or produce more efficiently: innovation)

Production function with substitutable factors.

Marginl productivity of labor :
(mP, L) = ∆Y / ∆L = dY/dL
The marginal productivity of labor is to be defined by production factors. Just like mean productivity.

If you increase the use of labor ny a small quantity (ex one unit) what is going to be the impact on production. That is the point of marginal productivity of labor. You increase to the margin. mP,L reflect the efficiency of the productive factors.

L1 = initial quantity of labor
L2 = new quantity of labor
∆L = L2 –L1
The difference must be very small

dY/dL : symbol of the derivative function.
A high marginal productivity of labor means that labor is very efficient. On the opposite, if the mP, L is getting smaller, it means that using one additional unit of labor will not alllor to increase production that much (since labor is not efficient).

mP,K ( marginal productivity with regard to capital)
Not very applicable in the real world. In fact it is difficult to increase
capital only by a very small increase.

Production function with complementary factors.

Here you can’t make any substitution. The proportion between K and L is rigid, fixed. For instance, one unit of capital for 3 units of labor. Regardless to how much you produce, if you want to produce more, you will have 2K for 6L etc… It is here of course impossible to calculate the marginal productivity of L and K.

Chapter 2 : Costs and the firm

As soon as you define a production system, then a cost function is going to be defined as well. One is necessarly leading to another. In fact, factors are costly !

The different kind of cost

Different costs exist in a company. Production costs are often critical. But they are other costs in a company. The micro approach focus maybe too much on those costs.

They are two other ways of reprensenting the different categories of costs.

a) First way

Procurement costs : costs linked to the fact that we will buy all that is needed to produce ( achats, approvisionement).

Operations : (gestion de la production ) everything linked to production = production costs. Here just one of the categories of the structure.

Administrative and management costs : to coordinate procurement, operations, taking decisions, etc…

Distribution costs.

b) Second way : the value chain

In the value chain, each actitvity of a company is a link (maillon) in the value chain. Each activity is going to be value-generating as well as cost generating.

Costs minimization within the firm

Here we have to distinct short terma and long run, just as for production. Long run : you can move from a given production function to another one Short term : you do with what you have.
With cost function, it is exactly the same.

2.1 : Short term costs

➢ How to make the mst out of a given cost function :

TC = FC + VC(Y)

TC : total costs, overall costs for a company.
FC : Fixed costs : independent from the quantity produced (equipments, infrastructure, plants…) VC(y) : variable costs. They change with production. Supposed to be a growing function of production. The more you produce, the higher the variable costs. For example : the more you produce the more you will use energy.

In the short term, the proportion of FC and of VC is given. But this proportion is specific to each company. It is very interesting for a company to know this proportion because it will help minimizing costs.

In the second figure : example of variable costs strictly proportional to production ( you double Y, you double VC).

Here, at a given point, called tipping point, there is a change in the soap of the curve. Bellow Y1, you have a proportional increase. But beyond, there is a shift, a tipping point. VC grow faster than production.

It is usually when you have reached the maximum of your capacities. At full capacities : technical problems appears, such as maintenance problems. Workers must be paid extra jour, very costly…

Average cost, mean cost = Total Cost (TC) / Quantity of production (Y). AC = TC/Y
Then, TC/Y = FC/Y + VC(y)/Y

a) FC/Y : if Y is increasing, FC/Y is going down.

Here it is an economy of scale. We are making economies : a fraction of cost is going down. Producing more, you begun more efficient. The higher the FC, the more this relationship is going to be true.

b) VC(y)/Y

i) If VC growth is smaller than the production growth ( if CV growth< Ygrowth).

In this case, VC(y)/Y go down.

Very unlikely to occur

ii) If VC(y) growth is proportional to Y growth
Then VC(y)/Y remains constant

iii) If VC(y) growth > Y growth, VC(y)/Y will increase.

To minimize the average costs over the short term, you need to find the appropriate level of production (here Y3).

Y and C are necessarly linked. At Y3 you have reached the lowest VC. Producing at Y”, you have a very efficient cost function, with high margins.

The marginal cost

mC = ∆TC/∆Y ( change is TC/change in production) = dTC/dY

marginal cost : what is going to be the impact of a small increase of production on the total cost.

➢ If mC is negative : if you increase Y by a small amount, total cost is going to decrease

➢ If mC = 0 : ij you increase Y the level of cost is gonna be unchanges.

➢ If Mc is positive : if you increase Y, total cost will go up.

The marginal cost curv cut the AC curv in its minimum.

2.2 : Costs, scale and technology

When you produce less than Y1, massive scale economy.
From Y1 to Y2 : range of production for which there is a minimum average cost. Beyond Y2 : costs go up because VC go up.

If you produce Y3 :

– Good news : you have a market, a possibility to produce a lot.

– Bad news : your cost function is not efficient, very costly with little margins.

Conclusion : you will have to think to a new cost function.

Usually, the range of possible solutions is quite narrow. Besides, the most efficient cost functions are also the most capital intensive, with very high fixed costs.

Technological progress led to higher FC in the manufacturing business. The best technologies are very expensive. We went from moderate to very high FC. (ex : the pharmaindustry, microprocessing…)

The cost function B corresponds to investment in new technologies. Here to benefit from the low costs oallowed by the new technology, you have to produce at least Y4. Because if you stay at Y3, it is worse ! With huge FC, you need to produce a lot. AT Y3, you are trapped.

Then, to be able to invest in alternative technologies you can :

– Merge (you can produce more together and you production level is ok with the market

– Outsource.

2.2.1 Merging

Let’s take an example : Take 8 companies YA, YB, YC, YD… YH The sum of their production (Y) = YS
YS equals demand.
One of the company can’t just increase its production. Because if it does, YS will overpass the demand. A solution is that YA and YB can merge. There will be seven company instead of eight, with one larger company. The new company will be able to produce more, without jeopardizing the equation Ys= demand. There won’t be any oversupply.

When companies wish to invest in new technologies, they will have to increase the scale of production ( to cover higher fixed costs). But the market often cannot absorb those new outputs. Then it is very interesting to merge, it is the only solution to produce more without creating oversupply.

But, if there are too many mergers, then there are less companies , then there are less individual competitors. This can be a problem for states and public authorities because the corporate world become less competitive.

2.2.2 Outsourcing

[externaliser]
How to define it ?
To outsource = to contract out part of the activity.
To contract out a n activity, service, parcel of one’s business to an independent firm.

There are different possible solutions with regard to a company’s activity.

|In-house local |Outsourcing local | |In-house off shore |Outsorcing local |

Why outsourcing ?

– To cut costs (number one reason)

– To specialize -> to focus on activities for which you have more skills

Pitfalls ?

– You loose know-how

– You become dependant on your contractors, which represents a huge risks.

Chapter 3 : Production in today’s business

Productivity indexes

Remind : MPL = Y/L. To calculate it, we will have to use indexes to calculate labor productivity.

I1 (Index 1) = sales/staff per period

I2 : another index = value added (VA)/hours worked in the company per period

The objective in both case : that the indexes increase.
Companies compute index level over time to compare, decide how to improve, to look at the trends. Can also be used to benchmark your firm with regards to competitiors.

How to do to increase I2 ?
There are 2 ways to deal with the same idea :

– You can create the same VA as before but will try to reduce the hours worked

– You can keep the same number of hour worked and increase the VA. For that you have to upgrade your goods and services.

The outsourcing phenomenon

[externaliser]
How to define it ?
To outsource = to contract out part of the activity.
To contract out a n activity, service, parcel of one’s business to an independent firm.

There are different possible solutions with regard to a company’s activity.

|In-house local |Outsourcing local | |In-house off shore |Outsorcing local |

Why outsourcing ?

– To cut costs (number one reason)

– To specialize -> to focus on activities for which you have more skills

Pitfalls ?

– You loose know-how

– You become dependant on your contractors, which represents a huge risks.

Conclusion of the first part: the breakeven point.

Remind : cost efficiency is finding the right rate of production. Break-even point is the production level at which sales are just equal to cost. B/E is a quantity of production Y=YB so as total cost(TC) = total sales (TS). TS = price of production (P.Y). profit = TS-TC.

At Y= YB (B/E point), then profit is 0
If Y>YB, then profit >0, TS>TC
If Y Demand
• New price: P* < P1,
o If P* = P1 ( Offer = Demand
o If P* > P1

( If P’ < P*,

P’ = P1 ( Offer = Demand

But if P’ > P1

( P# < P’

If P# = P1 ( Offer = Demand

Step by step process. We have to lower the price at the first step. If we are not at the equilibrium, we have to lower the price once again. And so on.

The auctioneer is not able to set the right price right now, because the price is too excessive. But the auctioneer doesn’t know the equilibrium price. He will try step by step.

Partial equilibrium

The overall economy is structured on different markets.

Partial equilibrium = equilibrium given for one market.

General equilibrium

Arrow and Debreu.

General equilibrium does exist.

Less likely to occur but it is possible.

The French job market has not been at the equilibrium since the 70’s

Conclusion :

There is no profit for company when there is equilibrium. mS=mC=P. Marginal sales = marginal cost = price. Companies have no hability to put a different price on the market. They have to follow the price set by the market. Just like for oil, gas… a trading platform set the price. It is just the same for the pure and perfect competition but with actionnaires. The price being set by the market is going to be caracterised by this equation : mS=mC=P. But company don’t make any profit, since they just equalize cost with sales. Competition is so strong that it unable the creation of profit.

The more competition you have, the more difficult it is to make profit. The less competition, the easier it is gonna be to make profit.

There are 2 ways to see at profit when it happens. A positive, a negative. Profit is a reward of being the best, better than competitor. Or profit are due to uncompetitive market.

Chapter 2 : other types of markets

Monopoly

The monopoly framework is absolute opposite of the pure and perfect competition model. It is the other extreme.

A monopoly is a situation in a market whent supply is made of only one company. The supply function is structured by one company only. So we move from the infinite to only one. But we still assume that there is a very high number of consumers. One the demand side, same context. But on the supply side, exactly the same. Huge consequence : the price. In the pure and perfect competition framework and in makets where there is a trading platform, price is set by the market, and companies will take the price as something given. Companies have no ability to change the price. Here the firms that benefit from a monopoly situation are going to set themselves the price. The monopolist will make the price. The monopolist is the “price-maker”, as opposed to the “price-taker” of a highly competitive environment.

The objective of the monopolist is the same than other companies : they want to maximize profit. So they want to set the price as high as possible. but there can be negative consequences for the monopolist themselves : they will be facing a declining demand. Consumers will not be able to offer the good. You increase the prices but decrease the quantity, so the result is not necessarly positive.

You also run the risk of having new competitors. This is the second risk.

The third risk is the apparition of substitutes on other markets. Substitutes provide roughly the same products. Example : train transportation. There is roughly a monopoly in France in train transportation for custoumers. In spite of this monopoly, consumers have the choice. They can choose airline, the car, etc.

There are several types of monopoly.

1 : Pure monopoly

There is one firm only
There are very high barriers to entry

The risk of new competitors is very low. Low risk of substitute. The only constraint is the demand one. So here, it is possible to set very very high prices.

What are “ barriers to entry” ? Usually, it is impediment ( obstacle). The most common one is the price. The price of the minimum investments you have to make to enter the market. Example : air craft manufactury.

Then, the number two barrier is regulation law. Some markets are regulated. You need a license, an agreement before entering a market.

The third one is knowledge, expertise, know-how. In some markets the level of expertise of knowledge is so high that no companies can manage to get it and enter the market. We are speaking of knowledges that you can’t buy on the market. Example : air craft manufacturing. Here, companies can take a lot of time to build up their knowledge. They have to be subsidize.

Other solution : technology or knowledge transfer.

2 : Real monopoly

There is one firm, but low barriers to entry and some substitutes.

If you go too far into increasing prices, companies will enter the market.

Bit of competition!

– One firm
– Low barriers to entry
– Some substitutes

In a pure monopoly case, the only limit to increase price is declining demand.

Whereas in a real monopoly, if you increase prices, you will provide incentives to some companies that are outside of the market, in order to join you. It is appealing for companies that are outside. They are tempted. So, it means losing the monopolistic position if we go too far.

And, because we have substitutes, we run the risk to loose our customers.

For instance: train transportation. It is a monopoly for customer. But if prices increase, maybe some customers will quit and will go to airline transportation.

3 : Why does a market evolve into a monopoly

What could be the reason why monopoly is not so well regarded?

– No incentives to improve the product ( decline?
– No incentives to innovate
– The price is going to be much higher: welfare transfer. ( Consumers will be worse off. They will pay more for the service they get.

( Low quality, high prices, low incentives to innovate

Why do we have some monopolies?

It does exist; it is possible to find them. But why do we have those strange markets situations?

Economists regard monopoly as something that is not efficient, that is not incentive.

To rip off consumers. Benefits from the expenses of consumers. Monopolies have no incentive to innovate: there is no need to innovate.

4 : Profit maximization in a monopoly

The goal of any company : maximize profit. The monopolist has a huge privilege : he has the power to make the price.

But what price ? the monopolist will set the price as high as possible. The only limit : the demand. In fact, there is a “normal demand” ( if price go up, demand go down). You can push up prices and have no gain because you had just the same amount of declining sales.

Oligopoly

An oligopoly is a specific situation in the market when you have few competitors. If you produce a lot, and if the other companies are producing a lot as well, you’ll have a situation of overproduction.

Most market are oligopolies. There are 2 kinds of oligopolies. The first one (we will focus on) is when there is only few companies involved. The second is were there are many companies in competition. This second monopoly is going roughly to behave more or less like pure and perfect competition.

In the first oligopoly, there is an idea of mutual influence. Companies influence each others. Each firm is big enough to have an impact on the market.

Then how is the price set ?

There is an uncertainty. Two mechanism deal with this uncertainty.

2.1 : Implicit agreements and imperfect competition

Implicit agreements : not a written contract, something discussed by CEOs… Means something like a convention, a custom, a usual way to doing thing.

Here someone is going to make a price. And the other one will comply, follow. The solution is quite simple. Usually the company who set the price is the dominant firm. In the second case of oligopoly, the company the more sensitive to price/cost will make the price and the other will comply.

2.2 : Explicit agreement : cartel

Second solution. Here companies settle an agreement. It is not “official” because it is illegal. It is an agreement, but not written. In fact, it is a “non-competition” agreement. But is does exists. It is usually organized aroud two elements :

– Price : a floor price is fixed

– Quantities :

Duopoly

3.1 : Bertrand and Edgeworth duopoly

3.2 : Cournot duopoly

3.3 : Von Stackelberg duopoly

Conclusion : competition and game theory