Aluminum Industry in 1994: Long Run Supply and Equilibrium Managerial Economics Alp Atakan This material is for the exclusive use in MGEC classes at Koc University. No other use is allowed without my permission. 1 Road Map • • Why is the price of Aluminum so Volatile? • Demand analysis Long-Run Supply Curve – – – – – Difference between short-run and long-run supply curves ATC and the exit price FR-ATC and the entry price Building the long-run supply curve What drives the long-run price path in a commodity market? 2 Demand Curve Answers the Question: What Quantity Will be Demanded at Different Possible Market Prices? Movements along a given demand curve tell us how quan4ty demanded changes with respect to changes in the good’s price Price ($ per unit) P0 Shi7s in the demand curve tell us how quan4ty demanded changes with respect to changes in demand drivers other than the good’s price (e.g, income) P0 P1 D0 D X0 X1 Quan?ty (units per period) Measure of sensi4vity: price elas:city of demand % QD = % P QD /QD dQD P = ⇥ D P/P dP Q X0 X2 D1 Quan?ty (units per period) Measure of sensi4vity: other elas:ci:es of demand, e.g., income elas:city of demand % QD = % Y QD /QD dQD Y = ⇥ D Y /Y dY Q 3 Is Price Elasticity Constant along a Linear Demand Curve? El as ?o or P ?c 1 n P0 a el In P1 s? ?o or c P n Price ($ per unit) E= D X0 % QD = % P X1 Quan?ty (units per period) D QD /QD dQ P = ⇥ D P/P dP Q 4 Market Demand for Aluminum is Quite Insensitive to Price $2,500 • Large increase in price results in small decreases in quan?ty demanded • Put another way: to choke off even a small amount of demand, requires a big increase in price Price ($ per ton) $2,000 $1,500 1 $1,000 $500 2 D 0 2,000 4,000 U.S. Quan4ty (thousands of tons per year) 6,000 8,000 5 “Quick and Dirty” Forecast of Market Price • At 1993 prices of $1,110/ton, supply is about 19.5 million tons. – Suppose that the demand curve is almost vertical – 2% growth in the next 3 years è $1,600, 1.5% è $1,500 and 1% è $1,250 – Macroeconomic trends could push price upwards significantly! • Are the other factors that may lead to higher prices in the next 2-3 years? • Will the prices rise indefinitely? 6 Short-‐Run versus Long-‐Run Supply: Theory Adjustments in supply may take 4me … • If market price goes up … • If market price goes down … – In the very short run (over the next 24 hours), no firm can adjust supply – In the very short run (over the next 24 hours), no firm can adjust supply – In the short run (over the next week or few months), ac?ve smelters can increase produc?on rates and near-‐ ac?ve smelters can come back on line – In the short run (over the next week or few months), ac?ve smelters can decrease, and some may temporarily suspend opera?ons (in near-‐ac?ve condi?on) – In the long run -‐-‐-‐ if price is expected to stay up -‐-‐-‐exis?ng firms can expand or build new capacity. New firms can also build new capacity – In the long run -‐-‐-‐ if price is expected to stay down -‐-‐-‐exis?ng firms can put exis?ng expansion plans on hold. They can also withdraw their capacity from the market 7 Short-‐Run versus Long-‐Run Supply: Theory Price ($ per unit) VSS 1. Price is ini?ally at $100 per unit … but unexpectedly falls to $80 per unit 2. In the very short run, (24 hours a[er the change in price) quan?ty supplied doesn’t change (it’s as if industry “moves along” market supply curve VSS) 100 80 1 2 50 Quan?ty (units per period) 8 Short-‐Run versus Long-‐Run Supply: Theory Price ($ per unit) VSS SS 1. Price is ini?ally at $100 per unit … but unexpectedly falls to $80 per unit 2. In the very short run, (24 hours a[er the change in price) quan?ty supplied doesn’t change (it’s as if industry “moves along” market supply curve VSS) 3. In the short run (3 months a[er the change in price), quan?ty supplied has fallen from 50 to 40 as ac?ve producers adjust their produc?on levels 100 80 1 2 3 40 50 Quan?ty (units per period) 9 Short-‐Run versus Long-‐Run Supply: Theory Price ($ per unit) VSS SS LS 1. Price is ini?ally at $100 per unit … but unexpectedly falls to $80 per unit 2. In the very short run, (24 hours a[er the change in price) quan?ty supplied doesn’t change (it’s as if industry “moves along” market supply curve VSS) 3. In the short run (3 months a[er the change in price), quan?ty supplied has fallen from 50 to 40 as ac?ve producers adjust their produc?on levels 4. In the long run (18 months a[er the change in price), quan?ty supplied has fallen from 50 to 20 as some ac?ve withdraw unprofitable capacity from the market 100 80 1 2 4 3 20 40 50 Quan?ty (units per period) 10 Short-‐Run Versus Long-‐Run Supply: Impact of Unexpected … but Permanent … Shock in Demand Very Short Run: 24 hours aHer drop in demand Price VSS Price 100 Price SS LS 100 90 100 85 80 D1 D0 D1 What this might look like on the commodi?es page of the Financial Times D0 Quan?ty Quan?ty Price 100 Long Run: 18 months aHer drop in demand Short Run: 3 months aHer drop in demand Shock hits long-‐run price path 90 80 Time 18 months later D1 Quan?ty Key point: long run price path of industry determined by intersec?on of demand and long-‐run supply curve 11 D0 Short-run Supply Decisions ✴ The relevant cost categories for volume decisions are those that vary across alternative volume choices (variable costs) ✴ The marginal cost (MC) curve summarizes the rate at which variable costs change with output as the firm produces a little bit more or a little bit less output ✴ A price-taking firm will be willing to supply a unit of output as long as the market price exceeds marginal cost of that unit. This creates a tight link between a firm’s supply curve and its marginal cost curve: the firm’s supply curve is it’s marginal cost curve. ✴ The market supply curve is the aggregation of the supply curves of all the price-taking firms that might potentially produce. 12 How Do We Construct the Long-run Supply Curve for a Commodity Market • Consists of two parts: • • Exit prices and cumulative capacity of incumbent firms Entry price of “typical” potential entrants (or expanders of capacity) Price ($/unit) poten4al new capacity incumbent firm 4 incumbent firm 2 incumbent firm 1 exit prices of incumbent producers incumbent firm 3 entry price of new capacity Cumula?ve Capacity (units per year) 13 Some Cost Concepts ✴ Total Cost (TC): All-in cost plus any annualized redeployment value ✴ Average Total Cost (ATC): All-in cost per unit plus any annualized redeployment value per unit ✴ Full-reinvestment Total Cost (FR-TC): Costs of starting the business from scratch • All-in cost plus annual capital charge ✴ Full-reinvestment Average Total Cost (FR-ATC): All-in cost per unit plus annual capital charge per unit 14 Returning To a Typical Smelter … ($/ton) P = $1,400/ton ATC $1,200 • Suppose the market price is expected to be $1,400/ton for the foreseeable future. Should the smelter stay open? • What is the exit price for an exis?ng smelter? MC = AVC $925 Volume of produc?on (tons per week) capacity of smelter 15 Consider Inves?ng in a New Smelter … ($/ton) • $1,500 FR-‐ATC P = $1,400/ton ATC • $1,200 MC = AVC $925 Volume of produc?on (tons per week) Suppose the market price is expected to be $1,400/ton for the foreseeable future. Is investment in the new smelter a posi?ve NPV investment? What is the entry price for a new smelter? capacity of smelter 16 Cost Concepts: Summary ($/ton) • ATC = all-‐in cost per unit plus any annualized redeployment value entry price FR-‐ATC exit price ATC MC = AVC Volume of produc?on (tons per week) • FR-‐ATC = all-‐in cost per unit plus annual capital charge • Exit price = minimum level of ATC • Entry price = minimum level of FR-‐ATC capacity of smelter 17 Determining the Exit Price is a Breakeven Calculation stay in and produce at full capacity Alcan’s Saramentha B in Brazil Capacity: 41,000 tpy “All-‐in” cost at full capacity: $1,427/ton shut down the plant (P -‐ $1,427) × 41,000 Scrap value, S • Verbally: Find the market price, Pexit , so that present value of cash flows from keeping the smelter in opera?on equals the scrap value, S • Mathema?cally: (assume 8 % cost of capital) annualized redeployment value • To simplify, let’s assume S = 0. Thus, in this case, ATC = $1,427/ton. The exit price for Saramentha B is $1,427/ton 18 Determining the Entry Price is Also a Breakeven Calculation Typical new state-‐of-‐the-‐art smelter Capacity: 230,000 tpy (case, p. 5) “All-‐in” cost = $1,210/ton (Ex. 6) Cap-‐Ex = $1 billion (case, p. 5) • Verbally: Find the market price, Penter , so that present value of cash flows from opera?ng the new smelter equals the upfront cost of building the smelter • Mathema?cally: (assume 8% cost of capital) annual capital charge • The entry price for a typical new smelter is thus $1,558/ton. 19 $ per ton Long-‐Run and Short-‐Run Supply Curves for Aluminum $2,500 $2,400 SS $2,300 $2,200 What are the implicaQons of this? $2,100 $2,000 $1,900 $1,800 $1,700 LS $1,600 $1,500 $1,400 $1,300 $1,200 P1993 $1,100 $1,000 $900 $800 $700 $600 $500 $400 $300 $200 $100 $-‐ 0-‐ 2,000 4,000 6,000 8,000 10,000 12,000 14,000 16,000 18,000 Cumula4ve Capacity (thousands of tons per year) 20,000 22,000 20 $ per ton Assuming No Demand Growth Over the Next 2 – 3 Years, Capacity Withdrawals Should Push Price Up to Between $1,400 and $1,500 per Ton $2,500 $2,400 $2,300 $2,200 $2,100 $2,000 $1,900 $1,800 $1,700 LS $1,600 $1,500 $1,400 $1,300 $1,200 P1993 $1,100 $1,000 $900 $800 $700 $600 $500 $400 $300 $200 D93 $100 $-‐ 0- 2,000 4,000 6,000 8,000 10,000 12,000 14,000 16,000 18,000 Cumula4ve Capacity (thousands of tons per year) 20,000 22,000 21 $ per ton Assuming Growth in Primary Aluminum Demand of About 1.75%, Price Should Rise to the Entry Price of $1,558/ton in 2 to 3 Years $2,500 $2,400 $2,300 $2,200 $2,100 $2,000 $1,900 $1,800 $1,700 LS $1,600 $1,500 $1,400 $1,300 $1,200 P1993 $1,100 $1,000 $900 $800 $700 $600 $500 $400 $300 $200 D93 $100 $-‐ 0-‐ 2,000 4,000 6,000 8,000 10,000 12,000 14,000 16,000 18,000 Cumula4ve Capacity (thousands of tons per year) D96 20,000 22,000 22 Case Update • • • • • Alusaf did build the Hillside plant and completed it on budget The “Hillside” plant was considered a significant success – Operating costs 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 Aluminum prices had recovered to about $1,568 per ton by 1996 Due the Asian financial crisis, prices declined from $1,434/ ton in March 1998, to $1,342/ton in Sep. then to $1,118/ton in March 1999 Prices have been rising steadily since 2002: As of January 11, 2008, LME price of aluminum stands at $2,416 per ton. 23 Take-Away Points • • • Supply and demand curves are more than just theoretical constructs – We can use them to formulate hypotheses about price trends in commodity markets, and sometimes they can be used to develop quick and dirty forecasts of price movements In the world aluminum market… – Industry is on edge of “short-run” supply curve …. Thus, demand growth can lead to a price recovery – In longer term, capacity withdrawals will also be a force resulting in price recovery in this market in mid-1990s – Prices won’t go up indefinitely. Entry price for new smelters will tend to cause price to remain between $1,500/ton - $1,600/ton in real terms Key concepts learned – Short-run market supply curve (supply adjustments by active or near-active firms) – Long-run market supply curve (supply adjustments by capacity withdrawal and entry of new capacity) – Elasticities of demand (e.g., price, income) 24
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