Notes on Supply

We now turn our attention to Supply. Work through the 2) Supply section of the Demand, Supply, and Equilibrium Tutorial by Frieda Mendelsohn. Think about what factors determine someone’s willingness to provide products to the market.

Since we’re using coffee as our product for analysis, read one or more of the resources on coffee before you work through this section. Think about what factors determine the amount of coffee that is likely to come to the retail market.

Opportunity Costs
Remember the question: What could you do instead?

Opportunity costs are key to understanding the costs of bringing anything to market. The fact is that everything has multiple uses, but some are more productive than others. So, for every laborer who picks coffee cherries by hand, that person could be a computer programmer. The land being used to grow coffee could grow something else or be used to build a call center. The trees on which the coffee grows could be cut down and used for lumber.

Everything has another possible use; what determines how each particular resource will be used is the relative price of that resource in different uses.

Price of Inputs
What inputs go into bringing coffee to the retail market? Here are some I thought of as I read “How Coffee Works,” by Debra Beller, published at HowStuffWorks.com:

  1. Growing the trees: fertilizer, labor
  2. Harvesting the coffee cherries: labor
  3. Retrieving the beans from the cherries (a) dry method: labor, space to spread, time in the sun (b) wet method: machinery, labor (less?), less time, energy
  4. Shipping green coffee beans to the wholesale market: energy (oil)
  5. Roasting the coffee beans: machinery, energy
  6. Packaging the roasted coffee beans: machinery, paper, energy

So, if the price of oil goes up, what can we expect to happen to the willingness to supply coffee to the market at each price?

Technology
Machinery is used in several steps of the process of turning coffee cherries into roasted coffee beans. If we assume that the price of energy stays the same, what would happen to the willingness of suppliers to supply roasted coffee to the market at each price if a new coffee roaster were developed that automatically determined the best time for roasting each bean and never made a mistake? What if someone developed a mechanical picker that could pick each bean at the optimum time?
If we change the word “technology” to “production process,” we might ask how a new genetically developed coffee tree that grows at a lower altitude and higher temperatures, like Robusta, but which tastes like Arabica, would affect the supply of coffee!

We need to think somewhat creatively when looking for all of the factors that might affect the market.

Natural causes
This should be fairly obvious to you. A crop failure or a good growing season would clearly change the supply of coffee. Can you think of other possibilities?

Sunk Costs vs Marginal Costs

Suppose we’re thinking about opening our own coffee house. What will we need?

  • a building
  • coffee brewing equipment
  • coffee roasting equipment if we decide to buy green coffee and roast our own
  • tables and chairs
  • cups or mugs, spoons, etc. (*Note: what kind? Reusable or disposable? Why does it matter?)
  • coffee
  • other ingredients (sugar, milk, cream, spices, flavorings, etc.)
  • advertising
  • utilities

At this point, we haven’t made any purchases yet — all of the costs are MARGINAL.

How will we make this decision? We’ll look at the “present value” (more on this later) of the total expected costs for the next few years and compare that to the total revenue that we expect to get from selling coffee.

How will we figure our total revenue? If we’re smart, we’ll look around at what other coffee houses are selling and the prices that they’re selling it for and estimate how many customers they have, how much they buy, and how much revenue they bring in each month.

OK – suppose we decide to go ahead. We buy the building, the equipment and furnishings, arrange for utilities, etc. These are now “sunk costs” — we’ve made the purchases and the only way we can stop payments for them is to sell out or go out of business. We’re stuck.

Suppose we’re not selling as much coffee as we expected at the prices we set? Which costs do we now have to cover in order to make it worth staying open? We need to make sure that the price of each cup of coffee pays for the ingredients, the time of someone to make and serve it, and the energy consumed by the machine – the costs directly associated with that cup of coffee. These are the marginal costs. Everything else is irrelevant — we have to pay for advertising whether we sell this one cup of coffee or not — they are sunk to the decision to price this cup of coffee. As long as the revenue we get from this cup of coffee is greater than the costs directly associated with this cup of coffee, then we should go ahead and sell it.

*Note: If we buy disposable cups and spoons, then these are marginal costs; however, if we buy durable cups and spoons, then only the cost of washing them is marginal – the durable goods are sunk costs.

Sunk costs is a very powerful concept and one we’ll come back to again and again.