Aluminum:

Demand and Equilibrium

Nemanja Antic
nemanja.antic@kellogg.northwestern.edu
What do we know?
• For its short-run production decisions, an individual plant trades
off the marginal benefit (price per ton) of producing one more
ton of aluminum against the marginal cost.
– This means that there is a direct relation between a smelter’s supply curve
and its marginal cost curve: the smelter’s short-run supply curve is its
marginal cost curve.
• The short-run market supply curve is the aggregation of the
supply curves of all the active and near-active smelters
• This means we can construct the short-run supply curve for the
industry from readily available cost data
• Next: Demand & long-run capacity management decisions
– Price forecasts in the short and long run
– Guide complex investment decisions
Real World Problem: Estimating a supply
curve from sparse data
• It’s possible to infer an industry supply curve from very little data
• Price of a long-stemmed rose is usually $0.22 with sales 2.5m/month
• In May and February, sales increase to 4.5m and 8.9m
• The price in February also goes up (to $0.55 per stem)

Month P Q (millions of 
stems)

February $0.55  8.9

May $0.22  4.5

July $0.22  2.5

Where’s the supply curve?
$0.60
S
Feb
$0.50

$0.40

P $0.30

$0.20
July May

$0.10

$0.00
0 1 2 3 4 5 6 7 8 9 10
Q (millions of stems/month)

What’s the MC? $0.22/stem!
 Recap: Short-Run Market Supply Curve for Al
S2004
2,000

1,850
• In 2004, the industry is “at the edge” of its short‐run supply curve.
• This suggests that if demand for primary aluminum grows faster 
1,600 than supply in the near term, we could have a price "fly‐up."
• This happened: between 2004 and 2006, price increased by 78%.
1,400 • Will price continue to soar? What is the likely price in the 
intermediate run (say 2010)? In the long run?
1,200
$ per ton

1,000

800

600

400 D2004
Critical for deciding: how much output to plan for, 
200
whether to expand or close plants/exit industry
0
5,000 10,000 15,000 20,000 25,000 30,000 35,000

Cumulative Capacity (thousand tons)
Demand Curve Answers the Question: What
Quantity Will be Demanded at Different Prices?
Movements along Shifts in the demand 
a given demand curve curve tell us how 
tell us how quantity quantity demanded 
demanded changes changes with respect to 
P0 with respect to P0 changes in demand drivers
changes in the  other than the good’s price 
Price ($ per unit)

good’s price (e.g, income, other prices)

P1 e.g. It is discovered 
e.g. price of gum goes that  gum cures
up by 1%, what happens  baldness!
to gum demanded.

D0 D1
D
X0 X1 X0 X2 Quantity
Quantity
(units per period) (units per period)

Why demand curve slopes down:
1. Substitution effect (opportunity cost of higher price, buy more substitutes)
2. Income effect (price up, income limited, something has to be cut)
3. Diminishing marginal utility (we all eventually get sick of even the best stuff…)
Demand Drivers

• Demand drivers are factors that shift the demand

curve, either to the right or left.
– Income/wealth
• Luxury good, income elastic. Good beer sales fell in recession.
• Inferior good, negative income elasticity. But cheap beer sales up (really
happened!).
– Price of other goods
• Substitutes, Cross price elasticity positive. Price of potato chips increase,
tortilla chip sales rise.
• Complements, Cross price elasticity negative. Price of avocados increase,
tortilla chip sales fall.
– Other reasons for demand shifts
• Usefulness of good. Super foods mania!
• # of buyers: Bears in playoffs on beer sales in Chicago (plausibility aside)
 Demand shock
S2004
1,850

Smelters
that produce
at P = $1,850
$ per ton

• Suppose no new capacity came on‐line between 
2004 and 2006 and demand grew at current rates.  D2006
What will happen to the market price by 2006?
• What is producer surplus?  Which smelters capture  D2004
the most surplus?

Cumulative Capacity (thousand tons) 29,699

 Negative demand shock
S2004
2,000

1,800

1,600

1,400

1,200
$ per ton

What happens to 
1,000
price if we hit a credit 
800
crunch and the auto 
loan market freezes 
600 up?
400 D2004

200 D2008

Cumulative Capacity (thousand tons)

 How about a supply shock?
S2004
2,000

1,800 What is the impact of a 
1,600
unilateral move by one 
firm to reduce 
1,400 production or withdraw 
capacity?
1,200
$ per ton

1,000
Not much … when the industry is on 
800
the flat part of the supply curve, 
unilateral reductions in supply have a 
D
600 small impact on price.  Why?

400

200

Cumulative Capacity (thousand tons)

 What if we are at the edge of the supply curve?
SS2004
2,000

1,800
Why would that be 
1,600 the case?
1,400

1,200
$ per ton

1,000

800

600

400 D2004

200

Cumulative Capacity (thousand tons)

 Supply shock in 1990 (with 2004 data)
S2004 S’
2,000

1,850

1,600

1,400

1,200
$ per ton

1,000

800

600
+ 3 million tons – Wait, 
400 what is MC? Does that 
matter?
200

0 5,000 10,000 15,000 20,000 25,000 30,000 35,000

Cumulative Capacity (thousand tons)
 How bad can it be?
S2004 S’
2,000

1,850
1,800

1,600

1,400

1,200
$ per ton

1,000

800
If demand is sensitive to price…
…a small drop in price suffices to clear the 
600 market

400

200

0 5,000 10,000 15,000 20,000 25,000 30,000 35,000

Cumulative Capacity (thousand tons)
 But it could be worse?
S2004 S’
2,000

1,850

1,600

1,400

1,200
$ per ton

1,000

800
But if demand is insensitive to price…
…we may get a 15% drop in price!
600

400

200

0 5,000 10,000 15,000 20,000 25,000 30,000 35,000

Cumulative Capacity (thousand tons)
Estimating a demand curve by playing
around with prices
• I’m selling packs of gum (for real U.S. currency).

• Write down your maximum price on a piece of paper.

• Stand up. Stay standing so long as you are willing to buy at the
called out price. When you no longer want to buy, sit.

• Let’s start the bidding at $0.00.

This is referred to as an English Auction.
We traced out the demand curve but what did we miss?  
Would this matter?
Playing with Pricing is Common 

Why might sports teams want to change prices weekly/daily/etc?
Price elasticity of demand: How
sensitive is demand to changes in price?
Price

Inelastic demand: Demand does not change much w. price

Elastic demand: Demand changes considerably w. price
D2
D1
Quantity
Price elasticity of demand: percentage change in quantity
demanded per one percent change in price Where are 
Inverse Slope of D curve on D curve

Q d P
Percentage change Q d
Price elasticity of demand    d
Percentage change P P Q
Price Elasticity of Demand: Example

Price
Inelastic demand: Demand does not change much w. price

$1.20
Elastic demand: Demand changes considerably w. price
$1.00
D2
D1

2 9 10
Quantity

Along D1: %ΔQ = –10%, %ΔP = +20%,

so price elasticity = –10% / 20% = –0.5
Price Elasticity of Demand: Example (2)

Price
Inelastic demand: Demand does not change much w. price

$1.20
Elastic demand: Demand changes considerably w. price
$1.00
D2
D1

2 9 10
Quantity

Along D2: %ΔQ = –80%, %ΔP = +20%,

so price elasticity = –80% / 20% = –4.0
Terminology

• In general, ∞ 0, i.e., price elasticity is negative

• If is between – 1 and ∞, we say demand is elastic

– Percentage change in demand is greater than percentage
change in price

• If is between 0 and – 1, we say demand is inelastic

– Percentage change in demand is less than percentage change
in price
About that minus sign

• Theoretically possible for demand curve to slope upward

– Empirical evidence quite limited
• Measured elasticities are almost always negative
• We often drop the minus sign and assume it
Guess the Price Elasticity of Demand
Percentage change Q d
e
Percentage change P

Random stuff Elasticities

• Eggs • -0.05
• Airline travel (1st class) • -0.10 “inelastic”

• Airline Travel • -0.30

(vacationers) • -1
• Soft drinks • -1.5 “elastic”
• Coca-Cola • -4.0
• Pediatric visits

Which product is most inelastically demanded?
Guess the Price Elasticity of Demand
Percentage change Q d
e
Percentage change P

Random stuff Elasticities

“inelastic”

• -0.30
• -1
• Soft drinks • -1.5 “elastic”
• Coca-Cola • -4.0

e higher for narrowly defined goods (more substitutes). 
Guess the Price Elasticity of Demand
Percentage change Q d
e
Percentage change P

Random stuff Elasticities

• Airline travel (1st class) “inelastic”

• Airline Travel • -0.30

(vacationers)
• -1.5 “elastic”

e higher for luxury items
Market-Level vs. Brand-Level Price Elasticity
of Demand: Examples
• Price elasticity of market • Price elasticity of demand for
demand for automobiles is on Mercedes SLS AMG’s is on the
the order of –1 and –1.5 order of –3.5 to –4.

• Price elasticity of demand for • Price elasticity of demand for

ready-to-eat breakfast cereal in individual brands, such as
the U.S. is on the order of Captain Crunch, is on the
–0.25 to –0.5. order of –2 to –4.

1. Why the difference between market‐level and brand‐level price 
elasticities of demand? 
2. Why the difference in elasticities between automobiles & breakfast 
cereals?
General Patterns in Price Elasticities

• The broader the definition of the good, the lower the price elasticity;
the narrower the definition, the more elastic the demand
• The greater the good as a fraction of the consumer’s budget, the
more elastic the demand
• Elasticity of demand is greater in long run than in short run (greater
scope for substitution)
Why Does a Business Care about the
Price Elasticity of Demand?
• If you (can) raise your price, would your revenue (P*Q) rise or fall?
• A price increase has two effects on revenue:
– Higher P means more revenue on each unit you sell.
– But you sell fewer units (lower Q).
• Which of these two effects is bigger? %  Q d
It depends on the price elasticity of demand. e
%P
• If e>1 (elastic), quantity reduction will outweigh benefit of higher price.
If e<1 (inelastic), higher price outweighs cost of lower output.
– If e=1.5  a 10% price increase means Qd falls by 15%.
Revenues fall.
– If e=0.5  a 10% price increase means Qd falls by 5%. Revenues
rise.

Raise prices on inelastic goods.  E.g. During recession, 
Starbucks raised prices $0.10 to 0.30 for specialty drinks but 
cut prices on basic drinks (for first time ever).  NYT 8/21/09.
Don’t believe me, believe this guy!

http://youtu.be/COf2bQEQ7Zw
Price & other elasticities
• So price elasticity of demand equals the
percentage change in demand per percentage
change in price: Slope of line (D curve)
% change Q d dQ d P
  d
% change P dP Q Where we are on the D curve

• But there are other demand drivers…

– Income Income elasticity of demand
– Price of substitutes/complements Cross-price
elasticity
Income elasticity of demand
• Income elasticity of demand equals the
percentage change in demand per percentage
change in income/wealth: Shift in D curve
% change Q d dQ d Y
  d
% change Y dY Q Where we are on the D curve

• Examples
– Luxury good, income elastic. Good beer sales fell in recession.
– Inferior good, negative income elasticity. But cheap beer sales
up (really happened!).
Cross-price elasticity of demand
• Cross-price elasticity of demand equals the
percentage change in demand per percentage
change in price of other good: Shift in D curve

% change Q d dQ d Pother
  d Where we are on the D curve
% change Pother dPother Q

• Examples
– Substitutes: Cross price elasticity positive. Price of digital
downloads decrease, CD sales fall. Similar: Blackberry & iPhone
– Complements: Cross price elasticity negative. Price of game
consoles increases, sales of software games fall.
Elasticities: Estimated By “Fitting” a Demand Curve to (US)
Data on Prices, Quantities and Other Demand Drivers
dQ d P
Recall: price elasticity 
dP Q d Motor vehicle
Linear demand model Price elasticity elasticity Income elasticity
P2004 = 1,764 M2004 = 11,960,000 Y2004 = 10,756
Q d t  1,408,896  341Pt  0.34M t  181Yt
Qd2004 = 6,590,000 Qd2004 = 6,590,000 Qd2004 = 6,590,000
dQd/dP = -341 dQd/dM = 0.34 dQd/dY = 181
Qt = quantity aluminum demanded in U.S. year t   
Pt = real price of aluminum in year t price elasticity motor vehicle income elasticity
of demand elasticity of demand of demand
Mt = U.S. motor vehicle production in year t 1,764 11,960,000 10,756
 341 0.34 181
Yt = U.S. real GDP in year t 6,590,000 6,590,000 6,590,000
 0.09  0.62  0.29

What are the implications 1 percent increase in 1 percent increase in 1 percent increase in
of this for the volatility real price  0.09% vehicle production  real GDP  0.29%
of the market price of drop in quantity 0.62% increase in increase in quantity
aluminum? demanded quantity demanded demanded
Price Change and Price Elasticity of
Demand • Aluminum 
Price S1 elasticity = ~0.1. 

S0 • Large increase 
in price (100%) 
results in small 
decrease (10%) 
in quantity 
demanded

• Put another 
way: to choke 
off even a small 
amount of 
D demand, 
requires a big 
D increase in price
Quantity

Big warning: With inelastic demand, price swings can be significant!!
Aluminum is experiencing these swings S2004

2,000

1,850

1,600

1,400

1,200
$ per ton

D2006
1,000

800

600

400
D2004?
200

0
5,000 10,000 15,000 20,000 25,000 30,000 35,000

Cumulative Capacity (thousand tons)
Demand Curves Can Be Estimated Through
Multiple Regression Analysis
Linear demand model
Qtd  1,408,896  341Pt  0.34M t  181Yt
Qdt = quantity of aluminum demanded in U.S. in year t
Price ($ 000 per ton) D1 D2 D3 Pt = real price of aluminum in year t
4 Mt = U.S. motor vehicle production in year t
Yt = U.S. real GDP in year t

3
D1 U.S. demand curve for aluminum, year
2004
Qd = 1,408,896 - 341P + 0.34(11,960,000) + 181(10,756)
2 Gives us: Q = 7,456,160 – 341P or P = 21,866 – 0.002933Q

D2 U.S. demand curve for aluminum, year 2004

1 if real GDP = 15,000

Qd= 1,408,986 - 341P + 0.34(11,960,000) + 181(15,000)

0
Gives us: Q = 8,225,910 – 341P or P = 24,123 – 0.002933Q
2,000 4,000 6,000 8,000

U.S. Quantity of aluminum  U.S. demand curve for aluminum, year 2004

D3
(thousands of tons per year) if motor vehicle production = 15,000,000

Qd = 1,408,986 - 341P + 0.34(15,000,000) + 181(10,756)

Gives us: Q = 8,497,437 – 341P or P = 24,919 – 0.002933Q
 Our estimated elasticities
“Quick and Dirty” Forecasts of Demand Growth
by 2010 Forecasting demand growth using the estimated elasticities
%Y %Q  %Y %Q % %Q %M %Q

1.15 =
4.1×0.28

% Q d
From Exhibit 10 e
% __
From Exhibit 11 AME Group's Demand Forecast*

*not in case
3.59 =
1.15+2.44
What is missing from our simple model?
A Few Words on Precision

• Grand Forks, ND , 1997.

Weather service predicts the
Red River will crest at 49 feet.
Levees are at 52 feet. What
could go wrong????

• A lot. River rose to 54 feet, causing billions in damage.

• Was this avoidable? Yes, the margin of error was 5 feet  35%
chance of flooding.
– No one paid attention. No extra precautions (e.g. sandbags).
Weather service afraid public would lose confidence in forecast
if they conveyed any uncertainty.
• Uncertainty is super important. Pay attention to uncertainty
(standard errors) and reasonable bounds for assumptions!

Example from Nate Silver, New York Times, 9/9/12.
 It’s of vital importance to Alcoa to understand price
dynamics…
Long-run average
price level NPV of Bakki smelter under
various long-run price scenarios

$3,250 = $13  250 thousand tons per year capacity.

$36,111 = ($3,250 / 0.09)

NPV = PV cash flow (Assume a constant cash flow
- Capital expenditures for simplicity.)
The Avocado Effect

• In the early 1970s, avocados became extremely popular, because of 
their claimed nutritional value

• Prices skyrocketed, leading a bunch of people to buy land and start 
avocado orchards.

• But it takes 7 years for a newly planted avocado tree to start 
producing...

• After 7 years, an avocado glut hit the produce market, coincident with 
a nutritionist backlash against eating fat of any kind. 

• So avocado prices crashed….
 Aluminum:
Long Run Supply

Nemanja Antic
nemanja.antic@kellogg.northwestern.edu
So far… We added demand S2004

2,000

1,850

1,600

1,400

1,200
$ per ton

D2006
1,000

800

600

400

200

0
5,000 10,000 15,000 20,000 25,000 30,000 35,000

Cumulative Capacity (thousand tons)
 Forecast for 2010
2,000 SS2004 SS2010
1,873
1,850
1,800
1,718

1,600

1,400

1,200
$ per ton

1,000

Forecast D-curve based on estimated elasticities.

800
Forecast D-curve based on AME growth forecast.

600

400
Implications for Alcoa?

200

D2010 D2010
0
0 5,000 10,000 15,000 20,000 25,000 30,000 35,000 40,000 45,000
Cumulative Capacity (thousand tons) 37,282 39,847
Short-Run versus Long-Run Supply: Theory
Adjustments in supply may take time …
• If market price goes up …
– 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), active smelters can
increase production rates and near-
active smelters can come back on
line.
– In the long run --- if price is
expected to stay up ---existing firms
can expand or build new capacity.
New firms can also build new
capacity.
• If market price goes down …
– 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), active
smelters can decrease, and some
may temporarily suspend
operations (in near-active
condition).
– In the long run --- if price is
expected to stay down ---existing
firms can put existing expansion
plans on hold. They can also
withdraw their capacity from the
market (shut down).
 Short-Run Versus Long-Run Supply: Impact of Unexpected …
but Permanent … Shock in Demand
Very Short Run:  Short Run:
24 hours after drop in demand 3 months after drop in demand
Price VSS Price SS

100 100
85
80 80

D0 D0
D1 D1

Quantity Quantity
 Short-Run Versus Long-Run Supply: Impact of Unexpected …
but Permanent … Shock in Demand
Very Short Run:  Short Run: Long Run:
24 hours after drop in demand 3 months after drop in demand 18 months after drop in demand
Price VSS Price SS Price
LS

100 100 100

90
85
80

D0 D0 D0
D1 D1 D1

Quantity Quantity Quantity

Price shock hits
What this might  long‐run  18 months later Key point: long run 
look like on  100 price path price path of 
the commodities  industry determined
90
page of the  by intersection of 
Financial Times 80 demand and long‐
run supply curve
Time
Example: SR vs. LR responses (demand
side)
• One research paper finds that a 10% permanent increase in gas
prices generate:
– a 0.22 percent increase in SR fleet fuel economy improvements.
– But a 2.04 percent increase in the LR.
– LR effect 10x bigger because there is time for consumers to
respond (e.g. switch to more fuel efficient cars, change driving
patterns).
How Do We Construct Long‐run Supply Curve 
for a Commodity Like Aluminum?
• Long‐run supply curve consists of two “pieces”:
– Piece 1: long‐run exit prices graphed against cumulative capacity of existing "blocks" of 
capacity.
– Piece 2: long‐run supply curve is "capped" by long‐run entry price of “typical” potential 
expanders of capacity or potential.

Typical simplifying assumption

• Wait! What's an exit price? What's an entry price? in practice: there is an unlimited
amount of potential new capacity,
Price ($/unit) and it has a common entry price

exit prices
of  entry price
incumbent  of new 

potential new capacity
producers capacity
incumbent firm 4
incumbent firm 3
incumbent firm 2
incumbent firm 1

Cumulative Capacity (units per year)
LR Supply Curve (in words)

• Exit Prices: Similar logic to SR supply curve...

– SR: Existing firms compare price to MC to produce.
– LR: Existing firms compare price to ATC (including opportunity
costs) to stay in business.

• With one critical difference:

– SR: Industry capacity cannot be increased.
– LR: Always possible to bring in new capacity if the price is right.
Key question: What are the relevant costs (including
opportunity costs) for an entrant? This is the Entry price
• Expected revenue: $150m
(50% cut of global sales of
$300m). Budget $100m –
includes all cost items.

• Should studio enter? What is

FR-TC?

• As filming began, $16m incl.

Costner’s guaranteed
minimum of $14m is gone.

• Few months into filming,

costs forecast to be $140m
of which $100m sunk.
(Hint: Don’t film on water)

• Then there was literal sunk

cost: part of set sank into
sea and had to be
recovered! Took 21 days.
Now forecasted costs up to
$175m, $140 sunk.
• Now costs up to $175m, $140m
• Expected revenue: $150m
sunk.
(50% cut of global sales of
• $300m).
Should Budget $100m –
studio exit?
includes all cost items.
• If •studio
Should it paysenter?
exits,studio $140m in sunk
costs.
• AsNet payoffbegan,
filming -$140m$16m incl.
Costner’s guaranteed
• minimum
If studio of $14m
continues, it getsisrevenue
gone. of
• Few
$150m and months into filming,
pays $140m in sunk costs
costs$35m
and extra forecast to be $140m
in completion costs.
of which
Net payoff 150$100m
– 140 -35sunk.
= -$25m
• Then there was literal sunk
• So it cost:
shouldpart of set- sank
continue Use TC intonot
FR-TC sea to and
makehad to be
decision!
recovered! Took 21 days.
Now costs up to $175m,
• After$140
initial sunk.
mistake in forecasting
costs, rest of decision-making
consistent with sound economic
principles. (P.S. worldwide sales were
$270m).
Building the Long-Run Supply Curve
• We can calculate the cash cost of each smelter (just add up all cost items).

• Smelters are highly specialized assets. It’s quite plausible to assume that
redeployment value is zero … which implies that the long-run exit price for a
smelter is its cash cost per unit (AVC + AFC at full capacity).

• But new capacity can be added all over the world … and cash costs and capital
expenditures vary greatly across regions!

• How do we identify a "typical entrant" for the purpose of constructing the long-
run supply curve?
Determining the Exit Price is a Breakeven Calculation
stay in and
produce at full capacity
(P - $1,427)  41,000
Alcan’s Saramentha B in Brazil
Capacity: 41,000 tpy
ATC at full capacity: $1,427/ton
shut down the plant Scrap value, S

• Verbally: Find the market price, Pexit , so that present value of cash flows from keeping the 
smelter in operation equals the scrap value, S

• Mathematically: ( Pexit  1,427)  41,000 (assume 8 % cost of capital)

S
0.08
0.08S annualized redeployment value
 Pexit  1,427  ,
41,000

• To simplify, let’s assume S = 0. Thus, in this case,  exit price = ATC = $1,427/ton. The exit price 

for Saramentha B is $1,427/ton
• Each smelter has its own exit price  
 Determining the Entry Price is Also a Breakeven 
Calculation
enter and
(P - $1,537)  300,000
produce at full capacity
– annualized entry costs
Typical new state-of-the-art smelter
Capacity: 300,000 tpy (case, p. 5)
ATC = $1,537/ton (North America)
Cap-Ex = $1 billion (case, p. 5) Do not enter 0

• Verbally: Find the market price, Penter , so that present value of cash flows from operating the new 
smelter equals the upfront cost of building the smelter

$ ∗ ,
• Mathematically:  $1 0
%
%∗$
• Annualized CapX per ton =  $333
,
• FR‐ATC = $1537 + $333 = $1870 = Penter
• The entry price for a typical new smelter in North America is thus $1870 per ton.
• Entry price lower for some other locations, but probably wouldn’t remain so if significant entry 
occurred.
Long-Run Supply Curve, 2010
2,500

2,000

1,870

ATC Exit prices
1,500
$ per ton

1,000

500

-
0 5000 10000 15000 20000 25000 30000 35000 40000 45000
Cumulative capacity (tons per year)
Long-Run Supply Curve, 2010
2,500

What does this “tail” tell us?

2,000

1,870

ATC Exit prices
1,500
FR‐ATC 
$ per ton

entry
price
1,000

500

-
0 5000 10000 15000 20000 25000 30000 35000 40000 45000
Cumulative capacity (tons per year)
Long-Run Supply Curve, 2010
2,500

2,000

1,870

ATC Exit prices
1,500
FR‐ATC 
$ per ton

entry
price
1,000

500

-
0 5000 10000 15000 20000 25000 30000 35000 40000 45000
Cumulative capacity (tons per year)
Long-Run Supply Curve
2,500

2,000

1,870

ATC Exit prices
1,500
FR‐ATC 
$ per ton

entry
price
1,000

500

D0 D1 D2
-
0 5000 10000 15000 20000 25000 30000 35000 40000 45000
Cumulative capacity (tons per year)
Shrinking Demand
• The industry is going to shrink by x% because demand is drying
up for the product.

• What are the Exit Prices of the bottom tail of businesses

currently operating? This will determine prices I can expect in
future

58
Increasing Demand

• The industry is going to grow by x%.

• What is the Entry Price of the lowest cost expected entrants?

This will determine prices I can expect in future.

• Basic idea: Cost Information can be used to forecast prices.

60
Recent Aluminum Prices
Case
3000

2500

2000

1500

1000
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

LME, Aluminum 99.7% purity
These Are Vital Questions for Alcoa
NPV of Bakki smelter under
various long-run price scenarios

Also: NPV assumes
payments start right
Entry price=$1,870 Away.  5 years to 
build…when do you
PV of cash flow assumes a constant cash flow for simplicity.
NPV=PV cash flow - Capex pay the $1billion?
 Stuck in a hard place
• Don’t want to be
stuck between FR-
($) ATC and ATC.
Market price range Doesn’t make
sense to exit but
wish had not
entered.
• Can take a long
entry time in some
price FR-ATC industries.
exit
Sometimes
ATC requires
price
equipment to wear
short-
run out (and thus
supply
MC = AVC “entry” decision to
price reinvest in
business).

Volume of production capacity

What actually happened?
• Bakki scrapped in 2011!
http://www.reuters.com/article/2011/10/17/alcoa-iceland-smelter-idUSL5E7LH3MR20111017

• Long-run price right on edge of economic profitability based on old

cost estimate but…

• "At this time, we are unable to acquire the amount of power we

need at a competitive price, in order to consider building a smelter
in Bakki.“

• DOA.
Or maybe it was the hidden people…
“Alcoa, the biggest aluminum company in the country, encountered 
two problems peculiar to Iceland when, in 2004, it set about 
erecting its giant smelting plant. The first was the so‐called  hidden 
people—or, to put it more plainly, elves—in whom some large 
number of Icelanders, steeped long and thoroughly in their rich 
folkloric culture, sincerely believe. Before Alcoa could build its 
smelter it had to defer to a government expert to scour the 
enclosed plant site and certify that no elves were on or under it.  It 
was a delicate corporate situation, an Alcoa spokesman told me, 
because they had to pay hard cash to declare the site elf‐free, but, 
as he put it, “we couldn’t as a company be in a position of 
acknowledging the existence of hidden people.” 
The other, more serious problem was the Icelandic male: he took 
more safety risks than aluminum workers in other nations did.  “In 
manufacturing,” says the Alcoa spokesman, “you want people who 
follow the rules and fall in line. You don’t want them to be heroes. 
You don’t want them to try to fix something it’s not their job to fix, 
because they might blow up the place.” The Icelandic male had a 
propensity to try to fix something it wasn’t his job to fix.”

http://cdixon.org/2011/12/22/michael-lewis-boomerang/
 Example: oil rigs in the 1980s
Market
Price 1. Price rises as industry moves to new short‐run  equilibrium
2. Price falls as rig fleet expands (“births”)
3. Price falls as industry moves to new short‐run equilibrium
1 2 4. Price rises as rigs exit industry (“suicides”)
5. Price rises slowly as old rigs wear out and are not replaced
(“death by old age”).  Busts can last a long time!
entry
price

3 5
exit
price
4

1979 1985 1986 1988 or thereabouts 1993

Unexpected positive  Unexpected negative 
demand shock occurs:  demand shock occurs: 
D curve shifts rightward D curve shifts leftward
Back
 Bad Entry Decisions

• Mr. Albanese made one such bad bet in 2011 when Rio Tinto bought 
Riversdale Mining Ltd. for $3.7 billion, enticed by the Sydney based 
company's coking coal operations in Africa….

• At the time, coking was fetching a relatively rich $290 a ton. Today the 
figure is $165.

Source: WSJ, Jan 17, 2013
Cost Concepts: Summary  • ATC = all‐in cost 
per unit plus any 
($/ton)
annualized 
redeployment value

• FR‐ATC = all‐in 
cost per unit plus 
annual capital 
entry charge
price FR-ATC
exit ATC • Exit price =     
price minimum
MC = AVC level of ATC

• Entry price = 
minimum
capacity level of FR‐ATC
Volume of production
(tons per week) of smelter
Back to Life Insurance
• Consider all life insurance contracts on sale in California
– e.g., healthy 35-year-old male, $500k contract with 20 year term
– There are 56 such contracts on sale – competition is high
• Insurers work off roughly the same actuarial tables which report data
such as the conditional probability of death for 35-year-old males for
the next 20 years (rounded to two decimal points):

• At the end of the contract, after receiving all payments due to them
on time and paying out the insured amount to anyone who died, how
much profit do insurers stand to make?
 Calculating Actuarially Fair Premiums
• Key component of costs here is payment to insuree. For example, the expected
payment in year 20 is:
$500,000 × 0.002741 = $1370.
• You would expect competition to drive prices to this level so companies make zero
profits. This logic implies premiums of:

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10
$110 $160 $195 $215 $230 $255 $289 $339 $399 $468
Year 11 Year 12 Year 13 Year 14 Year 15 Year 16 Year 17 Year 18 Year 19 Year 20
$542 $621 $700 $778 $861 $948 $1050 $1151 $1261 $1370
• But actual premiums for one company are:
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10
$255 $255 $255 $255 $255 $255 $255 $255 $255 $255
Year 11 Year 12 Year 13 Year 14 Year 15 Year 16 Year 17 Year 18 Year 19 Year 20
$255 $255 $255 $255 $255 $255 $255 $255 $255 $255
• Notice that initial payments are higher that actuarially fair premiums but then they
are lower. What does this mean for NPV?
 Life Insurance Policies in Detail
Actuarial Profits if Policy Lapses in Year X
2000

1500

1000

500

0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

‐500

‐1000

‐1500

‐2000

‐2500

‐3000

Gottlieb and Smetters (2015) Lapse‐Based Insurance
Explaining the Puzzle
• Q: Why are the actual premiums so different from the
actuarially fair prices?

• Fact: Every year about 4% of insurees let their policies

lapse because of an income shock, medical or other
expenses etc. But they do not anticipate this event when
they buy insurance. How does this affect premiums?
Life Settlement Industry and Value…
• The life settlement industry is very small but players buy
policies at a discount, pay the premiums and collect when
policy holder dies. E.g. Purchase a $1 million policy held by
an 82-year-old woman for $200,000. Actuarial tables say she
has five years to live….
• Q: Suppose insurees do not lapse or incorporate risk of
lapsing into their purchase decision. Does the life settlement
market add value for consumers, insurance companies and
settlement companies?
• Q: Suppose insurees lapse but do NOT incorporate risk of
lapsing into their purchase decision. Does the life settlement
market add value for consumers, insurance companies and
settlement companies?
• State Farm wants government to regulate life settlement out
of existence. What arguments can they make?
Main Points: Equilibrium and Long-run
• You’ve learned a general framework – supply and demand analysis – that
can be used to develop hypotheses about market price movements in
perfectly competitive industries.

• Demand curves are more just theoretical concepts. They can be estimated
with publicly available data.

• Combining the estimated (short-run) demand curve with an estimated

(short-run) supply curve, we can develop quantitative hypotheses about the
market price in the short run and the intermediate run.

• Long-run supply curves can be constructed with data on cash costs and
capacities and can be used to develop quantitative hypotheses about long-
run price trends in a perfectly competitive industry.

• In the last two weeks you have learned tools that are actually used in
practice by large global companies (and their consultants) to make high-
stakes capacity management decisions.