Luke Froeb ; 5 Nov, 2010.
CH 8 Script
OUTLINE
1.
2.
3.
4.
Intro
Explanation
Prediction
Examples
INTRO:
This is Luke Froeb at Vanderbilt University. I am the author, along with Brian McCann, of the
textbook “Managerial Economics: A Problem Solving Approach.” This lecture is designed to
supplement Chapter 8, “Industry Analysis.”
In 2009, the US government offered consumers a subsidy for trading in their high-mileage
used cars for low-mileage new ones. To qualify for the subsidy, new car dealers were required
to pour silicone into the engines of the used cars, guaranteeing that they would be destroyed
or sold only as scrap.
Although the Cash for Clunkers program might seem like a good idea to someone thinking
about buying a new car--you give up your old car and get paid $3000 if you buy a new one-the actual effects of the program were more complex. Cash for clunkers drove up the price of
used cars, raising the opportunity cost of trading in your used car, in addition to driving up the
price of new cars, raising the price that you pay. Together, these two factors change the
economics of the program, and a saavy consumer would consider them before deciding to
take advantage of it.
The purpose of this chapter is to show you how to predict changes like this by analyzing
industry or market level changes. This analysis is particularly useful for firms whose fortunes
are tied closely to the fortunes of the industry in which they compete.
SUPPLY CURVES & INDUSTRY ANALYSIS
Price determination at the industry level differs from the MR=MC pricing that we studied in
Chapter 6. There we studied pricing by a single seller facing a group of buyers whose behavior
was characterized by a demand curve. In this chapter, we consider price determination at the
industry or market level with a group of sellers competing to sell and a group of buyers
competing to buy. The supply curve describes the behavior of the sellers.
Luke Froeb ; 5 Nov, 2010.
Be careful to NOT use demand and supply analysis to say something about individual product
pricing for a product like an iPad. Rather this analysis applies at the industry level, to the
industry of mobile reading tablets.
<<GRAPHIC ABOUT THIS APPLYING AT THE INDUSTRY, BUT NOT THE FIRM LEVEL>>
If you want to analyze an industry, you obviously have some question you want to answer, like
“what is the effect of the cash for clunkers program.” The question leads naturally to a market
definition that focuses your analysis on a particular product, in a particular place, and during a
particular time period. To analyze the cash for clunkers program, we will analyze new and
used cars, sold in the United States, during a month.
In chapter 5, when we constructed a demand curve, we imagined that each consumer wanted
to buy one unit of the good. We arranged them by their values, and then figured out how
many would purchase by finding the consumers with values at least as big as the price. In
Table one, we construct a demand curve for 9 buyers with values={$9, $8, $7, …, $1}
<<GRAPHIC HIGHLIGHTING THE RELEVANT DEMAND COLUMN OF THE SPREAD SHEET, and
then a GRAPHIC OF AN EXCEL SPREAD SHEET SHOWING DEMAND >>
Luke Froeb ; 5 Nov, 2010.
Price
Demand
$9
1
$8
2
$7
3
$6
4
$5
5
$4
6
$3
7
$2
8
$1
9
3
4
5
6
7
8
9
$7
$6
$5
$10
$4
$9
$3
$8
$2
$7
$1
Demand
$6
$5
Demand
$4
$3
$2
$1
$0
0
2
4
6
8
10
We can construct a supply curve in much the same way. But instead of arranging buyers by
their values, we arrange sellers by their costs, i.e. by what they are willing to sell for. At a
given price, every seller with costs less than the price is willing to sell, which gives us a supply
curve. In Table 1, we construct a supply curve for 9 sellers with costs={$1, $2, $3, …, $9} . We
see that there are more sellers willing to sell at higher prices, than there are at lower prices—
exactly the opposite of a demand curve.
<<NOTE: DAVID, In the GRAPH BELOW, DEMAND AND SUPPLY ARE PUT ON THE WRONG
AXES—CAN YOU FIX THIS? (DEMAND IS DOWNWARD SLOPING, SUPPLY UPWARD SLOPING>>
Luke Froeb ; 5 Nov, 2010.
Price
Demand Supply
$9
1
$8
2
$7
3
$6
4
$5
5
$4
6
$3
7
$2
8
$1
9
3
4
5
6
7
8
9
9
8
7
6
5
4
3
2
1
$7
$6
$10
$5
$4 $8
$3
$2 $6
$1 $4
$3
$4
$5
$6
$7
$8
$9
Demand
Supply
$2
$0
0
2
4
6
8
10
<<GRAPHIC HIGHLIGHTING THE RELEVANT SUPPLY COLUMN OF THE SPREAD SHEET>>
<<IN THE TEXT THAT FOLLOWS, CAN YOU HIGHLIGHT THE CELLS IN THE TABLE THAT
CORRESPOND TO THE FIGURES AS I SAY THEM.>>
To figure out how price is set in a market, we try to find prices with equal numbers of buyers
who want to buy, and sellers who want to sell. Lets start by looking at a price of $8. At this
price, we see that there are only two buyers willing to pay $8, but eight sellers willing to sell at
this price. Competition among the sellers to to sell would tend to push price down. In this
case we say that “excess demand” pushes price down.
<<GRAPHIC OF DEMAND AND SUPPLY CURVE SHOWING THE EXCESS SUPPPLY AT A PRICE OF
OF $8, AND AN ARROW PUSHING PRICE DOWN TO $5 WHERE EXCESS DEMAND DISAPPEARS>>
Luke Froeb ; 5 Nov, 2010.
At a price of $5, we see that there are equal numbers of buyers and sellers. In this case we say
that the market is in “equilibrium.” Five buyers get to buy, and five sellers get to sell. The low
value buyers and the high cost sellers are priced out of the market.
If something were to decrease demand, like a fall in income or uncertainty about the future,
then the equilibrium price and quantity would fall as well. In the spread sheet below, we see
that the new equilibrium price falls to $4—at this price the quantity supplied equals the
quantity demanded, i.e., four. So a decrease in demand leads to lower price and a lower
quantity.
<<GRAPHIC OF A DECLINE IN DEMAND LEADING TO A DECLINE IN PRICE AND IN QUANTITY>>
Price
$9
$8
$7
$6
$5
$4
$3
$2
$1
Demand Supply
1
2
3
4
5
6
7
8
9
9
8
7
6
5
4
3
2
1
New Demand
0
0
1
2
3
4
5
6
7
Luke Froeb ; 5 Nov, 2010.
Demand
Supply
New Demand
$10
$9
$1
$7
$9
$8
$2
$6
$3
$5
$8 $7
$6
$4
$4
$7
$5
$5
$3
$6
$2
$6 $4
$3
$7
$1
$5
$2
$8
$0
$9
$4 $1
Demand
Supply
New Demand
$3
$2
$1
$0
0
2
4
6
8
10
In some markets, the adjustment to a new equilibrium would occur very quickly, but in others
the adjustment would take a long time. We can illustrate the process of adjustment by looking
at the real estate market in the United States. In figure 2 below, we plot the “months of
supply” of houses for sale by dividing the number of houses for sale by how many are sold
each month. For example, if there are 5 million houses for sale, and in one month, one million
houses are sold, we say that there is a five month supply of houses on the market. The
months of supply is plotted in blue and measured on the left axis.
From 2002-2005, we see that there was about 4 months of supply of housing on the market
which corresponded to about a 8-10% annual increase in price. The change in price is
measured on the right axis and is plotted in black.
The lines cross at about a six month supply of housing, which indicates that this is the
“normal” supply of houses on the market.
In 2006, demand began to decrease for houses, and this lead to an increase in the months of
supply, and this eventually lead to a price decrease. By Jan, 2009, there was a ten month
supply of houses on the market, and decline in price of about 20%. Recently the supply has
climbed to about 12 months, which should keep downward pressure on price.
Luke Froeb ; 5 Nov, 2010.
Note that housing has a very slow price adjustment, because people are reluctant to sell their
houses at a loss—even though the price has declined, people hang on to houses they would
otherwise sell.
CASH FOR CLUNKERS:
We now have the tools to allow us to analyze the effect of the “Cash for Clunkers” program. In
the graph below, we see that the program caused new car sales to increase in July and August,
but the sales dropped in September when the program ended. By looking at the graph, we
can imagine that the program served mainly to “accelerate” sales that would have occurred in
September to August. But once September rolled around, demand dropped precipitously.
The net effect of the program was almost nil.
<<MOVING GRAPHIC OF THE CASH FOR CLUNKERS PROGRAM>>
Luke Froeb ; 5 Nov, 2010.
To “explain” this movement in quantity, we could imagine that demand increased in August,
but declined in September, below what it ordinarily would have been, and then recovered to
its “normal” level in September. The demand increase would have caused an increase in price,
as well as an increase in quantity, while the September decrease would have reversed those
gains.
<<INSERT GRAPHIC OF DEMAND AND SUPPLY CUREVE SHOWING DEMAND INCREASING (Oct is
the same as June, so JuneAugOctSept, THEN DECREASING BELOW WHERE IT WAS
BEFORE, AND THEN RETURNING TO NORMAL to explain these price movements. It would be
interesting if you could make the demand and supply curve movement correspond to the
movements in the graph above.>>
Luke Froeb ; 5 Nov, 2010.
Quantity Aug. Dem.Supply
Oct. Dem. Sept. Dem.
1
$9
$1
$5
$7
2
$8
$2
$4
$6
3
$7
$3
$3
$5
4
$6
$4
$2
$4
5
$5
$5
$1
$3
6
$4
$6
$0
$2
7
$3
$7
$1
8
$2
$8
$0
9
$1
$9
Aug. Dem.
Supply
Oct. Dem.
Sept. Dem.
In the used car market, the destruction of over five million used cars decreased the supply of
high-mileage used cars: and increased prices: Used Cadillac Escalades were almost 36% more;
Chevy Suburbans jumped 34% in price; Dodge Grand Caravans saw a 34% increase; BMW X5
were 33% higher; and an Acura MDX will run you 29% more.
<<MOVING GRAPHIC of the different cars with different PRICES WITH ARROWS GOING UP THE
SIZE OF THE PRICE INCRESASE?>>
Luke Froeb ; 5 Nov, 2010.
Quantity Demand Supply
New Supply
1
$9
$1
$6
2
$8
$2
$7
3
$7
$3
$8
4
$6
$4
$9
5
$5
$5
$10
6
$4
$6
$11
7
$3
$7
$12
8
$2
$8
$13
9
$1
$9
$14
Demand
Supply
New Supply
The obvious explanation for these changes is a decrease in the supply curve caused.
<<GRAPHIC WITH A DECLINE IN THE SUPPLY CURVE OF USED CARS>>
Those of you who are paying close attention might also realize that new and used cars are
substitutes, and if the government offered a subsidy to buy a new car, it might make some
people choose to buy new rather than used. This decline in demand for used cars must have
been much smaller than the decline in supply because the net effect of the program was to
raise the price.
<<INSERT GRAPHIC OF BIG DECREASE IN SUPPLY AND A SMALL INCREASE IN DEMAND
SHOWING THE NET EFFECT IS TINY>>.
Luke Froeb ; 5 Nov, 2010.
Demand Supply
New Supply
New Demand
$9
$1
$6
$8
$8
$2
$7
$7
$7
$3
$8
$6
$6
$4
$9
$5
$5
$5
$10
$4
$4
$6
$11
$3
$3
$7
$12
$2
$2
$8
$13
$1
$1
$9
$14
$0
Demand
Supply
New Supply
New Demand
CONCLUSION:
I want you to be able to do two things after reading this chapter.
1. predict changes at the industry level using demand and supply analysis, and
2. how to explain changes in prices and quantities using demand and supply analysis.
Demand and supply analysis has become part of the business vernacular, and more than any
of the other tools presented in this class, it will help you in your interview questions. For
example,
1. if your interviewer asks you how the Federal Reserve’s policy of quantitative easing is
going to affect interest rates, I want you to immediately be able to say “the increase
in supply of long term loans should lower the price of borrowing, as measured by
long term interest rates.”
Luke Froeb ; 5 Nov, 2010.
Quantity Demand for
Supply
Loansof Loans
New Supply of Loans
1
$9
$6
$1
2
$8
$7
$2
3
$7
$8
$3
4
$6
$9
$4
5
$5
$10
$5
6
$4
$11
$6
7
$3
$12
$7
8
$2
$13
$8
9
$1
$14
$9
Demand for Loans
Supply of Loans
New Supply of Loans
2. If an interviewer asks you to tell him why the price of smart phones has come down
in the last two years while the quantity has gone up, I want you to immediately be
able to say “the only thing that could explain such a move is an increase in the
supply, likely caused by the reduction in the cost of making smart phones.”
Luke Froeb ; 5 Nov, 2010.
Demand Supply
New Supply
$9
$1
$6
$8
$2
$7
$7
$3
$8
$6
$4
$9
$5
$5
$10
$4
$6
$11
$3
$7
$12
$2
$8
$13
$1
$9
$14
Demand
Supply
New Supp
#REF!
CHAPTER 9: RELATIONSHIPS BETWEEN INDUSTRIES: THE FORCES MOVING US
TOWARDS LONG-RUN EQUILIBRIUM
Opening anecdote
Competitive Industries
The Indifference Principle
Monopoly
Summary & Homework Problems
Luke Froeb ; 5 Nov, 2010.