Producer & Consumer Decisions
Executive MBA 512
Session #5
Presented by
Brian Greber
October 19, 2012
5-1
INTRODUCTION TO
INSTRUCTOR
Brian Greber, Ph.D.
B.S. Forestry (WVU)
M.S. (WVU), Ph.D.(VT) Resource Economics
19 years industry/executive experience (most recently VP
Marketing & Technology in a Fortune 100 Forest
Products Firm)
16 years teaching, research, policy experience at
universities (VT, OSU, BSU)
Lots of public policy work at the state & federal levels
Senior Economist/Director at ECONorthwest
Live in Boise – avid fitness buff and enjoy most things
outdoors
Active with not-for-profits (Pres. The Arc Board)
Motorcycle safety instructor
5-2
Today’s Objectives
• Enable a structured approach to thinking through consumer, supplier,
and competitor reactions to changing events and how that can/should
influence your enterprise’s decisions.
• Focus on demand as a reflection of the value that consumers place
on products and supply as a reflection of costs of providing those
products.
• Practical application of demand and costs analysis to make wise
production and marketing decisions in the immediate, short-run, and
long-run scenarios.
• Understand common sources of data for demand and supply analyses.
5-3
The Book
• Chosen to get you to think about economic models; not a political
statement
• I like it because it makes people think beyond the rhetoric that
normally is in text books.
• The discussion of market failures is critical to discussions of
economics and economic policy.
• Most of my discussion will be the conventional view but the antitext should broaden your views.
5-4
Today’s Agenda
• Establish a framework for economic thinking.
• Use economic logic to think through consumer decision making.
• Use economic logic to think through producer/supplier decision
making.
• Extend the logic of individual decisions to a rational model of the
market.
• Provide guidance on how to conduct applied market analysis.
5-4
Business Research
An A?
5-6
Economic Thinking
• Economics is the study of choice
• It focuses on how rationale choices are made.
• There tends to be a particular focus on consumer and producer
choices within a market context (that is where exchange is
facilitated with a common currency)
• Two principle fields in legacy thinking
• Micro-economics – focused on individual firms, consumers, and
product markets.
• Macro-economics – focused on the aggregate performance of
economic systems.
5-7
Keys to Economic Thinking
1.
Scarcity
• Forces choice
• Creates value
2. Thinking “on the margin”
• Leave nothing on the table
• Do not sub-optimize
3. Recognizing opportunity cost as a real cost
• Scarcity forces sacrifices
4. Purposeful behavior
• Rationale and self interested individuals
• Firms pursue profits
• Individuals pursue “utility” – OK, happiness!
5-8
Economic Models
1.
Predictive
• Based on conditioning assumptions
• Destined to be wrong (a correct one is a lucky one)
• Extrapolative/inferential
• Best use is sensitivity analysis.
2. Paradigm
• A logical model to discuss cause and effects
• Provides a common frame of reference
We will be focusing principally on Paradigms – models for explaining behavior and
thinking through consequences of actions (or inaction!).
5-9
Law of Demand
• Other things equal, as price falls quantity demanded rises
• Corollary: as quantities consumed increase, marginal
value declines.
WHY?
5-10
Demand to an Economist
• The marginal value that consumers place on the next increment of
consumption, thus
• To put “marginal value” in context, think about “for each
dollar/penny I lower price what new purchases do I entice consumers
to make” – the incremental quantity sold at this lower price reflects the
vale that was placed on that and only that increment (the rest of the
volume clearly was valued higher.
• Amount consumers willing and able to purchase at a given price
• The value reflects the “maximum willingness to pay” for each
additional unit of volume (see above)
• Yields a Schedule or curve – quantitative, not ethereal
• Individual vs Market
5-11
Individual Demand
Of Course: D=MB
P
6
P
$5
Qd
10
4
20
3
35
2
55
1
80
Price (per bushel)
5
4
3
2
D2
1
D3
0
2
4
6
8
10 12
14 16 18
Quantity Demanded (bushels per week)
D1
Q
5-12
Individual Demand
P
Change in Demand
6
P
$5
Qd
10
4
20
3
35
2
55
1
80
Price (per bushel)
5
Change in Quantity
Demanded
4
3
2
D2
1
D3
0
2
4
6
8
10 12
14 16 18
Quantity Demanded (bushels per week)
D1
Q
5-13
A Graphical Nuance
• Typical economic supply and demand graphs have 2
dependent variables – P + Q
• This is not your typical graph where the horizontal axis
refelcts an “independent” variable and the vertical axis
reflects a “dependent” variable, i.e., a “cause and effect”
relationship.
• P+Q are both “effects” behavior
5-14
Market vs Individual Demand?
• We start with discussing the decision-making of the
individual consumer.
• This establishes the behavioral paradigm
• In reality, the range of choices for an individual are pretty
narrow/lumpy (e.g., cars, houses, or bags of oranges!).
• Focus becomes “market demand”
• the collective demand of all consumers for a product or
service.
• We infer this from historic price/consumption behavior
5-15
What causes demand to shift?
•
•
•
•
•
•
Number of buyers
Income
Price/quality/value of substitutes
Price/quality/value of complements
Price of unrelated goods (?)
Taste
• Drives satiation
• Impacts perceptions of opportunity cost
Remember Demand is all about the Consumer: what value do
they see in the product/service.
How can your business/industry influence demand?
5-16
Oct 8 article on Auto sales
What factors were listed as reasons for recent
upticks in auto sales/demand?
• Which cause demand to shift?
• Which cause “movement along the demand
curve?”
5-17
Shape/slope of demand
• Note, the shape is measuring the responsiveness of perceived
value to changes in quantity consumed
• Inversely, the shape reflects the responsiveness of quantity to
changes in price
• What economists call “price elasticity” of demand
EdX =
Percentage Change in Quantity
Demanded of Product X
Percentage Change in Price
of Product X
5-18
Price Elasticity of Demand
Extreme cases
Examples?
• Perfectly inelastic demand
• Perfectly elastic demand
• Unitary Elasticity
p
D
p
p
D
D
Q
Q
Q
5-19
What influences slope of demand
• Substitutability
• More substitutes, more elastic demand
• Proportion of income
• Price relative to income
• Luxuries versus necessities
• Luxuries are more elastic
• Time
• More elastic in the long run
5-20
Sample Elasticities
See also:
http://www.ers.usda.gov/data-products/commodity-and-food-elasticities.aspx
5-21
Cross price elasticity of demand
EdXY =
Percentage Change in Quantity
Demanded of Product X
Percentage Change in Price
of Product Y
• Elasticity > 0, substitutes
• Elastciity < 0, complements
5-22
2011 study by American Public
Transportation Asoc.
• How would you characterize the elasticty of demand for
gasoline for commuters?
• How different were the short run and long run elasticities?
• What would account for this difference?
• Using gasoline price was a proxy for the price of self
commute, how would you characterize the cross elasticty of
demand for mass transit?
• How did this vary with time?
• How did it vary with gasoline price?
5-23
• .
5-24
Estimating Demand – a bootstrap
approach
• Warning: do not simply regress Q = f(P)
• Why not?
• You can roughly approximate a demand curve for your
industry by using current quantity and price and published
elasticities:
5-25
Estimating Demand – a bootstrap
approach
5-26
Key take away: Demand
• Consumer demand reflects perceived value
• Demand shifters are those things that influence
perceived value
• Price is not a demand shifter; demand shifters are
“independent” variables, P+Q are both dependent variables.
5-27
Law of Supply
• Other things equal, as price rises the quantity supplied rises
• Corollary: as quantities produced increase, incremental
production cost per unit rise.
WHY?
5-28
Supply to an Economist
• The marginal cost of producing the next unit of output
• Assume supplier will supply as long as the price is sufficient
to cover that incremental cost, thus
• Amount suppliers are willing and able to supply at a given
price
• Other things equal
• Yields a Schedule or curve – quantitative
• Individual vs
• Market
5-29
Individual Supply
Let’s talk opportunity cost.
Example f – soccer balls vs
volley balls – incremental
cost of producing volleyballs
must recognize what?
P
6
S1
P
$5
Qs
60
4
50
3
35
2
20
1
5
Price (per bushel)
5
4
3
2
1
0
10
20
30
40
50
60
70
Quantity Supplied (bushels per week)
Q
5-30
Individual Supply
P
6
S3
S1
P
$5
Qs
60
4
50
3
35
2
20
1
5
Price (per bushel)
5
S2
4
3
2
1
0
10
20
30
40
50
60
70
Quantity Supplied (bushels per week)
Q
5-31
Individual Supply
P
6
P
$5
Qs
60
4
50
3
35
2
20
1
5
Price (per bushel)
5
S3
S1
Change in Quantity
Supplied
S2
4
3
2
Change in Supply
1
0
10
20
30
40
50
60
70
Quantity Supplied (bushels per week)
Q
5-32
Market vs Individual Supply?
• In contrast to individual consumers, it is often important to
understand the economic supplies of individual firms:
• Your firm
• Concentrated Industries
• From a price and market perspective the focus becomes
“market supply”
• the collective supply of all firms.
• We infer this from historic price/production behavior
5-29
What causes supply to shift?
• Number of sellers
• Anything that shifts marginal costs:
• Resource prices
• Technology
• Taxes and subsidies
• Prices of other goods (opportunity costs)
• Producer expectations
5-34
Shape/slope of supply
• Note, the shape is measuring the responsiveness of cost to
changes in quantity supplied
• Inversely, the shape reflects the responsiveness of quantity
supplied to changes in price
• What economists call “price elasticity” of demand
EsX=
Percentage Change in Quantity
Supplied of Product X
Percentage Change in Price
of Product X
5-35
Price Elasticity of Supply
Extreme cases
Examples?
• Perfectly inelastic supply
• Perfectly elastic supply
• Unitary Elasticity
p
S
p
p
S
Q
Q
S
Q
5-36
What influences slope of supply
• Shape of curve for inputs
• Diminishing returns
• Time
• Market period
• Perfectly inelastic supply
• Short run
• Fixed plant size
• Long run
• Adjustable plant size
• Supply more elastic
• More elastic in the long run
5-37
January 2012 Article on End of
Elastic Oil
• How did they characterize the overall elasticity of supply for
oil?
• How did they say it differed between the OPEC countries
and the US? Why
• Is the elasticity of oil greater in the long run or the short
run? Why?
• Did the article contend that the short-run elasticty of
supply is getting “more or less” elastic through time?
Why?
• Dies this contradict the preceding point?
• Diminishing returns
• Time
5-38
• Market period
Cross Price elasticity of supply
• Elasticity > 0, production complements ….. Examples?
• Elasticity < 0, production competitors …. Examples?
EsXY=
Percentage Change in Quantity
Supplied of Product X
Percentage Change in Price
of Product Y
5-39
Law of Diminishing Returns
• Fixed technology
• Add variable resource
to fixed resource
• Marginal product will
decline
• Beyond some point
• The faster the rate
of decline, the
steeper the marginal
cost/supply curve
They Need a Heavier Donkey...
5-40
Law of Diminishing Returns
(1)
Units of the
Variable Resource
(Labor)
0
1
2
3
4
5
6
7
8
(2)
Total Product
(TP)
0
10
25
45
60
70
75
75
70
]
]
]
]
]
]
]
]
(3)
Marginal Product
(MP),
Change in (2)/
Change in (1)
10
15
20
15
10
5
0
-5
Increasing
Marginal
Returns
Diminishing
Marginal
Returns
Negative
Marginal
Returns
(3)
Average
Product
(AP),
(2)/(1)
10.00
12.50
15.00
15.00
14.00
12.50
10.71
8.75
5-41
Total Product, TP
Law of Diminishing Returns
30
20
10
0
Marginal Product, MP
TP
20
1
2
3
Increasing
Marginal
Returns
4
5
6
7
8
9
Negative
Marginal
Returns
Diminishing
Marginal
Returns
10
AP
1
2
3
4
5
6
7
8
MP
9
5-42
Graphical Relationships
Average Product and
Marginal Product
Production Curves
AP
MP
Quantity of Labor
AVC
Cost (Dollars)
MC
Cost Curves
Quantity of Output
5-43
• .
5-44
Costs and decisions
• Average fixed cost
• Understand effect of scale on “leveraging” costs
• Average variable cost
• Key controllable cost on a day-to-day basis; key to shut down
economics
• Produce as long as P > AVC
• Average total cost
• Standard for “cost accounting”
• Marginal cost = Supply
• Key to determining profit maximizing output levels
• Competitive firm Produce to where P=MC
5-45
Estimating Supply – a cost curve
approach
• Use an engineering build up, treating each increment of
supply available in the market as a “marginal supply”
• This may be turning a plant on or off, opening /closing a
new supply reserve, etc.
• Examples from the web:
http://www.mckinseyquarterly.com/Strategy/Strategic_Thinki
ng/Enduring_ideas_The_industry_cost_curve_2343
http://www.minecost.com/curves.htm
5-46
Articles posted
• “GM Plant makes Volt Electric Car More Efficient?”
• Which way is the supply function shifting?
• What are the reasons for this supply shift?
• What would be the economic explanation?
• When the second shift is added, what does the ability to
spread fixed costs over more units of production mean for
the supply function?
• “P&G Cuts Jobs”
• What costs did P&G cut?
• Would these be components of MC? AVC? AFC?
• Does this change sort-run supply?
5-47
Key take away: Supply
• Supply reflects the marginal cost of production
• Any market or policy changes that influence marginal
costs will shift supply.
5-48
Putting D&S together
What happens if
you instill quotas,
price ceilings, or
floors?
5-49
Key take away: Market Equilibrium
•
•
•
•
The meeting of the minds that balances price and quantity
Avoids surplus and shortage
Uses price for Rationing
Leads to Efficient allocation
• Productive efficiency
• Allocative efficiency among consumers and producers
5-50
July 2012 Article on Ethanol and
Corn & October Article on Yeast
• If requirements for ethanol use stay the same and the price of gasoline
rises, what is apt to happen to the supply of corn for food purposes ?
What does that say about the cross price elasticity of supply?
• What would happen to food prices related to corn as a feed, grain, or
vegetable?
• If the demand and price of corn for ethanol falls, what would happen to
the demand for yeast?
• What does that say about the cross price elasticity of demand for
yeast?
• So what does that mean that an increase in oil prices will eventually do
to yeast prices?
• Now you are thinking like an economist…….
5-51
Assumptions for efficient market
• Private property
• Yields investment, innovation, exchange, maintenance,
& growth.
• Freedom of enterprise and choice
• Scalability, Entry and exit
• Self-interest
• Creates “checks and balances”
• Competition
• More “checks and balances”
• Markets and prices allowed to function
• Limited government/currency and trade facilitated
5-52
Special Topics from the Anti-Text
• Conventional economics focuses heavily on efficiency and
only cares about aggregate distribution (i.e., consumers in
general and producers in general).
• When can distributional issues cause inefficiencies?
• Comparative advantage
• When can you be less efficient at something and society
still benefits by having you specialize in it?
• Inverse demand or supply
• When might supply actually slope down?
• When might demand actually slope up?
5-53
Special Topics from the Anti-Text
• Price expectations
• They do cause shifts in demand and supply that do not
always lend themselves to simple modeling
• The basic theories still hold – they shift demand back and
forth through time.
• Imperfect or asymmetric information
• A key market failure
• Market assumes all values and costs are understood by
market participants
• Many of the anti-text’s arguments (including corporate
power) are actually rooted in mis-informations
5-54
Special Topics from the Anti-Text
• Shapes of the cost curves
• To some extent the argument is irrelevant, one needs to
believe in aggregate there is some form of upwards
sloping supply function. Individual firms need not see
significant price elasticity of supply.
• Switching suppliers (p. 107) – who can you turn to if all
producers are already producing at optimal levels?
• Do we overstate the freedom of choice argument in
markets?
• What does it depend upon?
• Does that invalidate the basic market model? Parts of it?
5-55
Assignment
• Participants will choose one of assigned commodities to do a preliminary
draft of a demand schedule (“curve”) and summarize 4 key demand drivers
and trends in those drivers. For the same commodity, summarize 4 key
supply drivers and trends in them. Graph the demand (Excel based using
technique shown on slide 21) plus 1500 words explanation (max) plus
references.
• Due 11/23
• Use any of the goods summarized in the table at this link:
http://www.mackinac.org/1247
• I am looking for clear separation of demand and supply , breadth in
types of shifters, and definitive statements about trend and the
directional impacts on supply or demand.
5-56
5-57