Chapter 6: Simple Pricing
I. Introduction
Hi, this is Luke Froeb of Vanderbilt University’s Owen School of Management. I am
the author of Managerial Economics: A Problem Solving Approach, along with Brian
McCann. This lecture is designed to supplement Chapter 6: Simple Pricing.
(Pause to create separation.)
II. Opening Anecdote:
From early 2007 to the middle of 2008, the average price of a gallon of gas in the
United States rose from under $2 to over $4. This was, of course, bad news for
drivers of gas-guzzling SUVs. However, it was very good news for two McMinnville,
TN, workers named Dolly and Molly—or perhaps bad news, depending on how you
look at it. You see, Dolly and Molly are mules, and when the price of gas rose, the
cost of running a tractor rose, meaning it now made sense for their owner to switch
back to use mules.
Similarly, farmers in India reacted to higher gas prices by increasing their use of
camels. This increased demand for camels caused a tripling of prices for camels
over a two-year period.
By contrast, NNS, a U.S. company producing potash fertilizer, failed to adjust the
price of their branded fertilizer in response to market signals, and thus lost out on
$13 million in earnings. You see, petroleum is a key ingredient of fertilizer, so when
the cost of oil, and thus fertilizer inputs, rose, NNS’s price of “generic” fertilizer
doubled. Historically, NNS had priced their branded fertilizer at a 35% premium
above the generic price. However, they failed to adjust the price in accordance to
rising input costs and ended up pricing their branded fertilizer at 25% below the
generic price. If the premium had simply been maintained, they would have sold the
same volume at a higher price and thus would have earned an additional $13
million.
This is not a unique case. Despite the power of pricing, it is an oft-neglected tool.
We all know that profit equals price times quantity minus cost times quantity, but
business seem to focus on selling more and reducing costs and forget about raising
price.
III. Background: Consumer Surplus and Demand Curves
Let’s consider a simplified relationship between price and quantity purchased by a
single customer at a hot dog stand. The table shows how many hot dogs the
customer will buy at various prices. As you can see, as price falls, the customer buys
more hot dogs, providing a fine illustration of the first law of demand, which says
that consumers demand more as price falls, assuming other factors are held
constant. This makes intuitive sense. We’ve all been there. That first hot dog is
amazing and extremely satisfying. The second might still be pretty good. By the
time you’re on your fifth hot dog, you might not be enjoying yourself too much. In
economic speak, you are experiencing diminishing marginal returns.
Now we can construct a chart with marginal values for various quantities—he
values the first hot dog at $5, the second at $4, and so on—as well as the total values,
which is the sum of the preceding marginal values.
The key here is to think in marginal terms. Looking at the chart, the total value of 5
hot dogs is $15, so you might be tempted to price the hot dogs at $3. However, the
marginal value of the fourth hot dog is only $2, so at a price of $3, the consumer will
only purchase 3.
When consumers behave optimally, they try to maximize the surplus they get from
consuming hot dogs, which is equal to the difference between their total value and
the price they pay. So if the consumer is charged a price of $3 and buys 3 hot dogs,
his surplus is the $12 total value minus the $9 cost, so $3. If he were to purchase
more or less than 3 hot dogs, his surplus will decrease.
To describe how consumers respond to price, economists use demand curves, which
tell us how much a consumer or group of consumers will consume as a function of
price. The demand curve slopes downward because, as we’ve learned, consumers
purchase more as prices fall.
This is true for both a single consumer and for groups of consumers. To describe
the buying power of a group of consumers, we add up all the individual demand
curves to get an aggregate, or market demand curve.
This aggregate demand curve is the relationship between the price and the number
of purchases made by this group of consumers. You can see that at a price of $7, 1
person is willing to buy; at $6, 2 people are willing to buy; and so on.
You can see on the graph that price, which is the independent variable, is on the
wrong axis. For now, you can just attribute that to economists being weird. Also,
when moving up and down the demand curve, we say that “the quantity demanded”
changes. When the demand curve itself moves, we say demand changes.
IV. Marginal Analysis of Pricing
Looking at the demand curve, you can see there is an implicit trade-off. The seller
can either raise the price, thereby earning more on each unit sold but selling fewer,
or reduce the price, thereby earning less on each unity sold but selling more. To
resolve the dilemma, we once again turn to marginal analysis and find ourselves a
great rule-of-thumb: If marginal revenue is greater than marginal cost, you can
increase profit by reducing the price and thus selling more. If marginal revenue is
less than marginal cost, then you should increase the price and thus sell less.
In order to see how to use marginal analysis to maximize profit, let’s take a look at a
table listing price, quantity, revenue, marginal revenue, marginal cost, and total
profit for our demand curve.
Remember, in order to entice new consumers into the marketplace, a firm has to
reduce the price for all customers, not just the additional customers attracted by the
lower price.
Okay, at a price of $7, one customer would purchase a hot dog, so revenue would be
$7. Cost would be $1.50, so profit would be $5.50. If we reduce the price to $6, two
customers purchase hot dogs, revenue goes up to $12, which makes marginal
revenue $5, which we get by subtracting the $7 from $12. In order to maximize
profit, the seller should continue lowering the price until the marginal revenue is
equal to the marginal cost of $1.50, or just higher if that is impossible. Here, we can
see that the seller should lower the price to $5, where marginal revenue is $3 and
the marginal cost is $1.50.
V. Price Elasticity and Marginal Revenue
Unfortunately, it’ll never be this easy in the real world. You’ll never see a demand
curve like the one we just looked at. In reality, it is very difficult to predict
consumer response to a price change. The best one can do is make an educated
guess as to what demand looks like away from current prices.
But hold on—don’t quit the class just yet. You might not see an entire demand
curve, but you don’t need to see an entire demand curve to know how to price—all
you need is information on marginal revenue and marginal cost. Remember, if
marginal revenue is greater than marginal cost, reduce price. If marginal revenue is
less than marginal cost, increase price.
So how do we estimate marginal revenue? Basically, you can either measure
quantity responses to past price changes, “experiment” with price changes, or run
market surveys to see how quantity would change in response to a price change. If
you can find any information on how consumers will respond to a price change, it’s
likely to be information on the price elasticity of demand, which is denoted by a
small e.
The price elasticity of demand is equal to the percent change in quantity demanded
divided by the percent change in price. It measures the sensitivity of quantity
demanded to price changes.
If quantity changes more than price, the demand curve is elastic, which means it is
sensitive to price. If quantity changes less than price, the demand curve is inelastic.
Note that, since price and quantity move in opposite directions, meaning as price
goes up quantity goes down, price elasticity is negative. To keep things clear, we use
the absolute value of price elasticity.
Let’s consider what happened when MidSouth, a grocery store, decreased the price
of Coke from $1.79 to $1.50 in order to match the price offered at a nearby WalMart. In response to the price drop, the quantity sold doubled from 210 to 420 units
per week.
To get the most accurate estimate, we need to divide the midpoint of price (P1 plus
P2) divided by 2 and the midpoint of quantity (Q1 plus Q2 divided by 2). Note that
since 2 divides by both denominator and numerator the two two’s cancel each other
out.
So we end up with Q1 minus Q2 over Q1 plus Q2 divided by P1 minus P2 over P1
plus P2. Plugging in the numbers gives us an estimated price elasticity of -3.8,
indicating that a 1% decrease in price of Coke leads to a 3.8% increase in quantity.
Revenue increases by $254.10, and, in general, the percent change in revenue is
equal to the percent change in price plus the percent change in quantity. Since price
and quantity move in opposite directions, one will be positive and one will be
negative. So whichever change is bigger—price or quantity—determines whether
revenue goes up or down.
Elasticity tells you which change is bigger. With elastic demand, the change in
quantity will, as we learned, be greater than the change in price. So if you increase
the price, the revenue will decrease. If you decrease the price, revenue will increase.
When demand is inelastic, the relationship is reversed, meaning that price increases
raise revenue because the price increase is bigger than the corresponding quantity
increase. Conversely, price decreases reduce revenue because the price reduction is
bigger than the quantity increase.
In order to test your understanding of the relationship between price changes,
elasticity, and revenue, you can turn to page 73 in order to derive the relationships
between elasticity, price changes, and revenue changes. (Note: Luke, this
derivation section had a lot of formulas, and it seemed like it’d be a little
awkward and confusing to go through it verbally. You might disagree,
however.)
VI. What makes demand more elastic?
We know now that the more elastic demand is, the lower the profit-maximizing
price is. Given the clear importance of elasticity to pricing, it’s worthwhile to
sharpen our intuitive feel for what would make demand more or less elastic. There
are four factors here, and we’ll go through them one by one.
First, products with close substitutes have elastic demand. Obviously, if the nextbest alternative is largely indistinguishable from a product you purchase, if the price
of the product goes up even a little bit, you will switch to the alternative.
Second, demand for an individual brand is more elastic than industry aggregate
demand. This makes sense because individual brands within a product category
have close substitutes in each other; product categories do not. As a general rule of
thumb, we can say that brand price elasticity is approximately equal to industry
price elasticity divided by the brand share. For example, if the elasticity of demand
for all running shoes is -.4, and the market share of Nike running shoes is 20%, price
elasticity of demand for Nike running shoes is -.4 divided by .2 which equals -2.
Using our optimal pricing formula, we can see that Nike has a desired markup of
about 50%.
Also, products with many complements have less elastic demand. Products that are
consumed as part of a larger bundle, say shoelaces with shoes, have less elastic
demand. If the price of shoelaces increases, you’re not going to just stop buying
shoelaces because you need them to wear with your shoes.
Third, there is the factor of time. Given more time, consumers are more responsive
to price changes because they have more time to find substitutes when price goes
up. In the long run, demand curves become more elastic, meaning the absolute
value of e increases. Also, as time passes, information about a new price becomes
more widely known and people react to that change.
Finally, as price increases, demand becomes more elastic as consumers find more
alternatives to the good whose price has gone up. And as they find more substitutes,
we can look back to maxim one to see that demand becomes more elastic. For
example, high fructose corn syrup and sugar are perfect substitutes for use in soft
drinks. However, due to various reasons, sugar costs about twice as much as high
fructose corn syrup in the U.S. As a result, all soft drink bottlers use high fructose
corn syrup because they have no close substitutes to the low-priced corn syrup; its
demand is relatively inelastic. But if the price of high fructose corn syrup rose, then
sugar would be a good substitute and demand for high-priced corn syrup would
become very elastic.
VII. Forecasting demand using elasticity
We can also use elasticity as a forecasting tool. With an elasticity and a percent
change in price, you can predict the corresponding change in quantity by
multiplying the elasticity by percent change in price. For example, if price elasticity
of demand is -2, and price goes up by 10%, then quantity is expected to go down by
20%.
Price is not the only factor affecting demand, though. To measure the effects of
other factors, such as income or advertising, we define factor elasticity of demand as
percent change in quantity divided by percent change in the factor. For example,
demand for iced tea is strongly influenced by temperature. If the temperature
elasticity of demand for iced tea is .25, then a 1% increase in temperature will lead
to a .25% increase in quantity demanded.
Income elasticity of demand measures the affect of changing income on demand. If
demand increases with income, the good is normal. If demand declines as income
increases, the good is inferior.
Cross-price elasticity of demand for Good A with respect to Good B measures the
change in demand of A caused by a change in the price of Good B. Positive crossprice elasticity, meaning as the price of one increases the demand for the other
increases, means the two goods are substitutes. Negative cross-price elasticity,
meaning as the price of one increases the demand for the other decreases, means
the two goods are complements.
We can use factor elasticities to forecast or predict changes over time or even
changes from one geographic area to another. Imagine you’re comparing the yearto-year performance of one of your regional salespeople over a period in which
income grew by 3%. If demand for your products has an income elasticity of 2, then
you would expect quantity to increase by 6% without the salesperson having to do
anything at all. A performance measure related to effort would subtract 6% from
the actual growth because that 6% is the growth related to income.
VIII. Stay-even analysis, pricing, and elasticity
To conclude this chapter, we are going to talk about stay-even analysis, a simple tool
that allows you to do marginal analysis of pricing. In particular, it is used to
determine the volume required to offset a change in price. We know that raising
price results in selling fewer units. Stay-even analysis tells you how many unit sales
you can lose before the price increase becomes unprofitable.
In combination with information about elasticity of demand, this analysis can tell
you whether changing price makes sense. If the predicted quantity decrease is
bigger than the stay-even quantity decrease, then the price increase is not
profitable, and vice versa.
The stay-even quantity is a function of the size of the price increase and the
contribution margin, where the contribution margin equals price minus marginal
cost divided by price. The stay-even % change in quantity equals percent change in
price divided by percent change in price plus the contribution margin. If you are
considering a price increase, and the predicted quantity decrease is bigger than the
stay-even quantity decrease, the price increase is unprofitable. This type of analysis
persuaded a judge to allow the 2008 Wild Oats-Whole Foods merger on the grounds
that the company would not find it profitable to raise prices after the merger.
That’s the end of Chapter 6. In the book, you can find a summary of the chapter and
homework problems on page 78.
In the next chapter, we will discuss economies of scale and scope.
Why aren't people buying more fuel efficient cars?
The Cross-elasticity of demand for cars with respect to the price of gasoline is bigger
than we thought:
"As the numbers show, vehicles with a rating of 30-plus miles per gallon have suffered a
dramatic drop in sales. For the first five months of 2010, sales of vehicles with that 30plus MPG rating have dropped by 10 percent compared to the same period in 2009,"
Loveday said.
"Overall, these high-efficiency cars accounted for four percent of the market in 2009, but
now only hold a three percent share," Loveday continued.
"A few of these efficient vehicles suffered mightily: sales of the Toyota Camry Hybrid
dropped 40 percent, Civic Hybrid sales plummeted by 77 percent and Honda Fit numbers
fell off by 19.7 percent. Ward's Auto suggests that low gas prices have led to the
decreased interest in fuel-efficient vehicles, which, can lead right into a discussion about
the need for a gas tax once again."
Posted by Luke Froeb at 6:35 PM 0 comments
Labels: 06. Simple pricing
Sunday, May 2, 2010
Housing demand is more elastic than we thought
Don't try to forecast demand by assuming that there will be 2.5 people/household:
Last year, 1.2 million households disappeared as unemployed adult children moved back
home and seniors moved out of assisted living to share living space with their grown
children. This will linger until the economy begins to recover and seniors can sell their
homes and live near but not with their relatives.
Posted by Luke Froeb at 8:07 AM 0 comments
Labels: 06. Simple pricing
Monday, April 12, 2010
Supply, Demand, and Reproduction
A new study from the American Sociological Review suggests that supply and demand
forces don't do a particularly good job of explaining the treatment and compensation of
sperm and egg donors.
Almeling, whose findings appear in the June issue of the American Sociological Review,
uncovered a topsy-turvy market that often defies not just conventional wisdom but also
the basic law of supply and demand.
“Men donors are paid less for a much longer time commitment and a great deal of
personal inconvenience,” she said. “They also are much less prepared for the emotional
consequences of serving as a donor of reproductive material. Women, meanwhile, are not
only paid more for a much shorter time commitment, they are repeatedly thanked for
‘giving the gift of life.’
...
“A pronounced double-standard exists in the way that men and women donors are valued
by the fertility industry, and it can’t be explained medically or by market forces,”
Almeling said. “Based on the availability of donors alone, you would expect the
abundance of potential egg donors to drive down compensation fees and the scarcity of
potential sperm donors to drive up their fees. But I found just the opposite.
Posted by Brian McCann at 8:10 AM 0 comments
Labels: 06. Simple pricing
Wednesday, January 27, 2010
Regulating Everclear Sales in Iowa
The state of Iowa is considering increased regulation of the sale of Everclear, a 151-proof
alcohol popular with college students (the 190-proof version of Everclear is illegal to sell
in a number of states according to Wikipedea). The consideration follows a recent hazing
incident in which a Drake University student nearly died with a blood alcohol level of 0.5
(Wow!)
So what do you think is happening to current sales of Everclear in Iowa? They're going
up.
Posted by Brian McCann at 1:02 PM 1 comments
Labels: 06. Simple pricing
Wednesday, January 13, 2010
Information and Prices
Soybean farmers in the Indian state of Madhya Pradesh sell their products in open
auctions to intermediaries, who then re-sell to food processing companies. Because each
market tended to have only a few intermediaries, it was relatively easy for them to
collude to pay lower prices. The farmers had little access to prices being paid by the food
processing companies or by intermediaries in other markets.
So what happened when internet kiosks that show prices in nearby markets were
introduced into the markets? Prices went up (around 1.7% on average) - here's (pdf) a
presentation by the study author and an article from the Economist.
What wasn't entirely clear to me was the incentives of the kiosk provider. The kiosks
were provided by one of the food processing companies. Part of the motivation seemed to
be to bypass the intermediaries but that doesn't really explain provision of the kiosks with
nearby market prices.
Posted by Brian McCann at 9:29 AM 0 comments
Labels: 06. Simple pricing, 18. Auctions
Monday, January 4, 2010
Optimal Toll Pricing?
Tolls on the New York Thruways are 5% higher today, the second increase over the last
year. According to Thruway Authority officials, the increase was necessary because of a
decline in traffic. The logic here might sound a little goofy on initial read: "we raised
price last year and traffic went down, so let's raise price again." But, what we don't know
is what the effect has been on revenue. If demand for use of the tollway is fairly inelastic
(I would guess that it probably is), raising price and decreasing quantity would lead to
higher revenue.
Posted by Brian McCann at 8:35 AM 0 comments
Labels: 06. Simple pricing
Monday, September 28, 2009
What do longer skirts, shorter hair, lipstick, hair coloring and hot
waitresses have in common
All are counter-cyclical indicators (inferior goods). On the last item:
“They slowly let the boys go, then the less attractive girls, and then these hot girls
appeared out of nowhere. All in the hope of bringing in more business. The managers
even admitted it. These hot girls that once thrived on the generosity of their friends in the
scene for hookups—hosting events, marketing brands, modeling—are now hunting for
work.” A Soho restaurateur I know recently received applications from “a couple of
classic Eastern European fembots. Once upon a time, these ladies must’ve made $1,500 a
night lap dancing. At my place, they’re not going to make that in a week.”
Posted by Luke Froeb at 9:33 AM 0 comments
Labels: 06. Simple pricing
Tuesday, September 15, 2009
Is the decline in spending permanent?
John Mauldin draws inference from the growing gap between essential, and non-essential
spending:
A gap this wide looks like a real structural shift in spending behavior, as austerity
becomes the new normal. Though Americans have shaken off bouts of prudence before,
like that of the early 1990s, with consumer credit constricted, household balance sheets
ravaged, and labor income weak, it's probably going to take some time before anything
resembling extravagance returns.
Posted by Luke Froeb at 9:32 AM 0 comments
Labels: 06. Simple pricing
Monday, August 17, 2009
Cash for Clunkers and Higher Prices
By now, you'd have to be in a coma not to have heard about the "Cash for Clunkers"
program. The G is spending our tax dollars to give people an incentive to trade in older,
less efficient vehicles and purchase new. So, what do you think happens to prices with
this demand stimulus. Not surprisingly, it looks like they are going up. So, if you are in
the market for a new car, you get to pay for the program twice - once through your tax
dollars and once through a higher price.
Posted by Brian McCann at 8:17 AM 1 comments
Labels: 06. Simple pricing
Wednesday, August 12, 2009
Outlet Mall Pricing Strategies
Here's a really interesting story about how outlet malls have convinced people that they
are getting a great deal by traveling to the middle of nowhere to shop (it's an excerpt from
a book called Cheap: The High Cost of Discount Culture). Skeptical about how
successful outlet malls are? According to the story, around 55 million Americans shop in
at least one of the nation's roughly three hundred outlet centers every year. The total
distance that Americans travel to outlet malls each year equals 440,000 trips around the
world.
The excerpt notes that one of the key tactics used in outlet malls is refererence pricing.
Noted somewhere on or near the product is a really high "suggested" or "retail" price
along with the much lower sale price. Individuals get anchored to that higher price, and it
affects their willingness to pay. The story mentions a jewelry pendant with a "suggested"
price of $3,329 and a sale price of $832 - sounds like a great deal, huh? The author later
found what appeared to be similar pendants on eBay for $299. Great example of
psychological pricing, a new topic in the second edition of everyone's favorite managerial
economics textbook.
Posted by Brian McCann at 8:35 AM 0 comments
Labels: 06. Simple pricing
Wednesday, August 5, 2009
Washer, Dryer and Pedestal Pricing
So my wife and I went out the other night to buy a new washer and dryer. We did a little
research beforehand and identified a couple of models priced in the $600 range ($600 per
appliance). After driving over to the Home Depot to check them out, we decided on one
of the two potential sets of models. And, then my wife said, "What about pedestals?" To
which I replied, "Huh?"
Pedestals are basically metal boxes that the washer and dryer sit on top of. As near as I
could tell, they serve two purposes. First, they raise the appliances up a little higher (just
over a foot) to make access easier, and second, the metal box includes a built-in drawer
for extra storage. So, how much do you think a metal box to accompany a $600 washer
costs? I'll give you a hint - think of a ridiculous price.
The pedestals to accompany our washer and dryer were priced at $230 each, over 1/3 the
cost of the appliance itself. Wow! I would be interested to see the analysis behind that
pricing decision.
Posted by Brian McCann at 9:26 AM 1 comments
Labels: 06. Simple pricing, 12. More realistic and complex pricing
Thursday, July 30, 2009
Income elasticity of demand for hotel rooms
Apparently, it is about +4:
... thought leaders envisions lodging demand recovering at 4 times the rate of the general
economy -- as part of a "snap back" to make up for the unprecedented 4 to 1 decline we
have just experienced. Such a snap back would create some very interesting and positive
results for hotel profits and hotel values!
Posted by Luke Froeb at 1:41 PM 0 comments
Labels: 06. Simple pricing
Thursday, July 9, 2009
What's the point?
Without the cooperation of the poorer countries, reducing carbon consumption in rich
countriies, e.g., by raising the price of carbon emissions, will simply move industry and
production to poorer countries. This used to be derisively called "exporting pollution,"
but now it seems like offical government policy.
’AQUILA, Italy — The world’s biggest developing nations, led by China and India,
refused Wednesday to commit to specific goals for slashing heat-trapping gases by 2050,
undercutting the drive to build a global consensus by the end of this year to reverse the
threat of climate change.
Peter Huber predicted as much:
By pouring money into anything-but-carbon fuels, we will lower demand for carbon,
making it even cheaper for the rest of the world to buy and burn. The rest will use
cheaper energy to accelerate their own economic growth. Jobs will go where energy is
cheap, just as they go where labor is cheap. Manufacturing and heavy industry require a
great deal of energy, and in a global economy, no competitor can survive while paying
substantially more for an essential input. The carbon police acknowledge the problem and
talk vaguely of using tariffs and such to address it. But carbon is far too deeply embedded
in the global economy, and materials, goods, and services move and intermingle far too
freely, for the customs agents to track.
But as these poor countries get richer, they will demand less pollution.
Posted by Luke Froeb at 10:37 AM 0 comments
Labels: 06. Simple pricing
Friday, June 5, 2009
iPhone price elasticity=-2
Cheaper iPhones are being introduced by Apple:
Citing a firm survey of consumers, Morgan Stanley analyst Kathryn Huberty said that a
$50 price cut could increase demand by 50 per cent and a $100 cut by 100 per cent.
This increases profit if the margin, (P-MC)/P, greater than 50%.
Posted by Luke Froeb at 9:22 AM 3 comments
Labels: 06. Simple pricing
Saturday, May 2, 2009
How does Starbucks respond to increased competition and falling
incomes?
By cutting price:
As it reported a 77% drop in quarterly profit, the company on Wednesday also said it will
adjust its pricing in some markets, raising prices of some of the more complicated drinks,
while lowering those on basic drinks. For example, Starbucks will offer a "grande" size
iced coffee for less than $2, shaving as much as 45 cents off the price, depending on the
market.
The moves come as Starbucks is struggling to attract and retain consumers in a recession.
Starbucks said U.S. comparable-store sales fell 8% in its latest quarter as traffic fell 5%,
and average transaction totals fell 3%.
Posted by Luke Froeb at 2:32 PM 0 comments
Labels: 06. Simple pricing
Monday, January 26, 2009
Breaking news: demand curves slope downwards
Vermonters are just finding this out
...proposed increases in monthly health care premiums and out-of-pocket payments will
reverse the state's progress shrinking the number of uninsured Vermonters. More than
11,000 Vermonters enrolled in state health programs over the past year, bringing the
percentage of uninsured down to 7.
"People are having trouble paying premiums now," said Trinka Kerr, health care
ombudsman, noting her office is getting "hammered" with calls. "Any increase in costsharing is going to decreased access, and this is a terrible time to be doing that. Making
access to health care more difficult is so short-sighted."
Maybe their legislature can repeal the law of demand.
Posted by Luke Froeb at 2:20 PM 0 comments
Labels: 06. Simple pricing
Monday, January 5, 2009
Price Elasticity for Retail Coffee Shop
So what do you think the price elasticity of demand for a cup of coffee is at a local coffee
shop? My guess would be that it's pretty elastic, especially if there are a lot of nearby
options.
Apparently, the owner of one of my local shops disagrees. I stopped by to buy a cup of
coffee last Friday, and the cashier says "$2.62". I told her I ordered just a regular cup of
coffee thinking she must have misunderstood my order because I know a coffee at this
store costs $1.89 from previous visits. She replied that "Prices have gone up a little bit."
A little bit?? Oof, that almost a 40% increase. And, this with another coffee shop right
next door to this one, and two others within a similar walking distance. I think the owner
is going to get an unpleasant lesson in basic economics (I know my quantity demanded is
going down, down, down.)
Posted by Luke Froeb at 7:56 AM 0 comments
Labels: 06. Simple pricing
Saturday, January 3, 2009
Prius demand off 50%
As predicted by my former colleagues at the US Dept of Justice, Prius demand is way
down, due to falling gas prices.
Toyota sold 2,174 Camry Hybrids last month, ... . The only two Toyota models to see an
uptick last month were the Sequoia and Lexus LX 570, which are two gigantic SUVs.
Posted by Luke Froeb at 10:16 AM 5 comments
Labels: 06. Simple pricing
Wednesday, December 17, 2008
You Can't Fight Supply and Demand
I think we should update the old phrase "You can't fight City Hall" to "You can't fight
supply and demand" to give people a better appreciation for economic forces that
influence outcomes (leaving aside the issue that as the feds slowly nationalize one
industry after another, we are all eventually going to be working for "City Hall"). The
thought occurred to me as I read this post from The Huffington Post complaining about
the treatment of adjunct professors in American colleges (or as the poster describes it "The Great Shame of American Colleges").
they are hired only on a part-time basis, made to sign a pledge that they will not work
more than twenty hours a week and will not--not now, not ever--have a claim to health or
retirement or any other kind of benefits, not even a parking pass. That they are "at will"
employees who can be let go at any time, for any reason. Their salaries are so meager,
they have to teach two, three, sometimes five classes a semester, at five different
universities, just to pay their rent.
And why do these "terrible" conditions exist? It's all about supply and demand. The
poster notes that for each position there are "two or three other PhDs waiting in line for
his job in case he dares complain or ask for more money." When supply exceeds demand,
prices get driven down. It's not shameful; it's reality. Conditions for adjuncts will improve
when fewer people are chasing the finite number of openings.
Posted by Luke Froeb at 7:41 AM 2 comments
Labels: 06. Simple pricing
Monday, December 15, 2008
Sales of Home Safes on the Rise
I saw an article this morning in the hometown newspaper about a recent rise in the sales
of home safes (see Google news for a bunch of similar articles). As people have become
concerned about leaving their money in banks, they appear to be turning more toward the
home safe solution.
The perceived cost of using banks for money storage has risen leading to an increase in
demand for a substitute product, the home safe. Perhaps this will, in turn, lead to an
increase in home robberies. Any thieves reading this blog now know that the incentive to
engage in robbery has increased with larger potential rewards from robbing the average
house (assuming you are the type of thief who can figure out how to crack a home safe).
That's one of the things that's cool about thinking in economic terms: what might be the
unintended consequences or unforseen outcomes of events like this.
Posted by Luke Froeb at 10:13 AM 0 comments
Labels: 06. Simple pricing
Prius prices are coming down
...because gasoline prices are coming down. From my former colleagues at the
Department of Justice:
The median effect of a one dollar increase in the gasoline price per gallon is a reduction
in the manufacturer price of $171. The calculation varies greatly across vehicles--for
example, the effects range from a reduction of $1,506 for the 2005 GM Montana SV6 to
a rise of $998 for the 2006 Toyota Prius.
Posted by Luke Froeb at 11:13 AM 0 comments
Labels: 06. Simple pricing
The Quintessential Inferior Good
As noted in this prior post about Wal-Mart, an inferior good is one whose income
elasticity of demand is negative, so that when income goes down, demand goes up. Sales
of another inferior good, Spam, are also on the rise with the recent economic difficulties.
Sales have increased over ten percent in the most recent three months, and the
manufacturer (Hormel) has instituted double shifts at its production facility.
For those of you not familiar with the product, Spam "is made of just a few simple
ingredients. Ham, pork, sugar, salt, water, a little potato starch, and a mere hint of sodium
nitrite to help SPAM® keep its color. Sounds delicious, and it is."
Posted by Luke Froeb at 7:22 AM 1 comments
Labels: 06. Simple pricing
Friday, November 7, 2008
Is Wal-Mart an inferior good?
An inferior good is one whose income elasticity of demand is negative, so that when
income goes down, demand goes up. From NY Times:
Sales at department stores and specialty retailers are falling rapidly. They are cutting
staff, discounting merchandise and liquidating stores to survive. But even as the financial
turmoil strangled discretionary spending at many stores, it sent struggling consumers into
the arms of Wal-Mart — and left it, the world's largest retailer, poised for a blockbuster
Christmas.
Posted by Luke Froeb at 4:20 AM 0 comments
Labels: 06. Simple pricing
Wednesday, October 22, 2008
Nifty pricing exercise
I rarely use the term "nifty" but this exercise from Michael Ward via Joel Waldfogel
certainly qualifies. Shows students how to make pricing decisions based on survey data.
Posted by Luke Froeb at 10:12 AM 1 comments
Labels: 06. Simple pricing, 13. Direct price discrimination
Monday, October 6, 2008
Price elasticity of demand goes mainstream.
Since when did screen writers learn econ?
Posted by Luke Froeb at 1:59 PM 0 comments
Labels: 06. Simple pricing
Monday, June 30, 2008
Gas and Prostitutes
As everyone's favorite Managerial Economics textbook tells us: when the price of a
complement increases, demand decreases. What's not always obvious is what products
might be complementary to your offering.
Nevada brothels have recently discovered that gasoline is a complement to their services,
that is, gas and brothel services tend to be consumed together. No, no, the brothels don't
have gas pumps out front. Their locations just tend to require a fair amount of travel.
Several of the hardest hit are the houses of prostitution in Nevada's rural northern areas,
which get roughly 60 percent of their business from truckers. "Some of these brothels are
out in the middle of nowhere so fuel prices have an effect, says Dennis Hof, owner of the
infamous Moonlite Bunny Ranch.
Posted by Luke Froeb at 7:31 AM 0 comments
Labels: 06. Simple pricing
Wednesday, June 4, 2008
Paid for with other people's money
What do college tuition, academic journals, and health care have in common besides
price inflation?
It is easy to see why this would make demand less elastic, which would imply a higher
price in any but a perfectly competitive industry, e.g., (P-MC)/P=1/|elasticity|. But what
is the mechanism behind the price inflation (change in price)?
Posted by Luke Froeb at 9:34 AM 0 comments
Labels: 06. Simple pricing
Saturday, March 22, 2008
Why won't Exxon increase output?
The Question:
Texas-based Exxon is the largest publicly traded company in the energy business. In fact,
it's the most profitable company in the history of capitalism, earning a record $40.6
billion on sales of $404 billion last year. Yet even with prices at the pump near all-time
highs, Exxon isn't planning on producing any more oil four years from now than it did
last year. That means the company's oil output won't even keep pace with its own
projections of worldwide oil demand growth of 1.2% a year.
The Answer:
... the contracts big oil companies sign with countries such as Angola and Nigeria. In
such contracts, foreign companies put up the capital to fund new projects, and they are
paid back in barrels. If oil prices rise above certain levels, Exxon gets to keep fewer of
those barrels as profit for itself.
In other words the extra revenue from higher prices goes to the governments, not the oil
companies.
Posted by Luke Froeb at 7:09 AM 0 comments
Labels: 06. Simple pricing
Friday, February 8, 2008
Putting the tax debate into historical perspective
One difference between the Democrats and Republicans is whether to let the Bush II tax
cuts expire. From the graph above we see the Kennedy tax cuts (from 91% down to 70%)
in 1962; the Reagan tax cuts (from 70% to 28%) in the early 1980's; the Bush I (28% to
35%) tax increases; the Clinton tax increases (from 35% to 39%); and the Bush II tax cuts
(from 39% to 35%).
Some economists predict a big negative effect on tax collections because elasticity of tax
receipts with respect to marginal tax rates is big for high income taxpayers; but small for
low income tax payers. This means that the tax cuts for low and middle income workers
will produce a big drop in tax receipts and the tax increases on high income workers will
produce a small increase in tax receipts.
Historical note: no Republican's (not Goldwater, not Bob Dole) supported the Kennedy
tax cuts. How things have changed.
Posted by Luke Froeb at 11:17 AM 4 comments
Labels: 06. Simple pricing
Monday, January 28, 2008
Charging for internet downloads could hurt AAPL, AMZN, NFLX
From Businessweek.com
Time Warner and other major Internet service providers (ISPs) often blame slowdowns
on the 5% of users who consume as much as 50% of network capacity downloading vast
numbers of large files, such as movies, videos, and songs. By charging such consumers
more, companies could encourage them to curb excess use, or generate enough extra cash
to enable their systems to handle higher data demands. "What we are trying to do is
create the best experience possible for all of our users," Time Warner spokesman Alex
Dudley says.
But the plan could also stifle demand for movie-download services from companies
including Apple (AAPL), Amazon (AMZN), and Netflix (NFLX), some consumer
groups say. "It depends on how they structure it," says Art Brodsky, communications
director of Public Knowledge, a nonprofit consumer advocacy group focused on digital
rights. "You don't want to do it so you totally discourage uploading videos and
downloading videos, and doing what the Net is used for."
Posted by Luke Froeb at 6:26 PM 0 comments
Labels: 06. Simple pricing
Thursday, January 24, 2008
Price elasticity of demand for gasoline=0.06
From the CBO:
The research suggests that a 10 percent increase in the retail price of gasoline would
reduce consumption by about 0.6 percent in the short run. [short run elasticity=0.06] ....
Estimates of the longrun elasticity of demand for gasoline indicate that a sustained
increase of 10 percent in price eventually would reduce gasoline consumption by about 4
percent. That effect is as much as seven times larger than the estimated short-run
response, but it would not be fully realized unless prices remained high long enough for
the entire stock of passenger vehicles to be replaced by new vehicles purchased under the
effect of higher gasoline prices—or about 15 years.
Posted by Luke Froeb at 3:03 PM 0 comments
Labels: 06. Simple pricing
Monday, November 5, 2007
Breaking the First Law
According to everyone's favorite Managerial Economics text, the First Law of Demand
states that consumers demand (purchase) more as price falls, assuming other factors are
held constant.
Despite its obvious importance in economics - it's the "first" law and we write it with all
capital letters, so it must be pretty important - the First Law sometimes appears to break
down. I was reminded of this when my wife went shopping for a new cell phone this
weekend. She was comparing two Bluetooth headseats to accompany her phone. She had
no basis for comparing the quality of the two headseats, but she was sure that the more
expensive one had to be better. So, my wife's quantity demand for the higher-priced
headseat rises as price increases. Curious.
Now your typical weasely economist is liable to say, "hey, we said 'assuming other
factors are held constant' in the First Law." If price affects perception of quality, maybe
other factors aren't held constant. With this kind of big qualification, maybe we should
call it the "First Guideline." ;)
For examples of other instances of quantity demanded increasing with price increases,
see Giffen goods and Veblen goods.
Posted by Luke Froeb at 7:09 AM 0 comments
Labels: 06. Simple pricing
Thursday, October 18, 2007
Immigrants are more price sensitive
As a consequence, prices are lower in communities with a large concentration of
immigrants. (Economist via Mangans)
Posted by Luke Froeb at 9:37 AM 0 comments
Labels: 06. Simple pricing
Thursday, August 30, 2007
Economics in the Whole Foods merger case
Last week, a federal judge refused to grant a preliminary injunction against the Whole
Foods acquisition of Wild Oats (FTC website; testimony: day1 am, day1 pm, day2 am).
He ruled that "premium, natural and organic supermarkets" was a not a "relevant product
market." A relevant market is one in which a hypothetical, multi-store monopolist,
owning all stores in the category (and eliminating competition among them), would raise
price.
In his decision, the Judge cited a break-even analysis (sometimes called "critical loss")
that asks how much quantity a monopolist could afford to lose and still want to raise
price. With retail margins of 40% (FTC complaint, p.21), a 5% price increase would
require a quantity loss of no more than 11.1% to be profitable [11.1%=5%/(5%+40%)].
Citing marketing studies showing that customers shopped at Whole Foods as well as
other grocery stores, former FTC Chief Economist and colleague David Scheffman
argued that the actual quantity lost would be greater than 11.1%, presumably to stores
outside the category.
University of Chicago economist Kevin Murphy criticized the break-even analysis by
focusing on the incentive of the merged firm to raise price. From my favorite textbook,
When you price commonly owned products, ... your concern changes from earning profit
on an individual product to earning profit on both products ... Aggregate demand for a
group of substitute goods is less elastic than the individual demand for the goods that
comprise the group. And with a less elastic aggregate demand, the merged firm wants to
raise price.
The closer substitutes the two stores are, the bigger incentive the merged has to raise
price (Murphy rebuttal report).
The heavily redacted court documents refer to entry "experiments" to determine the
degree of substitution between the two merging stores. We found the following on the
Whole Foods website,
If we [close the Wild Oats Store right across the street], we believe approximately 50% of
the volume their store does will transfer to our store, with the other 50% migrating to our
other competitors (these estimates are based on our past experience with similar
situations).
It is hard to believe that the diversion ratio is this big. But even at half the size, simple
models of competition would predict a big enough post-merger price increase to put the
two stores into a relevant market by themselves.
Posted by Luke Froeb at 4:35 AM 0 comments
Labels: 06. Simple pricing, 12. More realistic and complex pricing
Friday, July 20, 2007
The Power of P
Luke's post of yesterday regarding price discrimination reminded me of a great
article on the importance of pricing to profitability. We all know that Profit = PxQ CxQ, but too many businesses focus on either Q or C and forget about P. Think
about companies you've worked for - I bet they spent more time talking about
how they could sell more or about how to reduce costs and not a whole lot of
time about how to raise prices.
"Pricing: The Neglected Orphan" (available at
http://www.parthenon.com/OurWork/IntellectualCapital/Documents/ParthenonPricing%20The%20Neglected%20Orphan_09-2004.pdf) by Roger Brinner,
Partner and
Chief Economist at The Parthenon Group, should be required reading for all
managers and MBA students. He argues that nearly every company has the
opportunity to raise effective prices. The profitability impact of price increases is
dramatic. Raising price by just one percent flows directly to higher profits. He
notes that with an average pre-tax profit margin of 8.6% for an S&P company,
revenues would have to increase by 12% to get the same payoff.
The bottom line: don't forget the power of P.
Posted by Luke Froeb at 8:25 AM 2 comments
Labels: 06. Simple pricing
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=======================DEMAND AND SUPPLY====================
When should you sell Treasury Debt?
I have more than a few economist colleagues who lost money by betting that long term
treasury rates would increase and the dollar would fall. We know this will happen, but
we don't know when:
Dan Fuss, who manages the Loomis Sayles Bond Fund, which beat 94 percent of
competitors the past year, said last week that he sold all of his Treasury bonds because of
prospects interest rates will rise as the U.S. borrows unprecedented amounts. Obama is
borrowing record amounts to fund spending programs to help the economy recover from
its longest recession since the 1930s.
Posted by Luke Froeb at 2:09 AM 1 comments
Labels: 08: Understanding Market and Industry Changes
Thursday, June 3, 2010
Did Cash for Clunkers work?
One theoretical objection to Keynesian stimulus is that it merely "steals" economic
activity from the future. For Cash for Clunkers the future was only a couple of months
away.
Posted by Luke Froeb at 5:44 PM 0 comments
Labels: 08: Understanding Market and Industry Changes
Wednesday, May 19, 2010
When the tax credit expired,...
Monthly demand for mortgages first increased, then dropped. From calculated risk:
There was a spike in purchase applications in April, followed by a decline to a 13 year
low last week. As Fratantoni noted: "The data continue to suggest that the tax credit
pulled sales into April at the expense of the remainder of the spring buying season."
Posted by Luke Froeb at 11:10 AM 0 comments
Labels: 08: Understanding Market and Industry Changes
Thursday, March 25, 2010
Will mortgage rates increase soon?
Federal demand for mortgage backed securities is about to fall:
The NY Fed purchased an additional net $8 billion in MBS for the week ending March
24th. This puts the total purchases at $1.248 trillion or 99.84% complete. Just $2 billion
and one more week to go ...
recall that the price of a loan is inversely related to yield (interest rates). Another way to
think about this is that the supply of debt is declining (equivalent to demand for
mortgages) which raises the price of debt (interest).
UPDATE
The Fed has been buying mortgage-backed securities guaranteed by Fannie Mae, Freddie
Mac and Ginnie Mae since December 2008 to help drive down mortgage rates and spur a
housing recovery. In addition to the $1.25 trillion in mortgage-backed securities, the Fed
has soaked up $175 billion of the big mortgage firms' debt, which could be part of an
asset-sales program.
Fed officials have been debating for several months whether to sell the assets as the
economy heals. The large mortgage portfolio makes it harder for the Fed to manage
short-term interest rates because buying the securities meant flooding the financial
system with cash. Because of all that extra cash in the system, it might be hard to get
banks to lend it out at higher rates when the Fed wants to raise them.
Posted by Luke Froeb at 3:53 PM 0 comments
Labels: 08: Understanding Market and Industry Changes
Monday, November 2, 2009
Demand for Hand Sanitizer
H1N1 has caused demand for hand sanitizer to more than double.
Should I have gotten my flu shot in September? I am always on the margin for this
decision. I am at low risk for transmission, but the cost is low (though transactions costs
could be high). Hand sanitizing is effective against transmission of the H1N1 flu as well
as the run-of-the-mill annual flu bug. Because of this, the non-H1N1 flu is likely not to be
as big a problem this Winter (it will be interesting to see how much). Since there is a
smaller chance that I would catch non-H1N1 flu from some contagious student, my
willingness-to-pay for the non-H1N1 shot should have fallen. As it turns out, my
physician offered it to me at zero marginal price at my annual check up. My willingnessto-pay fell but the price fell even more.
Hat tip: Craig Depken
Posted by Michael Ward at 9:47 AM 0 comments
Labels: 08: Understanding Market and Industry Changes
Sunday, October 25, 2009
Defending the undefendable: insider trading
Before there was Freakonomics and the Armchair Economist, there was Walter Block
Defending the Undefendable. These arguments force students to think instead of simply
regurgitating knowledge.
Don Boudreaux channels Block (and Henry Manne) with his defense of insider trading:
Suppose that unscrupulous management drives Acme Inc. to the verge of bankruptcy.
Being unscrupulous, Acme's managers succeed for a time in hiding its perilous financial
condition from the public. During this lying time, Acme's share price will be too high.
Investors will buy Acme shares at prices that conceal the company's imminent doom.
Creditors will extend financing to Acme on terms that do not compensate those creditors
for the true risks that they are unknowingly undertaking. Perhaps some of Acme's
employees will turn down good job offers at other firms in order to remain at what they
are misled to believe is a financially solid Acme Inc.
Insider trading would force the stock price closer to its true value, and prevent all of these
mistakes.
...when prices lie, market participants are misled into behaving in ways that harm not
only themselves but also the economy writ large.
Posted by Luke Froeb at 10:40 AM 0 comments
Labels: 08: Understanding Market and Industry Changes
Wednesday, October 14, 2009
Was this Serious or Ironic?
I learn a lot from the funnies. Today's Pluggers suggests just why post offices are closing.
I know that my purchases of stamps fell dramatically when I fully embraced online bill
payments.
ADDENDUM
The November 2 comic suggest that it was serious.
Posted by Michael Ward at 9:47 AM 0 comments
Labels: 08: Understanding Market and Industry Changes
Monday, October 5, 2009
Should the H1N1 Vaccine be Sold?
We are big believers in markets to distribute products to those who value the product
most. However, economic theory recognizes that personal willingness-to-pay may not be
a good measure of economic value when the product is homogeneous and when income
differences among customers are large. That is, I have no reason to believe that the
marginal utility from avoiding the flu is greater for my college president than for his
secretary, but I suspect his willingness-to-pay would be many multiples of hers. In fact,
even if his marginal utility was a fraction of hers, he might outbid her simply because he
has more income. Thus, if we allocate based on price alone, we are not likely to
maximize total utility.
OK, a price system may be less than perfect, but is it better than the alternative? Is there a
simple mechanism for discerning where the value is highest? We know that health
professionals are at greater risk and we know the age cohorts that are more at risk. We
know how the flu is spread and so can target areas where transmission is highest. In this
case, I would argue that an average bureaucrat could devise a low cost, yet high return
rationing scheme.
What is lost by not selling? First, one loses the the price signal. I suspect that, were it
sold, the vaccine price would be quite high initially and then fall dramatically as it
mitigates the effect of epidemics. How fast it falls and where would be valuable
information for allocating supplies. Second, one loses the profit motive. Not only does
the price identify where demand is highest, it also provides an incentive for distributors to
meet demand. I suspect these supplies would flow to the greatest need faster than if
allocated solely by bureaucrats. Third, one can price discriminate. For some the personal
willingness-to-pay will be low, too low. I mean that they will not incorporate the positive
externality that they confer onto others in their personal calculations. A reserve of funds
from initial high demanders can subsidize these low demanders.
Posted by Michael Ward at 2:30 PM 0 comments
Labels: 08: Understanding Market and Industry Changes, 13. Direct price discrimination
Wednesday, September 16, 2009
Detroit - Where Houses are Cheaper than Cars
Economics Professor Mark Perry, from the University of Michigan-Flint, tracks house
prices in Detroit. In a recent post, he reports that the average year-to-date price fell to
$11,596 in July. The average had peaked in 2003 at $97,850; the current prices represent
an 88% decline.
Posted by Brian McCann at 2:09 PM 0 comments
Labels: 08: Understanding Market and Industry Changes
Wednesday, September 9, 2009
Cash for Clunkers blip
The sharp spike in demand suggests that the Cash for Clunkers car buying subsidy had
only a very short lived effect on demand.
Note the seasonal troughs in December. Seems to validate my ex-girlfriend's father's
practice of buying cars on Christmas eve. If there is no one else around, the opportunity
cost of selling a car to you is almost zero (The alternatives to agreement determine the
terms of agreement.)
HT: Calculated Risk
Posted by Luke Froeb at 8:17 AM 0 comments
Labels: 08: Understanding Market and Industry Changes, 16. Bargaining
Monday, August 31, 2009
Working on the Demand Side of Prostitution
Either a decrease in supply or a decrease in demand (or both) can lead to fewer goods
and/or services being traded in a market. For communities trying to reduce prostitution
transactions, a lot of the effort has been targeted at the supply side.
The City of Nashville (among others), however, is targeting the demand side with its
"John Schools." No, they are not going to teach you how to become a better john. For
those not familiar with the term (like me who knows nothing about prostitution so had to
look up the term), the "john" is the customer in the transaction.
If a john pleads guilty to the initial offense, pays a $250 fee and completes the course
without re-offending, the original charge can be dismissed after a year. The article claims
that John Schools are designed to try to reduce re-offending and thereby reduce demand.
And, I think the argument is that it's more than just the incentive to avoid re-offending in
the first year. Based on the article, the claim seems to be that educating the johns about
how bad prostitution is will lead to long-term changes in their behavior. Hmmmm.
Posted by Brian McCann at 7:48 AM 0 comments
Labels: 08: Understanding Market and Industry Changes
Tuesday, August 25, 2009
They Shoot Horses Don't They?
What is the effect of a "compassionate" stance towards animal cruelty? One state recently
banned the slaughter of aged horses. Which state: Birkenstock-wearing, granola-eating,
lotus-sitting California or pickup-driving, gun-toting, big buckle-wearing Texas? Brace
yourself, but my local paper is reporting on the adverse effect that Texas's ban on horse
slaughter is having on horse ownership.
Aside from the recession, the middle and low end of the market have been particularly
hurt by a steep drop in the floor price historically created by U.S. slaughter facilities,
whose buyers paid $500 to $600 for Texas horses that had outlived their usefulness.
But after the 2007 ban on horse slaughter — one of the country’s three plants was in Fort
Worth — the floor dropped to $200 because of the expense of shipping to Mexico, where
processing is still legal, said Rusty Addison of Lipan, who operates the monthly horse
auction in Stephenville. (More than 27,000 U.S. horses were exported to Mexico for
slaughter this year through Aug. 8; that’s nearly three times the total for all of 2006 but
down 5,300 from the first eight months of 2007, according to the U.S. Department of
Agriculture.)
Raising the cost of "disposal" decreases the supply.
ADDENDUM
An anonymous comment points out that I got the facts wrong. I had thought the ban was
due to legislative action but, in Texas, it was due to a judicial decision. This story
indicates that in 2007, the Society for Animal Protective Legislation (SAPL) won its case
upholding an existing but unenforced law that banned the horse slaughter. The affected
facilities existed only in Illinois and Texas. So my digs at my fellow Californians was
unwarranted.
Posted by Michael Ward at 7:09 AM 4 comments
Labels: 08: Understanding Market and Industry Changes
Monday, August 3, 2009
The Identification Problem - Video Game Edition
Video game sales, thought to have been recession-proof, are off. Is the recession the
culprit?
When there is a change in the quantity demanded it is important to know why so that you
know how to respond appropriately. Empirical economics is increasingly concerned with
how to distinguish the identity of one possible cause from another, or we are concerned
with the "identification strategy." Many students have been failed and many trees have
been felled due to the investigation of poorly identified effects.
Some of our techniques can become quite sophisticated and this limits their applicability
in business settings. One writer over at Hellforge (love the name) provides a seat-of-thepants argument that the recession is not completely to blame. Rather, the newer games
"suck."
The recession is not affecting the video game industry proportionally any more than it did
from the outset. Recent game releases are above average quality ... but aren't as good as
the AAA releases from last year.
Hat tip Craig Depken
Posted by Michael Ward at 10:03 AM 1 comments
Labels: 08: Understanding Market and Industry Changes
Thursday, July 30, 2009
Computer Care Crisis?
One piece of evidence for the existence of a health care crisis is that the spending on
health care has grown very fast. Implicit in the claim is that increasing cost, and not
increasing demand, is the main cause for the rise in expenditures. Such an upward shift in
supply might be a concern. Yet there is considerable evidence that new treatments, drugs
and levels of care have increased the quality of care. Just how much would you be willing
to pay for one more QALY? This upward shift in demand is simply the reward to
providers for doing a better job.
To make the case more forcefully, one can compare healthcare expenditures with
computer expenditures. The Bureau of Economic Analysis (BEA) website with the
Industry Economic Accounts (IEA) contains data on the dollar value of output by
industry over time. I aggregated the industries that I consider to be "Health" and "ICT,"
basically computers, software and telecom. (Since I am not familiar with the health data,
I could be missing some industires.) Normalizing 1998 = 100 you get:
I doubt policy makers would claim that computer costs are "out of control" requiring an
overhaul of the "computer care system" with more direct government intervention in the
"computer services delivery." I suspect that nearly all of the growth in computer output is
due to greater demand from ever better products and services from amazing innovations.
In fact, there would be a fear that more government intervention might stifle the flow of
yet-to-be-developed innovations. Might the same apply to healthcare?
Posted by Michael Ward at 9:25 AM 0 comments
Labels: 08: Understanding Market and Industry Changes
Saturday, July 25, 2009
Competition for Newspapers (or for bloggers?)
The Examiner.com is an attempt at "new media." The Examiner.com provides the
platform, ads, and other overhead. Individual "examiners" are private contractors
providing content and getting paid by their audience size - moral hazard is dealt with. But
just about anyone can contribute - adverse selection may be a problem.
Examiner.com is your inside source for everything local. From pets to careers,
entertainment to sports, health to parenting and hundreds of more topics, Examiners
across the country contribute unique, original content to enhance your life in your local
city – wherever that may be.
But... this is the site about that site. We are staff members of Examiner.com in Denver,
Colorado, and we will be talking about what there is to know about life at Examiner.com
— from the inside.
Is it an eNewspaper? Is it blogging? Is it a profitable business model?
Posted by Michael Ward at 4:44 PM 0 comments
Labels: 08: Understanding Market and Industry Changes, 19: The Problem of Adverse
Selection, 20 : The Problem of Moral Hazard
Friday, July 24, 2009
Profit Opportunities from "Cash for Clunkers?"
Tucked inside an NPR report on the "Cash for Clunkers" program is this gem:
Emich was surprised to learn that most of the customers were middle-class folks with
good credit ratings — usually thrifty people who kept their cars for a long time.
I was expecting low-income, poor credit," says Emich. "It has been the complete
opposite." He says a few of the customers paid cash for their new cars.
I wonder if our minivan qualifies? Other identified impacts are:
1. An increase in the demand for labor at wrecking yards - I am not a market
participant.
2. An increase in the supply of spare parts - the expected operating costs for my old
minivan just fell.
3. A decrease in the demand for gasoline from fewer low MPG cars - also good for
my minivan.
4. Oh yeah, an increase in the demand for new cars - an indirect auto industry
bailout.
Unlike the more direct GM and Chrysler bailouts, consumers need not support the "US"
auto industry with their new purchases. Will demand increase more for these "US made"
cars or for "imports?" Consumers turning in Chevys to buy Toyotas would indicate that
the US auto industry is continuing to lose its historic comparative advantage. Did the
German version of this experiment disproportionately affect German auto makers?
Posted by Michael Ward at 8:55 AM 3 comments
Labels: 08: Understanding Market and Industry Changes
Tuesday, May 26, 2009
Should we worry about the dollar?
The markets do:
The US dollar fell to its lowest level of the year against major currencies last week. Treasury
yields spiked to six-month highs as investors focused on the willingness of creditors to fund a
deficit that was expected to be about 13 per cent of GDP this year.
Posted by Luke Froeb at 6:57 AM 0 comments
Labels: 08: Understanding Market and Industry Changes
Sunday, May 10, 2009
Finally, markets react
T Bond markets tell President Obama that lunch is not free:
The U.S. Treasury auction of long-term bonds on Thursday was “terrible”, in the words
of one Wall Street economist, with the rate on the 30 year bond jumping from 4.1 to 4.3
percent.
Posted by Luke Froeb at 7:46 AM 0 comments
Labels: 08: Understanding Market and Industry Changes
Tuesday, April 28, 2009
Iceland's amazing boom then bust
Former student, Oli Arnarson, helped us write a new chapter on Iceland for the second
edition of our textbook. I recommend his book to anyone who reads Icelandic.
:
Posted by Luke Froeb at 10:58 AM 0 comments
Labels: 08: Understanding Market and Industry Changes
Monday, March 23, 2009
Small car demand collapses
Consumer demand for small cars reached a peak in the summer of 2008, coinciding with
very high gasoline prices. Now that gas prices have fallen, so has demand for small cars.
Practically every small car in the market is stacked up at dealerships. At the end of
February, Honda Motor Co. had 22,191 Fits on dealer lots -- enough to last 125 days at
the current sales rate, according to Autodata Corp. In July, it had a nine-day supply, while
the industry generally considers a 55- to 60-day supply healthy.
If expectations are rational, consumers should be looking ahead to the price of fuel over
the lifetime of the automobile. That demand has collapsed so suddenly suggests either
that consumers expect gas prices to stay low, i.e. that we will not recover quickly from
the recession, or that expectations are not forward looking, and are instead driven by the
current gas prices.
Posted by Luke Froeb at 6:58 AM 0 comments
Labels: 08: Understanding Market and Industry Changes
God help Venezuela
Ever since Valley Forge, when George Washington put controls on the price of meat and
found that the supply disappeared, politicians have had a hard time understanding why
they markets react so negatively to government regulation. President Chavez is repeating
George's mistake:
First, President Hugo Chavez announced that he had ordered troops to intervene in the
country's rice production.
He accused rice producers of evading a law on controlled prices.
"They are making a mockery of the Venezuelan people," said Mr Chavez.
He said companies were refusing to produce sufficient quantities of standard white rice which is subject to price regulations - and were producing flavoured varieties instead to
avoid government controls.
'No such law'
Polar foods, one of those involved, said there was no law which obliged them to produce
a certain quantity of basic white rice.
Within the day there was such a law. The government introduced quotas on 12 basic
foods, including rice.
Posted by Luke Froeb at 2:11 PM 0 comments
Labels: 08: Understanding Market and Industry Changes
Friday, March 6, 2009
Who benefits from class warfare?
SWHC=Smith & Wesson Holding Company
RGR=Sturm, Ruger & Co.
GSPC=S&P 500 index fund
Posted by Luke Froeb at 9:48 AM 0 comments
Labels: 08: Understanding Market and Industry Changes
Tuesday, March 3, 2009
Iceland is a hedge fund
Iceland is interesting mainly because it is so closely associated with the inflating and
bursting of the world's credit bubble:
it is Iceland’s de facto bankruptcy—its currency (the krona) is kaput, its debt is 850
percent of G.D.P., its people are hoarding food and cash and blowing up their new Range
Rovers for the insurance—resulted from a stunning collective madness. What led a tiny
fishing nation, population 300,000, to decide, around 2003, to re-invent itself as a global
financial power?
How did this happen?
For the past few years, some large number of Icelanders engaged in the same disastrous
speculation. With local interest rates at 15.5 percent and the krona rising, they decided
the smart thing to do, when they wanted to buy something they couldn’t afford, was to
borrow not kronur but yen and Swiss francs. They paid 3 percent interest on the yen and
in the bargain made a bundle on the currency trade, as the krona kept rising. “The fishing
guys pretty much discovered the trade and made it huge,” says Magnus. “But they made
so much money on it that the financial stuff eventually overwhelmed the fish.” They
made so much money on it that the trade spread from the fishing guys to their friends.
It must have seemed like a no-brainer: buy these ever more valuable houses and cars with
money you are, in effect, paid to borrow. But, in October, after the krona collapsed, the
yen and Swiss francs they must repay are many times more expensive. Now many
Icelanders—especially young Icelanders—own $500,000 houses with $1.5 million
mortgages, and $35,000 Range Rovers with $100,000 in loans against them. To the
Range Rover problem there are two immediate solutions. One is to put it on a boat, ship it
to Europe, and try to sell it for a currency that still has value. The other is set it on fire
and collect the insurance.
Posted by Luke Froeb at 3:13 PM 0 comments
Labels: 08: Understanding Market and Industry Changes
Monday, March 2, 2009
Next time, we won't be so easily duped
Martin Marietta and Vulcan Materials Company produce construction aggregates in the
United States. When President Obama sold us on the $800B stimulus bill in December, it
was mostly about bridges and roads, precisely the kinds of projects that would benefit the
two companies. Consequently, their stock prices soared.
But by February, when it became clear that the stimulus contained only $30B for
infrastructure, the stock prices told us what it was likely to accomplish.
Posted by Luke Froeb at 3:23 PM 0 comments
Labels: 08: Understanding Market and Industry Changes
Monday, February 23, 2009
Price of polluting falls
Due to a decline in demand:
A year ago European governments allocated a limited number of carbon emission permits
to their big polluters. Businesses that reduce pollution are allowed to sell spare permits to
ones that need more. As demand outstrips this capped supply, and the price of permits
rises, an incentive grows to invest in green energy. Why buy costly permits to keep a coal
plant running when you can put the cash into clean power instead?
All this only works as the carbon price lifts. As with 1924 Château Lafite or Damian
Hirst's diamond skulls, scarcity and speculation create the value. If permits are cheap, and
everyone has lots, the green incentive crashes into reverse. As recession slashes output,
companies pile up permits they don't need and sell them on. The price falls, and anyone
who wants to pollute can afford to do so. The result is a system that does nothing at all
for climate change but a lot for the bottom lines of mega-polluters such as the steelmaker
Corus: industrial assistance in camouflage.
Posted by Luke Froeb at 2:48 PM 1 comments
Labels: 03. Benefits; costs and decisions, 08: Understanding Market and Industry
Changes
Tuesday, January 13, 2009
What are you giving up during the downturn?
From the BBC:
Posted by Luke Froeb at 10:11 AM 0 comments
Labels: 08: Understanding Market and Industry Changes
Tuesday, December 16, 2008
Flexible labour supply
Not only is demand down, but there is new entry: WARNING: ADULT CONTENT
An escort agency owner told the Sun he’s getting about 40 interested applicants every
day, the majority of whom are women running from the wreckage of lost finance jobs.
Posted by Luke Froeb at 9:41 AM 0 comments
Labels: 08: Understanding Market and Industry Changes
Tuesday, December 2, 2008
Be glad you are not in Iceland
Current residents are facing a falling currency and much higher prices for imports, which
is most of what they consume. From a former student living in Reykjavik:
The Icelandic krona is the smallest currency in the world. The central bank failed to build
foreign currency reserves as the Icelandic banks expanded internationally. The central
bank pursued a policy of high interest rates to fight overheating of the economy. This was
a fatally flawed policy that many, including yours truly, warned against. Predictably the
high interest rates attracted investors who borrowed in low yield currencies and took
advantage of carry trade. This in turn drove up the krona and fueled economic expansion.
Icelanders, individuals and companies, borrowed in low yield currencies and the prices of
imported goods came down in krona. This was all fine until international credit tightened
and later crumbled. The Icelandic house of cards came crashing down. The central bank
tried to fight the international credit crisis by repeatedly raising interest rates but to no
avail. In a nervous financial world the krona was toxic and no one would touch it.
In hindsight Iceland may have been better off joining a larger currency area like the EU.
Posted by Luke Froeb at 11:40 AM 0 comments
Labels: 08: Understanding Market and Industry Changes
Monday, November 24, 2008
Loans are cheap; why isn't anyone buying them?
The Economist reports that ever since Secretary Paulson decided that it was a bad idea
for the Treasury to buy bad loans at high prices, demand for loans has fallen, and this has
lead to a fall in the price for loans.
DISTRESSED markets tend not to react well to offers of salvation being abruptly
withdrawn. Holders of toxic mortgage-backed securities had pinned their hopes on the
American government’s plan to buy large piles of the stuff through auctions as part of the
Troubled Asset Relief Programme (TARP). The decision on November 12th to abandon
that approach in favour of direct capital injections has left them shattered. The ABX
index, which is linked to residential mortgages, is plumbing new depths. Spreads on the
CMBX index, which is tied to securities backed by loans for offices, shopping malls and
so on, have been exploding (see chart).
John Mauldin suggests that there artificial restraints may be preventing funds from
buying these cheap loans:
Today, many highly rated loans are selling for 80 cents on the dollar. There is nothing
wrong with the collateral or the corporation which owes the money; there is just no one
with ready cash to buy the loans. I asked my friend why he doesn't buy them, since they
offer very good returns.
The problem is that his fund, and most other CLOs, have covenants in their offering
documents that prevent them from buying debt at less than 85 cents on the dollar. That
covenant is a good thing in normal markets, as it prevents possible mischief by the
manager, but right now it means that a lot of opportunity is being missed.
Posted by Luke Froeb at 3:00 PM 1 comments
Labels: 08: Understanding Market and Industry Changes
Wednesday, November 12, 2008
Why is the Peso falling?
Answer: The price of a
peso has fallen from about $0.10 to $0.07 in the last two months. Falling US demand for
Mexican exports to the US means a lower demand for Pesos. As demand for pesos falls,
the price of a peso drops.
Posted by Luke Froeb at 11:42 AM 0 comments
Labels: 08: Understanding Market and Industry Changes
Monday, October 27, 2008
Labor mobility attenuates shocks
Wall St refugees leave NYC in mass migration:
Bankers and brokers looking to escape the financial meltdown are scrambling to relocate
their families, possessions and rarified talent far from Wall Street to places such as
Florida, Chicago, Milwaukee, Virginia and Asia.
Just think how difficult it is for countries without a mobile labor force to respond to these
changes. Policies designed to ease the pain from these shocks has the perverse effect of
decreasing our ability to respond to them.
Posted by Luke Froeb at 8:55 AM 0 comments
Labels: 08: Understanding Market and Industry Changes
Tuesday, October 14, 2008
Is mark-to-market accounting causing the crisis?
One of the themes in our textbook is that seemingly innocuous rules can have real effects
if they are tied to decision making. Many argue that banks' reluctance to lend money is
tied to the mark-to-market accounting rules they are using. If the underlying value of a
bank's assets decline then then they have to mark down their equity which reduces the
amount of money they can lend.
If this is indeed causing the crisis, we may have a nice natural experiment to test the
hypothesis. FASB, the accounting folks who brought us mark-to-market accounting rules,
are now suggesting that banks use cash flow analysis instead:
What this means is that if financial institutions are able to argue cash flow analysis to the
auditors, the fire sale write downs of illiquid loan pools will no longer erode financial
market capital.
Posted by Luke Froeb at 10:39 AM 0 comments
Labels: 08: Understanding Market and Industry Changes
Wednesday, October 1, 2008
Could central planners have imagined these adjustments?
The flexibility of a capitalist economy is remarkable:






Hugh Hefner is laying off some of his bunny girls
Sales of turnips have rocketed
Tearooms are enjoying a renaissance
Children are being forced to walk to school.
fish and chip shops have seen an increase in sales for the first time in five years
Chocolate sales are soaring
Posted by Luke Froeb at 10:25 AM 2 comments
Labels: 08: Understanding Market and Industry Changes
Tuesday, September 30, 2008
Bank lending is getting expensive
Posted by Luke Froeb at 10:30 AM 1 comments
Labels: 08: Understanding Market and Industry Changes
Saturday, September 20, 2008
What spooked Paulson and Bernanke?
The decline in demand for commercial paper (used to purchase inventory or manage
working capital) caused price of commercial paper to fall and the interest rate to rise.
(inversely related to price). Quantity fell. [Note: the suppliers of loans demand
commercial paper.]
[thanks do Doc for correcting me on prices vs. interest rates]
Posted by Luke Froeb at 9:46 AM 2 comments
Labels: 08: Understanding Market and Industry Changes
Thursday, September 18, 2008
Will we ever see this again?
US TREASURY BONDS RATES
Last
Maturity Today Yesterday Week
Last
Month
3 Month 0.01
0.64
1.58
1.70
6 Month 0.69
1.43
1.80
1.90
2 Year
1.56
1.80
2.18
2.32
3 Year
1.41
1.67
2.03
2.18
5 Year
2.51
2.60
2.89
3.06
10 Year 3.41
3.46
3.63
3.81
30 Year 4.08
4.10
4.22
4.44
yields from yesterday
Posted by Luke Froeb at 8:43 AM 0 comments
Labels: 08: Understanding Market and Industry Changes
Tuesday, September 9, 2008
Did Paulson pull a fast one on the Dem's?
There is much to criticize about the nationalization of the two government sponsored
companies but judging from the interview of Christopher Dodd on NPR, it seems as if the
Bush administration duped the Democrats into giving them the ability to get rid of the
firms. In addition, the lobbying spigot that allowed the two firms to funnel money to
politicians (mostly Democrats?) may be shut off.
UPDATE: Fannie and Freddie using our money to "invest" in Democrats
Another interesting angle on the takeover is that the US government did not want to
punish the Chinese government for holding Fannie and Freddie debt. Recall that
investment demand for dollar denominated debt increases demand for dollars which
raises the "price" of a dollar measured in yuan. A strong dollar increases US demand for
Chinese exports, and allows the Chinese government to uphold their end of the Faustian
bargain they have struck with their citizens: in exchange for support of a totalitarian
regime, the Government promises full employment with income growth. But, as we have
blogged in the past, pegging your currency to the dollar means that you lose control of
the money supply and this leads to inflation. See our previous post, China is busted by the
laws of economics.
Posted by Luke Froeb at 8:14 AM 0 comments
Labels: 08: Understanding Market and Industry Changes
Friday, September 5, 2008
Housing bubbles are smaller where supply is elastic
The latest from Ed Glaeser:
places with more elastic housing supply have fewer and shorter bubbles, with smaller
price increases. However, the welfare consequences of bubbles may actually be higher in
more elastic places because those places will overbuild more in response to a bubble. ...
the price run-ups of the 1980s were almost exclusively experienced in cities where
housing supply is more inelastic. More elastic places had slightly larger increases in
building during that period. Over the past five years, a modest number of more elastic
places also experienced large price booms, but as the model suggests, these booms seem
to have been quite short. Prices are already moving back towards construction costs in
those areas.
Posted by Luke Froeb at 2:17 PM 2 comments
Labels: 08: Understanding Market and Industry Changes
Thursday, August 7, 2008
Co-payments for the un-insured
Emergency Room waiting times rise to an hour.
“There are more people arriving at the ERs. And there are fewer ERs,”
Posted by Luke Froeb at 10:18 AM 1 comments
Labels: 08: Understanding Market and Industry Changes
Wednesday, July 16, 2008
This seems so obvious...
At 2.9%, the home-owner vacancy rate, which measures the share of vacant homes for
sale, has reached its highest point since measurement began in 1956. But forget the
complicated bail out plans being crafted by politicians to help the housing sector. All you
have to do is reduce supply, and prices will increase:
Unlike mortgage bail-outs, this policy does not encourage risky lending. However, it
requires cities to spend money on demolition merely to lose money through reduced
taxes.
Posted by Luke Froeb at 12:21 PM 0 comments
Labels: 08: Understanding Market and Industry Changes
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Hummer, RIP?
GM is closing four factories that make SUV's and is
considering whether to kill the Hummer. Apparently the high fuel prices are reducing
demand.
Posted by Luke Froeb at 10:43 AM 0 comments
Labels: 08: Understanding Market and Industry Changes
Friday, June 6, 2008
What do oil and housing have in common?
Boom and bust cycles, driven by sudden changes in demand
both housing and oil supply react to a surge in demand with a long lag. In housing, the
lag is caused by restrictive zoning and development laws, especially in coastal markets
like California and Florida.
So when the economy roared back in 2002 and 2003, builders couldn't turn out homes
fast enough for buyers armed with those cheap mortgages. As a result, prices spiked.
They no longer bore any relation to the actual cost of buying and improving land, or
constructing and marketing a new house (at some reasonable profit margin). Instead,
frenzied buyers were setting the price.
Because builders were reaping huge windfall profits, they rushed to buy and develop
land. And sure enough, those new houses were ready just as buyers were retreating to the
sidelines because they could no longer afford to buy a home. That vast overhang of
unsold homes is what's driving down prices today.
The story is much the same with oil, with a twist. A big swath of the market isn't really
paying that $125 a barrel number you hear about seemingly every hour. In China, India
and the Middle East, governments are heavily subsidizing oil for their consumers and
corporations, leading to rampant over-consumption - and driving up prices even more.
But sooner or later the world won't keep paying those prices: Eventually, the price must
fall back to the cost of that last barrel to clear the market.
So what does that barrel cost today? According to Stephen Brown, an economist at the
Dallas Federal Reserve, that final barrel costs just $50 to produce. And when the price is
$125, the incentive to pour out more oil, like homebuilders' incentive to build more two
years ago, is irresistible.
"Cocaine is for horses, not for men; they say its going to kill me but they won't say
when."
It's impossible to predict how the adjustment this time will take shape, just as it was in
housing. There the surge in supply came in places the experts swore there was "no
supply," and wouldn't be any. Builders found a way to extend vast tracts of homes into
California's Inland Empire and Central Valley, and even build "in-fill" projects near the
densely-populated coasts.
Posted by Luke Froeb at 9:40 AM 1 comments
Labels: 08: Understanding Market and Industry Changes
Wednesday, May 28, 2008
The dollar in historical perspective
Historically, the dollar is
cheap. The first "spike" in the graph above was caused by the simultanous tightening of
monetary policy (dollars were scarce) under Volcker and the expansionary fiscal policy
under Reagan. The second "spike" is the financial or "internet" bubble of 2000, when
foreigners wanted dollars to invest in our equity markets.
Posted by Luke Froeb at 11:04 AM 0 comments
Labels: 08: Understanding Market and Industry Changes
Friday, May 9, 2008
How to take advantage of a downturn
Disney's net income is up 22% from a year ago on surpisingly strong demand for its
theme parks and resorts. Two reasons for this:

'75% of their hotel product is 'moderately priced' or 'value priced'. In contrast,
during the 1991 downturn, over 55% of the rooms were considered 'premium
priced'.

the U.S. vacation industry is benefiting from a weak dollar. At Disney, the
number of international visitors was up 25% from a year ago.
Posted by Luke Froeb at 9:10 AM 0 comments
Labels: 08: Understanding Market and Industry Changes
Thursday, May 8, 2008
The bottom looks a long way off...
How do we know that the
housing market is out of equilibrium?--By comparing it to rental prices. Fed economists
predict that housing is going to fall further:
...the rent/price yield in America ranged between 5% and 5.5% from 1960 to 1995, but
fell rapidly thereafter to reach a historic low of 3.5% at the height of the boom. Given the
typical pace of rental growth, Mr Feroli reckons house prices (as measured by the CaseShiller index) need to fall by 10-15% over the next year and a half for the rent/price yield
to return to its historical average. Again, that suggests the national housing bust is only
halfway through.
Posted by Luke Froeb at 6:56 AM 1 comments
Labels: 08: Understanding Market and Industry Changes
Tuesday, May 6, 2008
Would consumers benefit from a gas tax holiday?
All the economists who are theorizing about the effects of a federal gas tax holiday
apparently forgot to read the empirical literature on the topic. In 2000, the Illinois State
Legislature suspended the 5% gasoline sales tax. In response,
..retail gas prices are found to drop by 3% following the suspension, and increase by 4%
following the reinstatement...
This would imply a pass-through rate of about 70%. Ironically, a certain junior senator
from Illinois thought that this was a good idea at the time.
Posted by Luke Froeb at 7:07 AM 2 comments
Labels: 08: Understanding Market and Industry Changes
Tuesday, April 29, 2008
House prices still dropping
Posted by Luke Froeb at 6:55 PM 0 comments
Labels: 08: Understanding Market and Industry Changes
Monday, April 28, 2008
Watching the gales of creative destruction
In this blog, we have been watching the rapid demise of daily newspapapers. On the
circulation side, the aging and immigrant population hurts (young or non-English
speakers are less likely to read daily papers). On the supply side, more targeted and
attractive advertising media, like Google Adwords, have put a lot of pressure on the
dailies. Now more bad news, as the latest circulation figures are released.
The New York Times lost more than 150,000 copies on Sunday. Circulation on that day
fell a whopping 9.2% to 1,476,400. The paper's daily circulation declined 3.8% to
1,077,256.
Posted by Luke Froeb at 2:44 PM 0 comments
Labels: 08: Understanding Market and Industry Changes
Tuesday, April 15, 2008
Why is health care so expensive?
Because supply induces demand:
Where more alternatives are available, costs tend to be higher -- adding to the growing
evidence that the supply of health care drives its use...
Total U.S. health-care spending rose to about $2.1 trillion in 2006, and hospital care
made up the single largest chunk of that at $648 billion, or 31%, according to federal
figures.
Posted by Luke Froeb at 2:11 PM 0 comments
Labels: 08: Understanding Market and Industry Changes
Friday, April 11, 2008
Why is the US exporting cars?
From WSJ:
For years the U.S. has been one of the most expensive places in the world to make cars.
But the new contracts with the United Auto Workers union signed last fall significantly
improve the global competitive position of Big Three plants. The weaker dollar, which
makes production in the U.S. less expensive, is also helping to turn the economics of
domestic production upside down.
Posted by Luke Froeb at 6:46 AM 0 comments
Labels: 08: Understanding Market and Industry Changes
Friday, April 4, 2008
Demand is down, supply is up, so why are oil prices rising?
The answer: Investment demand is increasing because oil is a hedge against dollar
inflation:
the oil market is coming to resemble the gold market (which has also been soaring). ...
most gold traders don't even ask the question of how much gold was mined last year or
how much spare gold mining capacity there is.
Posted by Luke Froeb at 4:12 AM 0 comments
Labels: 08: Understanding Market and Industry Changes
Friday, March 28, 2008
Unions are bad for your health
Striking unions in Naples recently brought trash collection to a halt, prompting people to
burn their trash, which in turn released dioxins into the air, a class of chemicals that cause
cancer. Now we learn that samples of mozzarella cheese were found to be tainted with
dioxins. Japan and South Korea have already banned the cheese, and the EU could
follow. Domestic sales have already fallen by 30-35% in the days since the story broke,
Dow Jones Newswires reports.
Posted by Luke Froeb at 1:51 PM 0 comments
Labels: 08: Understanding Market and Industry Changes
Thursday, March 27, 2008
Are banks over reacting to risk?
Spreads between mortgage rates (prices) and risk-free treasury bills (costs) is getting
really big:
It doesn't seem that this spread between prices and costs could be explained by increased
risk. The Volatility Index (invented by colleague Bob Whaley) which measures the
implicit risk in options prices (the higher the options price, the bigger implied risk) hasn't
risen nearly as much. The expected annual change in stock prices is now 26%.
Posted by Luke Froeb at 6:17 AM 0 comments
Labels: 08: Understanding Market and Industry Changes
Tuesday, March 25, 2008
House prices falling faster
In past posts, (Let house prices fall, Sunk cost fallacy in real estate, One man's
foreclosure becomes another man's treasure), we have argued that the "stickiness" in
house prices is exacerbating the uncertainty in financial markets that trade assets tied to
the house prices. Now we have evidence that house prices are accelerating down, which
may "unstick" the financial markets:
A widely watched index of U.S. home prices fell 11.4 percent in January, its steepest
drop since data for the indicator was first collected in 1987.
Posted by Luke Froeb at 10:14 AM 1 comments
Labels: 08: Understanding Market and Industry Changes
Tuesday, March 18, 2008
Wheat on the Rise
Have you noticed that a loaf of bread is costing a bit more at your local grocery store
lately? Check out the chart below of wheat prices for at least a partial explanation.
So, what's driving higher wheat prices? Recent articles from the New York Times and
USA Today provide a nice reminder of various forces that affect supply and demand.
Growing international demand along with droughts that have reduced supply both
contribute to price increases. Also, some farmers have shifted from wheat to corn to try to
take advantage of ethanol subsidies further reducing supply.
Posted by Luke Froeb at 7:34 AM 1 comments
Labels: 08: Understanding Market and Industry Changes
Friday, March 7, 2008
Sawdust supply falling
From WSJ:
The sawdust article offers a great case for supply and demand analysis, with four good
points. The first point is regarding the shift in the supply of sawdust that is the impetus
for the recent increases in sawdust prices. With a decrease in the equilibrium quantity of
new home construction, the supply of wood byproducts, including sawdust, has
decreased. The result is an increase in the price of these byproducts. The second is a
movement along the supply function. With an increase in the price of sawdust,
entrepreneurial types now find it profitable to scavenge forest floors for scraps, which are
left by logging companies, that can be processed into sawdust. The third is a movement
along the demand function. With an increase in prices, byproduct consumers are
switching from sawdust to, for example, processed cow manure, almond hulls and walnut
shells. The fourth point is about the demand for employment in the sawdust industry.
With an increase in the price of sawdust, firms that distribute the material have laid off
workers because the workers and the purchased sawdust are complementary inputs.
EXTRA CREDIT QUESTION: Why is there no such thing as a shortage?
Posted by Luke Froeb at 11:10 AM 0 comments
Labels: 08: Understanding Market and Industry Changes
Thursday, March 6, 2008
Weak dollar brings hooligans to US
From Reason:
Drawn by a plummeting dollar, the British are arriving en masse on American shores. In
the streets of Manhattan, pale-skinned men in Manchester United shirts marvel loudly at
what all these iPods, “trainers,” and Nike track suits would cost them back home.
...Last December, Ricky Hatton, a stout-chugging, ruddy-faced British boxer, was laid
out on a Las Vegas canvas by the American welterweight champion Floyd Mayweather.
The crowd of Union Jack–bedecked fans —“drunken dullards” and “boors,” according to
The Daily Telegraph’s horrified sports correspondent—became so unruly that for the first
time in its history, the MGM Grand casino shut down its archipelago of bars.
Posted by Luke Froeb at 4:00 PM 0 comments
Labels: 08: Understanding Market and Industry Changes
Thursday, February 14, 2008
Benefits of a weaker dollar
From the NY Times:
The United States trade deficit shrank in 2007 for the first time in five years, buoyed by a
surge in exports that has helped domestic businesses stay afloat as the domestic economy
flags.
The gap between what Americans import and export contracted by 6.2 percent last year,
to $711.6 billion, the Commerce Department said on Thursday.
Posted by Luke Froeb at 1:16 PM 0 comments
Labels: 08: Understanding Market and Industry Changes
Tuesday, February 12, 2008
Is US economy losing its labor mobility?
In previous recesssions (early 1990's), there was a big migration from the rust belt to the
sun belt where jobs were plentiful. But this one is different. The downturn in housing is
making it difficult for people to move (unless they walk away from their mortgages),
reducing the flexibility of the US economy that has limited the duration and size of
previous downturns. From the Economist:
YOU won't hear the R-word much in the modest governor's mansion in Helena, Montana.
The occupant, Brian Schweitzer, insists that Montana's economy is in better shape than it
has ever been. It has had one of the fastest rates of job growth in the country. The state is
prospering on the back of booms in mining and farming, as well as steady growth in
tourism. Paul Polzin of the University of Montana forecasts that the state's economy will
grow by 4.1% this year, the fifth consecutive year of growth above 4%. “We've been
searching for realistic doomsday scenarios,” he says, “and we just can't find any.”
Go to Michigan, by contrast, and it is hard to find anything but gloom. The collapse of
America's car industry, coupled with a nasty subprime mortgage bust, has left the state
reeling. It has the highest unemployment rate in the country (7.6%) and the third-highest
foreclosure rate, and was the only state to lose a large number of jobs in 2007. In the runup to the state's Republican primary (which he won) Mitt Romney traversed Michigan,
promising to save voters from a “one-state recession”.
Posted by Luke Froeb at 4:21 AM 0 comments
Labels: 08: Understanding Market and Industry Changes
Monday, February 11, 2008
Understanding Changes in the Soybean Market
Here's a chart of prices in the soybean market over the last year from AgWeb
What's driving the increasing prices? As George Will notes in a recent Newsweek
column, at least two forces are combining to drive up prices. Demand is increasing thanks
to rising world population and incomes. Supply is also contracting because many farmers
have decided to switch production to agricultural products that can be turned into
biofuels.
Rising demand and falling supply = prices going up, up, up.
Posted by Luke Froeb at 7:58 AM 1 comments
Labels: 08: Understanding Market and Industry Changes
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Will they ever learn?
George Washington tried to reduce the cost of the food he purchased at Valley Forge by
imposing price controls. Predictably the supply disappeared. Now, the WSJ reports
similar efforts are underway in developing markets to combat high food prices caused by
the demand for biofuels.
Economists warn that price controls encourage hoarding and can lead to supply shortfalls,
fueling unrest. Faced with persistent food shortages, the government of Venezuela last
week warned it could "expropriate" any food company necessary to ensure the nation's
"food security and sovereignty."
Perhaps the biggest disadvantage of price controls, however, is that they short-circuit
potential changes in behavior by producers and consumers that might damp the
underlying causes of inflation
Posted by Luke Froeb at 10:23 AM 1 comments
Labels: 02: The One Lesson of Business, 08: Understanding Market and Industry
Changes
Thursday, February 7, 2008
Newspapers sinking fast
from NY Times:
In 2007, combined print and online ad revenue fell about 7 percent. In the last six
decades, only one other year — 2001, when there was a recession — had a steeper
decline, according to the Newspaper Association of America. Adjusted for inflation, 2007
ad revenue was more than 20 percent below its peak in 2000.
Circulation revenue has declined steadily since 2003, and the number of copies sold has
been slipping about 2 percent a year. Some of the largest papers — including The San
Francisco Chronicle, The Boston Globe and The Los Angeles Times — have lost 30 to
40 percent of their circulation in just a few years.
Posted by Luke Froeb at 2:01 PM 0 comments
Labels: 08: Understanding Market and Industry Changes
Wednesday, January 23, 2008
Understanding Changes in the Pork Market
Reading the local paper this morning, I stumbled across an article about predictions in the
pork market from the 2008 Central Indiana Pork Conference (welcome to the Midwest!).
Had you been able to attend you could have listened to sessions on "air quality in swine
production systems, reproductive inefficiencies and failures and how to incorporate dry
distillers grains."
One quote in the article from an agricultural economist perplexed me: "large pork
supplies may result from the lowest pork prices we've seen in five years." Anybody else
share my confusion? Low prices should lead to supply reductions, not supply increases.
Perhaps it's a misquote. Any pork experts out there?
Posted by Luke Froeb at 7:35 AM 2 comments
Labels: 08: Understanding Market and Industry Changes
Tuesday, January 15, 2008
New house prices down more than old ones
In past blog posts, we have noted that when the real estate market crashes, prices do not
adjust; rather quantity does. Now we learn that new house prices have declined by more
than old house prices:
And while new construction has declined from its highs of a year or two ago, it has not
disappeared. From January to October of this year, Los Angeles County has approved
about 17,000 new housing units. Owners of new units planned while prices were at their
peak may be loath to chop prices in the wake of the housing downturn, but newly
approved units, conceived amid the bad news of the past year, should enter the market
priced to move.
Posted by Luke Froeb at 4:35 PM 0 comments
Labels: 08: Understanding Market and Industry Changes
Thursday, December 6, 2007
Nashville housing market looks better than rest of US
In earlier posts, (Sunk-cost fallacy in real estate, Housing prices down only 4.5% but
unsold backlog reaches 10 months), we have blogged about "sticky" real estate prices.
Now, Bert Matthews gives us some hard data on Nashville relative to the rest of the
country. The unsold inventory (measured relative to current sales) is 6 months, compared
to a national average of 10 months.
And, over the past four years, Nashville has not
seen as much house price inflation as the rest of the country.
The housing sector is slowing, but not as much as in the rest of the country.
Posted by Luke Froeb at 4:04 PM 0 comments
Labels: 08: Understanding Market and Industry Changes
Tuesday, December 4, 2007
Who will come back to New Orleans?
NY Times:
Before the storm, more than half of the city’s population rented housing. Yet official
attention to help revive the shattered rental home and apartment market has been scant. ...
Last week, the city housing authority approved the demolition of 4,000 public housing
units at five projects damaged by the storm. In their place, the authority plans to build
mixed-income projects, large parts of which will not be affordable to previous residents.
One of the more striking changes to appear lately in New Orleans is the highly visible
number of homeless men and women living under bridges and in parks. Social service
groups say about 12,000 homeless people are living in the city, about double the number
before the storm.
Posted by Luke Froeb at 2:28 PM 0 comments
Labels: 08: Understanding Market and Industry Changes
Thursday, November 29, 2007
Declining dollar benefits US farmers
News from Memphis:
The declining dollar has sparked such a buying binge of U.S. farm commodities,
exporters are struggling to find room on steamships and enough containers to carry all the
wheat, soybeans and cotton. ...
In 18 months, the price of getting commodities from inland markets -- like Memphis -- to
markets overseas has doubled and is forcing traditional local exports -- cotton, lumber
and paper -- to compete for containers being gobbled up by grain.
Posted by Luke Froeb at 1:57 PM 1 comments
Labels: 08: Understanding Market and Industry Changes
Wednesday, November 7, 2007
Housing prices down only 4.5%, but unsold backlog reaches 10 months
In earlier posts (Sunk-cost fallacy in real estate), we documented the reluctance of
homeowners to sell at a loss. Now the Wall St Journal reports that housing prices have
fallen only 4.5% from their March 2006 peak and, due to the reluctance of sellers to
reduce price, there is a ten month backlog of unsold houses.
Keeping your house on the market can cost as much as 1% of the house value each
month. Their advice:
Ask your real-estate agent how many properties are on the market in your town today
and how many sold in each of the past six months, advises Chris Mayer, director of
Columbia Business School's Milstein Center for Real Estate.
"If there are 2,000 houses on the market and 200 houses sold last month, that means it's
taking 10 months to sell a house," Prof. Mayer says. "That's pretty simple math, but
nobody ever does it. If you price your house like everybody else, it might take 10 months
to sell it."
Posted by Luke Froeb at 3:37 PM 0 comments
Labels: 08: Understanding Market and Industry Changes
Monday, October 29, 2007
What does real estate have to do with politics?
Virginia Postrel compares Dallas and Los Angeles:
The Dallas model, prominent in the South and Southwest, sees a growing population as a
sign of urban health. Cities liberally permit housing construction to accommodate new
residents. The Los Angeles model, common on the West Coast and in the Northeast
Corridor, discourages growth by limiting new housing. Instead of inviting newcomers,
this approach rewards longtime residents with big capital gains and the political clout to
block projects they don’t like.
...
These differences also reinforce different norms and values—different ideas of what it
means to live a good life. Real estate may be as important as religion in explaining the
infamous gap between red and blue states.
Hat tip to Craig Newmark.
Posted by Luke Froeb at 6:09 PM 0 comments
Labels: 08: Understanding Market and Industry Changes
Friday, October 26, 2007
Prices Convey Valuable Information
Peter Klein at the Organizations and Markets blog has an interesting post questioning
why regulators, industry groups, and consumer representatives are resistant to rationing
by the price mechanism. Why don't we use prices to help allocate goods like airport
landing slots and Internet bandwidth?
As everyone's favorite Managerial Economics text notes, "prices are the primary
mechanism that market participants use to communicate with one another." When you
remove this communication mechanism from the market, you end up with problems like
those Klein mentions: shortages, delays, congestion, and misallocation.
Posted by Luke Froeb at 7:26 AM 0 comments
Labels: 08: Understanding Market and Industry Changes
Friday, October 12, 2007
Hay - Why Have Prices Doubled?
According to a number of stories in the media including this one from MSNBC.com, hay
prices have just about doubled this year. Why?
I am sure that the astute readers of this blog and anyone else who has read a managerial
economics textbook (perhaps, like this one) will consider possible shifts in supply and
demand as factors explaining this change. Drought-like weather conditions have certainly
contributed to a contraction in supply partially explaining the price increase.
But, a more subtle factor is contributing as well. Changes in the price of substitutes can
also impact demand for a product. And, prices for corn, one of the primary substitutes for
hay, have shot up this year thanks to the increased demand for ethanol. As more farmers
shift away from high-priced corn to feed their animals, demand for hay goes up and
prices increase.
Posted by Luke Froeb at 8:43 AM 2 comments
Labels: 08: Understanding Market and Industry Changes
Wednesday, October 3, 2007
Truckers are stockpiling dirty diesel engines
In 2007, new EPA regulations that mandate cleaner diesel engines took effect. The new
engines reduce particle emissions by up to 98% over the previous generation and cut
Nitrogen-oxide emissions in half.
But they increase the cost of trucks by $12,000, or about 10%. In addition, truckers
(consumers of the new engines) expect higher maintenance costs and worse fuel mileage.
Predictably, the new regulations caused a big increase in demand for 2006 engines and
trucks,
Truckers seeking to beat the price increases made 2006 a record year for truck makers.
More than 373,000 big-rig trucks were built in North America, says Ken Vieth of A.C.T.
Research, which follows truck sales trends. The tally easily topped the previous record of
330,000 trucks in 1999.
But next year, Vieth predicts "a production drought," with sales falling by more than
40% to 220,000 as trucking firms hold off buying to see how the new clean-diesel trucks
perform. ...
The cost to truckers goes beyond new big-rig purchases, according to Moskowitz. The
new fuel costs 5 cents to 10 cents more per gallon to refine and may produce lower fuel
mileage. The new engines weigh more, further cutting mileage. "Over the long run, their
increased costs will be passed on to the shippers and ultimately, the consumers,"
Moskowitz says.
Both the 2006 boom, and the 2007 bust were predictable with simple supply-demand
analysis, especially since a similar regulatory change occurred in 2002.
For policy makers, this points out yet another disadvantage of a command-and-control
approach to clean air. Mandates from Washington have to be phased in, and this gives
consumers an incentive to stockpile old, cheap, but dirty engines so they can use them in
the future. Instead of telling producers what to produce, or consumers what to consume
(by picking technologies, like ethanol, to subsidize), tax what you don't want (pollution)
and let the market decide how best to reduce it.
Bottom line: How many economists does it take to screw in a light bulb? None--the
market will do it.
Posted by Luke Froeb at 5:08 AM 1 comments
Labels: 08: Understanding Market and Industry Changes
Monday, September 24, 2007
Anatomy of a tainted dog food re-call: why did price go up, then fall?
In March 2007, after the Chinese recalled tainted wet dog food, what happened? In the
graph above, depicting weekly quantity and price for wet dog food sold in the US, we see
that price (red) initially peaked, and then fell. Meanwhile, quantity (blue) initially fell,
and then recovered to its pre-recall level. But price never returned to its pre-recall level.
A free copy of my textbook to the best explanation of these price and quantity changes in
the comments below.
Posted by Luke Froeb at 3:17 PM 11 comments
Labels: 08: Understanding Market and Industry Changes
Wednesday, August 22, 2007
It's Good to Be in Demand
A July 29 New York Times article reports that many state universities have begun to
charge higher tuition rates for certain majors like engineering and business. One factor
mentioned by university officials in driving the increases is “ high salaries commanded
by professors in certain fields.” The article quotes G. Dan Parker III, the associate
executive vice president of Texas A&M. Mr. Parker said, “The salaries we pay for
entering assistant [business] professors on average is probably larger than the average
salary for full professors at the university. That’s how far the pendulum has swung at the
business schools, and I sure wish they’d fix it.”
I am not sure who Mr. Parker thinks “they” are, but using
some simple demand and supply curves can give us an idea. As shown in the adjacent
graph analyzing the market for business professors in the United States over the past few
years, rising pay for business professors is consistent with an increase in demand for
business professors. What would then cause salaries to fall? Salaries will decrease when
one of two things happens: when demand falls or when supply increases.
“They” in this case is him, Mr. Parker. Universities demand the services of business
professors. So, people like Mr. Parker (although I must confess I don’t exactly know
what an associate executive vice president does – I think this breaks the rule for the
number of adjectives that should be placed in front of a noun) can either decrease their
demand (unlikely to be a wise choice given that student demand for business education
does not appear to be decreasing markedly) or they can work to increase the supply by
producing more business professors. I don’t see any other “theys” out there who are
going to fix the problem.
Aahh – the power of simple supply and demand analysis.
Posted by Luke Froeb at 7:19 AM 0 comments
Labels: 08: Understanding Market and Industry Changes
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