Producer & Consumer DecisionsExecutive MBA 512

Session #5Presented byBrian Greber

October 19, 2012

5-1

INTRODUCTION TO INSTRUCTOR

Brian Greber, Ph.D.B.S. Forestry (WVU)M.S. (WVU), Ph.D.(VT) Resource Economics19 years industry/executive experience (most

recently VP Marketing & Technology in a Fortune 100 Forest Products Firm)

16 years teaching, research, policy experience at universities (VT, OSU, BSU)

Lots of public policy work at the state & federal levels

Senior Economist/Director at ECONorthwestLive in Boise – avid fitness buff and enjoy most

things outdoorsActive with not-for-profits (Pres. The Arc Board)Motorcycle safety instructor

5-2

Today’s Objectives• Enable a structured approach to thinking through

consumer, supplier, and competitor reactions to changing events and how that can/should influence your enterprise’s decisions.

• Focus on demand as a reflection of the value that consumers place on products and supply as a reflection of costs of providing those products.

• Practical application of demand and costs analysis to make wise production and marketing decisions in the immediate, short-run, and long-run scenarios.

• Understand common sources of data for demand and supply analyses.

5-3

The Book• Chosen to get you to think about economic models;

not a political statement• I like it because it makes people think beyond the

rhetoric that normally is in text books. • The discussion of market failures is critical to

discussions of economics and economic policy.• Most of my discussion will be the conventional

view but the anti-text should broaden your views.

5-4

Today’s Agenda• Establish a framework for economic thinking.• Use economic logic to think through consumer

decision making.• Use economic logic to think through

producer/supplier decision making.• Extend the logic of individual decisions to a rational

model of the market.• Provide guidance on how to conduct applied market

analysis.

5-4

Business Research

An A?

5-6

Economic Thinking• Economics is the study of choice• It focuses on how rationale choices are made.• There tends to be a particular focus on consumer

and producer choices within a market context (that is where exchange is facilitated with a common currency)

• Two principle fields in legacy thinking• Micro-economics – focused on individual firms,

consumers, and product markets.• Macro-economics – focused on the aggregate

performance of economic systems.

5-7

Keys to Economic Thinking1. Scarcity

• Forces choice• Creates value

2. Thinking “on the margin”• Leave nothing on the table• Do not sub-optimize

3. Recognizing opportunity cost as a real cost• Scarcity forces sacrifices

4. Purposeful behavior• Rationale and self interested individuals• Firms pursue profits• Individuals pursue “utility” – OK, happiness!

5-8

Economic Models1. Predictive

• Based on conditioning assumptions• Destined to be wrong (a correct one is a lucky one)• Extrapolative/inferential• Best use is sensitivity analysis.

2. Paradigm• A logical model to discuss cause and effects• Provides a common frame of reference

We will be focusing principally on Paradigms – models for explaining behavior and thinking through consequences of actions (or inaction!).

5-9AIR_Yoram_med.mp4 - Shortcut.lnk

Law of Demand• Other things equal, as price falls quantity

demanded rises • Corollary: as quantities consumed increase,

marginal value declines.

WHY?

5-10

Demand to an Economist• The marginal value that consumers place on the next

increment of consumption, thus• To put “marginal value” in context, think about “for

each dollar/penny I lower price what new purchases do I entice consumers to make” – the incremental quantity sold at this lower price reflects the vale that was placed on that and only that increment (the rest of the volume clearly was valued higher.

• Amount consumers willing and able to purchase at a given price• The value reflects the “maximum willingness to pay”

for each additional unit of volume (see above)• Yields a Schedule or curve – quantitative, not

ethereal• Individual vs Market

5-11

Individual Demand

6

5

4

3

2

1

0

Quantity Demanded (bushels per week)

Pric

e (p

er b

ushe

l)

P Qd

$5

4

3

2

1

10

20

35

55

80

IndividualDemand

P

Q

D1

2 4 6 8 10 12 14 16 18

Demand Can Increase or Decrease

Increase in Demand

Decrease in Demand

D2

D3

Of Course: D=MB

5-12

Individual Demand

6

5

4

3

2

1

0

Quantity Demanded (bushels per week)

Pric

e (p

er b

ushe

l)

P Qd

$5

4

3

2

1

10

20

35

55

80

IndividualDemand

P

Q

D1

2 4 6 8 10 12 14 16 18

Demand Can Increase or Decrease

Decrease in Demand

D2

D3

Change in Demand

Change in Quantity Demanded

5-13

A Graphical Nuance• Typical economic supply and demand graphs

have 2 dependent variables – P + Q• This is not your typical graph where the

horizontal axis refelcts an “independent” variable and the vertical axis reflects a “dependent” variable, i.e., a “cause and effect” relationship.

• P+Q are both “effects” behavior

5-14

Market vs Individual Demand?• We start with discussing the decision-making

of the individual consumer.• This establishes the behavioral paradigm

• In reality, the range of choices for an individual are pretty narrow/lumpy (e.g., cars, houses, or bags of oranges!).

• Focus becomes “market demand”• the collective demand of all consumers for

a product or service. • We infer this from historic

price/consumption behavior

5-15

What causes demand to shift?• Number of buyers• Income• Price/quality/value of substitutes• Price/quality/value of complements• Price of unrelated goods (?)• Taste• Drives satiation• Impacts perceptions of opportunity cost

Remember Demand is all about the Consumer: what value do they see in the product/service.

How can your business/industry influence demand?

5-16

Oct 8 article on Auto salesWhat factors were listed as reasons

for recent upticks in auto sales/demand?• Which cause demand to shift?• Which cause “movement along

the demand curve?”

5-17

Shape/slope of demand• Note, the shape is measuring the

responsiveness of perceived value to changes in quantity consumed

• Inversely, the shape reflects the responsiveness of quantity to changes in price• What economists call “price elasticity” of

demand Percentage Change in QuantityDemanded of Product X

Percentage Change in Priceof Product X

EdX =

5-18

Price Elasticity of DemandExtreme cases• Perfectly inelastic demand• Perfectly elastic demand• Unitary Elasticity

p

Q

p

Q

p

Q

D

D

D

Examples?

5-19

What influences slope of demand• Substitutability

• More substitutes, more elastic demand• Proportion of income• Price relative to income

• Luxuries versus necessities• Luxuries are more elastic

• Time• More elastic in the long run

5-20

Sample Elasticities

5-21

See also:http://www.ers.usda.gov/data-products/commodity-and-food-elasticities.aspx

Cross price elasticity of demand

Percentage Change in QuantityDemanded of Product X

Percentage Change in Priceof Product Y

EdXY =

5-22

• Elasticity > 0, substitutes• Elastciity < 0, complements

2011 study by American Public Transportation Asoc.• How would you characterize the elasticty of

demand for gasoline for commuters?• How different were the short run and long run

elasticities?• What would account for this difference?

• Using gasoline price was a proxy for the price of self commute, how would you characterize the cross elasticty of demand for mass transit?• How did this vary with time?• How did it vary with gasoline price?

5-23

• .

5-24

Estimating Demand – a bootstrap approach• Warning: do not simply regress Q = f(P)• Why not?

• You can roughly approximate a demand curve for your industry by using current quantity and price and published elasticities:

5-25

Estimating Demand – a bootstrap approach

5-26

Key take away: Demand• Consumer demand reflects perceived value• Demand shifters are those things that

influence perceived value

• Price is not a demand shifter; demand shifters are “independent” variables, P+Q are both dependent variables.

5-27

Law of Supply• Other things equal, as price rises the quantity

supplied rises• Corollary: as quantities produced increase,

incremental production cost per unit rise.

WHY?

5-28

Supply to an Economist• The marginal cost of producing the next unit

of output• Assume supplier will supply as long as the

price is sufficient to cover that incremental cost, thus

• Amount suppliers are willing and able to supply at a given price• Other things equal• Yields a Schedule or curve – quantitative• Individual vs• Market

5-29

Individual Supply

6

5

4

3

2

1

0

Quantity Supplied (bushels per week)

Pric

e (p

er b

ushe

l)

P Qs

$5

4

3

2

1

60

50

35

20

5

IndividualSupply

P

Q

S1

10 20 30 40 50 60 70

Let’s talk opportunity cost. Example f – soccer balls vs volley balls – incremental cost of producing volleyballs must recognize what?

5-30

Individual Supply

6

5

4

3

2

1

0

Quantity Supplied (bushels per week)

Pric

e (p

er b

ushe

l)

P Qs

$5

4

3

2

1

60

50

35

20

5

IndividualSupply

P

Q

S1

Supply Can Increase or Decrease

S2

S3

10 20 30 40 50 60 70

5-31

Individual Supply

6

5

4

3

2

1

0

Quantity Supplied (bushels per week)

Pric

e (p

er b

ushe

l)

P Qs

$5

4

3

2

1

60

50

35

20

5

IndividualSupply

P

Q

S1

Supply Can Increase or Decrease

S2

S3

10 20 30 40 50 60 70

Change in Quantity Supplied

Change in Supply

5-32

Market vs Individual Supply?• In contrast to individual consumers, it is often

important to understand the economic supplies of individual firms:• Your firm• Concentrated Industries

• From a price and market perspective the focus becomes “market supply”• the collective supply of all firms. • We infer this from historic price/production

behavior

5-29

What causes supply to shift?• Number of sellers• Anything that shifts marginal costs:• Resource prices• Technology• Taxes and subsidies• Prices of other goods (opportunity costs)

• Producer expectations

5-34

Shape/slope of supply

• Note, the shape is measuring the responsiveness of cost to changes in quantity supplied

• Inversely, the shape reflects the responsiveness of quantity supplied to changes in price• What economists call “price elasticity” of

demand

Percentage Change in QuantitySupplied of Product X

Percentage Change in Priceof Product X

EsX=

5-35

Price Elasticity of Supply

Extreme cases• Perfectly inelastic supply• Perfectly elastic supply• Unitary Elasticity

p

Q

p

Q

p

Q

S

S

Examples?

S

5-36

What influences slope of supply• Shape of curve for inputs• Diminishing returns• Time• Market period• Perfectly inelastic supply

• Short run• Fixed plant size

• Long run• Adjustable plant size• Supply more elastic• More elastic in the long run

5-37

January 2012 Article on End of Elastic Oil• How did they characterize the overall

elasticity of supply for oil?• How did they say it differed between the

OPEC countries and the US? Why• Is the elasticity of oil greater in the long

run or the short run? Why?• Did the article contend that the short-run

elasticty of supply is getting “more or less” elastic through time? Why?• Dies this contradict the preceding point?

• Diminishing returns• Time• Market period• Perfectly inelastic supply

• Short run• Fixed plant size

• Long run• Adjustable plant size• Supply more elastic• More elastic in the long run

5-38

Cross Price elasticity of supply• Elasticity > 0, production complements …..

Examples?• Elasticity < 0, production competitors ….

Examples?Percentage Change in Quantity

Supplied of Product XPercentage Change in Price

of Product Y

EsXY=

5-39

Law of Diminishing Returns• Fixed technology• Add variable

resource to fixed resource

• Marginal product will decline• Beyond some point• The faster the rate

of decline, the steeper the marginal cost/supply curve They Need a Heavier Donkey...

5-40

IncreasingMarginalReturns

Law of Diminishing Returns

(1)Units of the

Variable Resource(Labor)

(2)Total Product

(TP)

(3)Marginal Product

(MP),Change in (2)/Change in (1)

(3)AverageProduct

(AP),(2)/(1)

012345678

01025456070757570

1015201510

50

-5

-10.0012.5015.0015.0014.0012.5010.71 8.75

]]]]]]]]

DiminishingMarginalReturns

NegativeMarginalReturns

5-41

0

10

20

30

Tota

l Pro

duct

, TP

1 2 3 4 5 6 7 8 9

20

10

Mar

gina

l Pro

duct

, MP

1 2 3 4 5 6 7 8 9

TP

MP

AP

IncreasingMarginalReturns

DiminishingMarginalReturns

NegativeMarginalReturns

Law of Diminishing Returns

5-42

Aver

age

Prod

uct a

ndM

argi

nal P

rodu

ctCo

st (D

olla

rs)

Graphical Relationships

MPAP

MCAVC

Quantity of Output

Quantity of Labor

Production Curves

Cost Curves5-43

• .

5-44

Costs and decisions• Average fixed cost

• Understand effect of scale on “leveraging” costs• Average variable cost

• Key controllable cost on a day-to-day basis; key to shut down economics

• Produce as long as P > AVC• Average total cost

• Standard for “cost accounting”• Marginal cost = Supply

• Key to determining profit maximizing output levels• Competitive firm Produce to where P=MC

5-45

Estimating Supply – a cost curve approach• Use an engineering build up, treating each

increment of supply available in the market as a “marginal supply”• This may be turning a plant on or off,

opening /closing a new supply reserve, etc.• Examples from the web:

http://www.mckinseyquarterly.com/Strategy/Strategic_Thinking/Enduring_ideas_The_industry_cost_curve_2343

http://www.minecost.com/curves.htm

5-46

Articles posted• “GM Plant makes Volt Electric Car More

Efficient?”• Which way is the supply function shifting?• What are the reasons for this supply shift?• What would be the economic explanation?• When the second shift is added, what does

the ability to spread fixed costs over more units of production mean for the supply function?

• “P&G Cuts Jobs”• What costs did P&G cut?• Would these be components of MC? AVC?

AFC?• Does this change sort-run supply? 5-47

Key take away: Supply • Supply reflects the marginal cost of production• Any market or policy changes that influence

marginal costs will shift supply.

5-48

Putting D&S together What happens if you instill quotas, price ceilings, or floors?

5-49

Key take away: Market Equilibrium • The meeting of the minds that balances price

and quantity• Avoids surplus and shortage• Uses price for Rationing • Leads to Efficient allocation• Productive efficiency• Allocative efficiency among consumers and

producers

5-50

July 2012 Article on Ethanol and Corn & October Article on Yeast• If requirements for ethanol use stay the same and the

price of gasoline rises, what is apt to happen to the supply of corn for food purposes ? What does that say about the cross price elasticity of supply?• What would happen to food prices related to corn as

a feed, grain, or vegetable?• If the demand and price of corn for ethanol falls, what

would happen to the demand for yeast?• What does that say about the cross price elasticity of

demand for yeast? • So what does that mean that an increase in oil prices

will eventually do to yeast prices?• Now you are thinking like an economist…….

5-51

Assumptions for efficient market • Private property

• Yields investment, innovation, exchange, maintenance, & growth.

• Freedom of enterprise and choice• Scalability, Entry and exit

• Self-interest• Creates “checks and balances”

• Competition• More “checks and balances”

• Markets and prices allowed to function• Limited government/currency and trade

facilitated5-52

Special Topics from the Anti-Text • Conventional economics focuses heavily on

efficiency and only cares about aggregate distribution (i.e., consumers in general and producers in general).• When can distributional issues cause

inefficiencies?• Comparative advantage• When can you be less efficient at

something and society still benefits by having you specialize in it?

• Inverse demand or supply• When might supply actually slope down?• When might demand actually slope up?

5-53

Special Topics from the Anti-Text • Price expectations

• They do cause shifts in demand and supply that do not always lend themselves to simple modeling• The basic theories still hold – they shift

demand back and forth through time.• Imperfect or asymmetric information• A key market failure • Market assumes all values and costs are

understood by market participants• Many of the anti-text’s arguments

(including corporate power) are actually rooted in mis-informations

5-54

Special Topics from the Anti-Text • Shapes of the cost curves

• To some extent the argument is irrelevant, one needs to believe in aggregate there is some form of upwards sloping supply function. Individual firms need not see significant price elasticity of supply.

• Switching suppliers (p. 107) – who can you turn to if all producers are already producing at optimal levels?• Do we overstate the freedom of choice

argument in markets?• What does it depend upon? • Does that invalidate the basic market

model? Parts of it?5-55

Assignment• Participants will choose one of assigned commodities to

do a preliminary draft of a demand schedule (“curve”) and summarize 4 key demand drivers and trends in those drivers. For the same commodity, summarize 4 key supply drivers and trends in them. Graph the demand (Excel based using technique shown on slide 21) plus 1500 words explanation (max) plus references. • Due 11/23• Use any of the goods summarized in the table at this

link: http://www.mackinac.org/1247• I am looking for clear separation of demand and

supply , breadth in types of shifters, and definitive statements about trend and the directional impacts on supply or demand.

5-56

5-57