Lecture 2: Elasticity, Control on Prices & Production Dr. Rajeev Dhawan Director Given to the EMBA 8400 Class Classroom South #608 January 6, 2007
Chapter 5 Elasticity
Elasticity & Its Application • Evaluating questions like- • Banana Republic store manager/headquarters needs to decide on sale on jeans vs. sale on shirts • Rain destroys strawberry crop, prices go . Does it benefit growers ? • Why don’t you ever see sale or discounts on pure milk but see it on orange juice ? • These can be answered with the concept of elasticity (or responsiveness of buyers & sellers to changes in market conditions)
Elasticity • Price elasticity of demand: a measure of how much the quantity demanded of a good responds to a change in the price of that good
Continued.. • Two types of demand: • Elastic – responds a lot e.g. luxury cars ( luxuries) • Inelastic – not much change e.g. milk, certain food items, gasoline ( necessities) • Preferences: Luxuries vs. Necessities • Availability of close substitutes: Elastic • Butter & margarine; cars, booze • Time horizon: • Gasoline – necessity in short run • Substitute long run (electric cars, walk, bike)
Elasticity • Inelastic Demand • Quantity demanded does not respond strongly to price changes. • Price elasticity of demand is < one. • Elastic Demand • Quantity demanded responds strongly to changes in price. • Price elasticity of demand is > one.
Demand Curves • Question: Can I tell from the graphical shape of the demand curve what kind of elasticity the curve has? • Answer: Yes, but not all the time.
Demand $5 4 1. An increase in price . . . 100 2. . . . leaves the quantity demanded unchanged. Perfectly Inelastic Demand Elasticity = 0 Price Quantity 0 3. . . . revenue goes from $4 x 100 to $5 x 100
$5 4 1. A 22% Demand increase in price . . . 90 100 2. . . . leads to an 11% decrease in quantity demanded. Inelastic Demand Elasticity < 1 Price Quantity 0 3. . . . revenue goes from $4 x 100 to $5 x 90
$5 4 Demand 1. A 22% increase in price . . . 80 100 2. . . . leads to a 22% decrease in quantity demanded. Unit Elastic Demand Elasticity = 1 Price Quantity 0 3. . . . revenue goes from $4 x 100 to $5 x 80
$5 Demand 4 1. A 22% increase in price . . . 50 100 2. . . . leads to a 67% decrease in quantity demanded. Elastic Demand Elasticity > 1 Price Quantity 0 3. . . . revenue goes from $4 x 100 to $5 x 50
1. At any price above $4, quantity demanded is zero. $4 Demand 2. At exactly $4, consumers will buy any quantity. 3. At a price below $4, quantity demanded is infinite. Perfectly Elastic Demand Elasticity = Infinity Price Quantity 0
Relationship Between Total Revenue (Sales) & Elasticity • Total Revenue = Price x Qty Sold = P x Qty • If demand is elastic, then a price decrease increases revenue • If demand is inelastic, then a price increase increases revenue • Example class to contribute
Box Shows the 50% Drop of New Paying Customers for the May & August 2004 Conference Caused by the Latest Price Hike 1st Price Hike 2nd Price Hike
Applications of Supply, Demand & Elasticity • Can good news for farmers be bad news for farmers? • Wheat is inelastic: Bumper crop bad news
1. When demand is inelastic, an increase in supply . . . 2. . . . leads to a large fall S1 S2 in price . . . $3 2 Demand 100 110 3. . . . and a proportionately smaller increase in quantity sold. As a result, revenue falls from $300 to $220. Increase In Supply In Market For Wheat Price of Wheat Quantity of 0 Wheat
Chapter 6 Controls on Prices
Controls on Prices • Price Ceiling (e.g. rent control) • A legal maximum on the price at which a good can be sold. • If the price ceiling is set below the equilibrium price, it leads to a shortage. • Price Floor (e.g. minimum wage) • A legal minimum on the price at which a good can be sold. • If the price ceiling is set above the equilibrium price, it leads to a surplus.
Supply Equilibrium price $3 2 Price ceiling Shortage Demand 75 125 Quantity Quantity supplied demanded Price Ceiling: Beer Shortage …RentControl Too Beer 0 Pints
Supply Surplus Equilibrium $4 price Price floor $3 Demand 75 125 Quantity Quantity supplied demanded Price Floor: Beer Surplus Price of Beer Quantity of 0 Beer
Article: Too Many Cars, WSJ; by: Paul Ingrassia • Overcapacity is the biggest problem for any automobile company in the world • GM buys Daewoo Motor, Fiat Auto, Saab • Ford motor owns Mazda, Land Rover • Daimler Chrysler is riding to rescue Mitsubishi • Oldsmobile and Chrysler’s Plymouth, are the first major automobile companies in 40 years • Why do ailing automobile companies who decry overcapacity keep ailing car companies? • National pride plays a big role • More brands mean more dealerships mean more sales. • But this also means more costs and complexity in business operations. In reality, overcapacity is not really a problem. One man’s overcapacity is other’s bargain. Thus, lower priced leases and generous rebates abound in today’s car market.
Chapter 2 Production
Production • What is production? • The activity by which we convert inputs (labor, land & capital) into goods and services • What limits production? • Inputs (resources) • Technology • Government interference
MARKETS FOR GOODS AND SERVICES • Firms sell Goods and Goods • Households buy services and services bought sold HOUSEHOLDS FIRMS • Buy and consume • Produce and sell goods and services goods and services • Own and sell factors • Hire and use factors of production of production MARKETS Labor, land, Factors of FOR and capital production FACTORS OF PRODUCTION • Households sell Wages, rent, • Firms buy and profit Circular Flow Diagram Circular Flow Diagram Revenue Spending Income = Flow of inputs = Flow of inputs and outputs and outputs = Flow of dollars = Flow of dollars
Production Possibilities Frontier • Definition: the amount of goods a firm or society can produce given a fixed amount of land, labor and other inputs.
4,000 D 3,000 C 2,200 E 2,100 2,000 Production A possibilities frontier B 1,000 300 600 700 750 1,000 Production Possibilities Frontier Quantity of Pretzels Produced a b d . c Quantity of 0 Beer Produced
Production Function I Y (Production) = F (Inputs) Y = I Marginal Product: it is the increase in output that arises from an additional unit of input. Marginal Product (MP) = ∆ Output / ∆Input
Production Function II Y = I2 Marginal Product (MP) = ∆ Output / ∆Input
Production Function III Y = √I Marginal Product (MP) = ∆ Output / ∆Input
Returns to Scale • Returns to Scale: the property of the production function that when you double your inputs, your output either doubles, more than doubles, or less than doubles. DRS Y=I MP ↑ IRS MP ↓ DRS CRS Y = √I Y=I2 IRS
Article: Japanese Auto Giants Accelerate Shift to U.S.WSJ; by: Shirouzu, Zaun • For Japanese auto giants Toyota, Honda, Nissan, what American consumers want is becoming more important than the wish lists of consumers in Japan’s shrinking market • The Japanese are accelerating their shift away from their home market, which they see headed for long-term decline • Simple Math: With the market shrinking back home, even boosting your share of the pie might not mean higher sales and profit for Japanese • Weak yen helps Japanese car makers • Japanese companies don't have pension and health-care costs • Customization for high demand products • Quality takes a back seat?
Automobile Industry Economic Analysis of General Motors – Light Truck Sector
Strengths • General Motors is currently a dominant force in the North American light truck market. • Strong history and brand name • Limited competition from foreign firms in the past • Owns GMAC Financing, so can offer financing incentives • Global automotive sales leader since 1931
Strengths • 8.6 million cars and trucks sold in 2002 • 15% of global vehicle market • Controls almost a third of the US market • 2002 U.S. industry sales records for total trucks and SUVs, 2003 may be the 3rd in a row of increased market share in US • 341,000 employees, 32 countries • Vehicles sold in over 190 countries
Weaknesses • GM’s productivity at 24 labor hrs/vehicle is the second lowest • GM has huge pension liabilities; $1900 per vehicle (retiree pension and health care) • Along with other US manufacturers Health care costs for all employees vs. overseas mfg with national health
Opportunities • Efficiency improvements through flexible manufacturing techniques, benchmarking Toyota to reduce costs • Product differentiation through options, like body styles, power packages, chassis. • Lead in Environment and Safety - Experimental fuel hybrid that is more advanced than Honda and Toyota
Industry Costs • Emissions, fuel efficiency, safety, performance, and technology • Vehicle updates lead to increased design, production, testing, marketing, and advertising costs • Steel as input cost • Pension costs • Product liability lawsuits
Macroeconomic Factors Key macroeconomics factors that influence new truck demand : • Consumer income • Unemployment level • Personal income growth • Inflation and interest rates
Other Macroeconomics Factors • Current GDP growth • Recession • Current Trade Deficit- FE Rates (U$, ¥) • Monetary & Fiscal Policy • Extraneous forces - OPEC oil prices • Labor Unions (UAW, etc)
Comparative Efficiency of US & Japanese Automakers: A Stochastic Frontier Production Function Approach Rajeev Dhawan & Marvin Lieberman RCB & The Anderson School at UCLA