Producer & Consumer Decisions

1. Producer & Consumer Decisions • Executive MBA 512 • Session #5 • Presented by • Brian Greber • October 19, 2012 5-1

2. INTRODUCTION TO INSTRUCTOR Brian Greber, Ph.D. B.S. Forestry (WVU) M.S. (WVU), Ph.D.(VT) Resource Economics 19 years industry/executive experience (most recently VP Marketing & Technology in a Fortune 100 Forest Products Firm) 16years teaching, research, policy experience at universities (VT, OSU, BSU) Lots of public policy work at the state & federal levels Senior Economist/Director at ECONorthwest Live in Boise – avid fitness buff and enjoy most things outdoors Active with not-for-profits (Pres.The Arc Board) Motorcycle safety instructor 5-2

3. 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

4. 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

5. 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

6. Business Research An A? 5-6

7. 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

8. Keys to Economic Thinking • Scarcity • Forces choice • Creates value • Thinking “on the margin” • Leave nothing on the table • Do not sub-optimize • Recognizing opportunity cost as a real cost • Scarcity forces sacrifices • Purposeful behavior • Rationale and self interested individuals • Firms pursue profits • Individuals pursue “utility” – OK, happiness! 5-8

9. Economic Models • Predictive • Based on conditioning assumptions • Destined to be wrong (a correct one is a lucky one) • Extrapolative/inferential • Best use is sensitivity analysis. • Paradigm • A logical model to discuss cause and effects • Provides a common frame of reference • We will be focusing principally on Paradigms – models for explaining behavior and thinking through consequences of actions (or inaction!). 5-9

10. Law of Demand • Other things equal, as price falls quantity demanded rises • Corollary: as quantities consumed increase, marginal value declines. • WHY? 5-10

11. 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

12. Individual Demand Of Course: D=MB Demand Can Increase or Decrease P 6 5 4 3 2 1 0 Individual Demand Increase in Demand P Qd $5 4 3 2 1 10 20 35 55 80 Price (per bushel) D2 D1 Decrease in Demand D3 Q 2 4 6 8 10 12 14 16 18 Quantity Demanded (bushels per week) 5-12

13. Individual Demand Demand Can Increase or Decrease P 6 5 4 3 2 1 0 Change in Demand Individual Demand P Qd Change in Quantity Demanded $5 4 3 2 1 10 20 35 55 80 Price (per bushel) D2 D1 Decrease in Demand D3 Q 2 4 6 8 10 12 14 16 18 Quantity Demanded (bushels per week) 5-13

14. 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

15. 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

16. 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

17. Oct 8 article on Auto sales • What factors were listed as reasons for recent upticks in auto sales/demand? • Which cause demand to shift? • Which cause “movement along the demand curve?” 5-17

18. 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 Quantity Demanded of Product X EdX= Percentage Change in Price of Product X 5-18

19. Price Elasticity of Demand Examples? Extreme cases • Perfectly inelastic demand • Perfectly elastic demand • Unitary Elasticity D p p p D D Q Q Q 5-19

20. 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

21. Sample Elasticities See also: http://www.ers.usda.gov/data-products/commodity-and-food-elasticities.aspx 5-21

22. Cross price elasticity of demand • Elasticity > 0, substitutes • Elastciity < 0, complements Percentage Change in Quantity Demanded of Product X EdXY= Percentage Change in Price of Product Y 5-22

23. 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

24. . 5-24

25. 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

26. Estimating Demand – a bootstrap approach 5-26

27. 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

28. 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

29. 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

30. Individual Supply Let’s talk opportunity cost. Example f – soccer balls vs volley balls – incremental cost of producing volleyballs must recognize what? P 6 5 4 3 2 1 0 Individual Supply S1 P Qs $5 4 3 2 1 60 50 35 20 5 Price (per bushel) Q 10 20 30 40 50 60 70 Quantity Supplied (bushels per week) 5-30

31. Individual Supply Supply Can Increase or Decrease P 6 5 4 3 2 1 0 S3 Individual Supply S1 S2 P Qs $5 4 3 2 1 60 50 35 20 5 Price (per bushel) Q 10 20 30 40 50 60 70 Quantity Supplied (bushels per week) 5-31

32. Individual Supply Supply Can Increase or Decrease P 6 5 4 3 2 1 0 S3 Individual Supply S1 Change in Quantity Supplied S2 P Qs $5 4 3 2 1 60 50 35 20 5 Price (per bushel) Change in Supply Q 10 20 30 40 50 60 70 Quantity Supplied (bushels per week) 5-32

33. 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

34. 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

35. 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 Quantity Supplied of Product X EsX= Percentage Change in Price of Product X 5-35

36. Price Elasticity of Supply Examples? Extreme cases • Perfectly inelastic supply • Perfectly elastic supply • Unitary Elasticity S p p p S S Q Q Q 5-36

37. 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

38. 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

39. Cross Price elasticity of supply • Elasticity > 0, production complements ….. Examples? • Elasticity < 0, production competitors …. Examples? Percentage Change in Quantity Supplied of Product X EsXY= Percentage Change in Price of Product Y 5-39

40. 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

41. (3) Marginal Product (MP), Change in (2)/ Change in (1) (3) Average Product (AP), (2)/(1) (1) Units of the Variable Resource (Labor) (2) Total Product (TP) ] ] ] ] ] ] ] ] Law of Diminishing Returns - 10.00 12.50 15.00 15.00 14.00 12.50 10.71 8.75 0 10 25 45 60 70 75 75 70 0 1 2 3 4 5 6 7 8 10 15 20 15 10 5 0 -5 Increasing Marginal Returns Diminishing Marginal Returns Negative Marginal Returns 5-41

42. Law of Diminishing Returns 30 Total Product, TP 20 10 0 20 Marginal Product, MP 10 1 1 2 2 3 3 4 4 5 5 6 6 7 7 8 8 9 9 TP Increasing Marginal Returns Negative Marginal Returns Diminishing Marginal Returns AP 5-42 MP

43. Average Product and Marginal Product Cost (Dollars) Graphical Relationships Production Curves AP MP Quantity of Labor MC AVC Cost Curves Quantity of Output 5-43

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45. 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

46. 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

47. 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

48. 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

49. Putting D&S together What happens if you instill quotas, price ceilings, or floors? 5-49

50. 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