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

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Presentation on theme: "Producer & Consumer Decisions Executive MBA 512 Session #5 Presented by Brian Greber October 19, 2012 5-1."— Presentation transcript:

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

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) 16 years teaching, research, policy experience at universities (VT, OSU, BSU) Lots of public policy work at the state & federal levels Senior Economist/Director at ECONorthwest Live in Boise – avid fitness buff and enjoy most things outdoors Active with not-for-profits (Pres. The Arc Board) Motorcycle safety instructor 5-2

3 Todays Objectives Enable a structured approach to thinking through consumer, supplier, and competitor reactions to changing events and how that can/should influence your enterprises 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 Todays 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 1.Scarcity Forces choice Creates value 2.Thinking on the margin Leave nothing on the table Do not sub-optimize 3.Recognizing opportunity cost as a real cost Scarcity forces sacrifices 4.Purposeful behavior Rationale and self interested individuals Firms pursue profits Individuals pursue utility – OK, happiness! 5-8

9 Economic Models 1.Predictive Based on conditioning assumptions Destined to be wrong (a correct one is a lucky one) Extrapolative/inferential Best use is sensitivity analysis. 2.Paradigm A logical model to discuss cause and effects Provides a common frame of reference We will be focusing principally on Paradigms – models for explaining behavior and thinking through consequences of actions (or inaction!). 5-9

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 Quantity Demanded (bushels per week) Price (per bushel) PQdQd $ Individual Demand P Q D1D Demand Can Increase or Decrease Increase in Demand Decrease in Demand D2D2 D3D3 Of Course: D=MB 5-12

13 Individual Demand Quantity Demanded (bushels per week) Price (per bushel) PQdQd $ Individual Demand P Q D1D Demand Can Increase or Decrease Decrease in Demand D2D2 D3D3 Change in Demand Change in Quantity Demanded 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 Percentage Change in Price of Product X E dX = 5-18

19 Price Elasticity of Demand Extreme cases Perfectly inelastic demand Perfectly elastic demand Unitary Elasticity p Q p Q p Q D D D Examples? 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 5-21 See also:

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

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 Quantity Supplied (bushels per week) Price (per bushel) PQsQs $ Individual Supply P Q S1S Lets talk opportunity cost. Example f – soccer balls vs volley balls – incremental cost of producing volleyballs must recognize what? 5-30

31 Individual Supply Quantity Supplied (bushels per week) Price (per bushel) PQsQs $ Individual Supply P Q S1S1 Supply Can Increase or Decrease S2S2 S3S

32 Individual Supply Quantity Supplied (bushels per week) Price (per bushel) PQsQs $ Individual Supply P Q S1S1 Supply Can Increase or Decrease S2S2 S3S Change in Quantity Supplied Change in Supply 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 Percentage Change in Price of Product X E sX = 5-35

36 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

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 Percentage Change in Price of Product Y E sXY = 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

41 Increasing Marginal Returns 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) Average Product (AP), (2)/(1) ] ] ] ] ] ] ] ] Diminishing Marginal Returns Negative Marginal Returns 5-41

42 Total Product, TP Marginal Product, MP TP MP AP Increasing Marginal Returns Diminishing Marginal Returns Negative Marginal Returns Law of Diminishing Returns 5-42

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

44 . 5-44

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: ng/Enduring_ideas_The_industry_cost_curve_

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

51 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

52 Assumptions for efficient market Private property Yields investment, innovation, exchange, maintenance, & growth. Freedom of enterprise and choice Scalability, Entry and exit Self-interest Creates checks and balances Competition More checks and balances Markets and prices allowed to function Limited government/currency and trade facilitated 5-52

53 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

54 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-texts arguments (including corporate power) are actually rooted in mis-informations 5-54

55 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

56 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: 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

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