managerial economics session 2 slides

The Microeconomic Se-ng Markets and economic value Session 2 HEC MBA Managerial Economics January 2015

Copyright 2015, J. Ghez 1

Goals of the sec:on 1. Consider the goals of microeconomics analysis; 2. Assess how markets funcHon, how demand and supply behave; 3. Draw implicaHons for business strategy.

Key ques:on to address Why could microeconomic analysis could help improve strategies? What are the sources of economic value?

Part I: All You Ever Wanted (and Needed) to Know About the Market


The market is the place where supply meets demand. It plays the central role of a clearinghouse uni:ng ra:onal actors looking to maximize their profits. The greater the size of the market and the fewer the obstacles, the more the opportuni:es to trade and therefore to create value. Analyzing exis:ng markets can help businesses adapt their strategy to compe::on and help them create more value But the real microeconomic challenge lies in iden:fying those markets which do not exist or do not func:on properly in order to create addi$onal opportuni:es.

Remember: The Market as a Clearinghouse


MEET THE DEMAND CURVE THE FIRST PROTAGONIST IN THE MARKET


Source: Chris Giles, China: Slower but steady, Financial Times, July 23, 2013 (h`p://goo.gl/jWHziY)

Demand for Energy (Illustra:on) The example of China


Fears about a Chinese slowdown notwithstanding, analysts sHll expect commodity and energy prices to remain high given the significant structural needs of China and other fast-developing economies over the coming years.

The demand func:on relates demand for a good to its determinants (drivers): It translates the rela:onship between demand for the good and its price, complements, subs:tutes and income.

The demand curve displays the rela:onship between demand for the good and price, all else remaining equal namely: no change in price of other goods, in income, in preferences and tastes and in price expecta:ons.

The Demand Func:on and Demand Curve Understanding the rela:onship


P

Q

The Demand Curve Drawing the rela:onship

The demand curve therefore describes the rela:onship between price and demand: the lower the price, the higher the demand and the higher the price, the lower the demand. At the individual level, this means that a high

price will lead me to consume less units of the good in ques:on (and vice-versa)

At the aggregate level, this means that given a high price, less people will be able to consume (and vice-versa)

Phigh

Plow

Qlow Qhigh Copyright 2015, J. Ghez 7

The price of the good The greater the price, the lower the demand and vice versa (except for luxury goods).

The price of subs:tutes and complements Cheaper alterna:ves could reduce demand or delay a purchase and vice versa; The price of complementary products (such as gas for cars) also influence demand.

Income

The first straighgorward ques:on is: Can I afford it? For some products (e.g. potatoes), the ques:on is trickier: Can I afford a be`er product

thanks to a higher income?

Preferences and tastes Your purchase should be congruent with your preferences!

The price expecta:ons The price of some products (such as gas) can be vola:le, so if you expect a change, it

might influence your decision further.

What If All Else Does Not Remain Equal? The five drivers which shape demand


P


Movement along the curve (up and down) means that the price of the good is changing (going up and going down).

Q


P


Movements of the curve mean that the other drivers of demand are changing.

Q


P



Movements to the right means that demand is increasing and that either: The price of subs:tutes increased; The price of complements decreased; Tastes and preferences are going up; The goods price is expected to increase; Or a combina:on of the above.

Q


P



Movements to the lel means that demand is decreasing and that either: The price of subs:tutes decreased; The price of complements increased; Tastes and preferences are going down; The goods price is expected to decrease; Or a combina:on of the above.

Q


P


Changes in the slope of the curve means that the nature of this rela:onship is changing: A steeper slope means demand is ge-ng

increasingly less reac:ve to price;

A fla`er slope means demand is ge-ng increasing more reac:ve to price.

Q


Well assume this rela:onship is linear Doing otherwise would bring not any addi:onal insights It simplifies our mathema:cal task!

This means that the generic demand curve looks like: P = a bQ Q = a bP

For example: P = 100 Q

Parameters a and b are considered as given Though there are ways in prac:ce to es:mate these

The Demand Curve A special note


The demand curve represents the downward slopping rela:onship between price and demand. It entails that a lower price will mean higher demand and a higher price lower demand. Changes of the other drivers of demand will shil the curve in parallel to the lel when demand decreases and to the right when demand increases. A shil in the demand slope indicates a new rela:onship between demand for the good and price.

The Bo`om Line What is the demand curve?


MEET THE SUPPLY CURVE THE OTHER PROTAGONIST IN THE MARKET



Source: IEA, Resources to Reserves: Oil and Gas Technologies for the Energy Markets of the Future, OECD Publishing Group, October 4, 2005 (h`p://goo.gl/V62nyf)

How Does Supply Work? The example of oil

In a market which works properly, the unit which is most cost-compe::ve will produce as much as it can in the limit of its capacity and if the capacity is lower than total demand on the market. The second most cost-compe::ve unit will do the same so long as the addi:on of its capacity and the first units capacity isnt sufficient to meet total demand. This will con:nue un:l total demand is sa:sfied. The units whose produc:on costs are higher and which are not needed to meet total demand will either be idle or shut down (or not built if they dont exist).


How Does Supply Work? A generic assump:on

Take the instance of the paper industry. We assume total demand for paper will be equal to 75,000 tonnes. There are three firms interested by this market: Alpha, Bravo and Romeo. Each one has producHon units whose costs per ton of paper and whose capacity are illustrated in the table below.


An Example from the Paper Industry Who produces? Whats the price?

The supply func:on relates supply of a good to its determinants (drivers): It translates the rela:onship between supply of the good and its price, the number of firms, cost of inputs (including labor) and produc:vity changes. The supply curve displays the rela:onship between supply of the good and price, all else remaining equal namely: no change in the number of firms, in the cost of inputs or in produc:vity.

The Supply Func:on and Supply Curve Understanding the rela:onship


P

The Supply Curve Drawing the rela:onship

The supply curve therefore describes how much suppliers are willing to produce and sell at a given price: The higher the price, the more able and willing

businesses will be to supply the market;

A higher price will indeed lead firms to expand their output and/or a`ract addi:onal firms;

A lower price will lead firms to reduce their outputs and/or lead them to leave the market.

Phigh

Plow

Qlow Qhigh Q


The price of the good A higher price means that more firms are able and willing to produce and sell the good; A lower price means that less firms are able and willing to produce and sell the good.

The number of firms Addi:onal firms can be a`racted by a profitable market and produce more; Addi:onal firms will leave a declining market, reducing total output.

The cost of inputs When it costs less to produce, firms will be more willing and able to supply the good; When it costs more to produce, firms will be less willing and able to supply the good.

Produc:vity change A posi:ve produc:vity shock allows a firm to produce more at equal or lower cost A nega:ve produc:vity shock forces a firm to produce less at equal or higher cost


What If All Else Does Not Remain Equal? The four drivers which shape supply

P


Movement along the curve (up and down) means that the price of the good is changing (going up and going down).

Q


P


Movements of the curve mean that the other drivers of supply are changing.

Q


P



Q

Movements to the right means that supply is increasing and that either: The number of firms has increased; The cost of inputs has decreased; Produc:vity has increased; Or a combina:on of the above.


P



Q

Movements to the lel means that supply is decreasing and that either: The number of firms has decreased; The cost of inputs has increased; Produc:vity has decreased; Or a combina:on of the above.


P


Changes in the slope of the curve means that the nature of this rela:onship is changing: A steeper slope means supply is ge-ng

increasingly less reac:ve to price;

A fla`er slope means supply is ge-ng increasing more reac:ve to price.

Q


Well assume this rela:onship is linear Doing otherwise would not bring any addi:onal insights It simplifies our mathema:cal task!

This means that the generic demand curve looks like: P = c + dQ Q = c + dP

Parameters c and d are considered as given

Though there are ways in prac:ce to es:mate these at the industry level especially

The Supply Curve A special note (the same as the demand curve)


The supply curve represents the upward slopping rela:onship between price and supply: It can be thought of also as a representa:on of the opportunity cost of self-consump:on or of not being present on the market. It entails that a higher price will mean higher output because exis:ng firms will increase their outputs and new firms will be a`racted onto the new market and vice-versa. Changes of the other drivers of supply will shil the curve in parallel to the lel when supply decreases and to the right when supply increases. A shil in the supply slope indicates a new rela:onship between demand for the good and price.

The Bo`om Line What is the supply curve?


MARKETS IN ACTION DEMAND AND SUPPLY MEET


The Market Equilibrium Quan:ty and price when nothing else changes

The equilibrium is defined by an equilibrium quan:ty (Q*) and an equilibrium price (P*) at which demand is exactly equal to supply. This outcome is considered as the only sustainable one in :me and the status quo if nothing else changes.

P

Q

P*

Q* Copyright 2015, J. Ghez 31

P

Q

Gains From Trade The benefits of free-markets

When equilibrium is reached, everyone who wanted to trade could and did. This is the point at which gains from trade are maximal and economic value is the greatest. In par:cular, at the equilibrium point, weve exhausted all opportuni:es to match up suppliers with consumers who value the product more than what it cost to produce it. The resul:ng value crea:on is represented by the red area which what well refer to as gains from trade.

P*



No:ce that gains from trade are maximal when the market is unimpeded by barriers to trade. For instance, consider the effects of a minimum price regula:on (such as a minimum wage). At Pmin, suppliers will be willing to supply Qhigh only when demanders actually demand Qmin only. Qmin will be the amount traded whereas Q* would have been traded otherwise in a market without any hurdles. Trade is ar:ficially limited because of price fixing.


P

Q

P*

Q*

Pmin

Qmin Qhigh

P

Q


The yellow area represents the gains from trade that fail to materialize as a result of this minimum price.

P*

Q*

Pmin

Qmin Qhigh Copyright 2015, J. Ghez 34

P

Q


The orange segment represents the difference between what consumers demand and what firms supply that is, the shortage of goods. If a maximum price had been set (that is, below the equilibrium price) at Pmax, for instance, we would have observed the opposite difference resul:ng in an excess of goods on the market (in green).

P*

Q*

Pmin

Qmin Qhigh

Shortage

Excess

Pmax


The waste caused by government interven:ons and regula:ons (such as minimum or maximum prices, quotas, or taxes) have led many economists un:l today to defend free markets which create the most value. An unhindered market creates the greatest amount of economic value by matching up consumers with a high valua:on and producers with a low cost of produc:on. This economic value is what microeconomists call gains from trade. In addi:on, in this system, because they are determined by market forces, prices force economic actors to adjust to reali:es of the landscape. Any a`empt to manipulate them through regula:on and/or subsidies will lead to distor:ons and limit the amount of accurate informa:on in an economy.

Bo`om Line: Economists Like Markets Without Any Barriers


The debate rages on today. Consider: In Mexico, the governments decision to open up the oil

industry in order to increase compeHHon and necessary investments for further exploraHon1;

The significantly different performances of East and West Germany, North and South Korea2;

How unleashing market forces in the U.S. airline industry created greater value for customers3;

Efforts from various regulators across the globe to punish companies (banks in parHcular) which have manipulated prices on markets (theres a paradox here!)4;

Excep:ons may apply!

Economists for Free Markets (Illustra:on) Some instances of good free markets


1 John Paul Rathbone, Reform will boost oil investment by $10bn a year, says Pemex chief, Financial Times, August 15, 2013 (h`p://goo.gl/MYKbcm) 2 John Kay, A real market economy ensures that greed is good, Financial Times, January 17, 2012 (h`p://goo.gl/QoqZxg)

3 The misery of flying: Is more regulatory reform really the answer?, The Economist, January 6, 2011 (h`p://goo.gl/Ve4kTa)

4 Theres a paradox indeed: regulators are at :mes needed to actually fix distor:ons and guarantee the normal func:oning of a market. Think about the Libor scandal and the an:trust law suits by the European Commission against oil majors suspected of manipula:ng oil prices on markets.

Addi:onal insights on free markets


CONCLUSION & WHERE WERE HEADING


P

Q


The demand curve therefore describes the rela:onship between price and demand: the lower the price, the higher the demand and the higher the price, the lower the demand. At the individual level, this means that a high

price will lead me to consume less units of the good in ques:on (and vice-versa)

At the aggregate level, this means that given a high price, less people will be able to consume (and vice-versa)

Phigh

Plow

Qlow Qhigh Copyright 2015, J. Ghez 41

P


The supply curve therefore describes how much suppliers are willing to produce and sell at a given price: The higher the price, the more able and willing

businesses will be to supply the market;

A higher price will indeed lead firms to expand their output and/or a`ract addi:onal firms;

A lower price will lead firms to reduce their outputs and/or lead them to leave the market.

Phigh

Plow

Qlow Qhigh Q


P

Q


When equilibrium is reached, everyone who wanted to trade could and did. This is the point at which gains from trade are maximal and economic value is the greatest. In par:cular, at the equilibrium point, weve exhausted all opportuni:es to match up suppliers with consumers who value the product more than what it cost to produce it. The resul:ng value crea:on is represented by the red area which what well refer to as gains from trade.

P*


Goals of the sec:on 1. Define economic costs; 2. Determine how the profit-maximizing firm behaves; 3. Define compeHHon and its various degrees; 4. Consider what the proper role of the state is.

Key ques:on to address What factors influence and reduce compeHHon? Are price wars worth avoiding? How? What is the nature of my strategic (dis)advantage?

Part II: What Economists Have Been Trying to Tell You (About Compe::on Especially)


Please tackle problem set 1 before next class


managerial economics session 2 slides

Documents

demand func

gljwhziy demand

high price

price of subs

price expecta

supply meets demand

p qthe demand curve

onship copyright