Lecture 2: Elasticity, Control on Prices

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Lecture 2 Elasticity, Control on Prices
Production
Dr. Rajeev Dhawan Director
Given to the EMBA 8400 Class Classroom South
608 January 6, 2007
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Chapter 5

• Elasticity

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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 dont 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)

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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

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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)

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Elasticity

• Inelastic Demand
• Quantity demanded does not respond strongly to
  price changes.
• Price elasticity of demand is lt one.
• Elastic Demand
• Quantity demanded responds strongly to changes in
  price.
• Price elasticity of demand is gt one.

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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.

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Perfectly Inelastic Demand
Elasticity 0
Price
Quantity
0
3. . . . revenue goes from 4 x 100 to 5 x 100
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Inelastic Demand
Elasticity lt 1
Price
Quantity
0
3. . . . revenue goes from 4 x 100 to 5 x 90
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Unit Elastic Demand
Elasticity 1
Price
Quantity
0
3. . . . revenue goes from 4 x 100 to 5 x 80
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Elastic Demand
Elasticity gt 1
Price
Quantity
0
3. . . . revenue goes from 4 x 100 to 5 x 50
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Perfectly Elastic Demand
Elasticity Infinity
Price
Quantity
0
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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

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Box Shows the 50 Drop of New Paying Customers
for the May August 2004 Conference Caused by
the Latest Price Hike
Conference Date Attendance New Paying of Total
Feb 01 72 6 8
May 01 66 10 15
Aug 01 101 31 31
Nov 01 163 49 30
Feb 02 189 28 15
May 02 160 42 26
Aug 02 195 62 32
Nov 02 169 44 26
Feb 03 260 55 21
May 03 196 37 19
Aug 03 220 43 20
Nov 03 222 40 18
Feb 04 238 48 20
May 04 201 25 12
Aug 04 211 23 11
1st Price Hike
2nd Price Hike
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Applications of Supply, Demand Elasticity

• Can good news for farmers be bad news for
  farmers?
• Wheat is inelastic Bumper crop ? bad news

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Increase In Supply In Market For Wheat
Price of
Wheat

Quantity of
0
Wheat
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Chapter 6

• Controls on Prices

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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.

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Price Ceiling
Beer Shortage
Rent Control Too
Beer
0
Pints
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Price Floor Beer Surplus
Price of
Beer
Quantity of
0
Beer
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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 Chryslers 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 mans overcapacity is others bargain.
• Thus, lower priced leases and generous rebates
  abound in todays car market.

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Chapter 2

• Production

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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

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Circular Flow Diagram
Circular Flow Diagram
Spending
Revenue






















Income




Flow of inputs
Flow of inputs


and outputs
and outputs


Flow of dollars
Flow of dollars
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Production Possibilities Frontier

• Definition the amount of goods a firm or society
  can produce given a fixed amount of land, labor
  and other inputs.

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Production Possibilities Frontier
Quantity of
Pretzels
Produced
a
b
d .
c
Quantity of
0
Beer Produced
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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
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Production Function II
Y I2
Marginal Product (MP) ? Output / ?Input
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Production Function III
Y vI
Marginal Product (MP) ? Output / ?Input
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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
YI
MP ? ? IRS MP ? ? DRS
CRS
Y vI
YI2
IRS
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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
  Japans 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?

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Automobile Industry

• Economic Analysis of
• General Motors Light Truck Sector

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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

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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

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Weaknesses

• GMs 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

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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

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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

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Economies of Scale
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Macroeconomic Factors

• Key macroeconomics factors that influence new
  truck demand
• Consumer income
• Unemployment level
• Personal income growth
• Inflation and interest rates

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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)

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Comparative Efficiency of US Japanese
Automakers A Stochastic Frontier Production
Function Approach
Rajeev Dhawan Marvin Lieberman RCB The
Anderson School at UCLA
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Table 1A. Comparison of OLS and SFPF Estimates
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Observations from technical efficiency scatter
plot (Japanese producers)

• Technical efficiency increased 50 from the
  mid-1960s to the mid-1980s. Little growth in
  subsequent years, even a decline.
• Toyota has the highest technical efficiency (A
  close second is Honda). Toyotas lead in
  technical efficiency is smaller than its lead in
  labor productivity.
• A number of the Japanese producers have
  historical performance that is well below the
  efficiency frontier.
• Efficiency estimates fluctuate with business
  cycle.

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Observations from technical efficiency scatter
plot (US producers)

• GMs efficiency is slightly above the Japanese
  level in the mid-1960s. By the 1990s, GMs
  efficiency falls below that of all Japanese
  producers except Fuji and Mazda.
• Chryslers efficiency falls sharply in the late
  1970s but recovers strongly in the 1980s. Ford
  also shows strong improvement in the 1980s. Both
  Chrysler and Ford have efficiency levels
  comparable to the Japanese average in the late
  1980s and 1990s.

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Conclusion

• Get away from firm-size issue and focus on
  cutting inventory (WIP) costs via flexible plants
  and JIT inventory methods i.e. suppliers
• Increase speed of new product introduction to
  market - benchmark Toyota
• Make cars that people in cities want not when you
  go Pheasant hunting in South Dakota!