MBA 620C: Understanding Market Dynamics

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MBA 620C Understanding Market Dynamics

• Fall 2006
• Aric Krause, Ph.D.

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Course Introduction

• Fall 2006

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What is this course?

• Reading the Firms Environment to choose the
  best solutions to problems.
• Restated Making Optimal Decisions in the face
  of limited information uncertainty.
• Restatement Redux Being able to interpret the
  information that IS available to make the best
  decisions.

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Decisions?

• Executives are not automatons. Why do they make
  so much money? Because, in general, they have an
  ability to Make the Call even though they do
  not have perfect interpretations of information.

Decisions Strategy
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Porters Forces Governing Competition in an
Industry
Threat of New Entrants
The Industry Jockeying for position among current
competitors
Bargaining Power of Suppliers
Bargaining Power of Customers
Threat of Substitute Products or Services
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In an Updated Context.
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In Different Terms
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To Kill a Horse Just a Bit More.
Your Rivals
Your Partners
Government
New Technology
Environmental Factors
Typical Value Chain Analysis
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• The successful Executive is able to Read these
  Environments and make the best decisions EVEN
  WITH limited information.

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Our Course, At The Macro

• How susceptible is the firm to Cycles?
• Where do cycles come from?
• What impacts on firms occur when the Fed or the
  Government use policy tools?
• How does technological change affect the firm?
• How do industries change over time (evolve)?
• How does regulatory environment impact the firm?

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At the Micro

• What markets are we in?
• What impacts these markets?
• Which of these factors do we control? Which are
  exogenous?
• How do we evaluate market changes?
• What competitive pressures exist?

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Decision Making, Revisited

• Faced with a decision,
• Understanding the context of the issue
• Understanding the vector of possible solutions
• Understanding the implications of each solution
  across the functional areas of the firm in
  context of the firms goals
• Choosing the best possible solution in context of
  the firms goals Strategy
• Implementing that solutionImplementation

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What is Strategy?Porters View

• Corporate direction based on
• Set of competitive advantages owned by, and
  exploitable by, the firm
• External competitive environment
• External technological environment
• Internal environment
• Strategy is not the same as Operational
  Effectiveness!

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Competitive Advantage?

• A technique, ability, or technology owned and
  controllable by the firm.
• Technique
• Ability
• Technology

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Questions?
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Session 1 The Firm in Markets
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What is a Market?

• Buyers and Sellers communicating to trade goods
  and services
• Multiple Actors
• Demanders
• Suppliers
• Regulators/External Forces?

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The Firm in Markets

• What side does the firm play in markets?
• When are they Buyers?
• When are they Suppliers?
• What other roles are played?

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GM or Any Auto Maker

• BUYER in labor markets, capital markets, parts
  markets, paint market, designs markets, product
  transportation markets,
• SUPPLIER vehicle markets, financial services
  markets, reseller (Dealer) markets, after-market
  services market, parts market (GM produces parts
  for other auto makers)
• Regulators/External Forces Other markets that
  the firm is not DIRECTLY involved in, but is
  influenced by.
• Government through trade agreements,
  environmental laws currency markets, unions,
  competitive environment

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Demanders (Buyers)

• Determinants of Demand
• Price of Good/Service
• Prices of Substitutes/Complements (What truly is
  a substitute for your G/S?)
• Consumer Income
• Expectations multi-faceted
• Tastes Preferences
• Number of Consumers

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Law of Demand

• When Everything else is held constant, there is
  an inverse relationship between quantity of good
  demanded and its price

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Lets Look at Demand Graphically for Ease
Price
The Price Increase Has Caused Quantity Demanded
to Fall
Quantity
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What Happens When Other Determinants Change?

• Price of Related Goods
• Substitutes
• Complements
• Consumer Income
• Expectations
• Tastes Preferences
• Number of Consumers

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What Happens When Other Determinants Change?
Price
How Would Determinants Have to Change to Cause
MORE to be demanded at EVERY Price???
D1
Quantity
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The Opposite?

• How would the determinants have to change to
  cause demand to FALL at all price levels?

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Lets Consider Slope

• Look carefully at the two demand curves below.
  Whats the difference?

Price
Price
Quantity
Quantity
What Could Cause this Difference???
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Sensitivity to Change

• How sensitive is our demand to changes in
  determinants (not just price!!)
• Very Sensitive?
• Not Very Sensitive?
• How can we tell?

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Price Elasticity of Demand

• Measures the sensitivity of demand to a change in
  a determinant

OR
How Can we Interpret Result??
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Other Interesting Elasticities
Interpretation If result is POSITIVE, then goods
are complements If result is NEGATIVE, then goods
are substitutes If result is ZERO, no
relationship between goods
What About MAGNITUDE of Result??
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Other Interesting Elasticities
Interpretation If result is POSITIVE, then our
good is NORMAL good If result is NEGATIVE, then
our good is INFERIOR good
What About MAGNITUDE of Result??
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Suppliers (Sellers)

• Determinants of Supply
• Price of the Good
• Prices of Resources used in the Good
• Technology/Productivity
• Prices of Other Goods Produced
• Expected Future Prices
• Taxes and Subsidies
• Number of Suppliers

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Law of Supply

• When Everything else is held constant, there is a
  direct relationship between price and quantity
  supplied.

Why?
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The Supply Curve
Shows Relationship Between the number of goods
firm is WILLING to produce and price
Price
Why?
Quantity
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What Happens When Other Determinants Change?
Price
How would determinants have to change to cause
this to occur?
Quantity
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Changes in Determinants

• How would determinants have to change such that
  the firm would only produce each amount at a
  higher price?

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Moving to the market

• Notice that our demand and supply curves only
  showed how much demanders WOULD demand at each
  price, and how much suppliers WOULD supply at
  each price.
• Price can only be determined by BOTH sides acting
  together.

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A PRODUCT Market
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What if a determinant changes?
Assume income increases, and the good we are
considering is a normal good. What will happen?
The market is now in disequilibrium at P and
Qhow does it adjust?
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Degrees of Adjustment
2 demand curves of differing slope
Suppose supply shifts due to higher labor costs.
P0
D2
Notice the different impact on price and
quantity For D1, small change in Q, large change
in P For D2, large change in Q, small change in P
D1
Q0
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Curve Sensitivity

• The difference in impact is caused by differing
  sensitivities to changes.
• Can we estimate sensitivities? Of course, using
  elasticities.
• Do firms need to know sensitivities? Yes! To
  know how external changes, such as income change,
  may impact their demand (and sales forecasts!).

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Different Markets Labor
Wage

• In Labor Market, who is demand?
• Who is Supply?
• Same dynamics occur if changes occur in
  determinants

LS
LD
Quantity
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Household Mortgage Market An Application of
Regulatory Change

• In last ten years, deregulation of
  banking/financial services industry has led to
  major increase in lending activity.
• How is the market affected as a result?
• How is market impacted?

S0
D0
Quantity
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Market Interventions Price Floors

• Price floors are price interventions that set a
  minimum price
• Price floors are only effective when they set a
  minimum price that is ABOVE the market
  equilibrium price
• Price Floor A versus
• Price Floor B. Which is effective?

A
PA
B
PB
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Market Interventions Price Ceilings

• Price ceilings are price interventions that set a
  maximum price
• Price ceilings are only effective when they set
  a maximum price that is BELOW the market
  equilibrium price
• Price Ceiling A versus
• Price Ceiling B. Which is effective?

B
PB
A
PA
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Examples Which type are they?

• Minimum wage
• Proposed gas price regulation
• Regulated prices (sugar)

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Other Types of Intervention

• Tariffs
• Quotas
• Subsidies (Agriculture)

Example Quota on imported steel. Supply is
restricted, so supply curve shifts in. Result is
higher price for all consumers.
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Some Market Thoughts

• MOST of the determinants of demand, and SOME of
  the determinants of supply are determined OUTSIDE
  the firm, and are therefore Uncertainties for
  the firm.
• The act of moving toward equilibrium is motivated
  by the sensitivities of both demand and supply,
  and is therefore OUTSIDE the control of the firm.
• The degrees of sensitivity determines who has the
  Power in a particular market.

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More Market Thoughts

• Markets are very fluid. They are always reacting
  to changes in determinants. They are always
  moving TOWARD equilibrium, but not necessarily
  ever reaching it (in reality).
• One MUST know the impact of determinant changes
  to know the DIRECTION of the markets movement.
• Example GM do you think it understands the
  direction of change in the auto market
  determinants?

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Power in Markets

• Whoever has the power makes the rules
• If there is only one firm in a particular market,
  they have great power in determining price.
• If there are very few true substitutes for a
  product, then buyer cant substitute away
  supplier has power.
• Many substitutes means supply is NOT powerful.

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Back to Strategy

• If a firm has a true competitive advantage, they
  can have a different supply condition than
  competitors, and therefore more Power in the
  market.
• Knowing the market gives one an understanding of
  ways to utilize competitive advantage, and
  therefore power. (NOT to exploit, of course).

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Lets Consider Recent Events How do they Impact
the Market(s)?

• Katrina (excluding energy issues)
• Iraq
• Oil prices (trick question!)
• Interest rate increases
• Marked increase in all price indexes

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Questions/Thoughts?