Chapter 8Understanding Markets and

Industry Changes

Managerial Economics: A Problem Solving Approach (2nd Edition)Luke M. Froeb, luke.froeb@owen.vanderbilt.edu

Brian T. McCann, brian.mccann@owen.vanderbilt.edu

Website, managerialecon.com

COPYRIGHT © 2008Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.

Chapter 8 – Summary of main points

• A market has a product, geographic, and time dimension. Define the market before using supply–demand analysis.

• Market demand describes buyer behavior; market supply describes seller behavior in a competitive market.

• If price changes, quantity demanded increases or decreases (represented by a movement along the demand curve).

• If a factor other than price (like income) changes, we say that demand curve increases or decreases (a shift of demand curve).

Chapter 8 – Summary (cont.)• Supply curves describe the behavior of sellers and tell you how much

will be sold at a given price.• Market equilibrium is the price at which quantity supplied equals

quantity demanded. If price is above the equilibrium price, there are too many sellers, forcing price down, and vice versa.

• Currency devaluation in a country increases demand for exports (supply to another country) and decreases demand for imports (demand for another country’s products).

• Prices are a primary way that market participants communicate with one another.

• Making a market is costly, and competition between market makers forces the bid–ask spread down to the costs of making a market. If the costs of making a market are large, then the equilibrium price may be better viewed as a spread rather than a single price.

Anecdote: Y2K and generator sales• From 1990-98, sales of portable generators grew 2%

yearly. • In 1999, public anticipation of Y2K power outages

increased demand for generators.

• Walters, Rosenberg and Matthews invested to increase capacity in anticipation of this demand growth – they vertically integrated their company to increase capacity and reduce variable costs.

• Demand grew as expected - Industry shipments increased by 87%. Prices also increased by an average of 21%.

• Discussion: What will happen next? Why?

Which industry or market?• Every industry or market has a time, product, and

geographic dimension. • For example: The yearly market for portable

generators in the U.S.• Time: annual

• Product: portable generators

• Geography: US

• When analyzing a problem, or investment opportunity, it helps to first define the time, product and geographic dimensions of the market in question.

Shifts in the demand curve• Movement along the demand curve indicates the

“quantity demanded” increased.

• Shifts in demand curve can occur for multiple reasons• Uncontrollable factor – affects demand and is out of a

company’s control.

• Income, weather, interest rates, and prices of substitute and complementary products owned by other companies.

• Controllable factor – affects demand but can be controlled by a company

• Price, advertising, warranties, product quality, distribution speed, service quality, and prices of substitute or complementary products also owned by the company

Anecdote: Microsoft• In the late 1970s, Microsoft developed DOS, an

operating system to control IBM computers. • The price for DOS depended on the price and availability

of computers that could run it and the applications that ran under it as well as the price of DOS itself.

• To increase demand for DOS Microsoft:

• Licensed its operating system to other computer manufacturers

• Developed its own versions of complimentary products

• Kept the price of DOS low

• Discussion: How did Microsoft control demand using these factors? How did competitors (Apple, for example) operate differently?

Demand increase• At a given price, more quantity demanded

Supply curves• Definition: Supply curves are functions that relate the

price of a product to the quantity supplied by sellers. • Discussion: Why do supply curves slope upwards?

Market equilibrium

• Definition: Market equilibrium is the price at which quantity supplied equals quantity demanded.

• At the equilibrium price, there is no pressure for the price to change given the equality of quantity demanded and supplied.

Market equilibrium (cont.)• Proposition: In a competitive equilibrium

there are no unconsummated wealth-creating transactions.

Price Demand Supply$12 1 9$11 2 8$10 3 7$9 4 6$8 5 5$7 6 4$6 7 3$5 8 2$4 9 1

Using supply and demand• Supply and demand curves can be used to describe changes that occur at the industry level

Portable generator market 1997-1998• 1997- Stable industry sales with intense competition (2% avg. sales

growth)

• 1997- Industry anticipates record demand will occur in 1999

• 1998 – Massive capital expenses throughout industry on vertical integration projects

• Demand shift due to fear of power grid failure caused by Y2K

• Supply shift caused by manufacturer’s eagerness to capitalize on record demand for product

• Manufacturers fail to anticipate reduced demand in 2000

• Sales from 2000 pulled forward into 1999

Portable generator market 1999 +

Generator demand shifts graph

Using supply and demand (cont.)• Discussion: “over the past decade, the price of computers

has fallen, while quantity has risen.” How? Why?

Problem: commercial paper• In September 2008 there was a significant

increase in prices and decrease in quantity in the commercial paper market

Commercial paper problem (cont.)• In the second week of September the price of

the loans (interest rate) shot up

Commercial paper: Question• These changes spooked Treasury Secretary

Paulson and Federal Reserve Chairman Ben Bernanke, and they were characterized as a “freeze” in the market for short-term lending, the essential “grease” that facilitates the movement of assets to higher-valued uses.

• What could have accounted for these changes?

Commercial paper: Answer• After a few big bank failures, commercial lenders

became increasingly worried that borrowers would not be able to repay the commercial paper loans.

• This resulting decrease in supply caused both an increase in the price of borrowing (the interest rate) and a decline in the amount of lending.

Prices convey information• Prices are a primary way that market participants

communicate with one another• Buyers signal their willingness to pay, and sellers signal

their willingness to sell with prices• Price information especially important in financial

markets

Prices convey information (cont.)

• Discussion: Gas pipeline burst between Tucson and Phoenix• What happened to gas prices in Phoenix, in Tucson and in

Los Angeles?

Market makers (cont.)• If there were but a single (monopoly) market maker,

how much would she offer the sellers (the bid)?• How much would she charge the buyers (the ask)? • How many transactions would occur?

Market makers

• Discussion: Compute the optimal “spread”

• Discussion: Competition forces spread down to the costs of market making, $2. What is bid-ask spread?

Competition among market makers• On May 26, WSJ & LA Times published results of Bill Christie’s research• On May 27, spreads collapsed• Discussion: WHY?

Alternate intro anecdote• Video enhancement products are state-of-the-art graphics

systems that capture, analyze, enhance, and edit all major video formats without altering underlying footage.

• In 1998, this market consisted of a small number of companies, and demand was relatively light due to the extremely high price of the technology (prices ranged between $45,000 and $80,000)

• In 2000, Intergraph entered the market at a price of $25,000, attempting to quickly capture a major share of the market. Intergraph produced a product at a substantially lower cost than the competition.

Alternate into anecdote (cont.)• What happened??

• Entry caused an increase in supply and a strong downward pressure on price (average pricing fell to around $40,000).

• A number of firms exited and prices rose back to around $45,000.

• Later, the events of 9/11/01 caused demand to spike. • What happened??

• In the short run, average prices shot up. • Higher prices eventually attracted more entrants, increasing

supply. Pricing fell back down to an average level of around $30,000.

Extra: using demand and supply

• Discussion: Is there a shortage of affordable housing?

• Discussion: Is there a shortage of kidneys?

28

1. Introduction: What this book is about2. The one lesson of business3. Benefits, costs and decisions4. Extent (how much) decisions5. Investment decisions: Look ahead and reason back6. Simple pricing7. Economies of scale and scope8. Understanding markets and industry changes9. Relationships between industries: The forces moving us towards long-run equilibrium10. Strategy, the quest to slow profit erosion11. Using supply and demand: Trade, bubbles, market making 12. More realistic and complex pricing13. Direct price discrimination14. Indirect price discrimination15. Strategic games16. Bargaining 17. Making decisions with uncertainty 18. Auctions19. The problem of adverse selection20. The problem of moral hazard21. Getting employees to work in the best interests of the firm22. Getting divisions to work in the best interests of the firm23. Managing vertical relationships24. You be the consultantEPILOG: Can those who teach, do?

Managerial Economics - Table of contents