Lecture 2: Elasticity, Control on Prices & Production

Given to theGiven to theEMBA 8400 ClassEMBA 8400 Class

Classroom South #608Classroom South #608January 6, 2007January 6, 2007

Dr. Rajeev DhawanDr. Rajeev DhawanDirectorDirector

Chapter 5

Elasticity

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 don’t 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)

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

P rice e las tic ity o f d em an d =P ercen tag e ch an g e in q u an tity d em an d ed

P ercen tag e ch an g e in p rice

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)

Elasticity

Inelastic Demand– Quantity demanded does not respond strongly

to price changes.– Price elasticity of demand is < one.

Elastic Demand– Quantity demanded responds strongly to

changes in price.– Price elasticity of demand is > one.

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.

Perfectly Inelastic Demand

Elasticity = 0

$5

4

Quantity

Demand

1000

1. Anincreasein price . . .

2. . . . leaves the quantity demanded unchanged.

Price

3. . . . revenue goes from $4 x 100 to $5 x 100

Inelastic Demand

Elasticity < 1

Quantity0

$5

90

Demand1. A 22%increasein price . . .

Price

2. . . . leads to an 11% decrease in quantity demanded.

4

100

3. . . . revenue goes from $4 x 100 to $5 x 90

Unit Elastic Demand

Elasticity = 1

Quantity0

$5

80

1. A 22%increasein price . . .

Price

2. . . . leads to a 22% decrease in quantity demanded.

4

100

Demand

3. . . . revenue goes from $4 x 100 to $5 x 80

Elastic Demand

Elasticity > 1

Quantity0

$5

50

1. A 22%increasein price . . .

Price

2. . . . leads to a 67% decrease in quantity demanded.

4

100

Demand

3. . . . revenue goes from $4 x 100 to $5 x 50

Perfectly Elastic Demand

Elasticity = Infinity

Quantity0

Price

$4 Demand

2. At exactly $4,consumers willbuy any quantity.

1. At any priceabove $4, quantitydemanded is zero.

3. At a price below $4,quantity demanded is infinite.

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 revenueExample class to contribute

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

Applications of Supply, Demand & Elasticity

Can good news for farmers be bad news for farmers?

Wheat is inelastic: Bumper crop bad news

Increase In Supply In Market For Wheat

Quantity ofWheat

0

Price ofWheat

3. . . . and a proportionately smallerincrease in quantity sold. As a result,revenue falls from $300 to $220.

Demand

S1 S2

2. . . . leadsto a large fallin price . . .

1. When demand is inelastic,an increase in supply . . .

2

110

$3

100

Chapter 6

Controls on Prices

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.

Price Ceiling:

Pints0

Beer

Demand

Supply

2 PriceceilingShortage

75

Quantitysupplied

125

Quantitydemanded

Equilibriumprice

$3

…Rent Control TooBeer Shortage

Price Floor: Beer Surplus

Quantity ofBeer

0

Price ofBeer

Demand

Supply

Quantitysupplied

Quantitydemanded

Equilibriumprice

$3

$4Pricefloor

Surplus

75 125

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 Chrysler’s 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 man’s overcapacity is other’s bargain.Thus, lower priced leases and generous rebates abound in today’s

car market.

Chapter 2

Production

Production

What is production?– The activity by which we convert inputs (labor,

land & capital) into goods and services

What limits production?– Inputs (resources)– TechnologyGovernment interference

Circular Flow Diagram

Spending

Goods andservicesbought

Goodsand servicessold

Labor, land,and capital

Income

= Flow of inputs and outputs

= Flow of dollars

Factors ofproduction

Wages, rent,and profit

FIRMS•Produce and sellgoods and services

•Hire and use factorsof production

•Buy and consumegoods and services

•Own and sell factorsof production

HOUSEHOLDS

•Households sell•Firms buy

MARKETSFOR

FACTORS OF PRODUCTION

•Firms sell•Households buy

MARKETSFOR

GOODS AND SERVICES

Circular Flow Diagram

Revenue

= Flow of inputs and outputs

= Flow of dollars

Production Possibilities Frontier

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

Production Possibilities Frontier

b

d .

a

c

4,000

E

Quantity of

Beer Produced

2,000

700

2,100

750

3,000

1,000

Quantity ofPretzels

Produced

A

1,000

300

B

0

D

2,200

600

C

Productionpossibilitiesfrontier

Production Function I

Production Function

0

2

4

6

8

10

12

0 2 4 6 8 10

Input

Y

Y (Production) = F (Inputs)Y (Production) = F (Inputs)Input Y MP0 0

1.001 1

1.002 2

1.003 3

1.004 4

1.005 5 Marginal Product (MP) = ∆ Output / ∆Input

Y = IY = I

Marginal Product: it is the increase in output that arises from an additional unit of input.

Production Function II

Production Function

0

20

40

60

80

100

120

0 2 4 6 8 10

Input

Y

Y = IY = I22Input Y MP0 0

1.001 1

3.002 4

5.003 9

7.004 16

9.005 25 Marginal Product (MP) = ∆ Output / ∆Input

Production Function III

Production Function

0

0.5

1

1.5

2

2.5

3

3.5

0 2 4 6 8 10

Input

Y

Y = Y = √I√IInput Y MP0 0

1.001 1

0.412 1.4

0.323 1.7

0.274 2

0.245 2.2 Marginal Product (MP) = ∆ Output / ∆Input

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.

0

1

2

3

4

5

6

7

8

9

0 1 2 3 4 5 6 7 8 9 10

DRS

CRS

IRS

MP MP ↑ ↑ IRS IRSMP MP ↓ ↓ DRS DRS

Y=IY=I

Y=IY=I22

Y = √IY = √I

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 Japan’s 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?

Automobile Industry

Economic Analysis of

General Motors – Light Truck Sector

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

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

Figure 1. Number of Employees

1,000

10,000

100,000

1,000,000

64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97

Chrysler

Daihatsu

Ford

Fuji (Subaru)

GM

Honda

Isuzu

Mazda

Nissan

Suzuki

Toyota

2003 Market Share of U.S. Retail Light Truck Sales

26%

31%

19%

9%

3%

6%

0%

1%

5% Company

Ford

GM

Daimler/Chrysler

Toyota

Nissan

Honda

Isuzu

Mazda

Other

Weaknesses GM’s 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

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

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

Economies of Scale

Macroeconomic Factors

Key macroeconomics factors that influence new truck demand :

Consumer income

Unemployment level

Personal income growth

Inflation and interest rates

Current GDP growth

Recession

Current Trade Deficit- FE Rates (U$, ¥)

Monetary & Fiscal Policy

Extraneous forces - OPEC oil prices

Labor Unions (UAW, etc)

Other Macroeconomics Factors

Comparative Efficiency of US & Japanese Automakers: A Stochastic Frontier

Production Function Approach

Rajeev Dhawan & Marvin LiebermanRCB & The Anderson School at UCLA

Figure 3a. Capital Stock per Worker (Japan)

0

50

100

150

200

64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97

Th

ou

san

ds

of

1982

do

lla

rs

Daihatsu

Fuji (Subaru)

Honda

Isuzu

Mazda

Nissan

Suzuki

Toyota

Figure 3b. Capital Stock per Worker (US)

0

50

100

150

200

64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97

Th

ou

san

ds

of

1982

do

lla

rs

Chrysler

Ford

GM

Figure 4. Cumulative Output of Vehicles

100,000

1,000,000

10,000,000

100,000,000

1,000,000,000

64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97

Chrysler

Daihatsu

Ford

Fuji (Subaru)

GM

Honda

Isuzu

Mazda

Nissan

Suzuki

Toyota

Figure 5. WIP/Sales Ratio

0

0.02

0.04

0.06

0.08

0.1

0.12

0.14

0.16

64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97

Chrysler

Daihatsu

Ford

Fuji (Subaru)

GM

Honda

Isuzu

Mazda

Nissan

Suzuki

Toyota

Figure 6. Average Vehicle Output per Plant

0

100000

200000

300000

400000

500000

600000

700000

800000

900000

64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97

Chrysler

Daihatsu

Ford

Fuji (Subaru)

GM

Honda

Isuzu

Mazda

Nissan

Suzuki

Toyota

Figure 7. Value-added/Sales (Vertical Integration)

0

0.1

0.2

0.3

0.4

0.5

0.6

64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97

Chrysler Daihatsu Ford Fuji (Subaru)

GM Honda Isuzu Mazda

Nissan Suzuki Toyota

Table 1A. Comparison of OLS and SFPF Estimates

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). Toyota’s 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.

Observations from technical efficiency scatter plot (US producers):

GM’s efficiency is slightly above the Japanese level in the mid-1960s. By the 1990s, GM’s efficiency falls below that of all Japanese producers except Fuji and Mazda.

Chrysler’s 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.

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!