Microeconomics/Industry Analysis

Session #1: Competitive Markets

Prof. Amine Ouazad

LLM in International Business Law, March 28 2014

About Me

• Has been teaching core economics in the INSEAD MBA program since 2008, 170+ students; and has about 30 PhD students in Management.

• Research in microeconomics & finance.

• Recent work featured in the press: Washington Post, France 24, Guardian, Daily Telegraph.

• Works/teaches in US, UK, France, Singapore.

This WorkshopCentral unifying theme

How does market competition affect prices?

Why should you care?

•As a consumer/investor, understand price dynamics.

•As a lawyer, understand the economics impacts of limited competition.

•Analysis of one of the largest antitrust cases in US history.

➥Forecast prices on a commodity market. (Session #1)

➥Detect & Deter collusion on that market. (Session #2)

Outline for this Session

1. Commodity Markets: Demand and Supply Analysis

2. Minimum wage

3. Selling less to earn more

1. Commodity Markets: Demand and Supply

April 8, 2012 Aluminium buckles under weight of supply pressureBy Jack Farchy in London

“I don’t like aluminium.”That may seem an unlikely statement from the world’s sixth-largest producer of the metal. But Marius Kloppers, chief executive of BHP Billiton, is putting his money where his mouth is. BHP will from now on run its aluminium division for cash, he announced in February.

After a decade of sub-par profitability, is it still worth investing in aluminium?

Daniel Brebner, metals analyst at Deutsche Bank, estimates that the operating profit margin for a marginal aluminium producer has been 14 per cent over the past decade, compared with 43 per cent for copper.“While copper has been exceptionally profitable, aluminium has had an unremarkable performance during one of the greatest commodity boom periods in history in terms of demand,” he says. “This is a condemnation of the state of the industry that it can’t generate super-normal returns in an environment of super-normal demand.”

If Mr Kloppers is correct, the future is bleaker still for producers of the metal used in the manufacture of everything from drinks cans to cars and aircraft.

The argument underpinning his pessimism is simple: years of overcapacity have kept prices subdued and led to a huge build-up of inventories – now estimated at more than 12m tonnes, or enough to build 180,000 Boeing 747s. And with the price of energy, which accounts for as much as half of aluminium production costs, rising rapidly, industry-wide profitability is flat at best.

“If you are the average Chinese producer you should probably quit this business right now or a few months ago,” says Oleg Mukhamedshin, head of corporate development at Rusal, predicting that many Chinese aluminium smelters will be forced to shut down in the next few months, pushing up global prices.

The most popular response among rival aluminium executives is to point to China which, as well as being the world’s largest aluminium consumer, is also the top producer.

(ktpy)

Built by 2013 students,Used by commodity analysts

Aluminum prices 2011-2013Source: London Metal Exchange

Homogeneous good?

Commodity Market Analysis

Price ($/ton)

Quantity (tons)

Supply curve

Demand curve

P*

Q*

Consumer surplus

Firms’ profit

$2000

40Mt2013

“We are positioned in the lower part of the supply curve” Cynthia Caroll

Demand Shock

Price ($/lb)

Quantity (lb)

Supply curve- Aluminum producers

Demand curve

P*

Q*

P’

Q’

“But the company added that it expected a slight pick-up in consumption in the fourth quarter thanks to a recovery in China’s economic growth and improvement in key sectors such as the US car industry.”

FT article on Rusal

Demand ShocksIn Business…

•“Demand for aluminum has started falling as construction growth slows.” FT Oct 26, 2011.

•McDonald’s same-store sales increased by 2.6% year-to-year in 2009.

… and in other aspects of life

•Demand for marijuana increased 8% in US states that decriminalized most posession offenses.

•Demand for prostitution services increases around 4th July.

Supply Shock

Price ($/lb)

Quantity (lb)

Supply curve- Lysine producers

Demand curve- Food producers

P*

Q*

P’

Q’

Supply Shocks are Everywhere

In business…

•Discovery of substantial new oil production capacity.

•Geopolitical events in the Middle East limiting supply of oil.

And in other aspects of life…

•Increases in drug punishment for dealers since 1985 rose the price of cocaïne by 5 to 15% in the US.

•The supply of prostitution increases in response to the demand for prostitution services (4th July).

2. Minimum wage

• “Do you want to get serious about expanding employment? Then it's time to realize that spending on jobs programs is the wrong approach. It would be much better to eliminate hurdles for people who want to find work. One of those hurdles is the minimum wage.”

His predictions:

1. “Minimum wages create unemployment. At above market prices people want to supply more labor than employers wish to hire.”

2. “Repealing the minimum wage would would create job opportunities.”

Really??

Scrap the Minimum WageForbes MagazineArt Carden

September 2010 edition

Raising hourly wages seemed like a good idea, but it has only destroyed jobs.

The

For

bes’

col

umni

st s

ays

this

Hourly wage ($)

Hours worked

Supply curve- Unskilled workers

Demand curve- Employers

w*

q*

Minimum wage

Supply of work

Number of hours worked

Forbes’ Carden says:1.“Minimum wages create unemployment. At above market prices people want to supply more labor than employers wish to hire.”In other words : supply of work > demand.

This is the wage that

would prevail

without a minimum wage law.

This is the wage that

would prevail

without a minimum wage law.

Should we believe the Forbes’ columnist ??Alan Krueger

Chairman of the Council of Economic AdvisersSince September 2011& Prof. of Economics at Princeton

Myth and Measurement:The New Economics of the Minimum Wage.

His statements:

1.“the minimum wage at levels observed in the United States has had little or no effect on employment.”

2. “increases in the minimum wage lead to increases in pay, but no loss in jobs.”

How can this make sense??How can this make sense??

“1992: New Jersey implements a state-level minimum wage above the Pennsylvania minimum wage.”

“➥ Employment did not change.”

“1992: New Jersey implements a state-level minimum wage above the Pennsylvania minimum wage.”

“➥ Employment did not change.”

What about a very steep demand curve?

Hourly wage

Hours

w*

q*

Minimum wage

Supply curve- Unskilled workers

Demand curve- Employers

This is the level of

employment without a minimum wage law.

This is the level of

employment without a minimum wage law.

Hours worked with minimum wage. Little change!

Hours worked with minimum wage. Little change!

Alan Krueger says:2.“increases in the minimum wage lead to increases in pay, but no loss in jobs.”

Why a very steep demand curve?

Employers willing to hire workers at hourly wages far

above $5.

Why a very steep demand curve?

Employers willing to hire workers at hourly wages far

above $5.

Main Lessons from Minimum Wage Example

Commodity markets are everywhere

A minimum wage above the market wage may lead to lower employment and higher unemployment.

But if the demand curve for unskilled work is very steep,the impact on employment is small, and it raises the wages of employed workers

For thought: Does this mean we should have very high minimum wages??

3. Selling less to Earn More

Price ($/ton)

Quantity (ton)

Supply curve

Demand curve

P*

Q*

Consumer surplus

Firms’ profit

Pc

Qc

Earning more by selling less?

In a commodity market, suppliers do not control the price… but they could gain by selling less at a higher price.

Price ($/ton)

Quantity (ton)

Supply curve

Demand curve

P*

Q*

Consumer surplus

Firms’ profit

Pc

Earning more by selling less? Inelastic Demand

In a commodity market, suppliers do not control the price… but they could gain by selling less at a higher price… especially if demand is very steep.

Elastic and Inelastic Products

“We think gold and platinum are an outright buy at present levels as both metals have very low supply elasticity and are key beneficiaries of loose monetary policy” UBS Gold Outlook 2013

“We think gold and platinum are an outright buy at present levels as both metals have very low supply elasticity and are key beneficiaries of loose monetary policy” UBS Gold Outlook 2013

“We’ve done price elasticity studies”

Jeff Bezos

-- HBR Interview, September 2012

“Heroin demand is inelastic”Steve Levitt

"We feel quite confident with the response we've seen to our pricing actions," Rosenfeld said. Price "elasticity has been essentially where we expected it to be.”

-- Irene Rosenfeld, Kraft CEO (now Chairman), 2011

In commodity or commoditized markets…

…and in other markets.

Take Aways

•On a commodity market, use demand and supply analysis to forecast prices.

• Upward demand shocks lead to higher prices and to higher production.

• Upward supply shocks lead to lower prices and to higher production.

•Commodity markets are everywhere: unskilled work, drugs, food.

•Firms may have an incentive to agree on a higher price,selling less to earn more…

This is particularly true when demand is ➥ inelastic. An inelastic demand is a demand that does not change much when the price increases.Example: drugs.

•Setting a higher price is hard on a commodity market.

Pork food additive: LysineIn a commodity market, suppliers do not control the price… but they could gain by selling less at a higher price.