session 3

The Microeconomic Se-ng Markets and economic value (Case Studies) Session 3 HEC MBA Managerial Economics – Winter 2014

Copyright © 2015, J. Ghez 1

WHERE WE STAND, WHERE WE GO


Goals of the secFon 1.  Consider the goals of microeconomics analysis; 2.  Assess how markets funcJon, how demand and supply behave; 3.  Draw implicaJons for business strategy.

Key quesFon to address Why could microeconomic analysis could help improve strategies? What are the sources of economic value?

Part I: All You Ever Wanted (and Needed) to Know About the Market


P

Q

The Demand Curve Drawing the relaFonship

The demand curve therefore describes the relaFonship between price and demand: the lower the price, the higher the demand and the higher the price, the lower the demand. ü  At the individual level, this means that a high

price will lead me to consume less units of the good in quesFon (and vice-‐versa)

ü  At the aggregate level, this means that given a high price, less people will be able to consume (and vice-‐versa)

Phigh

Plow

Qlow Qhigh


P

The Supply Curve Drawing the relaFonship

The supply curve therefore describes how much suppliers are willing to produce and sell at a given price: ü  The higher the price, the more able and willing

businesses will be to supply the market;

ü  A higher price will indeed lead firms to expand their output and/or aWract addiFonal firms;

ü  A lower price will lead firms to reduce their outputs and/or lead them to leave the market.

Phigh

Plow

Qlow Qhigh Q


P

Q

Gains From Trade The benefits of free-‐markets

When equilibrium is reached, everyone who wanted to trade could and did. This is the point at which gains from trade are maximal and economic value is the greatest. In parFcular, at the equilibrium point, we’ve exhausted all opportuniFes to match up suppliers with consumers who value the product more than what it cost to produce it. The resulFng value creaFon is represented by the red area which what we’ll refer to as gains from trade.

P*

Q* Copyright © 2015, J. Ghez 6

P

Q

Introducing the Consumer Surplus What’s in it for the buyer

These gains from trade can be divided up in two parts. The upper part (in green) relates to an interesFng concept: the consumer surplus. It’s the aggregate sum of money that consumers would have been willing to spend but did not have to because market forces led the price to be fixed at a lower level compared to how much some consumers valued the good.

P*


P

Q


The yellow area represents the gains from trade that fail to materialize as a result of this minimum price.

P*

Q*

Pmin

Qmin Qhigh


P

Q


The orange segment represents the difference between what consumers demand and what firms supply – that is, the shortage of goods. If a maximum price had been set (that is, below the equilibrium price) at Pmax, for instance, we would have observed the opposite difference resulFng in an excess of goods on the market (in green).

P*

Q*

Pmin

Qmin Qhigh

Shortage

Excess

Pmax


P

Q

The Meaning of the “Price” A very informaFonal benchmark

P*


SHARED VALUE VS. GAINS FROM TRADE


Read Porter and Kramer’s arFcle on creaFng shared value (see K-‐Hub). 1.   Summarize the overall argument.

2.   How does “shared value” relate to the concept of “gains from trade” we explored in session 2?

Michael Porter and Shared Value Porter, the microeconomist


First, the Argument What is “shared value”?


P

Q

The Link With Microeconomics How could we revisit “gains from trade”?

P*


The Argument What is shared value?


Shared Value and Gains from Trade Are shared value and economic value the same?


P

Q

By addressing externaliFes, the argument goes, firms can make themselves and their supply chains less vulnerable. This is akin to a reducFon in cost (or greater producFvity) leading to an expansion of supply and a shif of the supply curve to the right. We could also add that addressing these externaliFes could lead markets to expand, the demand

Shared Value and Gains from Trade Are shared value and economic value the same?


P

Q

Gains from trade are as a result far greater. There is therefore a correspondence between gains from trade and what Porter and Kramer call “shared value”.

ECONOMIC VALUE AND ITS BUSINESS IMPLICATIONS


In a concert room, the number of seats is fixed and constrained by the concert venue. Demand, on the other hand, follows the usual relaFonship we saw in class.

Organizing a U2 Concert (1) To fill or not to fill…


P

Q

P1

Q*

P2

P3

In a concert room, the number of seats is fixed and constrained by the concert venue. Demand, on the other hand, follows the usual relaFonship we saw in class. Imagine you’re the group manager and you are planning a concert at the Stade de France. 1.   What does P1 represent? Answer in plain English. Hint: if you are using the word

“equilibrium,” the answer is not in plain English.

2.   Why would you choose P2 over P1 ? What revenues would you forgo? What value could you create for yourself (the manager)?

3.   Why would you choose P3 over P1 ? What revenues would you forgo? What value could you create for yourself (the manager)?

For each quesFon, you should provide a visual for the value that you are creaFng for yourself (the producer)

Organizing a U2 Concert (2) To fill or not to fill…


What does P1 represent? P1 is the maximum price you can charge to get a sell-‐out crowd. Any price below will sFll lead to a sell-‐out crowd, but some people won’t get Fckets. Any price above will not lead to a sell-‐out crowd. P1 can be a clever price to charge: you maximize aWendance and necessarily make a higher revenue than at any lower price. For instance, P1 x Q* will be greater than P2 x Q* (See next slide). But you might be able to make a higher revenue at a higher price, depending on the slope of the demand curve. For instance, P1 x Q* could be smaller than P3 x Q3 (See next slide).


Organizing a U2 Concert (2) Ge-ng a sell-‐out crowd


P

Q

P1

Q*

P3

Q3

When you charge P3, you are charging a premium worth P3 – P1. This premium can help you build up your brand and/or achieve other markeFng objecFves. You are essenFally earning the red rectangle in addiFonal revenues, but you are losing the blue rectangle as a result. This blue rectangle is the supplier’s cost of charging a premium. In this debate, comparing the red and blue rectangles can help you determine what the appropriate tradeoff is.

Organizing a U2 Concert (2) Selling less (to make a point)


P

Q

P1

Q*

P2

Q3

When you charge P2, some of your clients who are willing to buy the good can’t because you have ran out. The headlines, in this case, are all about those who wanted to consume but who couldn’t because the product is so popular and cheap. EssenFally, you are creaFng a buzz measured by the red segment (or arguably, the light red rectangle). This could mean addiFonal dates for the concert that you may not have goWen before. The price of this buzz is measured by the revenue you forgo by charging a lower price. This is measured by the blue rectangle. Here too, the debate is about making the appropriate tradeoff.

Organizing a U2 Concert (2) Pricing less (to make a point)

Is this wise?



Is this wise? Consider the following story:

McDonald's Dinner Box promoFon offers two Big Macs, two regular cheeseburgers, 10-‐piece Chicken McNuggets, and four small fries for $9.99. Ordering the dinner box is $8 cheaper than purchasing the items individually. You can add drinks for just $1 each. (…) How can McDonald's turn a profit on these outrageous deals? The short answer: they probably aren't, at least not yet. (…) McDonald's is probably losing money in the short-‐term in order to gain customers over Fme, Sean O'Keefe, a professor in the Food Science department at Virginia Tech, told Business Insider. (…) "I expect they break even with this or have a small profit, but the promoFon gets McDonald's on people's radar and in the door," he said. "There appears to be a lot of buzz for this promoFon...so it certainly is adverFsing to boot."


Source: Allan Smith, “How McDonald's Profits From Selling An Insane Amount Of Food For $9.99,” Business Insider, June 24, 2014 (hWp://goo.gl/yyHmY5)


INTERNATIONAL TRADE AND ECONOMIC VALUE


P

Q

Gains From Trade Once more

PA

QA


Imagine this a local/naFonal economy with no economic Fes to the rest of the world. Any given market – say, for shoes for instance – will reach equilibrium defined by a volume in autarky and a price in autarky. The top end of the gains from trade goes to the consumer (consumer surplus) while the boWom end goes to the producer (producer surplus).

Consumer surplus

Producer surplus

P

Q

PA

QA


Imagine now that the country opens up and that cheaper shoes are available from abroad. On this market, the price will drop to the level of the world price for the good, which is lower than the autarky price. At the world price, while local suppliers will supply QS, local consumers will ask for QD. The difference – scarcity – will be imported from abroad. Who benefits most from this? Consider the consumer.

PW

QS

QD

Gains From Trade -‐-‐ Imports Once more

P

Q

PA

QA


PW

QS

QD


Imagine now that the country opens up and that cheaper shoes are available from abroad. On this market, the price will drop to the level of the world price for the good, which is lower than the autarky price. At the world price, while local suppliers will supply QS, local consumers will ask for QD. The difference – scarcity – will be imported from abroad. Who benefits most from this? Consider the producer.

P

Q

PA

QA


PW

QS

QD


Imagine now that the country opens up and that cheaper shoes are available from abroad. On this market, the price will drop to the level of the world price for the good, which is lower than the autarky price. At the world price, while local suppliers will supply QS, local consumers will ask for QD. The difference – scarcity – will be imported from abroad. Who benefits most from this? Overall, the gains for society are posiFve but diffuse: many people enjoy them while few suppliers pay the cost. Is this true in pracFce? Suppliers are likely to be vocal about this!

P

Q


Imagine this economy, observing that it is not compeFFve enough, decides to implement a tariff in order to protect its shoe industry – perhaps given the pressure coming from the suppliers! Local demand will shrink because local consumers will face higher prices. But local supply will expand and suppliers will enjoy higher market shares. This will also reduce imports from QS – QD to QST – QDT. (Could this trigger a response in the rest of the world?)

PW

QS

QD

Gains From Trade – The Tariff Example Once more

PT

QST

QDT

P

Q


Imagine this economy, observing that it is not compeFFve enough, decides to implement a tariff in order to protect its shoe industry – perhaps given the pressure coming from the suppliers! Local demand will shrink because local consumers will face higher prices. But local supply will expand and suppliers will enjoy higher market shares. This will also reduce imports from QS – QD to QST – QDT. What will happen? PW

QS

QD


PT

QST

QDT

P

Q


The producer surplus will expand. Suppliers are the key winners. For every unit imported (total worth: QST – QDT), the government will earn a tariff worth T, for a total revenue equal to the yellow rectangle. No one, however, will earn the two black triangles. Those gains from trade, which existed in the regime with no tariff, disappear and fail to materialize. They represent the deadweight loss incurred because of the tariff. How would you explain the persistent use of this tool?

PW

QS

QD


PT

QST

QDT

“… Different groups have different abiliFes to organize to defend their interests. Sugar producers and corn growers are geographically concentrated and focused on the prices of their products, unlike ordinary consumers or taxpayers, who are dispersed and for whom the prices of these commodiFes are only a small part of their budgets. Given insFtuFonal rules that ofen favor special interests (such as the fact that Florida and Iowa, where sugar and corn are grown, are electoral swing states), those groups develop an outsized influence over agricultural and trade policy. Similarly, middle-‐class groups are usually much more willing and able to defend their interests, such as the preservaFon of the home mortgage tax deducFon, than are the poor. This makes such universal enFtlements as Social Security or health insurance much easier to defend poliFcally than programs targeFng the poor only.” The same may hold true for texFles and Wal-‐Mart or Carrefour for instance. A tariff may increase the price millions of consumers (who have very limited ability to organize themselves) and represent a significant advantaged for a limited group of people.


Gains From Trade – The Tariff Example Sugar in the United States

Source: Francis Fukuyama, “America in Decay,” Foreign Affairs, September 2014 (hWp://goo.gl/mNsIQx)

P

Q

PA

QA


A similar reasoning for exports! Imagine that the country is good at making shoes, and that the rest of the world is willing to pay a higher price for these. The economy will export QS – QD worth of shoes. Consumer surplus will shrink but the producer surplus will become far greater. What do you think about benefits and costs in this case? How is this perceived in pracFce? This might come closer to what we usually characterize as supply-‐side policies.

PW

QD

QS

Gains From Trade -‐-‐ Exports Once more

session 3

Documents