Lecture 8 Understanding Markets and Industry Changes

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Lecture 8Understanding Markets and Industry
Changes
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Lecture 8 Summary of main points

• A market has a product, geographic, and time
  dimension. Define the market before using
  supplydemand 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).

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Lecture 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 depreciation in a country increases
  demand for exports (supply to another country)
  and decreases demand for imports (demand for
  another countrys 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 bidask 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.

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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?

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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.

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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 companys 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

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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?

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Demand increase

• At a given price, more quantity demanded

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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?

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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.

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Market equilibrium (cont.)

• Proposition In a competitive equilibrium there
  are no unconsummated wealth-creating transactions.

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Using supply and demand

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

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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

Portable generator market 1999

• Demand shift due to fear of power grid failure
  caused by Y2K
• Supply shift caused by manufacturers eagerness
  to capitalize on record demand for product
• Manufacturers fail to anticipate reduced demand
  in 2000
• Sales from 2000 pulled forward into 1999

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Generator demand shifts graph
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Using supply and demand (cont.)

• Discussion over the past decade, the price of
  computers has fallen, while quantity has risen.
  How? Why?

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Problem commercial paper

• In September 2008 there was a significant
  increase in prices and decrease in quantity in
  the commercial paper market

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Commercial paper problem (cont.)

• In the second week of September the price of the
  loans (interest rate) shot up

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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?

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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.

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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

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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?

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Market makers

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

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Competition among market makers

• On May 26, WSJ LA Times published results of
  Bill Christies research
• On May 27, spreads collapsed
• Discussion WHY?

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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.

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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.