The

Microeconomic Se-ng

Markets and economic value (Case Studies)

Session 3


HEC MBA
Managerial Economics Winter 2014

Copyright 2015, J. Ghez

WHERE WE STAND,
WHERE WE GO
Copyright 2015, J. Ghez

Part I: All You Ever Wanted (and Needed)

to Know About the Market
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?

Copyright 2015, J. Ghez

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.

Phigh

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)

Plow

At the aggregate level, this means that given a

high price, less people will be able to consume
(and vice-versa)

Qlow

Qhigh

Q
Copyright 2015, J. Ghez

The Supply Curve

Drawing the relaFonship

The supply curve therefore describes how
much suppliers are willing to produce and
sell at a given price:

The higher the price, the more able and willing

businesses will be to supply the market;

Phigh

A higher price will indeed lead rms to expand

their output and/or aWract addiFonal rms;

Plow

A lower price will lead rms to reduce their

outputs and/or lead them to leave the market.

Qlow

Qhigh

Q
Copyright 2015, J. Ghez

Gains From Trade

The benets 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, weve
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 well refer to as
gains from trade.

P*

Q*

Q
Copyright 2015, J. Ghez

Introducing the Consumer Surplus

Whats 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.

Its 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 xed at a lower level
compared to how much some consumers
valued the good.

P*

Q*

Q
Copyright 2015, J. Ghez

Gains From Trade

The benets of free-markets

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

Pmin
P*

Qmin Q*

Qhigh

Q
Copyright 2015, J. Ghez

Gains From Trade

The benets of free-markets

The orange segment represents the
dierence between what consumers demand
and what rms 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 dierence resulFng in an excess of
goods on the market (in green).

Pmin

Excess

P*
Pmax

Shortage

Qmin Q*

Qhigh

Q
Copyright 2015, J. Ghez

The Meaning of the Price

A very informaFonal benchmark

P*

Q*

Q
Copyright 2015, J. Ghez

10

SHARED VALUE VS.

GAINS FROM TRADE
Copyright 2015, J. Ghez

11

Michael Porter and Shared Value

Porter, the microeconomist

Read Porter and Kramers 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?

Copyright 2015, J. Ghez

12

First, the Argument

What is shared value?

Copyright 2015, J. Ghez

13

The Link With Microeconomics

How could we revisit gains from trade?

P*

Q*

Q
Copyright 2015, J. Ghez

14

The Argument

What is shared value?

Copyright 2015, J. Ghez

15

Shared Value and Gains from Trade

Are shared value and economic value the same?

By addressing externaliFes, the argument

goes, rms 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

Q
Copyright 2015, J. Ghez

16

Shared Value and Gains from Trade

Are shared value and economic value the same?

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.

Q
Copyright 2015, J. Ghez

17

ECONOMIC VALUE
AND ITS BUSINESS IMPLICATIONS
Copyright 2015, J. Ghez

18

Organizing a U2 Concert (1)

To ll or not to ll

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

P
P3
P1
P2

Q*
Copyright 2015, J. Ghez

Q
19

Organizing a U2 Concert (2)

To ll or not to ll

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

Imagine youre 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)

Copyright 2015, J. Ghez

20

Organizing a U2 Concert (2)

Ge-ng a sell-out crowd

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 wont 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).

Copyright 2015, J. Ghez

21

Organizing a U2 Concert (2)

Selling less (to make a point)

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 suppliers cost of charging
a premium.

In this debate, comparing the red and
blue rectangles can help you determine
what the appropriate tradeo is.

P
P3
P1

Q3

Q*

Q
Copyright 2015, J. Ghez

22

Organizing a U2 Concert (2)

Pricing less (to make a point)

When you charge P2, some of your clients who

are willing to buy the good cant because you
have ran out. The headlines, in this case, are
all about those who wanted to consume but
who couldnt 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 tradeo.

P1
P2

Q3

Q*

Q
Copyright 2015, J. Ghez

23

Organizing a U2 Concert (2)

Pricing less (to make a point)

Is this wise?

Copyright 2015, J. Ghez

24

Organizing a U2 Concert (2)

Pricing less (to make a point)
Is this wise?

Consider the following story:

McDonald's Dinner Box promoFon oers 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 prot 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 prot, 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 Prots From Selling An Insane Amount Of Food For $9.99, Business Insider, June 24, 2014 (hWp://goo.gl/yyHmY5)

Copyright 2015, J. Ghez

25

INTERNATIONAL TRADE
AND ECONOMIC VALUE
Copyright 2015, J. Ghez

26

Gains From Trade

Once more

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
dened 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

PA

Producer surplus
QA

Q
Copyright 2015, J. Ghez

27

Gains From Trade -- Imports

Once more

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 dierence scarcity will be
imported from abroad. Who benets
most from this?

Consider the consumer.

PA
PW

QS

QA QD

Q
Copyright 2015, J. Ghez

28

Gains From Trade -- Imports

Once more

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 dierence scarcity will be
imported from abroad. Who benets
most from this?

Consider the producer.

PA
PW

QS

QA QD

Q
Copyright 2015, J. Ghez

29

Gains From Trade -- Imports

Once more

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
dierence scarcity will be imported from
abroad. Who benets most from this?

Overall, the gains for society are posiFve but
diuse: many people enjoy them while few
suppliers pay the cost. Is this true in pracFce?

Suppliers are likely to be vocal about this!

PA
PW

QS

QA QD

Q
Copyright 2015, J. Ghez

30

Gains From Trade The Tari Example

Once more

Imagine this economy, observing that it is

not compeFFve enough, decides to
implement a tari 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?)

PT
PW

QS

QST

QDT
QD

Q
Copyright 2015, J. Ghez

31

Gains From Trade The Tari Example

Once more

Imagine this economy, observing that it is

not compeFFve enough, decides to
implement a tari 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?

PT
PW

QS

QST

QDT
QD

Q
Copyright 2015, J. Ghez

32

Gains From Trade The Tari Example

Once more

The producer surplus will expand. Suppliers

are the key winners.

For every unit imported (total worth: QST
QDT), the government will earn a tari 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 tari, disappear
and fail to materialize. They represent the
deadweight loss incurred because of the tari.

How would you explain the persistent use of
this tool?

PT
PW

QS

QST

QDT
QD

Q
Copyright 2015, J. Ghez

33

Gains From Trade The Tari Example

Sugar in the United States

Dierent groups have dierent 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 inuence 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 tari may
increase the price millions of consumers (who have very limited ability to organize themselves)
and represent a signicant advantaged for a limited group of people.

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

Copyright 2015, J. Ghez

34

Gains From Trade -- Exports

Once more

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 benets 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
PA

QD

QA QS

Q
Copyright 2015, J. Ghez

35