Understanding Markets and Industry Changes

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? Discussion Answer: But following the boom year of 1999, the year 2000 turned out to be a bust. Demand fell back to 1998 levels, and prices tumbled to below-1998 levels. Industry profit declined dramatically, along with capacity utilization rates. WRM’s Y2K strategy to increase production capacity turned out to be its undoing. Along with half the firms in the industry, they declared bankruptcy in 2000.

Summary of main points A market has a product, geographic, and time dimension. Define the market before using supply– demand 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).

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 devaluation in a country increases demand for exports (supply to another country) and decreases demand for imports (demand for another country’s 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 bid–ask 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.

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.

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 company’s 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

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?

Demand increase At a given price, more quantity demanded

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?

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.

Market equilibrium (cont.) Proposition: In a competitive equilibrium there are no unconsummated wealth-creating transactions.

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

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

Generator demand shifts graph

Using supply and demand (cont.) Discussion: “over the past decade, the price of computers has fallen, while quantity has risen.” How? Why?

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

Commercial paper problem (cont.) In the second week of September the price of the loans (interest rate) shot up

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?

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.

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

Prices convey information (cont.) Discussion: Gas pipeline burst between Tucson and Phoenix What happened to gas prices in Phoenix, in Tucson and in Los Angeles? ANSWER: all three prices increased. In phoenix the supply decreased. In Tuscon, local supply decreased when Truckers began driving down from Phoenix to fill up a the Tuscon “rack.” Supply to Los Angeles decreased as more supply was sent to Pyoenix.

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?

Market makers Discussion: Compute the optimal “spread” Discussion: Competition forces spread down to the costs of market making, $2. What is bid-ask spread?

Competition among market makers On May 26, WSJ & LA Times published results of Bill Christie’s research On May 27, spreads collapsed Discussion: WHY?   By ruling out cost-based explanations for the collapse, Christie and his coauthors concluded that publicizing the conspiracy led to its collapse. We’ll return to this theme later on when we examine the forces of competition and how firms attempt to control them.