Archive for the 'Determinants of Demand' Category

Sep 01 2015

The secret to succeeding in a competitive market? Know thine determinants of demand!

I love croissants (or “gipfeli” as they are known here in Switzerland). I also love using bakeries as examples of businesses operating in competitive industries when teaching the concepts of perfect competition in my Theory of the Firm unit. So I was thrilled to see this article from the Economist this week called Croissantonomics.

The nature of competition in the market for baked goods in New York City is clearly intense, as the baker featured in the article implies.

In all, it costs Mr Rubin $2.60 to make a $3.50 croissant. If he makes 100 and sells 70, he earns $245 but his costs are $260. Since he refuses to sell leftovers—all goods are sold within a day—he loses money. “Welcome to the bakery business,” Mr Rubin says

The article outlines the secret to success in this competitive market.

First, product differentiation“his best creations are distinctly American: pretzel croissants (surprisingly tasty), and recipes for making money.”

Second, know the determinants of demand for your product:

There are no brownies or carrot cake on Mondays or Tuesdays—people don’t buy rich desserts after decadent weekends. He watches the weather closely, as demand melts in the rain. He keeps an eye on school calendars, to bake less when children are away. He bakes more after the fasting of Yom Kippur, when demand from Jewish customers picks up.

The article provides an excellent example of how important it is for a producer of a good in a competitive market must be intimately familiar with his consumers in order to succeed. Markets are most efficient when perfect information and knowledge of the desires of consumers is communicated to producers, but in many markets there is information asymmetry, meaning that the sellers do not know what consumers truly want and are therefore unable to bring to market those goods and services that are most in demand.

Mr. Rubin’s bakery has discovered the secret to success in a competitive market: Know thine determinants of demand and make sure you only produce precisely what it is consumers want, and do so at the least possible cost in order to eliminate waste. In this way, Economic Darwinism assures the survival of the most efficient. 

Such strategies have helped the City Bakery survive since 1990. It now has seven smaller shops in New York and seven outposts in Japan, with plans to open in Dubai.

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Mar 10 2011

The economic benefits of bike commuting

I feel like I’ve been here before. Gas prices are rising, approaching $4 per gallon. American drivers are freaking out, demanding the government “does something” to halt rising fuel costs. The next thing you know, people start buying bikes and riding them to work. Just like that, Americans change their lifestyles, abandon their cars, and reinvent themselves as bike commuters!

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The economics of this phenomenon barely requires explanation, but since this is an Economics teacher’s blog, I suppose I should explain it. A major determinant of the demand for a product is the price of related goods. In the US right now, fuel and cars are related goods; in economics terms, they are complementary goods. “You can’t have one without the other”. As gas prices rise, demand for driving cars begins to fall, since it becomes more costly to drive. The other good related to cars in this picture is a substitute mode of transportation, bicycles. The more expensive it becomes to drive a car, the greater the demand for bicycles.

Now, allow me to take my econ teacher hat off and put my avid cyclist hat (or helmet?) on. Bikes are way more than just a substitute for cars. The fact that every time gas prices approach $4 per gallon bicycle sales start to spike is bewildering to me. Do consumers really not know that riding a bike is always cheaper than driving a car? Why does it take slightly more expensive gas to motivate consumers to think about buying a bike?!

Okay, economist had back on now: You see, operating a car involves monetary costs that far exceed the price of gas. When I last had a car in the US, I paid nearly $200 per month in insurance (young males always pay the most), far exceeding my expenditures on fuel. In addition, there’s the fixed cost of the car itself, which once spent is a “sunk cost”, so should not affect an individual’s decision to drive or not to drive when the price of gas changes.

In addition to these explicit, monetary costs, however, there are also external, invisible costs of operating cars that make them an even less perfect substitutes for bicycles. More traffic on the roads, more accidents, more air and noise pollution, greenhouse gas emissions, environmental impact of the production and ultimate disposal of the car itself: these external costs are not even born by the driver when he or she decides to drive to work every day, rather they are born by society, taxpayers, and the environment.

My point is, making the decision to switch to commuting by bicycle should not require a 25% spike in fuel prices. The cost of filling your tank is in fact the least significant cost associated with driving a car when you look at the whole picture, and include not only those explicit, monetary costs paid by the driver, but include the external, social and environmental costs born by society as a whole.

Maybe I’m just on a bike high right now, since I got my new 29 inch wheeled fully two weeks ago and have ridden the 30 km round trip to work nearly every day since! Then again, maybe it really would make more economic, environmental, physical, spiritual and social sense if more people would park their cars and hop on a bike tomorrow morning!

5 responses so far

Sep 23 2010

Is bicycle transportation an “inferior good”?

This article was originally published on May 12, 2008. It is being re-published since it relates to our current units in AP and IB Economics.

The Associated Press: Gas prices knock bicycle sales, repairs into higher gear

Greg Mankiw has an ongoing series of posts linking to articles illustrating the impact that rising gas prices have had on demand in markets other than that of the automobile.

One of the determinants of demand for goods and services is the price of related goods and services. As gas prices rise, drivers tend to switch from automobiles to alternative forms of transportation. A few days ago I blogged about the switch from tractors to camels in India, one illustration of the relationship between the price of one good and demand for its substitutes. Mankiw has so far linked to articles about the impact of high gas prices on demand for bicycles, small cars and mass transit.

These three “goods” are all substitutes for the most common form of transport among Americans, the private automobile (often times a gas-guzzler in “the bigger the better” America). When the price of a good like personal vehicular transport increases (in this case due to the price of an input required in private cars, gasoline), the demand for a substitute good will increase.

In the case of bicycles, evidence indicates that just such a change in demand is already underway in America today:

Bicycle shops across the country are reporting strong sales so far this year, and more people are bringing in bikes that have been idled for years, he said.

“People are riding bicycles a lot more often, and it’s due to a mixture of things but escalating gas prices is one of them,” said Bill Nesper, spokesman for the Washington. D.C.-based League of American Bicyclists.

“We’re seeing a spike in the number of calls we’re getting from people wanting tips on bicycle commuting,” he said.

Interestingly, the increase in demand for bicycle travel in response to high gas prices might be even more pronounced due to America’s sluggish growth, 4% inflation and rising unemployment. Real wages have seen little gain in the last couple of years as growth has fallen close to zero while prices have continued to rise. It may be possible that a fall in real incomes in America has spurred new demand for bicycle transportation, which could be considered an inferior good, meaning that as household incomes fall, consumers demand more bicycles for transportation.

Since bicycles represent such a drastically cheaper method of transportation, high gas and food prices, a weak dollar, and falling real wages accompanying the economic slowdown have had a negative income effect on American consumers, leading to increases in demand for inferior goods such as bicycle transportation

That said, having worked in a bike shop myself for two years in college, I can say that most consumers looking at new bicycles are not doing so because of falling incomes. Quite the opposite, in fact, indicating that new bicycles are normal goods (those for which as income rises, demand rises). However, the article states that in addition to increases in new sales, “more people are bringing in bikes that have been idled for years”.

It may be that while new bicycles themselves are normal goods, bicycle transportation as a whole is an inferior good. The increase in demand for new bicycles could be explained by the substitution effect (as the price of motor vehicle transportation rises, its substitute, bicycle transport, becomes more attractive to consumers) and at the same time explained by the income effect too (as real incomes have fallen, demand for the bicycle transport has risen).

This phenomenon is an excellent illustration of how the income and substitution effects work in conjunction to explain the inverse relationship between price and quantity demanded for automobiles (the law of demand), as well as the concept of cross-price elasticity of demand between two substitute goods.

Discussion Questions:

  1. Both the price of substitute goods and income affect demand for a particular product. How have both the prices of substitutes for bikes and the income of bike consumers influenced the demand for bicycles in different ways?
  2. What is the definition of an “inferior good” in economics?Do you believe bicycle transportation is an “inferior good”?
  3. Are all bikes the same? Do you think demand for some bicycles responds differently to changes in income than demand for other bicycles?

92 responses so far

Sep 23 2010

The magical recession proof bunny

Chocolate Sales: A Sweet Spot in the Recession – TIME

Living in Switzerland, I find an article featuring a local business from the town my school is in irresistible, particularly when it appear in TIME magazine. Lindt chocolate, the company featured in this article, manufactures its delicate treats right down the hill from the ZIS campus, which means that when the wind is just right, you can just catch the scent of fresh, creamy chocolate wafting up the hillside while walking to campus.

Lindt, as well as its global competitors in the chocolate business, is enjoying surge in demand even while countless other industries are forced to cut back production, lay off workers, and close their factory doors. From TIME:

While the credit crisis has slowed down sales of everything from cars to organic groceries, people seem happy to keep shelling out for chocolate. Last year, as the global recession was gaining ground, Swiss chocolate makers bucked the trend with record sales — nearly 185,000 tons, an increase of 2% over 2007, sold domestically and in 140 export markets…

“Switzerland’s image sells well abroad, and nothing says ‘Switzerland’ more than chocolate,” says Stephane Garelli, director of the World Competitiveness Center at the Institute of Management Development (IMD) in Lausanne, predicting that this comfort food will continue to sweeten the sour economy for months to come…

“Now that people don’t have a new television or a new car,” he noted, “they eat a bit more chocolate.”

“Chocolate is one of the more recession-resilient food sectors,” says Dean Best, executive director of Just-Food, a U.K.-based news and information website for the global food industry. “With consumers eating out less and eating at home more, there is evidence that they are still allowing themselves the occasional indulgence — and chocolate is a relatively inexpensive indulgence.”

But the question of why there is no meltdown in the chocolate business may be more a matter of psychology than economics. “There is well-documented evidence going back to Freud, showing that in times of anxiety and uncertainty, when people need a boost, they turn to chocolate,” says Garelli of the IMD. “That’s why when the economy is bad, chocolate is still selling well.”

Which goes to show that chocolate is more than a candy treat — it’s real food for the soul.

So does this mean chocolate is an inferior good, or one for which demand increases as incomes fall? I doubt many Swiss chocolate producers would consider their product inferior, but perhaps it does fit the definition.

On the other hand, perhaps the reason demand for chocolate increases during a recession has more to do with the substitution effect than the income effect. As people eat out less, they consume fewer expensive deserts at restaurants and instead fill their shopping baskets with more affordable dessert options for the home. I can say from experience that this is the case for myself.

Living in Switzerland, I find myself rarely going out to eat at restaurants, an activity reserved for special occasions in this country where a steak can set you back 75 dollars. Instead, I eat at home almost every night, and nothing is more appealing to me, especially during hard economic times, than a bar of delicious chocolate after a home cooked meal. Demand for chocolate may rise during recessions simply because the demand for one of its substitutes (restaurant desserts) falls.

Discussion questions:

  1. Do you think chocolate is an inferior good or a normal good? What’s the difference? What types of goods do YOU consome more of when you find yourself faced with a tighter budget?
  2. Does economics have a good explanation for the above situation? The article mentions Freud, a pioneer in  the field of psychology; do humans’ economic behavior always appear rational?
  3. If chocolate were an inferior good, what would happen to chocolate sales when the global economy finally turns around and incomes start increasing? What do you think will happen to chocolate sales when the economy starts imrpoving? Explain.

30 responses so far

Sep 22 2010

Luxury goods: the biggest rip off in the world or the “must have items” for any self-respecting European?

TDeluxe: How Luxury Lost Its Luster – Dana Thomas – Books – Review – New York Times

Unit 2 in IB and AP Economics begins by examining the interaction of supply and demand in product markets, and the importance of these factors in determining the equilibrium price in any particular product market.

In the above article from the NY times, the author reviews a book that exposes the diminished quality and attention to detail among manufacturers of luxury goods (think Prada, Gucci, etc…) The era of globalization and off-shoring of manufacturing has aided luxury firms in their quest for profits, as they’ve been able to significantly cut costs while maintaining exorbitant prices for their product.

The author takes issue with the alleged demise in the luxury market of attention to detail and craftsmanship, as competition and profit seeking behavior have led to an industry where the back alley workshops of Milan and Paris have been replaced by the factory floors of China and Vietnam. Free trade has allowed European luxury brands to produce more of their products at lower costs, which leads the author to her current question: “Why is this stuff still so expensive even as the cost of producing it goes down?”

Despite her accusations of poor quality and greedy, profit seeking managers in the luxury goods industry, the author seem unable to resist the luxury goods she claims to despise:

When, I asked myself, did it become commonplace to charge several thousand dollars for a mass-produced handbag? How could the flimsy designer sundress I bought on sale (a “steal”, the saleswoman assured me) still wind up costing a whole month’s salary? Why is my favorite brand of lipstick more expensive than a nice bottle of Italian wine? When did these products’ values grow so distorted, and what is the would-be customer to make of it all?

The author continues…

the luxury industry is a sham because its offerings in no way merit the high price tags they command. Yet once upon a time, they most certainly did. In the 19th and early 20th centuries, when many of luxury’s founding fathers first set up shop, paying more money meant getting something truly exceptional. Dresses from Christian Dior, luggage from Louis Vuitton, jewelry from Cartier: in the golden period of luxury, these items carried prestige because of their superior craftsmanship and design. True, only the very privileged could afford them, but it was this exclusivity that gave them their cachet. Although they may have “cared about making a profit” the merchants who served this pampered class aimed chiefly to produce the finest products possible.

It appears that the author never took an introductory economics course. If she had, she would clearly understand that price is not determined by the level of craftsmanship, the attention to detail, nor the level of exclusivity represented by a particular purse, shoe or dress. Rather, price is determined by the interaction of Demand AND Supply in the market for all goods, EVEN luxury goods!

When she claims that “the merchents who served this pampered class aimed chiefly ‘to produce the finest products possible'”, the reviewer is forgetting some of the basic teachings of capitalism’s founding father. Adam Smith himself could have corrected the NYT reviewer when he said,

Whoever offers to another a bargain of any kind, proposes to do this. Give me that which I want, and you shall have this which you want, is the meaning of every such offer…

Smith knew as any economics student should know that exchanges in any market happen not because of a mutual appreciation for craftsmanship or artistry, rather because a producer (firm) wants to make a profit by charging as high a price possible to a consumer (household). In the case of luxury goods, Gucci and Prada never made high quality goods because they loved making high quality goods, rather they made them cause consumers demanded them and were willing to pay top dollar for them.

What the author is missing is a basic understanding of the determinants of Demand. The price a good commands in the market has little to do with how much it cost to produce or where it was produced, and everything to do with the level of demand relative to the level of supply.

Discussion questions:

  1. Why do Prada, Gucci, Cartier and other luxury brands command such high prices relative to cheaper substitutes widely available to consumers?
  2. As nothing else changes and the price of luxury goods goes up, how is demand affected? Explain.
  3. What are some of the determinants of demand that have kept the price of luxury brand goods high even as the costs of production have been reduced due to cheap overseas manufacturing?

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37 responses so far

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