Cupcake Economics 3 Using our spreadsheet to show why prices decrease when utilization is low and prices increase when utilization is high.
Cupcake Economics 3
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- In the last couple of videos, I had started a cupcake factory and I was the richest guy in town
- and I was doing so well that it attracted competition.
- And then Imran came in and he started his own cupcake factory.
- And he took all of my business and he ended up charging $2.90.
- And, I think, the number I used in the last video, he sold 500,000 cupcakes.
- And he had this great return on asset.
- I think it was 20% of something.
- He took away all my business and I got decimated.
- I think my cupcakes-- I was originally charging something like $3.
- And my cupcakes, I only started selling 250,000 of them
- and then my return on asset essentially went to zero.
- I was kind of break-even.
- And at the end of the last video, not being a great businessman, I said,
- oh well, actually let me just raise prices.
- Because I have this set number of customers and they like the way I operate the cash register a little bit,
- or maybe they live a little bit closer to my cupcake factory, or my bakery, or whatever you want to call it.
- And so I actually raised prices.
- I cut out a little bit of a profit, but actually by doing that,
- I do lose a couple of these people because they are willing to walk a little bit further for a cupcake.
- But I get an OK return.
- But this is kind of maximizing it and then, over time,
- more and more people realize that Imran's charging so much less for cupcakes.
- So actually my revenue stream starts to decline because fewer and fewer people show up.
- I say this really isn't a sustainable situation.
- Imran came here. I think he was he was selling 500,000, right?
- He's getting this great return on asset.
- I'm getting this crummy return on asset.
- I'm only making $40,000 a year; he's making $300,000 a year.
- I need to get back at him.
- So what I do is, I say, let me lower the price and, besides taking some of his business,
- there will actually be some incremental more people in the town who will actually start buying it.
- So it's not a zero sum game.
- A zero sum game means that if I win, someone else is losing by that amount.
- If I lower prices, I'll take some business from Imran.
- But there will also be people who were probably eating something more nutritious than cupcakes
- who might now eat cupcakes to get their daily requirements of sugar and trans-fat then
- in the case of my cupcakes, nicotine.
- So, let's say, I cut prices below Imran because I realize this increase price strategy was kind of silly.
- So I lower my prices to $2.70 and, at $2.70, I'm able to sell, I don't know, 400,000 cupcakes.
- And I took some business from Imran, right?
- I'm not a lot cheaper than him, but I'm a good bit cheaper.
- So, let's say, I took some business, so he's only selling 400,000 cupcakes
- and now, the aggregate cupcake and-- actually not.
- Let's ignore this for a little bit because now, in this reality, I'm getting a 15% return on my asset.
- Imran's getting a 7% percent return on asset.
- Let's say there's a third party, Vikram and he just has a love for making cupcakes
- and he says, well, you know, what if I could spend my life making cupcakes
- and, even if I just get a 7% return, that's a pretty good living.
- And a 15% return would be great.
- So he also enters the market.
- He's kind of a smaller operator.
- He didn't have quite as much so he puts $500,000 into it.
- He has a 400,000 cupcake per year capacity.
- Since there's a smaller factory, it's a little less efficient.
- And he comes in and he says, you know, my joy in life isn't so much--
- he obviously has to pay his bills, he likes to be rich --
- but he says, he just derives joy from seeing people eat cupcakes.
- So he undercuts everybody.
- And in doing so he just operates at full capacity.
- He operates at 400,000. He operates at full capacity.
- And then he takes business from these guys.
- And then he takes business from me as well.
- And then, what's the state of affairs in our city now?
- So my return on asset is 7%.
- Imran is essentially at break-even. He's making no money.
- And then Vikram is making a 12% return on asset because--
- essentially, he undercut everyone and was able to take all the volume.
- And, if you look at the city as a whole, that's the aggregate capacity right here.
- And this is the second worksheet in that--
- Let me tell you where it is again, if you didn't watch the last video,
- is khanacademy.org/ downloads/cupcakes.xls.
- But anyway, Vikram had entered the market, and now I calculated here aggregate capacity.
- This is the total numbers of cupcakes all of the factories in the market can produce.
- This is the aggregate demand.
- So 1.1 million cupcakes are getting sold a year
- and then this is the average return on asset, right?
- But in this situation, what continues to happen?
- I have all of this extra capacity.
- Only 32% of my capacity is being utilized and, obviously, right now you can say,
- the market price for cupcakes is well above the marginal cost of producing a cupcake.
- And Imran's sitting there with this huge amount of capacity,
- and maybe he's the richest guy, because he has a huge inheritance from grandma.
- And so he says, this is silly.
- I'm the biggest guy in town.
- I'm the most efficient guy in town.
- I have all the capacity.
- I'm the richest guy in town and I'm making the worst returns on assets.
- So what he says is, you know what, I'm just going to undercut everybody.
- I'm going to charge $1.70 per cupcake.
- At $1.70 per cupcake, all of a sudden, there's a whole new market for people who want to eat cupcakes.
- There's a lot of people who might have been eating Twinkies and other things,
- that maybe they could get at $1.80 per Twinkie,
- and now cupcakes are the desired source of food.
- So, obviously, aggregate demand is going to go up and, let's say, he just sells out.
- He just goes and he sells two million cupcakes a year.
- And so he makes a huge return and he just kills our business.
- So I'm just taking huge losses and Vikram is taking huge losses, right?
- He's like, you know what, we have to match his prices.
- I sell it at $1.70 and then Vikram sells at $1.70.
- And we said at $1.70, people are willing to eat two million cupcakes in a year.
- So, let's say, at $1.70 it's split evenly between--
- Well Vikram can only produce 400,000 cupcakes.
- So let's say he sells 400,000.
- And then the remainder split between the other two.
- So, let's see, 800,000 and 800,000.
- And, as you can see here, there's a general trend that,
- as people have extra capacity, there's almost this incentive
- to lower your price relative to the other person.
- Because if you're not using your capacity,
- then that's a cupcake that's not being made that otherwise could have been made.
- And your cost of producing that incremental cupcake is a lot lower,
- so you're just like, well, as long as I charge something more than that,
- I'm going to make money that I otherwise wouldn't have made.
- But when you do that, you're actually lowering the market price.
- And then all the parties keep wanting to do that.
- And that's why competition really is good for customers.
- And that's why a monopoly is bad.
- If you were a monopoly, if Sal's Cupcakes were the only guy in town,
- he could just keep his prices high.
- And even if his utilization went down, there would be no incentive for him to lower prices.
- But in this reality with competition, there's this huge incentive
- that, when you have extra capacity, especially if you have a lot of extra capacity,
- there's this huge incentive to lower prices so that you can utilize that capacity.
- Likewise, if you're running near full capacity, there's a huge incentive to raise prices.
- Because if you're at full capacity, and we saw that in the last video, when it was just me,
- I went to full capacity and I was able to raise prices because all that extra money just goes to me.
- But, as you can see, there's a couple of key learning points in this set of videos.
- When you have huge returns, as Sal's Cupcakes had in this video or in this worksheet over here
- When you have huge returns, it attracts competition.
- The competition attracts capacity, right?
- We went from aggregate capacity from one million with my original factory, to now 3.4 million.
- And then, when you have that extra capacity, everyone's incentive is really to lower prices
- so that they can try to grab some of that utilization.
- The only way that you could avoid this is, if Sal, Imran, and Vikram were to meet in a room
- and say, hey guys what we're doing is silly, why don't we just all agree on a price.
- And you might say that's a good business move
- and, if you actually did it, you would end up in jail.
- Well, hopefully you'd be in jail if you had good regulators, because that's called collusion.
- You'd be forming a cartel. You'd be forming a group that is trying to control prices.
- So in a truly competitive environment, we're not allowed to communicate
- and we're not allowed to tell each other,
- hey, why don't we just set prices at X.
- We always have to be competing with each other and lowering our prices.
- But the general theme here is, when you're at high utilization
- the whole reason why I'm even entering into this whole spreadsheet and all of that,
- is to talk about inflation in general.
- But, in general, prices will go up when you have high utilization, right?
- If all of us were running at 100% utilization--Actually, let's do that scenario.
- Let's say, for whatever reason, everyone is able to get cheap loans, and they take home equity loans,
- and they decide to use all of that extra money that is coming from their home ATM to buy cupcakes.
- So aggregate demand goes up huge and all of the cupcakes in the market get sold out.
- So I'm selling a million cupcakes per year.
- Imran is selling two million cupcakes per year.
- And then Vikram is selling 400.
- So we're all tapped out, we're at 100% capacity utilization.
- And then the return on assets are pretty good.
- But we all, as a group, say, wow, you know, if I'm already sold out,
- why don't I just raise prices because it's not going to affect demand so much.
- People want cupcakes so badly, so I could raise prices to $2.
- That improves my return on asset.
- Imran's no dummy, so he does the same thing. He raises his price to $2.
- And let's say people are getting so much money from their home equity loans
- and they're still willing to buy the cupcakes from us.
- And Vikram does the same at $2.
- And so everyone's return on asset improves even more
- And you can even argue that it would attract competition.
- But I think three players is good enough.
- And let's say it just keeps happening and I realize that I can raise my prices all the way to $3
- without affecting my utilization, without any impact on demand.
- Let's say it has a slight impact on utilization.
- So I'm selling 950,000 cupcakes a year.
- He's selling, I don't know, 1.8 million cupcakes in a year.
- And let's say Vikram is selling 380,000 cupcakes in a year.
- But in general, if you look at returns in the industry, in this situation,
- by raising our prices, we're getting better and better returns, right?
- More money's coming to the bottom line.
- So, as long as we have a pretty high utilization
- and people debate on what is the level of utilization in lot of industries where it makes sense to raise prices.
- But, when you're at a relatively high utilization,
- it really pays to increase your price hurdle.
- And on the other side of the coin, when you have a low utilization of your asset,
- even though it might not be completely-- well, it is rational if you're a competitor.
- But when you have very low utilization, you essentially want to lower your prices
- so that you can utilize your factory more.
- And you can play around with this and just think about some scenarios yourself.
- And that's the real big take away I wanted you to get at, is
- that high utilization of anything, of our aggregate capacity, prices will increase.
- Low utilization, prices will decrease.
- And actually I'll say two things.
- High utilization will allow you to raise prices
- and when you raise price you'll get a better return on your asset,
- and then the other side effect is, when you have that high return on asset,
- you'll also have more investment going on to build more capacity.
- So aggregate capacity will go on.
- So those are the two side effects of high utilization.
- You have prices increasing and then you have more capacity or more investment coming on.
- Low utilization, you have kind of the opposite situation.
- No incentive for someone to add a factory, like we did in these situations,
- and there's every incentive for every player in the market to lower prices
- because they just want to use their factories.
- Otherwise their factories just go unutilized.
- Anyway, I think I said the same thing five times in different ways, but I think that's your point.
- I'll return to the drawing board, literally, in the next video
- and we can proceed with our discussion of inflation and deflation.
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