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Cupcake economics 3

Using our spreadsheet to show why prices decrease when utilization is low and prices increase when utilization is high. Click here to download the spreadsheets used in this video.. Created by Sal Khan.

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Video transcript

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. It costs them a little bit more to produce a cupcake. 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 number 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 the 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.