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Current time:0:00Total duration:12:58

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 you know charging $2 90 and I think the number I used in the last video you know he sold like 500,000 cupcakes and he had this great return on asset I think it was 20% 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 breakeven and at the end of the last video you know not being a great business man I said oh well actually let me just raise prices because you know 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 raise prices to cut out a little bit of a profit but actually to end up 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 in Ron's charging so much less for cupcakes so actually my revenue stream starts to decline because fewer and fewer people show up and say you know what this really isn't a sustainable situation and Ron came here hears this he has his own what was it he was he was selling 500 thousand right he's getting this great return acid 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 well you know 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 Enron but there'll 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 fats and in the case of my cupcakes nicotine so let's say I cut prices below Imran because I increased price strategy was kind of silly so I lower my prices to two dollars and seventy and at $2 seventy I'm able to sell I don't know 400 thousand cupcakes and I took some business from memmer I mean I'm not like 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 I'm actually not let's ignore this for a little bit because now in this reality I'm getting a 15% return on my asset in Ron's getting a 7% 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 you know a 15% return would be great so he also enters the market and he's kind of a smaller operator he didn't have quite as much so he puts $500,000 into it he has 400,000 cupcake per year capacity since as a smaller factor it's a little less efficient so it cost him a little bit more to produce a cupcake and he comes in and he says you know I just want my joy in life isn't so much well you know he obviously has to pay his bills and he likes to be rich but he says he just drives joy from seeing people eat cupcakes so he undercuts everybody and in doing so he just operates at full capacity he just takes he operates it 400,000 he operates at full capacity while 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 breakeven he's making no money and then Vikram is making a 12% return on asset because essentially he undercut everyone was able to take all of the volume and if you look at the city as a whole that's the aggregate capacity right here this is the second worksheet in that in that I'm actually let me tell you where it is again just so you know if you didn't watch the last videos khanacademy.org /downloads flash cupcakes dot XLS but anyway Vikram had entered the market and now I calculated here aggregate mass 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 you're getting sold a year and this is the average return on asset right but in this situation what what continues to happen right I have all of this extra capacity I have you know only 32% of my capacities being utilized and obviously you know right now kind of you can say the market price for cupcakes is well above the marginal cost of producing a cupcake and in Ron sitting there with this huge amount of capacity and he's maybe he's with the richest guy because he has huge inheritance from from Grandma and and so he says you know this is silly I'm making 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 one dollar seventy per cupcake and a dollar seventy per cupcake all of a sudden there's a whole new market for people who want to buy e two cupcakes there's a lot of people who might have been eating you know Twinkies and other things that maybe they could get at a dollar eighty per Twinkie and now cupcakes are the desired source of food so you know obviously aggregate demand is going to go up and let's say he just he just sells out he just goes he sells two million cupcakes a year and so he makes a huge return and he just kind of you know he kills our business so I'm just taking huge losses and Vikram is taking huge losses right we'd you know we're selling none so he's like oh you know what we have to match his prices so I sell I sell it at a dollar seventy and Vikram says at a dollar seventy and we said at a dollar seventy people are willing to eat two million cupcakes in a year so let's say at a dollar seventy it's it's split evenly between the well Vikram can only produce 400,000 cupcakes so let's say he sells let's say he sells 400,000 and then the remainder is split between the other two so let's see 800,000 and 800,000 and as you can see here I mean there's a general trend is is that you know as people have extra capacity there's this 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 that's a cupcake that's not being permits not being made that otherwise could have been made and your cost of producing that incremental cupcake is only you know is a lot lower so it's like well you know if I just 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 of the parties keep wanting to do that and that's why competition really is good for customers and that's why I'm monopoly is bad if you were a monopoly if Sal's cupcakes was the only guy in town he could just keep his prices high and even if his utilisation 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 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 and likewise if you're at 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 then when it was just me I went to full capacity now I was able to raise prices because it all that extra money just goes to me but you can see that you know there's a kind of a couple of key learning points in this set of videos is that when you have huge returns as I you know 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 1 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 and the only way that you can avoid this is if you know 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 hope so you'd be in jail if you had good regulators because that's called collusion you would be forming a cartel you'd before having 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 well actually just kind of what we we're always have to be competing with each other and lowering our prices but the general theme here is when you're at high utilization and this is you know the whole reason why I'm even entering into this whole spreadsheet and all 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 let's actually let's 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 gets sold out right so I'm selling a million cupcakes per year Imran is selling two million cupcakes per year and then Vikram is selling foreign so we're all tapped out we're at 100% capacity utilization and then the return on assets are pretty good but we all is you know we all as a group say wow you know if I'm already sold out why don't I just raise prices because you know it's not going to affect a man so much people want cupcakes so badly so I could raise prices to $2 that improves my return on asset Iran's no dummy so he does the same thing he raises price to $2 and let's say people are getting so much money from their home equity loans that they're still willing to buy the cupcakes from us and Vikram does the same to dollars and so everyone's return on asset improves even more and you could even argue that it would attract competition but I think three players is good enough and let's say it just keeps happening and we you know I decided I realize that I can raise my prices all the way to $3 without it affecting without affecting my utilization without any impact on demand $3 let's say it has a slight impact on utilization so you know I'm selling 950 thousand cupcakes a year he's selling I don't know one point eight 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 kind of the 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 kind of what is the level of utilization a lot of industries where it makes sense to raise prices but when you're at a relatively high utilization it really pays to 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 takeaway I wanted you to get at is that high utilization of anything of our aggregate capacity prices will increase lower utilization prices will decrease and actually I'll say two things high utilization high utilization will revert will will allow you to raise prices and it will 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 right 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 being unutilized anyway I think I've 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