Food and energy prices are notoriously volatile and make it difficult to read consumer price indices. But why are they so volatile? Why are things that we buy everyday in relatively constant quantities so volatile in their prices? Well, it’s all explainable by looking at the price elasticities and the slopes of the supply and demand curves. Since we do buy them in relatively constant quantities, that makes demand relatively inelastic. Since supply in the short term is also inelastic (it takes time to plant and grow more food), the result is that even very small shifts in demand (more people or a preference for meat which takes more grain) or small shifts in supply (a poor harvest in some country) will make price shift a lot. For a more detailed explanation and graphs, see below the fold how EconomicsHelp.Org explains it:
I know I’ve been posting mostly about macro and banking lately, but here’s one for the micro students. Let’s look at how a community college could collect more revenue while lowering the cost of education for students.
We studied about how there’s a relationship between the demands for any two products. Suppose we have product X and product Y. X and Y can be either complements to each other, substitutes for each other, or totally unrelated to each other. We also study how we use the cross-price elasticity of the products (see here and here). And of course, we interpret the resulting cross-price elasticity number (Ex,y) accordingly:
- if Ex,y > zero (is positive), then the two products are substitutes. The consumer/purchaser views them as alternatives, a choice — it’s either x OR Y, but not both.
- if Ex,y < zero (is negative), then the two products are complements. The consumer/purchaser views them as a package deal. They want to buy both X and Y together. It’s really the price of the bundle they’re thinking about.
- if Ex,y = zero, then there’s absolutely no relationship between the two products. Typically this means there’s no overlap between the purchasers of X and the purchasers of Y.
In class and textbooks, we typically give retail store examples of these relationships: Coke and Pepsi are substitutes. Hot dogs and hot dog buns are complements. Concrete blocks and candy bars are unrelated. We also usually talk about how knowing cross-price elasticity is important to retailing tactics. For example, knowing two products are strong complements allows Kroger to display products in a way that “suggests” an up-sale: put the hot dogs on sale, but display the full-price buns, ketchup, and charcoal right next to them.
Cross-price elasticity is also very important in larger business contexts such as strategy. Let’s think about the typical community college and tuition. The community college sells “credit for courses” to the students. Think of this as product X (yeah, it’s a service but we economists still think of it as a product). When most folks think of tuition, they think of it as the price of X, the price of the CC’s courses. If that’s all we think of, then there’s a tension between the two. The college (seller of X) wants more $, but the students want a lower price. In reality, though, there’s another player here: the textbook publishing industry. The publishers sell a different product: textbooks. Of course (pardon my pun), courses and textbooks are strong complements. They have a very large negative cross-price elasticity. After all, if you’re going to buy the course, you’re gonna buy the book, and vice versa. (yes, occasionally a student tries the course without the book, but that never ends well).
If we think of students as having only a limited amount of money to spend on education (an assumption most of you will agree with, no doubt!), then the complementary relationship between courses and textbooks means that colleges actually in competition with the publishers over how the student’s money will be split. If Stuart Dent only has $1000 to spend on education this summer, then the issue is how the money is split between the college and the publisher.
I’ve seen both sides. I’ve taught in a college (obviously) but in a former career as a strategic planning consultant I became familiar with the thinking on the publisher side. In my my experience, the publishers definitely see the relationship and view the college as a competitor. Their goal is to capture as much of the student’s money as possible. As a result, they implement many strategies and tactics intended to do that (material for later post). Unfortunately, I don’t think enough colleges understand this. Most colleges express concern about the rising costs of higher education (some are serious, some only give lip-service). But most of them, in my opinion, still think of it only from their perspective as the party who sets tuition prices. If colleges put a concerted effort toward developing alternatives that dramatically lowered the costs of textbooks to students, then both students and the college benefit. Students could have lower prices for the bundle they are buying (the education), yet the college could charge higher tuitions and get more revenue for what they are selling. Let’s work an example of this alchemy:
Suppose Pleasantview Community College presently charges $80 per credit for a 4 credit economics principles course. The course requires one of the latest, greatest textbooks from the publishing oligopoly that retails for $180 (typical for an econ text these days – although Mankiw has a list price of $220). For the student, the course as a bundle costs $500. We have 4 x 80 = 320 for tuition plus 180 for book. Now suppose the college and professor identify an open source textbook, or a low-cost print-on-demand text from some new start-up firm (like the one my students use). Let’s suppose further the student wants a printed copy, not just an online version. The printed copy of the open or low-cost book costs $30, which produces a total cost of the course as $350, a savings of $150 or 30%.
But my example is too easy. After all, my students are too smart to buy a full-retail copy of a mainstream text. They go to the used book market or to amazon.com (or they used to until I switched to low-cost book). Typical used book retail prices are 50% of new. So the expensive book would cost $90. That’s still a total cost of course for student of $410. Even compared to the used book market, the open option could save $60 or 15%.
But let’s suppose the college is in tight financial condition. The buildings budget needs more money and the (very deserving) faculty want more money. Suppose the school switches from the high-priced textbook to the low-cost and simultaneously raises tuition by 5%. Tuition goes from $80 to $84 per credit. The book drops from $90 (the used price) to $30. The total cost of the course drops from either $500 or $410 (depending on used choice) down to $366.
- The college gets a 5% increase in revenue to pay for much needed buildings, systems, and even more valuable faculty.
- which also means the students get a better education because the infrastructure and faculty are better
- The students experience a cost savings of between 27% to 11% depending on whether they would have purchased used books.
Of course, the large publishing company will experience a significant drop in revenue. This part does cause me to lose some sleep (not really) because it may mean less money for the $1 million advances paid to Ivy League professors to write books. Or the publisher might have to make do without the in-person sales force standing outside my office door so often and instead learn to use the Web to sell things. Or the publisher might not afford the tall deluxe New York office building. I don’t know. I’m sure they can figure out that part.
For more information about open textbooks and low-cost textbook options see these posts on my teaching blog or my e-learning blog:
Another former student asks:
Am I missing something here? What’s so remarkable about realizing that quantity demanded rises with a decrease in price? Are they just that dumb?
Well, no you’re not missing anything here, but obviously the reporters and possibly the Subway managements missed something in their Principles of Economics classes. Actually they missed three things.
First, you’re right. Lower the Price and people buy a larger quantity. Umm, that’s basic demand.
Second, apparently the Subway sandwich folks were also surprised that when they lowered the price it resulted in more total revenue! Well, as we teach in principles, if demand is price elastic, then a lower price results in more total revenue. We also teach that products with good substitutes are price elastic. When incomes decline, everything becomes more price elastic. News flash, folks, we’re in a recession and shoppers are price sensitive. That’s called elastic price elasticity of demand in techno-talk!
Finally, they seem surprised that overall profit margins didn’t decline. Well, they apparently don’t have a real good grip on their fixed vs variable costs. Selling more sandwiches doesn’t add to the rent or to the utility bill. Labor didn’t go up much since a 12 inch can be made in just about the same time as a 6 incher. Each one gets the same bag.
Yeah, reporters and a lot of managers don’t remember their principles of econ.