Welcome to week three of the Power of Markets course. Last week, we reviewed measures of elasticity. How much quantity is supplied or quiet demanded changes to one of the underlined determinants of supply and demand, because we don't just want to know qualitatively what direction the change will be, but quantitative measures are also important. Want to provide one additional way to test your understanding of elasticities. And then in this week, we'll turn to a deeper understanding of consumers. What motivates their behavior? Will want to dig further behind the demand curve. And not just to reinforce the law of demand, and our understanding of it, basically that when price of any good and service falls, we'll expect people to consume more of that good or service. But we'll want to get some deeper conceptual framework to allow us to tackle some other important issues. Some examples, if you are an investor or an individual advising people on how to make investments, to what extent should you take into account individual's preferences for risk versus returned, and how to make those trade-offs in their asset allocation decisions. If we want to promote, healthcare, what are some ways to do it? whether it's through, mandated quantities, whether it's through subsidized prices, etc. If we look at the debate over school choice, could a voucher program improve outcomes over the current public school system approach? Where individuals are assigned to local school districts and are mandated to send their children to that local school district in order to receive the state subsidy. So, a variety of these different and even how do you account for consumer preferences? So, if you're a company like Kraft and you produce a product like Oreos, how do you take into account traits, such a sweetness and texture if you're going to market in a market like China versus the United States? In the U.S. alone consumers spent close to 11 trillion dollars annually. So a deeper understanding of what, what drives those choices is very important. And then when we look with an increasing amount of globalization, it is estimated that by 2020, and additional 10 trillion dollars will be spent by the growing middle class in India and China, that estimate's based on a recent book published by the Boston consulting group. Before we get to understanding more deeply consumer behavior though, let's just test ourselves on our knowledge of elasticities of supply and demand. And the way to do that is let me give you the example of oil markets. Each of the economic downturns since the early 70s, has been precipitated by a recently small pertubation in oil markets. In 1998 for example, a pact was struck called the [UNKNOWN] Pact between three of the largest exporters of crude oil to the United States, Saudi Arabia, Mexico, and Venezuela. And what these three countries that participated in the [UNKNOWN] Pact agreed to do is to reduce production by 2 to 3% of the then current total global production. That cutback in supply of 2 to 3%, resulted in the price of oil going from $12 a barrel globally to $30 barrel, a 150% increase. Just as a result of 2% to 3% reduction in quantity supplied. So a hug swing in prices and what that uproot spike in prices did is it precipitated the Dot-com bubble. It exposed how over extended the economy was in pursuing different Internet based ventures. Si, similar events occurred later in the 20, 27, 28 2008, 2009, where there were cutbacks in oil supply that precipitated the economic downturn prolonged it. In 2009 for example, unrest in Nigeria, resulted in a 1% decline in global production. That 1% decline in global production, lead to a 75% increase in the price of crude oil. From $40 a barrel in 2009 to later in the year and early 2010, it rose to $70 a barrel. So a 1% decrease in quantity supplied resulting in a 75% increase in the global price of oil. Why such dramatic swings in prices resulting from such small swings in quantity supplied? Elasticity helps us explain why. First, when we think about elasticity demand in the short run, we're pretty stuck in terms of our energy use patterns. we can't easily change the cars we drive, our commute patterns, where we live, where we work, our appliances. So in the short run, the elasticity of demand for crude oil and it's derivative products such a gasoline and heating oil, is pretty low. it's approach, it's approaching not quite but very close to 0. So when elasticity of demand is so low and quantities supplied gets reduced, price has to rise by a lot to get consumers to reduce their consumption sufficiently to clear the market. That's the demand side of the story as to why a small perturbation in supply will lead to a pretty big increase in the prevailing price on the market. The elasticity of supply is the rest of the story. In the short run, it's very hard to add productive capacity onto the world energy market, onto the world oil market. You have to build pipelines, you have to undertake exploration for new sources of oil. So in the short run, when a country like Nigeria goes through some trouble and takes 1% of the world production off the market, it's very hard to replicate that 1%. So the price also has to rise by a lot to encourage any additional output, any additional intense effort to bring that additional supply on to the market. Between the elasticity to demand being low, an the elasticity of supply being very low, that accounts for the wild gyrations we see in the oil markets. An analogy to help drive this point home to you, is the next time you're stuck at an airport, and a, a flight is overbooked, if it's the last flight of the day notice how much the airline company will offer compensation to avoid the overbooking situation, to get, to convince some people not to take that flight. Very easily, the price will jump to 2 or 3 times what the actual ticket price is that the consumers have paid for the trip. Why? It's because of elasticity of demand and elasticity of supply in the short run. Elasticity of demand is low because if it's the last flight of the day the options to get to the destination city is limited. You'll have to wait until the next day or conceivably a couple of days until the free seat, is available. Elasticity supplied or not, another option, but, but potentially you can rent a car to get there, but it's a very expensive, and time consuming option. So that's why prices that airlines pay to compensate for overbooking situations tend to gyrate pretty substantially at the end of a travel day. So just one way to test our knowledge of elasticities of supply and demand. Lets now turn to Consumer Choice Theory. What we're going to do this week, week 3, is get a deeper understanding of both what drives consumer preferences, and then what drives the constraints consumers face. We'll bring those two tools together to understand consumer choices, and how different factors that influence demand, that influence consumer choices. Week 4, we'll take the building blocks we've developing in this week 3, and cover a whole host of applications. How we can use consumer choice theory to look at asset allocation decisions, to look at school choice decisions, to look at the health care debate. So, let's begin.
