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Finance and capital markets
Course: Finance and capital markets > Unit 3
Lesson 4: Capacity utilization and inflationCupcake 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.
Want to join the conversation?
- Why is 'collusion' / forming cartels, actually illegal? What is morally wrong with it?(13 votes)
- One of the things that underpins capitalism is the idea of efficient allocation of resources. From a competition standpoint this means that if I am not efficient and sensitive to the needs of consumers then a competitor will be able to enter the market and do a better job than me. I can either then improve or go broke. As companies compete on price/technology/efficiency the consumer can be expected to get a better deal. In addition, competition creates new methods, technology and efficiencies. Collusion, or cartels essentially slow or stop the efficiency of the market because the members of the cartel no longer have to compete under open conditions.
The first moral problem (and the most obvious) is that it means consumers will invariably end up paying more because the reason for the cartel's existence will be to keep prices high. I think the more damaging aspect is that it stifles technology and efficiency which can help the world as a whole.
So much of what we take for granted today has come about from competition and the associated improvements in technology that this has led to. The simple answer to the question is that it makes prices higher than they should be and reduces innovation both of which I would say are morally wrong - though as with everything economics you can make the argument the other way too.(24 votes)
- Trend shows that when you have more demand and the same supply prices should go up. But there are no other intangible elements, such as trademark loyalty, customer services, etc, that could cause people to stay buying the same cupcake no mather what the price it is? Or in the opposite they could feel that a decrease of prices is the meaning that the products does not have the same quality so they prefer to go and buy another one?(7 votes)
- Good catch! This is called price elasticity.
If the price of a good rises (or falls) significantly and yet people continue to buy it in the same quantities (due to any number of reasons such as brand loyalty or it is a necessity like fuel is to some) it is called inelastic.
In the same way if price changes only a little and then people hugely change the amount they buy of it then it is called elastic. (This could be due to there being lots of substitutes goods for example)
For more information see the elasticity series in the microeconomics sections starting with this one: http://www.khanacademy.org/finance-economics/microeconomics/v/price-elasticity-of-demand(16 votes)
- What about other factors, like deals where you get a stamp every time you buy a cupcake and if you get 10 stamps you get a free cupcake, or if you make an investment where you buy a ton of books so people can read them and then they won't care about waiting as much and more people will come to your store?(3 votes)
- Service, speed, cleanliness, taste/freshness, location, environment (ie: noise, tvs, children), themes and games, contests, cool factor, convenience, looks.(1 vote)
- You've mentioned that it's not a zero sum game - but I get confused about this assumption when I see it - how can you expect an unlimited supply of customers? Or do you mean this only for the purpose of demonstration?(3 votes)
- It's not a zero-sum game because at some price level, more people will want to buy cupcakes.
Example: Sal charges $2.50 and Imran charges $2.50 to start, and they each sell 500,000 cupcakes (1 million total). Then Sal lowers his price to $2.00, and he sells 1 million cupcakes but Imran still sells 250,000 (1.25 million total). 250,000 more people were willing to buy cupcakes because they were only $2. Sal got all that business plus what he took from Imran, but he didn't have to take all 500,000 new customers away from Imran.(1 vote)
- Is there any point in the entire price increase and decrease when whatever sal and vikram do there is no change in the revenues of imran?
Like, even when brands increase or decrease their prices, people stick to it, how much is brand loyalty in this scenario?(2 votes)- In this scenario brand loyalty is not discussed in great detail. This for the most part is a general overview of basic economics. But brand loyalty is very important when it comes to business and price increases/decreases. For instance, a brand like apple can charge high prices for the iphone and still set record sales figures even though, arguably, some android phones come with better features and technologies. They basically purchase the brand.
Because this scenario is so basic brand loyalty is a non-factor, and without having more information on his clientele and market it is not possible to determine the effect of brand loyalty in this scenario.(2 votes)
- How about, say, in the independent software business, where there really is no cap to the annual capacity? How would you measure utilization? Theoretically, you could produce an infinite amount of copies, but if it falls less than that, you don't really take a loss.(2 votes)
- is there other down loads? if so, what are the other down loads?(2 votes)
- Here are the other downloads as of 5-2-16:
https://fastly.kastatic.org/downloads/MortgageCalculator.xlsx (mortgage calculator)
https://fastly.kastatic.org/downloads/NormalIntro.xls (intro to normal distribution)
https://fastly.kastatic.org/downloads/NormalDistribution.xls (binomial and normal distribution comparison)
https://fastly.kastatic.org/downloads/cupcakes.xls (Sal's cupcake factory)
https://fastly.kastatic.org/downloads/buyrent.xls (home purchase model)(1 vote)
- When utilisation is low, shouldnt also the overhead go down/adjust? If Im only selling at half capacity, Id lay off workers to reduce my overhead costs and therefore increase my return.(1 vote)
- you can lay off workers, but as Andrew says, some costs will continue to remain in effect: Land taxes, salaries for office staff (HR, sales, etc.), utilities, internet presence, insurance, etc.
True some of that overhead might come down, but Sal is demonstrating these concepts with a few variables instead of every variable(2 votes)
- Why do they keep creating cupcakes at maximum capacity even though they're only selling less than half of what they make?(1 vote)
- At, Sal mentions how competition is better for consumers and monopoly is bad. Would this still hold true if producing cupcakes created a negative externality? So say when each company reduces price to increase utilization and as a result profits, many more people decide to buy cupcakes where they otherwise would have bought something else (I guess if it was something similar for your health such as cookies it wouldn't matter) more healthful perhaps then would this be worse for consumers as a whole because health declines which eventually costs everyone money and suffering, or would this be offset by the greater happiness from the greater ability for people to buy cupcakes for cheap? In this scenario maybe it would be better if Sal stayed as the only producer so that there would be greater price, but much lower production? 7:20(1 vote)
- Competition is not always better, and certainly not always better for everyone. But usually it's better for most consumers.(1 vote)
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.