Wednesday, October 26, 2005

Explaining economics to the crazies that come up with crazy ideas.

The above link has the conversation in entirety but let me start with the fable of the eggs and microeconomics outcomes (by handy77):
A man eats two eggs each morning for breakfast.
When he goes to the grocery store he pays .60 cents a dozen. Since a
dozen eggs won't last a week he normally buys two dozens at a time.
One day while buying eggs he notices that the price has risen to 72 cents. The next time he buys groceries, eggs are .76
cents a dozen. When asked to explain the price of eggs the store owner says,
"The price has gone up and I have to raise my price accordingly".
The store buys 100 dozen eggs a day. I checked
around for a better price and all the distributors have raised their prices.
The distributors have begun to buy from the huge egg farms. The small egg farms have been driven out of business.

The huge egg farms sell 100,000 dozen eggs a day
to distributors. With no
competition, they can set the price as they see fit.
The distributors
then have to raise their prices to the grocery stores and
on and on and on. As the man kept buying eggs the price kept going up.
He saw the big egg trucks delivering 100 dozen eggs each day.
Nothing changed there.w
He checked out the huge egg farms and found they
were selling 100,000
dozen eggs to the distributors daily. Nothing had
changed but the price
of eggs.
Then week before Thanksgiving the price of eggs shot
up to $1.00 a dozen, Again he asked the grocery owner why and was told,
"Cakes and baking for
the holiday". The huge egg
farmers know there will be a lot of baking going on and more eggs will be used. Hence, the
price of eggs goes up. Expect the same thing at Christmas and other times
when family cooking and baking happens.
This pattern continues until the price of eggs is
2.00 a dozen. The man says,"There must be something we can do about the
price of eggs". He starts talking to all the people in his town and
they decide to stop buying eggs. This didn't work because everyone
needed eggs. Finally, the man suggested only buying what you need.
He ate 2 eggs a day. On the way home from work he
would stop at the grocery and buy two eggs. Everyone in town started
buying 2 or 3 eggs a day.
The grocery store owner began complaining that he
had too many eggs in his cooler. He told the distributor that he didn't
need any eggs. Maybe wouldn't need any all week.
The distributor had eggs piling up at his
warehouse. He told the huge egg farms that he didn't have any room for eggs would
not need any for at least two weeks.
At the egg farm, the chickens just kept on laying
eggs.
To relieve the pressure, the huge egg farm told the
distributor that
they could buy the eggs at a lower price. The distributor
said, " I don't have the room for the %$&^*&% eggs even if they were
free".
The distributor told the grocery store owner that he
would lower the price of the eggs if the store would start buying again.
The grocery store owner said, "I don't have room for more eggs. The
customers are only buy 2 or 3 eggs at a time". "Now if you were to drop the
price of eggs back down to the original price, the customers would start
buying by the dozen again".
The distributors sent that proposal to the huge
egg farmers. They liked the price they were getting for their eggs but,
those chickens just kept on laying.
Finally, the egg farmers lowered the price of
their eggs. But only a few cents. The customers still bought 2 or 3 eggs at a
time. They said, "When the price of eggs gets down to where it was
before, we will start buying by the dozen."
Slowly the price of eggs started dropping. The
distributors had to slash their prices to make room for the eggs coming from
the egg farmers. The egg farmers cut their prices because the
distributors wouldn't buy at a higher price than they were selling eggs for.
Anyway, they had full warehouses and wouldn't need eggs for quite a
while.
And those chickens kept on laying.
Eventually, the egg farmers cut their prices
because they were throwing away eggs they couldn't sell. The distributors
started buying again because the eggs were priced to where the stores
could afford to sell them at the lower price. And the customers starting
buying by the dozen again.

Now, transpose this analogy to the gasoline industry.
What if everyone only bought $10.00 worth of gas each time they
pulled to the pump? The dealer's tanks would stay semi full all the time.
The dealers wouldn't have room for the gas coming from the huge tank
farms. The tank farms wouldn't have room for the gas coming from the
refining plants. And the refining plants wouldn't have room for the oil
being off loaded from the huge tankers coming from the Middle East.
Just $10.00 each time you buy gas. Don't fill it
up. You may have to stop for gas twice a week but, the price should come
down.
Think about it.
As an added note...
When I buy $15.00 worth of gas which leaves my tank
a little under half full. The way prices are jumping around, you can buy
gas for $3.15 a
gallon and then the next morning it can be $3.05. If
you have your tank
full of $3.15 gas you don't have room for the $3.05
gas. You might not
understand the economics of only buying two eggs at
a time but, you
can't buy cheaper gas if your tank is full of the high
priced stuff.
Also, don't buy anything else at the gas station;
don't give them any
more of your hard earned money than what you spend on
gas, until the prices come down...

Interesting fable, if you don't mind me saying so.
But let me explain some microeconomic ways of looking at this small issue.

While robert is correct that total consumption has not changed (Everyone is still consuming 2 eggs per day), inventory levels have changed and will indicate to the parties that business plans need to be changed. Let us count the inventory as of 12:01 am. The consumers inventory levels before was 24+22+20+18+16+14+12+10+8+6+4+2=156/12days=13 and then the process repeats. Now he averages 2 for each day as before it was 13. The extra 11 eggs he now holds on average becomes excess inventory for the grocer times the number of consumers. If the market feels this is a downtrend and does not reorder the distributors would also cut back ordering and thus the farmer now has a shock to the sales. Hopefully he will not panic and keep production up knowing that the consumers are still eating 2 eggs per day.

Now comes the tricky part, what will the distributor and grocer do? The grocer now has a higher transaction cost and packaging cost. This is derived from more clerks and repacking into 2 egg carton packages. This will result in higher per egg costs for the consumer and thusly not be any better off.

And Howard you are right that we often forget the transaction costs for the consumers. Every time the consumer goes back to the store he spends time that could be better spent with family or on his interests.

The story has the assumption that the farmer is a monopolist and can charge any rate he so desires (ie from starting at $0.60 to $2.00 per dozen). But any monopolist wants to charge the highest in the long run that will maintain his monopolistic rent and still keep competitors as well as substitute goods out of the market. In this scenario he could maintain his monopoly for the short term but other farmers seeing him making a killing would enter the market. Or consumers would switch to Captain Crunch (Sawdust). Or consumers would raise chickens themselves. Here is an example of less than $50 dollars to get started.

Ren, as you have pointed out not all lowering of consumption leads to a lowering of prices. As in the case of sewars where the fixed costs of production is high and marginal costs rise slowly with each additional unit of production or output. The graph on the marginal costs at Wiki also shows that if prodution is low then the per unit costs will increase. This is one reason that rural gas tends to cost more than urban gas. The costs to set up and maintain the station would be close between locations but the rural location would not have as much sales or production and thus fixed costs are higher on per unit basis of output.

So now let us move on to the issues of filling up gas tank. Since I think very few of us follow the gas markets well enough to bet on what direction the gas is going to go on a day or week, then market timing is probably not a factor in deciding when to fill up. Being concerned about the environment then your method of filling up is not good advice, handy. The best process I believe is to fill but not top off when the level is 1/2 or slightly less in the tank. As the tank is low the volume in the tank is filled up with air of "evaporative emmissions" and thus more is released into the air with low tank levels. But filling up the vehicle more times on a daily basis will also open the cap more often and increase again the evaporative emmissions. Some other good advice from here.
Lastly, before I have a nice healthy granola bar and a hot cup of coffee be sure to look at Urban Lengends: Pain in the Gas.

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