Cupcake economics 3 | Inflation | Finance & Capital Markets | Khan Academy

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In the last couple of videos, I had started a **cupcake factory**, and I was the richest guy in town. I was doing so well that it attracted competition. Then, Imran came in, and he started his own cupcake factory. He took all of my business and ended up charging **$2.90**. I think the number I used in the last video was that he sold like **500,000 cupcakes**, and he had this great return on asset— I think it was **20%**. He took away all my business, and I got decimated. I was originally charging something like **$3**, and I only started selling **250,000** of my cupcakes. My return on asset essentially went to zero; I was kind of break-even. 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." So, I actually raised prices to cut out a little bit of a profit, but by doing that, I lost a couple of these people because they were willing to walk a little bit further for a cupcake. I got an okay return, but this was kind of maximizing it. Over time, more and more people realized that Imran was charging so much less for cupcakes. My revenue stream started to decline because fewer and fewer people showed up. I said, "You know what? This really isn't a sustainable situation." Imran came here; he was selling **500,000** cupcakes and getting this great return on asset, while I was getting a crummy return on asset. I was only making **$40,000** a year, and he was making **$300,000** a year. I needed to get back at him. So, I said, "You know, let me lower the price." Besides taking some of his business, there would actually be some incremental more people in the town who would start buying cupcakes. 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 fats, and in the case of my cupcakes, nicotine. So, let's say I cut prices below Imran because I realized this increased price strategy was kind of silly. I lower my prices to **$2.70**, and at **$2.70**, I'm able to sell, I don't know, **400,000 cupcakes**. I took some business from Imran; I mean, I'm not a lot cheaper than him, but I'm a good bit cheaper. So, let's say I took some business, and he's only selling **400,000 cupcakes**. Now, the aggregate cupcake market—let's ignore this for a little bit—I'm getting a **15% return** on my asset, while Imran's getting a **7% return** on asset. Let's say there's a third party, Vicam, who just has a love for making cupcakes. He says, "Well, you know what? If I could spend my life making cupcakes, even if I just get a **7% return**, that's a pretty good living. 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 **400,000** cupcake per year capacity. Since it's a smaller factory, it's a little less efficient, so it costs him a little bit more to produce a cupcake. He comes in and says, "You know, my joy in life isn't so much about being rich, but I just derive joy from seeing people eat cupcakes." So, he undercuts everybody. In doing so, he operates at full capacity, taking business from both Imran and me. Now, what's the state of affairs in our city? My return on asset is **7%**, Imran is essentially at break-even—he's making no money—and Vicam is making a **12% return** on asset because he undercut everyone and was able to take all of the volume. If you look at the city as a whole, that's the aggregate capacity right here. This isn't the second worksheet in that. Actually, let me tell you where it is again just so you know if you didn't watch the last video: it's **khanacademy.org/download/cupcakes.XLS**. Anyway, Vicam had entered the market, and now I calculated here the aggregate capacity. This is the total number of cupcakes all of the factories in the market can produce. This is the aggregate demand—**1.1 million** cupcakes are getting sold a year—and this is the average return on asset. But in this situation, what continues to happen? I have all of this extra capacity; only **32%** of my capacity is being utilized. Obviously, right now, you could say the market price for cupcakes is well above the marginal cost of producing a cupcake. Imran is sitting there with this huge amount of capacity. Maybe he's the richest guy because he has this huge inheritance from Grandma, and he says, "You know, this is silly. I'm the biggest guy in town, the most efficient guy in town. I have all of the capacity, and I'm making the worst returns on assets." So, he says, "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 buy and eat cupcakes. There are a lot of people who might have been eating Twinkies and other things that they could get at **$1.80** per Twinkie, and now cupcakes are the desired source of food. Aggregate demand is going to go up. Let's say he just sells out; he sells **2 million cupcakes** a year. He makes a huge return and kills our business. I'm just taking huge losses, and Vicam is taking huge losses too. We're selling none. So, he's like, "Oh, you know what? We have to match his prices." I sell at **$1.70**, and then Vicam says, "At **$1.70**," and we all say, "At **$1.70**," people are willing to eat **2 million cupcakes** in a year. Let's say at **$1.70**, it's split evenly between the three of us. Vicam can only produce **400,000 cupcakes**, so let's say he sells **400,000**, and the remainder is split between the other two. As you can see here, there's a general trend: as people have extra capacity, there's almost this incentive to lower your price relative to the other person. If you're not using your capacity, then that's a cupcake that's not being made that otherwise could have been made. Your cost of producing that incremental cupcake is a lot lower, so you're just like, "Well, you know, 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. That's why competition really is good for customers and why monopoly is bad. If you were a monopoly, if Sal's Cupcakes were the only game in town, he could just keep his prices high. 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, as we saw in the last video, then 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 are a couple of key learning points in this set of videos. When you have huge returns, as I had in this video or in this worksheet, when you have huge returns, it attracts competition. The competition attracts capacity. We went from aggregate capacity from **1 million** with my original factory to now **3.4 million**. 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 can avoid this is if Imran and Vicam 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?" You might say that's a good business move, and if you actually did it, you would end up in jail—hopefully, you'd be in jail if you had good regulators because that's called collusion. You'd be forming a cartel, a group that is trying to control prices. 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. The general theme here is that when you're at high utilization—this is the whole reason why I'm even entering into this whole spreadsheet and all of that—to talk about inflation in general. Prices will go up when you have high utilization. If all of us were running at **100%** utilization—let's say for whatever reason everyone is able to get cheap loans, and they take home equity loans and decide to use all of that extra money coming from their home ATM to buy cupcakes—aggregate demand goes up huge, and all of the cupcakes in the market get sold out. I'm selling **1 million cupcakes** per year, Imran is selling **2 million cupcakes** per year, and Vicam is selling **400,000 cupcakes**. We're all tapped out; we're at **100% capacity utilization**. The return on assets is 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?" 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**. 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 Vicam does the same at **$2**. Everyone's return on asset improves even more, and you could even argue that it would attract competition. But I think three players are good enough. Let's say it just keeps happening, and I realize that I can raise my prices all the way to **$3** without it affecting my utilization. Let's say it has a slight impact on utilization, so I'm selling **950,000 cupcakes** a year, he's selling **1.8 million cupcakes** a year, and Vicam is selling **380,000 cupcakes** a year. But in general, if you look at the returns in the industry in this situation, by raising our prices, we're getting better and better returns. More money is coming to the bottom line. As long as we have pretty high utilization, people debate on what kind of level of utilization in a lot of industries makes sense to raise prices. When you're at a relatively high utilization, it really pays to increase your price hurdle. On the other side of the coin, when you have a low utilization of your asset, even though it might not be completely rational if you're a competitor, when you have very low utilization, you essentially want to lower your prices so that you can utilize your factory more. You could play around with this and just think about some scenarios yourself. That's the real big takeaway I wanted you to get at: when you have high utilization of anything, of our aggregate capacity, prices will increase. Low utilization means prices will decrease. I'll say two things: high utilization will allow you to raise prices, and when you raise prices, you'll get a better return on your asset. The other side effect is that 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 up. 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 has 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 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.

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