Demand Elasticity - Who pays?

In high school, through university and even in the CFA, economics is an important field of study. One of my favourite topics is the concept of elasticity.

Elasticity is literally defined as the percentage change in quantity over the percentage change in price and has several flavours (negative elasticity, positive elasticity for substitutes, negative cross elasticity for complements etc)

Elasticity = %ΔPrice / %ΔQuantity
%ΔPrice = ΔPrice / Pavg = P1 - P2 / Pavg
%ΔQuantity = ΔQuantity / Qavg = Q2 - Q1 / Qavg

Mathematically, note that as you move up and down the curve, the elasticity changes because percentage is affected by the absolute value of the average price. If the average price falls, the elasticity increases because the change becomes larger relative to the average to which it is compared for percentage purposes.

Another way of looking at elasticity is flexibility or bargaining power. If you review Michael Porter's five forces, you can see that elasticity for suppliers or customers increases their bargaining power. That is to say, the more competition and choices available means more options.

Let's look at a good which exhibits perfect inelasticity. This means that regardless of the price, consumers will always consume a constant amount (they set the quantity demanded). This manifests in a horizontal demand curve as shown below:

Note that the determining factor of the price is the supply curve. If there are more suppliers, the supply curve shifts right and the price drops. If there are less suppliers, the supply curve shifts left and the price rises. This is similar to what happens with oil and the "prisoner's dilemma" in OPEC's oligopoly.

Next, look at a perfectly elastic curve. This means that given the slightest change in price, the consumers will dramatically change their spending habits (that is to say, that consumers set the price). This manifests as a horizontal demand curve (at the price they set).
The only power suppliers have here is to set the quantity sold (they are price takers). If there are more suppliers, the supply curve shifts right and there is more quantity sold. Visa versa, if there are less suppliers the supply curve shifts left and there is less quantity sold.

This is important when determining how price changes will affect measures like total revenue, quantity consumed etc. This also applies regardless of whether you are talking about goods sold, wages paid, taxes paid etc.

[Example] The government is thinking of applying a tax on a good which exhibits perfectly elastic demand. Who bears the cost?

1. The supplier
2. The customer
3. The supplier and the customer share the tax burden

[Solution] One way to look at this is that if the good exhibits perfectly elastic demand, then the customers have all the bargaining power. This means that if any supplier were to simply "pass along the tax" and make the consumer pay, the consumer would just go to a different supplier. This means the supplier is forced to take on all the tax. The solution is 1. Notice this also means it eats into the producer surplus.

If the good were perfectly demand inelastic, the suppliers have all the bargaining power then the customer would bear all the tax and the solution would be 2. This would eat into the consumer surplus.

If the good were neither perfectly demand elastic or inelastic, the supplier and customer would split the difference in fractions based on who had more relative bargaining power. Both producer and consumer surplus would diminish. The solution would be 3.

Cash Flow and Operating Cycle

I've written about cash flow with queuing theory as the lifeblood of business in my blog, as well as activity (operations) ratios in my financial profitability analysis series on my investment blog, but I wanted to review an interested concept in the CFA level I regarding the cash conversion cycle.

First let's do a review of the tools and topic. Firstly, what affects operations from a cash flow perspective? Using the direct method, the operating items which affect cash flow is change in working capital and the three items that affect that is Accounts Payable (AP), Accounts Receivable (AR) and Inventory (Inv). Now let's look at a standard process for how changes in each affect the operating cycle.

Order of Operations (like the BEDMAS of elementary arithmetic):

1. Purchase supplies from vendor on credit (AP up, Inv up)
   
2. Process supplies into goods for sale
3. Sell products on credit (Inv down, AR up)
4. Pay back supplier (AP down, cash down)
5. Receive payment from customers (AR down, cash up)

Notice that you don't actually receive any cash until step 5, but you have to pay it back in step 4. This means that you have a negative cash flow until you complete the cycle.

Recall that in the indirect method (calculating CFO from NI):

• If more inventory is made than sold, some "cash value" is retained in Inventory (Inv up, cash down)
• Alternately, if more inventory is sold than made, then you are liquidating your inventory (Inv down, cash up)
• An increase in AP means that you owe your supplier more money. This means that instead of paying with cash, you paid with credit so your cash flow goes up
• A decrease in AP therefore means you paid back your debts
• An increase in AR means that your customers paid you with credit so your cash flow goes down
• A decrease in AR therefore means you were paid back (collected on sales on account)

This next little diagram illustrates the relationship between Operating Cycle, DOH, DSO, Days Payables and Cash Conversion Cycle:
Operating cycle is simply the time it takes from when you purchase supplies to when you collect the cash and is composed of two components, Days Inventory on Hand (DOH) and Days Sales Outstanding (DSO).

• Days Inventory on Hand includes the manufacturing process, as well as storage. In accounting terms, this means works-in-progress (WIP), finished goods, sales cycle.
• Days Sales Outstanding is the time between sales on credit and the collection of cash.
• Cash conversion cycle is the time between when you pay your vendor to when you yourself collect cash. It is the difference between operating cycle and Days Payables.

In looking at which company is more likely to have cash flow problems, cateris paribus, it would be the company with the largest cash conversion cycle. That is to say, it has a low Days Payables (bills due sooner - cash out), but a long Operating Cycle (takes really long to produce and sell goods as well as collect on credit - cash in). So the larger the cash conversion cycle, the worse the operational and implicit structural liquidity.

Meet the Dean - Roger Martin and Integrative Thinking

I figure I'll take a short CFA study break to write about an encounter I had at the Meet the Dean session at Rotman early last week. I thought it was an invitational event for those of us who were accepted, but it turns out there were some people who were still applying, waiting for acceptances or deciding.

Dean Martin spoke about how Rotman is different from other MBA programs and for once, I was actually impressed with the Rotman presentation. This may seem kind of odd, coming from someone who has already "sampled" the proverbial kool-aid so to speak by accepting my offer letter to start in September, but the truth of the matter is that I was more sold on Rotman by my colleagues and friends currently enrolled (or graduated) than I was from the Faculty administration. I'm quite embarrassed to say that the admin simply made it seem like just an MBA program whereas my friends were raving about their experiences.

The reason I bring up this point is that Dean Roger Martin brought it up and addressed it as well. Now from ANY MBA program, you would expect some pomp and circumstance regarding why their program is so fantastic. One of the major issues facing MBA programs today is their incremental value add. For instance, there are some top schools for which recruiting companies have stated they would rather hire students who were accepted, rather than students that had graduated. The reason? Top schools who accept good candidates are simply validating their position as top performers, whereas the marginal benefit of attending a top school doesn't necessarily justify the exorbitant increase in salary.

Dean Martin reframed this postulate as top schools resting on their laurels and not affecting the changes required by society in light of the financial crisis in the markets. He put up a rather simple diagram of a three dimensional box with the dimensions described as depth, breadth and flexibility. He called the current state of MBA education, shallow, narrow and static where it should be deep, broad and dynamic. I can't remember who he was quoting off hand, but he mentioned: "There aren't marketing or finance problems. Only business problems" (reflecting the interdisciplinary relationships).

He used the example of the Blacks-Scholes models for derivatives valuation and that stated limitations in the model made it inappropriate for use in many circumstances. However, this model is widely used in ALL derivatives valuations and therefore leaves models with large vulnerabilities in their assumptions.

The punch line?

Integrative thinking is a framework which systematically creates people who ask the right questions to make the right decisions.