In Mankiw's Elasticity chapter, he discusses four factors that help us determine the type of elasticity of demand. They include:
- Availability of close substitutes
- Definition of market
- Necessities versus luxuries
- Time horizon
In the examples cited by Buffett, we can see why his favored industries appear to have inelastic demand characteristics. His portfolio includes railroads and electricity producers. It should be noted that each of those industries have little competition due to their natural monopoly attributes. Natural monopoly occurs when a single firm can supply a good or service to an entire market at a smaller cost than two or more firms. That is fairly consistent with both railroads and public utilities that both incur extensive upfront investment costs that makes it prohibitive for competitors to enter. Buffett also mentioned Coca Cola and Kraft Foods. By mentioning their strong brand loyalty, he is implying that their customers are less likely to switch from their products even when they increase their prices. If this is true, then that is another example of inelastic demand.
In cases where competition is less, management quality is not as important. When you are the "only game in town", then your weaknesses in delivering or marketing a product will not be punished by market forces. That will only occur when there are a number of competitors that can exploit those weaknesses.
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ReplyDeleteAt first I found the part where you refer to a natural monopoly as having a inelastic demand curve confusing, because if they are a monopoly and the they are selling at a price on the inelastic part of the demand curve, a profit maximising firm would increase the price, generate more revenue and have lower costs. hence a profit maximising monopoly would never be on the inelastic part of the demand curve. But I think what you mean is that the curve it's self, rather than the position, has inelastic qualitites. But to be frank, whenever people talk about it in this way it always confuses me, because it doesn't appear to have a precise mathematical definition.
ReplyDeleteIs this something you can explain to me more clearly?
I'm just now noticing this post, so forgive me for the delay in responding. Yes, I do need to clarify that statement. With every monopolist demand curve, there is a region where there is inelastic and elastic demand. However for the monopolist to maximize profits, they must produce under the region where there is inelastic demand. This is a region where raising the price will increase total revenue. As for the article, I was mainly trying to point out why railroads would have inelastic characteristics.
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