Elasticity optimism

Jean Imbs, Isabelle Mjean 23 March 2009

Estimates of the elasticity of substitution between domestic and foreign varieties are small in
macroeconomic data and substantially larger in disaggregated studies. This column reconciles
those facts by taking into account the heterogeneity of goods. A better estimate of the
aggregate elasticity of substitution is twice the conventional value suggesting that the US
dollar need not depreciate as much as usually thought to reduce the US current account deficit.

Until the end of 2008, the US dollar had been steadily depreciating against most world
currencies, most prominently the euro. In effective terms, however, the magnitude of the
depreciation was small 10% to 15%.1 Over the same period, the US current account
deficit shrank substantially from a high of 6% of GDP in 2005 to 3.3% in the third
quarter of 2008. Of course, this has many potential explanations not least the ongoing
crisis and its impact on trade. But on the face of it, such a large reversal implies a large
response of traded quantities to changes in relative prices. It means that a reallocation
is ongoing, whereby US consumers have been shifting away from imported goods as
they have become relatively more expensive. Ultimately, it implies that US consumers
are willing to substitute domestic for foreign goods, even in the face of a relatively
modest shift in overall relative prices. In modelling terms, the episode suggests that a
representative US consumer displays a relatively high elasticity of substitution between
bundles of domestic and foreign goods.
The implication is surprising because most of the vast empirical research on the topic
has identified low values for the elasticity parameter, at least on the basis of
aggregated, country-level data. In historical data, aggregate traded quantities respond
little to changes in prices, so that the implied elasticity of substitution must be low.
Orcutt (1950) labelled this a cause for elasticity pessimism, because calibrated models
using such low estimates would translate large movements in prices into relatively small
changes in quantities. For example, a low elasticity means large exchange rate
movements are necessary to substantially affect traded quantities.
Thus, Obstfeld and Rogoff(2007) found a rebalancing of the US current account would
require a 30% dollar depreciation, quite a considerable change.
Interestingly, a second robust conclusion has emerged from the literature. Estimated
elasticities vary enormously across sectors, with an average that tends to take higher
values in disaggregated data than at the country level. The result is intuitive. Some
goods are much easier to substitute than others commodities, for instance, are close
substitutes, whereas branded goods, cars, and gourmet food are not. But the two facts
taken together seem a contradiction. Why would the aggregate elasticity of substitution

be a systematically lower number than the good-by-good estimates? After all, the former
is supposed to be a weighted average of the latter.

Reconciling the evidence

There is a simple way to reconcile the evidence. Estimating the response of aggregate
quantities to changes in aggregate prices is, by construction, forcing all elasticities to be
the same. This ignores the intuitive, tried-and-tested fact that different goods are not
substitutable to the same extent and thereby creates a pure econometric bias.
Furthermore, an estimate based on aggregate data gives equal weight to all goods,
when in reality some are more prominent in traded aggregated quantities. Suppose, for
instance, highly substitutable goods constitute a large fraction of imports. These are
goods for which small changes in price will have large effects on imported quantities.
But imposing equal weights across all imported goods will act to minimise their
importance, and aggregate quantities will appear to be less responsive to prices a
composition effect.
Both effects suggest estimates based on aggregate data can substantially differ from an
average elasticity of substitution accounting for the fact different goods are not equally
substitutable. In fact, both effects illustrate the possibility that the estimated response of
aggregate traded quantities is actually silent about the average aggregate elasticity of
substitution between a bundle of domestic goods and its foreign counterpart. To address
both concerns, we ought to obtain disaggregated estimates of the elasticity parameter
and then aggregate to the country level, using weights reflective of goods relative
importance in overall quantities.

A striking result
Implementing that procedure gives striking results. An appropriately weighted average
of good-specific elasticities is more than twice the estimate implied by aggregate data.
Interestingly, constraining good specific estimates to homogeneity i.e. simulating the
procedure imposed on the data in an estimation based on aggregates does reproduce
the low estimates that were the cause for elasticity pessimism in the first place. In other
words, using disaggregated data continues to pinpoint the elasticity of substitution but
imposing homogeneity has dramatic effects on the magnitude of the parameter (Imbs
and Mjean, 2009).
Does it matter that the true elasticity of substitution is more than twice the elasticity
implied by aggregate data? Surely, it will matter for the calibrated models seeking to
evaluate the depreciation required to alleviate global imbalances. For instance, doubling
the value of the parameter in Obstfeld and Rogoff (2007) implies the dollar depreciation

required to bring the US current account back to balance drops below 20%, a number
closer to what we have witnessed over the past few months.
But the correction has far-ranging implications beyond the resolution of external
balances. For example, the value of the elasticity of substitution determines how much a
monetary authority should care about exchange rate movements. If domestic and
foreign goods are close substitutes, a central bank should not care very much about the
exchange rate. And if they are close substitutes, shocks to the domestic economy will
not affect much international trade, since domestic varieties are readily available. Then
protectionist defences against the international diffusion of recessions seem out of
order. In general, the magnitude of the elasticity of substitution will substantially affect
the policy implications of most models in international economics beyond monetary or
trade policy.

McDonald's is the largest food chain of the world. It is present almost everywhere in the world. It has so
wide global presence that decision makers often use the products of McDonald's to devise economic
measures of well being. One such measure is purchasing power parity. BigMac index is used to measure
the purchasing power parity of various different currencies all over the world. Incidentally, this paper is
also going to use Big Mac (a product of McDonald's) and will consider various micro-economic and
macroeconomic factors that determine its demand and supply. The paper will be purely economics and
will make use of theories that were developed in the past and will apply them to the present scenario.
The paper will be deductive in nature as it will test various theories that were developed sometime back.
(Daft
1994)
Big Mac was developed by one of McDonald's earlier franchisees Jim Delligatti. The product in the early
years was positioned as a burger with two beef patties. Later the product was positioned as a hip hop
product which is liked by everyone. In 2004-2005, McDonald's realized the importance given by people
to the nutritional value of what they eat and they positioned the product as a ?healthy product?. This is
how McDonald's has achieved high growth rate of the brand and achieved great sales. The product is a
classic and has been churning in great amount of money for the company.
[...] Big Mac, case study McDonald's is the largest food chain of the world. It is present almost
everywhere in the world. It has so wide global presence that decision makers often use the products of
McDonald's to devise economic measures of well being. One such measure is purchasing power parity.
BigMac index is used to measure the purchasing power parity of various different currencies all over the
world. Incidentally, this paper is also going to use Big Mac (a product of McDonald's) and will consider
various microeconomic and macroeconomic factors that determine its demand and supply. [...]
[...] (Brigham & Ehrhardt 2010) Big Mac can experience cross elasticity of demand. Big Mac's substitutes
and complements can affect the overall demand of McDonald's. If there is a fall in the price of Big Mac
substitutes there are chances that people will shift to the substitute if McDonald's does not decrease its

price. Similarly, a rise in the price of soda or fries is going to dampen the demand for Big Mac because
the overall package would become expensive to them and they will search for new alternatives. [...]

Mcdonalds Case Analysis

CASE ANALYSIS
McDonalds, Inc.
COMPANY NAME: McDonalds, Inc.
INDUSTRY: Food Service
COMPANY WEBSITE: www.mcdonalds.com
COMPANY BACKGROUND:
As a company, McDonalds was first introduced in Des Plaines, Illinois in 1955. This was the very first
McDonalds restaurant, which all started in San Bernardino, California in 1954 when Ray Kroc
approached the McDonald brothers with a business proposition to start a new company. In 1965
McDonalds went public and was later, in 1985 added to the Dow Jones Industrial Average.
(www.mcdonalds.com) The company has gone through quite a few changes with its changing CEOs
over the years, but the company seems to be on track with CEO Jim Skinner, named in 2004. Skinner
was named the new CEO just in time to clean up after McDonalds first ever quarterly loss. He
succeeded by showing that McDonalds revenue had climbed 11% during 2006 and net profits had
climbed 36%. (Dess, Case 40 Pg. 1)
SWOT ANALYSIS:
STRENGTHS: Jim Skinner had to clean up a big mess after the 2003 slump, and did so by coming up
with a strategy to turn everything around. His strategy had to consist of staying competitive with the
numerous other fast-food restaurants popping up all over the world. In order to maintain this, they had to
reorganize the way they presented themselves to the community. Jim Skinner did so by cleaning up the
customer service, cleaning up and modernizing the physical buildings, and changing the menu to the
changing tastes of their customers. McDonalds also introduced their slogan Im Loving It to reach out
to the younger customers. The advertising is very much targeted toward teens and young adults. (Dess,
Case 40)
WEAKNESSES: The first weakness was the changing of three different CEOs in only one year. These
were unexpected changes, but all had to be dealt with by the newest CEO Jim Skinner, and directly after
McDonalds first ever quarterly loss in 2003. The second weakness is an issue with trying to find new
and exciting things to put on the menu to bring in new customers. Many of todays fast-food customers
are making different kinds of foods, like Chinese and Mexican food, normal to the everyday menu.
OPPORTUNITIES: McDonalds has many opportunities to change its look, menu, and customer service.

McDonalds started building newer building incorporating the arch, along with more modern furnishings.
The menu has changed by adding more breakfast items and introducing the McCafe in certain areas. It
has also added more health concerned items such as the Asian salad and Premium white chicken.
(Dess, Case 40)
THREATS: McDonalds biggest threat is competition. Wherever there is a McDonalds, there are at least
3 other fast-food restaurants near it. It constantly has to advertise what makes them unique to other fastfood places, which means there always has to be something different about them than anybody else.
Just the fact that McDonalds was the first company to go big with their burgers does not necessarily
help them today. Every customer is looking for a new experience and new products to keep them excited
with what they are eating and where they are going to eat, and with so many choices, it is hard for
McDonalds to compete with. (McDonalds 2007)
ANALYSIS VIA PORTERS FIVE FORCES MODEL:
THREAT OF NEW ENTRANTS: The threat of new entrants for McDonalds and the fast-food industry is
low. With so many different kinds of fast-food restaurants already in the industry, entering at this point
would cause struggle for the new entrant. (McDonalds 2007)
BARGAINING POWER OF SUPPLIERS: According to Siehoyono (2005), there are 3,700 new outlets
being built each year in the U.S., meaning the power of suppliers is not an issue for McDonalds.
BARGAINING POWER OF BUYERS: Consumers have more power over buying McDonalds products
because they can demand what type of products they want to see from them. Today, consumers are
demanding healthier food and beverage choices from fast-food restaurants such as McDonalds. After
the documentary film Supersize Me by Morgan Spurlock came out in 2004, McDonalds had to reclaim
its name by showing America that their company cares about the health of their customers and cut out
their supersize program.
SUBSTITUTE PRODUCTS/SERVICES: In the fast-food industry, including McDonalds, the threat of
substitutes is greater now more than ever with the convenience food industry growing. More
convenience food stores are offering similar products as the fast-food restaurants. The convenience
store / gas station, Quik Trip, sells many food items such as hot dogs, egg rolls, pizza stuffed
breadsticks, and countless beverage choices. (Siehoyono 2005)
COMPETITIVE RIVALRY: According to Siehoyono (2005), fast casual food chains such as Subway are
tougher competition to the fast-food chains in both the U.S. and international industries. Some
franchisers were also complaining that McDonalds was granting too many franchisees too close to each
other and actually stealing business away from each other.
STRATEGY USED: McDonalds has tried both cost leadership and differentiation as strategies to outdo
the competition. McDonalds is known for their low price product line and has been competitive with other
businesses in the industry. A representation of differentiation is their dollar menu. They were one of the
first in the industry to do a very low-cost smaller menu of items on their product line that cost only $1. As
soon as this came out and was advertised, many of the other fast-food businesses started something
similar to compete. There is only so much a business can do with a low-cost strategy before it starts
losing money. This only leaves differentiation or a focus strategy to use. Focus strategies would not work
as well in this industry mainly because their product line is similar in all areas of the world because that

is what they are known for. McDonalds has to stay true to what it started as and not fly too far away from
its roots. McDonalds has also tried a differentiation strategy with different products like the McRib or the
Big Mac. (Dess, Case 40)
ISSUES AND CHALLENGES: McDonalds competitive advantage is their differentiation. Their products
flavors and names are exclusive to them and the brand of McDonalds is distinguished by the looks and
tastes of their foods. If somebody set a row of burgers and fries each from a different restaurant, I could
pick out exactly which one is McDonalds burgers and fries. They have distinguished themselves this
way for years and this will continue, but the tastes of the customers may change. This will be the
problem. McDonalds will have to answer to the needs and wants of their customers to keep them
satisfied and coming back for more. Right now in the industry life cycle, McDonalds is a mature
company focusing on competition and their product lines survival. The culture of McDonalds is keeping
their customers happy and to do whatever they can to create a wider customer base along with a product
line that satisfies any taste. I think McDonalds customer service is not consistent. I have personally
experienced many different stores and some have very good customer service and some are not very
good at all. The stores cleanliness and overall appearance also is not consistent. (Siehoyono 2005)
COURSE OF ACTION RECOMMENDED: If I were in a position to make a decision for this company,
first I would require all management and supervisory positions to go through company training. They
would then be required to test their employees on customer service and sales skills. In doing this kind of
training all branches would have a better chance of happy customers and exceptional customer service.
Employees also need to be treated with respect and importance for them to want to do well in their
position. Some kind of incentives plan needs to be put into action for their employees. Older buildings
need to be updated so customers feel comfortable and clean while dining in.
OPINION: I think reading case studies is already interesting because it teaches you how the company
works and how it became what it is today. Anybody can tell just from reading a case study whether it is a
successful business and what their issues are. I thought that writing a case study analysis helped
understand how a company operates considering all challenges and opportunities.