Economics for Cheerleaders

With the Super Bowl finished (yeah Seahawks!) media attention has switched from the teams and players to the cheerleaders. A couple of recent articles caught our attention and, of course, we just couldn’t resist the temptation to comment. 

ABC News is reporting that a Cincinnati Bengal Cheerleader is suing the team over what she claims is a $2.85 per hour wage. The NY Daily News, meanwhile, published an article about the Oakland Raiderettes suing their team for similar reasons. While we don’t claim to know a lot about cheerleading, we do know a lot about economics and the way markets work. Given that, we feel it necessary to warn the cheerleaders that brought these suits to beware of the law of unintended consequences.

We checked a few of the NFL websites and found that the pay wasn’t all that great, and most had a very strict contract. These are not working conditions that we would be willing to accept, but then, we didn’t apply. A cheerleading squad consists of 30 very fit women, each of whom successfully made it through the audition process and accepted the terms of their contracts. The teams that we looked at admit that these are part-time jobs. No one should expect to make a decent living as a part-time cheerleader. 

That, in itself, suggest that there is some other non-pecuniary benefit to being an NFL cheerleader. Opportunities listed on team websites include modeling, exposure, networking, personal appearances and promotions. Indications are that between 200 and 1000 applicants pay $25 each to apply to be cheerleaders each year. They then attend training seminars just for the privilege of trying out. In economic parlance, there is an excess supply of cheerleaders. Most teams have at least 6 applicants for each available spot. 

If the $2.85/hr. figure claimed in the Bengals lawsuit is accurate, the equilibrium wage rate for cheerleaders is likely close to zero. The exposure, it appears, is sufficient compensation for the duties that they perform. 

What happens if the Raiderette and Ben-Gals are successful in their lawsuits and the NFL is forced to increase he pay of cheerleaders? Unfortunately for the existing cheerleaders, they may lose their jobs. Supply curves are upward sloping. An increase in the wage rate increases the number of people that are willing to work. If there are 200 people applying to be cheerleaders when the rate is a purported $2.85/hr., how many will apply at $7.85, the minimum wage in Ohio? Certainly more than 200. As the wage rate rises, it becomes sensible for professional dancers to audition. Not only does the number of applicants rise, but so too does the quality of the applicant. 

If, and when, the wage rate approaches the equilibrium level, the number of applicants will decrease and the quality of the applicant decreases. This fundamental rule of labour markets applies not only to NFL cheerleaders, but to bank presidents as well.

The Pricing of Wine and Beer

People in Canada are always whining about the price of beer. This is especially true once they compare prices in the U.S., and the vast majority of Canadians live within 200km of the border. The most recent case we’ve found is from a Globe and Mail article dated Dec 20, 2013. 

This provides us with an excellent opportunity to explain how retail prices are determined when firms are not perfectly competitive. The formula: P=MC/(1+1/ɛ) isn’t particularly hard to compute from the profit maximizing rule, but it is sufficiently difficult that it can’t be done with a calculator. Trust us (because it requires calculus) that it is the profit maximizing equation. P is the retail price, MC is the marginal cost of production and ɛ (a negative number) is the price elasticity of demand. It should be apparent that the price of a good rises as its cost of production rises. What is not so obvious is that as ɛ falls in absolute value, P rises. 

The elasticity of demand, ɛ, measures the responsiveness of consumer to changes in price. It is calculated as the percentage change in quantity demanded divided by the percentage change in price. Since people buy less of most things when price goes up, the elasticity is always negative. The more consumers react to price changes, the larger the elasticity number becomes (in absolute value – a bigger negative number). 

When consumers react strongly to price changes, we call the demand “elastic”. When they don’t respond the term is “inelastic”. The demand for a good will tend to be elastic if there are plenty of substitutes available, if the good is not a necessity, if the price is large relative to income, or if consumers have time to react. 

So, back to beer. The Globe news article is looking at the monopoly retailer of beer in Ontario: The Beer Store. There aren’t many good substitutes for beer, and there are no substitutes when it comes to purchasing beer in Ontario. The demand for beer in Ontario is likely to be relatively inelastic. Compare that to most places in the U.S. where beer can be purchased at Walmart, 7-Eleven and the local gas station. More places to buy beer means higher elasticity and lower retail prices. The price difference between Ontario and Quebec, where beer is available in convenience stores and grocery stores is 27%. It is safe to assume that the production costs are the same in the two provinces, so the price difference is caused by differences in elasticity. It shouldn’t be a surprise that the Beer Store rejects this claim and blames the differences on taxes.  

The major beer brands; Canadian, Kokanee, Blue, all have similar tastes (at least after the first couple). Craft beers, on the other hand, have very different flavours but their price is still limited by the availability of the major brands. Wine, on the other hand, is not easily substituted. A Merlot is not a substitute for a Riesling. A Beaujolais is not a Burgundy. In an article from Yahoo! Travel dated Sep 24, 2013, the author takes us through all kinds of reasons why wine is so expensive. The one reason that they miss is because restaurants can mark it up that much. A consumer that walks into a wine store and doesn’t like the price can choose not to purchase the wine and shop at a different location. A consumer in a restaurant cannot say to a waiter “excuse me while I go next door to the wine store and get a bottle for 40% of what you’re charging”. Once a consumer has entered a restaurant the demand for wine has become very inelastic and, because of that, the price can go up.

The demand for beer and wine tend to be relatively inelastic and elasticity falls as competition falls. That’s why we pay so much for beer and wine in Canada. 

(It’s also why red roses were so expensive today – Feb 14 – but we’ll save that one for next year)

On Coffee and Climate Change

Whether one accepts or rejects the hypothesis of anthropogenic climate change, evidences does suggest that our planet is going through yet another warming cycle.

Climatologists warn of dire consequences; global food shortages, flooding and other apocalyptic events. Such is the case of a LiveScience article, reposted on Yahoo News, that predicts that I may now be directly affected. It turns out that the coffee crop in Costa Rica is suffering from the higher temperatures.

Coffee is my life blood and I would have to take the climatologists seriously if I hadn’t been trained to observe and interpret human behavior. Economists, you see, study what people actually do, not what they should do, or what we would like them to do.

For example, climatologists warn that the polar ice caps will melt and result in increased ocean levels. One estimate I found suggests that the rise could be as much as 2 meters (6.5 ft) by the year 2100 (National Geographic). That’s about 91 mm per year (0.9 in).

Spanish Banks, Vancouver BC

Spanish Banks, a beautiful beach near the University of British Columbia, regularly has tide changes of 3.6 m (12 ft.) in a 7 hour period. That means that the water can move out by 400 meters (1/4 mile) at low tide. In the summer, families can be seen playing near the water’s edge at low tide. Children build sand castles in the wet sand.

When the tide comes in, the water level rises by a half meter (20 inches) every hour. Surprisingly, no one ever drowns. Even the children eventually realize that their fortresses are doomed and move to higher ground. Observation of human behavior suggests that, as the oceans rise, some people will build dykes to protect the property, and eventually, all will move to higher ground. This is not going to be a costless exercise, but it will happen.

The same basic human behavior will determine the price of my coffee. It may be that Peter Lehrer, author of the LiveScience article, loses his coffee plantation as temperatures rise but economics suggests that coffee prices won’t rise. As the article states, land that is higher up on the mountain and currently too cold for coffee, may become farmable. Enterprising coffee growers, reacting to price changes will plant coffee at higher altitudes. As the planet warms, it will be possible to grow coffee further from the equator, and the market mechanism suggests that people will plant there as well.

Mr. Lehrer will be incurring costs from global warming disproportionately when compared to others on the planet, but that is a topic for another blog.

Climate change will cause changes in where and how we live. The transition is going to be expensive and is going to happen when is it no longer prudent to maintain the status quo. I, for one, am going to buy some ocean front property … in Houston.

 

Why We Can’t Predict Interest Rates

An article in the Financial Post has impugned me honour and the honour of other fine economists (thanks Capt. Barbossa for the verbiage).The basis of the negative press has to do with the inability to accurately predict future interest rates. I thought, therefore, that I would take this opportunity to defend my colleagues and explain why forecasting some economic variables is so difficult. In particular, I want to look at interest rates.

First, let’s be clear that there are several different interest rates. The money market rate is the rate charged on overnight loans between financial institutions. This is the rate that the Bank of Canada uses as its policy instrument. As of Jan 2, 2014, this rate was 1%. The Bank uses this interest rate to influence economic activity and the inflation rate.

The bank rate is the interest rate the central bank charges for overnight loans to major financial institutions. The bank rate is always 25 basis points above the target overnight rate. (1 basis point = 1/100^th of 1%) When the target rate is 1%, the bank rate is 1.25%.

The prime rate is the interest rate that banks charge their best customers for short term loans. Since our banks can borrow as much money as they want from the Bank of Canada, the prime rate is closely linked to the bank rate.

The long term bond rate is the rate received for lending to government and corporations. Bond rates differ due to credit worthiness and by the length of the loan (maturity). Generally, the longer the maturity, the higher the interest rate will be. It is this interest rate that influences private business investment and the residential mortgage market.

Long term interest rates are determined by the demand and supply of loanable funds, or equivalently, the demand and supply of bonds. Central banks don’t have direct control on these rates but they can influence through open market sales and purchases of bonds with different maturities. This is what the US Fed is doing with its quantitative easing program.

To accurately predict short term interest rates we look to the Bank of Canada’s objectives and their policy tools. The Bank’s objective is to keep the inflation rate, as measured by the change in the core CPI, at 2% per year. They have an ‘operational guide’ of 2% plus or minus 1%. That is, they want to keep the inflation rate between 1% and 3% per year.

When economic activity; consumer spending, construction, exports etc. decreases, unemployment tends to rise and the inflation rate tends to fall. In response to this, the Bank lowers the target rate to encourage investment spending. When the economy expands too rapidly, the inflation rate rises, and the Bank raises the target rate to down the rate of expansion.

When will inflation rates rise? Not an easy question to answer. In the last several years the potential output of the economy has been growing faster than actual spending. Inflation increases when the economy gets close to capacity. A core inflation rate of 1.1% indicates that the Canadian economy is not operating at close to capacity. The US Bureau of Labor Statistics reports US inflation at 1.7% indicating that our biggest trading partner is also operating below capacity. Inflation.eu reports inflation rates of 2.09% in Great Britain, 1.34% in Germany, 0.68% in France, 0.23% in Spain and 0.66% in Italy. With little inflationary pressure in any of our other major trading partners, interest rates are not likely to increase there either.

So, when will interest rates rise? Not anytime soon!

Walmart … The Company We Love to Hate

One would think that, with all the people who claim to hate Walmart, they would be out of business by now. Apparently, they are not. For the year ending July 31, 2013, Walmart reported revenues of USD 473 billion. On average, everyone on the planet spent about $80 there last year. Clearly number one on the “hated company” list. See Walmart financial data on Yahoo!.

This blog is not about the evil dragon, it’s about the dragon slayer. In particular, the efforts of the Washington DC city council’s effort to penalize the company for wanting to create 1800 jobs in their city. In early September, the council voted to impose a minimum wage premium of 50% on big-box retailers. This would raise the minimum wage from $8.25 per hour to $12.50 per hour. The increase would be effective immediately for new entrants while existing retailers would have a four-year exemption. See the Reuters article for details.

The rationale of city council, according to Council member Vincent Orange is that “the value of our residents’ time is greater than $8.25. If that is true, I’m out of a job because economic theory is clearly wrong. The supply of labour is determined by the marginal value of leisure time. If the offered wage is greater than the value of leisure, people will sell their time. This follows from the assumption that individuals will act rationally, at least on average. There are people working for the minimum wage in Washington DC and doing so willingly (since slavery was abolished a long time ago). Therefore it is fair to assume that there are some people who value their time at less than $8.50 per hour.

To be clear, they are not happy about it, but that is natural. Work is bad. Play is good. That’s why we require compensation.

Backers of the bill justify the wage hike because “Walmart can afford it”. That is not the issue though. Firms exist to make profits. Without profits they just fade away. Where are Blockbuster, Borders and Kodak? Reducing a company’s profit removes their incentive to create jobs. In the case of Washington DC, Walmart could be at a disadvantage relative to Target since Target gets 4 more years at the existing minimum wage.

If there is a demand for Walmart in the DC area, then the optimal thing for Walmart to do is to build their stores outside the DC area as close as possible to the border. That way, DC residents will be able to enjoy Walmart’s low prices and cities in Virginia and Maryland can enjoy the benefits of the tax revenues.

There is still the possibility that DC Mayor Vincent Gray will veto the bill. Until the issue is resolved, expect Walmart to do nothing. The people that lose in this case are the shoppers in DC and the 1800 people that would have had jobs.

Shoppers Return and Workers Leave

It’s hard to feel sorry for businesses that don’t react to market changes in a timely manner. We have previously written about firms that couldn’t keep up with changes in consumer tastes (Krispy Kreme), or to changes in technology (Kodak, Borders, Best Buy). This story is a little different because in involves the effect of consumer demand on labour markets.

A recent Bloomberg News report that we first saw on Yahoo! News confirmed by our own observations, tells about the vast empty spaces on Walmart shelves. Unlike firms that are on the verge of bankruptcy and can’t afford to purchase additional merchandise, Walmart’s problems are caused by large numbers of consumers. Walmart has plenty of stock, it’s just hidden away in the back of the stores. Walmart has a labour problem.

When the economy collapsed after the financial crisis, household incomes fell and consumers spent less. A decline in consumption means less revenue for firms. When revenues decline, firms have to reduce their costs, typically by laying off workers. During the height of the recession in 2009-10, the unemployment rate hit 8.7% in Canada and 9.7% in the US.

When there is an excess supply, there is downward pressure on prices. Unemployment is an excess supply of labour and, during the recession, there was downward pressure on wages. Walmart was able to capitalize on this, not by ‘screwing workers’ as on commentator in the article put it, but by taking advantage of market prices.

As with all previous economic downturns, the post-crisis recession eventually ended. Consumer spending started to increase and the demand for labour recovered. Unemployment started to fall and there was upward pressure on wages. Walmart didn’t react. Target and Costco apparently did.

If Target raises wages and Walmart does not, we should expect workers to leave Walmart to work for Target. Staffing levels rise at Target and fall at Walmart. Customer service at Walmart falls because they don’t have enough cashiers and store shelves stay empty because they can’t hire workers to restock them.

The same commentator that accused Walmark of screwing workers also claims that workers that are treated better are more productive. This may not be entirely accurate. Workers at Target have to be more productive than workers at Walmart to keep their jobs. The premium that Target pays their workers prevents them from shirking their responsibilities. A worker that loses their job at Target is forced to go back to work for Walmart. This is the efficiency wage argument made by Alchian and Demsetz in their 1972 paper published in the American Economic Review.

The market for labour is not that much different from any other commodity. When demand falls, price falls and when demand rises, price rises. In an effort to keep costs down in a recovering economy, Walmart management has found themselves with a shortage of workers and with employees that are less productive than employees at their competitors.

The Faucet is Leaking … Call the Electrician!

In 1692 when the Pilgrims left London bound for Halifax aboard the Niña, the Pinta and the Santa Maria, they brought with them 100 head of dairy cattle. By 1776, when Canada separated from England to become the 51^st state, the dairy cattle roamed wild over most of the prairies.

There is a very good reason that economists don’t comment on history – it is not our field of expertise.

One must wonder, then, how accurate an op-ed piece that appeared in the Vancouver Province could be. The piece was a critique of a Fraser Institute study on milk marketing boards. It was, however, written by a historian.

In his effort to critique, our historian has made two errors that are common to any first year student. The first is the difference between ‘cost’ and ‘price’. The second is the difference between ‘demand’ and ‘quantity demanded’.

‘Cost’ refers to the market value of all of the inputs used in the production of a product. ‘Price’ is how much a consumer pays for the product, and is based on the consumer’s perceived value. When price exceeds cost, the producer earns a profit. Price can be determined either through a market system or by direct government control. Minimum wages are an example of government controlled pricing.

‘Quantity demanded’ is how much consumers will purchase at a particular price. ‘Demand’ is the relation between quantity demanded and ALL possible prices. The definitions of ‘quantity supplied’ and Supply are similar; referring to the amount that firms are willing to sell. Quantity supplied can equal quantity demanded, but supply can never equal demand. This many sound like semantics, but it is the key to understanding how markets actually function.

In his op-ed piece, Professor Muirhead states that, under supply management, “domestic demand is matched with domestic supply”.  Disregarding the aforementioned error in terminology, equating quantity demanded and quantity supplied is exactly what the market mechanism does through changes in price. When government determines the maximum amount that can be produced, the market still determines the price. Thus, comparing the price of milk between supply management and market determined is not like comparing apples to oranges.  It’s comparing milk to milk.

The key element missing from the article is the side effect of supply management. To restrict the quantity produced, and thus increase price, governments issue quotas, or licenses to produce. Because the restricted supply raises the price of milk, more farmers would like to enter the dairy industry. They can’t, however, without obtaining a quota. If there is a demand for the quotas, and there is a limited supply, then the quotas themselves have value. Each time a Canadian buys milk or cheese they contribute to the profitability of these quotas. In a study done several years ago, the single largest cost of dairy producers was the acquisition of the quota.

Getting rid of supply management and compensating the existing producers for the value of their quotas would almost certainly reduce milk and cheese prices. With some notable exceptions, free markets are always more efficient than government intervention. Milk markets are not one of these exceptions.

Need more evidence? Ask the Venezuelans about toilet paper.

Thanks to my colleague JM for bringing this article to my attention.