With the recent $39 billion offer by AT&T to purchase T-Mobile we thought we might say a little about the inefficiencies of monopolies. An article on 24/7 Wall St. explains what a monopolist is and lists ten companies in the U.S. that are effectively monopolists.
When economists investigate inefficiencies, we use the non-existent perfectly competitive market at the benchmark. In this market structure there are many buyers and sellers of a homogenous good and no barriers to entry. Individual firms are small and have no influence on the market price. When this is true, the marginal (incremental) cost of the last good produced is equal to the marginal benefit to the consumer and the sum of consumer and producer surpluses is maximized. (Consumer surplus is the total benefit received minus the total amount paid. Producer surplus is total revenue minus the variable cost of production) Price is equal to both marginal cost and marginal benefit.
In a monopoly, firms have the ability to set their price to maximize profits. Reducing the amount of output causes the product price to rise and the marginal cost of production to fall. A monopolist will produce until the marginal revenue is equal to the marginal cost. They will then set the price for that level of output to the maximum amount that consumers are willing to pay as determined by the marginal benefit.
At the profit maximizing level of output, the price equals the marginal benefit, but is higher than the marginal cost. The monopolist’s chosen output is less than the socially optimal level of output. There is a transfer of consumer surplus to the firm, and also a deadweight loss to society due to the monopolist’s output being below the socially optimal output level.
In the case of patent-protected monopolists, we are willing to accept the inefficiency, at least temporarily, since research and development tends to benefit society as a whole. Without the monopoly profits, firms would have no incentive to develop new products.
Unions are monopoly sellers of labour.
Saturday, March 26, 2011
Thursday, March 24, 2011
The Vern and Monica Parable
Vern worked hard and saved his money so that he could buy his own truck and start a delivery service. His continued hard work allowed him to keep buying more trucks and expanding his business. Each time he bought a new truck, he advertised that he was hiring and was willing to pay $15/hr. Kevin applied and Vern hired him.
One of Vern’s clients, Monica, worked hard and saved her money and opened a bakery. Every morning Kevin delivers Monica’s flour in one of Vern’s trucks. Monica’s specialty is sourdough cobs which she offers for sale at a price of $4.95.
On one particular Monday morning, Monica’s flour delivery doesn’t arrive and Monica has to close her bakery. When she phones Vern to find out what the problem was, he tells her that his drivers went on strike demanding an increase to $18/hr. Vern assures her that the problem has been solved and the her deliveries will continue tomorrow morning as usual.
Sure enough, early the next morning her delivery arrives and all is well in the bakery again. Later that day, Kevin drops by Monica’s on his way home and asks her for a sourdough cob. Monica takes one off the shelf, puts it in a bag and places it on the counter. She looks at Kevin and say “That will be $6.95 please.” Kevin looks at the price board and says to Monica “But you offered to sell it for $4.95”. Monica responds “I changed my mind”. Kevin doesn’t buy the loaf and turns to leave. The next person in line says “I’ll take that loaf” and Monica responds “That will be $4.95 please”.
Kevin looks back at Monica and mutters “That’s not fair”.
One of Vern’s clients, Monica, worked hard and saved her money and opened a bakery. Every morning Kevin delivers Monica’s flour in one of Vern’s trucks. Monica’s specialty is sourdough cobs which she offers for sale at a price of $4.95.
On one particular Monday morning, Monica’s flour delivery doesn’t arrive and Monica has to close her bakery. When she phones Vern to find out what the problem was, he tells her that his drivers went on strike demanding an increase to $18/hr. Vern assures her that the problem has been solved and the her deliveries will continue tomorrow morning as usual.
Sure enough, early the next morning her delivery arrives and all is well in the bakery again. Later that day, Kevin drops by Monica’s on his way home and asks her for a sourdough cob. Monica takes one off the shelf, puts it in a bag and places it on the counter. She looks at Kevin and say “That will be $6.95 please.” Kevin looks at the price board and says to Monica “But you offered to sell it for $4.95”. Monica responds “I changed my mind”. Kevin doesn’t buy the loaf and turns to leave. The next person in line says “I’ll take that loaf” and Monica responds “That will be $4.95 please”.
Kevin looks back at Monica and mutters “That’s not fair”.
Wednesday, March 16, 2011
Asymmetric Information in Labour Markets
Asymmetric information is a situation wherein one party in a transaction has a different information set from the other. In labour markets, the job seeker knows their true abilities and work ethic while the prospective employer does not. Firms must spend resources during the hiring process to overcome this problem. Anything that a job seeker can do to reduce these transaction costs improves their chances of obtaining employment.
When unemployment rates are low, an education credential can serve as a signal. For example, a university degree in almost any subject, indicates that the graduate has the ability to learn and has the commitment required to complete a four year program. These traits are valuable to an employer. While the same traits may be found in someone without a degree, that information is expensive for an employer to discover.
When unemployment rates are high, different signals are required. Being unemployed for a very long time sends a bad signal regardless of the job seekers abilities. A prospective employer must ask themselves why no one has hired this person. The answer to that question is expensive to determine. An article in Huffington Post citing a FRB Cleveland study shows the difference between unemployment rates by education, and length of unemployment by education. It also points out that “must be currently employed” is a common requirement in job ads.
The message is clear. Employed persons have a better chance of getting a job than unemployed persons. How then does someone with a BA in Economics find a job? Since it is almost impossible to convince a prospective employer that you have the traits they are looking for, get someone else to prove it to them. Get a job. Sounds counterintuitive, how does one get a job if no one will interview them? A job seeker should accept a job well below their qualifications. For example, they could apply at Starbucks. Any job sends a signal that is different from unemployment.
When unemployment rates are low, an education credential can serve as a signal. For example, a university degree in almost any subject, indicates that the graduate has the ability to learn and has the commitment required to complete a four year program. These traits are valuable to an employer. While the same traits may be found in someone without a degree, that information is expensive for an employer to discover.
When unemployment rates are high, different signals are required. Being unemployed for a very long time sends a bad signal regardless of the job seekers abilities. A prospective employer must ask themselves why no one has hired this person. The answer to that question is expensive to determine. An article in Huffington Post citing a FRB Cleveland study shows the difference between unemployment rates by education, and length of unemployment by education. It also points out that “must be currently employed” is a common requirement in job ads.
The message is clear. Employed persons have a better chance of getting a job than unemployed persons. How then does someone with a BA in Economics find a job? Since it is almost impossible to convince a prospective employer that you have the traits they are looking for, get someone else to prove it to them. Get a job. Sounds counterintuitive, how does one get a job if no one will interview them? A job seeker should accept a job well below their qualifications. For example, they could apply at Starbucks. Any job sends a signal that is different from unemployment.
Wednesday, March 9, 2011
Immiserizing Growth
Seems to be a week for International Trade Theory, so today’s topic is “immiserizing growth”, something that can happen when the ‘small country’ argument in the standard Ricardian model doesn’t hold. Two articles appeared in the same edition of the Globe and Mail that illustrate this phenomenon. Both deal with the acquisition of iron ore mining interests in Canada by foreign interests. One is a story about China, and one is a story about India.
A small country is one that is small enough, economically, that they can’t affect the world price of traded goods. When that is true, the world supply of the country’s imports appears to be perfectly elastic, as does the world demand for the country’s exports. For most countries in the world this is an accurate assumption. For large countries, however, an increase in imports and/or exports can alter world prices. Canada, for example, is too small to affect world prices. The United States is not. China has become a large country and India soon will be a large country.
The economic boom in China has caused a global increase in the demand for raw resources such as coal, iron ore, copper and oil. As a result, the global equilibrium price is rising. That is good news for countries like Canada, Brazil and Australia that export these commodities, but bad news for China and India that import them. As input prices rise, the cost of production rises and the price of their exports most rise. This reduces terms of trade in the growing countries and slows the export driven growth. Under extreme circumstances, the increase in input prices can cause economic growth to stop, and ultimately lead to an economic contraction – immiserizing growth.
In an effort to secure supplies of iron ore and thus prevent input prices from rising, both China and India have purchased interests in Canadian producers of iron ore. Watch for more investments in Canada, Australia and Brazil.
A small country is one that is small enough, economically, that they can’t affect the world price of traded goods. When that is true, the world supply of the country’s imports appears to be perfectly elastic, as does the world demand for the country’s exports. For most countries in the world this is an accurate assumption. For large countries, however, an increase in imports and/or exports can alter world prices. Canada, for example, is too small to affect world prices. The United States is not. China has become a large country and India soon will be a large country.
The economic boom in China has caused a global increase in the demand for raw resources such as coal, iron ore, copper and oil. As a result, the global equilibrium price is rising. That is good news for countries like Canada, Brazil and Australia that export these commodities, but bad news for China and India that import them. As input prices rise, the cost of production rises and the price of their exports most rise. This reduces terms of trade in the growing countries and slows the export driven growth. Under extreme circumstances, the increase in input prices can cause economic growth to stop, and ultimately lead to an economic contraction – immiserizing growth.
In an effort to secure supplies of iron ore and thus prevent input prices from rising, both China and India have purchased interests in Canadian producers of iron ore. Watch for more investments in Canada, Australia and Brazil.
Tuesday, March 8, 2011
Dutch Disease
A recent BusinessWeek article quoted an Australian bank economist as saying that “there is risk of Dutch disease effect”, in response to the growing exports of coal and iron ore from that country to China, and the incumbent rise in the value of the Australian dollar. We thought it would be a good time to explain the “Dutch disease”.
The phenomenon is based on an analysis of the Netherlands after the discovery of natural gas in the 1960’s. When the output and export of natural resources increases due either to an increase in demand or a new discovery, resources such as capital and labour are required to extract the natural resources. The increase in demand for capital and labour from the new export sector drives up wages, and diverts capital from existing exports and from non-traded goods. The cost of capital may or may not rise depending on the extent of international capital flows, but the return to capital will fall as other input prices rise.
The increased costs in the non-traded sector leads to price increases, while in the existing export sector, output falls. Prices of traded goods are determined in international markets and small countries have little or no effect on those prices. As exports increase, the domestic currency starts to rise in value. The domestic cost of imports falls and puts more pressure on domestic producers. So long as the new exports continue, real income rises.
The ‘disease’ occurs when demand for the new export falls or new supplies in other countries cause a global price decrease. Returns to capital, and the demand for labour, fall in the new export sector. Declining incomes reduce consumer spending in the non-traded sector. While the other export sector still exists, it takes time to shift capital from one industry to another and during this period of adjustment, output and incomes fall and unemployment rises.
The success of the new export sector can ultimately lead to recession. This is what Australia is worried about; though the problem is less severe for a geographically large diversified country such as Australia, than it was for a geographically small specialized country like the Netherlands.
The phenomenon is based on an analysis of the Netherlands after the discovery of natural gas in the 1960’s. When the output and export of natural resources increases due either to an increase in demand or a new discovery, resources such as capital and labour are required to extract the natural resources. The increase in demand for capital and labour from the new export sector drives up wages, and diverts capital from existing exports and from non-traded goods. The cost of capital may or may not rise depending on the extent of international capital flows, but the return to capital will fall as other input prices rise.
The increased costs in the non-traded sector leads to price increases, while in the existing export sector, output falls. Prices of traded goods are determined in international markets and small countries have little or no effect on those prices. As exports increase, the domestic currency starts to rise in value. The domestic cost of imports falls and puts more pressure on domestic producers. So long as the new exports continue, real income rises.
The ‘disease’ occurs when demand for the new export falls or new supplies in other countries cause a global price decrease. Returns to capital, and the demand for labour, fall in the new export sector. Declining incomes reduce consumer spending in the non-traded sector. While the other export sector still exists, it takes time to shift capital from one industry to another and during this period of adjustment, output and incomes fall and unemployment rises.
The success of the new export sector can ultimately lead to recession. This is what Australia is worried about; though the problem is less severe for a geographically large diversified country such as Australia, than it was for a geographically small specialized country like the Netherlands.
Friday, March 4, 2011
Sexual Discrimination or Risk-based Pricing
Just when you thought you’d seen the height of political stupidity, another politician opens their mouth and out comes absolute drivel. We’re not referring to Mike Huckabee’s recent “misspeak” when he said the President Obama grew up in Kenya. Nor do mean the Texas immigration bill introduced by Representative Debbie Riddle that would make it a crime to employ an illegal alien with punishments up to two years in jail and a $10,000 fine – unless, of course, that illegal alien is cooking, cleaning, minding the children or cutting the lawn of those wealthy Texans that can afford domestic help. (click here for article) And, no, we are not even including the proposed law in the State of Georgia that would make a miscarriage punishable by death. (click here if you don’t believe us)*
As silly as these are, the Europeans have decided that insurance companies that charge men more for life and automobile insurance than they do for women are practicing sexual discrimination. The price differential has nothing to do with women having statistically lower accident rates, or that women have statistically longer life expectancies. Women pay lower insurance rates because they are women, and that cannot be permitted in an enlightened society. (Click here for article)
Fairly priced insurance is based on the probabilities of a certain event happening within a certain time period. Individuals that are risk averse (those with diminishing marginal utility of consumption) will always choose to buy fairly priced insurance, and will often purchase insurance that is not fairly priced. An insurance company can estimate risk based on historical data and observable traits. For example, smokers pay higher premiums than non-smokers because, statistically, they die sooner. An insurer with many clients can rely on the law of large numbers to predict probabilities for the “average” client in a certain demographic subset. In Europe, apparently, women are not to be treated as an identifiable demographic subset.
What the European law makers are hoping for, no doubt, is that men and women will pay the same premiums based on the average of what they pay now. Sorry, not going to happen. One insurance company may try this, but a second would come along and realize that women are being over charged. They could create a policy that would be cheaper and attractive only to women. Women would then ‘self-select’ into that policy. When they do, the single priced policy would only be sold to men, and since the price is less than the risk for men, that company would go bankrupt. The men would then flock to the only other policy available, and the price of that policy is below the pooled risk, and that company also goes bankrupt. The result; no insurance market.
This is not a new idea. It comes from a paper written in 1976 by Michael Rothschild and Joseph Stiglitz: Equilibrium in Competitive Insurance Markets: An Essay on the Economics of Imperfect Information, The Quarterly Journal of Economics Vol. 90 No. 4 pp. 629-649
Clearly, insurance executives have read this paper, and politicians have not. The insurance industry has been notably silent on the issue because, in the short term, the only solution to non-discrimination is to increase the price women pay for insurance so it is the same as the premium that men pay. Women will be subsidizing the profits of the insurance company, but that is not discriminatory.
As we have previously tried to explain, markets are terribly efficient. We believe that insurance companies will create a mechanism that is not deemed discriminatory and that allows individuals to self-select into policies at the price they are currently paying. For example, insurance contracts are filled with exclusions – events under which the policy will not pay. (Terrorism, war etc.) We can propose a specific set of exclusions that will allow people to self-select into life insurance policies. Policy “A” has a low premium but does not pay out in the event of death from prostrate cancer. Policy “B” has a high premium and will not pay out in the event of breast cancer. Since there is no mention of the insured’s sex, these policies are not discriminatory. We will leave it up to the reader to figure out who buys which policy.
*Thanks to Graeme for drawing this one to our attention.
As silly as these are, the Europeans have decided that insurance companies that charge men more for life and automobile insurance than they do for women are practicing sexual discrimination. The price differential has nothing to do with women having statistically lower accident rates, or that women have statistically longer life expectancies. Women pay lower insurance rates because they are women, and that cannot be permitted in an enlightened society. (Click here for article)
Fairly priced insurance is based on the probabilities of a certain event happening within a certain time period. Individuals that are risk averse (those with diminishing marginal utility of consumption) will always choose to buy fairly priced insurance, and will often purchase insurance that is not fairly priced. An insurance company can estimate risk based on historical data and observable traits. For example, smokers pay higher premiums than non-smokers because, statistically, they die sooner. An insurer with many clients can rely on the law of large numbers to predict probabilities for the “average” client in a certain demographic subset. In Europe, apparently, women are not to be treated as an identifiable demographic subset.
What the European law makers are hoping for, no doubt, is that men and women will pay the same premiums based on the average of what they pay now. Sorry, not going to happen. One insurance company may try this, but a second would come along and realize that women are being over charged. They could create a policy that would be cheaper and attractive only to women. Women would then ‘self-select’ into that policy. When they do, the single priced policy would only be sold to men, and since the price is less than the risk for men, that company would go bankrupt. The men would then flock to the only other policy available, and the price of that policy is below the pooled risk, and that company also goes bankrupt. The result; no insurance market.
This is not a new idea. It comes from a paper written in 1976 by Michael Rothschild and Joseph Stiglitz: Equilibrium in Competitive Insurance Markets: An Essay on the Economics of Imperfect Information, The Quarterly Journal of Economics Vol. 90 No. 4 pp. 629-649
Clearly, insurance executives have read this paper, and politicians have not. The insurance industry has been notably silent on the issue because, in the short term, the only solution to non-discrimination is to increase the price women pay for insurance so it is the same as the premium that men pay. Women will be subsidizing the profits of the insurance company, but that is not discriminatory.
As we have previously tried to explain, markets are terribly efficient. We believe that insurance companies will create a mechanism that is not deemed discriminatory and that allows individuals to self-select into policies at the price they are currently paying. For example, insurance contracts are filled with exclusions – events under which the policy will not pay. (Terrorism, war etc.) We can propose a specific set of exclusions that will allow people to self-select into life insurance policies. Policy “A” has a low premium but does not pay out in the event of death from prostrate cancer. Policy “B” has a high premium and will not pay out in the event of breast cancer. Since there is no mention of the insured’s sex, these policies are not discriminatory. We will leave it up to the reader to figure out who buys which policy.
*Thanks to Graeme for drawing this one to our attention.
Tuesday, March 1, 2011
A Note on Sovereign Debt
A recent article, posted on Yahoo! News that discussed the possibility of the United States defaulting on their debt caught our attention, but only because of the misinformation that was implied. The United States Treasury currently owes approximately $14 trillion. (Click here for debt clock) The article suggests that if and when the US government defaults, debt holders will be able to take control of US assets.
The debt that is issued by sovereign nations is in the form of debentures, not bonds. The difference is that a bond is secured by a lien on a certain asset. In the event of default, the bond holder has the right to take possession of that asset. In this respect, a bond is similar to a mortgage. Stop paying your mortgage and the lender gets to take your house through foreclosure. A debenture, however, is not secured by any specific asset, but rather, is a claim on all assets. In the event of a default, assets are sold to meet the demands of debenture holders. In the event of a US default, debt holders are not entitled to seize ownership of Chicago.
Looking at the top 10 list, no regular reader of this blog should be surprised to see China in the number one spot. To keep the value of the yuan low, the Chinese government must continually buy up the excess supply of US dollars that result from the trade imbalance. These are held in the form of US government debt. The same is true of the Brazilian holdings. That country’s government is trying to prevent their currency from rising as well. Oil exporting countries also have a trade deficit with the US and thus hold US debt.
The Caribbean Banking Centres seems to surprise the author, but not us. Banks exist in the Caribbean to avoid taxes in the United States. Their deposits (liabilities) are predominantly in US dollars and therefore to avoid currency risk, most of their assets (debt instruments for example) should be held in US dollars. An educated guess would be that banks in Jersey and Guernsey would hold large amount of UK debt, and banks in the Seychelles would hold large quantities of euro denominated debt.
One last thing that the article does not mention is that the US government owes 14 trillion US dollars and the US Federal Reserve has the unlimited authority to print US dollars. If the world’s creditors demanded instant repayment of the entire outstanding debt, the US could simply turn on the printing presses and print $14 trillion. Note that this is not an option for the European PIIGS since they don’t have the authority to print euros.
We are currently negotiating with the US government to take control of Fort Zachary Taylor State Park as payment for our debt holdings. Not having much luck.
The debt that is issued by sovereign nations is in the form of debentures, not bonds. The difference is that a bond is secured by a lien on a certain asset. In the event of default, the bond holder has the right to take possession of that asset. In this respect, a bond is similar to a mortgage. Stop paying your mortgage and the lender gets to take your house through foreclosure. A debenture, however, is not secured by any specific asset, but rather, is a claim on all assets. In the event of a default, assets are sold to meet the demands of debenture holders. In the event of a US default, debt holders are not entitled to seize ownership of Chicago.
Looking at the top 10 list, no regular reader of this blog should be surprised to see China in the number one spot. To keep the value of the yuan low, the Chinese government must continually buy up the excess supply of US dollars that result from the trade imbalance. These are held in the form of US government debt. The same is true of the Brazilian holdings. That country’s government is trying to prevent their currency from rising as well. Oil exporting countries also have a trade deficit with the US and thus hold US debt.
The Caribbean Banking Centres seems to surprise the author, but not us. Banks exist in the Caribbean to avoid taxes in the United States. Their deposits (liabilities) are predominantly in US dollars and therefore to avoid currency risk, most of their assets (debt instruments for example) should be held in US dollars. An educated guess would be that banks in Jersey and Guernsey would hold large amount of UK debt, and banks in the Seychelles would hold large quantities of euro denominated debt.
One last thing that the article does not mention is that the US government owes 14 trillion US dollars and the US Federal Reserve has the unlimited authority to print US dollars. If the world’s creditors demanded instant repayment of the entire outstanding debt, the US could simply turn on the printing presses and print $14 trillion. Note that this is not an option for the European PIIGS since they don’t have the authority to print euros.
We are currently negotiating with the US government to take control of Fort Zachary Taylor State Park as payment for our debt holdings. Not having much luck.
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