An article in the Deutsche Welle caught our attention last night. (click here to read).
The author is suggesting that Europe could be facing a severe shortage of raw materials that are critical for technological advancements. The European Commission announced that an expert group has listed 14 materials facing a critical risk of shortage. They have also reported that demand for the materials could more than triple within 20 years. The main reasons for the shortage, according to their report, is due to the deposits being geographically concentrated (China, Brazil, Russia), the production function having low elasticity of substitution between inputs, and recycling rates. The report also warns that materials markets could become highly volatile due to rapid technological change that can lead to a change in the demand for these raw materials.
They go on to include the way some of these countries use trade and taxation policies to reserve their resources. China, which accounts for 95% of global rare-earth mineral production, will soon allocate the mining of its materials to a select number of state-owned companies.
EU Commissioner for Enterprise, Antonio Tajani, claims there is a need for “fair play” on raw material markets to allow the European industry access to these scarce resources.
Some of the EU’s recommendations in order to overcome the problem of materials shortage include proposals designed to increase mineral recycling, identifying substitutes and promoting greater exploration. They also advocate “the merits of pursuing dispute settlement initiatives” in order to ensure the supply of vital raw materials to the European industry.
The Government officials and industry representatives are discussing the launch of a raw materials agency. The agency, put together within the German Federal Institute for Geology and Raw Materials, would monitor global raw materials markets.
Ullrich Grillo, chairman of Grillo-Werke, a chemicals and minerals company and of the raw material working committee of the Federation of German Industries (BDI), told Deutsche Welle: "Without high-tech metals and also basic materials such as aluminum, copper and zinc, German industry is in danger."
Here is what we think... the authors got it all wrong. If economics teaches us anything, it is surely that the invisible hand is present and markets will adjust accordingly. If there is an expectation of a price increase, demand goes up and creates a shortage. So change the price! Those who value it the most will pay, and those who do not will find try and find substitutes, or move production to China.
When a shortage occurs, market prices will rise unless constrained by government. The increase in price signals firms to find more of these materials. For a historical lesson, see what happened to oil exploration spending after OPEC raised the price of oil from $6/bbl to $36/bbl in the early 1970’s. We note that an article last week in the Huffington Post suggested that there were abundant supplies of these metals in Afghanistan. (Click here for article)
Perhaps in future, we will delve into the Heckscher-Ohlin trade model which is based on factor endowments. We could also comment on the hypocrisy of Europe preaching about unfair trade, but not today.
Tuesday, June 29, 2010
Monday, June 28, 2010
Making a Market in Immigration
Gary Becker, Nobel laureate and professor at the University of Chicago has proposed a potential solution to the problem of illegal immigration, see article . He thinks the key is in market mechanisms, arguing that immigration is a problem due to the absence of a price to match supply and demand.
His suggestion was an allocation of visas, by which governments would either sell the right to migration at a price that would match the desired number of migrants, or by auctioning off a predetermined number of visas. (Think of it as what we learn in environmental economics 101 with pollution permits). Governments could also adjust the price yearly in order to maintain control over the desired number of immigrants with respect to changing labour-market conditions.
A price for immigrations would mean that those with the highest willingness to pay (or highest value) would get the ability to migrate. Not only are the migrants better off by paying this (large) fee, but the receiving country benefits as well. Immigrants with the highest value, would gain the most economic benefit from migrating, presumably those whose wages would increase the most. The innovative engineer for example. But what about those who would potentially be worse off, if they were opposed to immigration in the first place? As with all solutions in microeconomics to these welfare problems, we learn that these people must be made just as well off (if not better), say by compensating them with raised revenues from fees collected by migrants.
The article gives some simple math:
Charging $50,000 for the right to immigrate would net America $50 billion if it let in 1m immigrants, roughly as many as it currently admits legally.
For those who are talented and unable to pay, My Becker proposes a sort of “student-loan” repayment system under which they may borrow from the government or potential employers. The former does not do much at first to reduce budget deficits. The latter has been tried before, in the 19th century and was called indentured servitude.
Abhijit Banerjee of the Massachusetts Institute of Technology thinks the system of “indenture” would still have problems, claiming that the immigrant would receive a lower wage than if he were a local. But that doesn’t sound quite right to us, and sadly we have been absorbed in Alchien and Demsetz, Shapiro Stiglitz and Wellitz for a few months now.
The case for anti-shirking suggests that it is possible to get higher wages in team production with monitoring, not lower ones. Also it is possible that the marginal product of the new immigrant is higher than the locals, and in team production would thus increase overall productivity.
A last thought? The richer countries can try to help the poorer ones develop economically, as that would reduce the number of immigrants into who want to work elsewhere.
Gary’s website can be found here:
Production, Information Costs, and Economic Organization, Armen A. Alchian and Harold Demsetz, The American Economic Review, Vol. 62, No. 5 (Dec., 1972), pp. 777-795
Equilibrium Unemployment as a Worker Discipline Device, Carl Shapiro and Joseph E. Stiglitz, American Economic Review, Vol 74 No 3 (Jun 1984) pp 433-444
Supervision, Loss of Control, and the Optimum Size of the Firm, Guillermo A. Calvo and Stanislaw Wellisz, The Journal of Political Economy, Vol. 86, No. 5 (Oct., 1978), pp. 943-952
His suggestion was an allocation of visas, by which governments would either sell the right to migration at a price that would match the desired number of migrants, or by auctioning off a predetermined number of visas. (Think of it as what we learn in environmental economics 101 with pollution permits). Governments could also adjust the price yearly in order to maintain control over the desired number of immigrants with respect to changing labour-market conditions.
A price for immigrations would mean that those with the highest willingness to pay (or highest value) would get the ability to migrate. Not only are the migrants better off by paying this (large) fee, but the receiving country benefits as well. Immigrants with the highest value, would gain the most economic benefit from migrating, presumably those whose wages would increase the most. The innovative engineer for example. But what about those who would potentially be worse off, if they were opposed to immigration in the first place? As with all solutions in microeconomics to these welfare problems, we learn that these people must be made just as well off (if not better), say by compensating them with raised revenues from fees collected by migrants.
The article gives some simple math:
Charging $50,000 for the right to immigrate would net America $50 billion if it let in 1m immigrants, roughly as many as it currently admits legally.
For those who are talented and unable to pay, My Becker proposes a sort of “student-loan” repayment system under which they may borrow from the government or potential employers. The former does not do much at first to reduce budget deficits. The latter has been tried before, in the 19th century and was called indentured servitude.
Abhijit Banerjee of the Massachusetts Institute of Technology thinks the system of “indenture” would still have problems, claiming that the immigrant would receive a lower wage than if he were a local. But that doesn’t sound quite right to us, and sadly we have been absorbed in Alchien and Demsetz, Shapiro Stiglitz and Wellitz for a few months now.
The case for anti-shirking suggests that it is possible to get higher wages in team production with monitoring, not lower ones. Also it is possible that the marginal product of the new immigrant is higher than the locals, and in team production would thus increase overall productivity.
A last thought? The richer countries can try to help the poorer ones develop economically, as that would reduce the number of immigrants into who want to work elsewhere.
Gary’s website can be found here:
Production, Information Costs, and Economic Organization, Armen A. Alchian and Harold Demsetz, The American Economic Review, Vol. 62, No. 5 (Dec., 1972), pp. 777-795
Equilibrium Unemployment as a Worker Discipline Device, Carl Shapiro and Joseph E. Stiglitz, American Economic Review, Vol 74 No 3 (Jun 1984) pp 433-444
Supervision, Loss of Control, and the Optimum Size of the Firm, Guillermo A. Calvo and Stanislaw Wellisz, The Journal of Political Economy, Vol. 86, No. 5 (Oct., 1978), pp. 943-952
Sunday, June 27, 2010
Why There Aren’t Microeconomists at the G20
An op-ed piece in Thursday’s Globe and Mail written by a professor and the dean of the Haskayne School of Business at the University of Calgary has caught our attention and deserves a comment or six. The article makes an argument for having micro economists at the G20 Summit, claiming that more understanding of individuals’ behaviour and the effect of regulations and institutions is required to solve the world’s macro economic problems. (Click here for the article)
We agree with the contention, but think we can offer an explanation for why that doesn’t happen. First, let us point out that there are macroeconomic models that are built on the principles of microeconomics. Unfortunately, there are few textbooks that use these models and even fewer professors that teach these models. One notable exception is the intermediate text: Macroeconomics by Stephen D. Williamson, published by Pearson. Most principles and intermediate texts use the Keynesian model or some form of it. The Keynesian model suggests that governments can borrow and spend to correct business cycle activity. Unfortunately, the Keynesian model assumes away a lot of consumer and firm behaviour. We offer a couple of recent newspaper articles at to illustrate this concept.
An article in the Globe and Mail published June 14 talks about the proposed changes to the Canada Pension Plan. It is argued that Canadians are not saving enough for their retirement and so the government is stepping in to increase Canada pension plan benefits and to pay for these benefits are increasing the payroll tax. The argument here is that the government can get us to save by forcing us to do so through the tax system. The microeconomist, however, will tell you that income taxes reduce the incentive to work and also reduce the ability to save. Workers don't actually care what the stated wage rate is what they care about is how much money ends up in their bank account every two weeks. An increase in CPP contributions reduces the amount that ends up in their bank accounts. This causes a reduction in both consumption and savings. (Click here for the article.)
Another article on June 26 of the Vancouver province indicates that British Columbians plan to cut back on spending after the HST is introduced on July 1. In this case the microeconomist will tell you that the HST does not reduce disposable income but instead changes relative prices. The amount of money going into the bank account every two weeks will be the same before and after the implementation of the HST. What will happen is that some items will become relatively more expensive than others, while some will become relatively less expensive. This causes a change in spending patterns but not necessarily in the level of spending. That is why most economists favour consumption taxes over income taxes.(Click here for the article)
When we apply microeconomics theory to macroeconomic policy we begin to look at the reactions of individuals to government policies. One of the biggest debates is whether or not governments can stimulate the economy through borrowing. The argument in favour suggests that when consumer spending, private investment spending and/or net export spending falls, the government can (and should) step in and increase their spending to keep the economy moving. The argument against, looks at how the government funds this spending. If the government increases taxes to pay for the increase, consumer and investment spending may fall by an amount equal to the increase in government spending. If the government borrows the money, they create a future tax liability for payment of interest and perhaps the principal. In 1974 paper published in the Journal of Political Economy, Professor Robert Barro showed that the net effect of government spending financed by borrowing could be zero.
So why then do we not see more application of microeconomic principles to macroeconomic policy? Perhaps we need to look at the behaviour of politicians whose objective is to stay in power. Macroeconomic policies based on Keynesian models lead to big governments. Macroeconomic policies based on microeconomic principles lead to smaller governments. Politicians like bigger governments. Perhaps that is the reason there are no microeconomists at the G20 Summit.
Cited:
Are Government Bonds Net Wealth? Robert J. Barro, The Journal of Political Economy Vol. 82 No. 6, Nov 1974
We agree with the contention, but think we can offer an explanation for why that doesn’t happen. First, let us point out that there are macroeconomic models that are built on the principles of microeconomics. Unfortunately, there are few textbooks that use these models and even fewer professors that teach these models. One notable exception is the intermediate text: Macroeconomics by Stephen D. Williamson, published by Pearson. Most principles and intermediate texts use the Keynesian model or some form of it. The Keynesian model suggests that governments can borrow and spend to correct business cycle activity. Unfortunately, the Keynesian model assumes away a lot of consumer and firm behaviour. We offer a couple of recent newspaper articles at to illustrate this concept.
An article in the Globe and Mail published June 14 talks about the proposed changes to the Canada Pension Plan. It is argued that Canadians are not saving enough for their retirement and so the government is stepping in to increase Canada pension plan benefits and to pay for these benefits are increasing the payroll tax. The argument here is that the government can get us to save by forcing us to do so through the tax system. The microeconomist, however, will tell you that income taxes reduce the incentive to work and also reduce the ability to save. Workers don't actually care what the stated wage rate is what they care about is how much money ends up in their bank account every two weeks. An increase in CPP contributions reduces the amount that ends up in their bank accounts. This causes a reduction in both consumption and savings. (Click here for the article.)
Another article on June 26 of the Vancouver province indicates that British Columbians plan to cut back on spending after the HST is introduced on July 1. In this case the microeconomist will tell you that the HST does not reduce disposable income but instead changes relative prices. The amount of money going into the bank account every two weeks will be the same before and after the implementation of the HST. What will happen is that some items will become relatively more expensive than others, while some will become relatively less expensive. This causes a change in spending patterns but not necessarily in the level of spending. That is why most economists favour consumption taxes over income taxes.(Click here for the article)
When we apply microeconomics theory to macroeconomic policy we begin to look at the reactions of individuals to government policies. One of the biggest debates is whether or not governments can stimulate the economy through borrowing. The argument in favour suggests that when consumer spending, private investment spending and/or net export spending falls, the government can (and should) step in and increase their spending to keep the economy moving. The argument against, looks at how the government funds this spending. If the government increases taxes to pay for the increase, consumer and investment spending may fall by an amount equal to the increase in government spending. If the government borrows the money, they create a future tax liability for payment of interest and perhaps the principal. In 1974 paper published in the Journal of Political Economy, Professor Robert Barro showed that the net effect of government spending financed by borrowing could be zero.
So why then do we not see more application of microeconomic principles to macroeconomic policy? Perhaps we need to look at the behaviour of politicians whose objective is to stay in power. Macroeconomic policies based on Keynesian models lead to big governments. Macroeconomic policies based on microeconomic principles lead to smaller governments. Politicians like bigger governments. Perhaps that is the reason there are no microeconomists at the G20 Summit.
Cited:
Are Government Bonds Net Wealth? Robert J. Barro, The Journal of Political Economy Vol. 82 No. 6, Nov 1974
Friday, June 25, 2010
More on British Petroleum and the Cost of Capital
Just an Update on our previous blog about the market's estimate of the economic damage resulting from the Gulf of Mexico oil spill. Today, shares of BP closed below 300 pence in London representing a drop in market value of over $100 billion since the Deepwater Horizon sank on April 22nd. Click here to see the story from the Financial Times.
Earlier this week BP indicated that they would be raising $10 billion in the bond market to help fund a $20 billion escrow account that they had agreed to with the United States government. In addition BP has suspended their quarterly dividend to conserve cash. A June 8th article in the New York Times suggests that the cost of the oil spill may one day lead to the bankruptcy of British Petroleum in much the same way that Texaco was forced to file for bankruptcy protection in 1987. Bond markets appear to be pricing in the probability of bankruptcy as the yield spread is now 539 basis points above the benchmark. Before the Gulf crisis BPs bonds yielded 41 basis points above the benchmark. (The benchmark is the yield on British government bonds, and a basis point is 1/100 of 1%). A Bloomberg Businessweek article explains the effect of the higher interest rate on British Petroleum.
As the risk of default rises, bond prices fall and yields rise. To put the probability of bankruptcy into perspective, Greek 10 year bonds are trading today at 779 basis points over the benchmark German bonds. The market is suggesting that Greece is more likely to default than British Petroleum.
When a company such as British Petroleum needs to raise capital, for either investment purposes or contingency funds as in this case, they have several options. They could sell new common or preferred shares or use their retained earnings, all of which are forms of equity. The other option is to borrow the money. They can do this using lines of credit, issuing bonds, or debentures which are forms of debt. The choice between debt and equity depends on the relative costs of the two forms of capital. Firms attempt to minimize the cost of their capital by choosing appropriate weights for equity and debt. As the level of debt increases, the riskiness of the firm increases and interest rates on their debt rise. Increased levels of debt do however increase the yields on equity, so there is a trade-off between the higher levels of debt and high levels of equity. It is estimated that the yield on BPs $10 billion debt show will be in the 8 to 10% range. The last dividend payment in May represented a 6.75% yield on its equity. With the drop in BPs share price the cost of equity capital is now much larger, on an after-tax basis, then the cost of debt even with other risk premiums of over 500 basis points.
We will continue to follow this story and bring you updates when the bonds go to market.
For more on the cost of capital in the capital structure decision see:
Fundamentals of Corporate Finance; Richard A Brealey, Stewart C. Myers et al., McGraw-Hill Ryerson, Chapters 11 and 15
Earlier this week BP indicated that they would be raising $10 billion in the bond market to help fund a $20 billion escrow account that they had agreed to with the United States government. In addition BP has suspended their quarterly dividend to conserve cash. A June 8th article in the New York Times suggests that the cost of the oil spill may one day lead to the bankruptcy of British Petroleum in much the same way that Texaco was forced to file for bankruptcy protection in 1987. Bond markets appear to be pricing in the probability of bankruptcy as the yield spread is now 539 basis points above the benchmark. Before the Gulf crisis BPs bonds yielded 41 basis points above the benchmark. (The benchmark is the yield on British government bonds, and a basis point is 1/100 of 1%). A Bloomberg Businessweek article explains the effect of the higher interest rate on British Petroleum.
As the risk of default rises, bond prices fall and yields rise. To put the probability of bankruptcy into perspective, Greek 10 year bonds are trading today at 779 basis points over the benchmark German bonds. The market is suggesting that Greece is more likely to default than British Petroleum.
When a company such as British Petroleum needs to raise capital, for either investment purposes or contingency funds as in this case, they have several options. They could sell new common or preferred shares or use their retained earnings, all of which are forms of equity. The other option is to borrow the money. They can do this using lines of credit, issuing bonds, or debentures which are forms of debt. The choice between debt and equity depends on the relative costs of the two forms of capital. Firms attempt to minimize the cost of their capital by choosing appropriate weights for equity and debt. As the level of debt increases, the riskiness of the firm increases and interest rates on their debt rise. Increased levels of debt do however increase the yields on equity, so there is a trade-off between the higher levels of debt and high levels of equity. It is estimated that the yield on BPs $10 billion debt show will be in the 8 to 10% range. The last dividend payment in May represented a 6.75% yield on its equity. With the drop in BPs share price the cost of equity capital is now much larger, on an after-tax basis, then the cost of debt even with other risk premiums of over 500 basis points.
We will continue to follow this story and bring you updates when the bonds go to market.
For more on the cost of capital in the capital structure decision see:
Fundamentals of Corporate Finance; Richard A Brealey, Stewart C. Myers et al., McGraw-Hill Ryerson, Chapters 11 and 15
Thursday, June 24, 2010
Spirit Airlines
We can only imagine what must have taken place at Spirit Airlines.
Mr. Lacky from the CEO’s office must have called Mr. Spindoctor from the marketing department and the conversation went something like this:
Mr. Lacky: “Hey ‘Spin’, the boss is complaining that revenue is down this quarter and wants you to do something about it.”
Mr. Spindoctor: “Sure Lacky, I think there are two dumb economists on the Ft. Lauderdale beach I can contact to see what’s going on.”
Mr. Lacky: “Do it now and get a campaign going ASAP!”
The marketing department does indeed call the dumb economists. That conversation went something like this:
Ms. Anonyme: “Hello, who is it?”
Mr. Spindoctor: “I am looking for one of the two dumb economists.”
Ms. Anonyme: “Mike is out on the water trying to master the longboard what can I do for you?”
Mr. Spindoctor: “It's Spin calling from Spirit Airlines. I wonder if you can tell me why our revenues are down this quarter so that I can develop a marketing campaign.”
Ms. Anonyme: “Well, besides the fact that your pilots have been on strike, there is this little issue about reports of oil floating up on the beaches in and around the Gulf states. This would probably reduce demand for your services in Florida.”
Mr. Spindoctor: “Oh, so if we reduce our prices then demand will go back up. Have I got that right?”
Ms. Anonyme: “Not quite, but close. One of our first year students can explain the error in your statement. The number of tickets you sell will depend on the price elasticity and on the oil elasticity of demand. You may be able to reduce the price enough to offset the reduced demand because of the oil. You may also be able to increase the demand if you can give people a good enough reason to visit Florida in spite of the oil spill.”
Mr. Spindoctor: “Okay great. I got it now. Thanks.”
Spirit Airlines advertising campaign?
“Check out the oil on our beaches. You won’t be disappointed.”
Apparently, not very many people saw the humour. Given our fondness for Florida, we did, but you might have to read the CBS story for insight. (Click here)
Click here to find out more about Spirit Airlines.
Mr. Lacky from the CEO’s office must have called Mr. Spindoctor from the marketing department and the conversation went something like this:
Mr. Lacky: “Hey ‘Spin’, the boss is complaining that revenue is down this quarter and wants you to do something about it.”
Mr. Spindoctor: “Sure Lacky, I think there are two dumb economists on the Ft. Lauderdale beach I can contact to see what’s going on.”
Mr. Lacky: “Do it now and get a campaign going ASAP!”
The marketing department does indeed call the dumb economists. That conversation went something like this:
Ms. Anonyme: “Hello, who is it?”
Mr. Spindoctor: “I am looking for one of the two dumb economists.”
Ms. Anonyme: “Mike is out on the water trying to master the longboard what can I do for you?”
Mr. Spindoctor: “It's Spin calling from Spirit Airlines. I wonder if you can tell me why our revenues are down this quarter so that I can develop a marketing campaign.”
Ms. Anonyme: “Well, besides the fact that your pilots have been on strike, there is this little issue about reports of oil floating up on the beaches in and around the Gulf states. This would probably reduce demand for your services in Florida.”
Mr. Spindoctor: “Oh, so if we reduce our prices then demand will go back up. Have I got that right?”
Ms. Anonyme: “Not quite, but close. One of our first year students can explain the error in your statement. The number of tickets you sell will depend on the price elasticity and on the oil elasticity of demand. You may be able to reduce the price enough to offset the reduced demand because of the oil. You may also be able to increase the demand if you can give people a good enough reason to visit Florida in spite of the oil spill.”
Mr. Spindoctor: “Okay great. I got it now. Thanks.”
Spirit Airlines advertising campaign?
“Check out the oil on our beaches. You won’t be disappointed.”
Apparently, not very many people saw the humour. Given our fondness for Florida, we did, but you might have to read the CBS story for insight. (Click here)
Click here to find out more about Spirit Airlines.
Wednesday, June 16, 2010
Network Externalities
EasyJet Hopes Ash Cloud Radar Will Take Off
Dr Fred Prata of the Norwegian Institute for Air Research, has developed a new technology called AVOID (Airborne Volcanic Object Identifier and Detector). Click here for article.
The system uses infrared technology which is placed onto aircrafts, and allows pilots and flight control to receive images of ash clouds. Corrections to the plane’s flight path can then be made. This has the potential to minimise future disturbance to planes from volcanic ash clouds.
There was no commercial interest in the system until ash from Iceland’s volcano caused extensive disruption of European airspace in April and May, at an estimated cost to airlines of more than $1.7bn.
AVOID will initially be trialed by EasyJet airline, who announced the disruption cost the company an estimated £50-75m, or half of its expected profit. They have agreed with Mr Prata to spend £1m testing the technology. It will be assessed on an A340 test aircraft owned by Airbus and then, if the results are favorable, fitted to a dozen EasyJet planes.
On the ground, information from aircraft with the technology would be collected to build an image of the volcanic ash cloud using real-time data. Clear areas of airspace can then remain open that would otherwise be closed during a volcanic eruption, minimizing disruptions.
The goal is not for EasyJet to gain commercial advantage over other airlines, but rather to make AVOID an industry standard. The system does help individual pilots to avoid ash, but the main benefit would be in installing AVOID on hundreds of aircraft in order to build an accurate ash map for the whole of Europe.
Let’s look at this for fun…A list of the top ten airlines in the world by fleet size.
Microeconomics 5th Edition, Jeffrey M. Perloff, Pearson (Ch 11)
Intermediate Microeconomics, Hal R. Varian, Norton (Ch 35)
Dr Fred Prata of the Norwegian Institute for Air Research, has developed a new technology called AVOID (Airborne Volcanic Object Identifier and Detector). Click here for article.
The system uses infrared technology which is placed onto aircrafts, and allows pilots and flight control to receive images of ash clouds. Corrections to the plane’s flight path can then be made. This has the potential to minimise future disturbance to planes from volcanic ash clouds.
There was no commercial interest in the system until ash from Iceland’s volcano caused extensive disruption of European airspace in April and May, at an estimated cost to airlines of more than $1.7bn.
AVOID will initially be trialed by EasyJet airline, who announced the disruption cost the company an estimated £50-75m, or half of its expected profit. They have agreed with Mr Prata to spend £1m testing the technology. It will be assessed on an A340 test aircraft owned by Airbus and then, if the results are favorable, fitted to a dozen EasyJet planes.
On the ground, information from aircraft with the technology would be collected to build an image of the volcanic ash cloud using real-time data. Clear areas of airspace can then remain open that would otherwise be closed during a volcanic eruption, minimizing disruptions.
The goal is not for EasyJet to gain commercial advantage over other airlines, but rather to make AVOID an industry standard. The system does help individual pilots to avoid ash, but the main benefit would be in installing AVOID on hundreds of aircraft in order to build an accurate ash map for the whole of Europe.
Let’s look at this for fun…A list of the top ten airlines in the world by fleet size.
The total is 4,230. Generously multiply this by 7 to estimate roughly how many planes we have flying around, and we get 29, 610. If the present value of the royalty was $1,000 per plane the royalties would be $29, 610, 000. Compare this to the estimated losses of $1.7bn. With regards to our previous posts on patents, it is clear that the network externalities dominate the patent revenues. Here, the positive network externalities of AVOID are only beneficial to their full extent if everyone adopts (or a critical mass) this technology.
Not all network externalities are positive however. Take, for example, the case of the Indian transportation system - a topic we'll discuss later ... maybe. Click here for article.
Not all network externalities are positive however. Take, for example, the case of the Indian transportation system - a topic we'll discuss later ... maybe. Click here for article.
For a little refresher on network externalities see:
Intermediate Microeconomics, Hal R. Varian, Norton (Ch 35)
BP and the Efficiency of Markets
The efficient market hypothesis suggests that current stock market prices incorporate all of the information known about a company at the current time. There are three different forms of the hypothesis; the weak form that incorporates all information about current stock prices, the semi-strong form that incorporates all public information, then the strong form that incorporates all public and private information.
To illustrate how the efficient market hypothesis works we can examine the effect of the Deepwater Horizon and disaster on the price of British Petroleum shares. The Deepwater Horizon sank on April 22, 2010 and at that time British Petroleum estimated the leakage at 5000 barrels per day. On April 19th BP shares were trading at $58.50 on the New York Stock Exchange. Ten days after the sinking, BP shares had fallen to $51.70. The market did not believe that the leaker was 5000 barrels per day. With roughly 3.1 billion shares outstanding the market had effectively cut just over $21 billion from BP’s market value.
By the beginning of June when all other attempts to the leak had failed and BP finally cut the pipe BPs market price had fallen to less than $37 a share. At that time estimates of the leakage had risen to 95,000 barrels per day.
Today shares are trading in the $30 range and despite their best efforts estimates of the leakage are still 60,000 barrels per day. It would appear that the markets new on April 22 roughly how large the damage was and began to incorporate that information into the stock price even though official estimates at the time were far less severe. We may not yet know the full extent of the financial damage caused by the oil spill but the market is putting an estimate well in excess of BPs 12 billion dollar cash reserve. British Petroleum is facing a suspension of its dividend and the potential for issuance of debt to pay what is now estimated at cleanup cost and liability payments in excess of $20 billion.
Anecdotal evidence suggests markets knew right away that the BP oils bill was far larger than initially reported giving some credence to the strong form of the efficient market hypothesis.
Click here for an April 29th NY Times article suggesting damage in the “hundreds of millions”
Click here for a June 15th Reuters article estimating oil flow after the cap was installed.
Click here for a June 16th Associated Press article indicating BP is setting aside $20 billion for relief
To illustrate how the efficient market hypothesis works we can examine the effect of the Deepwater Horizon and disaster on the price of British Petroleum shares. The Deepwater Horizon sank on April 22, 2010 and at that time British Petroleum estimated the leakage at 5000 barrels per day. On April 19th BP shares were trading at $58.50 on the New York Stock Exchange. Ten days after the sinking, BP shares had fallen to $51.70. The market did not believe that the leaker was 5000 barrels per day. With roughly 3.1 billion shares outstanding the market had effectively cut just over $21 billion from BP’s market value.
By the beginning of June when all other attempts to the leak had failed and BP finally cut the pipe BPs market price had fallen to less than $37 a share. At that time estimates of the leakage had risen to 95,000 barrels per day.
Today shares are trading in the $30 range and despite their best efforts estimates of the leakage are still 60,000 barrels per day. It would appear that the markets new on April 22 roughly how large the damage was and began to incorporate that information into the stock price even though official estimates at the time were far less severe. We may not yet know the full extent of the financial damage caused by the oil spill but the market is putting an estimate well in excess of BPs 12 billion dollar cash reserve. British Petroleum is facing a suspension of its dividend and the potential for issuance of debt to pay what is now estimated at cleanup cost and liability payments in excess of $20 billion.
Anecdotal evidence suggests markets knew right away that the BP oils bill was far larger than initially reported giving some credence to the strong form of the efficient market hypothesis.
Click here for an April 29th NY Times article suggesting damage in the “hundreds of millions”
Click here for a June 15th Reuters article estimating oil flow after the cap was installed.
Click here for a June 16th Associated Press article indicating BP is setting aside $20 billion for relief
Monday, June 14, 2010
Monopoly vs Rent Seeking
Given that we have a "Rent-Seekers" Club, one might expect that we are fundamentally opposed to monopolies. One would be wrong.
A monopoly exists when there is only one firm in an industry and there is a barrier to other firms entering. Rent-Seekers attempt to influence government policy to create or maintain such barriers. This is the case of Indigo Books and Music Inc., and the B.C. Association of Optometrists that we referred to in previous posts. There is, however another way for a barrier to entry to be obtained and that is the granting of a patent.
A patent is an exclusive license to produce a product or use a process for a specified period (20 years from date of application). To obtain a patent, you must have an original invention and make an application to the Federal Government. As with rent-seeking, a patent restricts competition and allows for monopoly profits. They will both also create a dead-weight loss. The following illustration of the deadweight loss triangle can be found in any Micro Principles text.
This is where the difference lies. The dead-weight loss from rent-seeking is hard to justify. The dead-weight loss from a patent is easy to justify. Patents are issued for innovation, the result of research and development. Since R&D typically has positive spillover effects, the economy as a whole benefits and the dead-weight loss of the monopoly is at least partially, if not fully, offset.
The growth can be illustrated by looking at the effects of a technological change on the production possibilities curve, or by application of the Solow production function.
There is a time limit on patents to encourage further research. Typically, firms that are granted patents use some of the monopoly profits to fund their research departments. This reinvestment sustains growth over the long term.
A Globe and Mail article explaining the use of patents can be found by clicking here.
A monopoly exists when there is only one firm in an industry and there is a barrier to other firms entering. Rent-Seekers attempt to influence government policy to create or maintain such barriers. This is the case of Indigo Books and Music Inc., and the B.C. Association of Optometrists that we referred to in previous posts. There is, however another way for a barrier to entry to be obtained and that is the granting of a patent.
A patent is an exclusive license to produce a product or use a process for a specified period (20 years from date of application). To obtain a patent, you must have an original invention and make an application to the Federal Government. As with rent-seeking, a patent restricts competition and allows for monopoly profits. They will both also create a dead-weight loss. The following illustration of the deadweight loss triangle can be found in any Micro Principles text.
This is where the difference lies. The dead-weight loss from rent-seeking is hard to justify. The dead-weight loss from a patent is easy to justify. Patents are issued for innovation, the result of research and development. Since R&D typically has positive spillover effects, the economy as a whole benefits and the dead-weight loss of the monopoly is at least partially, if not fully, offset.
The growth can be illustrated by looking at the effects of a technological change on the production possibilities curve, or by application of the Solow production function.
There is a time limit on patents to encourage further research. Typically, firms that are granted patents use some of the monopoly profits to fund their research departments. This reinvestment sustains growth over the long term.
A Globe and Mail article explaining the use of patents can be found by clicking here.
Monday, June 7, 2010
Fireworks
Everyone loves a good fireworks show, so why is it so difficult to stage Vancouver's Celebration of Lights every year? After two weeks of uncertainty surrounding funding, the organizers have now confirmed that the show will go ahead this year.
It is estimated that 1.4 million people watch the pyrotechnic display over the four days in July.
In economics, we identify a "public good" as a good or service which is non-exclusive and non-rivalrous. The first term means that the exhibitor cannot stop someone from enjoying the show if they refuse to pay. The second term means that one more person watching the show does not detract from the enjoyment of everyone else. When these conditions are present, private firms have no incentive to produce.
If everyone that watched the shows sent $3 each to the organizers, the show would have sufficient funding for next year's production. But suppose that I go to English Bay and don't pay. After all $4.2 million minus $3 is still very close to $4.2 million. What if everyone thinks that way? No show next year.
Public goods must be provided by the government or by some institution that can raise funds. Previous to a change in advertising laws, Benson & Hedges sponsored the show under the name "Symphony of Fire".
Perhaps some marketing student somewhere can think of a novel way to raise funds for next year's show.
Click here for the Celebration of Lights website.
It is estimated that 1.4 million people watch the pyrotechnic display over the four days in July.
In economics, we identify a "public good" as a good or service which is non-exclusive and non-rivalrous. The first term means that the exhibitor cannot stop someone from enjoying the show if they refuse to pay. The second term means that one more person watching the show does not detract from the enjoyment of everyone else. When these conditions are present, private firms have no incentive to produce.
If everyone that watched the shows sent $3 each to the organizers, the show would have sufficient funding for next year's production. But suppose that I go to English Bay and don't pay. After all $4.2 million minus $3 is still very close to $4.2 million. What if everyone thinks that way? No show next year.
Public goods must be provided by the government or by some institution that can raise funds. Previous to a change in advertising laws, Benson & Hedges sponsored the show under the name "Symphony of Fire".
Perhaps some marketing student somewhere can think of a novel way to raise funds for next year's show.
Click here for the Celebration of Lights website.
Thursday, June 3, 2010
Lessons from the Labour Market
Suppose you manage a firm with 100 employees making $800 each per week for a total payroll of $80,000. As a result of the recession you must reduce payroll expenses by 10%. There are two ways to do this: layoff 10 employees, or cut everybody's pay by $80 a week. Both of these options will cause employee discontent so how do you decide which option to choose. Let's put it to vote. What do you think the results of the vote will be? The 10% of the employees that would likely face a layoff will vote in favour of the pay cut while the 90% of employees that would likely keep their jobs would go for the layoffs. By simple democracy 10% of people get laid off. This is one application of the insider-outsider theorem.
Michael Bloomberg, the mayor of New York, has recently announced that teachers in New York City must forgo their pay increase to prevent the loss of 4,400 jobs. (Click here for the article). Apparently Michael Mulgrew, president of the teachers union, is not impressed. The New York school board employs approximately 80,000 teachers. How you think the union members will vote if given the choice between a pay freeze and 4,400 layoffs?
Michael Bloomberg, the mayor of New York, has recently announced that teachers in New York City must forgo their pay increase to prevent the loss of 4,400 jobs. (Click here for the article). Apparently Michael Mulgrew, president of the teachers union, is not impressed. The New York school board employs approximately 80,000 teachers. How you think the union members will vote if given the choice between a pay freeze and 4,400 layoffs?
Tuesday, June 1, 2010
We Were Right!
Last week we predicted that interest rates would either rise or stay the same. Today, Bank of Canada Gov. Mark Carney raised the target overnight rate to 0.50% from 0.25%. Monetary policy really is easy!
Two factors determine the rate increase. First, the inflation rate is only slightly lower than the Bank's 2% target. Second, GDP growth in the first quarter of 2010 was an astounding 6.1% annualized. Higher growth rates signal increased inflation. An increase in interest rates is designed to slow growth and reduce inflationary pressure.
So why did the Canadian dollar fall today? Normally an increase in interest rates causes capital inflows. The demand for Canadian dollars increases in the dollar rises. Statements made by the Bank of Canada regarding global growth indicate that this may not be the start of a gradual rise in interest rates as was expected.
Unemployment in the euro zone increased in May to 10.1%, Chinese manufacturing slowed in May and their housing bubble is increasing the risk of an economic slowdown.
Global economic slowdown reduces resource demand and the Canadian dollar falls.
Two factors determine the rate increase. First, the inflation rate is only slightly lower than the Bank's 2% target. Second, GDP growth in the first quarter of 2010 was an astounding 6.1% annualized. Higher growth rates signal increased inflation. An increase in interest rates is designed to slow growth and reduce inflationary pressure.
So why did the Canadian dollar fall today? Normally an increase in interest rates causes capital inflows. The demand for Canadian dollars increases in the dollar rises. Statements made by the Bank of Canada regarding global growth indicate that this may not be the start of a gradual rise in interest rates as was expected.
Unemployment in the euro zone increased in May to 10.1%, Chinese manufacturing slowed in May and their housing bubble is increasing the risk of an economic slowdown.
Global economic slowdown reduces resource demand and the Canadian dollar falls.
The Penny hits Senior Age
The Senate Finance Committee is discussing the future of the Canadian penny. The issue is whether to keep it or abandon it and round prices up to the nearest five cents.
Currency has long been a source of revenue for governments. It currently costs nine cents to produce a $20 bill. The difference between the cost of production the face value is revenue to the government, known as seigniorage. (It's a little more complicated than this. See link for details on the seigniorage from currency).
It currently costs about 1.5 cents to produce a penny. The seigniorage is negative. In the last 100 years, 33.9 billion pennies have been minted. (Source: Royal Canadian Mint) They didn't wear out, so where are they all? In your penny jar and mine will of course.
Getting rid of the penny will cause prices to rise. A $0.96 item will now be $1.00, a 4.16% increase. A $499.99 item becomes $500, an increase of 0.002%. This, however, is not inflation. One day will explain why.
Currency has long been a source of revenue for governments. It currently costs nine cents to produce a $20 bill. The difference between the cost of production the face value is revenue to the government, known as seigniorage. (It's a little more complicated than this. See link for details on the seigniorage from currency).
It currently costs about 1.5 cents to produce a penny. The seigniorage is negative. In the last 100 years, 33.9 billion pennies have been minted. (Source: Royal Canadian Mint) They didn't wear out, so where are they all? In your penny jar and mine will of course.
Getting rid of the penny will cause prices to rise. A $0.96 item will now be $1.00, a 4.16% increase. A $499.99 item becomes $500, an increase of 0.002%. This, however, is not inflation. One day will explain why.
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