Proposition 19 is the ballot initiative in California that, if passed, will legalize the possession and cultivation of small amounts of marijuana for personal use. As economists, we get to ignore the ethical and political implications and focus only on the impact on markets. The Globe and Mail published and interesting article on Saturday about the implications for BC (click here for article).
There are some issues in the article that we believe need clarification. The first has to do with the increase in demand and supply of pot in California if Proposition 19 is approved. We agree that the cost of marijuana will fall, but only because of the reduction in risk, not due to economies of scale. Marijuana would still be illegal under the Federal Controlled Substances Act and thus, large scale facilities are not likely to emerge due to the threat of federal prosecution. There are roughly 37 million people living in California and there aren't enough DEA agents to arrest all users, only commercial growers. The demand for marijuana is not likely to increase if it is legalized. We need only look at the number of people that speed, run red lights, use cellular phone and refuse to buckle up to know that people don't obey laws. If the benefit exceeds the cost, people will break laws. The penalty for possession of small amounts of marijuana is trivial so the risk is not likely to change. The price of marijuana will almost certainly decrease (depending on the tax) and usage may increase.
Secondly, the author makes some claims about the economic effects on BC. There will be no reduction in BC's GDP, only because the marijuana trade is illegal and not included in GDP in the first place. Likewise, the people employed in the marijuana industry do not show up on Statistics Canada employment numbers and those wouldn't change either. The article implicitly assumes that all marijuana cultivated in BC is shipped to California. The US has a population of 310 million. (On a recent trip to Florida, I was golfing with some gentlemen from Baltimore. When the learned I was from BC, they commented that we grew great bud ... I don't think they meant beer)
If, and when marijuana is legalized in California, BC would stand to benefit by also legalizing the cultivation of marijuana. We have several greenhouses that currently grow bell peppers that retail at $1.99/lb. Enterprising greenhouse owners would remove those crops and replace them with marijuana. That would be the short term response. The long term response would be the construction of more greenhouses and an expansion of the industry, taking advantage of the economies of scale. GDP in BC would rise (now legal) as would the tax revenue of the provincial government.
The downside is that with the removal of the pepper crops, bell pepper prices would rise in BC.
Sunday, October 31, 2010
Thursday, October 28, 2010
Two out of three ain't bad
Economists are a strange bunch to be sure. You just never know what we are going to research. We are currently working on a paper that attempts to explain why college business instructors, and economics instructors in general, don't often serve on committees and don't rise to administrative positions. The topic for the next Economists Cafe at our institution is "Why duelling was an efficient way to solve disputes" presented by a colleague from SFU.
Today, however, the Globe and Mail reported on a working paper that caused us to shake our heads. Three Ontario based economists have written a paper on what characteristics affect the salary of university professors. (Click here for article) The usual suspects are present: rank (professor, associate, assistant), experience, age, sex, field (yes, economists are among the top earners) and quality of university. But the most unusual attribute ... number of chili peppers on Rate My Professor. (click here for working paper)
The results? Top earners are hot, male, economists.
Today, however, the Globe and Mail reported on a working paper that caused us to shake our heads. Three Ontario based economists have written a paper on what characteristics affect the salary of university professors. (Click here for article) The usual suspects are present: rank (professor, associate, assistant), experience, age, sex, field (yes, economists are among the top earners) and quality of university. But the most unusual attribute ... number of chili peppers on Rate My Professor. (click here for working paper)
The results? Top earners are hot, male, economists.
Thursday, October 21, 2010
Income Inequality: Too many causes to ignore
A recent article in the New York Times tackled the issue of income inequality and suggested that it had been growing over time and that it was now "too big to be ignored". (Click here for article)
We will acknowledge that income inequality has been increasing throughout the world. What we take exception to is the following paragraph:
"Yet many economists are reluctant to confront rising income inequality directly, saying that whether this trend is good or bad requires a value judgment that is best left to philosophers. But that disclaimer rings hollow. Economics, after all, was founded by moral philosophers, and links between the disciplines remain strong. So economists are well positioned to address this question, and the answer is very clear. "
First, there are many causes of income inequality. While all men (and women) are created equal ... that is only under the law ... not in economics. We all have different endowments. Some are tall, some are fast, some are intelligent, some are born into wealth, some are lucky. Income equality would first require equality at birth.
Second, not everyone has the same tastes. Personally, I greatly value my leisure time, so I am on the backward bending portion of my labour supply curve. Steve Jobs apparently has a labour supply curve that is always positively sloped. Surprise!! He earns more than I do. Income equality would require that everyone has the same tastes and behaves in exactly the same way.
What is unfair is to suggest that Steve Jobs should pay higher taxes to support me, just because we view leisure diffferently.
Third, welfare measures used to create income equality on a moral basis often rely on the assumption of diminishing marginal utility. And by that argument, the utility lost from a $10,000 decrease in income when income is at $2 million is less than the gain in utility from a $10,000 gain in income when income is $10,000. And therefore, society is better off when we take $10,000 from a rich person and give it to a poor person. The problem with this argument that, while it is true that a person values $10,000 more when they have $10,000 than when they have $2,000,000, we have no way of examining utility ACROSS individuals. No one, to my knowledge, has ever suggested that utility functions are cardinal, only ordinal. We can say that individual A gets more utility from two hotdogs than one, but we cannot say that A gets more utility from hotdogs than person B.
Redistribution of income always makes one person worse off. In that sense it cannot be a Pareto improvement, and that is the way most economists measure the welfare effects of social policy. And that is the reason we leave it to philosophers to argue the point.
We will acknowledge that income inequality has been increasing throughout the world. What we take exception to is the following paragraph:
"Yet many economists are reluctant to confront rising income inequality directly, saying that whether this trend is good or bad requires a value judgment that is best left to philosophers. But that disclaimer rings hollow. Economics, after all, was founded by moral philosophers, and links between the disciplines remain strong. So economists are well positioned to address this question, and the answer is very clear. "
First, there are many causes of income inequality. While all men (and women) are created equal ... that is only under the law ... not in economics. We all have different endowments. Some are tall, some are fast, some are intelligent, some are born into wealth, some are lucky. Income equality would first require equality at birth.
Second, not everyone has the same tastes. Personally, I greatly value my leisure time, so I am on the backward bending portion of my labour supply curve. Steve Jobs apparently has a labour supply curve that is always positively sloped. Surprise!! He earns more than I do. Income equality would require that everyone has the same tastes and behaves in exactly the same way.
What is unfair is to suggest that Steve Jobs should pay higher taxes to support me, just because we view leisure diffferently.
Third, welfare measures used to create income equality on a moral basis often rely on the assumption of diminishing marginal utility. And by that argument, the utility lost from a $10,000 decrease in income when income is at $2 million is less than the gain in utility from a $10,000 gain in income when income is $10,000. And therefore, society is better off when we take $10,000 from a rich person and give it to a poor person. The problem with this argument that, while it is true that a person values $10,000 more when they have $10,000 than when they have $2,000,000, we have no way of examining utility ACROSS individuals. No one, to my knowledge, has ever suggested that utility functions are cardinal, only ordinal. We can say that individual A gets more utility from two hotdogs than one, but we cannot say that A gets more utility from hotdogs than person B.
Redistribution of income always makes one person worse off. In that sense it cannot be a Pareto improvement, and that is the way most economists measure the welfare effects of social policy. And that is the reason we leave it to philosophers to argue the point.
Wednesday, October 20, 2010
Chinese Auto Market
A recent Business Day article outlines overcapacity concerns in the Chinese car manufacturing industry. Sales have boomed as China’s auto market overtook the U.S in 2009 as the world’s largest due to the emerging middle class and rapid increase in per capita incomes. The demand for cars far exceeds supply at the moment.
This year, up to 17 million vehicles are expected to be sold – an increase of 25-30% after last year’s 46% surge. This has caused manufacturers to increase production at a rapid pace, leaving analysts seriously concerned. The auto market has huge potential in China, a country with a massive population but relatively low percentage of car ownership.
The article reports that international joint ventures do not hold enough current capacity to meet the huge demand, resulting in new investment decisions.
Nissan, Toyota, Hyundai, Volkswagen and FAW to name but a few, have recently announced openings of new production facilities in mainland China. This increase in the supply-side capacity of the car industry seems to be at risk of too much inward investment.
Some concerns of the National Development and Reform Commission, China’s powerful economic planning agency claims:
“Serious overproduction capacity will lead to negative market competitiveness, a loss in enterprise efficiency, factory stoppages and other problems.”
Perhaps this should serve as a reminder of elasticity of supply in a rapidly growing sector. As a general rule for the resposniveness of producers to changes in the price of their goods, if prices rise then so does supply. But we know that cars are a normal good. So long as your income is rising, you will purchase more. Which leads to our next point...
Forecasting is difficult in the auto industry and adding new plants takes time. Our readers will recall a previous blog on the devaluation of the yuan (see below). We would like to point out that just last week The People's Bank of China said it was raising benchmark rates by 25 basis points in an effort to curb persistent inflation. An increase in the interest rate is designed to slow investment. The Business Day article is evidence of this inflation. We could likely be seeing too much capacity in a few years when markets have cooled.
For more on the People's Bank click here.
This year, up to 17 million vehicles are expected to be sold – an increase of 25-30% after last year’s 46% surge. This has caused manufacturers to increase production at a rapid pace, leaving analysts seriously concerned. The auto market has huge potential in China, a country with a massive population but relatively low percentage of car ownership.
The article reports that international joint ventures do not hold enough current capacity to meet the huge demand, resulting in new investment decisions.
Nissan, Toyota, Hyundai, Volkswagen and FAW to name but a few, have recently announced openings of new production facilities in mainland China. This increase in the supply-side capacity of the car industry seems to be at risk of too much inward investment.
Some concerns of the National Development and Reform Commission, China’s powerful economic planning agency claims:
“Serious overproduction capacity will lead to negative market competitiveness, a loss in enterprise efficiency, factory stoppages and other problems.”
Perhaps this should serve as a reminder of elasticity of supply in a rapidly growing sector. As a general rule for the resposniveness of producers to changes in the price of their goods, if prices rise then so does supply. But we know that cars are a normal good. So long as your income is rising, you will purchase more. Which leads to our next point...
Forecasting is difficult in the auto industry and adding new plants takes time. Our readers will recall a previous blog on the devaluation of the yuan (see below). We would like to point out that just last week The People's Bank of China said it was raising benchmark rates by 25 basis points in an effort to curb persistent inflation. An increase in the interest rate is designed to slow investment. The Business Day article is evidence of this inflation. We could likely be seeing too much capacity in a few years when markets have cooled.
For more on the People's Bank click here.
Thursday, October 14, 2010
The Wok Calling the Kettle Black
We have previously blogged on the dispute between China and the rest of the world regarding the pegged value of the yuan. In short, China refuses to let the yuan rise to it's equilibrium value. By keeping their currency artificially low, they encourage exports and discourage imports. The U.S. has tried to get China to abandon this policy to no avail. In the last month, the Federal Reserve in the U.S. has undertaken a policy of quantitative easing - increasing the money supply. The result is a decline in the value of the US dollar against most other currencies and gold prices hitting record highs (in US dollars).
You can't blame us for being a little surprised that China would actually criticize the US for actively depreciating the dollar given that the yuan has been undervalued for years. (Click here for article) China argues that the quantitative easing will lead to inflation and upward pressure on the yuan. The only way that China can maintain the relative price advantage is to continuously purchase the US dollar and issue yuan. The result of this action, as we previously explained, is inflation in China.
The depreciation is starting to spread. Brazil, Indonesia and Japan have already started to impliment policies to lower their currencies. Looks like we may have a race to the bottom. The first one with a valueless currency wins.
You can't blame us for being a little surprised that China would actually criticize the US for actively depreciating the dollar given that the yuan has been undervalued for years. (Click here for article) China argues that the quantitative easing will lead to inflation and upward pressure on the yuan. The only way that China can maintain the relative price advantage is to continuously purchase the US dollar and issue yuan. The result of this action, as we previously explained, is inflation in China.
The depreciation is starting to spread. Brazil, Indonesia and Japan have already started to impliment policies to lower their currencies. Looks like we may have a race to the bottom. The first one with a valueless currency wins.
Rolling back to recession
A little macroeconomic lesson from the chief thinkers at Walmart.
An article from Time magazine online edition dated Oct 5 (click here for article) indicates that Walmart will reduce its Rollback program in an attempt to increase sales revenue. During the recession, Walmart had reduced prices in an attempt to increase sales. Why didn’t the discounts help, and why the change in policy?
During a recession, disposable income falls and consumption in general falls. Demand for normal goods decreases and sales fall. That is something Walmart can’t fix, but they may not have known it. There is an information problem when using macroeconomic data to make microeconomic decisions. While Walmart surely knew that its same store sales were down, they had no way of knowing, in real time, whether the decline in sales was due to a decline in GDP or whether customers were shopping at their competitors. The government statistical agencies typically take months to produce accurate macro data, and it wasn’t likely that Target and Fred Meyer were sharing their sales figures with Walmart.
Since Walmart can’t fight the recession all on their own, they did what they could, they dropped prices trying to get customers back in the door. The customers, however, did know that the recession was the reason they were not shopping. Because of that, consumers stalked up on the 40 oz bottle of ketchup and the 50 oz bottle of Tide. The demand for these products is inelastic meaning that consumers don’t use more when prices fall, and total expenditure falls as price falls. When consumers expect prices to rise, as they will after a temporary sale, they will buy at the low price. This just shifts the pattern of spending, not the total spending.
Abandoning this plan, Walmart is now raising prices. Paradoxically, that will increase sales revenue, unless of course, Target and Fred Meyer drop their prices.
An article from Time magazine online edition dated Oct 5 (click here for article) indicates that Walmart will reduce its Rollback program in an attempt to increase sales revenue. During the recession, Walmart had reduced prices in an attempt to increase sales. Why didn’t the discounts help, and why the change in policy?
During a recession, disposable income falls and consumption in general falls. Demand for normal goods decreases and sales fall. That is something Walmart can’t fix, but they may not have known it. There is an information problem when using macroeconomic data to make microeconomic decisions. While Walmart surely knew that its same store sales were down, they had no way of knowing, in real time, whether the decline in sales was due to a decline in GDP or whether customers were shopping at their competitors. The government statistical agencies typically take months to produce accurate macro data, and it wasn’t likely that Target and Fred Meyer were sharing their sales figures with Walmart.
Since Walmart can’t fight the recession all on their own, they did what they could, they dropped prices trying to get customers back in the door. The customers, however, did know that the recession was the reason they were not shopping. Because of that, consumers stalked up on the 40 oz bottle of ketchup and the 50 oz bottle of Tide. The demand for these products is inelastic meaning that consumers don’t use more when prices fall, and total expenditure falls as price falls. When consumers expect prices to rise, as they will after a temporary sale, they will buy at the low price. This just shifts the pattern of spending, not the total spending.
Abandoning this plan, Walmart is now raising prices. Paradoxically, that will increase sales revenue, unless of course, Target and Fred Meyer drop their prices.
Wednesday, October 13, 2010
Drought in Kazakhstan, steak prices rise in Vancouver
In our principles classes we try and show the interdependencies of different markets in different countries. We know it happens, but journalists aren’t normally cooperative in giving us articles we need to demonstrate this ... until this week.
An October 11 article from the Globe and Mail (click here for article) and an October 12 article from the NY Times (click here for article) provide just the kind of obscure relationship that we’ve been looking for.
The story starts with a catastrophic drought in Russia, Ukraine and Kazakhstan, countries that normally grow a large amount of wheat. As the supply of wheat falls, the price of wheat will rise. Since corn is a substitute for wheat, the demand for corn then begins to rise. Shift the focus 6,500 miles west to the American Corn Belt where there was too much heat and too much rain. The weather in the USA reduced the supply of corn. Go another 6,500 miles west and we find that China has been importing American corn. The increase in demand from China and the increase in demand due to the increase in wheat prices together with the decrease in supply from the weather have caused corn prices to rise.
Now turn around and head 7,000 miles west to Texas where they raise cattle. Corn is used as feed stock and, since corn prices are rising, the cost of raising cattle rises. The supply of beef decreases and beef prices rise, including the price of steak in Vancouver.
Next, we`ll head 1,300 miles north to Saskatoon, where they produce potash. Potash is used in the production of fertilizer. When the price of corn increases, the quantity supplied increases. Farmers try and grow more corn. They do this by planting in areas less suitable and use more fertilizer. The demand for fertilizer is a derived demand – derived from the demand for corn. The demand for fertilizer rises and the demand for potash rises. Therefore the price of potash rises.
As potash prices rise, the profits of potash producing companies, such as the Potash Corporation will rise. If profits are expected to continue to rise, and/or the firm is not maximizing profits, they may become a takeover target. Another firm may attempt to purchase most or all of the outstanding shares of the company.
That brings us to the last stop on our trip, 9,000 miles southwest from Regina to Melbourne Australia, the home of BHP Billiton. BHP has recognized the upside potential for potash and has made an unsolicited $38.6 billion hostile bid for Potash Corp.
Our story is complete. From the wheat fields of Kazakhstan, 30,000 miles to the corporate offices of BHP Billiton we have seen the interdependence of markets.
An October 11 article from the Globe and Mail (click here for article) and an October 12 article from the NY Times (click here for article) provide just the kind of obscure relationship that we’ve been looking for.
The story starts with a catastrophic drought in Russia, Ukraine and Kazakhstan, countries that normally grow a large amount of wheat. As the supply of wheat falls, the price of wheat will rise. Since corn is a substitute for wheat, the demand for corn then begins to rise. Shift the focus 6,500 miles west to the American Corn Belt where there was too much heat and too much rain. The weather in the USA reduced the supply of corn. Go another 6,500 miles west and we find that China has been importing American corn. The increase in demand from China and the increase in demand due to the increase in wheat prices together with the decrease in supply from the weather have caused corn prices to rise.
Now turn around and head 7,000 miles west to Texas where they raise cattle. Corn is used as feed stock and, since corn prices are rising, the cost of raising cattle rises. The supply of beef decreases and beef prices rise, including the price of steak in Vancouver.
Next, we`ll head 1,300 miles north to Saskatoon, where they produce potash. Potash is used in the production of fertilizer. When the price of corn increases, the quantity supplied increases. Farmers try and grow more corn. They do this by planting in areas less suitable and use more fertilizer. The demand for fertilizer is a derived demand – derived from the demand for corn. The demand for fertilizer rises and the demand for potash rises. Therefore the price of potash rises.
As potash prices rise, the profits of potash producing companies, such as the Potash Corporation will rise. If profits are expected to continue to rise, and/or the firm is not maximizing profits, they may become a takeover target. Another firm may attempt to purchase most or all of the outstanding shares of the company.
That brings us to the last stop on our trip, 9,000 miles southwest from Regina to Melbourne Australia, the home of BHP Billiton. BHP has recognized the upside potential for potash and has made an unsolicited $38.6 billion hostile bid for Potash Corp.
Our story is complete. From the wheat fields of Kazakhstan, 30,000 miles to the corporate offices of BHP Billiton we have seen the interdependence of markets.
Saturday, October 9, 2010
A little Congested
A recent report by the Campaign for Better Transport has released its findings for the M6 Toll. Click here for the article in BBC News.
The M6 Toll is a 27-mile privately-financed motorway that runs around the north west of Birmingham, between junctions 3a and 12 of the M6. It opened in December 2003 and was intended to relieve congestion on the busiest section of the M6 by providing an alternative route.
For those unfamiliar with toll pricing, here is a little review.
What price to charge for the toll may have been decided by considering a number of factors:
•The cost of building the road
•The expected usage of the road and therefore the time taken to 'break even'
•The cost of maintaining the road
•The price elasticity of demand for road use
•The cross price elasticity of demand for other roads
The report however, finds that the UK’s only private motorway toll has not significantly cut congestion. The owners (Midland Expressway) are losing close to £26million a year since the toll opened. In order for the toll to work, enough people have to be persuaded to use the new motorway even though by doing so they will incur some private cost. Charge too high a price and people will avoid using the road, too low a price may not generate enough revenue to make a profit.
The main reason for the lost revenue to Midland Expressway is that again, tolls only work if there is an incentive for people to pay them. If the marginal benefit to me (in terms of travel time, reduced discomfort and so on), is worth the £5 per car to use the M6 then I will gladly be willing to pay.
In truth, the journey times on the M6 are only slightly better than before the toll opened. As a driver, this does not equate MB=MC and there is no value to me in paying to use the toll road. Added to which, the toll for users has risen well above inflation each year.
We think Midland Expressways may need to go back to their economics 101.
For more information on the M6 Toll click here for their website.
The M6 Toll is a 27-mile privately-financed motorway that runs around the north west of Birmingham, between junctions 3a and 12 of the M6. It opened in December 2003 and was intended to relieve congestion on the busiest section of the M6 by providing an alternative route.
For those unfamiliar with toll pricing, here is a little review.
What price to charge for the toll may have been decided by considering a number of factors:
•The cost of building the road
•The expected usage of the road and therefore the time taken to 'break even'
•The cost of maintaining the road
•The price elasticity of demand for road use
•The cross price elasticity of demand for other roads
The report however, finds that the UK’s only private motorway toll has not significantly cut congestion. The owners (Midland Expressway) are losing close to £26million a year since the toll opened. In order for the toll to work, enough people have to be persuaded to use the new motorway even though by doing so they will incur some private cost. Charge too high a price and people will avoid using the road, too low a price may not generate enough revenue to make a profit.
The main reason for the lost revenue to Midland Expressway is that again, tolls only work if there is an incentive for people to pay them. If the marginal benefit to me (in terms of travel time, reduced discomfort and so on), is worth the £5 per car to use the M6 then I will gladly be willing to pay.
In truth, the journey times on the M6 are only slightly better than before the toll opened. As a driver, this does not equate MB=MC and there is no value to me in paying to use the toll road. Added to which, the toll for users has risen well above inflation each year.
We think Midland Expressways may need to go back to their economics 101.
For more information on the M6 Toll click here for their website.
Friday, October 8, 2010
A Burning Situation
A fire broke out at a baker's in the City of London on September 2nd, 1666. This lead to The Great Fire of London which burned for 4 days consuming 436 acres, including 80% of the City. Out of the ashes of this ruin came a new business; the competing for-profit fire insurance companies, each one of which also owned a fire brigade. For the next two centuries London held this form of protection.
History tells us that in the earliest days of insurance, companies gave plaques to policy holders who would display them on their homes. This showed them to be covered. The brigades would refuse assistance to those homes not holding a plaque. Further, an insurance company would extinguish a fire only if it was in a home insured by that exact company, so a house with the plaque of a different company would receive no assistance.
In present day Obion County, homeowners must pay $75 annually for fire protection services from the nearby city of South Fulton. Residents in the rural area of Obion had no fire protection until the county established the $75 fee in 1990. If they did not pay the fee and their home caught fire, they do not get fire protection services under any circumstances. Someone must always learn the hard way.
An article found here, describes how a man’s home caught fire last week and he called 911. Having not paid the $75 fee, he was offering to pay all expenses related to the Fire Department’s response. He was refused service. Firefighters did however come out when the man’s neighbour (who had paid the fee) called 911, worried that the fire might spread to his property. Once there, members of the fire department stood by and watched, acting only when the fire reached the neighbour's property. What did the man have to say for himself?
"I thought they'd come out and put it out, even if you hadn't paid your $75, but I was wrong."
This quote captures the “free rider” problem perfectly. Many economics textbooks discuss fire protection with respect to public goods. Economists define public goods in terms of non-rivalry and non-excludability. Non-rivalry is when a good can be used by one person without affecting the use of the good for another person. Specifically, the marginal cost of an additional person enjoying the good is zero. Non-excludability occurs when it is impossible to exclude anyone from the benefits of a particular good. A pure public good is one that has both absolute non-rivalry and absolute non-excludability.
The supply of pure public goods requires government involvement in order to be efficient. A free-rider problem often arises due to the non-excludability, meaning no one person has any incentive to provide it. Thus private provision of these goods leads to production of an insufficient level of consumption or supply. Many goods may have only a degree of non-rivalry and/or non-excludability. These goods are sometimes called “impure” public goods. Fire protection falls in this category.
According to Joseph Stiglitz, in his Economics of the Public Sector, fire protection is similar to a pure public good in that the marginal cost of use is very low. The article from Obion, states that the firefighters were at the scene and had all the equipment available to put the fire out.
However, the ease of exclusion for fire protection is similar to that of the pure private good. If fire companies cannot discriminate between the insured and uninsured, a significant free-rider problem will exist. Without discrimination, no incentive would exist for people to pay fees like the one for $75. With fire companies only interested in protecting those who paid the fees, they had no incentive to help burning uninsured houses. So there you have it, fire protection possesses attributes of both a public and a private good.
From Economics of the Public Sector:
'Most of the time, fire fighters are not engaged in fighting fires but are waiting for calls. Protecting an additional individual has little extra cost. Only in that rare event when two fires break out simultaneously will there be a significant cost to extending fire protection to an additional person. But even here, matters are more complicated: if we want to protect the building next door which has paid for fire protection, it may be necessary to put out the fire in the building which has not paid for protection – exclusion may not really be feasible (Stiglitz, 2000, p. 134).'
In another article by Levy, which hits closer to home for this blog, the idea that buildings would be allowed to burn in a fee-based system was suggested. We would encourage those interested to read it.
Stiglitz, J. (2000) Economics of the Public Sector, 3rd edn., New York: W. W. Norton & Company.
Levy, J. (1995) Essential Microeconomics for Public Policy Analysis, Westport, CT: Greenwood Press.
History tells us that in the earliest days of insurance, companies gave plaques to policy holders who would display them on their homes. This showed them to be covered. The brigades would refuse assistance to those homes not holding a plaque. Further, an insurance company would extinguish a fire only if it was in a home insured by that exact company, so a house with the plaque of a different company would receive no assistance.
In present day Obion County, homeowners must pay $75 annually for fire protection services from the nearby city of South Fulton. Residents in the rural area of Obion had no fire protection until the county established the $75 fee in 1990. If they did not pay the fee and their home caught fire, they do not get fire protection services under any circumstances. Someone must always learn the hard way.
An article found here, describes how a man’s home caught fire last week and he called 911. Having not paid the $75 fee, he was offering to pay all expenses related to the Fire Department’s response. He was refused service. Firefighters did however come out when the man’s neighbour (who had paid the fee) called 911, worried that the fire might spread to his property. Once there, members of the fire department stood by and watched, acting only when the fire reached the neighbour's property. What did the man have to say for himself?
"I thought they'd come out and put it out, even if you hadn't paid your $75, but I was wrong."
This quote captures the “free rider” problem perfectly. Many economics textbooks discuss fire protection with respect to public goods. Economists define public goods in terms of non-rivalry and non-excludability. Non-rivalry is when a good can be used by one person without affecting the use of the good for another person. Specifically, the marginal cost of an additional person enjoying the good is zero. Non-excludability occurs when it is impossible to exclude anyone from the benefits of a particular good. A pure public good is one that has both absolute non-rivalry and absolute non-excludability.
The supply of pure public goods requires government involvement in order to be efficient. A free-rider problem often arises due to the non-excludability, meaning no one person has any incentive to provide it. Thus private provision of these goods leads to production of an insufficient level of consumption or supply. Many goods may have only a degree of non-rivalry and/or non-excludability. These goods are sometimes called “impure” public goods. Fire protection falls in this category.
According to Joseph Stiglitz, in his Economics of the Public Sector, fire protection is similar to a pure public good in that the marginal cost of use is very low. The article from Obion, states that the firefighters were at the scene and had all the equipment available to put the fire out.
However, the ease of exclusion for fire protection is similar to that of the pure private good. If fire companies cannot discriminate between the insured and uninsured, a significant free-rider problem will exist. Without discrimination, no incentive would exist for people to pay fees like the one for $75. With fire companies only interested in protecting those who paid the fees, they had no incentive to help burning uninsured houses. So there you have it, fire protection possesses attributes of both a public and a private good.
From Economics of the Public Sector:
'Most of the time, fire fighters are not engaged in fighting fires but are waiting for calls. Protecting an additional individual has little extra cost. Only in that rare event when two fires break out simultaneously will there be a significant cost to extending fire protection to an additional person. But even here, matters are more complicated: if we want to protect the building next door which has paid for fire protection, it may be necessary to put out the fire in the building which has not paid for protection – exclusion may not really be feasible (Stiglitz, 2000, p. 134).'
In another article by Levy, which hits closer to home for this blog, the idea that buildings would be allowed to burn in a fee-based system was suggested. We would encourage those interested to read it.
Stiglitz, J. (2000) Economics of the Public Sector, 3rd edn., New York: W. W. Norton & Company.
Levy, J. (1995) Essential Microeconomics for Public Policy Analysis, Westport, CT: Greenwood Press.
Ireland Update
Ratings agency Fitch cut Ireland's credit worthiness Wednesday, downgrading it to A+ from its previous AA- rating follows a similar move earlier this week by rival agency Moody's.
However, both Moody's and Standard & Poor's still rate Ireland at the higher grade of AA2 and AA-, respectively.
This had an immediate negative impact on Ireland's borrowing costs on international bond markets. The interest rate, or yield, that investors demand to buy Ireland's 10-year bonds rose to 6.4% Wednesday.
Next month Ireland will publish a 4 year deficit plan and will then unveil a 2011 budget that reduces debt by at least 4 billion euros, which could depress Ireland's already deflated economy.
“The downgrade of Ireland reflects the exceptional and greater-than-expected fiscal cost associated with the government's recapitalization of the Irish banks, especially Anglo Irish Bank,” said Chris Pryce, director of Fitch's government debt group. “The negative outlook reflects the uncertainty regarding the timing and strength of economic recovery and medium-term fiscal consolidation effort.”
But Fitch said Ireland has enough cash stockpiled (more than 34 billion eruos, including its national pension reserves) and borrowing capacity to ride through the crisis, with full funding for government spending already secured through mid-2011. Excluding the bank bailout costs this year, Ireland's 2010 deficit is projected to reach 11.9 per cent, “a more appropriate measure of the underlying fiscal position.”
To read the full story, click here for the article.
However, both Moody's and Standard & Poor's still rate Ireland at the higher grade of AA2 and AA-, respectively.
This had an immediate negative impact on Ireland's borrowing costs on international bond markets. The interest rate, or yield, that investors demand to buy Ireland's 10-year bonds rose to 6.4% Wednesday.
Next month Ireland will publish a 4 year deficit plan and will then unveil a 2011 budget that reduces debt by at least 4 billion euros, which could depress Ireland's already deflated economy.
“The downgrade of Ireland reflects the exceptional and greater-than-expected fiscal cost associated with the government's recapitalization of the Irish banks, especially Anglo Irish Bank,” said Chris Pryce, director of Fitch's government debt group. “The negative outlook reflects the uncertainty regarding the timing and strength of economic recovery and medium-term fiscal consolidation effort.”
But Fitch said Ireland has enough cash stockpiled (more than 34 billion eruos, including its national pension reserves) and borrowing capacity to ride through the crisis, with full funding for government spending already secured through mid-2011. Excluding the bank bailout costs this year, Ireland's 2010 deficit is projected to reach 11.9 per cent, “a more appropriate measure of the underlying fiscal position.”
To read the full story, click here for the article.
Wednesday, October 6, 2010
Principal Agent Problem - or what we should now call the Jerome Kerviel Problem
Jerome Kerviel , ex-trader for Société Générale, was found guilty and convicted in what is now history’s biggest rogue trading scandal. Breach of trust, forgery and entering false data into computers all linked to covering huge stock bets, he was sentenced to at least 3 years in prison and must pay his former employer damages of 4.9 billion Euros. That was not a typo.
His illicit stock bets are estimated to have cost France’s 2nd largest bank about 5 billion Euros in losses.
Let’s take a look at a quote from the article in yahoo news;
“Kerviel maintained that the bank and his bosses tolerated his massive risk-taking as long as it made money - a claim the bank strongly denied.”
This is an example of the principal agent problem. The principals (bank) hire an agent (Kerviel) to perform tasks on their behalf but they cannot ensure that the agent performs them in exactly the way the principals would like. The actions and decisions of the agent are impossible or very expensive to monitor and the agent and the principal may have differing incentives.
This lack of information was a costly failure of information and bank office controls and systems. It was reported that Kerviel had taken speculative positions on selected stocks without the knowledge of the bank. Société Générale has already been fined four million Euros after admitting to lax financial controls.
It is also reported that “The bank says Kerviel made bets of up to 50 billion Euros - more than the bank's total market value - on futures contracts on three European equity indices, and that he masked the size of his bets by recording fictitious offsetting transactions.”
The principal agent problem stems in part from a separation of principal from agent, where the agent (trader) acts in their own self-interest, not in support of the aims of the principal (bank), the incentive problem we listed above. Much has been published and written in recent years about the incentives to cheat.
Typically, the incentive to cheat is greatest when given the chance to “play” with other people’s money (no real sense of ownership leads to risk loving). The Kerviel case shows just how risky this can be for huge financial organizations if there is a failure of control over the trading floors.
It was calculated that, based on his current salary of 2 300 Euros a month as a computer consultant, it would take Kerviel 177, 536 years to pay off his damages. Spokeswoman Caroline Guillaumin called the verdict "an important ruling that acknowledges the moral and financial harm done to the bank and its staff."
His illicit stock bets are estimated to have cost France’s 2nd largest bank about 5 billion Euros in losses.
Let’s take a look at a quote from the article in yahoo news;
“Kerviel maintained that the bank and his bosses tolerated his massive risk-taking as long as it made money - a claim the bank strongly denied.”
This is an example of the principal agent problem. The principals (bank) hire an agent (Kerviel) to perform tasks on their behalf but they cannot ensure that the agent performs them in exactly the way the principals would like. The actions and decisions of the agent are impossible or very expensive to monitor and the agent and the principal may have differing incentives.
This lack of information was a costly failure of information and bank office controls and systems. It was reported that Kerviel had taken speculative positions on selected stocks without the knowledge of the bank. Société Générale has already been fined four million Euros after admitting to lax financial controls.
It is also reported that “The bank says Kerviel made bets of up to 50 billion Euros - more than the bank's total market value - on futures contracts on three European equity indices, and that he masked the size of his bets by recording fictitious offsetting transactions.”
The principal agent problem stems in part from a separation of principal from agent, where the agent (trader) acts in their own self-interest, not in support of the aims of the principal (bank), the incentive problem we listed above. Much has been published and written in recent years about the incentives to cheat.
Typically, the incentive to cheat is greatest when given the chance to “play” with other people’s money (no real sense of ownership leads to risk loving). The Kerviel case shows just how risky this can be for huge financial organizations if there is a failure of control over the trading floors.
It was calculated that, based on his current salary of 2 300 Euros a month as a computer consultant, it would take Kerviel 177, 536 years to pay off his damages. Spokeswoman Caroline Guillaumin called the verdict "an important ruling that acknowledges the moral and financial harm done to the bank and its staff."
Tuesday, October 5, 2010
More on Fiscal Policy
There are just too many stories to ignore, so once again we blog on fiscal policy. Our previous blogs were a story on the Quebec City arena, and examples of stimulus spending in the U.S.
Today we want to look at infrastructure spending in general and a baseball stadium in particular. Our first article comes from the St. Petersburg Times and looks at the benefits of the spring league to the state of Florida. (Click here for article) The article quotes a study undertaken by The Bonn Marketing Research Group that suggests the economic benefit to the State is $752.3 million annually. (Click here for study) This has prompted government spending to maintain, or increase the number of MLB teams that hold spring training in Florida. The alternate destination is Arizona. In the article, Professor Philip Porter from the University of South Florida is quoted as saying that the study is flawed – having used inappropriate methodology. We have to agree with Prof. Porter. The study looked at benefits, but not costs. This is definitely a shoddy way to do economic analysis. We look at net benefits, not gross benefits.
That brings us to our second article, taken from Bloomberg. (Click here for article) This one deals with the decision by Lee County officials to borrow $81.2 million to build a training center outside of Fort Myers, Florida for the Boston Red Sox and the Minnesota Twins. In this case, an economic analysis could be undertaken. Not all the relevant numbers are presented in the article so some research would be required. To decide whether the County has an economic case for building the stadium, we would look at the capital cost and the annual operating costs of the stadium and compare that to the benefits derived from the stadium, including lease revenues, concession and parking revenues as well as the benefits to the community. All values would have to be discounted to take account for the time value of money. This is known as net present value analysis and is similar to what a profit maximizing firm would do. The difference between public and private analysis is the inclusion of external benefits. If the article is accurate and the stadium would account for $41 million in tourist revenue, a legitimate business case might be made.
Our third article comes from the Washington Post. (Click here for article) In this article, the author argues that the U.S. government should borrow $2 trillion (that’s $2,000,000,000,000) and spend it on infrastructure including roads, railroads, runways, water systems, schools and levees. The argument is that there is so much labour and so much material available due the recession and the fact that interest rates are so low, that the costs will never be lower. Once again, the analysis is flawed. Current interest rates are, in fact low. There is no guarantee that they will stay low. Most of the demand for bonds is currently at the short end of the maturity spectrum. This usually happens when rates are expected to rise. The article does say that current government spending needs no cost-benefit analysis and is completely political. Does it not make more sense then, to initiate broad based tax cuts and let individuals decide what is cost effective? Just a thought.
Today we want to look at infrastructure spending in general and a baseball stadium in particular. Our first article comes from the St. Petersburg Times and looks at the benefits of the spring league to the state of Florida. (Click here for article) The article quotes a study undertaken by The Bonn Marketing Research Group that suggests the economic benefit to the State is $752.3 million annually. (Click here for study) This has prompted government spending to maintain, or increase the number of MLB teams that hold spring training in Florida. The alternate destination is Arizona. In the article, Professor Philip Porter from the University of South Florida is quoted as saying that the study is flawed – having used inappropriate methodology. We have to agree with Prof. Porter. The study looked at benefits, but not costs. This is definitely a shoddy way to do economic analysis. We look at net benefits, not gross benefits.
That brings us to our second article, taken from Bloomberg. (Click here for article) This one deals with the decision by Lee County officials to borrow $81.2 million to build a training center outside of Fort Myers, Florida for the Boston Red Sox and the Minnesota Twins. In this case, an economic analysis could be undertaken. Not all the relevant numbers are presented in the article so some research would be required. To decide whether the County has an economic case for building the stadium, we would look at the capital cost and the annual operating costs of the stadium and compare that to the benefits derived from the stadium, including lease revenues, concession and parking revenues as well as the benefits to the community. All values would have to be discounted to take account for the time value of money. This is known as net present value analysis and is similar to what a profit maximizing firm would do. The difference between public and private analysis is the inclusion of external benefits. If the article is accurate and the stadium would account for $41 million in tourist revenue, a legitimate business case might be made.
Our third article comes from the Washington Post. (Click here for article) In this article, the author argues that the U.S. government should borrow $2 trillion (that’s $2,000,000,000,000) and spend it on infrastructure including roads, railroads, runways, water systems, schools and levees. The argument is that there is so much labour and so much material available due the recession and the fact that interest rates are so low, that the costs will never be lower. Once again, the analysis is flawed. Current interest rates are, in fact low. There is no guarantee that they will stay low. Most of the demand for bonds is currently at the short end of the maturity spectrum. This usually happens when rates are expected to rise. The article does say that current government spending needs no cost-benefit analysis and is completely political. Does it not make more sense then, to initiate broad based tax cuts and let individuals decide what is cost effective? Just a thought.
Sunday, October 3, 2010
What Happens in Vegas, Stays in Vegas
At least that's what the rest of the U.S. is hoping.
A New York Times article on the state of the Nevada economy reports that the unemployment rate in Las Vegas is now 14.7 percent, compared with a national average of 9.6%. (Click here for article). In addition, Nevada has led the nation for 44 consecutive months in housing foreclosures.
Nevada has two problems, the first is the downturn in gambling activity in Las Vegas. Gambling is a form of entertainment and, as such, we should expect that demand is very sensitive to changes in income. A 2008 article entitled:
The Income Elasticity of Gross Casino Revenues: Short-Run and Long-Run Estimates by Mark W. Nichols & Mehmet Serkan Tosun
published in the National Tax Journal (Vol. LXI, No.4, Part 1) suggests that the short run income elasticity is about 1.85. What that means is that a 10% drop in income causes a 18.5% drop in gambling expenditures. The two year recession in the U.S. has been particularly deep and widespread and the effect on Vegas has been more severe than the rest of the country. Las Vegas gets a lot of its clientele from nearby California, but California's unemployment rate is 12.4%. Airlines have cut back flights to Las Vegas in an attempt to keep their revenues up, so even though the planes are full, there are fewer of them.
With fewer people gambling in Las Vegas, the casinos and hotels have been laying off staff. This contributes to the unemployment rate. Nevada residents are generally not a large source of income for the casinos, but an increase in the unemployment rate causes a decrease in the demand for housing. This is the second problem. Housing is a derived demand, derived from the number of residents and their incomes. When the economy was expanding, from 2002-2007, construction in Las Vegas was booming. The credit crisis, the reduction in gambling revenue and subsequent layoffs dramatically reduced the demand for housing and therefore the price of housing. As more and more homeowners found themselves under water, the foreclosure rate increased. Median home prices in Las Vegas peaked at $344,900 in April 2006 and currently sit at $129,950.
Las Vegas will recover. People will return. The question is not 'if', but 'when'. In the meantime, if you have never been to Vegas, now is the time. Room rates are cheap, the food is good and there are plenty of shows to see if you don't like to gamble.
Sources:
Employment Development Department, State of California
United States Department of Labor, Bureau of Labor Statistics
Housingtracker.net
A New York Times article on the state of the Nevada economy reports that the unemployment rate in Las Vegas is now 14.7 percent, compared with a national average of 9.6%. (Click here for article). In addition, Nevada has led the nation for 44 consecutive months in housing foreclosures.
Nevada has two problems, the first is the downturn in gambling activity in Las Vegas. Gambling is a form of entertainment and, as such, we should expect that demand is very sensitive to changes in income. A 2008 article entitled:
The Income Elasticity of Gross Casino Revenues: Short-Run and Long-Run Estimates by Mark W. Nichols & Mehmet Serkan Tosun
published in the National Tax Journal (Vol. LXI, No.4, Part 1) suggests that the short run income elasticity is about 1.85. What that means is that a 10% drop in income causes a 18.5% drop in gambling expenditures. The two year recession in the U.S. has been particularly deep and widespread and the effect on Vegas has been more severe than the rest of the country. Las Vegas gets a lot of its clientele from nearby California, but California's unemployment rate is 12.4%. Airlines have cut back flights to Las Vegas in an attempt to keep their revenues up, so even though the planes are full, there are fewer of them.
With fewer people gambling in Las Vegas, the casinos and hotels have been laying off staff. This contributes to the unemployment rate. Nevada residents are generally not a large source of income for the casinos, but an increase in the unemployment rate causes a decrease in the demand for housing. This is the second problem. Housing is a derived demand, derived from the number of residents and their incomes. When the economy was expanding, from 2002-2007, construction in Las Vegas was booming. The credit crisis, the reduction in gambling revenue and subsequent layoffs dramatically reduced the demand for housing and therefore the price of housing. As more and more homeowners found themselves under water, the foreclosure rate increased. Median home prices in Las Vegas peaked at $344,900 in April 2006 and currently sit at $129,950.
Las Vegas will recover. People will return. The question is not 'if', but 'when'. In the meantime, if you have never been to Vegas, now is the time. Room rates are cheap, the food is good and there are plenty of shows to see if you don't like to gamble.
Sources:
Employment Development Department, State of California
United States Department of Labor, Bureau of Labor Statistics
Housingtracker.net
Ireland’s Economic Crisis
For those in Canada who may not be fully aware of Ireland’s economic crisis, we thought it would be a good idea to blog about what is really going on. The country has been in recession since the second quarter of 2008.
Last Thursday the government shockingly disclosed that the final cost of bailing out the Irish banks could rise to 50 billion Euros ($60 billion) – much more than previously announced. So what could this mean for the 5 million people who live there? It will cost roughly 10,000 Euros for every man, woman and child, huge amounts of public money will be required. The country will have to undergo major cuts in expenditure along with tax increases. For the time being, the government has promised not to borrow any more money nor will it seek any more emergency funding from international lenders at least until next year.
This all stems from reckless lending by its banks during a boom that ended in 2007, and as property prices fall, is now becoming one of the biggest busts in history. The deficit for this year will be 32% of GDP – 10 times the limit set for member countries of the EU, mainly due to the extra cost of capital for major banks. But unlike some other European economies (Greece), Ireland has acted early to tackle its debt. Greece was on a threshold before it cut public wages and raised taxes. It acted slowly to address its troubles, and only then as a condition of a 110 billion euro ($145 billion) bail-out by the European Union and the IMF.
Ireland did this early on. Markets have not yet rewarded these steps, largely due to its bank struggles. Apart from the money poured into its banking system this year, Irish government bond yields are increasing. The yield on ten-year government bonds neared 7% on September 29th, a record spread of 4.7 percentage points above those of Germany.
These increased bank losses required bail-outs which raised deficits and lead to even more budget cuts. Another shock came when Allied Irish Banks, one of the two largest financial institutions, was practically nationalized with an injection of 3 billion Euros (not to mention the sudden removal of its chairman and managing director last Thursday).
It is also speculated that if bond yields rise further, Ireland and Portugal might have to borrow from the European Financial Stability Facility (EFSF). This probably is not the case.
Reports show that Ireland has raised enough money to finance this year’s borrowing requirement (it will spread the cost of bank bail outs over several years). Portugal is also not as desperate for cash as Greece was in the spring. In the unlikely event that Ireland was forced to borrow from the EFSF, the fund might find it hard to impose conditions harsher than the ones it has volunteered for already. Click here, for an article in the Economist, and for news on further actions Ireland may be taking click here, for an article in the daily mail.
European Financial Stability Facility: €440 billion fund established in June for struggling euro-zone countries.
More information can be found here.
Last Thursday the government shockingly disclosed that the final cost of bailing out the Irish banks could rise to 50 billion Euros ($60 billion) – much more than previously announced. So what could this mean for the 5 million people who live there? It will cost roughly 10,000 Euros for every man, woman and child, huge amounts of public money will be required. The country will have to undergo major cuts in expenditure along with tax increases. For the time being, the government has promised not to borrow any more money nor will it seek any more emergency funding from international lenders at least until next year.
This all stems from reckless lending by its banks during a boom that ended in 2007, and as property prices fall, is now becoming one of the biggest busts in history. The deficit for this year will be 32% of GDP – 10 times the limit set for member countries of the EU, mainly due to the extra cost of capital for major banks. But unlike some other European economies (Greece), Ireland has acted early to tackle its debt. Greece was on a threshold before it cut public wages and raised taxes. It acted slowly to address its troubles, and only then as a condition of a 110 billion euro ($145 billion) bail-out by the European Union and the IMF.
Ireland did this early on. Markets have not yet rewarded these steps, largely due to its bank struggles. Apart from the money poured into its banking system this year, Irish government bond yields are increasing. The yield on ten-year government bonds neared 7% on September 29th, a record spread of 4.7 percentage points above those of Germany.
These increased bank losses required bail-outs which raised deficits and lead to even more budget cuts. Another shock came when Allied Irish Banks, one of the two largest financial institutions, was practically nationalized with an injection of 3 billion Euros (not to mention the sudden removal of its chairman and managing director last Thursday).
It is also speculated that if bond yields rise further, Ireland and Portugal might have to borrow from the European Financial Stability Facility (EFSF). This probably is not the case.
Reports show that Ireland has raised enough money to finance this year’s borrowing requirement (it will spread the cost of bank bail outs over several years). Portugal is also not as desperate for cash as Greece was in the spring. In the unlikely event that Ireland was forced to borrow from the EFSF, the fund might find it hard to impose conditions harsher than the ones it has volunteered for already. Click here, for an article in the Economist, and for news on further actions Ireland may be taking click here, for an article in the daily mail.
European Financial Stability Facility: €440 billion fund established in June for struggling euro-zone countries.
More information can be found here.
Saturday, October 2, 2010
Greed and the Pharmaceutical Industry
A relative of mine, whom I greatly respect, has a chronic disease and shared his frustrations on facebook. His posting and subsequent comments inspired this blog, and to him it is dedicated.
"...every individual...endeavours as much as he can .. to employ his capital in support of the domestick industry, and so to direct that industry that its produce may be of the greatest value.......and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, ... led by an invisible hand to promote an end which was no part of his intention."
An Inquiry into the Nature and Causes of the Wealth of Nations, Adam Smith 1776
Smith's basic premise regarding the workings of a market economy is that decisions are based on personal welfare (greed) and that people respond to incentives. Be clear though, the greed applies to both sides of the transaction.
The pharmaceutical industry is an easy target for those that do not like the results of free markets. A drug company develops a drug that can cure millions of people and then charges enormous sums of money to those people that want the drug. The argument goes something like: "The drug companies are just in business to make a profit off the backs of the sick".
A quick search of the web brought up numerous articles attesting to this. For example:
Pharmaceutical companies are in business to earn a profit. To that end, they undertake medical research develop new drugs, patent them and submit them to clinical trials. If the clinical trials show sufficient efficacy with tolerable side effects the drug is licensed for sale in a particular jurisdiction. Each different jurisdiction requires its own licencing procedures. A 2003 article in the Journal of Health Economics estimates that the capitalized cost of bringing a drug to market is around $800 million. (Click here)
Why would a firm invest $800 million on a product? To earn a profit. They are greedy. They make no apologies for their greed, nor should they.
So what of those people who think those drugs should be available to them for free? Or at least at a price where the developer doesn't earn profits? Why is it that people want pharmaceuticals? To make their quality of life improve, or to extend the length of their lives, or the lives of loved ones, or a combination thereof. All of these reasons create benefits for the drug user and their families ... they are greedy, they want to increase their well being.
Adam Smith tells us that it is this mutual greed that drives a market economy. People want drugs to make them better and firms will develop those drugs to earn profits. If no one wanted the drug, the firm wouldn't bother to create it.
There is a lot of hypocrisy on the anti-profit side. I have never heard of an accountant, sales rep, biochemist, secretary or fork lift driver offering to work for a pharmaceutical company for free. So why do these same people expect that a pharmaceutical company will do all that work producing drugs for free? These very people, that object to the profit motive, are also among those that sue drug companies when the drugs don't perform exactly as intended. Is that not greed?
Our patent system gives the developer of a drug the exclusive right to produce and sell a drug for a period of 20 years. After that time, other firms may produce and sell the drug. This system encourages the research and development needed to produce new drugs and also ensures that the price of drugs will eventually fall.
Greed is not a bad thing. It is the motivation for decision making. We tend to do what is best for ourselves. Everyone doing this is how a market works. Market economies have their shortcomings, but they are better, by far, than anything else we have tried to date.
Now, I have to go take my medications that are way too expensive!!!
"...every individual...endeavours as much as he can .. to employ his capital in support of the domestick industry, and so to direct that industry that its produce may be of the greatest value.......and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, ... led by an invisible hand to promote an end which was no part of his intention."
An Inquiry into the Nature and Causes of the Wealth of Nations, Adam Smith 1776
Smith's basic premise regarding the workings of a market economy is that decisions are based on personal welfare (greed) and that people respond to incentives. Be clear though, the greed applies to both sides of the transaction.
The pharmaceutical industry is an easy target for those that do not like the results of free markets. A drug company develops a drug that can cure millions of people and then charges enormous sums of money to those people that want the drug. The argument goes something like: "The drug companies are just in business to make a profit off the backs of the sick".
A quick search of the web brought up numerous articles attesting to this. For example:
- A November 2009 article from BBC regarding a drug for liver cancer. (Click here)
- A March 2010 article from the Telegraph regading a drug for bone marrow cancer. (Click here)
- An August 2002 article from New Zealand TV regarding a leukaemia drug (Click here)
Pharmaceutical companies are in business to earn a profit. To that end, they undertake medical research develop new drugs, patent them and submit them to clinical trials. If the clinical trials show sufficient efficacy with tolerable side effects the drug is licensed for sale in a particular jurisdiction. Each different jurisdiction requires its own licencing procedures. A 2003 article in the Journal of Health Economics estimates that the capitalized cost of bringing a drug to market is around $800 million. (Click here)
Why would a firm invest $800 million on a product? To earn a profit. They are greedy. They make no apologies for their greed, nor should they.
So what of those people who think those drugs should be available to them for free? Or at least at a price where the developer doesn't earn profits? Why is it that people want pharmaceuticals? To make their quality of life improve, or to extend the length of their lives, or the lives of loved ones, or a combination thereof. All of these reasons create benefits for the drug user and their families ... they are greedy, they want to increase their well being.
Adam Smith tells us that it is this mutual greed that drives a market economy. People want drugs to make them better and firms will develop those drugs to earn profits. If no one wanted the drug, the firm wouldn't bother to create it.
There is a lot of hypocrisy on the anti-profit side. I have never heard of an accountant, sales rep, biochemist, secretary or fork lift driver offering to work for a pharmaceutical company for free. So why do these same people expect that a pharmaceutical company will do all that work producing drugs for free? These very people, that object to the profit motive, are also among those that sue drug companies when the drugs don't perform exactly as intended. Is that not greed?
Our patent system gives the developer of a drug the exclusive right to produce and sell a drug for a period of 20 years. After that time, other firms may produce and sell the drug. This system encourages the research and development needed to produce new drugs and also ensures that the price of drugs will eventually fall.
Greed is not a bad thing. It is the motivation for decision making. We tend to do what is best for ourselves. Everyone doing this is how a market works. Market economies have their shortcomings, but they are better, by far, than anything else we have tried to date.
Now, I have to go take my medications that are way too expensive!!!
Friday, October 1, 2010
UK Budget Deficit Figures
According to the Office for National Statistics (ONS), new public sector borrowing hit a record £15.9bn for August. This comes after inflation led to a rise in interest payments on index-linked government bonds. Officials claim this is further evidence that the coalition is right to press ahead with cuts. Net debt, relative to GDP, rose to 56.3%. That borrowing figure was about £3bn more than economists expected.
An article in BBC news quotes the latest figures for borrowing in the first 5 months of the financial year reaching £58.1bn. Interest paid out on government debt was close to £4bn in August. This disappointment on the spending side is caused by the retail price index (RPI), being negative a year ago and interest spending being low.
What the article does not mention is that debt interest costs will not deviate much from £70bn under the coalition’s plans, increasing to £66.5bn in 2015-16. In comparison, under labour’s plans, the Office for Budget Responsibility (OBR) claims it would have reached this level earlier, in 2014-15. That is a lot of money.
Tax revenue is rising, but so is the cost of dealing with the nation’s borrowing. The article notes that the forecast for 2010-11 borrowing as a whole is around £149bn, down from last year's total of £155bn.
The ONS figures leave out the impact of financial intervention by the government, which reduce overall borrowing because of profit contributions from the part-nationalized banks. The rise in the RPI (used to set payments on index-linked bonds), meant interest payments were at £3.8bn, almost three times what they were in August last year and the country’s finances could be out of whack for some time.
But it may be too early in the fiscal year to draw major doom and gloom conclusions. Before this month, borrowing figures had come in lower than expected in 9 of the previous 12 months, with revenues coming in unexpectedly strong.
The bottom line still stands that revenues are usually always weak in August, and so far they are still 9% up on last year, compared to a Treasury forecast of 6.6% growth in 2010-11. If nothing changes, total borrowing this year would still come in several billion below forecast.
And for those suggesting the government’s borrowing will lead the country to bankruptcy, well it is simply not the case and an old saying of ours comes to mind. When pigs fly?
Governments can default on their debt but they can’t go bankrupt. Before the election, the UK still had triple-AAA credit rating, and the market was demanding and interest rate of only 3.9% to lend the government money. For a reference, U.S bonds were 3.7%. Whatever the coalition is facing, it is certainly not bankruptcy or default.
Investors are worried about the huge debt in the financial sector, and of those debts, how many the government will be forced to honour. This ties in to the latest headlines in Ireland, where the government has lost control of it’s balance sheet.
Another article in today’s BBC news gives the latest report on Irelands banking and property crisis. We should be reminded here, that reducing public borrowing is only part of the problem as governments also need to be concerned with what is happening in the private sector. This ties in to the latest headlines in Ireland, where the government has lost control of it’s balance sheet.
Index linked: An investment, where the return rises in line with inflation.
UK National Statistics website found here.
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