Walmart … The Company We Love to Hate

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

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

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

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

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

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

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

Shoppers Return and Workers Leave

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

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

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

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

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

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

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

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

The Faucet is Leaking … Call the Electrician!

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

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

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

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

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

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

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

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

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

Need more evidence? Ask the Venezuelans about toilet paper.

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

When ‘Money’ isn’t really ‘Money’

Since the financial collapse of 2007-2008 there has been a rapid increase in the U.S. monetary base and plenty of discussion about the impending hyperinflation. This is more prevalent in the U.S. than in Canada due to structural differences in our banking systems, but that would take more than 500 words to explain.

Today’s objective is to explain Mike Moffat’s recent article in the Globe and Mail. First, some definitions: Hyperinflation is a period of rapid, broad-based price increases, normally defined as inflation in excess of 50% per month. The monetary base is the liability of the central bank. This typically consists of issued currency plus reserve deposits of commercial banks. The money supply (M2) consists of currency in circulation (in the hands of the non-bank public) plus chequing and savings accounts at commercial banks and credit unions plus money market mutual funds. M2 is ‘money’ as a medium of exchange.

The Quantity Theory of Money tells us that there is a relationship between the money supply and prices. More specifically; the inflation rate will be equal to the growth rate of the money supply minus the growth rate of real GDP (gross domestic product).

The journalists and commentators that are predicting hyperinflation as a result of the Fed’s loose monetary policy are confusing the money supply with the monetary base. To maintain liquidity in the commercial banks, the Fed has been purchasing money market instruments – short term treasury bills and commercial paper off the market and paying for them with newly created reserve deposits. This action causes an increase in the monetary base. The commercial banks lost billions in the financial collapse and are still fighting liquidity problems. As a result, they have been increasing their reserves. When banks hold reserves and don’t lend them out, the monetary base increases, but the money supply does not. Inflation is caused by an increase in the money supply, not the monetary base. Until banks start lending these reserves, there is very little threat of inflation.

The Globe and Mail article suggests that the markets understand this even if the journalists don’t. The Fisher equation tells us that the nominal interest (the interest rate measured in dollars) is approximately equal to the real interest rate (purchasing power) plus the expected rate of inflation. Nominal rates for 10-yr treasuries are just under 2% at the time of writing. This implies that money market professionals do not expect to see inflation in the near future, regardless of what the commentators say.

At a dinner hosted by the Boston Fed last May, it was apparent that officials in the US are aware of the buildup in reserves and do actually have a plan to prevent inflation in the event that lending activity increases.

Until then, just remember, the sky is not falling … except in Russia.

Greg Mankiw on Immigration Policy

I got the idea for writing this blog from Prof. Makiw's blog. When he writes articles, it leaves very little for me to ad. So ... See Greg's commentary in the New York Times on why Economists are generally in favour of liberal immigration policies.

And yes ... I also benefited from immigration, my mother was born in England.

Principles of Agents

Any Introductory Business course will teach you that shareholders are the owners of the firm. The shareholders elect the Board of Directors to oversee the firm on their behalf. The Directors appoint the company President and the other members of the executive team who are responsible for the day-to-day operations. The Directors and executive team are the agents of the principal owners of the company.

Economists have long studied a situation known as the Principal-Agent problem. This inefficiency occurs when the objectives of the principals, the shareholders, differs from the agents, the executives. Finance theory suggests that individual investors want to maximize returns and minimize risk. This implies using the equi-marginal principle to strike a balance between the two.

The Board and executive may have an objective of maximizing their own income or their own power. Agents typically share in profits by way of bonuses, but not in losses. A company that has negative net income does not require the company president to pay back salary or previous bonuses, nor do they encumber future bonuses. This is just one example of how the Principal-Agent problem can manifest itself.

Evidence of the Principal-Agent problem appeared in several places this week. The first, as related in a Reuters article, involves the investment bank Goldman Sachs (GS). There is currently a proposal to split the role of Board Chairman and the role of CEO between two people.  The idea is that the Chairman oversees the activity of the CEO which is a management position. This may prevent the risk taking activity that lead to the banking collapse of 2007-2008. The company, however, has put forward a legal challenge to prevent a vote on the motion. Essentially, the company is using shareholders’ money to the detriment of shareholders.

JP Morgan Chase (JPM) is also fighting a legal battle in an attempt to prevent shareholders from voting on a motion to break up the company. See the American Banker article for the details. The rationale is similar to the Goldman Sachs situation.  JP Morgan has four distinct businesses, some of which are vastly riskier than others. This not only puts the whole company at risk, but affects the optimal pricing of the firm. In the finance world, they refer to the plan to break up the company as “unlocking value”. Again, the company is using shareholders’ money to their detriment.

Perhaps the most troubling revelation this week was something that was not reported. Apple (AAPL) has $136 billion in cash and marketable securities on its balance sheet that it refuses to return to shareholders. (Source: SEC filing) Apple is currently showing Owners’ Equity of $127 billion which means the entire book value of the company, plus some, is being held in cash. The problem with this is that cash earns less than 2% on average. For example, if that money were returned to shareholders they could purchase shares of Altria Group (MO), that currently pays dividends of 5.3%. Returning half of the $127 billion would double Apple’s return on equity without hampering their ability to operate.

Goldman Sachs, JP Morgan and Apple are just three examples of the Principal Agent problem that caught our attention this week. There will be more next week and the week after that. We can’t help but wonder if the Principal-Agent problem would exist if agents had principles.

 

Sticky Buns and Sticky Wages

One explanation often found in textbooks for the relatively slow pace of price adjustment in the macroeconomy is ‘sticky wages’. The idea is that, due to long term contracts and other structural impediments, firms cannot reduce wages when the demand for their product falls. 

Microeconomic theory tells us that firms will hire workers up to the point where the marginal product of labour is equal to the real wage rate. When the demand for a firm’s product falls, the price of their product falls and the real wage rises. In order to restore the cost minimizing solution, firms must either cut nominal wages or increase the marginal product. Increasing marginal product of labour requires using less labour. So firms must cut jobs or cut wages. Both of these can prove difficult to accomplish in the short run. 

This is the unfortunate circumstance that Hostess Brands was facing late last year. A Reuters article in the Montreal Gazette tells of the demise of the Twinkie. As people have become more health conscious the demand for the 150 calorie high-fat snack has decreased. At the same time, droughts and agriculture policy have increased the price of the flour used to produce the Twinkies. Both of these circumstances have led to a decrease in the production of Twinkies, and Hostess was faced with either laying off employees or reducing wages. 

Faced with a staggering 300 different labour contracts, the company had no success in reducing wages. The article quotes one baker as saying he would rather be unemployed than take a wage cut. This is consistent with an upward sloping labour supply curve. With no opportunity to cut labour costs and no control over flour prices, Hostess decided that the only way to preserve its cash was to shut down production. This is what our theory suggests will happen if price falls below the average variable cost of production.  

Hostess has now filed for bankruptcy protection in the United States and has ceased production of the infamous Twinkie. While Hostess could not profitably produce Twinkies, it may be possible for another company, with lower labour costs, to do so. Hostess still owns the rights to the Twinkie and is currently seeking a buyer for the recipe and brand name. If and when the Twinkie returns to the US, there is no doubt that it will be manufactured and shipped by workers with lower wages than those that worked at Hostess. 

Sticky wages in the sticky bun business. Result: unemployment.

Hunting: Market Style

Teddy Roosevelt was credited by the NY Times recently as saying that ‘wildlife belongs to all, and not just to those with land and wealth’. Of course Mr. Roosevelt was president of the United States from 1901 to 1909 when the population was around 90 million and there were only 46 states (New Mexico and Arizona joined in 1912 and Alaska and Hawaii in 1959). In Mr. Roosevelt’s time, wildlife was not terribly scarce.

Now, with 50 states, 320 million people and an estimated 223 million firearms held by individuals, there is not enough wildlife for everyone to shoot. When a shortage occurs, the most efficient allocation method usually involves a market.

This is the approach that Utah has taken. Some licenses are available for $35 in a blind draw, the method used in most jurisdictions. The supply of licenses is determined to conserve wildlife which, for most species means there will be an excess demand.

Some of the licenses are given to non-profit organizations that support conservation. These licenses are auctioned off to the highest bidder; and that will be the market equilibrium. Still others are given to private land owners willing to open their land to hunters. These tend to be the most expensive licenses. Landowners that participate in this program have a profit incentive to create an environment that is conducive to the survival of wildlife. As such, the likelihood of ‘bagging’ an animal is higher on private land and thus the price is higher. This further increases the incentive for land owners.

The primary objection to this profit-maximizing program is that ‘money’ is being used to determine who gets to hunt. This is true, but it is also a tried and true method of allocating scarce resources in an efficient manner. When a resource is scarce, efficiency dictates that it should be used I the most ‘valuable’ endeavor.

One may argue that wildlife is a social resource, as President Roosevelt did, and this implies that hunting should maximize ‘social welfare’. I’ll admit that I am not a hunter, but as a member of the society that ‘owns’ an elk, I would hope that that elk would be ‘sold’ for the highest possible price.

The NY Times article quotes a dentist from Utah that is complaining about the market allocation of game. We can’t help but wonder if the dentist uses something other than the price mechanism to allocate his services. Perhaps he treats patients for a nominal fee and then schedules his appointments by lottery. Somehow, we doubt that.