Network Externalities

EasyJet Hopes Ash Cloud Radar Will Take Off

Dr Fred Prata of the Norwegian Institute for Air Research, has developed a new technology called AVOID (Airborne Volcanic Object Identifier and Detector). Click here for article.

The system uses infrared technology which is placed onto aircrafts, and allows pilots and flight control to receive images of ash clouds. Corrections to the plane’s flight path can then be made. This has the potential to minimise future disturbance to planes from volcanic ash clouds.

There was no commercial interest in the system until ash from Iceland’s volcano caused extensive disruption of European airspace in April and May, at an estimated cost to airlines of more than $1.7bn.

AVOID will initially be trialed by EasyJet airline, who announced the disruption cost the company an estimated £50-75m, or half of its expected profit. They have agreed with Mr Prata to spend £1m testing the technology. It will be assessed on an A340 test aircraft owned by Airbus and then, if the results are favorable, fitted to a dozen EasyJet planes.

On the ground, information from aircraft with the technology would be collected to build an image of the volcanic ash cloud using real-time data. Clear areas of airspace can then remain open that would otherwise be closed during a volcanic eruption, minimizing disruptions.

The goal is not for EasyJet to gain commercial advantage over other airlines, but rather to make AVOID an industry standard. The system does help individual pilots to avoid ash, but the main benefit would be in installing AVOID on hundreds of aircraft in order to build an accurate ash map for the whole of Europe.

Let’s look at this for fun…A list of the top ten airlines in the world by fleet size.

The total is 4,230. Generously multiply this by 7 to estimate roughly how many planes we have flying around, and we get 29, 610. If the present value of the royalty was $1,000 per plane the royalties would be $29, 610, 000. Compare this to the estimated losses of $1.7bn. With regards to our previous posts on patents, it is clear that the network externalities dominate the patent revenues. Here, the positive network externalities of AVOID are only beneficial to their full extent if everyone adopts (or a critical mass) this technology.

Not all network externalities are positive however. Take, for example, the case of the Indian transportation system - a topic we'll discuss later ... maybe. Click here for article.

For a little refresher on network externalities see:

Microeconomics 5th Edition, Jeffrey M. Perloff, Pearson (Ch 11)
Intermediate Microeconomics, Hal R. Varian, Norton (Ch 35)

BP and the Efficiency of Markets

The efficient market hypothesis suggests that current stock market prices incorporate all of the information known about a company at the current time. There are three different forms of the hypothesis; the weak form that incorporates all information about current stock prices, the semi-strong form that incorporates all public information, then the strong form that incorporates all public and private information.

To illustrate how the efficient market hypothesis works we can examine the effect of the Deepwater Horizon and disaster on the price of British Petroleum shares. The Deepwater Horizon sank on April 22, 2010 and at that time British Petroleum estimated the leakage at 5000 barrels per day. On April 19th BP shares were trading at $58.50 on the New York Stock Exchange. Ten days after the sinking, BP shares had fallen to $51.70. The market did not believe that the leaker was 5000 barrels per day. With roughly 3.1 billion shares outstanding the market had effectively cut just over $21 billion from BP’s market value.

By the beginning of June when all other attempts to the leak had failed and BP finally cut the pipe BPs market price had fallen to less than $37 a share. At that time estimates of the leakage had risen to 95,000 barrels per day.

Today shares are trading in the $30 range and despite their best efforts estimates of the leakage are still 60,000 barrels per day. It would appear that the markets new on April 22 roughly how large the damage was and began to incorporate that information into the stock price even though official estimates at the time were far less severe. We may not yet know the full extent of the financial damage caused by the oil spill but the market is putting an estimate well in excess of BPs 12 billion dollar cash reserve. British Petroleum is facing a suspension of its dividend and the potential for issuance of debt to pay what is now estimated at cleanup cost and liability payments in excess of $20 billion.

Anecdotal evidence suggests markets knew right away that the BP oils bill was far larger than initially reported giving some credence to the strong form of the efficient market hypothesis.

Click here for an April 29th NY Times article suggesting damage in the “hundreds of millions”

Click here for a June 15th Reuters article estimating oil flow after the cap was installed.

Click here for a June 16th Associated Press article indicating BP is setting aside $20 billion for relief

Monopoly vs Rent Seeking

Given that we have a "Rent-Seekers" Club, one might expect that we are fundamentally opposed to monopolies. One would be wrong.

A monopoly exists when there is only one firm in an industry and there is a barrier to other firms entering. Rent-Seekers attempt to influence government policy to create or maintain such barriers. This is the case of Indigo Books and Music Inc., and the B.C. Association of Optometrists that we referred to in previous posts. There is, however another way for a barrier to entry to be obtained and that is the granting of a patent.

A patent is an exclusive license to produce a product or use a process for a specified period (20 years from date of application). To obtain a patent, you must have an original invention and make an application to the Federal Government. As with rent-seeking, a patent restricts competition and allows for monopoly profits. They will both also create a dead-weight loss. The following illustration of the deadweight loss triangle can be found in any Micro Principles text.

This is where the difference lies. The dead-weight loss from rent-seeking is hard to justify. The dead-weight loss from a patent is easy to justify. Patents are issued for innovation, the result of research and development. Since R&D typically has positive spillover effects, the economy as a whole benefits and the dead-weight loss of the monopoly is at least partially, if not fully, offset.

The growth can be illustrated by looking at the effects of a technological change on the production possibilities curve, or by application of the Solow production function.

There is a time limit on patents to encourage further research. Typically, firms that are granted patents use some of the monopoly profits to fund their research departments. This reinvestment sustains growth over the long term.

A Globe and Mail article explaining the use of patents can be found by clicking here.

Fireworks

Everyone loves a good fireworks show, so why is it so difficult to stage Vancouver's Celebration of Lights every year? After two weeks of uncertainty surrounding funding, the organizers have now confirmed that the show will go ahead this year.

It is estimated that 1.4 million people watch the pyrotechnic display over the four days in July.

In economics, we identify a "public good" as a good or service which is non-exclusive and non-rivalrous. The first term means that the exhibitor cannot stop someone from enjoying the show if they refuse to pay. The second term means that one more person watching the show does not detract from the enjoyment of everyone else. When these conditions are present, private firms have no incentive to produce.

If everyone that watched the shows sent $3 each to the organizers, the show would have sufficient funding for next year's production. But suppose that I go to English Bay and don't pay. After all $4.2 million minus $3 is still very close to $4.2 million. What if everyone thinks that way? No show next year.

Public goods must be provided by the government or by some institution that can raise funds. Previous to a change in advertising laws, Benson & Hedges sponsored the show under the name "Symphony of Fire".

Perhaps some marketing student somewhere can think of a novel way to raise funds for next year's show.

Click here for the Celebration of Lights website.

Lessons from the Labour Market

Suppose you manage a firm with 100 employees making $800 each per week for a total payroll of $80,000. As a result of the recession you must reduce payroll expenses by 10%. There are two ways to do this: layoff 10 employees, or cut everybody's pay by $80 a week. Both of these options will cause employee discontent so how do you decide which option to choose. Let's put it to vote. What do you think the results of the vote will be? The 10% of the employees that would likely face a layoff will vote in favour of the pay cut while the 90% of employees that would likely keep their jobs would go for the layoffs. By simple democracy 10% of people get laid off. This is one application of the insider-outsider theorem.

Michael Bloomberg, the mayor of New York, has recently announced that teachers in New York City must forgo their pay increase to prevent the loss of 4,400 jobs. (Click here for the article). Apparently Michael Mulgrew, president of the teachers union, is not impressed. The New York school board employs approximately 80,000 teachers. How you think the union members will vote if given the choice between a pay freeze and 4,400 layoffs?

We Were Right!

Last week we predicted that interest rates would either rise or stay the same. Today, Bank of Canada Gov. Mark Carney raised the target overnight rate to 0.50% from 0.25%. Monetary policy really is easy!

Two factors determine the rate increase. First, the inflation rate is only slightly lower than the Bank's 2% target. Second, GDP growth in the first quarter of 2010 was an astounding 6.1% annualized. Higher growth rates signal increased inflation. An increase in interest rates is designed to slow growth and reduce inflationary pressure.

So why did the Canadian dollar fall today? Normally an increase in interest rates causes capital inflows. The demand for Canadian dollars increases in the dollar rises. Statements made by the Bank of Canada regarding global growth indicate that this may not be the start of a gradual rise in interest rates as was expected.

Unemployment in the euro zone increased in May to 10.1%, Chinese manufacturing slowed in May and their housing bubble is increasing the risk of an economic slowdown.

Global economic slowdown reduces resource demand and the Canadian dollar falls.

The Penny hits Senior Age

The Senate Finance Committee is discussing the future of the Canadian penny. The issue is whether to keep it or abandon it and round prices up to the nearest five cents.

Currency has long been a source of revenue for governments. It currently costs nine cents to produce a $20 bill. The difference between the cost of production the face value is revenue to the government, known as seigniorage. (It's a little more complicated than this. See link for details on the seigniorage from currency).

It currently costs about 1.5 cents to produce a penny. The seigniorage is negative. In the last 100 years, 33.9 billion pennies have been minted. (Source: Royal Canadian Mint) They didn't wear out, so where are they all? In your penny jar and mine will of course.

Getting rid of the penny will cause prices to rise. A $0.96 item will now be $1.00, a 4.16% increase. A $499.99 item becomes $500, an increase of 0.002%. This, however, is not inflation. One day will explain why.