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.

New posting on the Pearson site regarding the fiscal cliff.

Is an Increase in Demand is “Price Gouging” ?

Keeping with the recent theme of price adjustments, or lack of them, today we are looking at one of the expected results of hurricane Sandy. An article on Yahoo! Finance’s ‘The Daily Ticker’ suggests that retailers in the Northeast United States were ‘gouging’ customers trying to purchase gas, water, food and batteries ahead of the hurricane.

The confluence of Hurricane Sandy and a strong nor’easter (as they are known) was predicted to create a massive storm over the densely populated regions of the US North East. These predictions started a week to 10 days before the storm actually hit. Hurricane force winds reek havoc with power lines and widespread power outages were expected. Hurricanes also cause storm surges, abnormally high water levels and big waves. Flooding was expected in all coastal areas.

The 50 million people that faced the potential for flooding and power outages all went to try and purchase emergency supplies at the same time. The demand for these items increased. The free market reaction to an increase in demand is an increase in price. If prices don’t rise, shortages will occur. See our previous posts on bacon and disposable diapers. This increase in price is not ‘gouging’, it is a natural reaction to an increase in demand.

In several areas there are laws against price gouging by retailers during a disaster. For example, in New Jersey prices are not permitted to rise by more than 10%. North and South Carolina both have similar laws. The general argument is that consumers should not be ‘ripped off’. But, as I teach my students, demand is defined as how much consumers are willing and able to purchase at every price. When a storm is approaching, their willingness to purchase increases – they are willing to pay more. Politicians call it gouging, economists call it equilibrium pricing.

If effective ‘price gouging’ laws are in effect, the amount that consumers are willing to purchase will be greater than what firms have available for sale and there will be a shortage. Some lucky customers will be able to purchase some batteries, or water, then stand outside the store and when the store runs out, the lucky ones will be able to sell their batteries and water at higher prices. (Sounds like ticket scalping for sporting events and concerts, doesn’t it?). The reality is that the equilibrium price must rise. The only question is who is going to benefit, the store owners, or the battery scalpers.

Lies, Damn Lies, and Medical Research

According to a recent finding published in the New England journal of Medicine and reported by Reuters, eating more chocolate increases the likelihood of winning a Nobel Prize. With the amount that I consume, I expect to be receive mine in the near future.

I’m not holding my breath however, since the study, at least as reported, has made some obvious errors in their use of statistical methods and the interpretation of the results. (Though perhaps it was intended to be facetious) The author of the study plotted the number of Nobel prizes per capita against consumption of chocolate per capita. What he found was that they appeared to form a line. A simple regression showed that the relationship was positive with a probability of error (that there was no relationship) equal to 1/10,000. Compelling evidence to be sure, until one delves into the world of statistical analysis.

The underlying theory behind the relationship between chocolate and Nobel Prizes has to do with the effects of flavonoids (whatever they are) on cognitive abilities. The more chocolate (or wine) consumed, the higher is cognitive function and this increases the probability of being awarded the Nobel Prize. There is no indication, however, that the Nobel Prize winners ever consumed chocolate. Nor did the study consider those that did consume chocolate and did not win the Nobel Prize. Forrest Gump comes to mind.

Without doing any analysis of my own, I suspect that chocolate consumption per capita is correlated with Nobel Prize winners per capita, but there is no causal relationship. There is likely a causal link between chocolate consumption and income, as chocolate is a normal good. This could be confirmed by finding, or determining the income elasticity of demand for chocolate. Alternatively, one could regress chocolate per capita against GDP per capita (PPP estimates) and the GINI index – to control for income distributions. The coefficient on income should be positive and I suspect the coefficient on the GINI Index to be negative if significant.

Next, run a regression of average education or literacy rates as a proxy for education, against income per capita; again, checking the effect of income distribution. Since education is a normal good, the coefficient on income should be positive. This shows correlation, not causation. Higher income leads to higher spending on education and higher education leads to higher income.

Finally, regress average education or literacy rates against Nobel Prize winners. More education leads to more research. More research leads to more Nobel Prizes.

The relationship observed between chocolate consumption and Nobel Prizes likely has very little, if anything to do with chocolate consumption. There is a causal relationship between income and both education and chocolate consumption. Thus, there is a correlation between chocolate consumption and education and therefore, between chocolate and Nobel Prizes.

Consider this an open invitation for any reader to undertake the proposed research. Perhaps the New England Journal of Medicine will publish it.

The Story CBC Didn’t Get Wrong

We commented this month on two stories about supply shocks that the CBC got wrong. The first was prediction of a bacon shortage, which was subsequently recanted. The second was a prediction of a disposable diaper shortage.

This week, the CBC reported nothing about the start of the annual cocoa harvest in Ivory Coast, where 40% of the world’s chocolate originates. This is a good thing, because the CBC can’t get it wrong if they don’t report it. Fortunately, Reuters’ African branch did file a report. The weather has, apparently, been ideal for the harvest of cocoa beans and that suggests that there will be an increase in supply. Given the CBC’s last two reports, we suspected that they would predict a surplus of chocolate (like that could ever happen). An increase in supply would, initially, cause a surplus but competition among the sellers would quickly drive the price down and get rid of the surplus. This is exactly the opposite case of the bacon and diaper stories where supply decreased and price went up.

Before you go and get all excited about lower chocolate prices, however, we need to explore another Reuters article that explains some misguided government policy. In an effort to protect and/or increase the incomes of Ivory Coast cocoa farmers, the government has imposed a minimum farm-gate price on cocoa. This year’s price has been set at about 9% above last year’s price. The problem with this strategy is that last year’s harvest was unusually poor and the price rose as a result. This year’s abundant harvest should cause prices to fall, not rise.

As every student that has every taken a micro course from me knows, effective price floors always lead to surpluses. In labour markets, minimum wages cause unemployment. In cocoa markets, there will be a surplus of cocoa in Ivory Coast. Not surprisingly, “Farmers said very few buyers were active”.

The price controls in Ivory Coast are good news for Ghana where Bloomberg reports that a lack of rain fall has hurt this year’s crop. The higher farm-gate prices in Ivory Coast increase the demand for cocoa grown in Ghana. The higher prices will partially offset the lower crop yields, and the total effect will depend on the price elasticity of demand – a topic for another day.

No bacon shortage … but a diaper shortage is imminent.

The CBC reported today that there will be no bacon shortage as was suggested just last week. The whole bacon shortage has been written off as a pile of hogwash. Apparently, bacon prices are expected to rise which will induce more production and reduce consumption. We certainly wish that we had thought of that (they say tongue-in-cheek).


But CBC also reported today that there will be a shortage of disposable diapers. It seems that there has been a fire in a Japanese plant that produces 20 percent of the world’s acrylic acid which is used to make superabsorbent polymer, a key ingredient in disposable diapers. Supply of diapers will fall and there will be a shortage.

Remember last week when feed prices went up and the supply of bacon fell causing a shortage?

So, once again, you are hearing it here first. There will be no shortage of diapers. A decrease in the supply of acrylic acid will induce the other producers to increase output. The decrease in the supply of diapers will cause diaper prices to rise. Some people will switch to cloth diapers and/or diaper services.

Next week, CBC will announce that the whole diaper shortage scare was nothing but a pile of ****.