Automobile Accounting

Stories have been circulating this week about the production costs of the Chevy Volt hybrid automobiles. The numbers are astounding! According to a Reuters article in the National Post story, it costs US$89,000 to produce a car that sells for US$39,995. GM is losing US$40,000 per car. Yet GM continues to produce and market these vehicles. There is something seriously wrong with the management at GM, or there is something wrong with these numbers.

Basic economic theory suggests that a firm will be willing to sell its product for any price greater than the marginal cost of production, provided that the price is higher than the minimum average variable cost. The same economic theory tells us that “sunk costs” are irrelevant for decision making. A sunk cost is a fixed cost that has been incurred that can never be recouped. An example would be research and development costs. These costs certainly effect profits, but not the profit making decisions.

The article referenced above suggests that the $1.2 billion spent by GM should be divided up among the number of Volts that have been sold. While an accountant might agree with this, an economist certainly would not. The R&D money is a sunk cost. It can never be recovered. It reduced profit by $1.2 billion dollars. That money is an investment in a technology that is still developing, and will be used in other models in the future. The patents are intellectual property of GM and could, in theory, be sold to other automobile manufacturers.

The costs that are relevant to the production of the Volt, are the materials, labour and equipment used to produce each vehicle – the marginal costs of production. We haven’t asked GM for their cost figures, and we suspect that the batteries add significant costs over internal combustion engines, but to suggest the marginal cost of producing a Volt is US$89,000 is ridiculous.

Another issue surrounding the Volt, as reported by CBS news, is the lackluster sales of the Volt. GM has recently reduced the price of the volt (increasing the loss per vehicle reported by the industry analysis in the Financial Post article) in an attempt to increase sales. Demand curves are downwards sloping, so a reduction in price should increase the number of vehicles sold. The biggest problem that electric vehicles face is that oil prices, and therefore gasoline prices have fallen. Electric cars are a substitute for gasoline fueled cars, and a drop in the cost of operating a gasoline vehicle reduces the demand for electric cars. On our road trip through the western states this summer, we were able to purchase gasoline for about the equivalent of C$0.90 per litre. At this price, electric cars don’t make economic sense.

At some point in the future, oil prices will be high enough and the technology used in electric cars will be efficient enough that we will see more electric cars on the road. Until then, we’re investing in the oilsands.

The Story of Isaac and Joe

On the morning of August 21^st of this year, I stumbled out of bed at the Marriott Key Largo Resort and went out on the balcony to drink my morning coffee. (Tough life, I know) I called back in to my niece, who accompanied me on this particular adventure, and told her that a storm must be coming. The wind in the Keys usually blows from the west, but on that particular morning, it was blowing from the south. Later that day we learned that the National Hurricane Center was predicting that Tropical Storm Isaac would strengthen to hurricane force as it crossed the Straits of Florida and would then hit somewhere in the Keys in 5 days. Fortunately, we flew home from Miami on the 23^rd and didn’t have to cross “hurricane” off the bucket list.

The euphoria was short lived as the economic impact was felt back home. Not the minor damage in the Keys, or the more substantial damage in Plaquemines Parish LA, but the devastating damage to the Louisiana crabbing fleet. Crab is one of my favourite foods, and I have been known to drive the 275 miles (440 kms) just to get a steamer pot from the closest Joe’s Crab Shack. In Louisiana, they catch mainly Blue crab, and my particular favourite is Dungeness so why, might you ask, will the hurricane have any effect on me.

The supply of Blue crab is down as a result of the hurricane. Boats, docks, coolers and traps have been lost and flooded roads make it impossible to get to those that were not destroyed or damaged. According to a New Orleans Times-Picayune, the current daily catch is 6,000, down from 18,000. This reduction in supply is sure to raise the price of Blue crab. (Sounds like something straight out of Forrest Gump – but that was shrimp, not crab – and I digress.)

Dungeness crab, which is found in the North-Eastern Pacific Ocean off the coast from Northern California to Alaska, is a substitute for Blue crab. As the price of Blue rises, the demand for Dungeness increases. As the demand for Dungeness increases, so does its price. When the price of Dungeness increases, the marginal cost of producing steampots at Joe’s will increase. Joe’s supply curve is dependent on their marginal costs. As Joe’s supply curve shifts left, they may be forced to increase their prices.

That’s where I get hurt. An increase in prices at Joe’s will not stop me from eating at Joe’s, but it will reduce the consumers’ surplus I receive – the difference between the value that I receive and the price that I pay. Consumers’ surplus is what generates my happiness. Higher prices means lower consumers’ surplus which means less happiness. Blame it on Isaac.

Psst … Senator Dorgan … It’s ALWAYS an issue of supply and demand!

He’s actually the former Democratic Senator from North Dakota, but that doesn’t make the story for Yahoo! Finance’s Daily Ticker any less interesting. The quote in the title of this blog refers to the current price of gasoline – C$1.40/litre in Canada and US$4.00/gal in the US (1 US gallon = 3.8 litres). In the Yahoo! article, former Senator Byron Dorgan is quoted as saying that “(it) is not an issue of supply and demand”.

What Mr. Dorgan probably meant was that the pump price of gasoline is not being determined by the current production and consumption of gasoline. He suggests that the price has been driven up by “excess speculation” in commodity markets. To this end, he is suggesting that regulators “ensure that the price of gasoline reflects the fundamentals of supply and demand”.

Today’s lesson, for Senator Dorgan and politicians everywhere, is about the fundamentals of supply and demand, and the role of speculators.

Part I: Supply depends on the availability of raw materials and the costs of production. When politicians block the construction of pipelines, they increase the cost of moving oil from the point of origin to the refineries. When they ban drilling for oil, they prevent new supplies from holding down prices. When they don’t authorize the construction of new refineries, they prevent supply from increasing.

Part II: Commodity futures markets are all about speculation. Futures markets exist due to the uncertainty of future spot prices. (A spot price refers to the price for immediate delivery). If the price of a commodity was known for certain, there would be no benefit to contracting for future delivery, and all bets on future values would have no payoff. The uncertainty surrounding future prices creates a market for hedging and a market for speculators.

Hedgers buy and sell commodities for future delivery to reduce their risk. Speculators are betting that current spot process and future spot prices will be different and they “bet” accordingly. Without speculators willing to take on the risk, hedgers may not be able to reduce their risk.

When prices are expected to rise, current demand will increase, current supply will decrease and current price will rise. If my new sources are even remotely accurate, Iran is enriching uranium in an effort to produce nuclear weapons. Most of the rest of the world condemns Iran and has placed embargos on Iranian oil. Israel wants to blow up Iranian research centers and Iran has threatened to blockade the Straits of Hormuz. A large portion of the world’s oil passes through that body of water.

If Iran closes the Straits, the spot price of oil will certainly rise. Since there is a positive probability of that happening, expected prices for crude oil in the future are rising. Higher future oil prices cause higher current oil prices. Higher crude prices mean higher gasoline prices.

Part III: For speculators to make a profit, they have to be correct on average. If the price of oil is not going to rise, speculating that it will rise results in losses. Speculators cannot, by themselves, drive up spot prices and keep them there long enough to liquidate their positions. Anyone that doubts that should ask the Hunt Brothers who tried to corner the silver market in the late 1970’s and watched their fortune evaporate in 1980.

Gasoline prices are high because demand has been increasing faster than supply. More cars, more planes, more electricity, fewer drilling permits, no new pipeline, no new refineries. Oil prices are rising due to uncertainty in the Gulf. It’s all about supply and demand.

B.C. Ferries – A Giffen Good?

A Giffen good is a theoretical violation of the law of demand. When the price of a good rises, the quantity purchased of that good normally declines. Sir Robert Giffen is credited by Alfred Marshall with making the observation that, under certain circumstances, price and quantity demanded may move in the same direction, not the opposite direction.

When the price of a product decreases the consumer is subjected to both substitution and income effects. The substitution effect is the result of the change in relative price. When the price of good ‘A’ falls, good ‘B’ becomes relatively more expensive. Consumers purchase more ‘A’ and less ‘B’. Consumers substitute the relatively cheaper product for the relatively more expensive product.

Consumers also face an income effect. When the price of good ‘A’ falls, the purchasing power of their nominal income rises. An increase in real income leads to an increase in the demand for normal goods and a decrease in demand for inferior goods.

When a good is normal, the substitution and income effects work in the same direction and demand curves are unambiguously downward sloping. When goods are inferior, however, it is theoretically possible that the negative income effect is greater than the positive substitution effect and demand curves are upward sloping.

A recent Victoria Times-Colonist article tells about the BCFerries Corporation’s decision to increase fares “due to rising operating costs, increased capital expenditure and lower-than-anticipated traffic levels” (italics added).

It seems that BC Ferries may be trying to increase their traffic levels by increasing their fees. Perhaps they believe that their service is a Giffen good and we can add that to rice and wheat as discussed in blogs by Greg Mankiw (July 18, 2007) and Timothy Taylor (January 4, 2102).

CAMELS: Holier Than Cows

India, as usual, is rejecting the ways and regulations of the West in favour of internal and customary Banking regulations. Currently, India is regulated by a CAMELS system which grades banks based on their reliability, compliance with regulations, and probability of default. (See article)

The problems with this system become apparent when examining the Reserve Bank of India, equivalent to the Bank of Canada or Federal Reserve, and their measurement methods. The banks within India are being assessed by a corporation that answers only to their own country. It is difficult to assign quantitative values based on the qualitative information being used to classify each bank as being either Composite 1 rating, down to Composite 5 rating. Composite 1 rating would classify the bank as sounds, safe, and reliable in their investments and deposits, and the safety and soundness of the bank decreases with the increased number, leaving Composite 5 rating used to classify a bank which is unsound, unsafe, and unreliable in their loans, with a high rate of default. Because these classifications are assigned within the country, there is no international standard with which to standardize them.

Basel III is a system that would apply internationally. It works to hold every bank within its jurisdiction to the same quantitative standards. Basel III sets percentage rates based on loan risk and total assets. Basel III removes the opportunity for asymmetrical information in the global financial market.
As it stands, CAMELS regulations, within any given country, reduces asymmetrical information, in the form of moral hazard, by holding each bank accountable to the same national standards. India is arguing that they should maintain this method of regulation, because they see the problem of moral hazard as remedied. If the banks within India are kept to the same standard, and all of their banking information is shared, the problem of moral hazard is solved.

Unfortunately, this does not provide any solution to the international problem of moral hazard. Basel III does. Basel III maintains consistent standards for all banks, and has a strict implication system which does not allow for differing classification standards within any nation. The regulators, such as the Reserve Bank of India, would now answer to a system which supersedes their classification structure, which would disallow for any asymmetrical information on the global financial market.

So, not only would the moral hazard issue within the country be resolved, because the Reserve Bank of India would still be regulating the classifications, but on an international scale, all regulators would be answering to the same banking reserve structure. The report made on India’s position, regarding the CAMELS to Basel III debate, was largely misguided, as the writer failed to see the bigger picture. Too much focus was made on an East versus West basis, and not enough was spent on the global economic picture. It’s global interaction on the financial markets that will increase the stability of every country’s economic standing, including their GDP.

Jaci MacKendrick
Nicole Hanbury
Rhonda Sandve
Michael Daigle
James Trujillo
Christie Aquino

Citigroup: Stressed OUT

On Wednesday the 19 largest banks in the United States had to undergo a stress test. The stress test was designed to see how the capital of the banks would hold up through a deep recession in a second housing crisis.  While most of them passed, there were a few that failed the minimum requirements.  The most notable of these was Citigroup Inc. whom received the largest bailout from the US government during the financial crisis ($45 billion).  Citigroup had planned on paying out higher dividends but since they failed the stress test they must now revise and resubmit their capital plans for approval by the fed.

The stress test was based on the Basel III accord which is to be implemented in 2013.  Basel III requires that the total Tier 1 capital be 6%, however during the test Citigroup’s was only at 4.9%.  Not only did this fail to meet the Basel III accord but it also failed their own requirement of 5%.

If Citigroup had not planned to pay out higher dividends they would have passed the stress test however their plan to pay it out caused them to fail the stress test and put their Tier 1 capital below the requirement of the central bank.  Citigroup scrapped their dividend payout in 2009 when they received the federal bail out.  It was only last year that they reinstated a 1 cent payout.  Citigroup would like to increase their dividends to return capital to the shareholders.  If they were to follow through with this plan it would drive their capital even lower putting them and all of the stocks at higher risk.  Paying out higher dividends would cause their owners’ equity to decrease therefor capital would decrease as well.  Lower capital results in Citigroup having less money to lend out.

By depleting the banks capital they’re creating a similar situation to what occurred in the crisis of 2007 when mortgages went bad and banks like Citigroup needed a bailout.  Citigroup will now have to revise their capital plan and pursue a lower dividend as they’re still looking to return funds to their shareholders.  If Citigroup doesn’t revise their plan they will have trouble balancing their need to meet the Basel III requirements as well as maintaining the interests of the shareholders.

Cavan Lungren
Karsten Gulbransen
Joel Francis
Andrew Nemeth
Alex Dupuis
Patrick Ascue

with articles from Bloomberg and International Law

The Economist’s Son

My son is in grade 7 and this month his social studies topic is the economy. So being the diligent student that he is, he borrowed a copy of a macro principles text and did a little reading. Have pity on the student teacher, she didn’t stand a chance. When she asked “What is an economist?”, my son’s response was “My Dad”. Things apparently went downhill from there. 

There is another economist’s son that did not do his economics reading, or if he did, he didn’t understand it. That would be the son of Barack Hussein Obama Sr., an economist for the Kenyan government. You may be more familiar with the son, the President of the United States. As reported in a Reuters article, the President’s budget recommends ending the tax-free status of municipal bonds. With only a few moments thought on the subject, this economist can come up with several reasons why this is a bad idea, and will not increase the tax burden on “the wealthy”. 

Bonds trade in financial markets and bonds of equal risk and equal duration will sell for prices that create the same after-tax expected yield. A bond that gets downgraded, for example, will require a higher after-tax yield and that bond’s price must fall to raise its yield. The interest on municipal bonds in the U.S. is currently exempt from federal income tax. The President believes that most municipal bonds are held by individuals with high incomes and thus, should be taxed. A tax on the interest on these bonds will decrease the after-tax expected yield, and bond markets will react to this by reducing the price of these bonds. Municipal bond prices will fall and their yields will rise. The high income investor, who paid no tax on the interest, will sell his or her bonds and realize a capital loss. That capital loss can be used to offset capital gains on other investments reducing the overall tax liability. The change in tax status will have little effect on high income earners. 

Once the interest on municipal bonds becomes taxable, the pre-tax yield must increase to that the after-tax yield remains the same. Financial markets require that. Suppose that a municipal bond yielded 5% when it was tax-free. With a proposed maximum tax rate of 28%, the price of municipal bonds will have to fall until the pre-tax yield is 6.94% so that it continues to yield 5% after tax. All newly issued municipal bonds would also have to yield 6.94% on a pre-tax basis and the interest would have to be paid by the property owners that are ultimately responsible for those debts. I’m sure the middle class homeowners will be thrilled to learn that their property taxes have risen because the President wanted to tax high income earners. 

As property taxes rise, the cost of owning a home increases and the demand for housing decreases. When this happens, housing prices must fall. This is going to happen just as the housing market begins to recover from the collapse of 2007. Depending on how much taxes increase, and how sensitive housing prices are to local taxes, mortgage defaults may start to increase again. That would be more good news for cities like Phoenix, Las Vegas and Miami. 

Municipal bonds have an interesting use in infrastructure financing. A local government that wants to undertake a revenue generating infrastructure project such as a toll-bridge or county stadium, can initially finance the construction with zero-coupon municipal bonds. These bonds are sold at a discount (less than $100) and then mature at a price of $100 when the project is completed. The interest on the bond is determined by the difference between the issue price and the maturity value. No payments are made while the project is under construction. This type of financing only works for municipal bonds since interest is taxed on an accrual basis, not a cash basis. A corporate bond structured this way would be cash-flow negative to the investor – not an overly attractive selling feature. Once the infrastructure project is completed, the zero-coupon bond is redeemed using the proceeds of a revenue bond; a bond whose interest and principle is guaranteed by the revenue stream from the project. If municipal bonds lose their tax-exempt status, this type of financing will be unavailable and reduce the availability of funding for government infrastructure projects. More good news for the economy. 

Changing the tax exempt status of municipal bonds has more far reaching consequences that changing the tax liability of the high income earners that are believed to hold these bonds. An economist would predict a shifting of the tax burden from investors to property owners and a reduction in infrastructure spending. An economist’s son should know better.

© 2012 Pearson Canada Inc., All rights reserved, Used by permission