'How to Live Dangerously' - Why we should all stop worrying, and start living by Warwick Cairns is a straight talking book which seeks to assess the reality of perceived dangers. Some of the statistics show how we can gain a false impression of risk and as a consequence make misinformed risk.

For example, the book produces statistics such as:

• The chance of someone abducting your child is so low, it would only happen once every 200,000 years; and even then you would almost certainly get your child back anyway.
• Flying is much safer than driving a car. You'd have to fly every day for the next 26,000 years to die in a crash. (during that time you would have died 20 times driving to the airport.)

It is a theme we have mentioned previously on this blog; certain fatalities receive big newspaper headlines because they are high impact. If 3,000 people die in a single terrorist attack, it of course, makes front page news. But, did you know that, worldwide, an average of 3,000 people die every day from car accidents? Yet, because people die in ones or twos it rarely makes more than a local paper. Therefore, our perceived risk of car fatalities and terrorist incidents are skewed by the impressions generated by the media.

Even staying in the home can be dangerous, according to Professor Richard Wilson of Harvard University, falls kill 16,000 Americans every year.

What is the relation to economics of this book - Living Dangerously? In economics we try to undertake cost benefit analysis to help achieve the optimal distribution of resources. For example, apparently 59% of parents think it a good idea to fit an electronic tracking device into children, so that if they get abducted they can be tracked. However, if this scheme costs several million pounds, the opportunity cost is very high. Why spend so much money on electronic tracking, when teaching about road safety or DIY safety would have a much bigger impact in terms of lives saved?

It is only when we keep things in perspective and understand the real costs and benefits that we can make the correct decisions. There is also a growing trend in modern society to try and eliminate risks when actually doing this creates bigger problem. For example, last week, the economist reported how many trees in the UK were being cut down because councils are worried about being sued over falling trees. Yet, the actual risk from being killed whilst walking under a falling tree is minimal to say the least.

• How To Live Dangerously at Amazon.com
• How To Live Dangerously at Amazon.co.uk

Why is a Bottle of Water More Expensive Than a Bottle of Beer?

Beer incurs a significant tax. Excise duty on beer costs upto 50% of the price. Therefore, you would expect a beer to cost 50% more than water. Yet, if you go into a bar, you will probably find that a 500ml bottle of mineral water costs more than beer. Why do firms put a higher profit margin on water than they do on beer?

1. Quantity consumed.

People who buy water, are probably the kind of consumer who will be sitting in the bar, nursing their water for several hours. Therefore, that customer is not a profitable customer. However, someone who buys a beer, is much more likely to buy several beers. Downing several mineral waters, just doesn't have the same effect as enjoying several beers. Therefore, although the profit margin is smaller per item a beer drinker is probably more profitable in total than a water drinker.

2. Competition.

When trying to attract customers, you will advertise the price of beer, not of mineral waters. It is the headline price which will attract the most attention from consumers. If you are going to spend a night in a bar, the price of mineral water is not a big deal; but, the price of water is probably much more important.

Why Does a $700 computer in the US cost £700 in the UK, when the official exchange rate is $2 = £1?

Looking at the official exchange rate, you would expect a $1,000 computer in the US, to cost £500. But, many computers and electronic goods cost up to £1,000 making it effectively twice as expensive in the UK compared to the US.

Example:

• Mac Book Pro at Amazon.com US - $1,7999
• Mac Book Pro at Amazon.co.UK - £1,616.34

What can explain this discrepancy in the price?

Transport costs.
If the goods were produced in the US and exported to the UK, this could explain a small divergence in price. However, this is not even the case, many of the manufactured goods are produced in China and other Asian Countries

Higher Rent.
This is a more powerful argument. If living costs and wages are higher in the UK, then electronic shops would have to charge higher prices to cover the extra costs. Some things are more expensive in the UK e.g. petrol prices; but petrol is an insignificant % of the cost of buying a new compueter. )However, average wages in the UK are not higher than the US; also the cost of rent could not explain discrepancies of upto $1,000. Also the argument becomes even less convincing for an online retailer like Amazon, where renting costs are lower

Exchange Rates don't reflect Local purchasing Power.

In theory, if exchange rates are skewed like in our example, it should cause an appreciation in the dollar and decrease in the value of Pound Sterling. Because goods are much cheaper in the US, it makes sense for British consumers to buy from America. This increases demand for dollars and should cause the value of the dollar to rise. However, in practice it is difficult for people to import computers from America; there are customs, transport costs and inconvenience factors e.g. how do you return a faulty good to the US.

Many Factors influence Exchange Rates apart from local purchasing power.

This shows that there are many factors influencing exchange rates apart from basic competitiveness and attractiveness of goods. Furthermore, these discrepancies can last for a long time. The dollar is basically undervalued compared to Pound Sterling and the Euro. The weakness of the dollar could be attributed to:

• Lack of Confidence in the future of the US economy and strength of the dollar
• Large Current account deficit in the US.
• The US Dollar losing status as the world's reserve currency.

For some countries, this discrepancy between exchange rates and effective purchasing power of countries can be even larger. The Economist use a Big Mac index to give a rough idea of different living costs. For example, a Big Mac in South Africa may cost less than $1.50. A Big Mac in Japan can cost over $4.00. This difference reflects the fact, currency investors have much more confidence in holding Japanese Yen than South African Rand.

Related

• Car Prices in the UK and Europe

Why is it that holiday companies will often sell holiday packages at a huge discount if you buy a few days before. However, if you buy a train ticket the day before, the cost can be 100% higher than if you had bought in advance?

Both are examples of price discrimination where companies are seeking to maximise profits. With package holidays, the companies have already paid for them; they have signed contracts with the hotels. This is like a sunk cost - no matter how many holidays they sell there costs have already been paid. Therefore, the marginal cost of selling an extra holiday package, is pretty close to zero. Therefore, getting any price is better than nothing. Therefore, it makes sense for the travel company to sell at a discount; it even makes sense to sell for less than they bought the holidays for. In this case they are able to minimise their losses. (It is a bit like selling Christmas trees at a discount on Christmas eve)

Because some package holidays are very cheap at the last minute, you might expect customers to wait. However, consumer behaviour suggests people rarely want to do this. When it comes to holidays, price is not the only issue; they are also concerned about getting their preferred destination. Therefore, only a small % of customers are willing to leave it to the last minute and the pot luck of getting a suitable have very elastic demand.

With train tickets, their is a similar marginal cost for selling train tickets however, the last minute buyers of train tickets are liable to have an inelastic demand. Maybe businessmen who find they need to travel at last minute. Therefore, train companies seek to maximise this willingness to pay a high price by charging higher prices. Although it makes sense to fill a train; they maximise revenue by setting higher prices to those willing to pay, rather than cutting prices to ensure a full train.

• Price Discrimination

When Mrs Thatcher came to power, one of the things she promised is that her government would take the attitude of a careful housewife, only spending what they receive. If it is reckless for a housewife, to spend more than she receives in income, then why should the government spend more than their tax revenue?

Many argue that political pressures encourage governments to borrow and therefore, we should have legislation to force governments to balance their budget. (A similar constitutional amendment in the US, only narrowly failed). But How Bad is Government Borrowing?

Problems of Government Borrowing.

Crowding out of Private Sector.

The government needs to borrow by selling bonds to the private sector. The argument is that if the government borrows from the private sector, the private sector has less money to spend and invest. Furthermore, many, especially those of free market principles, argue that government spending has a tradition of being more inefficient than the private sector. This is because governments are subject to special interest groups and lack of a profit incentive. Therefore, if you cut government borrowing, you will increase the role of private sector investment and help the economy to be more efficient.

• However, it is argued that government borrowing may not cause crowding out, because people who buy bonds are just using money which otherwise would have been idle. Also, it is argued government spending is not more inefficient than the private sector. For example, government spending is necessary to overcome market failure such as lack of education, health care and investment in trains.

Interest Payments.

The problem with borrowing money is that you have to pay interest on your debt. For a government like the UK, the government has an annual interest payment of £26 billion on the National Debt. Borrowing incurs a cost on future generations and future tax payers.

• Government borrowing is a way of foregoing higher current tax rates. We get lower tax now, but, we have to pay for this in the future with higher tax rates to pay for the interest rates. Some economists argue, this is not a problem because you could invest the lower tax rates in the present to increase your economic wellbeing so that you will be able to pay back the government's borrowing in the future. Therefore, they argue, eliminating government borrowing will reduce interest payments but at the expense of higher tax rates and foregone investment opportunities. The problem I have with this argument is most tax payers do not invest current lower tax rates so that they are in a better position to pay higher tax and the future interest. We not only have to pay the government borrowing, but also the market interest rate. Rather than paying £25 billlion in interest payments, the government could be investing in public services.

Expansionary Fiscal Policy

Government borrowing can stimulate the economy in times of a slowdown and recession. Lower taxes should increase consumer's disposable income and encourage consumer spending and therefore economic growth. To balance the budget in a recession would require higher taxes and lower spending; this would make the recession worse. Monetarists argue that fiscal policy is ineffective in increasing Real GDP. But, most economists would argue rigidly sticking to a balanced budget in the time of a recession, would be a disaster (e.g. as UK government did in 1931 at height of Great Depression) This is why balanced budget proposals usually make provisions for 'balancing the budget over the course of the economic cycle.'

• Fiscal Policy
• Problems of government borrowing
• Problems of Government borrowing
• What went Wrong with US economy?
  

If your struggling with rising petrol prices (gas prices to our American cousins) these are my top 10 Ways to Save on Petrol costs.

1. Don't Own A Car

If you don't own a car you will be forced to use alternative methods of transport, such as public transport and buses. When we have a car, we think they are indispensable, but, when we live without a car we realise how many other alternatives there are.

2. Buy a Fuel Efficient Car

If the idea of not owning a car sounds too drastic, at least buy a fuel efficient car. Some cars especially SUVs, can require double the amount of petrol of ordinary cars. Switching to smaller, more fuel efficient cars will save you money in the long term. Many cars have engines far larger than necessary; what is the point of having a car with a top speed of 160mph, when the speed limit is 70 mph?

3. Car Sharing

For commuting or long distance travelling, always think if you could share the journey with other people. This has the potential to halve your petrol costs. Many cities such as Leeds UK and Los Angeles see the benefits of encouraging car sharing and offer special lanes just for people with more than 1 person in the car.

4. Drive Less

Instinctively, we get used to driving everywhere, because it is often the easiest mode of transport. However, for each journey we can examine whether:

• Is it necessary?
• there is an alternative type of transport.

5. Buy a Bike

50% of car journeys are less than 2 miles. These journeys will involve low speeds at which fuel consumption will be relatively high. These journeys can easily be taken by bike. They will save both money and time. A bike is also easier to park and navigate. If you get a bike you will save many car journeys are petrol. (see 7 ways to save money with cycling)

6.. Avoid Speeding

A car has the greatest fuel efficiency at about 60mph. If you accelerate hard from 60 to 80, there will be a big % increase in fuel consumption. If you stick in the left hand lane of a motorway, you will use less petrol because:

1. 60-70 is the most fuel efficient speed
2. You will also benefit from the drafting effect of being behind lorries (not too close) but even at a difference you will benefit from reduce air flow.

7. Smooth Speed.

I learnt this technique through cycling. When cycling you think hard about how to save effort. For example, if you see traffic lights in the distance, you allow the car to slow down naturally, neither accelerating or braking. Some people keep the foot on the accelerator and then have to brake hard for the lights. This uses excess petrol. It is better to try and allow the car to travel with its own momentum, and slow down in anticipation of roundabouts and lights rather than leave it to the last second. In traffic jams, try to avoid sudden start and stopping, instead try to keep the car crawling along, this will save petrol.

8. Buy Cheapest Petrol

The price of petrol can vary by 5-15% depending on where you buy it. Make a note of cheapest petrol stations and buy it whenever you pass. Avoid having to fill up on motorways where the cost will be upto 15% higher

9. Increase Efficiency of Car.

The fuel consumption of your car can be increased by maximising the efficiency of your car in various ways:

• Use correct tyre pressure and check regularly. Many motorists fail to check tyre pressure and end up using more petrol because their car has become more inefficient
• Reduce Weight. Don't carry around unnecessary weight in the boot. More weight will increase fuel consumption especially driving up hills.
• Increase aerodynamics. Keeping an empty roof rack on a car will increase the inefficiency of driving and fuel consumption. Remove it where possible.

10. Buy Mail Order

Rather than driving to out of town centre shops, take advantage of online delivery. These not only save you money, but also time.

Related

• Rising Petrol prices reducing obesity

George W. Bush has left America and the World many different legacy's - Guantanamo Bay, a snub to Kyoto, Iraq; but, on the economy one issue is worth exploring - a legacy of debt.

National Debt

National debt has passed a remarkable $9.3 trillion. (see debt clock) As a % of GDP it is approaching a 50 year high; a level not seen since the effects of WWII spending.

National Debt as a % of GDP Fell Under Clinton and Rose under Bush


National debt has increased for various reasons including:

• Tax Cuts, especially for high income earners and business. However, spending has not fallen to match the tax cuts.
• Military operations in Iraq (not necessarily accounted for in defense budget) have increased spending
• Demographic changes of an ageing population leading to more welfare spending.
  

The result has been an increase in national debt. As the economy slows down in 2008 and 2009, the National Debt as a % of GDP will only deteriorate further.

Personal Debt

The boom years of the 00s, were financed by unprecedented levels of consumer borrowing. According to latest figures from the Federal Reserve, US consumer debt has reached $2.5 trillion (link)
The US savings rate dipped to a remarkably low figure. IN 2006, it dipped into a negative savings ratio. Debt increased because:

• changes in attitudes - good times will keep rolling
• People remortgaged against rising property prices - leaving many facing negative equity.
• Lack of regulation in the finance sector.

The government cannot take all the blame. Partly it relies on individual spending patterns. Partly we can blame financial institutions which encouraged lax lending criteria. But, the government can be criticised for not doing more to regulate a financial system, seemingly incapable of regulating itself.

Sub Prime Debt

Perhaps the most caustic legacy is the subprime mortgage loans which have caused so many repercussions around the financial system. Many mortgages were sold to people who had little chance of repaying them. When interest rates rose slightly, there was a rise in mortgage arreas which led to banks having to write off billions of pounds in bad debts. The rise in interest rates in 2006 was relatively modest, but, the problems it caused showed how the banks had willingly taken on excessive risk and passed it around the whole financial sector. The losses in various banks have involved billions of dollars and has threatened the survival of many banks and mortgage companies.

Current Account Deficit.

The current account deficit measures how much America has imported relative to exports. The current account deficit reached a peak of 6.5% of GDP (imports $600 more than exports). The current account deficit has been financed by capital flows from Asian countries such as China and Japan. The legacy of this continued deficit is that a high % of American debt has been purchased by America's creditors - China, Japan and others. However, as their appetite for purchasing American debt fell, it became more difficult to finance the deficit and as a consequence the dollar's depreciation accelerated.

Current Account Deficit in US

Should we feel Guilty for Buying A Strawberry Grown in New Zealand?

There is a lot of media coverage and interest in the concept of 'air miles'. There is a reasonably good argument that says it is bad to buy food flown from the other side of the world because it unnecessarily contributes to carbon emissions. It is far better to buy local food that needs less transport and therefore helps to reduce global warming. There are also emotional arguments to support your local farmers, rather than buying from 'foreigners.'

From one perspective it seems crazy to buy a strawberry grown in New Zealand, when I could grow strawberries in my own backyard Whilst, I believe in reducing pollution, how powerful is this argument? And if it is crazy to import a strawberry from New Zealand why does it happen?

1. Transport costs are a relatively low % of production costs. Transport costs account for approximately 11% of the total GHG emissions. From producer to retailer, the % is only 4% . Therefore, if we buy locally, we will only make a small dent in overall GHG (Greenhouse Gas) emissions. [ - Report by Christopher L.Weber published in Environmental Science and Technology link]

If we were buying red meat locally, the environmental impact is far greater. Red meat is very intense on the environment. Red meat has 150% more GHG emissions than chicken or fish. The GHG emissions of chicken is similarly much higher than vegetarian diet. With meat, you have to grow crops just to feed the animals. These multiple layers of farming creates pollution much more significant than the transport costs.

• If you really want to help the environment the answer is not to buy local but become a vegetarian or least eat fish and chicken. It is much better to import soya beans and strawberries from Brazil and New Zealand than it is to eat red meat from your local farmer.

2. Theories of Comparative Advantage.

The theory of comparative advantage states that society can benefit if we specialise in producing goods at which we are better at producing. Free trade enables lower prices, greater efficiency, economies of scale and greater choice. If we buy food only from our local area, we will be worse off, paying higher prices, and more inefficient production methods.

What about importing a Kiwi fruit from New Zealand? A kiwi fruit just wouldn't grown in the UK environment. Importing from New Zealand enables greater choice. If we don't feel guilty for buying cuddly toys from China, why should we feel guilty for buying Kiwi fruits from New Zealand?

3. The Solution?

If importing foods from New Zealand incurs an external cost (pollution from the transport) the solution is to impose a 'carbon tax' equivalent to the cost of pollution. Admittedly, this might be hard to precisely define. But, if consumers pay the social cost of importing the food then this can enable the most efficient production and distribution of resources around the world. We can then import strawberries from New Zealand without feeling guilty. We can also continue to enjoy the benefits of specialisation. The Tax raised from the carbon tax could be earmarked for 'environmental projects'

I actually quite like the idea of buying in season fruit and vegetables. If it can be sourced locally that is an added bonus. I also would be happy to pay a tax on the import of goods from overseas to cover the external cost of pollution (However, this should apply to all goods - not just fruit and veg).
Also, I would expect this tax to be a relatively low % of the price. If the GHG emissions from transporting food from oversees is only 4% of total GHG, it may be more efficient to tax meat on the grounds that this does greater environmental damage.

• Economics of Global Warming
• Can Economics solve global warming?
  

It has been argued that American politics has become increasingly blurred on economics between left and right. Under Clinton, the Democrats lost the mantle of being a tax and spend party. Perhaps unexpectedly, they gained a reputation for being a party of fiscal responsibility, managing to achieve a budget surplus - a rare event in modern American history. However, looking at the campaign promises of Obama and McCain a clear choice is emerging.

Obama Tax Plans

Mr Obama has suggested:

• Raising the top income-tax rate from 35% to 39.6% (This is the level before Bush's tax cuts)
• Remove earnings cap on payroll tax. This could lead to a top marginal tax rate rate of 46%
• He also suggests increase capital gains from 15% to 25%

Some of the details are sketchy, but, he has left no doubt about his willingness to increase tax on the well off; a reversal of the strategy under Bush.

McCain Tax Policies

McCain by contrast has focused on promising more tax cuts, such as cutting corporation tax to 10% and keep income tax for the rich high. He promises to pay for these tax cuts through 'spending cuts' But, like many republicans before him, talking about 'spending cuts' is much easier than actually being able to implement them. If the tax cuts were implemented, it is likely the budget deficit (already had dangerous levels) would continue to grow.

But, these policies do present voters with a clear choice. If you own a business and receive a high income McCain will make you better off, Obama will make you worse off. If you on a low / middle income you will be more favoured by an Obama presidency.

It will be interesting to see whether many Americans agree with Warren Buffet's assessment that high income earners deserve to pay more tax.

Source: Economist

US house prices continue to drop like the proverbial brick.

One of the most respected house price indexes - S&P/Case-Shiller national index reported house prices fell by 14.1% in the 12 months to April 2008.

Why are House Prices falling faster than in Great Depression?

Bubble and Bust: Prior to the Great Depression there wasn't really a housing bubble; the housing market was more stable and less prone to fluctuations. Recently, more people have viewed the housing market as an investment (and a one way bet at that).

Irrational Exuberance.

It is easy to be wise after the event, but, even Alan Greenspan will probably regret making this prediction about US house prices in 2005:

“A DESTABILISING contraction in nationwide house prices does not seem the most probable outcome...nominal house prices in the aggregate have rarely fallen and certainly not by very much.”

There was a strong feeling that house prices were bound to keep rising, therefore, it was a no brainer to keep investing in housing. However, now the irrational exuberance has reversed and prices have reversed.

Over Supply

The boom in house prices caused a mirror boom in building; the consequence is that falling demand for housing has occurred simultaneously to a substantial rise in supply. Even the slowest economic student will realise this is a basic recipe for falling prices.

Credit Crunch

The well documented credit crunch has hit mortgage availability. From eager, irresponsible lending, banks have had to retreat and become very cautious about lending. The result is many would be home buyers have pulled out of the market as they are unable to receive finance.

Negative Multiplier Effect and lower confidence.

With house prices falling so rapidly, if seems to make sense to wait, rent and buy when house prices recover. If house prices are falling 14%, waiting 1 years could save you $28,000 on a $200,000 house - that's a pretty big incentive to 'wait and see'. In the great depression, people's attention was focused on plummeting share prices and rising unemployment. There wasn't even a national house price statistic at the time. In fact towards the end of the 1930s, the housing market was one of the strongest sectors of the economy. Low interest rates encouraged homebuilding as a new generation of people considered buying a house.

See also:

• Boom and bust in US Housing Market
• US Housing Market in Decline
  

Part of the remit of the Bank of England is to keep inflation within the government's target of CPI 2% +/- 1. If inflation falls outside the target of 1 - 3% then the Governor of the Bank of England has to write a letter of explanation to the Chancellor. It sounds a little bit like a naughty school boy writing to the headmaster to say why he hasn't done his homework.

The Governor of the Bank of England will probably find himself writing a lot of letters in the coming months. They will probably be saying something like:

"Dear Alistair,

Unfortunately, because of rising oil prices, cost push inflation has risen significantly in recent months. Usually at this stage of the economic cycle we would expect lower inflationary pressures. With house prices falling and lower consumer spending, demand pull inflation is relatively low. However, it is the rise in food and energy prices which is the main reason behind the high inflation we see today.

Because of the slowdown in the economy, we have been reluctant to raise rates to reduce inflation as higher rates at this time could push the economy into recession.

However, we expect inflation to fall back to the target in the coming months as oil prices stabilise and the slowdown reduces demand further.

Give my best wishes to Gordon, Sarah and the cat who lives at no. 11.

yours, Mervyn"

Satire on Inflation

Since we are talking about inflation targets, I can't resist adding this satirical article about the hyper inflation in Zimbabwe.

Gideon Gono, the embattled Governor of the Bank of Zimbabwe has been forced to write to the President of Zimbabwe explaining why the country’s inflation target of one million per cent has not been met this financial quarter.

The Zimbabwe retail price index just edged over the official target to 1,000,003%, although it is hard to gain a precise guide to current prices as there is nothing in any of the shops across most of the country. However official figures claim that cornmeal and maize have remained steady at 25,000,000 Zimbabwean dollars a kilo, though machetes and ankle irons have edged up in price due to increased demand over the holiday period....

Read More at News Biscuit....

Bank of England Inflation target

Readers Question: What is the Importance of Economics?

This is a very open ended question. We could write anything between 20 words and a whole book.

I would suggest the main importance of economics is helping society decide the optimal allocation of our limited resources.

In particular economics is important in these areas.

How to manage the macro economy.

Economists can advise governments how to manage the economy and avoid inflation and unemployment. Both hyper inflation and mass unemployment can be devastating for society. Economists argue that both can be avoided through careful economic policies.

However, the problem is that economists may often disagree on the best solution to these problems. For example, at the start of the great depression in 1930, leading economists in the UK Treasury suggested that the UK needed to balance the budget. (This led to the fall of the Labour government as the Prime Minister Ramsay McDonald was one of the few Labour MPs who agreed to the economists suggestions to cut unemployment benefits and increase tax. ) As you might expect this Classical approach only made the great depression worse.

The Great Depression led to John Maynard Keynes developing his general theory of Employment, income and money, arguing that classical economics had the wrong approach for dealing with depressions. Keynes argued that the economy needed to expansionary fiscal policy.

Overcoming Market Failure.

Generally it is considered that free markets offer a better solution than a planned economy (Communist) However, free markets invariable lead to problems such as the over production of negative externalities (pollution) and underproduction of goods with positive externalties (education, health care, public transport). An economist can suggest policies to overcome these market failures.
Note: these policies are often politically unpopular and may not get implemented, but they show possible solutions to social problems. For example:

• Should We tax Fatty foods?
• Arguments for Road pricing
  

Efficiency

Another area where economists have a role to play is in improving efficiency. For example economists may suggest supply side policies to improve the efficiency of an economy.

Individual Economics.

Economics is also important for an individual. For example, every decision we take involves an opportunity cost - which is more valuable working overtime or having more leisure time?

Future Issues in Economics

Economics is constantly evolving. For example, in the future economic issues will involve:

• How to deal / combat global warming.
• Does globalisation help or hinder developing countries.
• How best to eradicate poverty in developing countries.
• How to live in society without oil.

On this blog I invite questions from the readers on Economics. I don't do mathematical questions nor am I interested in giving answers to coursework. I publish any answer online in the public domain so that students know they can't try to pass it off as their own work. I hope these answers will be a learning device. There is nothing here I wouldn't offer to my own students studying economics.

However, before the exam season I became inundated with questions - I was getting up to 10 a day and I couldn't keep up. It was a simple case of demand being greater than supply, which is not unexpected given the price was zero.

Diagram of Supply and Demand


Price of 0 leads to excess demand of Qy - Qx (shortage)

Therefore, I had to change my pricing strategy. Rather than answering questions for free I would charge £1. In theory this would return the market to equilibrium. I would get less questions and the people who really valued the answers would pay. It was also a case of price discrimination charging a higher price in a time of inelastic demand (the exam season).

In practice not may wanted to pay £1. I think this was largely because of the difficulty in transferring money - maybe students didn't have a paypal account e.t.c. I think more students would have paid £1 if it was easier to transfer money

However, now the exam season is over I am going to revert to free questions, at least temporarily.

To be honest I prefer having questions free. When people pay there is an expectation to give complete answers. I'd rather be picky about the questions I answer and in some cases I feel I need to give just hints rather than full answers.

If you have any economic questions feel free to ask. But, please forgive me if I don't have time to answer!

You are also welcome to donate if you find this site useful.

When a salesman comes to your door he benefits - he has the chance to sell you goods, if you don't want to buy it hasn't cost him anything. He has no renting costs and he has direct access to the consumers. On the other hand the homeowner invariably loses out. We have the cost of answering the door to an unwelcome visitor. The cost here is in terms of time wasted, and disruption to our leisure time.

This is an ingenious solution to this problem of market failure. - Pay a dime to ring the bell.


If the caller is a friend they get the dime back. If the caller is a nuisance - salesman or canvasser, they don't. This means that the unwelcome salesman has to pay you something equivalent to the cost of you having to answer the door. In this case you can't lose. If the salesman is unwelcome at least you have been compensated for your inconvenience. It also forces the salesman to think whether they really want to knock on the door. If they have really attractive goods, they may be willing to pay the entrance costs because they think they will recoup them. However, if they goods are mostly useless they may be unwilling to pay the entrance fee - the rent and therefore not bother you. This means an unnecessary transaction is avoided increasing market efficiency.

Problems

• What if your friend has no cash on them?
• Cost of buying the box
• It makes you look a bit tight
• I think the principle is not so much about money but the fact you get your own back on the irritating salesmen.
• Rather than ringing the bell they may just knock very loudly.

Interest rates are constantly in the news, and we all know they have an important effect on the economy and our personal finances; but, the bewildering array of interest rates can become confusing. This is hopefully a simplified guide to how interest rates affect the economy and individuals.

What are Interest Rates?

Interest rates are often referred to as the Cost of Money. This is because interest rates determine the cost of borrowing money. When interest rates are high, there is a disincentive to borrow, but saving money becomes more attractive.

Real Interest Rates.

• Real interest rates = Nominal Interest rates - Inflation

It is important to bear in mind that the impact of interest rates depends upon the inflation rate. If interest rates are 10% and inflation is 9%. It means that saving money in a bank will give a real interest rate of only 1%

If interest rates are 5% and inflation is 3% (like at the present) it means real interest rates are actually higher than other example (2%) In a period of deflation, real interest rates can be quite high even if nominal interest rates are quite low.

Base Rates

This is the main interest rate set by the Monetary authority. In the UK base rates are set by the Bank of England. In the US base rates are set by the Federal Reserve. This base rate is the rate at which commercial banks borrow from the Central Bank and therefore influences all the other interest rates in an economy. But, note, the federal Reserve does not control commercial interest rates - it only controls the base rate.

• How the Bank of England set interest rates

Interest Rates and the Economy

Interest rates are used to influence inflation and economic growth. Basically, higher interest rates will reduce consumer spending and investment. This will slow down economic growth and help reduce inflation. The Monetary authorities thus face a trade off between reducing inflation and slower economic growth.

• For more detail see: Effect of Higher interest rates

Commercial Bank Rates.

Recently, it has been noted that banks have been increasing interest rates for borrowing, even though Central banks have been cutting rates. This is because the credit crisis has encouraged banks to increase their commercial rate margin. Because banks are short of credit they want to encourage people to save and reduce availability of credit. This means the margin between bank rates and the main base rate has increased. Basically, the banks are seeking to make saving more attractive. This is also reflected in an increase in the interbank lending rate.

Interbank Lending Rates.

Banks are often temporarily short of cash, so they borrow from other banks. This helps to maintain greater liquidity in the banking system and means banks can have lower liquidity ratios. However, because of the credit crunch the interbank lending rate has increased making it more expensive for banks to borrow from each other.

Interest Rates and Risk

If you take out a mortgage loan, the bank sees the loan as fairly secure because the loan is guaranteed against the value of the house. Therefore, the borrowing rate for mortgages is quite low. However, if you take out an unsecured loan, it means if you fail to repay the bank will lose all their money because they cannot claim against an asset. To compensate for the risk they will set a higher interest rate. This is why people with poor credit tend to face higher rates.

Interest Rates and homeowners.

Homeowners with a variable mortgage will be affected by any change in interest rates. For example, if you have a £100,000 mortgage a 50 basis point change in interest rates will affect your monthly payments by about £50. If homeowners want to avoid interest rate volatility then can get a fixed rate mortgage. Otherwise the cost of your mortgage will vary with changes in the interest rate.

Forecasting Interest Rates

The future trend of interest rates depends mostly on the future direction of the economy. If the economy is forecast to grow and increase inflation, interest rates are likely to increase to keep inflation low. In a recession, inflationary pressures diminish and so rates can usually be cut.

• See: - Predictions for interest rates

Interest Rates and Oil Prices

If oil prices increase (e.g. 2007-08) it causes both inflation (cost push inflation) and lower growth. Therefore this presents a dilemma. The monetary authorities would like to cut rates to boost growth. But, they would also like to increase interest rates to reduce inflation. This shows that interest rates can not solve a country's problems.

• What determines effectiveness of Monetary Policy?

Interest Rates and the Exchange Rate

An increase in interest rates makes a currency more attractive. This causes hot money flows into an economy causing an appreciation. Similarly a cut interest rates will often cause a depreciation in the currency.

Why Do Interest Rates vary from 0% to 2,000%?

The reason is that banks use interest rates to determine the profitability of lending. Credit card companies charge interest rates of 17% basically because they can get away with it. Credit card debt is therefore very profitable for credit card companies. Pay day loans can have annual interest rates of upto 2,000%. It is a very expensive way to borrow money, but there is still the demand for this kind of loan.

• See: Why are there so many interest rates?

If you put money in a current account (checking account in US) then the interest rate may be very low. This is because the bank may not see a current account as very profitable. A savings account with time limits on withdrawals will give a higher interest rate.

More on Interest Rates

• Effect of Interest Rates on Housing and Shares
• Gross, Net and AER interest rates
• Monetary Policy
  

Earlier in the year, I posted - Why is US economy facing a recession?

Since then, the economy has managed to avoid entering into a recession; but, recent statistics suggest an economic slowdown is gathering pace

• Rise in joblessness. Unemployment rate increased from 5% to 5.5.%. Over 350,000 people have lost their job this year (real estate and construction have been badly hit)
• Rise in Oil prices close to $140 a barrel. This has reduced consumer's disposable income; it is has even caused a fall in demand for petrol - something very rare in the UK.
• Rise in Mortgage arrears.
• Rising inflation, raising prospect of increased interest rates to reduce demand.

Stagflation

The economy is experiencing an example of stagflation - rising inflation and rising unemployment.
see also: falling house prices - rising oil prices

There was a time in the 1950s and 1960s, when a current account (trade) deficit was a political disaster. People felt a deficit was a reflection of a weak economy and a sense of national shame. In the UK, there was even a 'buy British' campaigns, which amongst other things sought to help improve the UK's trade deficit.

Nowadays, in an era of globalisation, 'buy British' campaigns sound rather out of touch. In fact, some economists argue that with the free movement of capital, a current account deficit is no problem because the deficit can easily be easily financed. However, a current account deficit can give insights into the performance of an economy, and in some cases cause economic problems.

Effects of A Trade Deficit

Competitiveness. A deficit may imply a decline in competitiveness; e.g. higher labour costs. The UK's persistant deficit since the early 1980s, is arguably a reflection of the deterioration in the competitiveness of the manufacturing sector.

Depreciation. In the long term, a current account deficit can cause a depreciation of the exchange rate which reduces living standards (imports are more expensive). This is because a deficit means foreign exchange is flowing out of the country. If the deficit is small, it may be easy to finance it through capital flows; but, if the deficit is large like US (6.5% of GDP in 2007, it will almost certainly cause a depreciation in exchange rate.

High Growth. A deficit may simply be because the economy is growing quickly. When the economy is growing people will be buying more imports. Therefore, a current account deficit may be a reflection of high growth and falling unemployment, which is a good thing. Japan has had a current account surplus but very sluggish growth in the 1990s.

• However, a deficit may also indicate the economy is growing too quickly causing domestic inflation and so people buy from abroad to avoid high domestic prices.

Low Savings Ratio. A deficit may also indicate that the savings ratio is too low. When savings ratio is low people are spending and investment levels are lower. Therefore, people are enjoying high consumption now at the expense of better living standards in the future.

• E.g. China has economic growth of 10%, but, has a current account surplus. This reflects its high savings ratio. The US current account was partly due to a very low savings ratio and high level of personal debt, which suggests an unbalanced economy.

How Deficit is Financed. It depends how the current account deficit is financed. If the deficit is financed through long term capital investment, this can be beneficial for an economy. If it is financed through short term borrowing and hot money flows, this is likely to be more problematic. The problem with the US current account deficit was that they were relying on Asian investors buying dollar securities at relatively low interest rates. However, with a falling dollar these dollar securities suddenly started to look very unattractive hence the long depreciation in the currency.

Related

• Does a current account deficit matter?
• Balance of Payments
  

With Barack Obama now having a good chance of becoming the new American President in November, he will probably be hoping that, if he does win, he will be able to inherit an economy in reasonable shape. Unfortunately, any new President is likely to inherit an economy characterised by falling house prices and declining living standards. In particular, falling house prices continue to accelerate and give cause for concern.

"America's house prices are falling even faster than during the Great Depression. As house prices in America continue their rapid descent, market-watchers are having to cast back ever further for gloomy comparisons. The latest S&P/Case-Shiller national house-price index, published this week, showed a slump of 14.1% in the year to the first quarter, the worst since the index began 20 years ago. Now Robert Shiller, an economist at Yale University and co-inventor of the index, has compiled a version that stretches back over a century. This shows that the latest fall in nominal prices is already much bigger than the 10.5% drop in 1932, the worst point of the Depression. And things are even worse than they look. In the deflationary 1930s house prices declined less in real terms. Today inflation is running at a brisk pace, so property prices have fallen by a staggering 18% in real terms over the past year.

" ("The Economist")

Effects of Falling House Prices

• Reduce Consumer wealth and consumer confidence. This is why many fear a recession in the US. To some extent the lower interest rates and tax cuts have provided a temporary boost. But, if house prices continue to fall, even these maybe insufficient to avoid a recession.
• Losses for banks. With repossessions rising; banks are losing out because homes are being sold for less than the initial mortgage (especially for people who took out 100% mortgages). The Federal reserve. Banks have stepped up their borrowing from the Federal Reserve.
• Bank borrowing from the Federal Reserve averaged $15.95 billion in daily borrowing for the week ending May 28.
• At least some first time buyers may be able to buy a house in the future. Falling house prices are helping to restore affordability. The only difficulty is getting sufficient mortgage finance.
  

As oil prices keep increasing, many are looking to a future without oil. It is hoped that if oil prices keep rising, alternatives will be developed and this will enable a smooth transition. Already, car manufacturers have cars which run on hydrogen, natural gas, even solar panel. The longer oil prices rises, the more attractive these options will be. It is not unfeasible that in a decade, we will simply not need or want to consume oil any more. However, this transition to a world without oil may not be as smooth as many hope. The transition to a post oil world could be a lot more painful that we would like to admit.

How would an oil free world impact on the world economy?

The Doomsday Scenario. The impact of declining oil availability depends on whether the alternatives to oil materialise. For example, it was hoped nuclear fusion would provide low cost energy, but, technological developments have been disappointing. If we don't find realistic alternatives to oil, the consequences for the global economy could be serious. Rising prices and costs, declining growth and living standards as people struggle to meet their energy needs. The world has become so dependent on oil, the question is could we survive without?

Wealth of Oil exporters would be reduced. At the moment, oil exporting countries are earning billions of dollars in oil revenues; this gives them economic power and to a large extent political power. If oil is no longer in demand, these countries would face a rapid period of readjustment; they are likely to face a fall in wealth, unless they could create growth in other sectors. The problem is that it is currently so easy for them to make money from oil other sectors of the economy are fundamentally underdeveloped, therefore they would struggle in an economy no longer reliant on oil.

Oil Importers Could be Relatively Better off.

The change in the use of oil could lead to a readjustment of global finance and power. Currently OPEC countries have disproportionate amount of wealth. Oil importers are struggling with the rising oil prices. This would all change if oil was no longer the key world commodity. But, this relies on good alternatives being found

Cost of Transport.

The new technologies are unlikely to be as cheap as petrol powered cars were in the past. If this is the case, it means transport will be permanently more expensive. This could help to reduce our reliance on the motor car; it could encourage other forms of transport such as buses, trains and bikes. However, this is very much an unknown. It is difficult to predict the future price and availability of alternatives. At the moment they are more expensive than petrol; but, maybe cheap alternatives could be found in the future.

Environment.

Consumption of oil has contributed significantly to global warming and pollution. One side benefit of the rising oil prices is the improvement in pollution emissions in the US and Europe as higher oil prices discourage consumption. It is hoped that the alternatives to oil will be more environmentally friendly and help to reduce carbon emissions. However, will it be too late to stop global warming by the time the world makes the transition to a non-oil based energy?

Oil Companies.

The most profitable companies are often oil companies. like Shell and BP. They may struggle to move into a post oil world. BP has given itself the slogan Beyond Petroleum; but, whether they will be able to be as profitable from other energy sources is doubtful.

Related:

• Should Governments seek alternatives to oil?

Today is the fortieth anniversary of industrial action by 3 Ford workers, campaigning for equal pay for women. The women machinists found that they were getting 15% less pay than a group of men doing the same job. The dispute, with the help of Barbara Castle, was settled and this action led to the 1970 Sex Discrimination Act which outlawed the principle of paying genders different wages for the same job. However, 40 years later, the pay gap between men and women is still high. - Women are paid 17% less than men.

However, the reasons for differences in pay are much less straightforward than this Guardian article would suggest. From an economic perspective, wage differentials could be explained due to factors others than discrimination. This is a previous essay I wrote - Why Women are paid less than men

What do you think are the main causes of differences in pay and what should be done about it?

Man can put a man on the moon, and develop a bewildering array of new technology. Yet, for all our material advancements and success, the twentieth century has left us with the seemingly intractable, yet fundamental, problems of people around the world struggling to get enough food to eat. This problem of malnutrition and insufficient food supplies has been magnified by the sharp rise in food prices which are causing real hardship for those on the poverty line.

What are the Solutions to Food Shortages?

Market incentives.

In theory rising prices should encourage the production of food crops. Sometimes it is government intervention that prevents market signals working effectively. For example, maximum food prices, may seem to make sense in the short run. But, by keeping prices artificially low you prevent the inventive to increase supply and deal with the long term problem. Governments should allow prices to rise to market levels. If necessary they should increase the incomes of the poor so that they can buy food. But, this is much better than keeping incomes and prices low.

End Government Subsidies of Food for Bio Fuels.

Recent years have seen a huge expansion in crops grown for the purpose of bio fuels and not food. Governments are rightly concerned about oil supplies and so they feel bio fuels are an alternative. Therefore, bio fuels have been heavily subsidised encouraging farmers to grow crops for fuel rather than food. The effect of this is that food prices have risen since effectively there is lower supply of food crops. Bio fuels also hurt developing countries the most. It is the west who is concerned about alternative energy supplies; the West doesn't really mind food inflation that much; but, for developing countries food inflation is devastating.
This does not mean the governments should not promote alternative fuel supplies; it just means they should promote alternatives which don't disrupt food supplies.

Efficiency of Existing Farming.

In the developed world farming productivity is much higher thanks to technology such as chemicals and fertilisers. There is scope for increasing the productivity of land in developing countries. This may require government intervention such as improved infrastructure and education about the correct use of fertilisers. There are also difficulties; greater productivity often requires economies of scale. Merging small farms into bigger ones is not straightforward; one thinks of China's disastrous leap forward.

Genetically Modified Crops.

To some GMO crops is a dirty word conjuring images of Frankenstein food and runaway supercrops. However, for those in developing countries, the pressing issues is lack of food. When you are starving ideological opposition to GM crops is likely to fade away. If it can provide real solutions, at least it should not be dismissed out of hand.

The real economic crisis - food