Archive | economics

Napoleon, eggs and capturing consumer surplus

On campaign in the early 1800s, Napoleon approached a hostelry on the slopes of  Col du Pin Bouchain near Roanne. (BTW: the Col du Pin Bouchain at 759m was the first mountain ever used in the Tour de France in the 1903 edition.)

GroceryStoreEggs

Napoleon was shocked at the price of eggs, and so he asked the owners of the hostelry

“Are eggs so rare in this region that they justify such a bill?’

The owner of the hostelry replied.

“It’s not the eggs that are rare, it’s Emperors.”

Supply and Demand in action!

This is an example of a monopoly seller capturing the consumer surplus of Napoleon – assuming an Emperor would have deep pockets and would be willing to pay more money to get some eggs, rather than walk to the next village.

Just imagine if shop owners could always know the income of the consumer and how much they would be willing to pay. They could make up a price depending on the consumer.

The only thing is I don’t know how this story ended. Perhaps Napoleon said.

“Since there is only one Emperor, I’m going to make a new law that the Emperor is allowed to requisition all eggs to help fund his military campaigns.”

Still you’ve got to admire the guts of the hotel owner for trying to capture Napoleon’s consumer surplus.

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Bond Spreads

Readers Question: How do bond spreads affect the value of the Dollar or Euro?

A bond yield refers to the interest payment that you receive from holding the bond yield. If the yield is 4%, you can expect £4 a year from a £100 bond.

A bond spread refers to the differences in bond yields. For example, it could mean the spread between different government 10 year bond yields. In the US bond yields may be 2%, whereas in the Eurozone, bond yields may be 4%.

There could be many different reasons for this bond spread (difference) But, if markets are concerned that one country is at risk of debt default or liquidity shortages, investors may be unwilling to hold those bonds and therefore bond yields go up to try and attract investors. (See inverse relationship between bond price and bond yield)

EU bond Yields

A time when Italian and Spanish bonds had a large bond spread over UK and German.

If investors are nervous about holding Eurozone bonds, due to fears of illiquidity, then international investors will be demanding less Euros – they would prefer to hold dollars and buy US bonds. Therefore, in this case, we would expect to see an appreciation in the US dollar and a fall in the Euro.

If you look at government bond yields (FT) – Greece has a high bond yield 6%. If Greece had its own currency, you would expect the Greek Drachma to fall.

Argentina has had periods of high bond yields because investors are nervous about holding Argentinian debt due to fears of a debt default. This corresponded with a fall in the Argentinian currency.

However, high bond yields are not necessarily a reflection that markets are nervous about the state of government finances. Bond yields can rise when markets are optimistic about future economic growth. See: Factors affecting bond yields

However, it is worth bearing in mind, many other factors determine exchange rates, apart from bond spreads, such as:

  • Higher interest rates can attract hot money flows. If people are confident of a country and they see high interest rates, they may move their currency to benefit from better interest rates.
  • Relative inflation rates. If inflation is relatively low in a country, then demand for the currency will be higher in the long-term as their goods will become more competitive.
  • See: Factors influencing exchange rate

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European unemployment crisis

Unemployment in many European countries has risen sharply due to the credit crunch and global recession. The worst hit countries include Spain (ES) and Greece (EL), who both have unemployment rates of over 25%.
  • Unemployment rate in the Eurozone area: 11.8% (March 2014)
  • EU-28 Unemployment is slightly lower at 10.5% (March 2014)
  • Total unemployment in the EU-28 is 25.699 million (March 2014)
  • The Eurozone  (EA-18) jobless total is now 18.913 million. (link) The highest since records began.
  • Youth unemployment rates in the EU 27 is 22.8% (March 2014)
  • The lowest unemployment rates are in Austria (4.9 %), Germany (5.1 %) and Luxembourg (6.1 %). The highest rates are in Greece (26.7 % in January 2014) and Spain (25.3 %).
  • By comparison, unemployment in Japan is 3.6%, and in US 6.8%
  • Eurostat unemployment figures

EU unemployment

Source: ECB

 Causes of European unemployment crisis

After falling to 7.5% in 2008, the prolonged recession of 2008-13, has caused a sharp rise in unemployment.  The continent seems to be stuck in a deflationary spiral and is facing a prolonged double dip recession. Hardest hit debtor countries, such as Spain, Greece, Portugal and Italy are facing stringent budget cuts – which are depressing demand.

Will Eurozone break up?

But, in the Eurozone, there is little relief available to boost demand. Countries are unable to devalue. Monetary policy set by the ECB has been unflinching in targeting low inflation and offering little monetary easing – despite the prolonged recession. Also, depressed demand throughout the region is making it difficult to grow through increasing exports. Even northern Europe, which has had large current account surpluses are engaging in modest austerity. The result is that demand has remained depressed across Europe.

Despite its potentially damaging social and economic impact, throughout the 2008-13 European crisis, unemployment has had a relatively low profile -  European policy makers have always given the impression they are more concerned about appeasing bond markets and low inflation than tackling the more pressing problem of unemployment. There has  been a reluctance to tackle the fundamental deficiency of aggregate demand which is leading to lower growth and falling employment. Efforts to reduce unemployment have centred on talk of more flexible labour markets. This may be part of the solution for structural unemployment, but increasing labour market flexibility alone cannot deal with the cyclical unemployment.

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Policies to ease pressure on the housing market

Readers Question: What policies could be used to ease pressure on housing market?

Firstly, the main pressure in the UK housing market is the persistent and continued above inflation price increases. Back in 2004, Kate Barker’s report into housing market trends found that the UK would need to build 250,000 houses to reduce the house price inflation rate to 1.1%. But, since 2004, the UK housing market has fallen short of this target. In the middle of the recession, the number of home starts fell to just over 100,000. (Housing supply)

The  Home Builders Federation claim to catch up, we would need to increase home building to 320,000  a year – something not seen in the UK since the 1950s.

Policies to ease pressure on housing market

1. New Garden cities The building of new cities, in the mode of Milton Keynes, can enable a significant increase in homes. Currently there are plans for a new city in Ebbsfleet, Kent on the high speed railway line to London.

However, from planning to completion this will take a long time. It also means building on greenbelt land, which is likely to raise objections.

2. Government subsidy / council homes. Additional government spending to subsidise the building of ‘social’ housing could help increase supply. In the past decades, council housing has fallen out of vogue as the government have sought to sell off council housing and cut back on the building of council housing. But, it was council houses which provided a significant boost to the UK’s housing stock in the post war period.

housebuilding_464

Clement Attlee’s post-war Labour government built more than a million homes, 80% of which were council houses. In recent years, local authority building of new houses has virtually ceased. It is notable that since local authorities ceased to build homes, the UK housing shortage has become more acute. Housing associations have never been able to replace the large numbers built by local authorities.

It would require a change in political commitment and the willingness to spend extra money. Also, since the Thatcher era, the notion of council housing has gained a form of social stigma. However, it could make a big difference to the number of homes built.

3. Greater flexibility in planning. Planning restrictions are quite strict in the UK. Loosening the number of restrictions and making it easier for builders will make supply more elastic. This could involve reducing the amount of protected greenbelt land. It could also involve streamlining the regulations home-builders have to meet.

However, this could lead to significant local objections as people protest about the increased building, congestion and loss of green fields. One other solution would be to provide grants for turning derelict brown field sites into new homes.

4. Incentives for local authorities

Home building is a local issue. Local authorities have to deal with opposition to home building, so there is often local political pressure to stop house building. However greater financial incentives, such as allowing the council to keep council tax receipts from new housing developments, could give them a greater motivation to allow home building.

5. Introduction of a Planning-gain Supplement scheme

At the moment, building new houses tends to give the greatest benefit to landowners. Local residents feel they just lose out – depressed house prices, loss of unique village e.t.c. One solution is to make sure local residents near new housing schemes gain some compensation in return for accepting more houses. For example, a new housing development could be accompanied with a bypass or better public transport links. This is interesting from an economic perspective as it is seeking to provide a pareto improvement (one where everyone benefits).

The difficulty is that in the real world, it can be difficult to ensure people are compensated. Some local residents may feel there is nothing to compensate for the loss of a beautiful view. People may also exaggerate how much they lose from a new housing scheme.

6. Government’s Help to to buy

The government’s help to buy scheme is controversial because it is seeking to ease the problem through helping homeowners borrow more money. Critics argue this merely fuels demand and keeps prices artificially high.

However, to some extent, the Help to Buy scheme has provided some incentive for private builders to increase supply. In particular the first part of the scheme which offers buyers an interest-free loan worth up to 20% of the value of a new-build home. This increased demand for new build homes, encourages house builders because they are more confident there will be demand for the new homes. Continue Reading →

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What happens when you destroy money?

Readers question: What happens to the underlying money (supply) if someone destroys currency rather than saving it or spending it?

The money supply is the total stock of notes, coins and bank deposits in the economy.

If money is destroyed (taken out of circulation) and not put back in by the Central Bank, then the overall money supply in the economy will fall. There will be less money circulating.

keep-calm-print-money

If the money supply is reduced how does that affect the economy?

If the money supply falls, it is likely to cause deflation (falling prices) or at least reduce the inflation rate.

It is the opposite of printing more money. If you print more money, it doesn’t change the output of an economy, it just creates more money and so puts upward pressure on prices. See: The problem of printing money

If the money supply falls, that doesn’t directly affect output. The amount of goods and services in the economy is not directly affected by people destroying or creating money But, with less money circulating, there is a downward pressure on the price of the same number of goods.

Suppose in an economy, you have a 10,000 goods and a money supply of £10 million. Then the average price of those goods will be £1,000.

  • If the money supply falls to £8 million, the average price of those 10,000 goods will be now £800. You still enjoy the same number of goods, it’s just that the goods will be cheaper.
  • After the fall in prices, the nominal GDP is lower. But, because prices are cheaper, people are still able to enjoy the same number of goods and services as before.
  • It is the opposite to inflation. With inflation, we see a rise in nominal GDP. But, because prices go up, the amount of goods and services you enjoy remains the same.

Effect of deflation in the real world

In theory, reducing the money supply shouldn’t have any affect on real incomes or real output. However, in a situation where the money supply is falling, it could cause a fall in aggregate demand and lower economic growth.

If consumers notice a fall in the money supply (e.g. through lower nominal wages) they may lose confidence and because they fear lower incomes or unemployment start saving a higher percentage of their income.

Even falling prices can have the effect of reducing spending:

  • If prices are falling, consumers are more likely to delay purchasing them – until they are cheaper. This causes lower aggregate demand.
  • If prices and wages are falling, the real value of debt increases. It becomes harder to pay old debts back with falling wages, therefore this also causes lower economic growth.
  • see more at: Problems of deflation

In recent years, deflation or very low inflation has created significant economic problems in both Japan and the Eurozone.

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Problems of Agriculture – Market Failure

Agriculture often appears to be one of the most difficult industries, frequently leading to some form of market failure. In the EU, agriculture is the most heavily subsidised industry, yet despite the cost of the subsidy it fails to address many issues relating to agriculture.

Types of market failure in agriculture

  1. Volatile Prices / volatile supply
  2. Low and volatile income for farmers
  3. Environmental costs of intensive farming (negative externalities)
  4. Agriculture key component of rural life (positive externalities)
  5. Monopsony power of food purchasers.

Volatile Prices in Agriculture

Prices in agricultural markets are often much more volatile than other industries. This is because:

  1. Supply is price inelastic in short term. (It takes a year to grow most crops)
  2. Demand is price inelastic. (Food is essential and people are not usually put off by higher prices)
  3. Supply can vary due to climatic conditions.

prices

This diagram shows that a ‘good’ harvest leads to an increase in supply. This leads to a significant fall in price (P1 to P2). See also volatile food prices

The problem of volatile prices is that:

  1. A sharp drop in price leads to a fall in revenue for farmers. Farmers could easily go out of business if their is a glut in supply because prices can plummet below cost.
  2. Cobweb Theory. The cobweb theory suggests prices can become stuck in a cycle of ever-increasing volatility. E.g. if prices fall like in the above example. Many farmers will go out of business. Next year supply will fall. This causes price to increase. However, this higher price acts as incentive for greater supply. Therefore, next year supply increases and prices plummet again!.
  3. In some years, consumers can be faced with rapid increase in food prices which reduces their disposable income.

2. Low income for farmers

Often farmers don’t share the same benefits of economic growth. As the economy expands, firms don’t see a similar increase in income. Food has a low income elasticity of demand. As incomes rise, people don’t spend more on food. Also, technological advances can lead to falling prices rather than rising incomes. Many developed economies feel it is necessary to subsidise farmers to protect their incomes.

For a developing economy, their current comparative advantage may lie in producing primary products. However, these may have a low income elasticity of demand. With global growth the demand for agricultural products doesn’t increase as much as manufacturing. Therefore, relying on agriculture can lead to lower rates of economic growth.

3. Environmental costs of intensive farming

Modern technology has enabled increased crop yields. However, this often requires chemical fertilizers which cause pollution. As farming becomes more competitive there is a greater pressure to produce more leading to increased use of chemicals. However, artificial fertilizers have diminishing returns, so it becomes more expensive and greater environmental cost for little benefit. Many farming methods have led to deforestation and cutting down trees. This can upset the eco-balance making regions more susceptible to flooding.

4. Positive externalities of farming

You could argue farming communities play an integral role in rural life. If farmers go out of business it has adverse consequences for rural communities and the environment they live in. This is often a justification for subsidising farmers (e.g. the social benefit of subsidising sheep farmers in the Lake District)

5. Monopsony

Supermarkets can have monopsony buying power over local farmers. This means farmers may see their profit margins squeezed by the big supermarkets who have substantial buying power. If farmers don’t sell to the big supermarkets they can’t sell their products, this is why it puts them in a difficult position.

 

Government intervention in agriculture

  • Buffer stocks - to help stabilise prices though having minimum and maximum prices
  • Minimum prices – to guarantee farmers basic income by subsidising food prices. However, minimum prices may encourage oversupply and lead to wasted food production.
  • Subsidies for farmers who follow more environmentally friendly methods.
  • Tariffs on imports. This increases the domestic price of agricultural produce, but leads to lower trade.

Problems of government intervention in agriculture

  1.  Cost of subsidising agriculture in developed world It is estimated support to agricultural producers in advanced countries was $245 billion in 2000, five times total development assistance. In the members of OECD as a whole, a third of farm income came from government mandated support in 2000. (Martin Wolf, Financial Times, 21 November 2001) (problems of Agriculture)
  2. Subsidies have often been given to farmers with large amounts of land and with little incentive to follow more environmentally friendly procedures.
  3. Minimum prices have led to over-supply
  4. Tariffs on agriculture have led to lower income for food exporters in the developing world and have been a big stumbling block to trade.

 

Related

Photo: A field in the Cotswolds by Tejvan

Examples of Elasticity

Price elasticity of demand measures the responsiveness of demand to a change in price. see: Price elasticity of demand

  • Price inelastic – a change in price causes a smaller % change in demand.
  • Price elastic – a change in price causes a  bigger % change in demand.

Examples of price inelastic demand

inelastic-demand

We say a good is price inelastic, when an increase in price causes a smaller % fall in demand, e.g. if price of petrol falls 30%, but demand for petrol only increases 10%  the PED = - 0.33

  • Petrol – petrol has few alternatives because people with a car, need to buy petrol. For many driving is a necessity. There are weak substitutes, such as train, walking and the bus. But, generally, if the price of petrol goes up, demand proves very inelastic.
  • Salt. If the price of salt increased, demand would largely be unchanged. It is only a small % of income and people tend to buy infrequently. It is a good with no real substitutes at all. Continue Reading →

How has China affected UK Economy?

Readers Question: How Has China’s Economic Industrialisation affected the UK’s Economy? And What Policies Could The UK Government Implement To Rectify The Problems Created From China’s Growth?

The rapid growth of China’s economy has had various effects on the UK economy – some positive and some which have created challenges and problems for the UK.

1. Lower Goods Inflation. Chinese economic growth has been characterised by low priced manufactured goods. The price of items such as clothes and electronic goods has consistently fallen, helping to maintain low inflation in the UK. This downward pressure on prices is particularly helpful for consumers, who have experienced rising cost-push inflation in areas such as energy and food in recent years. The falling prices of electrical goods and textiles have helped to increase UK living standards and have enabled a higher percentage of income to be spent on other goods and service

2. Higher price of raw materials. As well as contributing to lower goods inflation. You could argue China’s growth is contributing to rising prices of raw materials e.g. oil. The economic growth in China is pushing up demand and therefore price of oil, which is having an impact on Western inflation. China’s growing demand for oil and raw materials was a key factor in creating cost push inflation in the past few years. Therefore, even though the West has been in recession (2009-2013), we have also seen cost-push inflation. This cost-push inflation arguably exacerbated the recent recession. However, the rising price of oil is not just due to China, but also supply disruption in the Middle East and other factors. Also, the rising price of oil may encourage the developments of greater fuel efficiency and alternatives to oil which will benefit in the long run.

3. Relative decline in manufacturing sector. The UK’s manufacturing sector has been in relative decline since early 1980s. Chinese growth has in a way speeded up this process as British firms with higher labour costs become uncompetitive compared to Chinese firms. However, the manufacturing sector may have declined anyway and up to recently job losses in manufacturing sector have been absorbed into the service sector. Arguably, it is not a problem if we do have a relative decline in manufacturing. The theory of comparative advantage states that we should specialise in those industries, which we are best at. Continue Reading →

Advice for giving an economics presentation on austerity

Readers Question: I have to visit the college I went to and give 5-10 min talk to A2 Economics students about anything economics related, preferably macro-economics.. something going on in the economy. Suggestions?

Giving a presentation on economics can be a daunting thing. I often ask students (at this time of the year) to come and give their own presentation on economics. Let them be the teacher for 5 minutes. But, it’s hard work and they don’t usually enjoy it.

Firstly, know your audience. A college of A2 students is good in that you know the level of economics to target. You can keep it fairly simple, and try and use A2 terminology – for example, bringing in AD and AS.

  • What I would suggest is choose a topic, that you like and is fairly topical. For example, you choose the issue of austerity. Alternative topics that spring to mind include – The Euro, traffic congestion, monetary policy, exchange rates.
  • Start off, with simple explanations – never assume that the audience knows everything. In fact try to keep the language as simple as possible.

Once, you’ve chosen a topic, divide it into subtopics, and keep a short list. This will give your presentation some focus and direction. If you’re worried about running out of things, you can always have some back up sub-topics. If you run over time, it is easy to leave out some of the sub-topics.

Make sure your first topic is your strongest and most interesting. It is always important to get off to a good start.

If it was me, I would think of these sub-topics for austerity.

  • What is austerity? – explaining what austerity is – preferably in the language of A2 economics. i.e. government attempts to reduce budget deficits through spending cuts and tax increases.
  •  Why austerity? – a short background on global credit crisis and  EU crisis. Euro countries were facing high bond yields and felt the need to reduce government debt. In the UK, government claimed UK debt too high. Though arguably also interest in reducing government spending in the long term.
  • Pros and cons of austerity. – At least in the beginning of the presentation, it is good to offer a balanced view, and both sides of the argument. Later you can offer a stronger conclusion whether you think it has been good or bad. But, avoid being one sided as A2 students need to learn evaluation and examining both sides. e.g. Pros – debt is lower. Cons, aggravated recession, leading to high unemployment. Debt reduc
  • Is Austerity  self defeating? - After a while, it’s good to pick a controversial sub-topic; this may regain interest. Start off by asking a question. Trying to keep the audience thinking is a way of engaging them and avoiding a one way dialogue.
  • Timing of austerity – Why did we pursue austerity in recession, when monetary policy was also tight in Europe.
  •  What is the impact of austerity? – impact on main macro-objectives of growth, inflation, unemployment e.t.c.
  •  What was the alternative? – Could we have kept borrowing more? The Bank of England created money electronically to partly finance deficit. Growth is the best way to increase tax revenues, not austerity.
  •  How did austerity impact Europe? - Talk about other countries, such as Greece and Spain will give a wider perspective on the issue. e.g. the political and economic cost

Just in case you run out of things, perhaps bring up issues like

Ask questions

If you feel confident, you can also leave time for questions, which can be a productive use of time, as long as questions are reasonably relevant.

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Preparing for Economics Exam

At this time of the year, my students are preparing for their exams with a mixture of trepidation, confidence, resignation, hope or fear. The best way to prepare is to simply do one thing at a time. Concentrate on making small improvements and importantly keep practising past papers.

Students who just do a bit of reading, will never be properly prepared. The most important aspect of revision is to make it active. Force yourself to keep thinking and understanding what you have been studying. When you explain things to others, you learn yourself. My students often complain that I always seem to ask them what they don’t know. But, this is on purpose. If you can be aware of what you don’t know, it’s a great incentive to learn. A problem students can have revising on their own is that, unconsciously, they can revise what they are good at and already know. This is why I’m not a big fan of long periods of ‘exam leave’. It’s better to have someone picking out things you might not know.

How To Revise

  • Make simple targets for getting through the material. Don’t spend hours on revision timetables which are overly optimistic. But, do have a clear plan what subjects need doing as you go through the exam period.
  • Start off by knowing the syllabus and likely questions.
  • Test Yourself Frequently. The key to learning is active engagement in the material. If you read a textbook, you will think – yes I understand that. But, the real test is to close all books and just put a question on a blank sheet of paper. Write what you can, but then go back and check.
  • Do a certain amount of written work. This is the best test to make sure you are on the right track.
  • Don’t count the number of hours sitting at a desk, but count papers written or topics where you have improved your learning.

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