Readers Question: With Oil prices rising towards $100, what are the economic effects of rising oil prices?

Demand for oil is inelastic, therefore the rise in price is good news for producers because they will see an increase in their revenue. Oil importers, however, will experience increased costs of purchasing oil. Because oil is the largest traded commodity, the effects are quite significant. A rising oil price can even shift economic / political power from oil importers to oil exporters.

Current Account

Higher oil prices will lead to an improvement in the current account position of oil exporters like OPEC countries. It will lead to a deterioration in the current account position of oil importers (e.g. Germany, China). Oil exporters will see an increase in foreign currency reserves which they could use to purchase foreign assets. e.g. Arabic countries, such as Saudi Arabia are an important purchaser of US securities.

Inflation

A marked rise in oil prices will contribute to a higher inflation level. This is because transport costs will rise leading to higher prices for many goods. This will be cost push inflation which is quite different to inflation caused by rising aggregate demand / excess growth.

Monetary Policy

Cost push inflation caused by rising oil prices presents a dilemma to policy makers. Higher inflation usually requires higher interest rates to keep inflation on target. But, to reduce inflation may not  be appropriate because output could be well below full employment. Arguably, in early 2008, policy makers gave too much importance to the cost push inflation and too little weight to the impending economic downturn.

Long Term Effects.

In the short term, demand for oil is inelastic. This means a rise in price only causes a small fall in demand. Demand is price inelastic because consumers need oil based products, e.g. their car only runs on petrol. However, in the long term, higher oil prices will encourage consumers to diversify consumption (e.g. buy hydrogen powered cars e.t.c.)

Also, higher oil prices will encourage firms to try and find more oil supplies, even if it is expensive, remote places like the Antarctic.

Related

• A world without Oil
• Higher oil prices and marginal consumption

National Minimum Wage Rates from 1 October 2009

• Workers Aged 16-17  – £3.57
• Workers Aged 18-21 – £4.83
• Workers Aged 22 and over – £5.80

The post which has attracted the most comments is this post on the National Minimum wage for workers aged 16 and 17. It was actually in response to a question of whether a minimum wage for young workers would increase labour market participation. But, most comments have focused on whether it is justified to pay young workers a lower minimum wage than those over 22.

Reasons for Setting A Lower Minimum Wage for  Young Workers

• Young workers have less experience and therefore a lower MRP (Marginal Revenue Product). As they have lower productivity, economic theory dictates a lower wage.
• Young workers may need more training to develop skills and work experience. The costs of training need to be borne by lower wages otherwise the firm couldn’t afford to pay young workers and train them. In a way, this is like the old apprentice scheme where young workers were paid a low wage during their training period.
• If the NMW for 16 year old workers was the same as 22 year old workers. It would be much more difficult for 16 year olds to get a job because firms would rather pay the more experienced workers.
• During a recession, many firms would struggle to pay more than £3.57 for 16 year olds.
• Firms can, of course, pay more than a minimum wage. If they think 16 year olds are doing as good a job as 22 year olds, they could give same wage.

Reasons to Pay Young Workers the Same as Adults

• As many commentators point out, many 16 year old workers are doing the same job as adults. Therefore, if they are doing the same job, it seems unfair to pay a different wage.
• Firms may substitute 16 year olds for 22 year olds. I know of certain fast food restaurants where young workers are given preferential treatment for overtime compared to 22 year old workers. This is because 16 year olds are much cheaper to employ. This makes it more difficult for 22 year old workers to get employment. Arguably, 22 year olds need a job more than 16 year old workers living at home.

Conclusion

It would be really very hard to justify a minimum wage of nearly £6 for 16 year old workers. If this was implemented, firms would be reluctant to employ young people and there would be far few job opportunities.

One issue that may need addressing is the correct implementation of the minimum wage. If some comments are correct, many young workers (e.g. in hairdressing salons) are getting paid far less than the statutory minimum wage.

Related

• National minimum wage
• Why increase in NMW led to higher employment
• Minimum wage for 16 year olds

Readers Comment: I believe if you want to solve the recession then look at footballers.
they earn millions and for what/kicking a ball around!! I think their wages should be cut down to say 75k a year and the remaining money should be used wisely.

This recession illustrates that economic policy often involves making decisions based on economic utility rather than a sense of justice.

For example, the government was right to bail out the banks, even though the incompetent bankers didn’t deserve to be bailed out. (Why we need to bail out banks)

By contrast, the honest car worker who lost his job, probably deserves to keep his job. But, unfortunately, the government can’t subsidise every potential job loss in an economy.

The high wages and economic rent of footballers is a good example of the laws of supply and demand in practice. See Wages of footballers

If the top footballers had their wages cut and the income was distributed to lower paid workers, it may create a small increase in consumption. Even though there is no extra money in the economy, it is likely that low paid workers will have a higher marginal propensity to consume than footballers on over £50,000 a week.

In other words, those earning over £50,000 are likely to save a higher % than workers selling burgers for £15,000 a year. However, the impact on overall aggregate demand would be limited at best.

In a recession, the inequities of income distribution seem more unfair, but, it is not  inequality which directly causes a recession. Nor is solving inequality a solution to the recession. Can a recession be avoided?

This does not mean inequality of income is necessarily good, but, it is not directly related to the problems of a recession.

Interestingly, many professional footballers will be affected by the new 50% income tax band. – Some Premiership players have even threatened moving to countries with lower tax regimes.

Readers Question: In what way or how do the economic growth possible ? Currently technology and infrastructure are growing apart from Europe esp UK to Asia. Financial stability per family is also sinking ! right (esp to white people-majority ) Then where is growth of economy and how it drives UK to a new positive level of growth ? Now a days people forget to save money and remember how to spend the same? Where is the growth ?

The immediate problem facing the UK economy is a large output gap and decline in aggregate demand. To boost economic growth we need to increase aggregate demand. To increase demand the government and monetary authorities have tried.

• Cutting interest rates to 0.5%. Lower interest rates should make borrowing cheaper and increase the disposable income of homeowners with mortgages. This should increase consumer spending
• Cutting tax rates (expansionary fiscal policy) e.g. VAT to 15%. This should increase consumer spending as they have more disposable income and goods are cheaper.
• Quantitative easing. Increasing the money supply by the Bank of England buying assets from banks. In theory, this should improve bank balance sheets and increase bank lending which in turn will boost investment and spending.
• Also, the weak pound has helped boost exports

However, it is difficult to increase consumer spending because:

• After a decade of low savings and high borrowing, consumers have become more risk averse and consumers are now seeking to increase their savings rate. This will limit consumer spending and make growth more sluggish. (see: problem of saving)
• Also, banks are reluctant / unable to lend as they seek to improve their balance sheets. Thus, the low levels of bank lending is a limit to consumer spending and investment.
• Also, falling house prices have reduced consumer wealth and discouraged spending. – If house prices stabilise this may enable consumer spending to rise in the future.
• Also, the tax cuts are likely to expire as the government seeks to reduce the very large budget deficit. In fact, fiscal policy could soon be deflationary which will hold back growth.

In the long term, economic growth will depend on productivity growth and increases in aggregate supply. However, in the short / medium term, growth will be held back by the many factors limiting consumer spending.

I think the growth will come from a period of low interest rates and a continued policy of quantitative easing.

For more detail see: Causes of economic growth

Readers Question: What effect does expansionary fiscal policy have on the fishing sector?

If successful, expansionary fiscal policy will increase Aggregate demand and increase the rate of economic growth. In a recession, expansionary fiscal policy could play a significant role in increasing level of living standards and levels of consumption.

Expansionary fiscal policy involves changes to tax and spending to increase overall aggregate demand in the economy. E.g. lower income tax rates will increase disposable incomes of consumers. With an increase in disposable income they can afford to buy more fish. Therefore, in a recession, the fishing sector may benefit from expansionary fiscal policy.

However, I’m not sure of the income elasticity of demand for fish. In a recent post, we looked at how the demand for Champagne had been drastically reduced by the recession. Expansionary fiscal policy would certainly be good for Champagne growers.

However, a fish and chip supper is unlikely to be a luxury good. If incomes fall, it is possible some consumers will buy fish and chips rather than go to a more expensive restaurant. In a recession, I doubt the demand for fish falls too significantly.

Also, there is the wider question of whether fiscal policy can actually increase the rate of economic growth.

See: Limitations of fiscal policy.

Champagne is a very good example of a luxury good. (a change in income causes a bigger % change in demand) Furthermore, supply of Champagne is limited to certain regions of France. With this monopoly power over supply,  French wine producers have been able to set very high prices. Champagne can easily go for over £100 a bottle. But, several years of over supply combined with the current recession is causing wine merchants to consider selling Champagne at knockdown prices.

Exports of Champagne to Britain fell 45% in the first 6 months of this year. This is a classic example, of how in a recession, people avoid expensive luxury items and choose cheaper alternatives.

If we assume income fell by 4% this year, a 45% fall in demand gives an income elasticity of demand of approximately 10.

The problem for wine merchants is that they have a dilemma.

• They have so many unsold stocks, the law of supply and demand suggests they should reduce prices to perhaps £10.
• But, if they do reduce prices so much, Champagne may lose its lustre as being a special ‘luxury good’. It’s like being able to buy Levi Jeans in Tesco for £10.99. Levi would lose their brand image for being special. If Champagne is sold for £10, it will be harder to command those high prices when the economy recovers.

see: Times Article – Vintage Champagne could be £10

Readers Question: What is the difference between depression economy and underdeveloped economy?

A depression economy suggests the economy is experiencing a deep recession, characterised by falling output and rising unemployment. An economy experiencing a recession could have a high GDP per Capita or a low GDP per capita. E.g. UK and the US have  both experienced a recession in the past year.

There is a difference between the definition of a recession and depression, which you can view here: Depression and Recession definition. Basically, a depression is a much more severe recession.

In everyday use, people may interchange depression and recession. For example, people may refer to the current situation as a depression. Even though the current situation doesn’t really meet the guidelines of having a fall in GDP of more than 10%.

An underdeveloped economy is an economy characterised by

• Low GDP per capita. Perhaps less than $2,000 a year
• Low levels of infrastructure – education, transport and health care.
• Low levels of human development. E.g. low levels of Literacy, low life expectancy e.t.c

There are different ways of measuring underdeveloped economies. For example, the United Nations uses

Less Developed Countries (LDCs) and Least Developed Countries (LEDCs) – These are countries with very low levels of economic indicators

The Independent featured an interesting article on the Demise of the Dollar.

There are more reasons for the dollar’s economic weakness here

The weak dollar is causing the price of gold to rise and the Euro to appreciate.

In some respects, the US won’t mind a weak dollar at the moment. This is because:

• Weak dollar will help boost exports and limit imports. Overall domestic demand should be stronger
• It will help reduce their long term trade deficit.
• With inflation currently very low, they will not be worried about the inflationary impact of a depreciation.

The danger comes if the gradual depreciation becomes an a sharp fall because investors fear for the future of the US economy.

The Falling dollar is bad news for

• The Eurozone. With Eurozone in recession or growing very slowly. The appreciation of Euro against dollar will harm EU exports and make a sustained recovery difficult.
• Countries with Large Dollar Reserves. Since the US is the global reserve currency, most countries have exposure to the falling dollar and will see their dollar assets reduce in value. This may make it more difficult to attract foreign investors to buy US treasury bills to fund the US government deficit.

See also: Benefits and costs of a falling dollar

Readers Question: Why Do we Study Economics In School?

1. It’s Good to Study and improve the mind. At least, that is what I was told when I was learning ancient Greek and Latin.

Many Employers are not looking for a specific degree but, the ability to learn, write and understand relevant ideas. I guess the idea is that if you have an A level in Economics (or other subject), you would be able to understand a firm’s business plans and be a competent employer.

2. Understand Practical Mathematics

I often teach students doing further Maths (double A Level Maths) but can they calculate a percentage? No! – Only differentiation and calculus. At least in A Level economics you should learn how to calculate a percentage.

3. Understand What is Happening.

The current crisis has shown that it is hard to separate our daily lives from Economics. Many people get confused over interest rates, inflation and government borrowing. But, these are issues which affect our daily lives and own financial well being. Understanding economcis helps comprehend what is happening and why we have lost our job.

4. Understand Graphs.

Ask anyone what is happening to price level between Aug and Nov 2008, and the majority will say prices fell. But, a good A level student will understand the difference between absolute changes and rates of changes. Of course, the answer is prices are rising at a slower rate. I have seen TV newsreaders and newspaper columnists get confused over this issue.

5. Understand Two Sides of the Argument.

We live in a sound bite society, where the mass media often try to portray issues in black and white. – Medicare good / Medicare bad. In economics, you hopefully learn to appreciate there is more than one side of the argument and see issues from different perspectives. This gives a more balanced view of economic / social issues.

6. The Economic Perspective.

The standard of political debate can be depressing. Learning economics gives a different insight. e.g. understanding:

• the opportunity cost of spending more on health care / cutting taxes e.t.c
• The social benefit of taxing goods with negative externalities.
• The social benefit of subsidising goods with positive externalities.

See also: Top 10 Reasons for being an economist

Readers Question I am confused by the statement that is written in my O’level text book (Economics Author: Dan Moynihan & Brian Titley). It says that if the current account is in surplus the financial account will be in deficit. Is this true?

Yes, it is true

• Firstly, the current account on balance of payments measures trade in goods,  services, investment incomes and current transfers
• The financial account measures capital flows / short term and long term. For example, long term investment in building a factory or financial flows such as buying bonds or depositing money in bank accounts.

Current Account = (Financial + Capital Account)

Note: The (Financial + Capital Account) used to be just called the capital account

Why does Current Account and Financial account balance?

Basically, if we import goods and services, we need an inflow of capital (financial flows) to be able to pay for them.

If you take a simplistic model.

Suppose, we import £1m of clothes from China. We need to buy £1m of Chinese Yuan. To get this foreign currency, we need an inflow of foreign currency in the financial account.

For example, if the Chinese deposited £1m of Chinese Yuan in British Banks, the foreign currency comes into the UK and this is how we can afford the goods. This bank deposit would be counted as a short term capital flow and included in financial account as a credit item. This balances the debit on our trade in goods.

What would happen if we couldn’t attract capital flows from China?

Suppose we wanted to import goods from China, but, China wasn’t sending capital flows to the UK. This would mean more money is flowing out of the UK than coming in.

This would mean the supply of pounds is greater than the demand and the Pound would fall in value. This would make our exports cheaper and imports more expensive. This depreciation would reduce the current account deficit.

Since the Credit Crunch the UK has found it harder to attract capital flows. Because we have a current account deficit, we have seen the Pound fall in value. So a large current account deficit often causes a depreciation, especially, if the country struggles to attract a balancing item on the financial / capital account.