After oil the most frequently traded commodity in the world is coffee. Coffee is an important export for many developing countries and coffee bars have become increasingly popular as an alternative to the old fashioned pub. Coffee is big business.

The price of coffee can vary hugely. I am currently writing this essay at Café Nero in Blackwells Bookshop Oxford. For a small cappuccino it cost me £1.95. On the one hand this is expensive; especially if you consider the raw materials of coffee and milk cost less than 4p. How do Costa Coffee justify charging such a high profit margin?

1. We are not just paying for the coffee but for the opportunity of sitting in a pleasant environment for up to 1 and half hours. Not only can I spend as long as I want but I can also consult books to help me write essays. (1) From this perspective £2 to stay in a premium location in the centre of town for 1 hours seems quite a good deal.

2. Coffee shops have to deal with low volume. A pint of beer in a pub used to have a low profit margin, but customers would regularly drink several pints. Lower profit margins worked because they were able to sell quantity. Coffee is not the kind of drink where you consume more than 1 or 2. With lower volume coffee shops need a higher profit margin to maintain profitability.

3. Price Discrimination. Like any firm coffee shops are seeking to charge the profit maximising price. Many consumers have a very inelastic demand for coffee. This is because there are few close alternatives to coffee and it is a relatively small % of income. If the coffee had been £3.00 I probably would still have paid it. The challenge for coffee shops is to find a way to charge to more to people like me without putting off customers who are sensitive to price changes.

4. Charging for Extras. This idea of price discrimination can be viewed in more detail by looking at how coffee shops charge for extras. One example is the extra price charged for the “fair trade” version. Fair trade coffee involves paying poor farmers a premium for their coffee. This can help them to gain a decent living. Café direct pay a premium to farmers of about 45p per pound. However to make a cappuccino requires only ¼ an ounce of coffee. Therefore the extra cost should be equal to less than 1p. However most coffee shops charge a premium of at least 10p. (1) This means most of the extra price goes in higher profit to the coffee shops.

However there are many customers who are price insensitive therefore they do not mind paying an extra 10p. In effect they are paying a premium for enjoying coffee with a conscience. From the firms point of view they are grasping consumer surplus from those with inelastic demand.

Other extras on offer at Costa coffee.
5 oz Soya milk (instead of milk) 30p
Decaffeinated 30p
Syrup 40p





(1) Tim Harford The Undercover Economist p33.

Labels: coffee, economics explained

As oil starts to run out the price inevitably increases. Demand for oil is inelastic (higher prices only have a small impact on reducing demand) therefore as supply falls there is a correspondingly bigger increase in price. Basically this is good news for oil producers and bad news for oil importers.

Problems of rising Oil Prices in the west.

1. Increased economic dependence on Oil producing countries. With each increase in the price of oil it gives increased economic and political power of Oil producing countries, which happen to be mostly in the middle east.

2. Inflation. Increased price of oil leads to higher costs for transport. This has the effect of increasing the price of most goods produced in the economy. Therefore it can contribute to rising inflation. This rising cost-push inflation makes it more difficult for the MPC to keep inflation within the government’s inflation target of 2% without lowering growth rates. In the 1970s a tripling of the price of oil contributed to stagflation, a corresponding mid of rising prices, falling growth and rising unemployment.

3. Balance of Payments deficit. A rise in the price of oil automatically makes the value of imports more expensive. Therefore oil-importing countries will experience deterioration in the current account. In the long term this may reduce the quantity of other imports they can afford. It can also lead to devaluation in the exchange rate reducing the value of the Domestic currency.

4. Market failure in developing alternatives. In theory economic principles suggest that as oil becomes scarce it becomes increasingly attractive to develop alternatives. Already cars can run on alternative energies such as Gas and hydrogen. As oil runs out firms should invest more in these alternatives creating an economic alternative to oil. However there is no guarantee that the free market will develop alternatives to offer the same benefits as oil.

Benefits of Rising Oil Prices.

1. Will have the effect of limiting growth in demand for oil and petrol. This will help to limit CO2 emissions, a major contributor to global warming.

2. Encourage greater efficiency of engines. The US in particular has a wide range of inefficient cars SUVs that contribute the most to global warming. Higher oil prices will reduce demand for these.

Revision notes on Oil at tutor 2u

Labels: economics explained, oil

A simple Monopoly Diagram.

Profit Maximisation will occur where Marginal Revenue MR = Marginal Cost MC.

The Green shaded area is the level of supernormal Profits (AR-AC) Q

More on Monopoly

This is a photo of a diagram I drew on a white board. Much easier using a digital camera than using word and lots of lines. It will make it much easier to add diagrams to Economics Help.

Soon I hope to put up my Economics Revision Guide. It is more professional than the current notes. I think it will be very helpful for students and it will be free! (not for resale of course)

I also have many model Economics essays which will go up at some time.

Monopoly Tutor 2U

Labels: economics explained, monopoly

A current account deficit measures the balance of trade in

• goods
• services
• Net Investment incomes

A deficit on the current account means a country is importing more than we are exporting. This will have to be matched by a surplus on the financial and / or capital account.

The financial account comprises of 2 main features:

• a) Short Term Capital flows e.g. hot money flows and purchase of securities
• b) Long Term Capital flows e.g. investment in building new factories

Some economists argue we need not worry about a Current Account Deficit. This is because:

1. If a current account deficit is financed from long term capital inflows then this can be beneficial for the economy. Inward investment can increase the productive capacity of the economy.

2. In an era of globalisation it is much easier to attract sufficient capital flows to finance the deficit.

3. If the deficit gets too large it will cause a devaluation which helps to reduce the deficit. Also when there is a slowdown in consumer spending the deficit will fall.


Reasons to Worry about a Current Account Deficit.

1. There could be problems financing the deficit in the long term. A short term deficit is not a problem, but if you have a deficit of over 6% of GDP then it is a problem if you rely on Capital flows. A significant part of the current account deficit in US is finance by Chinese investors buying US securities, at relatively low interest rates.

2. Most countries would not be able to borrow such large amounts at low interest rates. The US currently can because the US is seen as the World’s reserve currency. However if attitudes to the US economy change and investors lose their confidence in the US economy, they will stop buying US debt. This will cause 2 problems.

1. US interest rates will need to rise to attract enough people to buy the debt. These higher interest rates will reduce demand in the economy. Higher interest rates will particularly hurt American consumers who have large amounts of debt at the moment.
2. If capital flows can’t be attracted then the dollar will continue to devalue further. This could cause inflationary pressures, interest rates may need to rise to stabilise the dollar.

Basically to correct the deficit would be a painful experience for the US economy and result in a slowdown or possibly recession

3. In the US the current account deficit is to a large extent caused by excess spending in the economy. It is partly caused by government borrowing which increases Aggregate Demand in the economy and hence growing demand for imports. A large current account deficit is often a sign of an unbalanced economy. It could be a sign of structural weakness and an uncompetitive manufacturing sector.

4. A deficit on the current account increases foreign liabilities. In the beginning a current account deficit could be just a deficit on buying goods. However over time the deficit will be increased by the interest payments on the capital surplus. Foreigners invest in the US. On these investments they receive interest payments or dividends. These dividends count as a debit on the current account. Therefore the longer the deficit goes on the higher the level of investment income debits will be accrued. This means that in the future the economy will need to attract capital flows just to pay off the investment income. As well as the deficit on goods and services.

See also

• Is the US economy heading towards recession?
  
• Do Current Account deficits matter?
• Do Current Accound deficits matter? Axel Merk, May 23rd 2006

Labels: current account, economics explained, US economy

1. Immigration causes Unemployment.

It is an argument often repeated. It goes something like this. “Immigrants who come over here are willing to work for lower paid jobs and thus they create unemployment for local people.”

This argument is wrong because.

• Immigrants increase the supply of labour but they also increase Aggregate Demand in the Economy. This means that they buy more goods and create additional demand in the economy. They provide labour supply and increase labour demand.
• If immigration caused unemployment why did America not have high unemployment during times of mass immigration? Because the immigrants created as many jobs as they took.
• Often immigrants take jobs that native workers just don’t want to do. – You won’t see big multinationals cueing up to stop immigration.
• Furthermore immigrants tend to be of working age. Therefore they tend to contribute more tax than receive in benefits. Without immigration US demographics would have a larger % of dependent old people.

2. House Prices in London will keep rising because of shortage of supply.

True there is a shortage of supply in big cities like London and New York. However this doesn’t mean house prices will always keep on rising. House prices can fall just like anywhere else. It just means that they will be higher on average than elsewhere in the country. Note house prices in Tokyo and Japan fell over 25% after the end of the speculative bubble in the 1980s. – American house prices have a lot further to go.

3. War is good for the Economy.

This fallacy is deeply embedded in many people’s mind. One reason is because it was felt the Second World War ended mass unemployment in US and UK.

To some extent it is true unemployment fell because of the Second World War. However war is not necessary to solve unemployment. The government could have intervened to create jobs through public work schemes.

• War does create more output, but only in some industries related to war. Arms manufacturers do very well out of war. But total output of the economy doesn’t increase instead there is a change in economic priorities. Resources are diverted from peaceful industries to industries for creating the mechanisms of war.
• Increase in government spending for wars create either taxes and or higher debt payments. This is a burden on current and future taxpayers. Note The UK is still paying off debt from second world war.

4. Tax Cuts make people work harder.

• Ronald Reagan’s economic advisers told him something along the lines of “cut taxes” and you can increase total tax income. This theory is based on the laffer curve which states that if taxes are 100% people won’t work. Therefore if you cut taxes more people work and you can increase tax revenue.
  

• The problem is that this may work if you cut taxes from 95% to 90%. But when you cut income tax from 25% to 23% it doesn’t make any difference.
• Some people want a target income of say £20,000. Thus if taxes fall they can earn the same by working less. Empirical evidence suggests there is little if any supply side incentive for cutting US or UK tax rates.

5. A Current Account deficit doesn’t matter.

Maybe this fallacy isn’t so common. But it is a common belief in the Current US administration. A current account deficit of 7% of GDP does matter. See: Does a Current Account deficit Matter?

6. Trade Wars. - Retaliation is Best

• The instinctive reaction of politicians is that if one country places a tariff barrier on our exports, we should respond by doing the same. However economic theory suggests that placing a tariff barrier on imports leads to a loss of economic welfare. It is better to not retaliate.

7. Tax Cuts will boost the Economy.

• Another justification given for cutting income tax is that it will increase Aggregate Demand and hence increase economic growth. However this is not always true because:

• If you cut income tax for high-income earners, they are likely to save a high % of their extra disposable income. Their marginal propensity to consume is low.
• If you cut income tax the government has to either cut government spending or borrow. If the government has to borrow from the private sector then they will have less income to spend causing a decline in private sector spending.
  

• This is called crowding out. (Although there are certain times when a government deficit can boost AD – like in a recession.)

See also: Ten Economic Fallacies

Labels: economics, economics explained