Author Archives: Mark

New Zealand Supermarket Duopoly – maximax and maximin strategies

Michael Cameron did a very relevant post on his blog ‘Sex, Drugs and Economics’ which focused on the duopoly market structure of New Zealand’s supermarkets. Part of the NCEA Level 3 and the CIE A2 economics courses look at market structures – monopolistic, oligopoly, duopoly, monopoly, and monopsony. A duopoly refers to two firms in a market whilst an oligopoly has a small number of firms but greater than two. Therefore we can say that Oligopoly and Duopoly are very similar market structures and they can co-ordinate their behaviour to exploit the market by lowering competition which in turn leads to greater profits for all.

Using the example of the supermarket duopoly Foodstuffs and Woolworths. Each company has two options – high price or low price. Obviously if they both price low they stand to be worse off and if they price high they are both set to gain. The outcome and payoffs are illustrated below:

Maximax – riskier strategy
A maximax strategy is one where the player attempts to earn the maximum possible benefit available. This means they will prefer the alternative which includes the chance of achieving the best possible outcome – even if a highly unfavourable outcome is possible. This strategy, often referred to as the best of the best is often seen as ‘naive’ and overly optimistic strategy, in that it assumes a highly favourable environment for decision making.

In this case, for both food providers, the aggressive maximax strategy is $140m from a low price and $120m from a high price, so a low price gives the maximax pay-off.

Maximin – conservative strategy
A maximin strategy is where a player chooses the best of the worst pay-off. This is commonly chosen when a player cannot rely on the other party to keep any agreement that has been made – for example, to deny.

In terms of the pessimistic maximin strategy, the worst outcome from a low price is $100m, and from a high price is $70m – hence a low price provides the best of the worst outcomes.

Again, lowering price is the dominant strategy, and the only way to increase the pay-off would be to collude and increase price together. Of course, this requires an agreement, and collusion, and this creates two further risks – one of the food companies reneges on the agreement and ‘rats’, and the competition authorities investigate the food companies, and impose a penalty.

Nash equilibrium
Nash equilibrium, named after Nobel winning economist, John Nash, is a solution to a game involving two or more players who want the best outcome for themselves and must take the actions of others into account. When Nash equilibrium is reached, players cannot improve their payoff by independently changing their strategy. This means that it is the best strategy assuming the other has chosen a strategy and will not change it. For example, in the Prisoner’s Dilemma game, confessing is a Nash equilibrium because it is the best outcome, taking into account the likely actions of others.

Countries with early lockdown top the list for GDP in 2020

Below is a useful graph looking at the 2020 GDP levels in most developed countries. New Zealand had a quick rebound with its elimination strategy, a supportive fiscal response and an expansionary monetary policy. The 2020 GDP figures considered the scale of lost activity from the COVID-19 lockdown as well as the rebound when restrictions were lifted. There seemed to be the trend that early lockdowns led to better GDP figures. Taiwan (2.98%) and China (2.3%) were the only countries to experience positive growth levels with New Zealand down 2.9% compared to 2019. Taiwan’s investment into public health infrastructure pre-COVID-19 enabled them to avoid a national lockdown. Early screening, effective methods for isolation/quarantine, digital technologies for identifying potential cases and mass mask use led to a much more controlled environment. China did experience a positive growth rate (2.3%) but this was well below 7% which they have been averaging since 2010.

However it is important to be aware that some countries were more impacted by COVID-19 than others, not only because of their hesitation to lockdown but also their reliance on certain sectors for GDP growth. Countries like Spain, who are very dependent on the tourist industry were hit hard by the pandemic. Many emerging and developing countries were already experiencing weaker growth before the pandemic struck.

Source: Westpac Bank

A2 Economics – Credit Multiplier

When a bank accepts or collects deposits they keep some of the deposit as reserves (0.r is the reserve ratio) and advance the rest. As this money is spent it comes back into the banking system as someone else’s deposits. Some of this new deposit is kept as reserves and the rest advanced. This process continues until the new deposit becomes so small it can be ignored.

The value credit creation multiplier is an indicator of the final change in bank deposits which will stem from the initial change. We can calculate this as 1 / 0.r, where 0.r is the reserve ratio.

In the example below the credit creation multiplier equals 4 (that is, 1 / 0.25). Further we can work out the growth in the money supply (eventual increase in money supply), using the following formula: Eventual increase equals 1 / 0.r multiplied by the initial deposit in the money supply. In our example it is 4 times $100m equals $400m. The example below shows that loans given by one bank then become a deposit in another bank. Of that $75m deposited 25% must be kept in reserve ($18.75) and the remainder can be lent out ($56.25). This process continues through the banking system. We can also calculate the secondary expansion or credit created using this formula: Credit created equals (1 / 0.r multiplied by the initial deposit) minus the initial deposit.In our example it is $400m – $100m equals $300m.

The change in the money supply may not be as high as calculated because of leakages or withdrawals from the credit creation process. Banks tend to lose reserves as the public will not deposit the whole of the loans back. The public may retain some of the loan in the form of cash, or banks may be unable to find creditworthy customers to make advances to, or funds may get diverted into government securities.

Reserves may also be lost to taxation and imports (under a fixed exchange rate). The reasons for the initial increase in bank reserves could be the public banking more notes and coins than they withdraw, or public debt maturing. If a Central Bank buys back (purchases) government securities or other financial assets from the public or financial institutions, then there will be an increase in bank reserves.

Read more at: elearn Economics

US Inflation on the rise?

There have been signals from investors that they are worried about the increasing threat of inflation in the US economy. With the supply bottlenecks already prevalent from the pandemic and although the Suez Canal is now operational the impact of it being blocked to shipping will inevitably lead to increasing costs for businesses. Furthermore the huge stimulus that has been injected into the circular flow by governments is expected to put pressure on prices i.e. lower interest rates and increased government spending

Below is a diagram that I have found useful to show the differences between cost push and demand pull inflation.

War on drugs – focus on supply or demand?

Been looking at Price Elasticity of Demand with my AS Level class and discussed the drug industry with reference to Tom Wainwright’s book “Narconomics: How to Run a Drug Cartel”. He also wrote an article for the Wall Street Journal on “How economists would wage the war on drugs”. Essentially, the war on drugs is being lost. Badly. As Wainwright notes:

The number of people using cannabis and cocaine has risen by half since 1998, while the number taking heroin and other opiates has tripled. Illegal drugs are now a $300 billion world-wide business, and the diplomats of the U.N. aren’t any closer to finding a way to stamp them out.

This failure has a simple reason: Governments continue to treat the drug problem as a battle to be fought, not a market to be tamed. The cartels that run the narcotics business are monstrous, but they face the same dilemmas as ordinary firms-and have the same weaknesses.

El Salvador – a leader of one of the country’s two gangs has a human resource issue with high turnover of employees.

Mexico – the Zetas cartel franchises its brand like McDonalds which in turn has led to arguments over territory.

Rich countries – street corner dealers are struggle to compete on price and quality with the ‘dark web’. It is a similar scenario with Amazon.

To combat the drug trade governments have focused on restricting the supply. Each year acres of coca plants and manufacturing activities are destroyed but the price has remains around $150-$200 per pure gram for the past 20 years. How have the cartels managed to keep this price?

However, supply of drugs might not even be appreciably reduced when drug crops are targeted. Wainwright points out that:

  1. Drug cartels are a monopsony – they are a single buyer of Andean coca leaves, so they have market power over the price of leaves (i.e. the cartels have the ability to strongly influence the market price of coca leaves). So if some crops are wiped out, the price is unlikely to rise because of the cartels’ market power.
  2. The price of cocaine is so much higher than the crop input costs that even a large increase in crop prices would have little effect on the market price of cocaine (i.e. even a big increase in the price of coca leaves would lead to only a small shift in the supply curve for cocaine).

Also because of its addictive nature demand for drugs is relatively inelastic – the decrease in quantity demanded is less than the percentage increase in price. Therefore reduced supply and a higher price doesn’t change demand that much.

Demand-Side interventions seem to be a better option and they are also a lot cheaper. Weighing up reducing supply by destroying coca crops in remote areas against drug education in schools and you find the latter is a much more plausible option. Tom Wainwright’s explain this below in his talk to the Cato Institute below:

A dollar spent on drug education in U.S. schools cuts cocaine consumption by twice as much as spending that dollar on reducing supply in South America

Bigger loses have be inflicted on cartels with some US states making marijuana legal.

Minimal monetised societies and happiness

For less developed countries economic growth is often assumed to improve the happiness of the population although this relationship has come under a lot of scrutiny in recent times. A new study shows that people in societies where money plays a minimal role can have a level of happiness comparable to those living in Scandinavian countries which typically rate highest in the world. An interview with Eric Galbraith (McGill University, Canada) on Radio New Zealand’s ‘Sunday’ programme caught my attention in which he discusses the research undertaken in the Solomon Islands and Bangladesh. The paper is entitled:

Happy without money: Minimally monetized societies can exhibit high subjective well-being

Public policy that has focused on GDP growth fails to capture other aspects such as income inequality, the depletion of natural resources, environmental concerns etc. However subjective well-being (SWB) is an indicator that is more associated with the variables that matter to people. Galbraith et al question the role of money in determining SWB and reference the Easterlin Paradox (see below) which found that people don’t tend to get happier when their income goes up – see graph below.

What is the Easterlin Paradox?

Easterlin Paradox
  1. Within a society, rich people tend to be much happier than poor people.
  2. But, rich societies tend not to be happier than poor societies (or not by much).
  3. As countries get richer, they do not get happier. Easterlin argued that life satisfaction does rise with average incomes but only up to a point. One of Easterlin’s conclusions was that relative income can weigh heavily on people’s minds.

It is generally believed that people in less developed countries that have minimally-monetised economies have low that SWB. However the fact that happiness has a universal feeling suggest that income may be just a substitute for other sources of happiness, an assumption that is easier to notice in settings where money has little or no use. They used three independent measures to assess complementary but distinct psychological dimensions of SWB.

  1. Cognitive life evaluation – this asks about a person’s satisfaction with life and questions are phrased in a few different forms.
  2. Affect balance – asks what emotions they had experienced throughout the previous day, and calculated as the difference between positive and negative emotions.
  3. Momentary affect – data was obtained by querying subjects by telephone at random times about their emotional state.

Researchers selected four sites in two countries:

Solomon Islands – round 80% of the population live in rural subsistence communities and it has a Human Development Index (HDI) of 0.546 (rank 152 in the world). The sites were Roviana Lagoon (rural site) and Gizo (urban site)

Bangladesh – 35.9% of it being urban, and has an HDI of 0.608 (world rank 136). The sites were Nijhum Dwip (rural) and Chittagong (urban).

Results
The graph below shows that the 4 sites, although are minimally monetised societies,
do experience high levels of SWB which challenge the prevailing view that economic growth is a reliable pathway to increase subjective well-being. While the data presented here were collected only in two countries and four sites this is the first study to that systematically compares standardised SWB measures in minimally monetised, very low-income societies.

A2 Economics – The Accelerator

Just been covering this topic with my A2 class. The accelerator will come up either as a multiple-choice question or part of an essay. The accelerator theory states that investment is determined by the RATE AT WHICH INCOME, AND HENCE OUTPUT, CHANGES OVER TIME. The principle states simply that unless the rate of increase in consumption is maintained, the previous level of investment will not be maintained.

This theory assumes that firms try to maintain some constant relationship between the level of output and the stock of capital required to produce that output. In other words, we assume a constant capital-output ratio which can be expressed in either physical terms or money terms. The accelerator helps us to understand how small changes in demand in one sector can be magnified and spread throughout the economy. The example below assumes that the firm starts with 8 machines each year and 1 machine wears out each year and that each machine can produce 100 units of output per year. In the second year, demand rises for capital goods rises by 200% (from 1 to 3). When the rate of growth of demand for consumer goods slows in year 4, demand for capital goods falls. In year 6 demand drops and they is no requirement for any investment.


Limitations of Accelerator:

* Firms can meet output with stocks – may not need investment
* Changes in technology may mean firms don’t need to invest in as much capital as before
* Firms need to be convinced that demand is long-term to warrant investment
* Limited supply of technology available

Adapted from CIE AS and A Level Economics Revision Guide by Susan Grant

Credit rating agencies polices could impact developing countries recovery.

The world’s three major private credit-rating agencies (CRA) Standard & Poor’s, Moody’s and Fitch are using their power to prevent low-income countries from restructuring their debts and stimulating their economies. Credit rating agencies realise that developing economies who engage with private creditors, which is part of the G20 Common Framework for Debt Treatments, run the risk that those creditors will incur losses and therefore CRA downgrade the developing country’s credit rating. The Common Framework is supposed to help debt-ridden countries and are the best chance for developing countries to reduce their liabilities but a ratings downgrading damage their prospects.

Standard & Poor’s, Moody’s and Fitch control more than 94% of outstanding credit ratings. They are basically an oligopoly influencing financial portfolio investments, the pricing of debt and the cost of capital. Their authority is also enhanced by the SEC (Security and Exchange Commission) who see them as the official CRA. Below are the ratings that each company uses.

We’ve been here before – conflict of Interest and the sub-prime crisis of 2008
Rating agencies are paid by the people whose products they grade and they are competing against other rating agencies for the business. Subsequently the rating agencies were being played-off against each other by the bankers in this market and this led to a systemic decline in standards and willingness not to check the underlying information as thoroughly as possible for fear of losing the deal. Even the rating agencies themselves admit mistakes were made is assessing sub-prime debt and that there were issues to do with data quality from their sources of research. However one has to consider whether the world have been better off if credit rating agencies had not existed as pension funds, bond funds, insurance companies etc would have had to do a lot more of their own research on what they were buying.

Remember before the credit crisis AAA investments mushroomed between 2000-2006 see graph below.

But consider the following:
Bear Stearns
– rated A2 a month before it went bankrupt
Lehman Brothers – rated A2 just days before it collapsed
AIG – rated AA within days of being bailed out
Fannie Mae & Freddie Mac – AAA rating before being bailed out by the government
Citigroup – A2 before receiving a bail out package from the Government
Merrill Lynch – A2 before being sold to Bank of America

A2 is considered a good investment grade

Source: Credit-Rating Agencies Could Derail Economic Recovery – Project Syndicate

Global GDP levels June 2019 – December 2020

A recent publication from the ANZ looked at the GDP in a range of economies. Useful for discussion in class if you are doing GDP and business cycles.

Note:

  • China has rebounded well
  • UK and Euro area had the more severe downturns
  • New Zealand has the steepest rebound from a lockdown period
  • Interesting to note that the bottom of the downturn in all countries is in June 2020 with the exception of China.

Global GDP levels (Q4 2019= 100)

Source: New Zealand Weekly Data – 19th March 2021.