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RIP – Pete Lyons

Very sad to hear the passing of Pete Lyons – economics teacher at St Peter’s College in Auckland. He was well-know amongst economics teachers and produced some great resources – I have his Banquet of Beauties publication which has been very useful at all levels. Always prepared to challenge the economic theory in course syllabuses and had a great passion for the subject. As well as teaching he wrote very erudite pieces in the NZ Herald and the Otago Daily Times. See tribute below from the NZ Herald

https://www.nzherald.co.nz/nz/news/article.cfm?c_id=1&objectid=12354498&fbclid=IwAR1B1cCuHssdUhcADGJdgTK0pyNtUUXwLTCMJClEatUxd2IKrzU0kAWHt9s

Gold reaches record high.

Good clip here from the FT that looks at why Gold which has been getting up to record levels. Should we be buying gold today?

Gold’s ascent continues as real yields have to continue to fall. This requires that inflation expectations keep going up at the same time as low growth expectations keep nominal yields pinned right where they are – this leads to stagflation.

Back in 2011, in the last crisis, like today, the Fed was intervening strongly in a sluggish economy and Washington was in turmoil. Investors then made the same bet on stagflation and gold. As it turns out, they were wrong. The price of gold got cut in half in the years that followed. In fact, all predictions of inflation since the last crisis have turned out to be similarly wrong. And all efforts by the Federal Reserve to get inflation up to its two per cent target have failed. So a bet on stagflation and gold now is a bet against recent history. That many investors are willing to take that wager shows just how frightened they really are.

Barriers to trade not the answer during the pandemic

The WTO has warned that the reduction in global trade could be bigger than that following the GFC in 2008 – see graph below. For countries to start reducing the volume of imports because export volumes have been decreasing is not seen as the right way forward. With countries dependent on the global supply chain for PPE and pharmaceuticals, it would be wrong to focus on being self-sufficient in these essential products.

Source: WTO

As Martin Wolf of the FT pointed out the issue is not with trade but a lack of supply. Export restrictions merely relocate the shortages, by shifting them to countries with the least capacity. The natural response might be to become more self-sufficient in every product but free trade and globalisation does have its advantages:

US dollar under pressure as the reserve currency.

In doing most introductory courses in economics you will have come across the four functions of money which are:

  • Medium of exchange
  • Unit of Account
  • Store of Value
  • Means of deferred payment

Since the Bretton Woods Agreement in 1944 the US dollar was nominated as the world’s reserve currency and ranks highly compared to other currencies in the above functions. As a medium of exchange the US dollar is very prevalent:

  • 60% of the world’s currency reserves are in US dollars
  • 50% of cross-border interbank claims
  • After the GFC, purchases of the US dollar increased significantly – store of value.
  • Around 90% of forex trading involves the US dollar
  • Approximately 40% of the world’s debt is issued in dollars
  • n 2018 banks of Germany, France, and the UK held more liabilities in US dollars than in their own domestic currencies.

So why therefore is there pressure on the US dollar as the reserve currency?

The COVID-19 pandemic has closed borders and will inevitably lead to more regionalised trade, migration and money flows which suggests a greater use of local currencies. However China has made its intention clear that the Yuan should become a more universal currency. Some interesting facts:

  • Deposits in yuan = 1trn yuan = US$144bn
  • Yuan transactions have grown in Taiwan, Singapore, Hong Kong and London.
  • Investment by Chinese firms into Belt and Road project = US$3.75bn which was in yuan
  • China settles 15% of its foreign trade in yuan
  • France settles 20% of its trade with China in yuan
  • 2018 – Shanghai sock market launched yuan-denominated oil futures.
  • The IMF suggest that the ‘yuan bloc’ accounts for 30% of Global GDP – the US$ = 40%

However if the past is anything to go by the US economy has gone through some very turbulent times but the US dollar has remained firm. This suggests that how we perceive the US economy doesn’t seem to relate to the value of its currency.

Source: The Economist – China wants to make the yuan a central-bank favourite
7th May 2020

EU’s uncommon Common Agricultural Policy

At the outset of the EU, one of the main objectives was the system of intervention in agricultural markets and protection of the farming sector known as the common agricultural policy – CAP. Throughout most of its four decades of existence, the CAP has had a very poor public relations image. It is extremely unpopular among consumers, and on a number of occasions it has all but bankrupted the EU. The EU’s seven year budget (2021-2027), also known as the ‘multi-annual financial framework (MFF) is currently being discussed and agricultural subsidies are once again a controversial issue although have been reduced from previous years – 70% of the EU budget in 1980 to 37% in 2018 – see graph right from The Economist.

The aim of discussions is to reduce the amount to between 28% and 31% of the MFF. EU support levels are very high when compared to other countries. The graph below shows the support that other countries receive – producer support estimate (PSE), as a share of total farm income. EU is 20.% (2018) above the OECD average and well ahead of China, USA, Russia, Canada, Brazil, and Australia. Norway is at 62.36% whilst New Zealand is 0.48%.

Source: https://www.cgdev.org/publication/new-estimates-eu-agricultural-support-un-common-agricultural-policy

Who gets what from EU farm subsidies?

Source: https://www.cgdev.org/publication/new-estimates-eu-agricultural-support-un-common-agricultural-policy

There is wide variation in the support provided to agriculture within the “Common” agriculture policy. Latvia does the best of any country in the EU with a lot of other more recent eastern European entrants into the EU – of the top 10 Greece and Finland are the only non East European countries. The Netherlands gets a mere 7% of their income from EU support and traditional supporters of agriculture spend like Ireland, Luxembourg, Italy, and Poland are all below the EU average

  • Despite being a vocal critic of the CAP (and receiving a separate rebate) UK support is broadly the same as the EU average
  • France’s support is only just above average, while Germany’s is in the bottom quarter
  • In terms of the “market price support” element—which inflates EU food prices—Belgium, Hungary, Malta, Poland, and UK producers benefit most

The variation seen here reflects a combination of factors, few of which relate to a policy objective. Most payments are distributed on the basis of a farm’s size in hectares—though per hectare rates vary and were often based on the historical value of production. Other payments relate to sustainability of farming methods, numbers of young farmers, or how much farms produce. With agriculture seen as a significant contributor to global emissions should subsidies be tied to those farmers reducing their impact on climate change?

The economics behind CAP intervention price

An intervention price is the price at which the CAP would be ready to come into the market and to buy the surpluses, thus preventing the price from falling below the intervention price. This is illustrated below in Figure 1. Here the European supply of lamb drives the price down to the equilibrium 0Pfm – the free market price, where supply and demand curves intersect and quantity demanded and quantity supplied equal 0Qm. However, the intervention price (0Pint) is located above the equilibrium and it has the following effects:

  1. It encourages an increase in European production. Consequently, output is raised to 0Qs1.
  2. At intervention price, there is a production surplus equal to the horizontal distance AB which is the excess of supply above demand at the intervention price.
  3. In buying the surplus, the intervention agency incurs costs equal to the area ABCD. It will then incur the cost of storing the surplus or of destroying it.
  4. There is a contraction in domestic consumption to 0Qd1
    Consumers pay a higher price to the extent that the intervention price exceeds the notional free market price.

Figure 1: The effect of an intervention price on the income of EU farmers.

The increase in farmers’ incomes following intervention is shown also: as has been noted, one of the objectives of price support policy is to raise farmers’ incomes. The shaded area EBCFG indicates the increase in the incomes of the suppliers of lamb.

Sources:

  • https://www.cgdev.org/publication/new-estimates-eu-agricultural-support-un-common-agricultural-policy
  • The Economist: 23-11-19 – Milking taxpayers

A2 Revision – Oligopoly and the kinked demand curve – download

With the A2 Essay paper tomorrow I thought something on the kinked demand curve might be useful. I alluded to in a previous post that one model of oligopoly revolves around how a firm perceives its demand curve. The model relates to an oligopoly in which firms try to anticipate the reactions of rivals to their actions. As the firm cannot readily observe its demand curve with any degree of certainty, it has got to estimate how consumers will react to price changes.

In the graph below the price is set at P1 and it is selling Q1. The firm has to decide whether to alter the price. It knows that the degree of its price change will depend upon whether or not the other firms in the market will follow its lead. The graph shows the the two extremes for the demand curve which the firm perceives that it faces. Suppose that an oligopolist, for whatever reason, produces at output Q1 and price P1, determined by point X on the graph. The firm perceives that demand will be relatively elastic in response to an increase in price, because they expects its rivals to react to the price rise by keeping their prices stable, thereby gaining customers at the firm’s expense. Conversely, the oligopolist expects rivals to react to a decrease in price by cutting their prices by an equivalent amount; the firm therefore expects demand to be relatively inelastic in response to a price fall, since it cannot hope to lure many customers away from their rivals. In other words, the oligopolist’s initial position is at the junction of the two demand curves of different relative elasticity, each reflecting a different assumption about how the rivals are expected to react to a change in price. If the firm’s expectations are correct, sales revenue will be lost whether the price is raised or cut. The best policy may be to leave the price unchanged.

With this price rigidity a discontinuity exists along a vertical line above output Q1 between the two marginal revenue curves associated with the relatively elastic and inelastic demand curves. Costs can rise or fall within a certain range without causing a profit-maximising oligopolist to change either the price or output. At output Q1 and price P1 MC=MR as long as the MC curve is between an upper limit of MC2 and a lower limit of MC1.

Criticisms of the kinked demand curve theory.
Although it is a plausible explanation of price rigidity it doesn’t explain how and why an oligopolist chooses to be a point X in the first place. Research casts doubt on whether oligopolists respond to price changes in the manner assumed. Oligopolistic markets often display evidence of price leadership, which provides an alternative explanation of orderly price behaviour. Firms come to the conclusion that price-cutting is self-defeating and decide that it may be advantageous to follow the firm which takes the first steps in raising the price. If all firms follow, the price rise will be sustained to the benefit of all firms.

If you want to gradually build the kinked demand curve model download the powerpoint by clicking below.
Oligopoly

A2 CIE Economics – 50 question quiz

During the last session of an A2 revision course today I put together a 50 question quiz which is based on the CIE A2 Economics course. I split the class into 5 teams (approx 4-5 in each) and asked 5 questions at a time – with a time limit also. Each team had whiteboards to draw / write answers – it gets quite competitive and today it came down to a tiebreak question.

  1. What conditions have to be met to achieve allocative efficiency?
  2. Draw two features of productive efficiency
  3. What is dynamic efficiency
  4. Social cost = ?
  5. Draw negative externalities of consumption
  6. What is meant by Tragedy of the Commons?
  7. What does an indifference curve show?
  8. Draw a giffen good.
  9. Where does the firm’s supply curve commence?
  10. Draw minimum efficient scale
  11. What assumption is made about a product in Perfect Competition?
  12. Draw short-run to long-run in Perfect Competition
  13. List 3 characteristics of an oligopoly
  14. Draw dead weight loss for a monopoly
  15. What is significant about the output where MC=MR=AC=AR.
  16. A natural monopoly achieves economies of scale at what outputs?
  17. What are the three types of price discrimination?
  18. It is a mistake to believe that ALL oligopolists face a kinked demand curve. Why?
  19. List 4 objectives of firms other than profit maximization.
  20. Contestable markets are characterised by 2 features. What are they?
  21. What is meant by X-inefficiency?
  22. Draw the impact of a pollution tax that reduces but does not eliminate a DWL.
  23. Draw buffer stock theory.
  24. Show the impact of an increase in GST on a Lorenz Curve.
  25. Perfect Labour market has a perfectly elastic supply curve. Why?
  26. Draw a monopsony labour market.
  27. Why does Christiano Ronaldo have a lot of economic rent?
  28. Define HDI, MEW and MPI
  29. List 5 limitations of GDP as an indicator of standard of living.
  30. Using LF, WAP and unemployed -work out the unemployment and participation rate
  31. Draw a reduction in the natural rate of unemployment.
  32. Consumption function = ?
  33. What are recessionary and inflationary gaps?
  34. Give the 2 equations to work out the multiplier.
  35. Explain the credit multiplier and what is the equation.
  36. How are bonds and interest rates related?
  37. Give 2 differences between Keynesians and Monetarists
  38. Draw a flow chart to show how microfinance can help developing countries.
  39. Why does the Phillips curve no longer have significant relevance?
  40. Deflation is…………………………
  41. What did Arthur Laffer draw on a paper napkin?
  42. How can healthy growth impact the balance of payments?
  43. Explain Hot Money
  44. Explain the internal and external value of money.
  45. Draw a recessionary gap using the 45° line.
  46. What is the hysteresis effect?
  47. A positive output gap is associated with what conditions in an economy?
  48. Name two limitations of the accelerator  theory.
  49. What components of the Fisher equation stay constant?
  50. Who is Chairman of the US Federal Reserve?

New Zealand labour market – unemployment gap around zero.

The unemployment rate gap is the unemployment rate minus the estimate of the natural rate of unemployment. The natural rate of unemployment is the difference between those who would like a job at the current wage rate – and those who are willing and able to take a job. In the above diagram, it is the level (Q2-Q1).

The natural rate of unemployment will therefore include:

Frictional unemployment – those people in-between jobs. Structural unemployment – those people that don’t have the skills that fit the jobs that are available.

It is also referred to as the Non-Accelerating Inflation Rate of Unemployment (NAIRU) – the job market neither pushes up inflation nor holds it back.

The size of the gap gives us an idea about the amount of capacity in the labour market, and hence pressure (or otherwise) on wages and inflation. ASB estimate that the NAIRU is currently hovering just above 4%, the bottom of the RBNZ’s recently estimated range (4.0-5.5%). With the current HLFS unemployment rate at 4.2%, a NAIRU of 4% suggests the unemployment gap is currently around zero. In other words, the labour market is neither particular tight nor loose. This is of course quite a change from a few decades ago when a 4% unemployment rate would indicate a super tight labour market and strong pressure on wages to rise. Broadly, what we have seen is a fundamental change in the capacity and inflation trade-off, not just in the labour market but economy-wide.It could be that increased globalisation and technological change are facilitating a shift in these trade-offs, which likely explains why inflation both here and abroad has been so low despite historically-low rates of unemployment and elevated measures of resource utilisation. Source: ASB Bank Economic Note

Market structures and Netflix

Covering this topic with my A2 class and fortuitously came across a very relevant blog post from Michael Cameron’s blog Sex Drugs and Economics. He talks about Netflix increasing its subscription price by 19% (now $21.99) for the premium plan and how Kiwi subscribers are going to social media to announce their departure from the streaming service.

However although people are voting with their feet it is highly likely that Netflix are not too perturbed by this. With the law of demand a higher price will reduce the demand for the service – simple Law of Demand.

The diagram below from the Cameron Blog shows a horizontal MC=AC curve which means that the cost of producing one more unit of output is the same. Some would suggest that it could be close to zero as the additional cost of providing one more subscriber with the service doesn’t involve significant costs.

Let’s assume that Netflix originally charged a price of P0 and sold a quantity of Q0 before the increase. Note here that they still make a supernormal profit rectangle – P0 C H F.

However they are not producing at the profit maximisation which is where MC=MR. Therefore although Netflix is increasing their price it is unlikely that they are charging a price at profit maximisation output as Netflix has too many subscribers to maximise profits. If they did produce at profit maximisation output Q1 and charge price P1 they would make profits of P1 B E F. So at a price of P1 – they gain profit of P1 B G P0 but lose the area G C H E. However the former area is bigger than the latter.

So with the market power that Netflix has it is not surprising that they are increasing their subscription price. With the video stores like Blockbuster, Video Ezy, United now struggling to survive and in some cases out of the market, they are less alternatives out there for the consumer.

UK pound under pressure

From the FT – a weaker pound makes imports more expensive raising prices in the shops and eroding the real value of their earnings and savings. If the pound falls against other currencies, it makes those of us whose earnings or savings or investment income is in pounds poorer. However with a weaker exchange rate it should makes UK exports cheaper – but this doesn’t seem to be the case as although the pound depreciated significantly after the GFC it had little or no effect on the trade balance. Companies that rely on imports haven’t been able to reduce their price as the overall production cost has increased.