The flattening of the Phillips Curve

Part of the CIE A2 macro syllabus focuses on the wage price spiral which relates to the Phillips Curve. Here are some excellent notes that I picked up from Russell Tillson in my early days teaching at Epsom College in London. As from previous posts, the Phillips Curve analysed data for money wages against the rate of unemployment over the period 1862-1958. Money wages and prices were seen to be strongly correlated, mainly because the former are the most significant costs of production. Hence the resulting curve purported to provide a “trade-off’ between inflation and unemployment – i.e. the government could ‘select’ its desired position on the curve. During the 1970’s higher rates of inflation than previously were associated with any given level of unemployment. It was generally considered that the whole curve had shifted right – i.e. to achieve full employment a higher rate of inflation than previously had to be accepted. Milton Friedman’s expectations-augmented Phillips Curve denies the existence of any long-run trade off between inflation and unemployment. In short, attempts to reduce unemployment below its natural rate by fiscal reflation will succeed only at the cost of generating a wage-price spiral, as wages are quickly cancelled out by increases in prices.

Central Banks

Central banks have found that inflation has been the pest it has been in the past – most countries inflation rates have been short of its target rate. After the GFC the level of unemployment rose and inflation was quite subdues. However, with the post GFC recovery unemployment began to fall whilst the inflation rate was still showing no signs of accelerating which went against the original Phillips Curve. A further problem was that imported goods and services in one country have little relevance on the wages in another and the low levels of unemployment tempted people back into the labour force who hadn’t been counted as unemployed. This is particularly the case in Japan.

When there is an increase in job numbers, with a boom period, inflation may also be slow to rise. Although firms tend to be reluctant to lower wages when the economic climate slows as it is harmful to staff morale. The same could be said in good times as wages tend not to rise that quickly.

For many businesses changing the price of their goods or services can be costly especially for a small increase in price. Therefore the change in the business cycle tends not to be reflected in price changes as there needs to be major swings before prices will move at all. Central bank policy tends to manipulate interest rates to maintain a stable inflation causing unemployment to move up or down – unemployment is what changes not inflation.

The problem that central banks face today is that to keep the phillips curve flat they need to be able to cut interest rates to stimulate growth when inflation threatens to become deflation. However there is little room for further easing with rates so low. Central banks will need to work with the government’s fiscal policy to stimulate growth and spend the money that the central bank’s create.

Does a higher minimum wage mean higher unemployment?

In most economics textbooks the labour market is shown with a simple graph of the supply of labour and the demand for labour and where they intersect the wage that employees receive for their service and the amount employed. The theory is based on the following:

Demand for Labour
In this context the demand for labour is determined by the marginal revenue product where workers are paid the value of their marginal revenue product to the firm. The demand for labour is downward sloping as when there is a fall in the wage rate the firm will expand employment as the labour input has become relatively cheaper for a given level of productivity, compared to other inputs. A rise in the wage rate will causes a contraction of labour demand.

Supply of Labour
Economic theory would suggest that the real wage (adjusted for inflation) is a key determinant of the number of hours. Therefore the supply curve for labour slopes upward because people want to work more hours if you pay them more, at least in theory. An increase in the real wage on offer in a job should lead to someone supplying more hours of work over a given period of time, although there is the possibility that further increases in the going wage rate might have little effect on an individual’s labour supply.

The Minimum Wage

The minimum wage distorts the market equilibrium as there is now a wage floor – a level which the wage cannot fall below. If the minimum wage is below the equilibrium wage then there is no impact as the market will ensure that is reaches equilibrium. However a minimum wage above the equilibrium means that companies will hire fewer workers and therefore result in more unemployment. On the graph below a minimum wage of W1 means that the level of employment has fallen but those prepared to work but are involuntary unemployed has increased. However the people still employed are better off as they are paid more for the same work; their gain is exactly balanced by their employers’ loss. The jobs that someone would have been willing to do at less than the wage of We and for which some company would have been willing to pay more than We. Those jobs are now gone, as well as the goods and services they would have produced.

Real Impact of the Minimum Wage.

In reality the theory of the minimum wage explained above is not as simple as it is made out to be. From records in the USA there is no obvious relationship between the minimum wage and unemployment: adjusted for inflation, the federal minimum wage was highest from 1967 through 1969, when the unemployment rate was below 4%. One study in 1994 by David Card and Alan Krueger evaluated an increase in New Jersey’s minimum wage by comparing fast-food restaurants on both sides of the New Jersey – Pennsylvania border. They concluded, “contrary to the central prediction of the textbook model … we find no evidence that the rise in New Jersey’s minimum wage reduced employment at fast-food restaurants in the state.”

The idea that a higher minimum wage might not increase unemployment goes against the the theory in textbooks as if labour becomes more expensive firms will take on less employees. But there are several reason why this might not be the case:

  • The standard model states that firms will replace labour with machines if wages increase, but what happens if labour saving technologies are not available at a reasonable cost.
  • Some employers may not be able to maintain their business with fewer workers especially in service based industries. Therefore, some companies can’t lay off employees if the minimum wage is increased.
  • Small firms are traditionally labour intensive and can’t afford large capital investment. Therefore the minimum wage doesn’t have the impact of laying off workers.
  • If employers have significant market power that the theory of the supply and demand for labour doesn’t exist, then they can reduce the wage level by hiring fewer workers (only those willing to work for low pay), just as a monopolist can boost prices by cutting production (think of an oil cartel, for example, see graph Monopsony Labour Market). A minimum wage forces them to pay more, which eliminates the incentive to minimize their workforce.
  • Even though a higher minimum wage will raise labour costs many companies can recoup cost increases in the form of higher prices; because most of their customers are not poor, the net effect is to transfer money from higher-income to lower-income families. In addition, companies that pay more often benefit from higher employee productivity, offsetting the growth in labor costs.
  • Higher wages boost productivity as they motivate people to work harder, they attract higher-skilled workers, and they reduce employee turnover, lowering hiring and training costs, among other things. If fewer people quit their jobs, that also reduces the number of people who are out of work at any one time because they’re looking for something better. A higher minimum wage motivates more people to enter the labor force, raising both employment and output.
  • Higher pay increases workers’ buying power. Because poor people spend a relatively large proportion of their income, a higher minimum wage can boost overall economic activity and stimulate economic growth, creating more jobs.
Monopsony Labour Market

All the above add a range of variables that are not considered in the simple supply and demand model for labour. It maybe useful as a starting point in discussing the minimum wage but has its limitations in the more complex real world

Source: Economism by James Kwak

Record Terms of Trade for New Zealand – Q2 2020

New Zealand’s terms of trade rose by 2.5 percent in the June quarter, reaching a new record high.

Terms of Trade – Q2 2020

  • Export prices rose by 2.4 percent – forestry product prices rising by 11.1%, and dairy product prices by 4.1%.
  • Import prices fell by 0.1 percent in the quarter, driven by lower petroleum and petroleum product prices. This is despite higher prices for cellphones, televisions and laptops.

NZ’s high Terms of Trade highlights how NZ’s role as a food exporter will likely provide the NZ economy with some buffer as the global economy is rocked by the COVID-19 pandemic.

What is the Terms of Trade.
The terms of trade index measures the value of a unit of exports in terms of the number of imports it can buy, or the purchasing power of our exports. This is similar to comparing the number of sheep exports that will buy a typical imported family car, from one time to another.

Formula: Terms of Trade (TOT) =

Export Price Index (Px)           x   1000 (base year)
Import Price Index (Pm)

  • An increase in the TOT (e.g. from 1050 to 1200) is called “favourable”
  • A decrease in the TOT (e.g. from 1050 to 970) is called “unfavourable”

A “favourable” (increase) in the TOT may come about because the average:

– export price rose and import price stayed the same
– export prices rose faster than import prices
– export prices stayed the same and import prices fell
– export prices fell but import prices fell faster

The index number that results tells us whether merchandise export price movements have been favourable relative to import price movements. An increase in the terms of trade from 1000 to 1100 represents an increase in the purchasing power of our exports of 10% which means, other things being equal, we would be able to buy 10% more from overseas. As a country we would be wealthier. A decline in the terms of trade would result in the opposite situation.

Limitations of the Terms of Trade

Terms of trade calculations do not tell us about the volume of the countries’ exports, only relative changes between countries. To understand how a country’s social utility changes, it is necessary to consider changes in the volume of trade, changes in productivity and resource allocation, and changes in capital flows.

The price of exports from a country can be heavily influenced by the value of its currency, which can in turn be heavily influenced by the interest rate in that country. If the value of currency of a particular country is increased due to an increase in interest rate one can expect the terms of trade to improve. However this may not necessarily mean an improved standard of living for the country since an increase in the price of exports perceived by other nations will result in a lower volume of exports. As a result, exporters in the country may actually be struggling to sell their goods in the international market even though they are enjoying a (supposedly) high price. An example of this is the high export price suffered by New Zealand exporters since mid-2000 as a result of the historical mandate given to the Reserve Bank of New Zealand to control inflation.

In the real world of over 200 nations trading hundreds of thousands of products, terms of trade calculations can get very complex. Thus, the possibility of errors is significant.

Evaluation

  • A decline in the terms of trade is not necessarily a bad thing. For example, a decline in the terms of trade may occur due to a devaluation in the exchange rate. This devaluation may enable a country to regain competitiveness and increase the quantity of exports.
  • The impact of a decline in the terms of trade will depend on the elasticity of demand. If demand is elastic, the lower price of exports will cause a bigger % increase in demand.
  • Some Less Developed Countries (LDCs) have seen an improvement in terms of trade because of rising price of commodities and food post 2008. It is not always LDCs who see a decline in the terms of trade.
  • It is important to distinguish between a short term decline in terms of trade and a long term decline. A long term decline is more serious for reflecting a fall in living standards.



Carbon Footprint – NZ v UK primary industry

Useful video on Food’s true carbon cost from the FT – mentions New Zealand apples being sold in the UK not necessarily having a greater global footprint. Apples kept in cold storage would cause a greater carbon footprint than apples being shipped from New Zealand.

Previously food miles (the total distance traveled as food is transported from its place of origin to the consumer’s plate) was one measure of the global footprint and New Zealand is particularly vulnerable due its large quantities of agricultural exports and its geographical isolation. However, transport had been taken out as it was difficult to single out one part of the food system and conclude that because it has come from thousands of miles away it is automatically less sustainable. Therefore, the food miles argument for favouring domestic produce was only valid if food is produced using identical processes around the globe.

In order to reduce CO2 emissions, merely taxing imported food can’t be seen as the answer. As CO2 is emitted at roughly all stages of the process of transporting food to the dining room table, an appraisal of the environmental cost of devouring food from different countries should assess CO2 emissions throughout the product’s complete lifecycle. Stages in a food’s lifecycle include sowing, growing, harvesting, packaging, storage, transportation and consumption. Every phase uses energy and consequently create CO2. These include; Direct Inputs, Indirect Inputs, and Capital Inputs. A simplified flow chart representation of these inputs and the farm outputs, including environmental impacts, but excluding the transport occurring outside the farm gate is shown in Figure 1. Although it was done in 2006 a study by Saunders et al assessed the total CO2 emissions released in the supply of four New Zealand and UK food products to British markets. The report showed (see Table 1 for report data) that in the case of dairy and sheepmeat production NZ is by far more energy efficient even including the transport cost than the UK, twice as efficient in the case of dairy, and four times as efficient in case of sheepmeat.

In the case of apples NZ is more energy efficient even though the energy embodied in capital items and other inputs data was not available for the UK. Onions – where transport emissions account for around two-thirds of all CO2 resulting form the supply of New Zealand crops – are the only product for which UK consumers can reduce CO2 emissions by favouring domestic produce.

A major contributor to New Zealand’s relative CO2 efficiency in dairy production is that New Zealand agriculture tends to apply less fertilisers (which require large amounts of energy to produce and cause significant CO2 emissions) and animals are able to graze year round outside eating grass instead large quantities of brought-in feed such as concentrates. European dairy farms involve housing animals for extended periods of time. The fact that New Zealand farmers do not require subsidies to be internationally competitive, unlike their British counterparts, indicates these efficiencies of production.

Eight body problem in economics

Physicists and mathematicians have puzzled over the three-body problem – the question of how three objects orbit one another according to Newton’s laws. No single equation can predict how three bodies will move in relation to one another and whether their orbits will repeat or devolve into chaos.

John Mauldin of Mauldin Economics wrote about the eight-body problem in economics in which we cannot predict how the economy will react when eight variables change. He lists the following:

What is certain is that as government fiscal intervention starts to lose its effectiveness it will be inevitable that monetary policy will continue to remain very accommodating with bond buybacks and record low interest rates. COVID-19 has turned conventional economic thinking upside down.

Reduced inflation in New Zealand with Covid-19

The inflation rate in New Zealand, as in many countries, is on a downward trajectory – it will take a lot of stimulus form the Reserve Bank to meet its policy target agreement of maintaining the CPI between 1-3%. Westpac have forecast a drop to 0.2% in 2021 and to remain below 1% until the middle of 2022. There have been some obvious reasons for less pressure on inflation:

  • Demand for goods and services both in NZ and overseas has dropped significantly and tamed any inflation. Most notably there has been a major drop in oil prices.
  • The use of ecommerce and, without the overheads of rents / staff, prices are often much lower than the high street.
  • With zero net migration and as excess capacity in long term rental market prices haven’t moved. Add to this the Government’s rent freeze.
  • A lack of tourist dollars has meant a shift inwards of the aggregate demand curve as exports of services fall – AD = C+I+G+(X-M).
  • With people having the growing uncertainty of job security there has been little additional spending or borrowing with the threat of redundancy hanging over them.
  • The wage subsidy has kept some companies afloat but there has been no room for wages increases/negotiations for such uncertain times. Therefore consumer spending has been limited compared to previous years.

Important to note that inflation figures that are quoted are usually on a yearly basis so it is the change in prices from today to this time last year. It will be interesting to see what state the economy will be in this time next year.

V U Z W L recoveries and the inverted square root

Usually we talk about U V W or L recoveries but with the impact of Covid-19 there has been much mention of an inverted square root (as mentioned by George Soros in video below) in some countries as an economy tries to gain some semblance of pre-covid normality. Below is an image from the Wall Street Journal that describes each of the following recoveries: – V U Swoosh Z W L.

Probably the inverted square root sign illustrates the most likely scenario today, with some recovery of the lost GDP but not a return to the previous trajectory. This represents a surge in demand after the relaxing of restrictions but it doesn’t last and starts to plateau after a period of time. For a lot of countries a second wave of Covid-19 has meant a return to lockdown and a further dampening of demand with the economy unable to compensate for people in bars / restaurants / sports events etc. Furthermore the fear of physical proximity will keep the recovery of services subdued.

Although from 2011 the video below from the PBS Newshour shows reporter Paul Solman and Simon Johnson – former IMF economist and now at MIT. Johnson explains the different types of recoveries – L U V W shapes. Note George Soros and the inverted square root sign.

A2 Economics – Concentration Ratio

Part of the CIE A2 syllabus deals with the concentration ratio and by good fortune a recent edition of The Economist schools brief looked at this area.

The concentration ratio is the percentage of market share taken up by the largest firms. It could be a 3 firm concentration ratio (market share of 3 biggest) or 5 firms concentration ratio. Concentration ratios are used to determine the market structure and competitiveness of the market. The most commonly used are 4, 5 or 8 firm concentration ratios which measure the proportion of the market’s output provided by the largest 4, 5 or 8 firms.

Example of a hypothetical concentration ratio
The following are the annual sales, in $m, of the six firms in a hypothetical market:

Firm A = 56
Firm B = 43
Firm C = 22
Firm D = 12
Firm E = 3
Firm F = 1

In this hypothetical case, the 3-firm concentration ratio is 88.3%, that is 121/137 x 100.

According to the OECD, member countries between 2000 and 2014 experienced an increase in concentration ratios. The share of sales accounted for by the top eight firms in a given industry in the EU and North American were as follows:

Some policy makers are unconcerned with industrial concentration as it doesn’t tell you how competitive the market is for a particular good. Although others have blamed falling levels of competition, the stagnant labour markets and growing inequality. Add to that low interest rates and weak investment the rising power of companies has been increasing.

However one could argue that those firms which have high concentrations (especially in the technology sector) have also been very productive. The internet has broken down barriers to entry into markets and enabled firms to deliver goods and services in a very convenient manner at lower prices to a vast consumer market. But although this sounds encouraging there are barriers to new firms entering into this medium:

  • a new firm will require masses of data to tailor their services to individual users
  • other firms already in the market can see what preferences consumers have and because they already have a client base they can easily provide similar products/services.
  • established firms already in the market can buy out new entrants – Facebook bought Instagram and WhatsApp. Between 2009-2019 technology firms made over 400 acquisitions with little interference from regulators.

Source: The Economist – Economics brief – Competition. 8th August 2020

Veblen goods and how to own part of a Birkin Bag

Online trading site Rally Rd has introduced an opportunity to part own various luxury items. For instance you could become part owner of a $61,500 Birkin Bag or top of the range Lamgourghini car. Rally Rd acquire the most noteworthy items from collections and individuals all over the world and make them into “a company”. They then split it into equity shares and open an “Initial Offering” where investors can purchase shares & build a portfolio. After 90 days, investors have the chance to sell shares in-app or add to their position on periodic trading days (through registered broker dealers).

The market for investing in fractions of items otherwise seen as collectibles — and largely reserved for the wealthiest people — has seen an uptick in interest during the pandemic as people spend more time at home. Although there is a potential return on the investment you never get to see your Birkin Bag or Lambourghini. Shares are traded until the owner of the marketplace sells the asset.

Are Birkin Bags Veblen Goods?

Conspicuous consumption was introduced by economist and sociologist Thorstein Veblen in his 1899 book The Theory of the Leisure Class. It is a term used to describe the lavish spending on goods and services acquired mainly for the purpose of displaying income or wealth. In the mind of a conspicuous consumer, such display serves as a means of attaining or maintaining social status.

Economists and sociologists often cite the 1980’s as a time of extreme conspicuous consumption. The yuppie materialised as the key agent of conspicuous consumption in the US. Yuppies didn’t need to purchase BMWs or Mercedes’ cars for example; they did so in order to show off their wealth. This period had its origins in the 1930’s with Austrian economists Ludwig von Mises and Fredrick von Hayek – the latter being the author of “The Road to Serfdom”, in which he said that social spending rather than private consumption would lead inevitably to tyranny. Margaret Thatcher (UK Prime Minister 1979-1990) and Ronald Reagan (US President 1981-1989) believed in this ideology and cut taxes and privatised the commanding heights in a move to a free market environment.

So-called Veblen goods (also as know as snob value goods) reverse the normal logic of economics in that the higher the price the more demand for the product – see graph below

Over the last three decades conspicuous consumption has accelerated at a phenomenal level in the industrial world. Self-gratification could no longer be delayed and an ever-increasing variety of branded products became firmly ingrained within our individuality. The myth that the more we have the happier we become is self-perpetuating: the more we consume, the less able we are to tackle the myth.

The Economist 1843 bi-monthly magazine had a very good article on Hermès’s Birkin handbag (named after Jane Birkin, an Anglo-French actress who spilled the contents of a overfull straw bag in front of Jean-Louis Dumas, Hermès’s chief executive) and how it has become one of the world’s most expensive – prices start at $7,000; in June Christie’s Hong Kong sold a matte Himalayan crocodile-skin Birkin with a ten-carat diamond-studded white-gold clasp and lock for $300,168. The rationale for its expense is that it is hand crafted and can take up to 18 hours to complete although the production cost is estimated to be around $800.

One would think that this would be a Veblen Good – a good in which the higher the price the more demanded. However there are a couple of ways that the Birkin handbag is not.

1. The bag is not all that conspicuous as although most people can identify Gucci, Louis Vuitton or Chanel, a Birkin is not so easy to find. In fact it is an inconspicuous but expensive bag. This theory was explained in the article “Signalling status with luxury goods: the role of brand prominence” from the Journal of Marketing (2010). It divided the high income earners into two groups;

Parvenus – who want to associate themselves with other high income groups and distinguish themselves from those who do not have material wealth.

Patricians –  who want to signal to other people in their high income bracket and not to the masses. They are of the belief that more expensive luxury goods aimed at them will have less obvious branding than cheaper products made by the same company. This was achieved with smaller logos for more expensive items and larger ones for cheaper goods which are aimed at the masses. People who cannot afford the luxury items will buy the big logo items (louder products) and this is where the counterfeiters have a field day.

2. Normally producers of Veblen goods should raise the price till the point where the demand curve starts to follow it normal shape – downward sloping from left to right. However with Birkin they maintain its exclusivity not by raising the price but by limiting the supply. Unlike other Veblen goods you just can’t walk into a shop and buy a Birkin bag – you have to place an order and wait for it to arrive. But you would wonder why they don’t sell more and make more money? It is a supply constraint – limited availability of high-quality skins and craftspeople to make them – it takes two years training. Hermès suggests, Birkins are mined, not simply made.

Commercial Reasons to limit supply of Birkins

Rationing by supply rather than price does make good commercial sense for the following reasons:

1. It gives Hermès a buffer as if demand drops, sales will not.

2. It creates excess demand for the bags, which overflows into demand for other Hermès products – wallets, belts, beach towels etc.

3. Profitability in the short run would reduce its exclusiveness as the main buyers of the bags would eventually be those concerned with social climbing. Therefore the rich may lose interest in the bags and so will those that aspire to be like them.

However I not sure Hermès actually want you to buy their amazingly expensive bag.

Should we stop consumption?

Geoffrey Miller is his book – Spent: Sex, Evolution, and Consumer Behaviour – examines conspicuous consumption in order to rectify marketing’s poor understanding of human spending behaviour and consumerist culture. His thesis is that marketing influences people—particularly the young—that the most effectual means to show that status is through consumption choices, rather than conveying such traits as intelligence and personality through more natural means of communication, such as simple conversation. He argues that marketers still tend to use naive models of human nature that are uninformed by advances in evolutionary psychology and behavioural ecology. As a result, marketers “still believe that premium products are bought to display wealth, status, and taste, and they miss the deeper mental traits that people are actually wired to display—traits such as kindness, intelligence, and creativity.

The recent global downturn with Coivd-19 has sent out a few mixed messages. Firstly there has been the reduction in consumption as people’s credit lines have dried up but there are those that believe that you should spend more to maintain growth and employment in the economy. With household budgets being very tight smarter consumption rather than less consumption has been advocated by Geoffrey Miller. He refers to this as more ethical consumption where the production of produce does not involve the abuse of natural resources or the exploitation of people or animals.