Feb 27 2009

## The “delicate balance of terror”: How game theory can be used to predict firm behavior (oh, and save the human race from utter annihilation)

This week in AP Microeconomics students get to play online games, watch movies, and compete with their classmates in strategic competitions in which there are proud winners and sad losers. That's right, we're studying oligopoly!

What makes oligopolistic markets, which characterized by a few large firms, so different from the other market structures we study in Microeconomics? The answer is that unlike in more competitive markets in which firms are of much smaller size and one firm's behavior has little or no effect on its competitors, an oligopolist that decides to lower its prices, change its output, expand into a new market, offer new services, or adverstise, will have powerful and consequential effects on the profitability of its competitors. For this reason, firms in oligopolistic markets are always considering the behavior of their competitors when making their own economic decisions.

To understand the behavior of non-collusive oligopolists, economists have employed a mathematical tool called Game Theory. The assumption is that large firms in competition will behave similarly to individual players in a game such as poker. Firms, which are the “players” will make “moves” (referring to economic decisions such as whether or not to advertise, whether to offer discounts or certain services, make particular changes to their products, charge a high or low price, or any other of a number of economic actions) based on the predicted behavior of their competitors.

If a large firm competing with other large firms understands the various “payoffs” (referring to the profits or losses that will result from a particular economic decision made by itself and its competitors) then it will be better able to make a rational, profit-maximizing (or loss minimizing) decision based on the likely actions of its competitors. The outcome of such a situation, or game, can be predicted using payoff matrixes. Below is an illustration of a game between two coffee shops competing in a small town.

As illustrated above, the tools of Game Theory, including the “payoff matrix”, can prove helpful in helping firms decide how to respond to particular actions by their competitors in oligopolistic markets. Of course, in the real world there are often more than two firms in competition in a particular market, and the decisions that they must make include more than simply to advertise or not. Much more complicated, multi-player games with several possible “moves” have also been developed and used to help make tough economic decisions a little easier in the world of competition.

While Game Theory can be useful in predicting firm behavior in oligopolistic markets, believe it or not that is not its most useful application developed. In fact, would you believe me if I told you that Game Theory may be precisely what saved the world from nuclear holocaust during the 20th Century? It's true. The US government employed Game Theory to avert annihilation by nuclear attack from the Soviet Union during much of the 20th Century. This video tells the story!

[youtube]http://www.youtube.com/watch?v=o1r99OPKVF4&feature=related[/youtube]

Feb 26 2009

## An Asian Exodus?

FT.com / China / Economy & Trade – Downturn drives expat exodus from Shanghai

Having recently moved from Shanghai to Zurich myself, I was interested to see this headline in today's Financial Times.

Korean companies are shipping workers home, cutting off school fees and repatriating wives and children without their menfolk to cut costs. They are the first large wave of expatriates to have begun leaving China’s financial capital as a result of the global economic crisis but their departure raises the prospect of a broader exodus of foreigners who may take investment, skills and job creation opportunities with them.

The press officer of the Korean consulate in Shanghai could not answer questions about the exodus of her countrymen – because her post had just been abolished and she was being sent back to Korea…

Japanese relocation companies, meanwhile, say there has been a marked rise in Japanese families returning home from Shanghai compared with last year and they expect the pace to pick up further during the traditional peak relocation months of March and April.

As Korean and Japanese families pack up and leave Shanghai, the impact is likely to be felt at international schools catering to the expat community in Eastern China. Koreans made up around 15% of the students at Shanghai American School, while other schools in the city had even larger numbers of Japanese and Korean students. In Beijing the exodus is also underway:

The pain has not been limited to Shanghai. A parent with children enrolled in an expensive Beijing international school says most of her daughters’ Korean classmates have left the school almost overnight.

This story reminds me of my own experience as an international school student in the late 1990′s, when the Asian financial crisis plunged Korea's economy into deep recession. At the time, 30% of my school in Malaysia were Korean students, and in one semester over half of them packed up and moved back to Korea. In one year enrollment at the International School of Kuala Lumpur's high school fell from 600 students to 420!

One reason the Korean and Japanese economies are struggling is that they are heavily dependent on exports to the rest of the world. With incomes falling and unemployment rising among their trading partners, the effect is amplified in Japan and Korea by significant falls in aggregate demand and GDP due to lower net exports, investment and consumption in the Japanese economy.

According to this article in the FT, the current fall in exports in Japan is the worst in 50 years.

Japanese exports fell 45.7 per cent in January, eclipsing a 35 per cent drop in December and big declines last month for Taiwan and South Korea.

The slide in exports was the steepest since 1957 and highlighted the severe impact of the global slowdown on demand for Japanese products ranging from cars to heavy machinery and electronics. Exports to the US fell 52.9 per cent and those to China were down 45.1 per cent .

Falling demand has forced manufacturers such as Toyota and Sony to cut production and jobs. It has reinforced concerns the economy will suffer another quarter of falling output. Gross domestic product shrank 3.3 per cent in the last three months of 2008, the largest fall in 35 years.

The diagram below provides a graphical representation of the impact of falling exports on Japan's economy.

Discussion questions:

1. Some economists believe that recessions are a crisis of confidence. What do they mean by that and how does the situation in Japan seen above reflect this theory?
2. What is the multiplier effect and how does the fall spending on Japanese exports by the rest of the world result in an even greater fall in Japan's GDP?
3. If you were the manager of a Japanese firm facing falling demand from international customers and you had to cut costs, what costs would  you cut in the short-run to remain competitive? What about in the long-run, assuming demand for your products remained weak?

Feb 25 2009

## Starbucks instant coffee: a sign of the times?

Chicago, Seattle first markets to get instant Starbucks — chicagotribune.com

I consider myself a Seattleite. I discovered the joy of drinking coffee in the home of Starbucks, Tully's, Seattle's Best, and countless local coffee shops that inhabit every corner of the rainy city. To me, the experience of drinking a latte, machiato, cappuccino, or simply a “coffee of the week” encapsulates the smells, soft decor and friendly greetings from the barista at my favorite coffee shop. Living overseas, I have turned to Starbucks over and over for a taste of Seattle and a feeling of home.

There is no denying that the Starbucks experience is one that does not come cheap. Here in Switzerland, a grande latte, my drink of choice, sets the consumer back nearly \$7. In an economic downturn such as that the US and the rest of the world are experiencing right now, such expenses are often the first to be reduced by cash strapped consumers. In fact, I recently began bringing a thermos of homemade coffee to work every day, rather than stopping at the Starbucks at the train station as I had done for several months not long ago.

Starbucks, which recently announced the closure of hundreds of its locations around the world, is actually expanding its product line while simultaneously closing down shops. It may not be in the way you expect, though. Soon, I'll be able to get my \$7 cup of coffee for as little as \$1, it will just come in a different form:

Starbucks Corp. will launch its new instant coffee product next month in Chicago and its home turf of Seattle, with a full-scale, national offensive set for the fall.

Starbucks on Tuesday formally unveiled the new product, called Via Ready Brew. It will be available in Starbucks retail outlets in the Chicago and Seattle areas on March 3, Howard Schultz, the company's chief executive, said in an interview with the Tribune.

Instant coffee from the king of gourmet blends? Sounds suspicious. Well, it's all about economics, you see. Starbucks coffee is a normal good, one for which demand falls as incomes fall, as evidenced by falling sales at its coffee shops around the world. In order to maintain its customer base even as incomes fall, a company like Starbucks must expand its product line to include inferior products, or those for which demand increases even as incomes fall. Clearly, instant coffee is viewed as an inferior product, due to its significantly lower price and reputation of poor quality.

Furthermore, Starbucks' new product is in response to increased competition from lower-end fast food chains that traditionally did not compete in the coffee market, but recently have begun offering various blends and varieties of coffee to the price-sensitive coffee consumers, further harming business at Starbucks' higher end coffee outlets.

Via marks Starbucks second announcement this month of a cheaper menu alternative, as the famous coffee chain struggles in a weak economy. Starbucks is also now selling pairings of coffee and breakfast offerings for \$3.95.

Starbucks' troubles have occurred at the same time value-oriented fast-food chains, particularly Oak Brook-based McDonald's Corp., have thrived. McDonald's owes part of its success to improving the quality of its basic coffee, and expanding into new drinks like iced coffee, and, more recently, flavored specialty coffees such as lattes and cappuccinos.

Still, Schultz said McDonald's coffee offensive hasn't really affected Starbucks: “We have a lot of respect for McDonald's as a company. But we have not seen any significant issues with McDonald's share of the coffee business affecting Starbucks.”

McDonald's offers “a different product, a different value proposition,” he said. In fact, Schultz said McDonald's should expand the overall coffee market, thus leading some customers to “trade up” to Starbucks.

Despite the CEO's claims that Starbucks and McDonald's coffees are “different” products, it is clear by his firm's decision to expand into the instant coffee market that Starbucks is concerned about the loss of customers to lower-end coffee retailers.

The theory of firm behavior as studied in AP and IB Economics teaches us that firms in oligopolistic or monopolistically competitive markets, such as that for coffee shops in the US, tend to compete using non-price methods such as product differentiation and advertising. Rather than slashing the prices of all of its coffee in the face of a recession and falling consumer incomes, Starbucks has instead diversified its product line to include lower end options for consumers whose sensitivity to price and demand for gourmet coffee have been adversely affected by the weak economy.

Feb 24 2009

## Welker’s daily links 02/23/2009

Published by under Daily Links

• All told, Varvares and his fellow forecasters now expect the economy to shrink by 1.9 percent this year, a much deeper contraction than the 0.2 percent dip projected in the fall.

If the new forecast is correct, it would mark the first time since 1991 the economy actually contracted over a full year and would be the worst showing since 1982, when the country had suffered through a severe recession.

Vanishing jobs, shrinking nest eggs, rising foreclosures and tanking home values have forced American consumers to cut back, which in turn has caused businesses to lay off workers and slash costs in other ways, feeding a vicious downward cycle for the economy.

The current recession, which started in December 2007, is posing a major challenge to Washington policymakers, including President Barack Obama and Fed Chairman Ben Bernanke. That's because its root causes — a housing collapse, credit crunch and financial turmoil — are the worst since the 1930s and don't lend themselves to easy or quick fixes.

“As the news on the economy has darkened, so too, have the forecasts,” said Ken Mayland, president of ClearView Economics. “We are suffering a period of maximum stress on the economy.”

The economy is expected to remain feeble this year — even with new efforts by the administration and Congress to provide relief.

Posted from Diigo. The rest of my favorite links are here.

Feb 24 2009

## Market Failure and the role of government in the economy ~ an introduction to Environmental Economics

Economics is the field of study that attempts to address the basic problem faced by society relating to the environment and natural resources: the problem of scarcity in a world of infinite wants. Many, if not all, of our planet's environmental woes are attributable to an economic phenomenon known as market failure. A market failure results whenever too much (or in some cases too little) of a good or service is produced and consumed by the economy.

What does this have to do with the environment? The connection lies in the reality that everything we produce and consume (and I mean everything!) originates from the earth. Nothing can be made by the sweat of man alone; in fact, three resources are required to produce any good or service: labor, capital (i.e. tools), and land. Sometimes we think of the resource of land as gifts of nature. However, in a world where environmental threats like those mentioned above are staring us in the face, it is becoming more and more obvious that the natural resources we've exploited for so long may not, in fact, have been gifts from Mother Nature at all, and their overuse may impose significant and unaccounted for costs on society AND the environment.

But let's be honest, consuming is fun! Nothing is more gratifying than scoring a fantastic deal at your favorite boutique, walking out of a fast food joint with a plastic bag full of tasty treats for super cheap, and getting your hands on the latest high tech gizmos as soon as they're launched (and dumping that old technology out so you're not the lame one with the three pound cell phone!) However, the true cost of our obsessive consumption habit is not always represented by the price we pay for our fast food, our blue jeans, and our iPads.

In reality, the prices we pay for our goods and services are far lower than they should be; and the quantity of these things we consume is far higher than it should be. How do we know this? Look around. The very environmental issues with which environmental groups are most concerned can be traced back to the consumer behavior we enjoy partaking in so much. We're conditioned to buying what we want, when we want it, and for a price that places little burden on our pocket books.

What we don't realize, however, is that nature is bearing the burden of our high levels of consumption. In its attempt to absorb the pollutants that are emitted in the manufacture of our products, the waste that's created from the disposal of our products, and the destruction that's left behind from the extraction of the natural resources that go into our products, Mother Nature is more than ever choking on the waste created by our economic behavior. The costs born by nature are not accounted for in the production costs faced by firms, nor in the prices paid by consumers. These costs are externalized, or passed on for others to worry about.

The problem is, these days the bill has come due, and the environment is calling in its debts. Humans must now face up to the failures of its markets, and internalize the costs that for so long have been passed on to the environment and society, which suffers from the effects of environmental degradation.

The reality that we've used too many natural resources to produce too much stuff for too long is evidenced by simple examination of the natural world around us. Or, in the case of China, the complete lack of a natural world around us. From the pollution filled skies, to the waste clogged waterways, to the traffic jammed highways, China is a case study in market failure. The world, now used to the cheap imports China is so good at pumping out, does not consider the impact that the manufacture and consumption of such a massive variety of cheap products is having on China's, and these days the world's, environment.

In the following audio clips, you'll hear three short stories about how the over-exploitation of resources is causing harm to human welfare and the environment. Each of these stories contains a market failure, usually in the form of a negative externality, or the production and consumption of certain goods creating spillover costs on somebody or something not involved in its production or consumption. See if you can identified who's being harmed, and who's at fault:

### E-waste [ 7:36 ] Play Now | Play in Popup | Download Trash Island [ 2:01 ] Play Now | Play in Popup | Download Nauru [ 6:57 ] Play Now | Play in Popup | DownloadpodPressShowHidePlayer('1', 'http://search.saschina.org/storage/HTTCT3C/Ewaste.mp3', 290, 24, 'false', 'http://welkerswikinomics.com/blog/wp-content/plugins/podpress//images/vpreview_center.png', 'E-waste', 'Jason Welker');podPressShowHidePlayer('2', 'http://search.saschina.org/storage/CCTH0MD/trashisland.mp3', 290, 24, 'false', 'http://welkerswikinomics.com/blog/wp-content/plugins/podpress//images/vpreview_center.png', 'Trash Island', 'Jason Welker');podPressShowHidePlayer('3', 'http://search.saschina.org/storage/W8IGYEF/Nauru.mp3', 290, 24, 'false', 'http://welkerswikinomics.com/blog/wp-content/plugins/podpress//images/vpreview_center.png', 'Nauru', 'Jason Welker');

Story #1: “Where does all that E-waste go?” from Public Radio International's “The World: Technology” podcast

Story #2: “Trash Island” from WBEZ Chicago's “This American Life”

Story #3: “Nauru – the island in the middle of nowhere” from WBEZ Chicago's “This American Life”

After listening to these stories, reflect for a moment on the true cost of the environmental and human tragedies of which they told. What role does our consumer culture play in these tragedies? What could have been done to prevent the conditions in those E-waste markets in Africa and China, the islands of garbage floating in our deep oceans, and the complete destruction of an island paradise 1,100 miles from the nearest land? Is there anyone to blame? Should we blame our politicians, our leaders? The answer to these questions is: there's no easy answer, unless we want to get really personal here and point to humans' own flawed nature: the fact that we are motivated primarily by greed and self-interest.

If that's true, then perhaps hope for the environment can only be found in the responsible hands of benevolent governments, who once and for all take steps to mitigate the destructive impacts of our endless patterns of production and consumption. In fact, it is often government which is needed to intervene and correct market failures like those in the stories.

Three tools have emerged for governments wishing to correct such negative externalities. These involve three fundamentally different approaches, some more effective than others. One involves direct government control. This is when governments intervene in a market in which negative externalities exist and try to make producers clean up their acts. They threaten producers with penalties and fines, and monitor industries to try and force firms to manufacture their products in a clean, efficient way. (this is like what the Europeans are doing to minimize their e-waste).

The next option also involves a large roll for the government: corrective taxes. Businesses that produce goods that end up polluting the environment (either through their production or consumption) can be taxed based on the amount of pollution they create. If creating more pollution means paying more taxes, the companies will find ways to produce in a more environmentally responsible manner, in order to keep their costs low and to maximize their profits.

The third method for externality reduction is also the most recently adopted. A market for pollution permits is set up, where a government actually gives all the companies in a polluting industry permits that allow them to pollute a certain amount. WHAT? The government's allowing firms to pollute? Well, yes. The fact is, they're going to do it anyway, they HAVE to in order to produce anything! The benefit of this system is that the government will only give each firm so many permits, and they're not allowed to pollute beyond what their permits allow, UNLESS they go and buy more permits from producers that don't need all theirs. This way, firms have an incentive to pollute less, because any permits they don't use they can sell to other producers and make profits on those sales! Dirty firms have to buy more and more permits, clean firms get to sell those they don't need… can you see where this is going? ALL FIRMS want to become clean firms in this scenario!

The three methods introduced above are being used to different degrees by different countries in various industries to try and mitigate the negative effects of some types of pollution and greenhouse gas emissions. Unfortunately, not nearly enough is yet being done, especially by some of the worlds largest economies (and thus, polluters), namely the United States, China, and India.

If our world is to avoid a fate like that of the tiny island of Nauru, where every last resource was exploited to the point where the island could no longer sustain life, then more must be done to reduce the spillover costs that accompany the production and consumption of so many of our precious goods.

I tell my econ students a story about how one day hundreds of years ago some smart guy decided to start calling products (you know, the stuff we consume), GOODS. From that day on humans would always associate consumption with something GOOD. Today, in an era where the goodness of consumption is offset by the evil of environmental destruction, more than a strong government hand is needed. Conservation and appreciation for the gifts of nature, not insofar as they can be exploited by industry, but left intact for the appreciation and welfare of society, both today's generation and that of our grandchildren, must be fostered and encouraged among global citizens young and old.

Hopefully, this article and the stories you heard here will help you understand a little more about the economics of the environment, and help you become more educated about what can and should be done to correct the market failures that have led to the dire challenges faced by our world today.

A great website on environmental economics written by two economists WAY smarter than Mr. Welker can be found here: http://www.env-econ.net/

Feb 14 2009

## Lest we forget… Milton Friedman on the power of free enterprise

Milton Friedman: “there is no alternative way so far discovered of improving the lot of ordinary people that can hold a candle to the productive activities that are unleashed by the free enterprise system”

With all the talk of government spending, fiscal stimulus, nationalization of the financial industry, the “new new deal”, infrastructure, education, health, “job creation”, and on and on… I thought it wise to share this bit of wisdom from the greatest advocate of free markets of the last 100 years, Milton Friedman.

AP Economics teacher Michelle Hastings sent the link to this video to the AP Econ email list. Thanks, Michelle.

[youtube]http://www.youtube.com/watch?v=RWsx1X8PV_A[/youtube]

Discussion Questions:

1. What is Friedman's view of command economies?
2. Does Friedman imply that “greed is good”? To what extent is greed an important component of free markets?
3. Do you think Milton Friedman would support the current \$800 billion fiscal stimulus package being debated in Washington right now? Why or why not?

Feb 14 2009

## Will the stimulus package “crowd-out” private investment and reduce long-run growth potential in America?

CBO Director’s Blog » Macroeconomic Effects of the Senate Stimulus Legislation

The February 9th edition of the excellent NPR show, Planet Money reported on a letter sent from the director of the Congressional Budget Office to the Senate, forecasting the short-run and long-run macroeconomic effects of the House Stimulus Package.

### Crowding-out and the Stimulus Package [ 1:23 ] Play Now | Play in Popup | DownloadpodPressShowHidePlayer('4', 'http://welkerswikinomics.com/blog/wp-content/uploads/2009/02/crowding-out.mp3', 290, 24, 'false', 'http://welkerswikinomics.com/blog/wp-content/plugins/podpress//images/vpreview_center.png', 'Crowding-out and the Stimulus Package', 'Jason Welker');

It turns out the director of the CBO has his own blog on which he published his letter to the Senate. Here are some highlights:

CBO estimates that the Senate legislation would raise output by between 1.4 percent and 4.1 percent by the fourth quarter of 2009; by between 1.2 percent and 3.6 percent by the fourth quarter of 2010; and by between 0.4 percent and 1.2 percent by the fourth quarter of 2011. CBO estimates that the legislation would raise employment by 0.9 million to 2.5 million at the end of 2009; 1.3 million to 3.9 million at the end of 2010; and 0.6 million to 1.9 million at the end of 2011…

Most of the budgetary effects of the Senate legislation would occur over the next few years. Even if the fiscal stimulus persisted, however, the short-run effects on output that operate by increasing demand for goods and services would eventually fade away. In the long run, the economy produces close to its potential output on average, and that potential level is determined by the stock of productive capital, the supply of labor, and productivity. Short-run stimulative policies can affect long-run output by influencing those three factors, although such effects would generally be smaller than the short-run impact of those policies on demand.

In contrast to its positive near-term macroeconomic effects, the Senate legislation would reduce output slightly in the long run, CBO estimates, as would other similar proposals. The principal channel for this effect is that the legislation would result in an increase in government debt.  To the extent that people hold their wealth in the form of government bonds rather than in a form that can be used to finance private investment, the increased government debt would tend to “crowd out” private investment—thus reducing the stock of private capital and the long-term potential output of the economy.

The negative effect of crowding out could be offset somewhat by a positive long-term effect on the economy of some provisions—such as funding for infrastructure spending, education programs, and investment incentives, which might increase economic output in the long run. CBO estimated that such provisions account for roughly one-quarter of the legislation’s budgetary cost. Including the effects of both crowding out of private investment (which would reduce output in the long run) and possibly productive government investment (which could increase output), CBO estimates that by 2019 the Senate legislation would reduce GDP by 0.1 percent to 0.3 percent on net.

The fascinating thing about this letter from the Congressional Budget Office to the Senate is that it mentions so many of the Macroeconomic principles we teach in both AP and IB Economics.

• The nation's potential output (PPC) is “determined by the stock of productive capital, the supply of labor, and productivity”.
• Fiscal stimulus' effects, while possibly significant in the short-run, may result in less long-run growth due to “crowding-out” of private investment as the public puts its savings into government debt and takes it out of the market for loanable funds.
• A stimulus package should be made up of “funding for infrastructure spending, education programs, and investment incentives, which might increase economic output in the long run.” The negative effects of crowding-out could be offset through responsible government spending.

I find this letter to be surprisingly positive. The short-run forecast seems optimistic: as much as 3.6% GDP growth and as many as 3.9 million new jobs by the end of 2010. The negative growth effects of the stimulus resulting from increased government debt and the subsequent “crowding-out” of private investment are not predicted to set in until 2019.

I always tell my students that humans are “short-run creatures living in a long-run world”. I have to admit, this short-run creature is inclined to think that a stimulus package that puts nearly 4 million people to work and turns the US Economy back onto a path towards growth within two years is probably worth the long-run risk of sluggish growth ten years down the road due to the decline in private investment resulting from the debt-financed spending today.

This letter from the CBO also seems to address a debate recently undertaken in the AP Economics teacher email list: whether deficit-financed government spending affects the supply of or the demand for loanable funds in the economy.

To the extent that people hold their wealth in the form of government bonds rather than in a form that can be used to finance private investment, the increased government debt would tend to “crowd out” private investment—thus reducing the stock of private capital and the long-term potential output of the economy.

This passage from the director's letter indicates that it is the supply, not the demand for loanable funds that shifts, driving up real interest rates in the economy. Savers will take their money out of banks and other lending institutions and put it in government bonds, reducing the amount of capital available for private investment. This can be illustrated as a leftward shift of the supply of loanable funds.

Discussion questions:

1. In evaluating the use of expansionary fiscal policy, we learn in IB Economics that the crowding-out of private investment will reduce the expansionary effect of increased government spending. Is crowding-out a problem during a recession? Why or why not?
2. Discuss the following statement: “In order to finance its budget deficit, the US government must borrow from the private sector.” How does the government borrow from the American people?
3. Will fiscal stimulus in the short-run lead to increased growth or decreased growth in the long-run? Discuss.

Feb 13 2009

## Welker’s daily links 02/12/2009

Published by under Daily Links

• Leave it to a brainy Indian to come up with the cheapest and surest way to stimulate our economy: immigration.

“All you need to do is grant visas to two million Indians, Chinese and Koreans,” said Shekhar Gupta, editor of The Indian Express newspaper. “We will buy up all the subprime homes. We will work 18 hours a day to pay for them. We will immediately improve your savings rate — no Indian bank today has more than 2 percent nonperforming loans because not paying your mortgage is considered shameful here. And we will start new companies to create our own jobs and jobs for more Americans.”

• Bribing smokers with cash incentives helps them stop, US research suggests.

Smokers are three times more likely to kick the habit for at least six months when they are paid up to \$750 (£520), a new study has found.

Nearly 900 General Electric workers took part in the test across 85 US sites. The results were published in the New England Journal of Medicine.

GE will launch a similar scheme in 2010 for all US employees, believing it will be cost-effective in the long term.

It aims to save some of the estimated \$50m spent annually on extra costs for smoking employees.

The company believes it will get back what it spends over three to five years, through reduced illness and increased productivity.

Financial incentives

Previous studies had indicated that smaller financial incentives had little effect on quitting smoking, said Kevin Volpp of the University of Pennsylvania School of Medicine, who led the research project.

Incentive programs work if they're well designed and adequately funded,” Mr Volpp told Reuters news agency.

“If you do a low-budget incentive program, it may have little effect.”

“Our study shows that if you're able to get people smoke-free and keep them smoke-free for six months or more, there's a fighting chance they can stay smoke-free on their own,” he said.

In the GE study, half the participants were given the financial incentive, while the rest were merely encouraged to join quit-smoking programmes.

Posted from Diigo. The rest of my favorite links are here.

Feb 11 2009

## Will the economy self-correct?

Does the Economy Self-Correct? – Welker’s Wikinomics Page

The debate in Washington over Obama's fiscal stimulus package, which has now been re-written by both the House and the Senate, is ultimately one of the validity of orthodox economic theories. By voting for a nearly \$1 trillion government spending bill, the Obama administration and Congress are clearly taking the position that an economy in recession will either not be able to correct itself, or will take too long to self-correct, thus the government is needed to accellerate the recovery process.

Washington's stimulus package presents students and teachers of economics with an all too rare opportunity to put to the test the two competing hypotheses of macroeconomics: the Demand-side Theory versus the Supply-side Theory.

At the core of the long-running macroeconomic debate is the simple question, “Does the economy self-correct in times of recession?” The supply-side theory, attributed to the “classical” economists dating back to Adam Smith and David Ricardo, argues that the answer to this question is YES. The rationale between this laissez faire approach to macroeconomics is the following:

1. Falling demand in an economy means less output by firms, forcing them to lay off workers.
2. As inventories build up due to their inability to sell their output, firms will be forced to lower their prices, putting downward pressure on the price level in the economy (deflation).
3. High unemployment and falling prices eventually lead to workers in the economy being willing to accept lower wages.
4. Weak demand for commodities such as oil and minerals put downward pressure on raw material and energy prices faced by firms.
5. Falling wages and raw material prices mean more potential for profits for firms in various enterprises, even as overall demand in the economy is weak. Firms begin hiring workers at lower wages, and increase production to take advantage of lower input costs. Overall supply of goods and services in the economy begins to increase due to lower costs faced by firms in all sectors.
6. The downward spiral caused by weak aggregate demand, rising unemployment, falling prices for output, falling wages and commodity prices, is eventually reversed and turns into an upward spiral as firms hire more workers, employ more resources, creating more income and spending, moving the economy towards recovery and economic growth.

The supply-side theory of self-correction (so called because recovery results due to an outward shift of aggregate supply) outlined above depends on the downward flexibility of wages. If wages do NOT fall, as some demand-siders propose, then the idea that firms will eventually begin to hire more workers is busted, and unemployment will only continue to increase as overall demand remains weak.

Today, there is some evidence that wages in the United States may in fact be downwardly flexible.

…the base pay of higher-level U.S. executives will be lowered by 10 percent, while other salaried employees will face cuts of between 3 and 7 percent.

General Motors employees are beginning to accept lower wages. Rising unemployment, especially in the white collar sector, mean that the number of highly educated and skilled American workers unable to find work will grow as corporate layoffs continue.

A “shovel-ready” stimulus package from Washington may indeed help to “create or save” 3 million jobs, as Obama claims, but it is the self-correcting nature of markets due to flexible commodity prices and wages that will ultimately contribute to a recovery of the US economy. As prices of commodities fall, combined with lower wages for white collar workers and deflation in the overall economy, firms will find it profitable to begin employing resources at their lower costs, putting people back to work, stimulating spending through market forces.

Fiscal stimulus may accellerate the recovery process, but the threat it poses is the same threat posed by all forms of government intervention in the free market: that the nearly trillion dollars will go towards satisfying the priorities of politicians rather than the wants and needs of society as a whole, resulting in a misallocation of the nation's resources towards goods, services, and infrastructure projects that are chosen by legislators, not the market itself. Stimulus is needed, but only the right kind. The recognition by politicians and the media that markets may also self-correct is also needed. News like GM's wage cuts may sound dire, but the underlying implication of falling wages may be a sign that the US economy is already on the path to recovery, even before Washington has spent a single dollar on stimlus.

Feb 07 2009

## McAfee on Price Discrimination: a must-read for teachers of Microeconomics

Professor Preston McAfee on Price Discrimination

(you must have RealPlayer to view this video. Mac users can download it here)

CalTech Economics professor Preston McAfee is an expert on prices. His research spans three decades and examines the pricing behavior of firms in various market structures. In the lecture linked above the professor shares several examples of firms practicing price discrimination. I was surprised to see that many of the examples he discusses are ones that I have been using in my own lectures on price discrimination for the last few years.

McAfee presents a mathematical formula for monopoly pricing, which no AP or IB text that I've seen has included:

Monopoly Price = [PED/(1-PED)] x MC where PED is the price elasticity of demand of the customer and MC is the firm's marginal cost of production.

The basic idea is that the more inelastic the customer's demand, the higher price the monopolist should charge over its marginal cost. The implication, therefore, is that a monopolist prefers to charge higher prices to customer's whose demand is inelastic and lower prices to customers who are “price sensitive” or whose demand is elastic. The charging of different prices to different consumers for the exact same product is what economists call price discrimination.

McAfee begins talking about price discrimination at minute 8:44 in the video. His examples include:

• Movie theaters: Charge different prices based on age. Seniors and youth pay less since they tend to be more price sensitive.
• Gas stations: Gas stations will charge different prices in different neighborhoods based on relative demand and location.
• Grocery stores: Offer coupons to price sensitive consumers (people whose demand is inelastic won't bother to cut coupons, thus will pay more for the same products as price sensitive consumers who take the time to collect coupons).
• Quantity discounts: Grocery stores give discounts for bulk purchases by customers who are price sensitive (think “buy one gallon of milk, get a second gallon free”… the family of six is price sensitive and is likely to pay less per gallon than the dual income couple with no kids who would never buy two gallons of milk).
• Dell Computers: Dell price discriminates based on customer answers to questions during the online shopping process. Dell charges higher prices to large business and government agencies than to households and small businesses for the exact same product!
• Hotel room rates: Some hotels will charge less for customers who bother to ask about special room rates than to those who don't even bother to ask.
• Telephone plans: Some customers who ask their provider for special rates will find it incredibly easy to get better calling rates than if they don't bother to ask.
• Damaged goods discounts: When a company creates  and sells two products that are essentially identical except one has fewer features and costs significantly less to capture more price-sensitive consumers.
• Book publishers: Some paperbacks cost more to manufacture but sell to consumers for significantly less than hard covers. Price sensitive consumers will buy the paperback while those with inelastic demand will pay more for the hard cover.
• Airline ticket prices: Weekend stayover discounts for leisure travelers mean business people, whose demand for flights is highly inelastic, but who will rarely stay over a weekend, pay far more for a roundtrip ticket that departs and returns during the week.

McAfee also goes into a fascinating discussion of price dispersion which is essentially a theory of oligopoly pricing. All Econ teachers should watch this video and find examples of price discrimination and oligopoly pricing that they can incorporate into their own class.

If you're up for a challenge, try deciphering some of the mathematics in McAfee's free, downloadable intro to economics text, available here.

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