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!

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

• 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/

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