Economics in Plain English » Cost-minimization

Resource market case study: New York’s manhole covers forged with human sweat and blood…

Jason Welker — Tue, 29 Mar 2011 20:32:55 +0000

New York Manhole Covers, Forged Barefoot in India – New York Times

In the revealing story above, the NYT reports on the manufacture of the New York’s thousands of manhole covers, which it turns out come primarily from a foundry in the Indian state of West Bengal. An NYT photographer discovered the Indian factory, and his photos prompted the report here:

Eight thousand miles from Manhattan, barefoot, shirtless, whip-thin men rippled with muscle were forging prosaic pieces of the urban jigsaw puzzle: manhole covers.

Seemingly impervious to the heat from the metal, the workers at one of West Bengal’s many foundries relied on strength and bare hands rather than machinery. Safety precautions were barely in evidence; just a few pairs of eye goggles were seen in use on a recent visit.

In AP Economics, we have begun learning about resource markets, where firms hire the productive resources needed to produce their output. Land, labor, and capital are all needed to produce any output; the combination of these resources a firm will use depends on several factors, including the productivity and the prices of the resources. When the price of labor is low, firms tend to use more labor and less capital. In developing countries, especially those with a large, unskilled workforce (like India), firms are likely to specialize in the production of labor-intensive products, such as the manholes found in American cities like New York.

The scene at the Indian foundry sounds like something from the Middle Ages:

The temperature outside the factory yard was more than 100 degrees on a September visit. Several feet from where the metal was being poured, the area felt like an oven, and the workers were slick with sweat.

Often, sparks flew from pots of the molten metal. In one instance they ignited a worker’s lungi, a skirtlike cloth wrap that is common men’s wear in India. He quickly, reflexively, doused the flames by rubbing the burning part of the cloth against the rest of it with his hand, then continued to cart the metal to a nearby mold.

Once the metal solidified and cooled, workers removed the manhole cover casting from the mold and then, in the last step in the production process, ground and polished the rough edges. Finally, the men stacked the covers and bolted them together for shipping.

Why are New York’s manhole covers being made over 8,000 miles away, anyway? Wouldn’t it make more sense for American cities to buy such items from firms making them right here in the United States? To understand this question, we need to consider the principle of comparative advantage, which says that a nation should specialize in the production of the products for which it has the lowest opportunity costs.

Manhole covers manufactured in India can be anywhere from 20 to 60 percent cheaper than those made in the United States, said Alfred Spada, the editor and publisher of Modern Casting magazine and the spokesman for the American Foundry Society. Workers at foundries in India are paid the equivalent of a few dollars a day, while foundry workers in the United States earn about $25 an hour.

Bengali laborers working in India’s foundries most likely face the trade off of an agrarian existence or maybe another factory job in the pre-industrial economy of the impoverished region, alternatives presenting a much low opportunity cost than American workers whose alternatives include jobs offering much higher productivity. The productivity of a worker depends on the quality and quantity of capital available, the level of training and education of the worker himself. Clearly, Indian workers have less access to capital, lower quality capital, and much less training and education than their American counterparts.

The result is that jobs that require large inputs of low-skilled labor, such as the manufacture of manhole covers, end up being “off-shored” to remote corners of South Asia. The added cost of shipping thousands of ton of iron around the world is more than made up for by the lower resource prices (thus costs of production) in the West Bengali foundries.

Discussion Questions:

Why do the Indian foundries use such large inputs of labor, and relatively little machinery?
What factors might reduce the demand for labor in the Indian foundries?
How does a firm know if it’s using the right combination of capital and labor in its production?

From short to long: Economies of scale and the long-run average total cost curve

Jason Welker — Mon, 22 Nov 2010 02:50:33 +0000

Look closely at the two cost curves below:

The curve on the left is a firm’s (In macroeconomics): The period of time over which wages and prices are relatively inflexible. A fall in aggregate demand will lead to unemployment and recession in the short-run. Due to the inability of the nation's producers to reduce wages paid to worker, they must lay workers off to reduce costs as demand falls.');" onmouseout="tooltip.hide();">short-run average total cost curve. The one on the right represents a firm’s long-run average total cost curve. See the difference?

I didn’t think so. The shape of a typical firm’s short-run and long-run ATC curves may in fact be identical. But there are some very important differences to understand about the short-run costs and long-run costs faced by firms.

The Short-Run: In microeconomics, we define the short-run as the period of time over which a firm’s plant size is fixed. The only variable resource is labor and raw materials, meaning that when demand increases for a firm’s product, the firm is able to increase employee work hours, hire more workers and use existing capital more intensively, but it does not have the time to acquire new capital or expand factory size. Likewise, when demand falls for a firm’s products, it can cut back on work hours, fire workers, but cannot downsize its plants or factories.

The Long-Run: The long-run is defined as the variable-plant period. A firm can adjust the number of all its inputs: land, labor and capital. One way of thinking about the difference between the short-run and the long-run is imagining the long-run as several different short-runs spread out over a larger range of output. The graph below will illustrate this concept for you.

When we examine the long-run ATC more closely, it becomes apparent that there are in fact lots of little short-run ATC curves along the length of the long-run curve. Each of the gray lines in the graph above represent a short-run period in which this firm opened a new factories. There are three distinct phases of this firm’s long-run ATC:

Economies of scale: As this firm first begins to grow and open new factories, it becomes better and better at what it is producing, is able to get more output per unit of input, and thus experiences lower and lower average total costs as it grows larger. “Scale” is a synonym for size. The bigger the firm’s size, the lower its costs of production: this is called “economies of scale”. My favorite illustration of the concept of economies of scale is to think about two shoe companies: Nike and Luigi’s Fine Italian Shoes. Nike makes shoes in giant factories in Indonesia, ships them in giant containers to all corners of the world in shipments containing 100,000 shoes each. Luigi makes shoes in his basement in Milan, has two employees, and ships shoes one at a time to customers around Europe. Who will have a lower average total cost of producing shoes? Luigi or Nike? Clearly, Nike has economies of scale, Luigi does not. If Luigi were to grow his business, chances are his average total costs would decline.
Constant Returns to Scale: For the firm above, economies of scale assure that the larger it becomes, the lower its average total costs get. Efficiency in production improves whether through the lower price of inputs achieved through bulk-ordering, its ability to attract and hire skilled managers, the lower per unit cost of shipping larger quantities of products, or other such benefits of being big. At a certain point, however, the benefits of getting larger begin to diminish. This firm’s tenth factory is its minimum efficient scale: The level of total output this firm must achieve to minimize its long-run average total cost. Beyond this level of production, as this firm continues to grow, it will see no further cost benefits; in other words, it will achieve constant returns to scale (size).
Diseconomies of scale: Why did the Mongol, the British and the Soviet empires collapse? Some historians argue it was because they became too big for their own good. When an organization (whether it’s a country or a firm) becomes TOO big, it begins to experience inefficiencies. When a firm grows so large that it has factories in all corners of the world, a dozen levels of management, and countless opportunities for corruption and miscommunication, its efficiency decreases and its average total costs begin to increase. In the 1980′s General Motor Company began to lose lots of business to smaller Japanese rivals. The outcome was the gigantic corporation broke up into smaller divisions, which then began to operate as different firms. For a while, GM remained competitive, partially because as a smaller firm, it was more efficient and able to compete on cost with its foreign rivals.

Diminishing Returns versus Economies of Scale: A common area of confusion for economics students is the difference between these two seemingly similar concepts. The difference lies in the two curves above, the short-run ATC and the long-run ATC.

The shape of short run costs (MC, ATC and AVC) are determined by the law of diminishing returns. Since short-run costs are determined by the productivity of the variable resource in the short-run (labor), diminishing returns assures that at first, since a firm can expect to get MORE output for additional units of labor (as fixed capital is used more efficiently) ATC declines as output increases. But beyond a certain point, diminishing returns sets in and the additional output attributable to more units of the variable resource declines. Inevitably, a firm will experience higher and higher average costs as its output continues to grow, since it’s only able to vary the amount of labor used, not capital.
The shape of long run ATC is determined by economies of scale (and diseconomies of scale). All resources are variable in the long-run, but lower costs cannot be guaranteed the larger a firm gets. At first, efficiency is improved as the firm grows, but at some point it becomes “too big for its own good” and costs start to rise as productivity of resources (land, labor and capital) is inhibited due to the firm’s massive size.

Discussion Questions:

What does it mean that a firm can become “too big for its own good”? Can you think of any other organizations (economic or otherwise) that have gotten so big that they’ve failed?
Why does your hometown have only one electricity company? Why aren’t utility industries such as water, natural gas, and garbage collection more competitive? How does the concept of economies of scale lead to certain industries being “natural monopolies”?
Why don’t more companies make jumbo jets?

Recession’s effects on small vs. large companies: some evidence in support of the Classical view of self-correction

Jason Welker — Mon, 02 Mar 2009 23:09:47 +0000

Why Are Large Companies Losing More Jobs Than Small Ones? – TIME

This is a fascinating, short article from TIME. Before reading it, see if you can answer the multiple choice question below:

Q: Why do small companies lay off proportionately fewer workers during a recession than large companies?

A) Because small firms are less likely to be in the industries hardest hit by a recession (such as manufacturing)?
B) Because small firms are less focused on maintaining profits to satisfy greedy shareholders?
C) Because small companies are able to hang on to employees and even hire new ones during a recession because of all the talent being laid off by big firms.

Still thinking? Well, it’s likely that all three are true to some extent. But it’s the third one that seems most intriguing as a student of economics. Here’s what the article says:

…small companies hire disproportionately more early on in an economic recovery because it’s easy for these firms to find good workers while unemployment is still high—and easy for workers to come across small companies since there are so many of them. Once the economy is chugging along at full-steam and the labor market is tight, larger companies regain the advantage, since they’re likely able to offer more money—and poach from smaller outfits.

Seems pretty straight forward, right? Sure, but the fact that small firms are likely to hire when unemployment is high supports one side in a long-running economic debate over the economy’s ability to “self-correct” in times of recession.

As any student of Macroeconomics learns early on, there are two dominant theories of macroeconomics, both which are represented in the aggregate demand/aggregate supply diagram that we learn and use in AP and IB Economics.

The two models below represent the two opposing views of macroeconomics. First we see the Keynesian model, which shows that when overall demand in an economy falls, unemployment increases drastically and output tanks, plunging the economy into a deep recession. This is primarily because of the “inflexible” nature of wages, meaning that even when unemployment rises, workers are unwilling to accept lower wages and firms therefore are unwilling to hire more workers.

According to Keynesians, the only way to get the economy out of the recession is by increasing overall demand through heavy doses of government spending (case in point, the $775 billion stimulus in the US).

Next is the Classical AD/AS model with a vertical long-run aggregate supply curve. The implication of the vertical AS curve is that regardless of the level of overall demand in the economy, output will always return to the full-employment level, and thus unemployment will always return to its natural level. The major assumption underlying the Classical model is that wages are in fact flexible in times of recession. As unemployment rises, workers will accept lower wages since they’d rather be making less than making nothing at all. As wages fall firms will begin hiring more workers, increasing overall output and decreasing unemployment until full-employment output is restored.

The implication of the model on the right is that government is NOT needed to get the economy out of a recession, because it will self-correct due to the new hiring and production by firms in response to falling wages in the labor market.

The reason this article stood out to me was that it seems to offer some evidence in support of the flexible-wage, Classical model of macroeconomic self-correction. There has been surprisingly little talk among news anchors, pundits and politicians about the likelihood of the US or ANY economy suffering in the global slowdown “self-correcting” as the Classical model would suggest it should. But the fact that small businesses are less likely to lay off workers in a recession and more likely to begin hiring them due to the large number of workers being laid of by big companies offers at least an inkling of evidence in support of the Classical model of flexible wages and macroeconomic self-correction.

Discussion Questions:

Why is laying off workers the first thing big companies do when faced with falling demand for their products? Why don’t they shut down factories instead?
What pressures does a publicly traded company (one that sells stocks to investors) face in times of recession that a small, privately owned business does not?
When the global recession is finally over, do you think more people or fewer people will be working for small companies (less than 50 people) than before the recession? What would you rather work for, a small firm or a large one? Why?

Competition and rising costs force Southwestern farmers to consider alternatives

Jason Welker — Sun, 18 Jan 2009 12:45:10 +0000

NPR : Farmers May Switch Crops Due to Labor Shortage

Pure competition forces firms to produce their output in the most efficient manner. Productive efficiency is achieved when producers achieve their minimum average total cost. Any increase in costs may lead to economic losses for a firm, and if costs increase too much a firm may be forced to shut down.

The scenario above is basically a textbook explanation of the reality faced by farmers in the American Southwest this very day. Hundreds of fruit and vegetable farmers are facing higher variable costs as tougher border security and immigration laws has led to a shortage of cheap labor, which the farmers depend on in the labor-intensive fruit and vegetable industry.

Listen to the podcast above, then study the graphs that accompany this article.

Rising costs for in a perfectly-competitive (PC) industry: Click on the thumbnails of the graphs to see the full-sized versions

Discussion Questions:

What changes have occurred in the American fruit and vegetable industry?
What are the possible outcomes for Southwest farmers?
How might technology help save these growers from having to shut down their operations?
What other alternatives do they have to shutting down in the long run?

American auto makers insult the intelligence of high school Econ students!

Jason Welker — Tue, 02 Dec 2008 20:48:09 +0000

Automakers turnaround plans sent to Congress – Dec. 2, 2008

…and hopefully every other American with a functioning cerebral cortex. Ford Motor Company announced today its ambitious plan to cut costs and restore its profitability as it appeals once again to Washington for a $25 billion “low-interest bridge loan” (aka bailout).

The company announced that the salary of Ford CEO Alan Mulally would be cut to $1 a year if Ford actually borrowed money from the government. When Mulally appeared before the House Financial Services Committee last month, he did not agree to the suggestion of such a paycut…

Ford and GM also announced plans to get rid of corporate jets. Mulally, Wagoner and Nardelli were all roundly criticized at a House hearing last month when they admitted they had each flown their corporate jets to Washington to ask for help…

Mulally and Wagoner will be driving to Washington in hybrid vehicles made by their companies when they return to Capitol Hill later this week to make their case for loans. Nardelli is also not planning to fly to Washington but Chrysler has not disclosed any more specifics of his travel plans.

So the CEOs of the three largest auto companies are agreeing to be exploited for one year by accepting a salary of one dollar. The combined savings from the salary cuts of the three companies’ CEOs equal roughly $6 million, or about 0.024% of the sum the companies are asking for from the government. Selling corporate jets during a recession when demand for such frivolous luxuries is at a record low will also do little to cut the costs of the incredibly inefficient US automakers.

As for any serious cost cutting plans, Ford had little to report:

…the Ford plan is perhaps most notable for what it did not include. The company did not mention that it would be dropping any brand or unprofitable models…

There was also no announcement of additional plants being closed or capacity being eliminated. Ford said it continues to work with its unions and dealers to achieve additional savings, but it did not set any cost savings targets for those discussions.

Ford highlighted many of the cuts it has already made, including closing 14 plants and reducing salaried personnel by 36% over the past three years. The company also touted labor cost savings that would bring the cost of factory workers’ pay and benefits close to those of the nonunion U.S. plants operated by Asian automakers

Real cost savings will only be achieved by the further closing of plants. With the economy in a deep recession and auto sales at their lowest in decades, the demand for new cars is just not there. Until Ford and its American competitors begin adjusting their plant capacities to the realities of market demand, the chances of achieving profitibility seem slim.

Allow me to make a connection between the situation faced by American auto makers and a basic economic concept we are currently studying in Microeconomics class. Firms, as any first year econ student knows, are profit maximizers. In fact, all companies are trying to make the same thing as all other companies, profits. When a firm experiences negative profits, or losses, as American auto makers are today, it can do one of two things to restore profitability: 1) Increase its revenues or 2) Lower its costs. Since demand for new cars is so low, the revenue increasing option is just not there, so American auto makers must reduce costs to restore profits.

There are two main types of costs we study in microeconomics. (In macroeconomics): The period of time over which wages and prices are relatively inflexible. A fall in aggregate demand will lead to unemployment and recession in the short-run. Due to the inability of the nation's producers to reduce wages paid to worker, they must lay workers off to reduce costs as demand falls.');" onmouseout="tooltip.hide();">Short-run and long-run costs. In the short-run, which in the case of the auto industry we can consider the last few months since the financial crisis began, firms can do one thing to lower their costs: reduce the use of labor. Workers can be asked to take unpaid vacations, jobs can be eliminated, work hours can be cut back. In the short-run, plant size is fixed, meaning firms cannot add nor eliminate capital and land resources. The only variable resource is labor. By “reducing salaried personnel by 36% over the past three years” Ford has taken steps to lower its short-run costs of production.

Long-run costs must also be considered when firms are faced with negative profits. The long-run in the automobile industry is considered the period of time over which auto makers can either add new plant facilities or shut down existing facilities, lowering the costs of capital and land to firms. Long-run cost reductions have also been undertaken by Ford, including “closing 14 plants… over the past three years”.

Clearly, Ford has made an effort to reduce short-run labor costs and long-run capital costs by eliminating some of its work force and closing some of its factories in recent years. But today, as the US officially enters what is likely to be a deep, long recession, the announcement by Ford and its competitors that its new strategy for further cutting costs hinges on paying its CEOs one dollar and making them travel across the country in hybrid cars represents a laughable insult to the intelligence of high school Econ students.

Discussion Questions:

What is the “variable resource” that firms can use less of in the short-run if cost reductions are needed?
In Microeconomics, we sometimes refer to the long-run as the “variable plant period”. Explain the meaning of this concept.
The law of diminishing marginal returns would indicate that if Ford were to close additional factories, it would almost certainly have to simultaneously lay off thousands of additional workers. What is the law of diminishing marginal returns and why does it require firms to lay off workers as plants are closed?

Eight basic economic arguments against a bailout of the auto industry

Jason Welker — Thu, 20 Nov 2008 23:55:22 +0000

This week the CEOs of the “Big Three” US auto makers boarded their private jets in Detroit and touched down in Washington to beg and plead in front of Congress for a “low-interest bridge loan” from the US government to help them avoid bankruptcy. They are asking Congress for $25 billion of taxpayer money to give them the chance to re-structure and re-equip themselves for the future.

Click here to view the embedded video.

Below are eight arguments based on basic economic principles for why a bailout of the United States automobile industry is a bad idea and is bound to fail:

Incentives matter: A bailout of the US auto industry ignores the basic economic principle that incentives matter. Individuals and firms respond to incentives, pursuing behavior that is likely to bring them the greatest rewards. In the face of falling demand for their product and ever-increasing competition from more efficient foreign producers, providing a $25 billion bailout creates a disincentive to drastically reduce costs and increase competitiveness, and an incentive to continue using tired old techniques and providing the same old models for which demand has declined among Americans for over a decade.

Comparative advantage: The basic economic principle of comparative advantage states that in an era of free trade and globalization, countries should produce the types of goods for which they have the lowest opportunity cost. Since the average American car of a particular class costs the Big Three $2000 more in wages and benefits for workers than its Japanese counterpart, it makes sense that Japan (and other lower-cost countries) produce more cars, and the Big Three produce less.

Efficient allocation of resources: The United Auto Workers Union has a member ship of over 400,000 workers. Since the 1970s the union has lost over 1 million workers. Clearly the US auto industry has been in decline for decades, a fact that should be taken as a sign: resources employed in America’s car industry are inefficient and represent a over-allocation of resources. A drastic down-sizing of the auto industry, while resulting in (In macroeconomics): The period of time over which wages and prices are relatively inflexible. A fall in aggregate demand will lead to unemployment and recession in the short-run. Due to the inability of the nation's producers to reduce wages paid to worker, they must lay workers off to reduce costs as demand falls.');" onmouseout="tooltip.hide();">short-run hardships for the hundreds of thousands whose jobs will be lost, will in the long run strengthen the US economy as labor and other resources will be freed up to be employed in sectors in which the US has comparative advantage.

Economic Darwinism or “the survival of the most efficient”: America has stood for free trade in the world since helping found GATT in 1948 and later the WTO. The gains from embracing free trade are shared among all stakeholders in the economy. Consumers enjoy lower prices (thus higher real income), firms enjoy access to cheaper inputs and larger markets for their products, and governments enjoy the increased tax revenues from rising incomes driven by export-led economic growth. To bail out an uncompetitive, inefficient, and long-declining industry is to spit in the eye of free trade and denies America any moral suasion it may hold in the future over potential trading nations in our attempt to open their markets to our nation’s products. To protect our own dying industry now will send a clear message to our trading partners. “America does NOT stand for free trade”. If we believe in free trade and the allocative power of markets, then we must let the dinosaurs of American industry meet the fate the natural selection of the marketplace has determined for it.

The benefits enjoyed by the few represent costs born by the many: A bailout by the US government of the auto industry will protect a few hundred thousand jobs for a few years at the most but spells a reduction in the disposable incomes and spending power of millions for years to come. The US does not have $25 billion laying around to give the Big Three, which means the money must be borrowed. Increased government borrowing raises interest rates now (further tightening the credit markets) and will result in increased taxes down the road. All government debt must eventually be paid off, and in the immediate future interest on this debt must be paid directly from tax revenue. A $25 billion bailout is the same as a subsidy, meaning it redistributes income and welfare from consumers to producers. Millions are asked to sacrifice for the continued survival of a few hundred thousand in an industry that has failed to evolve in a global auto market that has seen increased competition and efficiency from foreign firms for decades.

Moral hazard: Bailing out the Big Three today represent a classic case of moral hazard. When American industries fail to take steps to increase their efficiency and remain competitive in the face of increased global competition, they find themselves not surprisingly on the brink of collapse. To reward these firms by taking money out of Americans’ pockets and handing it to them to do as they will, we send the wrong message and create the wrong incentives in the American economy. The message is: “Don’t worry, the market doesn’t choose the winners and losers in the economy, the government does, and certain industries are too big to fail”.

Market failure, or Firm Failure?: The fate of the auto industry is in the hands of the US government. But so is the fate of the free market. My fear now is that the pendulum will swing too far to the left in America’s state of panic over the ill-fated downfall of the financial markets, rooted in the irrational exuberance and over-leveraging of big financial institutions. The failure of the financial markets, however, is an entirely different story from that of a dinosaur industry like automobiles. The Big Three have had decades to reform themselves, lower their costs, improve their products, and remain competitive. THEY have failed, NOT the market. Government intervention is necessary in instances of market failure, but NOT IN CASES OF FIRMS’ FAILURE TO COMPETE IN A WELL FUNCTIONING MARKET like the global auto industry.

Inflexible labor markets: I saw the president of the UAW on the news today giving 101 reasons why the government should approve a bailout deal for the Big Three. In fact, the unions that supposedly represent American Auto Workers are a big part of the problem the industry is facing. For decades the UAW has fought against wage and benefit cuts for auto workers, lobbying instead for higher tariffs and other barriers aimed at keeping foreign cars out of the country. This anti-competitive behavior is a major reason the Big Three cannot compete with European and Asian car makers today. Wage inflexibility leads to higher unemployment. Unions keep wages from going down, leaving the Big Three with one of two choices: Drastically downsize your workforce and employ fewer high paid auto workers, or beg the government for a multi-billion dollar subsidy to that the unions can be placated and you can survive for a couple more years until you’re in the same situation all over again. The unions helped cause the problem, now they should pay the price by experiencing the downsizing their demands inevitably foretold.

The US government should allow the free market to function and let the dinosaurs go extinct. Cars will still be made in America, they’ll just be made by the better, more efficient firms that emerge from bankruptcy when this is all over, as well as the numerous foreign firms already making cars in the US. Survival of the most efficient, that’s what markets are all about. Allowing the market to work will strengthen the US auto industry far more than a “short-term low-interest bridge loan” ever will, it will free up labor and capital resources to be employed by industries the country is better at, and make sure household income is NOT reallocated to inefficient firms to be squandered on the manufacture of a product for which demand has steadily declined for the last decade plus.

Free trade and low death rate = bad business

Jason Welker — Tue, 04 Mar 2008 14:16:00 +0000

How do Chinese granite quarries and a decline in the US death threaten a family business in rural Vermont?

Listen and find out…

Source: NPR Economy Podcast, 2/29/2008

Reducing negative externalities – the European market for carbon emissions

Jason Welker — Fri, 11 Jan 2008 05:44:45 +0000

Tighter European limits set to push up price of carbon emissions – Times Online

When it comes to correcting the market failure of negative externalities, governments have several options. The most interventionist approaches may involve placing strict limits on the amount of a pollutant firms are allowed to emit and fining them for exceeding this limit, taxing firms that pollute in order to increase their costs and decrease market supply, reducing output and increasing price closer to a socially optimal level, or simply banning the production and consumption of goods whose existence places excessive spillover costs on society.

Such interventionist approaches to externality reduction tend to require a complex bureaucracy to administer, monitor, execute and enforce. The government may not be able to determine the appropriate level of a tax on a polluter if it can’t determine the exact level of the externalized costs placed on society; the government cannot always check up on every producer in the economy to determine just exactly how much pollution each factory’s producing, and then levying a fine on excessive polluters again raises the question of how high should a penalty be?

Because of the complexities involved in the interventionist approaches above, economists have recently promoted and the worlds’ governments have begun adopting a market-based approach to reducing negative externalities, involving the creation of a whole new market: one in which the right to pollute is bought and sold by firms. This may sound crazy at first, but here’s a basic summary of how these markets work:

A government or international agency decides on the acceptable amount of pollution in a particular region and issues permits that firms can purchase giving them the right to pollute. Each permit will allow a certain amount of pollution. The total supply of permits is perfectly inelastic since it is decided by the government agency.
The demand for pollution permits is downward sloping. At high prices, firms will either stop polluting or pollute less by acquiring pollution-abatement equipment, which is more attractive when the rights are more expensive. If the “cost of pollution” is cheap, then firms will chose to buy permits rather than acquiring expensive abatement equipment or upgrading to “greener” technology.
In the market for pollution permits, the “price to pollute” will be determined by the downward sloping demand among firms for pollution permits and the perfectly inelastic supply of permits determined by the number issued by the government. If the price of permits is too low to make firms bear the full environmental and social costs of their production, the government can reduce the supply thus increase the price and decrease the quantity of pollution permits demanded, reducing the negative externalities of pollution as firms will shift to greener production techniques.

There are several advantages to this system over direct government controls:

It reduces society’s costs because pollution rights can be bought and sold. Some firms will find it cheaper to buy the rights than to acquire abatement equipment; other firms can sell their rights because they may be able to reduce pollution at a lower cost. The incentive for all firms is to reduce their own pollution and sell the permits they no longer need, adding to the profits of “green firms”.
Conservation groups and individuals can buy permits as well as producers. If conservation or individuals wish to make it more expensive for firms to pollute, they can buy permits and hold them. This drives up the price of remaining rights, further encouraging polluters to reduce emissions.
The revenue from the sale of pollution rights could be used to improve the environment or subsidies more environmentally friendly methods of production.
The rising cost of pollution rights should lead to improved pollution-control techniques.

In the article above, we see how the creation of a market for carbon pollution permits in Europe evolved from a fledgling, ineffective experiment in market-based externality reduction a few years ago to a major market where billions of dollars worth of carbon permits are exchanged each day between firms, all of which have incentives to continually reduce their level of carbon emissions so as to minimize their costs and perhaps even earn revenue through the sale of unneeded permits.

The first phase (of the carbon permit market) was launched in 2005 but was widely dismissed as a failure, primarily because too many permits were granted by member states to individual polluters, leading to a collapse in market prices to as little as €1 (74p) per tonne. The slide undermined the principle of the scheme – to make carbon emissions a meaningful cost for big polluters, thereby encouraging reductions.

The key difference in the second phase is a reduction of between 5 per cent and 10 per cent in the emissions permits granted. Mr Marcu said that he expected the tougher regime to “start delivering some substantive reductions” in carbon emissions.

City analysts believe that it will lead to a big increase in the market price of carbon. Deutsche Bank expects forward prices to rise from the present level of about €23 a tonne to €35. UBS has predicted a rise to €30 a tonne.

35 euros per ton of carbon may not sound like a lot, until you consider how many millions of tons of carbon are emitted by the big factories of Europe each year. In fact, when we realize the size of this market at $100 billion, we then begin to grasp just how significant such a market can be in reducing greenhouse gas emissions. That means that firms are spending $100 billion for the right to pollute!

Just imagine, if you were a manager of a firm that was polluting heavily, the more expensive these permits get, the higher your average costs of production get, the less competitive you become with firms who have taken steps to clean up their production. Not only do you not have to buy as many permits once you start cleaning up, but you actually start earning revenue by selling the permits you no longer need!

A market for externality permits minimizes the role the government must play in managing the production and emission practices of the economies big polluters. Furthermore, if the permits are auctioned off from the beginning, billions can earned in revenue for the government, which in theory could be used to subsidize the research and development of pollution abatement technologies and “green energies” like wind and solar power.

While it still may seem weird that governments are giving firms the right to pollute, the logic of such a plan makes sense once the picture is clear. Markets work, even when they’re being used to correct a market failure.

Discussion questions:

What are some ways a government could invest the revenue earned from the sale of pollution permits to firms?
Why is a market for pollution permits easier to implement than strict government control of the pollution of individual firms?
What is the importance of incentives in achieving reduction of negative externalities? Does a market for pollution permits create more or less of an incentive to reduce emissions than direct government controls?

Red Storm Rising!! China bashing picks up steam…

Jason Welker — Mon, 20 Aug 2007 09:43:00 +0000

Made in China: News & Videos about Made in China – CNN.com

Click here to view the embedded video.

Thanks to James Hannam from my IB Econ class for providing the link to the site above. CNN jumps on the China bashing bandwagon and does its part to trump up fears of the danger posed by the “Wild West” of China’s manufacturing sector. This site has a wealth of anti-Chinese features including videos, quizzes, investigative reports and so on. Here’s the headlines warning us to be afraid of Chinese imports:

Given the tendency of media to dramatize and blow out of proportion certain issues for the sake of entertainment and to feed the American appetite for scandal, the full blown anti-Chinese campaign is no real surprise. Americans’ own insecurity about the strength (or should I say weakness) of their manufacturing sector surely fuels the Sino-bashing trend that seems to be dominating the media. All this will provide political fodder for lots of nationalistic, pro-America “protect American jobs” rhetoric in the upcoming presidential race too, I’m sure.

What I would challenge you, my students and readers, to ask is: who’s really at fault here? Are Chinese factory owners, whose sole purpose is to make a profit, really to be trusted to uphold standards of product quality and safety that America’s highly industrial economy took over a century to put in place? China only started industrializing in a modern way less than 30 years ago, and much of the development has been spearheaded and overseen by, yes, American firms. The sourcing of manufacturing to third party factories in recent years is a sign of the growing entrepreneurial spirit of China’s new generations of capitalists. Weak regulation by Chinese authorities is a sign not of corruption or malice on the behalf of Chinese producers, but of American consumer’s expectation that goods from China will get cheaper and cheaper.

American consumers seem to have forgotten an old adage, “you get what you pay for”. Just today, in my principles course, we talked about how you don’t always get what you pay for (i.e. diamonds). But in the case of cheap Chinese products, it would appear today that perhaps this adage holds true. Americans take for granted that products like seafood maybe aren’t supposed to be cheap! The freezers of Costco and Wal-Mart are filled with giant bags of shrimp, frozen fish, and other cheap seafoods that we have grown to expect to be there. If Americans want guarantees of their products’ safety, they should look for quality rather than quantity. Try eating locally if you fear the safety of imported food products.

Ultimately, the harm caused by Chinese products will be minimized not only by more and more government regulation, but also by consumers who change their buying patterns to reflect an appreciation for quality and safety over quantity and cheapness. Consumers who demand quality should vote with their pocket books, not rely on government to protect them from the dangers of the “Red Storm” Lou Dobbs warns us of. Markets contain the perfect mechanism for improving the quality and safety of products coming from China, and that’s the power of consumer sovereignty and strength to influence producer behavior through their buying behaviors.

Students, debate and discuss!

IB: US protectionism threatens trade liberalization – and a little irony to stir things up

Jason Welker — Sun, 19 Aug 2007 12:44:48 +0000

Trade protectionism could cause economic isolation – Poole – Aug. 17, 2007

In our coming unit on International Economics we will weigh the various arguments for and against protectionism, or the erecting of barriers to trade, and examine examples of various types of protection, its aims and effects on international trade.

In the article above, St. Louis Federal Reserve Bank President William Poole warns that the US is working against trade liberalization goals established in Doha, Qatar in 2001 by playing on fears among American consumers of harmful food and toy imports from countries such as China:

Poole said in his speech that the slackening in trade liberalization could have serious consequences. “The Doha Development Agenda multilateral trade negotiations are on the verge of collapse. A collapse of the Doha round would raise doubts about the future effectiveness of the World Trade Organization,” he warned.

The current world trade talks to reduce barriers to imports are called the Doha round because they were launched in Doha, Qatar, in 2001.

Poole also said recent safety worries on product imports from China must not be allowed to create barriers to trade.

“My concern is that certain groups will attempt to use concerns over safety and job loss to restrict imports and thereby pursue an agenda of economic isolation in an increasingly globalized world.”

Recent scares following the discovery that Chinese imports of pet food and toothpaste into the United States contained impurities were compounded after a major U.S. toy maker withdrew millions of toys with lead paint.”

It is easy for retaliatory trade measures to escalate and derail the desirable movement to a more open trading environment. It is in the best interests of all the countries of the world to avoid trade wars,” Poole
said.

Ironically, some say the blame for the potentially dangerous imports from China lay not entirely on Chinese manufactures, but on American companies that own the factories producing the dangerous products. Check out this article:

Recalls: Should U.S. companies share some blame with China? – Aug. 14, 2007

The recent spate of product recalled – melamine-tainted pet food, toothpaste laced with antifreeze and a second batch of Mattel-branded toys made with lead paint – were all made in Southern China’s low-cost manufacturing hub that’s notorious for its lax regulations.But some industry watchers say U.S. importers that do business with these factories are more to blame than even their Chinese suppliers for allowing those unsafe products to enter the U.S. marketplace.

“U.S. law is pretty clear. The importer is responsible for quality and safety of goods imported into the country,” said Erin Ennis, vice president with the U.S.-China Business Council

Part of the problem, says the article, is that competition has forced American firms to cut costs wherever possible, and often this means “sourcing” production to factories owned not by the American company, but by Chinese (or Vietnamese, Mexican, Malaysian, and other foreign owners) where strict oversight of product quality is not assured. Does this mean American firms are no longer responsible for their own product safety? Should the blame be placed on China when an American company produces toys that turn out to be dangerous?

One reason manufacturing products such as toys in China (80% or the world’s toys are made in China, according to the article) is because standards for products safety are so low, so the regulatory obstacles to production are almost non-existant, making production cheap.

Another connection this article makes to our IB course is in the area of development economics. The theory of comparative advantage says that a country should specialize in the products for which its resources are most adept at production. For two decades, China has emerged as a manufacturing giant. But with new fears of product safety, and more significantly the rising cost of labor and land in manufacturing hubs such as Shenzhen and Shanghai, Western firms are looking to China’s less developed neighbors as an alternative:

“If I was sourcing heavily in China, I would be exploring alternatives like Vietnam and Cambodia,” said Sean McGowan, an analyst with Wedbush Morgan Securities, referring to rising labor and production costs in the southern China’s manufacturing belt.

If China moves towards enforcing tighter standards of product safety in its thus far highly unregulated manufacturing industry, this will surely result in higher costs of production for companies like Mattel (the toy manufacturer who recalled 14 million toys last week because of safety issues). Higher production costs in China will send firms looking elsewhere for manufacturing options (such as Vietnam and Cambodia). In effect, the demand for higher quality standards will lead to tighter regulation by the Chinese government, leading to higher production costs in Chinese factories, leading to loss of business from Western firms, leading to the opening of new factories in even less regulated countries like Cambodia.

Discussion Questions:

Are retaliatory measures by the US government necessary to punish China for the dangerous exports that have arrived in the US recently?
Does tighter enforcement of quality standards by the Chinese government assure products like toys being imported to the US will be safer? Explain.
As wages and production costs continue to rise in China, how will less developed countries in Asia and elsewhere be affected?

Bali economics: “thinking like an economist” on the Island of the Gods!

Jason Welker — Tue, 26 Jun 2007 08:39:50 +0000

IF you’ve visited this blog in the last two weeks, you’ve probably seen the picture below of a beautiful sunset, a distant island and a wispy palm. Turns out I stayed two nights on the beach that picture was taken from, Ahmed in Bali’s remote northwest corner! What a beautiful island Bali is! Unlike many touristy places in Southeast Asia such as Phuket and Samui in Thailand, Bali is an island paradise that has managed to develop a thriving tourist industry while simultaneously maintaining its distinct Hindu culture and traditions that awe visitors and help them understand why it’s called the “island of the gods”. Not only do most Balinese outside the one or two major cities still live in the traditional style houses, but they actively practice their unique form of Hinduism (imported from India via Java in the 11th century), maintain the traditional forms of dance and religious ritual, and sustain themselves by practicing any number of artistic trades rooted in the island’s rich and colorful history. Indeed, in most villages we passed through, it was hard to tell which buildings were temples and which were houses. As much of Indonesia and the rest of Asia have rushed head-on into the age of globalization (often meaning westernization), Bali has thankfully held on to and even fostered one very precious and all too rare commodity: its own history.

Certainly after a year in Shanghai, where the closest thing to religion among urban Chinese is the pursuit of wealth, a couple of weeks in the rich spiritual heart of an ancient Hindu island culture was just what I needed to remind myself what was important in life. But alas, once an economist always an economist, and even with a thousand years of rich cultural heritage to turn my attention from school and economics, I could not help but notice the intricacies of Bali’s economy and how tourism and globalization have affected this remote island culture. My next few posts will cover casual observations made during my 16 day trip to Bali about its local economy and how it has been shaped by the global economy and tourism.