Archive for the 'Free Markets' Category

Mar 23 2009

America Has Gone Mad! (The AIG Bonus Payments Should Be Defended!)

The $165 M in AIG bonuses that we have heard so much about this past week should have, in my opinion, been paid and then defended by Congress and the President!

As a former CFO, I can say with certainty that I have never paid an employee a bonus for poor performance. To underscore this point, I am 100% against any publicly-traded company ever making any bonus payment to an employee for poor performance regardless of the circumstances. The recently paid AIG bonuses are not an exception to my strong conviction. The true facts surrounding the $165 M in AIG bonus payments have not been made clear to the American public. Moreover, our cowardly American leadership (President, Treasury Secretary, Congress, AIG CEO) refuse to do what is right and defend the bonuses because, in my opinion, of their fear of public opinion.

The $165M in recently paid AIG bonuses, funded with a portion of approximately $170B in taxpayer “bailout” funding, are not PERFORMANCE bonuses being paid to the same AIG executives that got us into this financial mess in the first place. That is what most of America mistakenly believes. In fact, the senior executives, including the CEO, whose decisions caused the company’s collapse, are long gone. Moreover, the top 7 officials currently at AIG have agreed to forego all bonuses. The recent bonus payment outrage also excludes the next 43 highest ranking AIG leaders whose bonus payments are appropriately being linked to restructuring the company and paying back the taxpayers the $170B that has been already sent to bail them out.

So what exactly are these bonus payments for that all of America has gone mad over? The $165 Million in recent bonuses paid to AIG employees were RETENTION or STAY bonuses and not performance bonuses. AIG employees assigned to unravel the mess were offered retention bonuses to stay and work out the problems of AIG’s Financial Products division which has already been announced to be shut down. These retention bonuses were paid to incent remaining and new workers to stay until the billions of dollars of derivatives, still at risk, were unwound. Using basic common sense, which is why retention bonuses have been paid for decades, no reasonable, talented worker would agree to work in a discontinued division receiving hate mail and death threats without receiving a retention bonus. A retention bonus helps keeps top employees working on problems of a division being shut down rather than them resigning and moving on to another company.

As Congress tries to recover these just recently paid bonuses, either through the AIG employees paying them back or having them be taxed close to 100%, the tax payer is already losing as these employees working out the problems that they did not create are already starting to resign. Yes, America and the taxpayer will not save $165 M but rather lose far more than we save as those working the issues are resigning.

So, why didn’t the new AIG CEO, Edward Liddy, defend the $165 M in retention bonuses in front of Congress this past week and explain to Congress that these were not performance bonuses paid to the people that got us into this mess? Why didn’t Tim Gheitner, U.S. Treasury Secretary, defend his decision to allow the retention bonus payments as outlined in the recently passed stimulus bill? Why didn’t Ben Bernanke, Chairman of the FED, defend the retention bonuses that were know by him since last summer? And of course, where was our Harvard-schooled president when we needed his articulation skills the most as he could have clearly explained and defended these payments so we would not have to rehire new employees for all of the AIG employees who are now turning in their resignations for having to repay their contractual retention bonuses?

In summary, our U.S. government has increased the exposure to the American taxpayers by not supporting the AIG retention bonuses being paid to the workers that did not create the problem and who are assigned to fix up the mess. This is cowardly leadership, in my opinion. It is an easy path to for our leaders to keep the AIG bonus discussion at a very surface level and say “bonuses shouldn’t be paid to business leaders that fail”. Well, of course, everyone agrees with that! But that is not what is being paid at AIG.

14 responses so far

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.

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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?

6 responses so far

Feb 11 2009

Will the economy self-correct?

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

GM Slashing 10,000 White-Collar Jobs, Cutting Pay - washingtonpost.com

…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.

2 responses so far

Nov 21 2008

Eight basic economic arguments against a bailout of the auto industry

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.

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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:

  1. 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.
  2. 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.
  3. 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 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.
  4. 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.
  5. 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.
  6. 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”.
  7. 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.
  8. 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.

30 responses so far

Oct 24 2008

The clear and simple gains from trade

Russell Roberts of George Mason University is a well-known advocate of free trade. This article is one of my favorite and certainly one of the clearest explanations of the mutual benefits resulting from free trade that I have read.

Foreign Policy: Why We Trade - by Russ Roberts

To hear most politicians talk, you’d think that exports are the key to a country’s prosperity and that imports are a threat to its way of life. Trade deficits—importing more than we export—are portrayed as the road to ruin… Politicians are always talking about the necessity of other countries’ opening their markets to American products. They never mention the virtues of opening U.S. markets to foreign products.

This perspective on imports and exports is called mercantilism. It goes back to the 14th century and has about as much intellectual rigor as alchemy, another landmark of the pre-Enlightenment era.

The logic of “exports, good—imports, bad” seems straightforward at first—after all, when a factory closes because of foreign competition, there seem to be fewer jobs than there otherwise would be. Don’t imports cause factories to close? Don’t exports build factories?

But is the logic really so clear? As a thought experiment, take what would seem to be the ideal situation for a mercantilist. Suppose we only export and import nothing. The ultimate trade surplus. So we work and use raw materials and effort and creativity to produce stuff for others without getting anything in return. There’s another name for that. It’s called slavery. How can a country get rich working for others?

Then there’s the mercantilist nightmare: We import from abroad, but foreigners buy nothing from us. What would the world be like if every morning you woke up and found a Japanese car in your driveway, Chinese clothing in your closet, and French wine in your cellar? All at no cost. Does that sound like heaven or hell? The only analogy I can think of is Santa Claus. How can a country get poor from free stuff? Or cheap stuff? How do imports hurt us?

We don’t export to create jobs. We export so we can have money to buy the stuff that’s hard for us to make—or at least hard for us to make as cheaply. We export because that’s the only way to get imports. If people would just give us stuff, then we wouldn’t have to export. But the world doesn’t work that way.

It’s the same in our daily lives. It’s great when people give us presents—a loaf of banana bread or a few tomatoes from the garden. But a new car would be better. Or even just a cheaper car. But the people who bring us cars and clothes and watches and shoes expect something in return. That’s OK. That’s the way the world works. But let’s not fool ourselves into thinking the goal of life is to turn away bargains from outside our house or outside our country because we’d rather make everything ourselves. Self-sufficiency is the road to poverty.

And imports don’t destroy jobs. They destroy jobs in certain industries. But because trade allows us to buy goods more cheaply than we otherwise could, resources are freed up to expand existing opportunities and to create new ones. That’s why we trade—to leverage the skills of others who can produce things more effectively than we can, freeing us to make things we otherwise wouldn’t be able to afford.

Discussion Questions:

  1. “Self-sufficiency is the road to poverty” - Discuss…
  2. Explain the logical economic fallacy of the mercantilist philosophy of “exports good, imports bad”
  3. “…because trade allows us to buy goods more cheaply than we otherwise could, resources are freed up to expand existing opportunities and to create new ones”. What basic economic principle is Professor Roberts alluding to here?

17 responses so far

Oct 02 2008

Will limiting exectutive pay send American business leaders packing for Europe? Probably not…

This post is in response to my colleague and fellow WW blogger Steve Latter’s recent post titled “Private market compesation: AIG CEO vs. Kobe Bryant”. It’s always enlightening to read Steve’s excellent posts, which really put things in perspective. With regards to CEO pay, it is a bit ironic that while Americans are all worked up about the high pay of its top executives, no one’s up in arms about the exorbitant salaries received by America’s professional athletes!

However, I wonder if Steve’s claim that limiting professional athletes’ pay would send the country’s top basketball players packing for leagues in other countries is true. A while back I blogged an article that asked the question of whether Lebron James would be offered a contract from a European club. James claimed that in order for him to even consider playing in Europe, he would require an offer of at least $50 million per year, more than double what he makes playing for Cleveland.

ESPN.com - Source: LeBron would consider European offer of $50M a year or more

…the Cleveland Cavaliers’ strongest competition for LeBron James’ long-term services could be the deep-pocketed new kid on the block — Europe.

A person close to James said Tuesday that the Cavaliers’ superstar would strongly consider playing overseas if he was offered a salary of “around $50 million a year.”

James’ current contract expires after the 2010-2011 season, but he can opt out after the 2009-2010 season, and while several NBA teams are working to create salary cap space for his impending free agency, none could offer a contract beginning at even $20 million a year.

So, would Kobe be on the next plane to Lithuania if the US government (or the NBA) limited his pay to $5 million? I doubt it. That brings us to the more urgent question: Would America’s top business executives begin shipping their families and all their belongings off to Jakarta or Dhaka, Delhi or Singapore, London or Paris, if the US government attempted to limit the compensation packages of its executives? Maybe, but there are many reasons to work and live in the United States beyond the salaries offered by firms for their top executives. And upon a little research, it turns out that European executives’ pay packages have in fact been under regulation by governments for quite some time, and as a result, the incentive for American executives to jump ship for European firms should US executive compensation come under regulation may not be as strong as Steve implies.

Executive pay in Europe | Pay attention | The Economist

How excessive is bosses’ pay in Europe? It has certainly risen sharply in the past ten years, as European firms have had to compete globally for talent.  Foreign bosses now run seven of the firms in France’s CAC 40 index and five of Germany’s DAX 30. American-style bonuses and long-term incentive plans are now the norm.

European firms now benchmark pay against international peer groups in their own industries, rather than against domestic rivals, according to Piia Pilv, a pay expert at Mercer, a consultancy. But they still pay a fraction of the sums trousered each year by American executives. According to Hay Group, a management consultancy, the median European executive earns just 40% as much as his equivalent in America (see chart).

Most importantly, European companies appear to be more determined than American ones to link pay to performance. “Firms in Europe have tended to put more stringent conditions on long-term incentive awards than in America,” says Richard Bednarek, global director of executive remuneration for Hay Group. In America grants of shares are often not tied to performance, whereas European firms generally attach performance criteria to any grant of shares, typically depending on a comparison with a peer group. Such schemes often do not pay out at all, says Mr Bednarek. Dan Vasella, boss of Novartis, a Swiss pharmaceutical giant, and a favourite target of pay activists, earned SFr17m ($14m) in 2007, down 33% from 2006, because he missed his targets.

Clearly, the incentive to head to Europe as a result of increased scrutiny of executive compensation in the US is not as great as it would be if there did not already exist a threefold gap between US and European executive pay.

The liberal in me wonders if there is such a thing as “unfair” CEO compensation. The free market advocate in me points to other markets governments have attempted to control prices in, and the clear inefficiency that such regulation creates. Governments limiting executive pay, in theory, should have a similar effects to rent controls, or price ceilings in other markets. The quality and quantity of apartments available under rent controls declines, and price ceilings on other goods often result in shortages, meaning there’s not enough to go around among consumers… the quantity demanded exceeds the quantity supplied.

In the case of CEO pay in America, limiting compensation should, in theory, result in a shortage of highly qualified executives willing to head up American firms. But let’s be honest, even if the government placed highly stringent limits on the compensation of the country’s executives, the average executive in America would still likely be earning more than his counterpart in Europe. And since the average American CEO earns something on the order of 250 times what the average worker in his firm gets paid, increased regulation of CEO pay only help narrow this enormous gap slightly, but the incentive to make it to the top will still be strong among American workers.

Conclusions? It’s a tough issue. I want to have faith in the free market, in the price mechanism, in the efficacy of laissez faire economics. But the moral hazard of “golden parachutes” is a real concern. Should an American CEO be rewarded if he fails in his job? Steve makes the case that this “insurance” policy is necessary to attract the best and brightest to the firms willing to pay them most. Then again, something about the way the free market has created such a huge gap between executive pay and the pay of the average worker, and the threefold gap between America’s CEOs and Europes makes me think, “forget the free market, we need to get this insanity under control.”

2 responses so far

Sep 22 2008

The Costs of the Bailout, More Government Debt

Economists see financial bailout as necessary - Yahoo! News

Economists in the US are calling this week’s bailout of numerous US companies a necessary step in ensuring that no permanent harm is caused to the financial system and that we do not head into a deep recession.

The Treasury Department under the leadership of Henry Paulson is currently asking congress to move quickly on a bill that would provide $700 billion to the Department to buy up much of the bad debt that many financial institutions have incurred over the past years. Where’s this money going to come from? Since it doesnt look like the Bush Administration will be pushing for increased taxes anythime soon, Congress will have to borrow the money. 

Though most economists are agreeing that this is a necessary step in ensuring the integrity of the economy, I believe that it is important to look at how this additional debt may effect our government and economy in the future. So lets start with some numbers. The following statisitics are taken from the above article.

The deficit for this budget year, which ends on Sept. 30, is expected to rise to $407 billion, a figure that is more than double the $161.5 billion imbalance for 2007, reflecting what the economic slowdown and this year’s $168 billion economic stimulus program are already doing to the government’s books.

The Bush administration is estimating that the deficit for the budget year that begins Oct. 1, which will cover the new president’s first year in office, will hit $482 billion, a record in dollar terms.

And that forecast doesn’t include the $200 billion the administration committed to spending two weeks ago when it took over the nation’s two biggest mortgage companies, Fannie Mae and Freddie Mac.

And it doesn’t have any of the $700 billion the administration is seeking to soak up the bad mortgage-backed securities that have been at the heart of the severe credit crisis the country has been struggling with since August 2007.

The legislation the administration is now seeking to authorize the financial system bailout, according to a draft obtained by The Associated Press, would boost that debt limit to $11.3 trillion, up another $700 billion.

It is the rapidly rising debt that is cause for concern. The government is already spending more than $400 billion a year just to pay interest on the national debt. The higher that debt goes, the higher the government’s borrowing costs and the less it has to spend on other programs.

Discussion Questions:

  1. What impact does the knoweldge that the government will bailout struggling financial firms have on investors willingness to take risks?
  2. Should the government intervene in these finacial markets or leave the “invisble hand” to its own devices?
  3. What are the opportunity costs associated with this decision?
  4. What are some short term and long term implications of this bailout?


10 responses so far

Sep 15 2008

Globalization in a Balinese produce market

The summer before last, I spent three weeks exploring the mountains, beaches, volcanoes and temples of the Indonesian island of Bali. While crossing Bali’s central mountain range, I stopped at a produce market where local fruits, vegetables, coffee and nuts were brought in from the surrounding hills to be sold. As I strolled the market snapping pictures, I caught out of the corner of my eye a flash of a familiar shade of red. Upon closer inspection, I was surprised to find a “Blue Chelan” apple from Washington state (my home state!).

Washington apples in BaliI could not help but be shocked to see a fresh red apple grown on another continent in another hemisphere on the Eastern slopes of the Cascade mountain range of Washington state for sale in a farmer’s market in a remote village 60 km from the nearest port. It got me thinking about globalization, trade, specialization and comparative advantage. So I pose these questions to you, my Econ students:

Discussion Questions:

  1. How did a ripe apple grown 9,000 miles away in the United States end up fresh and shiny in a market 1500 meters up in the mountains of Bali? I mean, literally, HOW did it get there?
  2. Why would Indonesia import apples from so far away when surely it could grow apples domestically and avoid the hassle of transoceanic transport?
  3. Where did Indonesians get the dollars to buy US grown apples?
  4. How does trade between Indonesia and the US affect consumers? Producers? Is trade between these distant countries good or bad? Discuss.

24 responses so far

Sep 08 2008

Is Switzerland becoming a feudal state?

Switzerland “could become a feudal state” claims an economist. - swissinfo

One Zurich economist thinks so:

In Switzerland 71 per cent of the wealth is concentrated in the hands of just ten per cent of the population – a figure that economist Hans Kissling finds alarming.

Kissling tells swissinfo that the gap between the rich and everyone else is growing and that this could threaten traditional Swiss democracy and the economy. He makes a call for an inheritance tax for the wealthy.

Statistics show that the 300 richest people have become 40 per cent wealthier in the past eight years, whereas most of the population has a lower income than at the beginning of the 1990s

Kissling has nothing against wealth, he just thinks that if someone did not earn their wealth but inherited it instead, they should have to share a bit with the rest of society.

I call for a tax on very high inheritances, from SFr1 million ($900.000) upwards, and only on the excess value of that. I certainly don’t want people to think that they can’t pass on their family home to the next generation.

I’m only interested in trying to stop any creeping feudalisation, to avoid having huge clans like in South America, which threaten the economy and the political world

He’s most concerned that if the gap between rich and middle class continues to widen and the middle class of Switzerland don’t start benefiting from the country’s growing wealth, there could be a dangerous backlash against the free market system.

…the richest one tenth of a percent in Zurich – there are no full Swiss statistics – had 677 times more wealth than an average citizen in 1991. By 2003, 12 years later, the richest one tenth of a percent had 1,027 times more wealth. So the gap has really grown.

The middle classes, unlike the lower classes, have not benefited from any concessions, such as health insurance or childcare allowances. Here they have to use up all their assets before they receive any support. The lower classes have help from the beginning. This is why the middle classes are threatened

Discussion Questions:

  1. Why does a growing gap between rich and middle class threaten social stability in Switzerland?
  2. What would advocates of socialism propose in order to avoid future struggles between the rich and the middle class?
  3. What kind of tax system would help re-distribute the wealth of Switzerland and narrow the enormous gap that exists here?

12 responses so far

Aug 29 2008

Free markets and free societies may not go hand in hand

Capitalism and democracy: friends or foes? | Free exchange | Economist.com

How Capitalism Is Killing Democracy - Foreign Policy (abstract only)

“Why is FREEDOM so important in a market economy? If people in society are not free, can a market economy truly succeed?”.

Friday’s class discussion focused on the different answers to the basic economic questions offered by centrally planned versus market economies. 

The question I left them to ponder over the weekend had to do with an apparent paradox visible in China today: that of a free market economy seemingly thriving in a society where political and social freedoms are severely limited by the communist dictatorship. It has long been claimed that free markets will be followed closely by political freedom, and vis versa. The two are thought to go hand in hand. According to the Economist.com’s blog, Free Exchange:

The late Milton Friedman emphasized that economic freedom promotes political freedom and is also necessary for the sustainability of political freedom over time. His underlying logic is that competitive capitalism separates economic power from political power. One could point to Chile, Taiwan and South Korea as examples where Friedman’s logic seems to hold.

So if, as Friedman said, free markets lend themselves to free societies, then how has China’s thriving market economy not resulted in a freer society, even after 30 years of economic liberalization? Robert Reich, writing in the Foreign Policy Journal examines the issue in some depth:

Conventional wisdom holds that where either capitalism or democracy flourishes, the other must soon follow. Yet today, their fortunes are beginning to diverge. Capitalism, long sold as the yin to democracy’s yang, is thriving, while democracy is struggling to keep up. China, poised to become the world’s third largest capitalist nation this year after the United States and Japan, has embraced market freedom, but not political freedom. Many economically successful nations ”from Russia to Mexico” are democracies in name only. They are encumbered by the same problems that have hobbled American democracy in recent years, allowing corporations and elites buoyed by runaway economic success to undermine the government’s capacity to respond to citizens’ concerns.

Of course, democracy means much more than the process of free and fair elections. It is a system for accomplishing what can only be achieved by citizens joining together to further the common good. But though free markets have brought unprecedented prosperity to many, they have been accompanied by widening inequalities of income and wealth, heightened job insecurity, and environmental hazards such as global-warming.

What can explain the recent divergence of capitalism and democracy in countries like China, Russia and Mexico? The Free Exchange blog explains:

The cause of this divergence, Mr Reich contends, is that companies seeking an advantage over global competitors have invested increasing amounts of money in government lobbying, public relations and bribery. This process of corporations’ writing their own rules has weakened the ability of average citizens to have their voices heard through the democratic process.

So it appears that as capitalism and free markets have flourished, freedom of the individual has been trumped by freedom of the corporation to lobby and thus influence government into creating favorable environments for investment and growth, often times at the expense of society’s health and the best interests of the public as a whole. We will learn a term for this kind of activity in AP and IB Economics: rent-seeking behavior.

As firms grown larger and industrial and commercial power becomes concentrated in powerful multi-national corporations, the priorities of governments seem to be shifting away from individual freedoms and civil rights and towards the interests of the corporate world, whose money and influence run deep through the veins of the world’s governments.

So perhaps I was wrong. Maybe Milton Friedman was wrong too. Perhaps the 21st Century has bred a new relationship where free market capitalism is wed not to democracy, but to a new kind of corporatocracy, a term used by Noam Chomsky, in which governments bow not to the will of the people they govern, rather to the pressures from corporate entities. Freedom and justice for all (firms, that is). Gives you something to think about, huh

Discussion Questions:

  1. Do free markets lead to free societies?
  2. Is political freedom a prerequisite for a successful market economy?
  3. Has “corporatocracy” surpassed democracy as the dominant influence in the rich, developed countries of the world?
  4. In what ways could economic strength come at the expense of individual freedom?

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48 responses so far

Aug 20 2008

International Trade Made Simple

Is international trade really as good for a nation’s standard of living as economists say? And, what the heck is comparative advantage anyway? And what about the foreign currency market and those confusing supply & demand curves? Yes, the quest to understand the economic benefits of international trade is enough to make any citizen or first-year economic student vomit, tremble, get a headache, or at least curse.

Having been an AP Economics’ teacher for 8 years now, I must candidly admit that it took me a few years of study and research to try to reduce international trade to pure simplicity and understanding. Let me give it a shot below. I love simplicity.

The average “Joe Citizen” in almost any country in the world is suspicious of trade, and rightfully so, since he reads or observes factories being closed, jobs lost, and the feeling that somehow his country is going down the toilet as his own home fills up with foreign-made products. Unfortunately, what Joe Citizen does not understand is that the money his own nation is spending for those foreign products (imports) is spent right back into the pockets of his own country, increasing employment and income.

Let’s take a single, real-world, international trade example being careful to accurately explain the whole economic story:

Let’s say that the United States (we’ll say Wal-Mart) decides to buy several shirts costing $400 from a Chinese shirt manufacturer, in lieu of buying those same shirts from a shirt manufacturer in Elon, North Carolina (USA). As a US AP Economics’ teacher I am one of about only 47 Americans in Fairfax County Virginia, which not coincidentally ties to the number of AP Students I taught this year, that quickly understand that the decision to purchase the shirts from China, in lieu of the US manufacturer in North Carolina, is actually BETTER for America and will make my home country better off in the long run! What? Mr. Latter, are you Benedict Arnold, the American traitor, reincarnated?

Let me explain how the US benefits (and China too!) in simple terms ignoring foreign currency transactions, which will just confuse the discussion and cause the student to lose sight of what is really happening:

The first key point is that when Wal-Mart buys the shirts from China for $400 it can only pay China with US dollars. Why? Because Wal-Mart has only US dollars! It has no Chinese currency (Yuan). It literally drains its bank account of US dollars that are transferred/paid to China!

The second key point is that when China receives that same $400 US dollars for the shirts, China cannot, unfortunately, spend any of the $400 in its own economy since only the Yuan is accepted as a medium of exchange in China! China is now forced to either throw the currency away (not advised!), or immediately spend the money back to the USA (advised!).

In summary, China has actually traded a product (shirts!) for paper (US dollars!), and those US dollars cannot be spent in China. For China to receive any value at all for the shirts it sent to America, China must now spend the $400 back into the US economy for, say, a global positioning system (GPS) from FleetMatics out of Waverly, Massachusetts (USA). Cutting through to simplicity, in essence, it’s almost as if Wal-Mart (USA) just paid FleetMatics (USA) $400 directly for the shirts!

Yes, the “punch line” is that all home-currency spending by the domestic nation on foreign products (imports), in turn, are spent right back to the domestic nation increasing the domestic nation’s employment, income, and standard of living. (Note; this is shown in a nation’s balance of payments schedule which always nets to zero, but, yuk, who cares about that right now with summer coming!)

And, yes, let’s not forget that Elon, North Carolina shirt maker that did not get the original $400 from Wal-Mart in our above example! Our nation loves competition (ready for the Olympics?) and I am excited to see if that North Carolina shirt manufacturer can “raise their game” (increase productivity), and hopefully get the next shirt contract from Wal-Mart or some other firm! If not, well, that North Carolina firm may just have to close down.

If you are still reading this post at this point, you may be thinking the following if you have a little economics’ background: “But the US has a growing trade deficit with China, so China may not immediately buy that GPS system from FleetMatics for $400”. And, you are correct, but that is also not a problem for either the United States or China. What China is really doing right now is deciding to temporarily save or invest a minority percentage of their US dollars received back into America in lieu of buying US products. Said another way, China is not buying as many GPS’ as the US is buying shirts and, of course, we call that phenomenon the US trade deficit which immediately seems to speak “problem”. But it is really no problem at all! China is still spending their “saved” US dollars back into the US economy, but in different ways. China is saving and investing some of those US dollars directly into the United States economy by building plants in America, buying US stock to fund American companies’ expansions, and temporarily saving some of their dollars, for future US purchases, by buying US bonds to help the US government pay for the war in Iraq, the war against terrorism, and several other US government initiatives necessitating borrowing. Eventually, China will sell these US bonds and buy that GPS system or build more plants to employ more Americans!

Now one last thing. Promise! Let’s get back to why trade is really so economically advantageous to any nation that pursues it. And by advantageous, I mean how it increases our incomes and standards of living. In one word, the answer is “productivity”. If we go back to the original example of the US buying shirts from China and China taking the US dollars to buy the GPS, we remember that the shirt manufacturer from North Carolina was “left out in the cold” because Wal-Mart did not buy the shirts from them. We can logically conclude that perhaps some Chinese manufacturer of GPS systems was “left out in the cold” because some Chinese business elected to buy from FleetMatics in the USA, and not the Chinese GPS manufacturer. Wow, I love global competition! What a great way to incent businesses in both the USA and China to compete against each other and increase their productivity and conserve our nations’ scarce resources, increase our choice, and lower our costs!

Discussion Questions:

  1. Which basic economic principles underly the emergence of international trade as a global economic force.
  2. Who are the winners and losers of trade between the US and China as explained above?
  3. Why do you think free trade is such a controversial topic among certain groups of Americans an other Western nations’ people?

40 responses so far

Jun 09 2008

Letting markets work: the Malaysia fuel subsidy goes bye bye

Asia Sentinel - Malaysia cuts fuel subsidy

One of the recurring themes of this blog is the conflict between good politics and good economics. Most of the time in government, smart economic policy is sacrificed in order to achieve political favor with voters. Whether it’s price ceilings on petrol in China, Zimbabwe’s slashing of food prices, harmful import restrictions to benefit domestic producers, or the proposed suspension of gas taxes in a time when fuel conservation is really what’s needed, politicians often act in economically stupid ways to bolster or hang on to their popularity.

So when a government makes a bold move that is economically sound, it sometimes comes as a surprise, as in the case of the Malaysian government this week. The government in Kuala Lumpur has for years subsidized domestic fuel prices, which at under 2 Malaysian Ringit per liter have been the equivelant of roughly $2.40 US per gallon, far below the average price in the west. Drivers benefited from this subsidy, but were not forced to bear any of the burden of rising oil prices, nor had they any incentive to conserve or switch to more fuel efficient automobiles or alternative forms of transportation. The Malaysian government, on the other hand, has had to allocate more and more of its limited budget towards subsidizing petrol prices.

Well, as of yesterday, all price supports for petrol are cancelled, and the effect will be sweeping in the Malaysian economy:

The government announced Wednesday evening that petrol prices would rise by 78 sen (US24¢) at midnight — a 41 percent jump from RM1.92 per liter to RM2.70. That means those spending RM2,000 per month to fill the tanks of their BMWs will now be paying RM2,820. Regardless of income levels, it is likely most Malaysians will feel the pinch.

The subsidy would have cost the Malaysian government 56 billion ringit (around $17 billion) this year. With the money it will now save by ending the subsidy, the government will begin making public transport cheaper and more convenient for commuters who wish to avoid paying for the more expensive petrol to fuel their personal automobiles:

The government hopes to channel the savings into improving public transportation, as it promised many years and elections ago but with little to show. In Kuala Lumpur, despite having a light rail train service and monorail, public transportation is expensive and inconvenient. Worse, intercity travel is still being serviced by old and slow trains, and accident-prone buses.

Malaysia is not the only country taking measures to end government fuel-price supports:

Indonesia has hiked fuel prices by an average of 29 percent, saving about 34.5 trillion rupiah and kicking off a series of street demonstrations… Similarly, after slashing subsidies, Taiwan will distribute US$659 million to middle and low-income families. The latest to raise oil prices is India, whose government announced Wednesday that gasoline and diesel prices will increase by 10 percent.

As more and more countries allow the market mechanism to work, and in the short-run fuel prices rise with the price of oil, the chances are that the long-run equilibrium price of petrol will actually begin to fall.

Price controls and subsidies distort market demand. In Malaysia, where a government subsidy kept the price consumers paid around 2 RM, the quantity demanded exceeded the free market quantity. With the removal of the subsidy, consumers will respond by driving less, reducing overall quantity demanded for petrol. As other Asian nations follow suit, global quantity demanded for petrol will decline, while higher prices incentivize producers to increase output. New prouction facilities will come online, just as drivers begin to find alternative ways to get to work, either through carpooling, public transportation, cycling or walking.

The combined effect of slowing increases in demand (or perhaps even a decline in demand if enough substitution of alternative forms of transportation takes place), and increases in supply as new production facilities come on line will be a stabilization and eventual fall in the price of oil.

The future fall in oil prices is explained in more detail here. Malaysia’s repealing of the fuel subsidy is one example of how markets work to restore equilibrium in a market such as that for oil today, where short-term bubbles always burst. $135 oil is probably not here to stay, if only the market is allowed to works its magic.

Discussion Questions:

  1. Why does a subsidy create disequilibrium in a product market like the petrol market in Malaysia?
  2. Give two examples of how consumers may respond to the 40% increase in petrol prices once the subsidy is removed in Malaysia.
  3. How could making fuel more expensive to consumers in the short-run actually lead to a fall in oil and fuel prices in the long-run?

2 responses so far

May 17 2008

Down is Often Up & Black is Often White (Why I Love Economics!)

One of the many reasons that I find the study of economics so fascinating is that what so often appears to be a negative situation to the average citizen is actually a positive one. In other words: “down is often up” and “black is often white”. One of my favorite examples of this “180 degree moment”, and why I love to teach AP Macroeconomics, relates to the study of unemployment.

Candidates running for President in the United States often campaign to potential voters that “the United States has 7.5 million Americans out of work”, which is very true. But I say, “Wow, where does the U.S. pick up its’ first-place trophy for being so excellent at employment.” To me, having only 7.5 million out of work is like getting a 5 on yesterday’s AP Macro test! Of course, 7.5 million unemployed in the United States is only 5.0% of our 150 million labor force, and the unemployed workers consist almost entirely of “frictionally” and “structurally” unemployed workers. Frictionally unemployed workers are those workers who are transitioning between jobs or entering the job market. This transitional unemployment is a normal and desirable occurrence in any market-based economy as it evidences free choice. Structurally unemployed workers are also a by-product of a successful, market-based economy as workers are only temporarily unemployed, for the long-run benefit of the economy, as new automated technologies are replacing manual labor, and/or trade agreements are implemented allowing a country’s citizens to purchase less expensive, but still high-quality imported products. Let me be sarcastic for a moment: maybe we can get the U.S. Government to pass two new laws to lower their unemployment rate; one law to outlaw new technology so they can reduce their structural unemployment, and a second law to prevent their citizens from quitting their current jobs so the country can reduce the frictional portion of the unemployment rate as well. Maybe after that (I’m still being sarcastic if you hadn’t noticed!) the U.S. Government will then establish a new goal of 0% unemployment, which is what I hear the unemployment rate is in the US prison work camps!

Another specific example of this “180 degree moment” relating to unemployment is that manufacturing in the U.S. is somehow declining. This misperception has been created primarily on the large loss in U.S. manufacturing jobs and the declining share of manufacturing jobs as a percentage of total U.S. jobs over the last 20 years. It is widely believed that the U.S. global share of manufactured products has decreased which is an incorrect belief. Basically, the misperception has been created because: 1) employment in manufacturing is at an all time low, and 2) the U.S. has increased their share of imports from countries like Japan and China.

The reality, however, is that U.S. Manufactured real product has more than doubled over the last 20 years and they have accomplished this feat with an amazing increase in worker productivity via technology. U.S. manufacturing output per employee has increased markedly due to technology and the effective use of capital.

Yes, I believe “down often really is up”, and “black often really is white”!

11 responses so far

Apr 21 2008

Why learning economics is SO IMPORTANT! The case of Ban Ki Moon…

UN chief warns world must urgently increase food production - Yahoo! News

So you don’t say things that make you sound stupid to people who have studied economics, i.e. AP Econ students. Here’s UN chief Ban Ki Moon speaking at a UN conference in Ghana this week:

“One thing is certain, the world has consumed more (food) than it has produced” over the last three years, he said.

Ban blamed a host of causes for the soaring cost of food, including rising oil prices, the fall of the U.S. dollar and natural disasters.

He said he would put together a special task force to help deal with the problem and called on the international community to help…

“We need a real world and not the world of economic theories,” Ban said. “I will work on this right now with a sense of urgency.”

You know who says things like that? People who don’t understand the basic economic theories. Sadly, the theory Mr. Moon is missing here is one of our science’s most basic and simple to understand: that of supply and demand.

First of all, I’d just like to point out the absurdity of his first statement, that “the world has consumed more than it has produced.” Mr. Moon, I’d like to ask you this: If our world has not produced all the food we’ve consumed, then whose world DID produce it? Can’t we just call up the world where all the extra food we’ve consumed was grown and ask them to send us more?

Next, regarding Mr. Moon’s “task force” that he plans to form to deal with the problem, my question is this: What can a handful of bureaucrats accomplish around a table in New York that the market can’t do on its own? Rising food prices send signals to farmers who grow food; a signal that sends a very clear message: “GROW MORE FOOD!”

I’m sorry, but Mr. Moon and his “task force” can spend all the time and money they want brainstorming ways to get farmers to grow more food, but in the mean time the invisible hand of the market, guided by price signals sent from consumers to producers, will work its magic to allocate more resources towards food production and away from alternative uses of grain crops such as ethanol production, eventually shifting the supply curve of food out, stabilizing food prices.

Mr. Moon’s intentions are honorable, but his means of achieving his goal are misguided in an era of the market mechanism, which underpins most of the world’s agricultural economies today.

25 responses so far

Apr 21 2008

China’s challenge - reestablishing its standing as an economic superpower

Live from Shanghai - OnPoint with Tom Ashbrook

The 21st century has been called “China’s Century”. With the Olympics in Beijing in a couple of months, the torch relay touring the worlds’ major cities has been met with fierce anti-China protests as angry activists have accused China of countless offenses from human rights violations to oppression of democracy movements to environmental destruction. Although it may be “China’s Century”, it sometimes seems that the rest of the world is not too happy about China’s emergence as a global superpower.

Last week, NPR’s Tom Ashbrook, journalist and host of the OnPoint radio program, visited Shanghai and featured daily stories about China in the world today. Below is an excerpt from the first of these stories, which caught my attention because it shared a minor fact that I had never heard before but which I find extremely interesting. Ashbrook’s guest, David Lampton, is a leading scholar on China’s re-emergence as a global superpower. Listen to what he says here:

 
icon for podpress  China's Challenge - OnPoint with Tom Ashbrook: Play Now | Play in Popup | Download

“Re-claim their share of global GDP?” you might be asking? Here’s the thing… for much of the last 2,000 years, China was THE leading superpower in the world. In fact, up to the 1430’s, China had the largest navy in the world, had established tributary relations with dozens of kingdoms from Southeast Asia to India to Africa, had established and secured trade routes stretching overland to Europe and by sea as far away as East Africa, and some even think Chinese explorers had made it to North America seventy years before Columbus! While Europeans were dying of the plague by the millions and struggling under absolute poverty in a feudal society where the idea of national unity was still a century off, China had grown to be the largest empire the world had ever seen, first under the Yuan Dynasty and then the Ming.

As professor Lambert says, China’s GDP, or its total output of goods and services, accounted for ONE THIRD of the world’s output during much of the common era. This fact shocked me, but made sense once I thought about it. China truly was the greatest example of a global superpower the world had known by the 15th Century. Much of its wealth and power was a result of its efforts to globalize, or to integrate itself with the economies of the foreign nations, empires and kingdoms. Trade with its neighbors, near and far, had helped enrich China, but also built among China’s leaders a rightful sense of superiority over the other peoples of the world.

It was this sense of superiority that would lead to a long period of decline in Chinese dominance of the global economy. In 1432, the Ming emperor ordered the trading vessels of Admiral Zheng He destroyed. 3,000 of the largest ships the world had ever seen were sunk to the bottom of the Yangtze river and the East China Sea. The emperor declared China as “The Middle Kingdom” and ordered that all links with the outside world be severed, as China had no need for trade with others. China, the emperor claimed, was totally “self-sufficient” and could flourish without trade with the “barbarian” outsiders.

What followed was a long period of decline in China’s superpower status. From 1432, through the fall of the Ming in 1644 throughout the subsequent Qing Dynasty, into the 20th Century which saw repeated shifts in power between KMT, the Japanese and finally the CCP, China for the most part resisted attempts by its own and by foreigners to open its doors to the world, welcome trade, and encourage globalization of China’s rapidly dwindling domestic economy. The belief that China was “self-sufficient” endured while China’s share of total economic activity in the world dwindled to nearly nothing.

In the mean time, Europeans “discovered” the New World, philosophized about the gains from trade, integrated their own markets and later the markets of the colonies in Asia, America, and Africa, and grew wealthy as a result of these global exchanges. All the while, China stuck to its path of isolationism and self-sufficiency, as its influence and power slipped ever deeper into obscurity.

This period of isolation essentially lasted until the death of Mao Zedong, who could basically be called China’s last emperor. Since 1978, China has followed a new path, one that has attempted to reverse the mistakes of past dynasties, based on the doctrine of isolation and protection of domestic markets. Since its re-emergence as a global economic superpower, China has rapidly seen its share of global GDP increase from less than 2% in the 1970’s to around 16% today; a rebound achieved only through year after year of rapid economic growth, fueled by exports to the rest of the world. Isolation, it appeared, was not the path to wealth and power. China had discovered a new path, one that has done wonders for it income and standing in today’s circles of global power.

China’s re-emergence was made possible by one simple shift in doctrine and philosophy among its leaders: the belief that trade is good. While today the country still has many obstacles to overcome, such as the environmental challenges posed by growth, achieving a more equal distribution of wealth and income, fostering the growth of a domestic market to lessen its dependence on exports, and the challenges relating to human rights and demands for democratization, it would be wrong to say that China has not benefited from economic globalization in many ways.

A little history lesson is sometimes necessary to better understand where China is coming from and where it is going on its path towards re-emerging as a superpower in the global economy. The West, in the mean time, should pause to consider the rightful place the Chinese people believe is theirs based on their long history of economic power and dominance that for hundreds of years placed China at the pinnacle of power in the world economy.

9 responses so far

Feb 12 2008

A macroeconomic mystery - the gap between America’s “rich” and “poor”

You Are What You Spend - New York Times

Fact:
The richest 20% of Americans earn 15 times the income of the bottom 20%.

Fact: The richest 20% of Americans only consumer 4 times as much as the poorest 20%.

Question:
Why don’t the richest 20% consume 15 times as much as the poorest 20%?
Consumption Gap
The author of this NYT opinion piece claims that the gap between America’s rich and poor is not as stark as the income figures suggest. While before tax income of the top 20% is around $150,000, the poorest 20% earn only around $10,000. Clearly these numbers indicate an enormous income gap in America.

However, when it comes to consumption, the poor consume an average of $18,000 on everything from food to housing to entertainment to transportation. The richest 20%, on the other hand, consume an average of only $70,000, less than half their before-tax income.

So the question is, is standard of living based on our income, or on our consumption? If it’s income, then there’s certainly a huge gap in standard of living between the rich and poor. But if we believe it’s consumption, then the gap is narrowed dramatically. The author claims the latter:

To understand why consumption is a better guideline of economic prosperity than income, it helps to consider how our lives have changed. Nearly all American families now have refrigerators, stoves, color TVs, telephones and radios. Air-conditioners, cars, VCRs or DVD players, microwave ovens, washing machines, clothes dryers and cellphones have reached more than 80 percent of households.

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15 responses so far

Jan 14 2008

When markets work…

Michael Munger, Bosses Don’t Wear Bunny Slippers, If Markets Are So Great, Why Are There Firms: Library of Economics and Liberty

The other day when we introduced our unit on market failure, we began by revisiting the concept of free markets as mechanisms for allocating scarce resources efficiently. As I was reading blogs tonight, I stumbled upon this blog post by Michael Munger, professor of political economy at Duke University, where he shares an anecdote he uses when introducing the allocating power of markets through the price mechanism:

When I teach political economy, I start with the neoclassical theory of consumption, and then cover production. And I show students how miraculous is it that the actions of millions of people who have never met can be directed by prices. Resources move toward their highest valued use, and consumption goods are delivered to the consumers who want them.

For example, the United States promoted ethanol as an auto fuel. This sharply increased the price of corn worldwide. As Brazilian reporter Kieran Gartlan put it: “Higher prices are leading Brazilian farmers to plant more second crop corn this year, and the country’s modest corn exports are expected to expand [from 42 million tonnes to 48 million tonnes, an increase of 230 million bushels.]” (DTN, March 2, 2007, emphasis mine).

No one directed the Brazilian farmers to shift to corn production. The article puts it perfectly: “Higher prices are leading farmers….” The leadership comes from the prices themselves! The farmers may have had no idea why the price of corn had increased, to $4.00 per bushel. (After all, Brazil uses sugar, not corn, to produce its ethanol.) But Brazilian corn production increased within a year, by nearly 15%. No one made the farmers switch; they made choices. Other corn producers, in Argentina, Mexico, and several African countries, followed suit. No one talked about it, no one gave any orders; prices led them.

The reason I post this excerpt from professor Munger’s blog now is that it serves as a great response to a student who on the first day of our market failure class posited that perhaps the government could do a better job of deciding what goods and services and how much of them should be produced in an economy.

Yes, markets fail, and for many reasons: a concentration of power among a few large firms, an underallocation of resources towards goods that have spillover benefits, the over-provision of goods that have spillover costs, the failure of the market to provide public goods: these are examples of how market fail.

But when markets work, they really work! The efficiency of resource allocation that results from free, competitive, markets is unrivaled by any central planning agency. Munger’s example above is a simple illustration of this allocative power of markets and prices.

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Dec 06 2007

America: Land of the free, home of “jackass” economists

Recently, in AP Economics, we have been learning about Labor markets; in IB Economics we’ve been focusing on the benefits and costs of international trade and global economic integration. As students of market economics, it is ingrained in us that economic liberalization, the freeing of markets, enabling resources to be allocated based on the price mechanism; these are all are good things. Removing barriers to the free movement of products and resources across national and political boundaries should eventually result in greater world output, and subsequently increases in living standards and wealth for the citizens of all free trading countries.

Nations will produce the products for which they have a comparative advantage, and trade with their neighbors for those products for which they don’t. Resources will flow from markets in which they are in low demand to those where they are in high demand. Prices in both product and resource markets will rise and fall, allocating scarce resources to the markets where they are needed most.

So why, in an era where the benefits of free trade and free flow of productive resources seem so visible around the world, do Americans seem so susceptible to views like those exhibited in the video below:

YouTube Preview Image

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One response so far

Nov 20 2007

Exports, good - Imports, ALSO GOOD!

Foreign Policy: Why We Trade

Professor Russ Roberts, host of the EconTalk podcast, has an essay in the latest issues of Foreign Policy journal titled “Why We Trade”. In this piece, Roberts defends the benefits of trade from a broad perspective, beyond the popular political view of trade, usually along the lines of “exports, good - imports, bad”. Roberts compares this line of thinking (characteristic of presidential candidates of both the Republican and Democratic parties), to the 14th century, pre-Adam Smith view of world trade, known as mercantilism.

Mercantilism was a view of global economic interaction that placed emphasis on the accumulation of gold and other precious metals from abroad in exchange for your country’s exports. The doctrine failed to recognize the importance of imports from abroad, as this was viewed as a loss of wealth to foreigners. Mercantilists viewed wealth in terms of bullion or the amount of precious metals a country owned. Today, of course, our understanding of wealth has evolved to account for the amount of output, or products (goods and services), we are able to consume. Herein lies the flaw in the rhetoric of modern politicians who, “are always talking about the necessity of other countries’ opening their markets to American products. They never mention the virtues of opening U.S. markets to foreign products.”

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Nov 01 2007

Beijing caves in to the indisputable power of the MARKET!

Well, not exactly, but that’s kind of a dramatic headline, isn’t it? The other day I blogged about the shortages experienced in the petrol market in eastern provinces, evidenced by the long queues at gas stations around Shanghai last weekend.

Petrol stations resorted to rationing their product in small doses (between 20 and 40 litres) as the price of oil hit $92 and Chinese refiners scaled back production due to rising costs that they were unable to pass on to their customers. Beijing had previously imposed a price ceiling on fuel in an attempt to keep inflation low and Chinese consumers content; the actual impact of this price control was predictable: not enough fuel to go around as the quantity demanded exceeded the quantity supplied, leading to shortages and rationing at the pump.

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