Archive for the 'Law of Supply' Category

Sep 29 2009

Letting markets work: the Malaysia fuel subsidy goes bye bye

This article was originally published on June 9, 2008

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?

39 responses so far

Oct 17 2008

Advice from an economic oracle – buy American stocks now!

Op-Ed Contributor – Buy American. I Am. – NYTimes.com

So Wall Street has recently experienced its worst shocks since the great depression. Every day the Dow Jones is like a roller coaster, DOWN 800 points, then  UP 500 points, then DOWN 200 followed by another rally of 600! In just three weeks the Dow has gone from 11,500 to below 900 points. Surely, the wise thing to do is get OUT of the stock market, right? WRONG! At least, so says the richest man in the world, Warren Buffet, someone who should know a thing or two about smart investing.

Why?

A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors. To be sure, investors are right to be wary of highly leveraged entities or businesses in weak competitive positions. But fears regarding the long-term prosperity of the nation’s many sound companies make no sense. These businesses will indeed suffer earnings hiccups, as they always have. But most major companies will be setting new profit records 5, 10 and 20 years from now.

Let me be clear on one point: I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month — or a year — from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.

A little history here: During the Depression, the Dow hit its low, 41, on July 8, 1932. Economic conditions, though, kept deteriorating until Franklin D. Roosevelt took office in March 1933. By that time, the market had already advanced 30 percent. Or think back to the early days of World War II, when things were going badly for the United States in Europe and the Pacific. The market hit bottom in April 1942, well before Allied fortunes turned. Again, in the early 1980s, the time to buy stocks was when inflation raged and the economy was in the tank. In short, bad news is an investor’s best friend. It lets you buy a slice of America’s future at a marked-down price.

Over the long term, the stock market news will be good. In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.

You might think it would have been impossible for an investor to lose money during a century marked by such an extraordinary gain. But some investors did. The hapless ones bought stocks only when they felt comfort in doing so and then proceeded to sell when the headlines made them queasy.

Today people who hold cash equivalents feel comfortable. They shouldn’t. They have opted for a terrible long-term asset, one that pays virtually nothing and is certain to depreciate in value. Indeed, the policies that government will follow in its efforts to alleviate the current crisis will probably prove inflationary and therefore accelerate declines in the real value of cash accounts.

Equities will almost certainly outperform cash over the next decade, probably by a substantial degree. Those investors who cling now to cash are betting they can efficiently time their move away from it later. In waiting for the comfort of good news, they are ignoring Wayne Gretzky’s advice: “I skate to where the puck is going to be, not to where it has been.”

I don’t like to opine on the stock market, and again I emphasize that I have no idea what the market will do in the short term. Nevertheless, I’ll follow the lead of a restaurant that opened in an empty bank building and then advertised: “Put your mouth where your money was.” Today my money and my mouth both say equities.

Discussion Questions:

  1. Why does holding cash seem like the smart thing to do during periods of volatile stock prices like the last month or so? Why does Mr. Buffet think that holding cash is NOT so smart?
  2. Mr. Buffet’s advice is counter-intuitive to some. Buying more of something that is falling in value (American stocks) may appear unwise… but what is Buffet’s rationale for why buying now may in fact be the smartest thing for an investor to do?
  3. Does the behavior of investors on the stock market reflect the behavior of consumers in a typical product market? In other words, do the laws of supply and demand apply to the stock market? Discuss…

11 responses so far

Sep 19 2008

It’s all about DEMAND!

FT.com / World – Air fares nosedive amid falling travel demand

Our IB and AP Econ classes here at Zurich International School have just begun our second unit of the year, where the concepts of Demand and Supply are introduced and the effect these have on prices is examined. The first assignment of the new unit was for each student to find an article discussing the demand for a particular good, service or resource, and post it to our Unit 2 wiki page.

If it’s ever unclear whether a change in demand for a good or a service can actually affect the price, the article linked here should make it perfectly clear that demand is a powerful market force. In an industry where it has seemed recently that prices only rise, a recent fall in market demand has driven prices downward, as firms have responded to consumer demand in order to sell their product, which in this case are seats on short and long-haul flights within and from Europe.

Falling demand for business and leisure travel is causing a marked decline in air fares, with UK fares to North America declining by nearly a half, according to American Express.

Air fares peaked earlier this year as a result of rising oil costs. But the slowing global economy has caused that to reverse.

The lowest economy class fares in Europe, the Middle East and Africa fell on average by 12.5 per cent in April to June compared with the first quarter, with long-haul fares down more than a quarter.

But UK fares suffered the sharpest falls, with the lowest economy fares down by an average of 20.2 per cent, including a 49 per cent fall in fares to North America and a 22 per cent decline in fares to Japan, Asia-Pacific and Australia.

Discussion questions:

  1. What factors are driving demand for air travel down within, to and from Europe?
  2. Why does the price of air travel fall as demand for air travel weakens?
  3. Which other industries may have to lower their prices as fewer and fewer people travel between European countries and North America?

14 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 11 2008

“Agflation”, conservation, and the loss of wildlands in America

How does a growing Chinese middle class threaten duck populations in the American Midwest? Here’s the story:

As Prices Rise, Farmers Spurn Conservation Program – New York Times

“You can’t pay me NOT to farm this land!”

This is the view being expressed by more and more American farmers today. Since 1985 the US government has paid hundreds of thousands of farmers around $50 per acre of land per year to NOT grow food. In other words, if you were a farmer with 1,000 acres, you could earn $50,000 a year for not doing anything with it at all, just letting it sit idle.

What is the logic of such a program? In the mid-80′s food prices were so low that farmers working their tails off to cultivate and harvest their lands often found themselves losing money when they went to sell their crops. The traditional farming lifestyle was in jeopardy as farmers experienced year after year of economic losses. Improvements in farm equipment, along with the widespread use of chemical fertilizers, pesticides and herbicides had increased farm yields to levels never before achievable in human history. What increases productivity for all farmers, however, also increases total supply of crops, driving prices to historic lows. All this meant farmers could barely get by in the American heartland.

Enter the government:

…the Conservation Reserve was conceived as part of the 1985 Farm Bill. Participants bid to put their land in the program during special sign-ups, with the government selecting the acres most at risk environmentally. Average annual payments are $51 an acre. Contracts run for at least a decade and are nearly impossible to break — not that anyone wanted to until recently.

Things were great for the farmers. Output fell as millions of acres went into disuse, while farm incomes rose due to rising prices for their outputs and transfer payments from the American taxpayers. Farmers now had to work less to earn more money.

Today, however, farmers are putting millions of idle acres back into cultivation. They are choosing to work harder and farm more land in order to take advantage of the rising world food prices caused by the increasing demand for meat among the world’s emerging middle class and the rising price of grains due to the push to promote ethanol as a renewable energy.

The farmers’ behavior today is a perfect demonstration of the law of supply, which acknowledges the direct relationship between a product’s price and the quantity that producers will bring to market. There are actually two markets at work here: the market for cropland, and the market for wildlands. Farmers face a tradeoff in their decision of whether to farm their land or let it lay fallow. In 1985, the government made the decision that not enough land was lain fallow, so it subsidized farmers who set lands aside for conservation. Since subsidies are a determinant of supply, the supply of idle land increased while the supply of cultivated land decreased, driving up food prices.

In addition to the law of supply, this article also encompasses the concept of market failure. The Farm Bill of 1985 inadvertently corrected a market failure relating to “merit goods”, or those that create positive externalities or spillover benefits for society. In the case of farmland, the less land was used for farming, the healthier the wildlife populations on the now idle lands of the American Midwest. Hunters, environmentalists, and conservation groups had much to cheer about:

,,,hunters had more land to roam and more wildlife to seek out, with the Agriculture Department estimating that the duck population alone rose by two million; and environmentalists were pleased, too. No one disputes that there are real environmental benefits from the program, especially on land most prone to erosion.

At its peak the “Conservation Reserve”, as it was known, saw more than 36 million acres set aside for wildlife. Today, however, farmers are choosing to put this land back into cultivation.

Markets are complicated things. Markets do a fantastic job of assigning values to easily tradeable commodities like corn, soybeans, sunflower seed oil, and wheat, which happen to be some of the crops most commonly grown on the millions of acres set aside for conservation since 1985. What market fail to do, however, is to assign adequate values to the non-tradeable goods in our society. The biodiversity of a wild grassland, the health of a water fowl population, the carbon-sequestration capacity of a standing forest, and the joy a hunter gets from roaming a fenceless wild land.

As food prices continue to rise in response to the shift towards bio-fuels and the growing demand for meat among developing countries’ consumers, there will be more and more pressure for farmers in the industrialized world to take their lands out of conservation and put them into cultivation. This is not only a rich world phenomenon either. In Brazil, farmers are responding to rising sugar prices by cutting down ever growing chunks of the Amazon, one of the world’s last great rainforests, sometimes called “earth’s lungs” because of its ability to trap carbon from the atmosphere.

If balance between conservation and cultivation is to be achieved, it requires a market system that puts a tangible, tradeable value on the sometimes intangible “goods” relating to the environment. For now, a short-term solution might be a new Farm Bill that offers farmers a more substantial payment for keeping lands idle. Such an interventionist approach may stem the loss of wild lands, but does little to address the bigger problem of market failure underlying the degradation of the world’s remaining natural environments.

10 responses so far

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