Competitively Priced Electricity Costs More, Studies Show – New York Times

The problem with monopolies, as our AP students have learned, is that a monopolistic firm, left to its own accord, will most likely choose to produce at an output level that is much lower and provide their product at a price that is much higher than would result from a purely competitive industry. A monopolist will produce where its price is greater than its marginal cost, indicating an under-allocation of resources towards the product. By restricting output and raising its price, the monopolist is assured maximum profits, but at the cost to society of less overall consumer surplus or welfare.

Unfortunately, in some industries, because of the wide range of output over which economies of scale are experienced, it sometimes makes the most sense for only one firm to participate. Such markets are called “natural monopolies” and some examples are cable television, utilities, natural gas, and other industries that have large economies of scale. (click graph to see full-sized)

Government regulators face a dilemma in dealing with natural monopolistic industries such as the electricity industry. A electricity company with a monopoly in a particular market will base its price and output decision on the profit maximization rule that all unregulated firms will; they’ll produce at the level where their marginal revenue is equal to their marginal cost. The problem is, for a monopolist its marginal revenue is less than the price it has to charge, which means that at the profit maximizing level of output (where MR=MC), marginal cost will be less than price: evidence of allocative inefficiency (i.e. not enough electricity will be produced and the price will be too high for some consumers to afford).

Here arises the need for government regulation. A government concerned with getting the right amount of electricity to the right number of people (allocative efficiency) may choose to set a price ceiling for electricity at the level where the price equals the firm’s marginal cost. This, however, will likely be below the firm’s average total cost (remember, ATC declines over a WIDE RANGE of output), a scenario which would result in losses for the firm, and may lead it to shut down altogether. So what most governments have done in the past is set a price ceiling where the price is equal to the firm’s average total cost, meaning the firm will “break even”, earning only a “normal profit”; essentially just enough to keep the firm in business; this is known as the “fair-return price”.

Below AP Economics teacher Jacob Clifford illustrates and explains this regulatory dilemma. Watch the video and see how he shows the effect of the two price control options on the firm’s output and the price in the market.

Click here to view the embedded video.

The article above examines the differences in the price of electricity in states which regulate their electricity prices and states that have adopted “market” or unregulated pricing, in which firms are free to produce at the MR=MC level:

“The difference in prices charged to industrial companies in market states compared with those in regulated ones nearly tripled from 1999 to last July, according to the analysis of Energy Department data by Marilyn Showalter, who runs Power in the Public Interest, a group that favors traditional rate regulation.

The price spread grew from 1.09 cents per kilowatt-hour to 3.09 cents, her analysis showed. It also showed that in 2006 alone industrial customers paid $7.2 billion more for electricity in market states than if they had paid the average prices in regulated states.”

The idea of deregulation of electricity markets was that removing price ceilings would lead to greater economic profits for the firms, which would subsequently attract new firms into the market. More competitive markets should then drive prices down towards the socially-optimal price, benefiting consumers and producers by forcing them to be more productively efficient in order to compete (remember “Economic Darwinism”?). It appears, however, that higher prices have not, as hoped, led to lower prices:

“Since 1999, prices for industrial customers in deregulated states have risen from 18 percent above the national average to 37 percent above,” said Mrs. Showalter, an energy lawyer and former Washington State utility regulator.

In regulated states, prices fell from 7 percent below the national average to 12 percent below, she calculated…

In market states, electricity customers of all kinds, from homeowners to electricity-hungry aluminum plants, pay $48 billion more each year for power than they would have paid in states with the traditional system of government boards setting electric rates…”

That $48 billion represents higher costs of production for other firms that require large inputs of energy in their own production, higher electricity bills for cash-strapped households, and greater profits and shareholder dividends for the powerful firms that provide the power. On the bright side, higher prices for electricity should lead to more careful and conservative use of power, reducing Americans’ impact on global warming (since the vast majority of the country’s power is generated using fossil fuels).

Here arises another question? Should we be opposed to higher profits for powerful electricity firms if their profits result in much needed energy conservation and a reduction in greenhouse gas emissions? An environmental economist might argue that if customers are to pay higher prices for their energy, it might as well be in the form of a carbon tax, which rather than increasing profits for a monopolistic firm would generate revenue for the government. In theory tax revenue could be used to subsidize or otherwise promote the development and use of “green energies”.

Whether customers paying higher prices for traditionally under-priced electricity is a good or bad thing depends on your views of conservation. But whether higher profits for a powerful electricity company are more desirable than increased tax revenue for the government are beneficial for society or not seems clear. If we’re paying higher prices, the resulting revenue is more likely to be put towards socially desirable uses if it’s in the government’s hands rather than in the pockets of shareholders of fossil fuel burning electricity monopolies.

Discussion Questions:

1. Why do governments regulate the prices in industries such as natural gas and electricity?
2. Why would a state government think that de-regulation of the electricity industry might eventually result in lower prices in the long-run?

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Related posts:

1. China’s “visible hand” clamps down on rising prices
2. Question: Why would a firm voluntarily tax its own customers?
3. Deflation: why lower prices spell doom for any economy!

The following is an excerpt from chapter three of my upcoming IB Economics Textbook published by Pearson Baccalaureate

Understanding price elasticity of supply, which measures the responsiveness of producers to changes in the price of different goods, allows firm managers and government policymakers to better evaluate the effects of their output decisions and economic policies.

Excises taxes and PES: A tax on a particular good, known as an excise tax, will be paid by both the producers and the consumers of that good. When a government taxes a good for which supply is highly elastic, it is the consumer who ends up bearing the greatest burden of the tax, as producers are forced to pass the tax onto buyers in the form of a higher sales price. If the producer of a highly elastic good bears the the tax burden itself, it may be forced to reduce output to such a degree that production of the good becomes no longer economically viable. A tax on a good for which supply is highly inelastic will be born primarily by the producer of the good. The price paid by consumers will only increase slightly while the after-tax amount received by the producer will decrease significantly, but in the case of inelastic supply this will have a relatively small impact on output. A graphical representation of the effects of taxes on different goods will be introduced in chapter 4.

Price controls and PES: A common policy in rich countries aimed at assisting farmers is the use of minimum prices for agricultural commodities. The European Union’s Common Agricultural Policy (CAP) involves a complex system of subsidies, import and export controls and price controls, the objective of which is to ensure a fair standard of living for Europe’s agricultural community. The use of minimum prices in agricultural markets can have the unintended consequence of creating substantial surpluses of unsold output. Take the example of butter in the EU. The following excerpt was taken from the January 22, 2009 issue of the New York Times:

“Two years after it was supposed to have gone away for good, Europe’s ‘butter mountain’ is back… Faced with a drastic drop in the [demand for] dairy goods, the European Union will buy 30,000 tons of unsold butter. Surpluses… have returned because of the sharp drop in the [demand for]… butter and milk resulting partly from the global slowdown.

In response, the union’s executive body, the European Commission, said it would buy 30,000 tons of butter at a price of 2,299 euros a ton… Michael Mann, spokesman for the European Commission, said that the move was temporary but that if necessary, the European Union would buy more than those quantities of butter — though not at the same price.”

The situation in the European Union butter market can be attributed to an underestimate by policy makers of the responsiveness of butter producers to the price controls established under the CAP. A minimum price scheme of any sort, if effective, will result in surplus output of the good in question, but the 30,000 tons of unsold butter in Europe appears to exceed the expected surplus considerably. The graph below illustrates why:

A price floor (Pf) is set above the equilibrium price of butter established by the free market. Butter producers in Europe are guaranteed a price of Pf, and any surplus not sold at this price will be bought by the European Commission (EC). Assuming a relatively inelastic supply, which corresponds with the (In macroeconomics): The period of time over which wages and prices are relatively inflexible. A fall in aggregate demand will lead to unemployment and recession in the short-run. Due to the inability of the nation's producers to reduce wages paid to worker, they must lay workers off to reduce costs as demand falls.');" onmouseout="tooltip.hide();">short-run period (Ssr), the increase in butter production is relatively small (Qsr), resulting in a relatively small surplus (Qsr – Qd). In the short-run, the amount of surplus butter the EU governments needed to purchase was minimal. But as we learned earlier in this chapter, as producers of goods have time to adjust to the higher price, which in the case of the CAP is a price guaranteed by the EC, they become more responsive to the higher price and are able to increase their output by much more than in the short-run. Slr represents the supply of butter in Europe after years of the minimum price scheme. As demand has fallen due to the global economic slowdown, butter producers have continued to produce at a level corresponding with the price floor (Pf), leading to ever growing butter stocks and the need for the EC to spend, in this case, 69 million euros on surplus butter.

Understanding the behavior of producers in response to changes in prices, whether due to excise taxes or price controls, better allows both firm managers and government policy makers to respond appropriately to the conditions experienced by producers and consumer in the market place and avoid inefficiencies resulting from various economic policies.

Discussion questions:

1. Explain why the price elasticities of both demand and supply of primary commodities tend to be relatively low in the short run and higher in the long-run.
2. Explain the factors which influence price elasticity of supply. Illustrate your answer with reference to the market for a commodity or raw material.
3. Discuss the importance of price elasticity of supply and price elasticity of demand for producers of primary commodities in less developed countries.

Related posts:

1. Price controls in the Chinese Petrol market – or why you may have to wait in line to fill your gas tank!
2. So, how are those Zimbabweans doing under Mugabe’s price controls?
3. The Price of Milk in New Zealand – domestic and world markets

China rations diesel as record oil hits supplies | Markets | Reuters

In the fall of 2007 I was living in Shanghai, China. At the time, oil prices were hitting record levels world wide, leading to rising petrol prices for drivers in most places.  However, at the time,  I began witnesing an unusual site on my taxi rides into the city of Shanghai: as our taxi passed petrol station after petrol station, I observed dozens of blue trucks (the ubiquitous medium of transporting good from Shanghai’s factories to her ports) spilling out of gas station parking lots into the road, apparently queued, waiting for a spot at the pump. I had never seen such long lines at any of the petrol stations around Shanghai before, and I began to wonder as to the reasons for these crazy long lines!

Well, an article at the time helped solve the riddle of the long lines. As it turns out, there was a simple explanation rooted in the principles of supply and demand that any first semester AP or IB economics student would understand! The Chinese government had been forced to ration petrol (limiting the amount that a driver can buy at one go) due to the shortages resulting from the government’s price controls in the petrol market.

Truck drivers reported long queues at petrol stations along a national highway linking Fujian and Zhejiang provinces, with each truck getting 100 yuan ($13) worth of diesel, or around 20 litres, per visit at a state-run station and 40 litres at a private kiosk…

“What’s wrong with the oil market? Our drivers had to queue the whole night for only a small amount of fill, slowing the traffic by almost one day,” said Gao Meili, who manages a logistics company.

China is a major importer of oil. With an economy growing around 12% in 2007, much of the country’s growth depended on the availability of crude oil at reasonable prices, which China’s oil refining firms turn into diesel and petrol, needed to get Chinese manufactured products from factory to port and from port to overseas consumers.

The problem with the oil market in China, however, was that as “Chinese refiners cannot pass the souring crude costs on to consumers.” Oil is an input needed to make a finished product, diesel. As the price of oil rose in 2007 (it reached a record of $92 per barrel in October of that year), the resource costs to petrol and diesel producers also rose, shifting the supply of petrol and diesel to the left, putting upward pressure on the equilibrium price.   As a first semester AP or IB student knows, resource costs are a determinant of supply, and as oil (the main resource in the production of petrol and diesel) increased in price, the supply of these important commodities invariably decreased.

In a free market, a decrease in supply leads to an increase in price. Herein lies the answer to the riddle of the long lies at petrol stations in Shanghai: the Chinese petrol and diesel market is not a free market. The government plays an active role in controlling prices paid by consumers for the finished product refiners are producing, petrol fuel:

Beijing fears stoking already high inflation and rigidly caps pump fuel rates to shield users from a 50 percent rally in global oil so far this year.

As the costs to petrol and diesel producers rose in 2007, the government in Beijing took the side of consumers and forbade fuel producers from raising the price they charge consumers.  The Chinese government essentially imposed a price ceiling in the market for petrol. A price ceiling is a maximum price set by a government aimed at helping consumers by keeping essential commodities like fuel affordable. As we have learned this week in AP and IB Economics, price controls such as this end up hurting BOTH producers AND consumers, since they only lead to a dis-equilibrium in the market in which the quantity demanded for a product rises while the quantity supplied by firms falls. The shortage of petrol and diesel resulting from the government’s price control are the perfect explanation for the long lines of blue trucks and motor scooters at all the gas stations in Shanghai during October of 2007.

So why, exactly, does the government’s enforcement of a lower than equilibrium price result in such severe shortages that truck drivers are only allowed to pump 20 litres of petrol per visit and made to wait hours each time they need to refill? Below is a supply and demand diagram that illustrates the situation in the Chinese fuel market in 2007:

In the graph above, the supply of petrol has decreased due to the increasing cost of the main resource that goes into petrol, oil. This decrease in supply means petrol has become more scarce, and correspondingly the equilibrium price should rise. However, due to the government’s intervention in the petrol and diesel markets, the price was not allowed to rise and instead remained at the maximum price of Pc.

At the government-mandated maximum price of Pc, the quantity of fuel demanded by drivers far exceeds the quantity supplied by China’s petrol producers. The result is a shortage of petrol equal to Qd-Qs.

The government’s intention for keeping petrol prices low is clear: to make consumers happy and keep the costs of transportation among China’s manufacturers low so as to not risk a slow-down in economic growth in China. However, the net effect of the price controls is a loss of total welfare in the petrol market. Notice the colored areas in the graph above. These represent the effect on welfare (consumer and producer surplus) of the price control.

• The total areas of the green, orange and grey shapes represent the total amount of consumer and producer surplus in the petrol market assuming there were NO price controls. At a price of Pe, the quantity demanded and the quantity supplied are equal (at Qe) and the consumer surplus and producer surplus are maximized. The market is efficient at a price of Pe. Neither shortages nor surpluses of petrol exist.
• However, at a price of Pc (the maximum price set by the government), the amount of petrol actually produced and consumed in the market is only Qs. Clearly, those who are able to buy petrol are better off, because they paid a lower price than they would have to without the price ceiling. But notice that there is a huge shortage of fuel now; many people who are willing and able to buy petrol at Pc simply cannot get the quantity they demand, because firms are simply not producing enough!
• The total consumer surplus changes to the area below the demand curve and above Pc, but only out to Qs. The green area represents the consumer surplus after the price control. It is not at all obvious whether or not consumers are actually better off with the price ceiling.
• The total producer surplus clearly shrinks to the orange triangle below Pc and above the supply curve. Petrol producers are definitely worse off due to the government’s action.
• So how is the market as a whole affected? The black triangle represents the net welfare loss of the government’s price control. Notice that with a price of Pe, the black triangle would be added to consumer and producer surplus, but with a disequilibrium in the market at Pc, the black triangle is welfare lost to society.

Price controls by government’s clearly have an intended purpose of helping either consumers (in the case of a maximum price or price ceiling) or producers (in the case of a minimum price or price floor).  But the effect is always predictable from an economist’s perspective. A price set by a government above or below the equilibrium price will always lead to either a shortage or a surplus of the product in question. In addition, there will always be a loss of total welfare resulting from price controls, meaning that society as a whole is worse off than it would be without government intervention.

Discussion Questions:

1. Why has the supply of petrol decreased?
2. With a fall in supply of a commodity like petrol, does the demand change, or the quantity demanded? What is the difference?
3. Define “consumer surplus” and “producer surplus”. Why does a government’s control of prices reduce the total welfare of consumers and producers in a market like petrol?
4. How would a government subsidy to petrol producers provide a more desirable solution to the high oil prices than the maximum price described in this post? In your notes, sketch a new market diagram for petrol and show the effects on supply, demand, price and quantity of a government subsidy to petrol producers. Does a subsidy create a loss of welfare? Why or why not?

Related posts:

1. The problem with price controls in Europe’s agricultural markets
2. Beijing caves in to the indisputable power of the MARKET!
3. So, how are those Zimbabweans doing under Mugabe’s price controls?

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.

Related posts:

1. When markets work…
2. Beijing caves in to the indisputable power of the MARKET!
3. “Living” evidence of a determinant of demand at work in the deserts of Northern India

This article was originally posted on September 19, 2007

FT.com / Asia-Pacific / China – China freezes government-set prices

Here’s a great article for both AP and IB students to pay attention to. The Chinese government is responding to rising prices at home by resorting to some good old fashioned “iron fist” measures, namely price controls on a wide range of products. For the rest of this year, prices on certain goods and services will not be permitted to rise, OR ELSE! (what? we don’t want to know!)

China has begun to enforce a freeze on all government-controlled prices in a sign of the central government’s alarm about rising popular anger over inflation, now at the highest rate in over a decade.The order freezes a vast array of prices still under the control of governments in China, ranging from oil, electricity and water, to the cost of parking and park entrance fees.

I find the following statement interesting:

“Any unauthorised price rises are strictly forbidden…and in principle, there will be no new price-raising measures this year,” the ministries’ announcement said. (italics added)

How strange is it that the government’s announcement pointed out that the freeze on prices is only in principle? Could this be the government’s attempt to placate a public that’s grown angry at their weakening purchasing power? Does this mean that if prices actually do go up, the government can just say, “Hey, at least we tried!” Looks like the old communist mentality has softened a bit in the era of market reforms!

So what’s the source of all these rising prices? Well, food plays a big role, thanks to a couple of factors:

The sharp spike in inflation is largely due to higher food prices, because of a shortage of pigs after a disease killed millions late last year and earlier in 2007, and the rising cost of feed, a global
phenomenon.

The China of today is very different from that of 20 or 30 years ago, when the government played a much larger role in the economy. Unleashing the beast of the free market in the early 80′s may have meant the government would have to loosen its grip in situations such as today’s inflation, and let the free market adjust on its own.

Economists said the price freeze is the kind of administrative measure redolent of China’s former planned economy, but it may be less effective in China today.

“They will not be able to control the price of everything,” said Chen Xingdong, of BNP Parisbas in Beijing.

Perhaps that’s for the better.

Discussion Questions:

1. Why might the government’s price controls actually make the matter worse for the average Chinese?
2. If the government were to take a “laissez faire” approach to the problems faced by China, how might the free market resolve them on its own? Any ideas?

Related posts:

1. “A glimmer of hope” – rising incomes in China lead to rising demand for US exports
2. The true causes of and solutions to inflation in China
3. Deflation: why lower prices spell doom for any economy!

FT.com | The Economists’ Forum | Will Americans demand the cars that Congress wants the big three to build?

It’s been driving me nuts, this whole bailout debate. My frustrations are definitely appartent to my students, who have had to put up with my occasional rants about the insanity of the whole affair since the issue came to the media forefront over a month ago. Here are some of the issues that just don’t add up from the perspective of a high school economics teacher:

The three companies asking for a bridge-loan supposedly want the money so that hundreds of thousands (some reports say as many as 2.6 million) jobs can be saved. But how could Ford, Chrystler and GM possibly maintain their labor force in a time of a recession when nobody is buying new cars in the first place? In the parlance of AP or IB Economics, automobiles are normal goods, ones for which demand falls as incomes fall. By definition, a recession in the United States means falling incomes. A government loan may allow the Big Three to keep making cars for the time being, but WHY WOULD THEY KEEP MAKING CARS when falling incomes point to falling demand in the immediate future? Making cars that nobody will buy represents a gross misallocation of the nation’s productive resources, not to mention taxpayers’ money. What is required of these industries is precisely what the government loan will prevent them from doing, DOWNSIZING, meaning the shrinking of their labor force as well as the number of plants in operation.

The US recession can not be avoided by allocating the nation’s scarce resources towards a bailout of the auto industry. In fact, it will be worsened because the capacity of any nation to emerge from a cyclical downturn requires the flexibility of the country’s labor force to adapt to the structural changes the country is experiencing in the era of globalization and free trade. America’s future does not reside in labor-intensive manufactured goods, especially in the production of a very expensive durable good for which demand falls drastically during recessions; specifically, automobiles.

The Finanacial Times Economists Forum approaches the issue of long-term falling demand for automobiles from another perspective. One of the conditions of the Big Three accepting a loan from the federal government is the mandate that Detroit will begin producing more fuel efficient automobiles to assure Americans more affordable, more environmentally friendly alternatives to the gas-guzzling SUVs that have dominated the industry for the last two decades. But here’s the problem, gasoline has fallen to a price as low as it was when SUVs were at their peak popularity back in the early 2000s! As any high school economics student knows, gasoline and SUVs are what we call complementary goods, or two goods for which demand and price are inversely related. As gas prices fall to their 2000 levels, demand for SUVs promises to rise once again, while demand for fuel-efficient automobiles will likely decline, creating market pressures for the Big Three to make not more fuel-efficient cars, but more SUVs instead! From the Financial Times:

The basic problem is that Americans like to drive sport-utility vehicles, minivans and small trucks when gasoline costs $1.50 a gallon…

Consumers may have regretted their behaviour when gasoline prices soared above $4 a gallon, but as gas prices descend, there is no reason to believe that left unchecked they will not return to their gas-guzzling ways.

Indeed, there is a distinct possibility that if they really do increase their small car production, in a few years the big three will be back asking for more help, on the grounds that they are losing money by doing exactly what Congress asked.

The only reasonable solution to this dilemma? If Congress DOES begin mandating that Detroit increase its production of fuel-efficient cars and phase out its manufacture of SUVs, any such requirement should be accompanied by a government-set price floor on gasoline. Several months ago, my colleague and fellow blogger Steve Latter blogged about a proposed price floor of $4 per gallon on gasoline. Such a scheme would likely prove nearly impossible to initiate politcally, but may be exactly what’s necessary to add legitimacy to any government requiremens of Detroit to manufacture fuel efficient automobiles. The FT appears to support such a scheme:

Congress should put their mouths where their money is. They should make binding commitments to ensure higher US oil prices and thereby sufficient demand for fuel-efficient cars and trucks in the future.

Discussion Questions:

1. What message does falling demand in the auto market send from buyers to sellers, and what contradictory message does a subsidy from the government send to auto makers?
2. If the auto makers receive a low-interest bridge loan (subsidy) from the government, how will this actually undermine the efficient functioning of markets in America?
3. Why would a price floor on gasoline be needed to accompany a government requirement that the Big Three make more fuel efficient automobiles after receiving a government loan?

Related posts:

1. Eight basic economic arguments against a bailout of the auto industry
2. Letting markets work: the Malaysia fuel subsidy goes bye bye
3. Is bicycle transportation an “inferior good”?

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 demand". Occurs when the price is below the equilibrium level, for example, when a government imposes a price ceiling in a market.');" onmouseout="tooltip.hide();">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.”

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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.

Well, it looks like Beijing is finally catching on to the flawed nature of their iron fisted attempts at overpowering the forces of the free market, sort of:

FT.com / Asia-Pacific / China – China pushes up fuel prices

“China raised the price of petrol and diesel by almost 10 per cent on Wednesday as crude oil prices hit a record above $94 a barrel.

The move, the first increase since May 2006, came in spite of a promise by Beijing not to put up state-controlled prices before the end of the year in an effort to keep inflation at bay.

Inflation in China exceeded 6 per cent in the third quarter amid rising food-price increases that some fear could lead to social unrest…

The retail price rise in China could stimulate demand in the short term as refiners resume production, and is unlikely to dampen long-term demand, analysts said.”

That last sentence seems strange to me. In what scenario that we have studied would a price increase ever “stimulate demand”? I suspect what the article means is that the price increase will “stimulate supply” as refiners (the producers of fuel), are now able to sell their output at a higher price (or marginal revenue), meaning that the profit maximizing level of output is greater, or higher along their marginal cost curves.

So, output should increase in the fuel industry, which means there will be more fuel for consumers to buy. But surely consumer demand will not increase; this seems to defy the law of demand! What does seem likely, however, is that the higher price (essentially a less restrictive price ceiling), will increase the quantity supplied, thus increasing the amount of fuel available for consumers to buy, alleviating the shortage and allowing Chinese to consume a greater quantity than when the price ceiling was more restrictive.

In fact, the quantity demanded will go down (as the higher price leads to leftward movement along the demand curve), but the quantity consumed will go up (as the higher price leads to a rightward movement along the supply curve). A shortage is being alleviated, but probably not eliminated, considering the price of the raw material in fuel (oil) has increased 40% in the last year, while the price of fuel has only increased 10% since May of 2006. It seems likely that the government set price is still an effective ceiling, meaning there is still excess demand, and therefore we may be seeing more lines of blue trucks around Shanghai in the future!

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Kremlin Secures Price Controls on Food Items Before Elections – New York Times

Okay, students. This article needs to introduction, no summary, no analysis, no passages quoted, I barely even glanced at the article myself! Read the headline… if you’re interested, read the article; but it should be nothing new to you at this point. It’s the same flawed economic thinking that led Zimbabweans to attempt to eat a poor giraffe, and the Chinese decision to freeze certain prices in the run up to the 17th meeting of the Chinese Communist Party Congress earlier this month.

What’s wrong with this sort of economic policy? Why do governments still attempt such policies, and why do people still fall for such tricks played by paranoid leaders obsessed with placating the masses through “generous” price controls? What do you expect will result from Russia’s price controls?

Hat tip to Greg Mankiw for the link.

Speaking of our old friend Robert Mugabe, the president of Zimbabwe has just announced he’s launching The Robert Mugabe Intelligence Academy. His stated purpose for opening this institute, which will train government officials from the greater Southern African region?

“The important role of defending our country cannot be left to mediocre officers incapable of comprehending and analytically evaluating the operational environment to ensure that the sovereignty of our state is not only preserved, but enhanced,” Mugabe said.

Before settling on the institutes’s official name, several options were tossed around, including the close runner up: “The Robert Mugabe Institute for People Who Can’t Do Economics Good and Want to Learn to Do Other Things Good Too.”

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Hungry Zimbabweans Try to Eat Giraffe

A while back we blogged about Robert Mugabe’s order to freeze all prices in Zimbabwe in order to halt the country’s hyperinflation. At the time we were studying equilibrium price and how it results in allocative and productive efficiency, meaning that neither too much or too little of a particular product is produced given the availability of resources and manufacturing technology.

A few months after the price controls took affect, the question remains, how are the people of Zimbabwe fairing? I think the headline above answers this question rather clearly. From the article:

Police stopped villagers from slaughtering and eating a giraffe that strayed into the outskirts of the capital amid chronic food shortages caused by an economic crisis, the official media reported Saturday.

The adult giraffe was believed to have wandered from nearby farmland. Wildlife authorities took the giraffe away after police kept a crowd from killing it “for the pot,” the state Herald reported.

Zimbabwe is suffering shortages of meat and basic foods in an economic meltdown that has left it with the world’s highest official inflation—nearly 7,000 percent. Independent estimates put real inflation closer to 25,000 percent and the International Monetary Fund forecast it reaching 100,000 percent by the end of the year.

A government order to slash prices of all goods and services by about half in June has left stores across the country empty of meat, cornmeal, bread and other staples and crippled transportation services.

The National Society for the Prevention of Cruelty to Animals said this month that it was launching a campaign to raise awareness about the moral and ethical issues surrounding cases of pets being slaughtered for meat.

Ironic, isn’t it, that a government agency is seeking to educate the people of Zimbabwe on how to treat animals better, when it’s the government itself whose poor understanding of market economics that led to the hunger and desperation driving people to try and eat a giraffe… Another sad yet poignant illustration of how markets work and command systems don’t. It’s a bad time to be a 17 foot tall mammal with horns in Zimbabwe.

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Thanks to Jeewon Oh, Shanghai American School AP Econ student, for posting the link to this excellent article about supply and demand for teachers in Mississippi. Jeewon posted this article and her below summary of it to our class’s “AP Econ in the News” page on the wiki. CLICK HERE to see the other articles and summaries posted by students relating to our current unit on Supply and Demand. Here’s Jeewon’s article:

Teachers: Shortages require pay hikes -The Clarion-Ledger- Real Mississippi

And here’s Jeewon’s summary from the wiki:

In Mississippi, there are not enough teachers in the classrooms. This teacher shortage is becoming a greater problem, as 50 percent of the teachers nationwide are estimated to leave the profession within five years. In August there were 1,270  requests for one-year education licenses, which would result in temporary and unqualified teachers in schools. Despite the fact that 1,400 education majors graduate from Mississippi colleges, only 900 become teachers. The State Superintendent of Education Hank Bounds realized that if wages increased, there would be more teachers willing to work. Bounds currently wants a 3 percent pay raise andaddition of 5 years to the pay schedule for teachers. This is asupply-and-demand issue, as the Legislative Budget Committee is planning to supply, or offer, higher wages, predicting that more teachers will be demanding and willing to take the job, due to the change in their income.

The reason this article jumped out at me is because it relates to so many of the topics we’ve studied in unit 2 of Microeconomics, particularly our last class where we learned about how free, competitive markets lead to an allocatively efficient outcome. In public schools in America, wages paid to teachers are essentially set by the state and local governments; in essence there is a price ceiling in the market for teachers. According to the article:

Mississippi has been on a plan to get pay competitive, but it still lags. Base pay for a starting teacher is about $30,000. The average salary is $40,594, short of the Southeastern average of $42,333. The national average is $47,674.

Given the severe shortage of teachers in Mississippi and the nation as a whole, what does this say about the average salaries being paid to teachers? What can we conclude about the allocation of resources towards education? Is the market for public education in the United States allocatively efficient? How does Jeewon’s article present a solid argument for the privatization of education in the US? How might taking some of the responsibility of providing education out of government hands result in a more efficient allocation of resources towards schools?

Great article, Jeewon, thanks for the link and the nice summary. From now on, when I see an excellent article like Jeewon’s accompanied by a fine summary such as the one above, I will plan to post it to this blog so others can benefit from the research and reading that our AP students are sharing through our class wiki. The AP Econ in the News page is a great place economics teachers and students to come find useful articles for their classes, as well, so I encourage you to bookmark it. A new page is added for each unit, and it can be found under each unit’s main page.

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FT.com / Asia-Pacific / China – Beijing rejects North American pork

Here’s a follow up to the previous post about China’s attempt to keep inflation low by clamping down on rising prices through price controls. The main cause of the record inflation figures is the shortage of pork in the country. This headline’s irony was obvious, only a few articles below the one linked in the last post!

Here’s the thing; pig shortages have driven up the price of pork by around 60-70% in China. What’s one obvious solution to this problem? Import more pork from overseas to meet the excess demand. So, what’s the government doing about it? Playing politics with the US and blocking imports of American pork! Ha! Looks like their concern for the common Chinese may take a backseat to the retaliatory message sent to the US, which has recently threatened new tariffs on Chinese goods in the wake of concerns over product safety and frustration over the persistent trade imbalance between the two countries.

Beijing has rejected consignments of pork from the US and Canada because they contain a banned additive – in spite of a domestic shortage of China’s staple meat, which pushed inflation to a
10-year high in August.

Again, China’s meddling in the market economy seems to only make things worse for the Chinese people.

Chinese officials have said they expect the pork shortage to remain a problem into next year, but prices have already started to come down from their August high, Xinhua, the official news agency, reported at the weekend. Prices decreased by 11.3 per cent in early September from the levels in August because of an increase in supplies of pigs, Xinhua said.

The number of pigs ready for sale was up 9.9 per cent early this month compared with a year ago, said Sun Zhengcai, the agriculture minister.

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Command vs. Market economics in Zimbabwe:
Mugabe’s decree on prices puts Zimbabwe economy in a tailspin – International Herald Tribune

And a blog post commenting on the news:
Managing Globalization » Economics 101 in Zimbabwe

Our first unit in AP Economics (and Friday’s lecture) examined the differences between command economies and market economies. One of the main points of yesterday’s lecture was that markets work because they result in an efficient allocation of resources towards the right products, using least-cost production methods, and putting those products in the hands of the people whose resources command the highest value in the resource market. If too much of one good is being produced and not enough of another, the “invisible hand” of the market will reallocate resources from the over-produced product to the under-produced product.

One of the reasons command economies fail is that central planners who attempt to control output and price, even when their intentions are to help consumers by assuring enough stuff is produced and available at an affordable price, are in essence acting against a basic economic law: that of supply and demand. In Zimbabwe, where inflation has reached nearly 10,000 percent (that means a candy bar that costs $1 today will cost $100 in a year!!) the president recently attempted to place price controls on all products by forcing merchants to slash their prices in half. The result? Food has vanished from the shelves of markets in Zimbabwe:

Essentials like bread, sugar and cornmeal, staples of every Zimbabwean’s diet, have vanished, seized by mobs of bargain-hunters who denuded stores like locusts in wheat fields. Meat is nonexistent. Gasoline is nearly unobtainable. Hospital patients are dying for lack of basic medical supplies. Power blackouts and water cutoffs are endemic.

Manufacturing has slowed to a crawl, because few businesses can produce goods for less than their government-imposed sale prices. Raw materials are drying up because suppliers are being forced to sell to factories at a loss. Businesses are laying off workers or reducing their hours.

As our first AP unit “Basic Economic Concepts” winds down, this article and blog post seem timely to remind us of one of the core principles of Economics: the importance of prices and markets in allocating resources (land, labor, capital and entrepreneurship) towards producing the goods and services society most wants. Later in the year we’ll examine what happens when markets fail, which they often do; but at this point in the course it is important to understand that despite their failures and shortcomings, free markets rarely experience the chaos associated with command economies of the past, and even the present as the Zimbabwe example shows. In the words of Daniel Altman, the blogger linked above:

The Soviets, Chinese and some of their allies kept their tightly controlled economies going for quite a few decades, though not perhaps with unalloyed success (former backyard smelters in China will get the pun). Mugabe’s version hasn’t even lasted through a change of seasons. Now, there are still a few lingering arguments in academia and policy circles about the merits of command economies. But a poorly planned command economy – no one seems to want that. Can anything short of total collapse follow?

Any thoughts? Why did Mugabe’s attempt to help consumers by keeping prices low only make the problem worse? What does this say about markets versus planned economies? Discuss!

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