Have a look at this article before reading the blog post below: Pasta prices rise after North Dakota loses million acres of wheat to heavy rain, flooding – Associated Press

Prices are determined by the relative scarcity of a good, service or productive resource. This fundamental lesson is one of the first things we learn in a high school economics class. Why are diamonds, which nobody really needs, so much more expensive than water, which everyone needs? The answer lies not in the relative demands for the two goods (clearly, water is far more demanded than diamonds), but rather the relationship between the relative demand and the supply. Between the two, diamonds are far more limited in supply than water, thus they are scarcer and accordingly more expensive.

This lesson applies not only to water and diamonds, but indeed to any product for which there is a market in which buyers and sellers engage in exchanges with one another. Commodities are goods for which there is a demand,  but for which the supply is standardized across all markets. For instance, bicycles are not a commodity, because there are hundreds of different types of bicycles, meaning it is not a standardized product. But steel, which is used to make bicycles, is a commodity since steel is fairly standard regardless of its ultimate use by manufacturers. Cookies are not a commodity, but wheat is, since wheat is a highly standardized ingredient used in the production of cookies.

Commodity prices, like the prices of anything, are determined in markets. Buyers are usually the manufactures of secondary products for which the commodities are an input. Since commodities are traded all over the world, there tends to be a common market price determined by the national or international supply and demand for the commodity. In recent weeks, one very important commodity has increased in scarcity, leading to an increase in the price for the finished product the commodity is used to produce.

Consumers are paying more for pasta after heavy spring rain and record flooding prevented planting on more than 1 million acres in one of the nation’s best durum wheat-growing areas.

North Dakota typically grows nearly three-fourths the nation’s durum, and its crop is prized for its golden color and high protein. Pasta makers say the semolina flour made from North Dakota durum produces noodles that are among the world’s best.

This year’s crop, however, is expected to be only about 24.6 million bushels, or about two-fifths of last year’s. Total U.S. production is pegged at 59 million bushels, a little more than half of last year’s and the least since 2006, according to the U.S. Department of Agriculture.

The cost of pasta jumped about 20 cents in the past few months to an average of about $1.48 a pound nationwide…

…North Dakota durum fetched about $15 a bushel this spring but has dropped to about $11, due to the lack of buying and selling.

Still, that’s about twice what it sold for at this time last year, she said…

“This is one of the few crops we have that can have such an immediate impact on the consumer,” Goehring said. “This year, they will experience higher pasta prices.”

The story above is one played out in countless markets for commodities (such as wheat) and the goods they are used to produce (pasta, in this case) all the time. Due to poor weather and a particularly wet spring, farmers were unable to plant as many of their fields with wheat as they have in the past. Therefore, the 2011 wheat harvest is less than it usually is, meaning the supply of wheat has decreased. However, since there has been no fundamental change to the demand for wheat (we still eat pasta!) the relative scarcity of wheat is greater than in the past. Demand remained constant, while supply fell, therefore the relative scarcity increased.

The value of anything is based on its relative scarcity. In product markets, like that for wheat, value is conveyed by the commodity’s price. As the article says, the price of wheat is currently selling at “about twice what it sold for at this time last year”. At the current price of $11 per bushel, we can assume that the price last year was $5.50. However, the price reached as high as $15 earlier in the summer, indicating that the reduced supply of 59 milliion bushels, which is “a little more than half of last years” (which we’ll assume was around 100 million bushels), caused the price to peak at $15 this year. All this is a complicated way of saying that as the output of wheat fell, wheat prices rose because demand remained constant.

Additionally, the price of the product for which wheat in an input also rose. Pasta prices have jumped “20 cents in the past few months” to $1.48. Since the price of wheat is a resource cost for pasta producers, higher wheat prices lead to a fall in the supply of pasta, making pasta more scarce and driving the price up for pasta consumers.

All this can be demonstrated graphically using simple supply and demand analysis.

Based on the figures in the graphs above, the responsiveness of wheat consumer (which are mostly pasta producers) to the rising price of wheat can be easily calculated. Price elasticity of demand (PED) is the measure of consumers’ sensitivity to price changes. It is measured by calculating the percentage change in quantity following a price change divided by the percentage change in price. The quantity demanded of wheat fell by 41%, while the price rose by 272%, meaning that the PED for wheat is 41/272, or 0.15. This is considered relatively inelastic since such a large price increase led to a relatively small fall in the quantity of wheat demanded.

It is likely that if wheat prices remain elevated throughout 2011, next spring farmers across the American Midwest will have a strong incentive to plant more acres of wheat than they have in years past. Assuming the weather conditions improve and the fields are dry enough to grow wheat, it would be expected that a year from now wheat prices will be much lower than they are today, as supply returns to or exceeds historical levels next year. High prices for wheat today have harmed pasta consumers, but in the long run everyone, both pasta producers and pasta consumers, will likely enjoy lower prices thanks to the high prices of today.

This is how the market system works. When resources are under-allocated towards a particular good, as they have been towards wheat in 2011, price rises in response to the good’s increased scarcity. But the higher prices incentivize producers to allocate more resources towards those goods’ production, and over time the supply increases once more, reducing its scarcity and bringing the price back down.

Discussion Questions:

1. Why did wheat become more scarce in 2011, even though the demand for wheat did not change?
2. Interpret the claim that “wheat consumers are relatively unresponsive to higher wheat prices”. Can you think of a reason why this is the case? Can you think of an example of a product for which consumers would likely be much more responsive to a change in the price?
3. How does the high price of wheat and pasta in 2011 likely assure that a year from now, prices will be much lower than they are today, assuming there are not further problems with flooding in wheat growing areas?
4. How do prices “allocate resources” in a market economy? What do you think would have happened to the number of acres farmers would plant in wheat next year if instead of the price doubling this summer, it had been half of what it was in previous years?

Related posts:

1. From disequilibrium to equilibrium – how prices allocate resources in a free market
2. As Chinese planes take off, prices may be coming in for a landing
3. From heart transplants to watermelons: Understanding price elasticity of demand

Consumers are interesting creatures to study. Economics offers us a unique set of tools for understanding the behavior of consumers in various markets. Elasticity is one of those tools, one which helps us understand how consumers will respond to the change in price of some goods more or less than others. Some of the questions about consumer behavior elasticity helps answer are:

• Why do governments place such huge taxes on cigarettes?
• Why did Apple cut the price of the new iPhone in half from the original one, despite the fact that it had so many new features?
• Why do movie theaters seem to raise their prices so steadily over the years, rather than doubling the price of tickets each year?

These and other questions can be answered by knowing something about the relative price elasticities of demand for the goods in question. Price elasticity of demand refers to the sensitivity of consumers to a change in price. For some goods, even the slightest increase in price will scare consumers away, while for others, price can go up and up and up and the quantity demanded won’t budge!

Here’s just one illustration of a good for which consumers are extremely sensitive to changes in price: Every autumn, around the city of Shanghai thousands of small farms harvest the Chinese watermelon, a small, green, juicy melon that looks and tastes the same regardless of which farm it came from. The farmers sell their melons to one of the hundreds of melon vendors who drive their big blue trucks into the city of Shanghai during about two weeks in October to sell the watermelons to the city folk who love their refreshing taste.

During the two weeks of the melon harvest, there are hundreds of blue trucks parked two or three per block all over the city. The hundreds of melon vendors sell an identical product, acquired at identical costs from thousands of farms using identical techniques for farming. In other words, the melon market in Shanghai during these two weeks is close to being perfectly competitive.

The price of melons is established through competition at something very close to the exact cost to the vendor of getting the melons into the city. Consumers know this, and therefore if one vendor tries to sell his melons for more than the equilibrium price, consumers will respond by buying NONE of that vendors melons. Conversely, if a vendor were to lower his price at all, rationally EVERY consumer would want to buy from that vendor, but since the price is already at the cost to the vendor, no vendor is able to lower the price without losing money. The outcome in the market for melons in Shanghai is that demand for melons is close to being perfectly elastic, meaning that consumers are completely sensitive to changes in price of watermelons.

Not all goods are like watermelons. In fact, for some goods demand is close to perfectly inelastic. Study the graph below, showing the relative elasticities of five different products, then answer the questions below in your comment!

Discussion Questions:

1. For which product is demand pefectly inelastic? Perfectly elastic? Unit elastic?
2. What relationship exists between relative slopes of demand curves and elasticity?
3. What are two characteristics of cigarettes that make demand for them inelastic?
4. What are two characteristics of heart transplants that make demand perfectly inelastic?
5. What are the characteristics of a good for which demand is perfectly elastic?

Related posts:

1. The role of advertising in determining price elasticity of demand
2. Calculating the price elasticity of supply of natural gas
3. McAfee on Price Discrimination: a must-read for teachers of Microeconomics

TDeluxe: How Luxury Lost Its Luster – Dana Thomas – Books – Review – New York Times

Unit 2 in IB and AP Economics begins by examining the interaction of supply and demand in product markets, and the importance of these factors in determining the equilibrium price in any particular product market.

In the above article from the NY times, the author reviews a book that exposes the diminished quality and attention to detail among manufacturers of luxury goods (think Prada, Gucci, etc…) The era of globalization and off-shoring of manufacturing has aided luxury firms in their quest for profits, as they’ve been able to significantly cut costs while maintaining exorbitant prices for their product.

The author takes issue with the alleged demise in the luxury market of attention to detail and craftsmanship, as competition and profit seeking behavior have led to an industry where the back alley workshops of Milan and Paris have been replaced by the factory floors of China and Vietnam. Free trade has allowed European luxury brands to produce more of their products at lower costs, which leads the author to her current question: “Why is this stuff still so expensive even as the cost of producing it goes down?”

Despite her accusations of poor quality and greedy, profit seeking managers in the luxury goods industry, the author seem unable to resist the luxury goods she claims to despise:

When, I asked myself, did it become commonplace to charge several thousand dollars for a mass-produced handbag? How could the flimsy designer sundress I bought on sale (a “steal”, the saleswoman assured me) still wind up costing a whole month’s salary? Why is my favorite brand of lipstick more expensive than a nice bottle of Italian wine? When did these products’ values grow so distorted, and what is the would-be customer to make of it all?

The author continues…

…the luxury industry is a sham because its offerings in no way merit the high price tags they command. Yet once upon a time, they most certainly did. In the 19th and early 20th centuries, when many of luxury’s founding fathers first set up shop, paying more money meant getting something truly exceptional. Dresses from Christian Dior, luggage from Louis Vuitton, jewelry from Cartier: in the golden period of luxury, these items carried prestige because of their superior craftsmanship and design. True, only the very privileged could afford them, but it was this exclusivity that gave them their cachet. Although they may have “cared about making a profit” the merchants who served this pampered class aimed chiefly to produce the finest products possible.

It appears that the author never took an introductory economics course. If she had, she would clearly understand that price is not determined by the level of craftsmanship, the attention to detail, nor the level of exclusivity represented by a particular purse, shoe or dress. Rather, price is determined by the interaction of Demand AND Supply in the market for all goods, EVEN luxury goods!

When she claims that “the merchents who served this pampered class aimed chiefly ‘to produce the finest products possible’”, the reviewer is forgetting some of the basic teachings of capitalism’s founding father. Adam Smith himself could have corrected the NYT reviewer when he said,

Whoever offers to another a bargain of any kind, proposes to do this. Give me that which I want, and you shall have this which you want, is the meaning of every such offer…

Smith knew as any economics student should know that exchanges in any market happen not because of a mutual appreciation for craftsmanship or artistry, rather because a producer (firm) wants to make a profit by charging as high a price possible to a consumer (household). In the case of luxury goods, Gucci and Prada never made high quality goods because they loved making high quality goods, rather they made them cause consumers demanded them and were willing to pay top dollar for them.

What the author is missing is a basic understanding of the determinants of Demand. The price a good commands in the market has little to do with how much it cost to produce or where it was produced, and everything to do with the level of demand relative to the level of supply.

Discussion questions:

1. Why do Prada, Gucci, Cartier and other luxury brands command such high prices relative to cheaper substitutes widely available to consumers?
2. As nothing else changes and the price of luxury goods goes up, how is demand affected? Explain.
3. What are some of the determinants of demand that have kept the price of luxury brand goods high even as the costs of production have been reduced due to cheap overseas manufacturing?

Powered by ScribeFire.

Related posts:

1. China’s Influence Spreads Around the World
2. The Price of Milk in New Zealand – domestic and world markets

A few summers ago, my wife and I spent three weeks travelling around the island of Bali in Indonesia. For six of those days we rented a jeep and circumnavigated the island. Our first stop was for two days of scuba diving in the northeast region of Ahmed. As we drove along the seven beaches near Ahmed, we observed there were around ten dive operators offering packages for the local dive spots (including one of Asia’s most famous dives, the WWII-era USS Liberty wreck). Based on our Lonely Planet recommendation, we settled on Eco-Dive, where we paid $60 a day for two dives and all our gear rental. We felt good about this rate and agreed that $60 was a fair and competitive price for a day of diving.

Our next stop, Pemuteran, a remote and relatively undeveloped area on the northwest coast just across the straits from Java, is also known for its great diving. On our first morning in Pemuteran, my wife and I strolled along the beach and found that there were only three dive operators to choose from! And guess what, they all charged between $95-$105 for a day of diving. That’s around 60% more than the operators in Ahmed charged! In the end, we decided to do only one day of diving in Pemuteran, and elected to spend our second day there reading by the pool.

Discussion Questions:

1. What was the difference between the scuba diving markets in Ahmed and Pemuteran? Which market was more competitive? Which of the four market structures did the two markets most resemble: perfectly competitive, monopolistically competitive, oligopolistic or monopolistic?
2. How were the dive operators in Pemuteran able to charge 60% more than the operators in Ahmed?
3. What do you think is keeping one of the three dive operators in Pemuteran from lowering their price to, say, $60 for a day of diving? How would the other two operators respond? Would this be good or bad for the dive operators of Pemuteran? Would it be good or bad for scuba divers?
4. Assuming that the cost of opening a dive operation was relatively low, and there were no government or other barriers to doing so in Pemuteran, what do you suspect will happen in the Scuba diving market as the tourism industry continues to develop in the remote town of Pemuteran? Explain.
5. Which village’s dive operators do you think were more “efficient” in their use of resources? Explain.

Related posts:

1. SAS Economists Podcast #6: The oligopolistic nature of the video game console market
2. Bali economics: “thinking like an economist” on the Island of the Gods!

Swine flu fear leads to shortage of garlic in China – Telegraph.

My colleague this morning happened to ask if I had heard about the garlic bubble in China. A quick news search led me to the story:

Garlic prices have increased fifteen fold in China in under a year because Chinese investors are said to be attempting to create an artificial shortage and drive up prices.

Chefs and housewives in some cities are struggling to get hold of one of the nation’s favourite ingredients, which has passed gold and oil to become the China’s best-performing asset.

Several factors have led to the “garlic bubble” in China. Firstly, low prices of garlic last year:

Falling garlic prices last year have contributed to the shortage with many farmers discouraged from planting the crop again…

To compound the problem, supplies of garlic have been further reduced due to speculation. Yes, speculators are hoarding warehouses full of garlic to drive price up in the face of rising demand. Chinese believe that garlic has medicinal properties and is therefore a remedy for swine flu. This year’s unusually high level of demand is attributable to the flu epidemic and Chinese desire to consume more garlic to fend off the illness.

The result of all these combined factors is illustrated below. The low prices in 2008 led to farmers to cut back on production, reducing supply to S2009normal. What the farmers did not predict, however, is the rise in demand due to swine flu. The reduced supply is exacerbated by speculators buying up output and warehousing it, shifting supply further left to S2009w/speculation.

As can be seen, prices have risen, but shortages persist. It should be expected, therefore, that prices will continue to rise until the shortages are eliminated. On the other hand, the speculators may begin to release their hoarded supplies, shifting supply outward and restoring equilibrium closer to the current price.

A third possibility is that the swine flu epidemic will subside and demand will return to a normal level. This, of course, would spell doom for speculators who put millions of RMB into garlic who would then find themselves with “assets” that had lost their value. This would mean the proverbial “bursting of the bubble”. This final possibility seems unlikely anytime soon, for among the Chinese, traditional beliefs run deep, and with the lack of widespread access to a swine flu vaccine, garlic will likely remain the remedy of choice for the country’s masses.

Related posts:

1. “Monster Hog” and the price of pork in China
2. Supply and demand shifters and the price of pork in China
3. Beijing caves in to the indisputable power of the MARKET!

FT.com / MARKETS / Commodities – Shortages stir coffee and sugar prices

My favorite economics blog, Environmental Economics, points to an article from the Financial times that appears to make a very elementary mistake in its use of basic economics terminology. Read the excerpt and answer the questions that follow.

Shortages stir coffee and sugar prices
By Javier Blas and Jenny Wiggins in London
Published: May 10 2009

Caffeine addicts face higher prices for their daily fix as the wholesale cost of both coffee and sugar rise sharply because of poor crops and robust demand.

“We are in a dangerous situation,” Andrea Illy, chief executive of Italy’s leading coffee ­company, told the Financial Times, warning that prices could “explode” due to supply shortages.

Discussion Questions:

1. Define “shortage”.
2. Does the rising price of coffee indicate that there are shortages in the market? Why or why not?
3. Would “poor crops and robust demand” necessarily combine to create a shortage of coffee? Why or why not?
4. What would lead to a shortage of coffee, based on the economic definition of the term “shortage”.

Related posts:

1. American auto makers insult the intelligence of high school Econ students!
2. Starbucks instant coffee: a sign of the times?
3. Wii shortage threatens to ruin Christmas for all the little boys and girls!

Professor Preston McAfee on Price Discrimination

(you must have RealPlayer to view this video. Mac users can download it here)

CalTech Economics professor Preston McAfee is an expert on prices. His research spans three decades and examines the pricing behavior of firms in various market structures. In the lecture linked above the professor shares several examples of firms practicing price discrimination. I was surprised to see that many of the examples he discusses are ones that I have been using in my own lectures on price discrimination for the last few years.

McAfee presents a mathematical formula for monopoly pricing, which no AP or IB text that I’ve seen has included:

Monopoly Price = [PED/(1-PED)] x MC where PED is the price elasticity of demand of the customer and MC is the firm’s marginal cost of production.

The basic idea is that the more inelastic the customer’s demand, the higher price the monopolist should charge over its marginal cost. The implication, therefore, is that a monopolist prefers to charge higher prices to customer’s whose demand is inelastic and lower prices to customers who are “price sensitive” or whose demand is elastic. The charging of different prices to different consumers for the exact same product is what economists call price discrimination.

McAfee begins talking about price discrimination at minute 8:44 in the video. His examples include:

• Movie theaters: Charge different prices based on age. Seniors and youth pay less since they tend to be more price sensitive.
• Gas stations: Gas stations will charge different prices in different neighborhoods based on relative demand and location.
• Grocery stores: Offer coupons to price sensitive consumers (people whose demand is inelastic won’t bother to cut coupons, thus will pay more for the same products as price sensitive consumers who take the time to collect coupons).
• Quantity discounts: Grocery stores give discounts for bulk purchases by customers who are price sensitive (think “buy one gallon of milk, get a second gallon free”… the family of six is price sensitive and is likely to pay less per gallon than the dual income couple with no kids who would never buy two gallons of milk).
• Dell Computers: Dell price discriminates based on customer answers to questions during the online shopping process. Dell charges higher prices to large business and government agencies than to households and small businesses for the exact same product!
• Hotel room rates: Some hotels will charge less for customers who bother to ask about special room rates than to those who don’t even bother to ask.
• Telephone plans: Some customers who ask their provider for special rates will find it incredibly easy to get better calling rates than if they don’t bother to ask.
• Damaged goods discounts: When a company creates  and sells two products that are essentially identical except one has fewer features and costs significantly less to capture more price-sensitive consumers.
• Book publishers: Some paperbacks cost more to manufacture but sell to consumers for significantly less than hard covers. Price sensitive consumers will buy the paperback while those with inelastic demand will pay more for the hard cover.
• Airline ticket prices: Weekend stayover discounts for leisure travelers mean business people, whose demand for flights is highly inelastic, but who will rarely stay over a weekend, pay far more for a roundtrip ticket that departs and returns during the week.

McAfee also goes into a fascinating discussion of price dispersion which is essentially a theory of oligopoly pricing. All Econ teachers should watch this video and find examples of price discrimination and oligopoly pricing that they can incorporate into their own class.

If you’re up for a challenge, try deciphering some of the mathematics in McAfee’s free, downloadable intro to economics text, available here.

Related posts:

1. Price Discrimination 101
2. Microeconomics teachers: Have you discovered Econgirl yet?
3. From heart transplants to watermelons: Understanding price elasticity of demand

YOUmoz | Price Discrimination in Pay Per Click Advertising

The article above gives a great introduction to and several examples of price discrimination among firms with market power. Read the excerpt below then discuss the questions that follow in your comments:

For any product or service, different people have different prices they are willing to pay. If you ever took an Economics course you surely remember the downward sloping demand curve, which is a graphical way of saying that you’ll get more buyers at a low price and fewer buyers at a high price. For a business that cannot price discriminate, this poses a problem. What price to offer?

There might be some consumers willing to pay 80, but twice as many consumers willing to pay 50. If you set the price at 50, you get more revenue, but the people who are willing to pay 80 are happy that your offering was 30 less than they were willing to pay. (Economists call this consumer surplus.) The ideal situation for the business would be to sell to some consumers at 80 and others (the price sensitive ones) at 50. Price discrimination – charging each consumer close to what he or she is willing to pay – increases revenue for the business.

Business strategists are forever trying to figure out ways to price discriminate. For commodities it can be difficult, but some markets are conducive to price discrimination. The classic example is the airline industry. Travelers have different itineraries and routes, and the airlines purposely impose complex pricing rules (e.g. cheaper if you stay over a Saturday) in order to price discriminate. Business travelers typically end up paying more than leisure travelers, and if you fly into or out of a small city you pay more than between large cities. On a flight with 100 passengers, it is possible that everyone paid a different price for the seat – 100 different prices for the same product. Consumers often resent these schemes, but economists love them.

Movie theaters price discriminate by charging lower admission for kids and seniors. Everyone gets the same product – a seat in the theater – but consumers that are more price sensitive pay less. Car dealers discriminate based on how much the customer haggles. Sellers of new products, especially consumer electronics, often price discriminate over time. When the iPhone was first released, consumers willing to pay $600 got to buy it. A couple months later, Apple lowered the price and a larger segment of the public was willing to buy. Apple could have charged $400 from the beginning, but then they would have lost all that revenue from the people willing to pay $600.

Buyers often feel like they are being played for chumps when they learn about price discrimination, but many economists absolutely are crazy about it and wish we had more price discrimination. Businesses are encouraged to make prices secret – create a fog of uncertainty – to get customers to accept prices offered to them. Preston McAfee, an economics professor at the California Institute of Technology, gave a talk about prices. He raves about Dell selling the same computer at different prices based on how the consumer identifies themselves at the website (small business, large business, home users).

Discussion Questions:

1. Who suffers as a result of price discrimination?
2. Who benefits from price discrimination and how do they gain?
3. Is society as a whole better or worse off when a monopolist is able to price discriminate? Explain…

Related posts:

1. McAfee on Price Discrimination: a must-read for teachers of Microeconomics
2. From heart transplants to watermelons: Understanding price elasticity of demand
3. Being discriminated in Singapore…

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”?

All of Inflation’s Little Parts – The New York Times

This is really cool… The Bureau of Labor Statistics releases monthly data on prices to let Americans know just how much inflation affects their livelihoods. The Consumer Price Index, which is studied in both AP and IB Economics, consists of a “basket of goods”, that when bundled together represent the “typical” American consumer’s expenditures. The CPI is broken into a few broad categories:

Here’s the cool part, though… within each broad category the BLS tracks the prices of dozens of specific categories, around 200 to be precise. Each of these is then broken down into individual products, around 84,000 in total! The task of tracking the prices of 84,000 individual goods and services every month is daunting, and just thinking about the tedium of this job makes me glad I’m a teacher!

The New York Times has assembled what can only be described as a mosaic of consumption, organizing the 200 specific CPI categories into what looks like an ornate stained-glass window, in which the size of each piece of glass represents the percentage of Americans’ income that go towards each specific category. Some of the categories represented in this mosaic include items such as:

This graphic is a great tool for teaching and understanding the Consumer Price Index, not to mention a beautiful pattern for any stained-glass artist looking for inspiration!
nyt-cpi-graphic

Related posts:

1. Unemployment and inflation: understanding the Fed’s balancing act
2. Enter the age of inflation…
3. Inflation in the headlines!

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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BBC NEWS | Technology | Nintendo warns of Wii shortages

Looks like Brits dreaming of the Wii from Nintendo may have to wait a while longer this holiday season, as British retailers are finding it nearly impossible to fill customers’ orders. It turns out there is quite a shortage for the hot new gaming system from Nintendo!

“Although we’re receiving regular deliveries from Nintendo, Sony and Microsoft and getting the products onto the shelves as fast as we can – it’s possible that demand will outstrip supplies on some products, for example the Nintendo Wii, which has been hugely popular all through the year,” read a statement from high street gaming specialist Game…

“The Nintendo Wii consoles have proved extremely popular with our customers and have been flying off the shelves whenever we get new stock in,” said a spokeswoman.

It seems like the shortage of Wii’s in the UK should send a message to Nintendo and its retailers: RAISE THE PRICE!! One way retailers have tried to do this is by bundling the consoles with up to three or four games, meaning to take home a console shoppers would have to fork over 300 GBP. This seems like a great strategy for retailers faced with strong demand from customers, given that they are probably not allowed to charge above Nintendos suggested retail price for the console itself.

It is too bad Nintendo cannot figure out how to price their consoles more effectively to avoid such shortages. Given that the Wii is the cheapest of the three main video game consoles, a price hike would seem the logical response to such shortages as that in the UK. So why isn’t Nintendo raising their price? What rational reason might they have for keeping the price low? The Undercover Economist, Tim Harford, wrote an article two years ago about the XBox 360, which at the time was experienced excess demand similar to that in the market for Wii’s right now. Here’s his reasoning for why companies like Microsoft and Nintendo may keep prices irrationally low in times of shortages:

Why don’t companies raise prices when supply is short and demand is frenzied? Leaving aside oxygen and a few other essentials, there is no such thing as an absolute shortage of anything: There is only a shortage if the price is too low. At the moment, Microsoft is easily selling out the half-million or so Xbox 360 units (there’s no official number) for prices starting at $300 for the basic package. Why doesn’t Microsoft price them at $700 instead? That’s the figure that the consoles are fetching on eBay.

Perhaps the sellouts are supposed to generate free publicity. By deliberately giving Xbox consoles away too cheaply today, Microsoft gets the column inches before Christmas, and that may boost demand and sell more in the long run. If you had put that theory to me last year I might have believed it, but after all the hot air over gasoline prices this fall, no longer. It’s now obvious that you can get just as much publicity by raising prices as you can by selling out at low prices. But raising prices makes money, and creating lines of frustrated customers who can’t get the product doesn’t.

Maybe Microsoft is worried that this would be the wrong kind of publicity, because customers would dislike a price hike. That’s possible, but the publicity is already bad: Many empty-handed customers seem convinced that Microsoft has a secret hangar in Roswell stuffed full of Xboxes that they’ve decided not to release just yet.

In any case, strange as it may seem, even if the consoles sold out at a higher price, the average Xbox aspirant wouldn’t be any worse off: The increased price should be exactly balanced by the shorter lines, reduced aggravation, and greater chance of getting a console. Customers are infuriated by the shortage itself, whether that shortage is expressed in lines (as it is today) or in high prices (as it could be if Microsoft raised them). If Microsoft is going to aggravate its customers, why doesn’t it at least make a buck out of it?

Harford then goes on to share the ideas expressed my his friends in several different universities’ economics departments about why companies like Nintendo and Microsoft don’t raise their prices in times of shortage. If you’re interested in the various theories, click here.

What about you? Do you think the execs at Nintendo are simply ignorant to the laws of Demand? Shortages should send the clear signal that price is too low, and that demand is highly inelastic, meaning that an increase in price should clearly lead to an increase in total revenue, and therefore greater profits for Nintendo. So why do you think they don’t take this opportunity to raise their profits?

If you haven’t seen it yet, check out this excellent podcast by two AP Econ students at SAS about the video game console market! SAS Economists Podcast #6: The oligopolistic nature of the video game console market.

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Freakonomics: Monkey Business: Keith Chen’s Monkey Research

No I’m not talking about the latest freshman class at an Ivy League school… rather a group of monkeys at Yale that have been taught how to use money:

The essential idea was to give a monkey a dollar and see what it did with it. The currency Chen settled on was a silver disc, one inch in diameter, with a hole in the middle — ”kind of like Chinese money,” he says. It took several months of rudimentary repetition to teach the monkeys that these tokens were valuable as a means of exchange for a treat and would be similarly valuable the next day. Having gained that understanding, a capuchin would then be presented with 12 tokens on a tray and have to decide how many to surrender for, say, Jell-O cubes versus grapes. This first step allowed each capuchin to reveal its preferences and to grasp the concept of budgeting.

Turns out the law of Demand is not only true for humans but for monkeys too. When Chen “lowered the price of grapes”, monkeys would buy more grapes and less Jell-O, following the basic rule of utility maximization. Interestingly, the introduction of money led to more than just the simple exchanges of currency for candy and cucumber; the monkeys were also taught to gamble. Through their observations of several gambling scenarios, the researchers found monkeys tended to display “loss averse” behavior in games of chance, leading to an amusing conclusion:

The data generated by the capuchin monkeys, Chen says, ”make them statistically indistinguishable from most stock-market investors.”

Sadly, gambling was not the only vice that accompanied the introduction of money in to monkey society:

Then there is the stealing. Santos has observed that the monkeys never deliberately save any money, but they do sometimes purloin a token or two during an experiment.

But the debauchery does not stop with gambling and theft:

Perhaps the most distinguishing characteristic of money, after all, is its fungibility, the fact that it can be used to buy not just food but anything. During the chaos in the monkey cage, Chen saw something out of the corner of his eye that he would later try to play down but in his heart of hearts he knew to be true. What he witnessed was probably the first observed exchange of money for sex in the history of monkeykind. (Further proof that the monkeys truly understood money: the monkey who was paid for sex immediately traded the token in for a grape.)

As if we needed any proof beyond the widespread immorality and loss of values that distinguish many rich human societies, the steep decline of monkey morality observed at Yale can only be attributed to the introduction of currency! The implications of the Yale study on economics are clear: humans are not necessarily unique in our understanding of currency as a means of exchange. As long as money has imbued human societies, the wont to enrich ourselves through immoral means such as gambling, theft and prostitution has stained civilizations from ancient Mesopotamia to modern America.

When taught to use money, a group of capuchin monkeys responded quite rationally to simple incentives; responded irrationally to risky gambles; failed to save; stole when they could; used money for food and, on occasion, sex. In other words, they behaved a good bit like the creature that most of Chen’s more traditional colleagues study: Homo sapiens.

To make a more poignant observation, one thing is clear and disturbing, among the human societies today, Americans are most like monkeys when it comes to saving.

Discussion Questions:

1. Of the various functions of money, which role does money play for monkeys?
2. What gives the money used by the monkeys its value?
3. Discuss the evidence from this article suggesting that monkeys follow the law of demand.
4. What is the utility maximization rule and what evidence from this article supports the suggestion that monkeys follow this rule?
5. How are monkeys more similar to American consumers than to, say, Japanese or Chinese consumers?

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