The tools of economics can be applied to almost any social institution, even the decision of individuals in society whether or not to have children. All over the rich world today, potential parents have decided against having babies, the result being lower fertility rates across much of Europe and the richer countries in Asia, including Japan, South Korea and Singapore. Lower fertility rates have some advantages, such as less pressure on the country’s natural resources, but the disadvantages generally outweigh the benefits.

The story below, from NPR, explains in detail some of the consequences of declining fertility rates in the rich world, and identifies some of the ways governments have begun to try to increase the fertility rates.

The problem of declining fertility rates can be analyzed using simple supply and demand analysis. In the graph below, we see that the marginal private cost of having children in rich countries is very high. The costs of having children include not only the monetary costs of raising the child, but the opportunity costs of forgone income of the parent who has to quit his or her job to raise the child or the explicit costs of child care, which in some countries can cost thousands of dollars per month. Marginal private cost corresponds with the supply of babies, since private individuals will only choose to have children if the perceived benefit of having a baby exceeds the explicit and implicit costs of child-rearing.

The marginal private benefit of having babies is downward sloping. This reflects the fact that if parents have just one or two children, the benefit of these children is relatively high, due to the emotional and economic contributions a first and second child will  bring to parents’ lives. But the more babies a couple has, the less additional benefit each successive child provides the parents. This helps explain why in an era of increased gender equality, families with three or more children are incredibly rare. The diminishing marginal benefit experienced by individual couples applies to society as a whole as well, therefore the market above could represent either the costs and benefits of individual parents or of society at large.

Notice, however, that that the marginal social benefit of having babies is greater than the marginal private benefit. In economics terminology, there are positive externalities of having babies; in other words, additional children provide benefits to society beyond those emotional and economic benefits enjoyed by the parents. The podcast explained some of these external, social benefits of having children: a larger workforce for firms to employ in the future, more people paying taxes, allowing the government to provide more public goods, more workers supporting the non-working retirees of a nation, and more competitive wages in the global market for goods and services. Higher fertility rates, in short, result in more economic growth and higher incomes for a nation.

When individuals decide how many children to have, they make this decision based solely on their private costs and benefits, since the external benefits of having more babies are enjoyed by society, but not necessarily by the parents themselves. Therefore, left entirely alone, the “free market” will produce fewer babies (Qe) than is socially optimal (Qso).

So what are Western governments doing about low fertility rates? The podcast identifies several strategies being employed to narrow the gap between Qe and Qso. In Australia households receive a $1000 subsidy for each baby born. In Germany mothers receive a year of paid leave from work. Here in Switzerland mothers get three months of government paid leave and $200 a month subsidy to help pay for child care after that. Each of these government policies represents a “baby subsidy”. In the graph above, we can see the intended effect of these policies. By making it more affordable to have children, governments are hoping to reduce the marginal private cost to parents, encouraging them to have more children, which on a societal level should increase the number of babies born so that it is closer to the socially optimal level (Qso).

Unfortunately, as the podcast explains, it appears that parents are relatively unresponsive to the monetary incentives governments are providing. This can be explained by the fact that the private demand (MPB) for babies is highly inelastic. Even if the “cost” of having a baby falls due to government subsidies, parents across the Western world are reluctant to increase the number of babies they have.

As we can see in the graph above, a subsidy for babies reduces the marginal private cost of child-rearing to parents. But the MPB curve, representing the private demand for babies, is highly inelastic, meaning the large subsidy has minimal effect on the quantity of babies produced. Without the subsidy, Qe babies would be born, while with the subsidy only Qs are born, which is closer to the socially optimal number of births at Qso, but still short of the number of births society truly needs.

The “market for babies” in rich countries is failing. Because of the positive externalities of having children, parents are currently under-producing this “merit good”. One of two things must happen to resolve this market failure. Either the marginal private costs of having babies must fall by much more than the government subsidies for babies have allowed, or the marginal private benefit must increase. Either larger subsidies are needed, or some moral revival aimed at encouraging potential parents to consider both the private and social benefits of having children when making their decisions.

Don’t you love economics? We make everything seem so logical! And like they say, it all comes down to supply and demand!

Discussion Questions:

1. What makes low fertility rates among parents in the rich world an example of a “market failure”?
2. What are the primary reasons fertility rates are lower in the rich world than they are in the developing world?
3.  What are the economic consequences of lower birth rates? What are the environmental consequences of lower birth rates? Should government be trying to increase the number of babies born?
4. Why have government incentives for parents to have more babies failed to achieve the fertility rates that government wish they would achieve?
5. Do you believe that government can create strong enough incentives for parents to have more babies? If not, what will become of the populations of Western Europe and the rich countries of Asia given today’s low fertility rates? Should we be worried?

Related posts:

1. Market Failure and Bullets
2. “I am the condom friend ever useful to you”
3. Market failure versus Government failure – what should we be more concerned about?

Milk seems like such a nice friendly product, but in New Zealand the rising cost of the essential good is getting everyone annoyed. In the past 5 years the price of dairy products in New Zealand has risen by 50%. Most assume that because of New Zealand’s comparative advantage (good weather, soils, grass growth and livestock) farmers produce milk in such great quantities that it should therefore also be cheap for consumers at the local shop. Our understanding of international trade is that it alters the domestic market, might suggest that firms who export on the global market are focused and motivated by world prices.

The NZ milk market

Fonterra is a virtual monopsony in New Zealand. This is like a monopoly except that the cooperative it is the sole buyer of raw milk products in New Zealand. It then sells 95% of its production of refined milk products to consumers around the world. The company supplies around 40% of global dairy product exports, and is by far New Zealand’s biggest company.

Related posts:

1. The problem with price controls in Europe’s agricultural markets
2. McAfee on Price Discrimination: a must-read for teachers of Microeconomics
3. Product differentiation in imperfectly competitive markets – the MacBook Wheel

The Global Coal Trade’s Complex Calculation : NPR

Sometimes when I read the news, I wonder what it would be like to NOT understand basic economics, and then I realize how much of what goes on around us can be explained by two simple concepts: demand and supply. The NPR story below talks about how the construction of two proposed coal exporting facilities on America’s west coast could, indirectly, lead to a greener future for America. Listen to the story then read on for more analysis:

China, already the world’s largest coal consumer, continues to build new coal burning electricity plants at an alarming rate. Its appetite for the “black gold” has driven the world price up to $100 per ton, as it has demanded increasing quantities from its own coal producers, but also those in other coal rich areas like Australia and the United States.

However, because of America’s lack of coal transporting and shipping infrastructure, US coal producers have been unable to sell their abundant coal to the Chinese, who are willing to pay 500% the equilibrium price in the US. The US market has remained isolated from the world market, not due to any explicit, government-imposed barriers to trade, rather due to fact that they simply can’t get their coal to the Chinese energy producers who demand it most.

Graphically, this situation can be illustrated as follows:

If the export facilities on the West coast of the US are not constructed, it will remain difficult for US coal producers to sell their output to China at the high price of $100, and the domestic quantity (Q2) will continue to be produced and sold for $20 per ton. But with the new port facilities, US energy producers will now have to compete with Chinese energy producers for American coal, and the US price will be driven up to the world price, since demand now includes thousands of Chinese coal-fired power plants. As the price rises from $20 to $100, the domestic quantity demanded in the US will fall to Q1, as domestic energy producers seek alternative sources of energy, switching instead gas, solar, or wind power.

The irony is that through increasing the ease with which American coal producers can sell their product to China, the US may reduce its own consumption of coal and its emissions of greenhouse gasses. Overall coal production in the US will rise with increased trade, but overall consumption within the US will fall.

Now, this may sound great if you’re the kind of person who thinks only locally. Air pollution will be reduced in the US, health will be improved, our electricity production will be greener and more sustainable. But globally, by making its coal available to China, the US market will contribute to the continued dependence on carbon-intensive energy production, and delay any progress among Chinese energy producers towards a transisttion to greener fuel sources.

The podcast also points out the fact that if the US did undertake the construction of the new coal-exporting facilities, it could be that the current high price of coal will have led to the entrence of several other large coal prodcuing countries into the world market, reducing China’s demand for US coal, reducing the price at which American producers can sell to China and thereby off-setting any domestic environmental benefit that may have resulted from the large decrease in quantity demanded among US producers at the current price of $100 per ton.

The whole conversation about the coal industry is somewhat depressing when the environmental costs of the industry are considered. Another NPR show, Planet Money, ran a story this week about the “gross external damages” caused by the production of coal-powered electricity. They cited a study which found that the damages caused by coal to human health and the environment outweight the benefits enjoyed by society from the generation of cheap electricity by around $10 billion in the United States alone. This means that if the US shut down every coal-powered energy plant in the country immediately, total welfare in the US would increase by $10 billion. There’s no doubt that energy prices would rise, but the gains in human and environmental health would outweight the added costs of electricity generation by $10 billion. If a similar analysis were undertakein in China, I would guess the potential welfare gain of transitioning to alternative energies would be far greater for the Chinese people.

Here’s the chart from Planet Money’s blog showing the net welfare loss of coal-generated electricity and other economic activities in the United States.

*GED = Gross external damages from pollution

Discussion questions:

1. How would the construction of two coal-exporting facilities on America’s West coast ultimately lead to a cleaner environment in the United States? Do you think this prediction is realistic?
2. Who stands to gain the most if the coal-exporting facilities are constructed? Who would suffer? In your opinion, should the facilities be constructed? Why or why not?
3. Interpret the colorful diagram above. What do the green bars represent? What do the yellow and red bars represent? According to the graphic, which type of activity is most harmful to American society? How do you know?
4. True, false, or uncertain. Explain your reasoning. “The burning of coal to make electricity should be completely banned in China, since China is the world’s largest greenhouse gas emitter.”

Related posts:

1. Tit, tat, tariff… China and America’s latest shoving match is underway
2. Supply and demand shifters and the price of pork in China
3. Monopoly prices – to regulate or not to regulate, that is the question!

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

I feel like I’ve been here before. Gas prices are rising, approaching $4 per gallon. American drivers are freaking out, demanding the government “does something” to halt rising fuel costs. The next thing you know, people start buying bikes and riding them to work. Just like that, Americans change their lifestyles, abandon their cars, and reinvent themselves as bike commuters!

Visit msnbc.com for breaking news, world news, and news about the economy

The economics of this phenomenon barely requires explanation, but since this is an Economics teacher’s blog, I suppose I should explain it. A major determinant of the demand for a product is the price of related goods. In the US right now, fuel and cars are related goods; in economics terms, they are complementary goods. “You can’t have one without the other”. As gas prices rise, demand for driving cars begins to fall, since it becomes more costly to drive. The other good related to cars in this picture is a substitute mode of transportation, bicycles. The more expensive it becomes to drive a car, the greater the demand for bicycles.

Now, allow me to take my econ teacher hat off and put my avid cyclist hat (or helmet?) on. Bikes are way more than just a substitute for cars. The fact that every time gas prices approach $4 per gallon bicycle sales start to spike is bewildering to me. Do consumers really not know that riding a bike is always cheaper than driving a car? Why does it take slightly more expensive gas to motivate consumers to think about buying a bike?!

Okay, economist had back on now: You see, operating a car involves monetary costs that far exceed the price of gas. When I last had a car in the US, I paid nearly $200 per month in insurance (young males always pay the most), far exceeding my expenditures on fuel. In addition, there’s the fixed cost of the car itself, which once spent is a “sunk cost”, so should not affect an individual’s decision to drive or not to drive when the price of gas changes.

In addition to these explicit, monetary costs, however, there are also external, invisible costs of operating cars that make them an even less perfect substitutes for bicycles. More traffic on the roads, more accidents, more air and noise pollution, greenhouse gas emissions, environmental impact of the production and ultimate disposal of the car itself: these external costs are not even born by the driver when he or she decides to drive to work every day, rather they are born by society, taxpayers, and the environment.

My point is, making the decision to switch to commuting by bicycle should not require a 25% spike in fuel prices. The cost of filling your tank is in fact the least significant cost associated with driving a car when you look at the whole picture, and include not only those explicit, monetary costs paid by the driver, but include the external, social and environmental costs born by society as a whole.

Maybe I’m just on a bike high right now, since I got my new 29 inch wheeled fully two weeks ago and have ridden the 30 km round trip to work nearly every day since! Then again, maybe it really would make more economic, environmental, physical, spiritual and social sense if more people would park their cars and hop on a bike tomorrow morning!

Related posts:

1. Mali’s Weed: Is this an economic development, economic growth, supply or demand issue??
2. Eight basic economic arguments against a bailout of the auto industry

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

It’s that time of the IB Economics course when I get to start teaching my year one students to write the dreaded Internal Assessment Commentaries. For their first IA, my students are writing a commentary on an article relating to Section 2.1 and 2.2 of the IB course, on supply, demand, market equilibrium and elasticities.

After reading a dozen or so out of my 38 students’ first drafts, I began to realize that what many of them needed was a clearer idea of what a good IB Economics commentary should look like. So I went back through past years’ commentaries and decided in the end just to write a sample commentary myself.

As you know, I do a lot of economics writing, so I thought this would be a breeze; I’d bust out a 700 word commentary modelling to my students what a top IA should look like. Well, I did it, but it proved to be much harder than I thought it would be. Why? Because after my first draft I was at 1100 words! The word limit, as IB students know, is 750, so I proceeded to spend as much time as it took me to write figuring out how to get it down to within the word limit.

Well, I did it. Below is my sample commentary for year one IB students. I do owe some credit to a past student of mine, Maren, whose article I stole and whose own commentary I adapted to write this one.

First, here’s the link to the article:

Where is Switzerland’s Cheapest Place to Live? – SwissInfo

And my commentary:

Introduction of theory:
Demand, supply and elasticity are basic economic concepts that when applied to different markets can help governments and individuals make informed decisions about things as basic as where to live and how to collect taxes.

Connection to article:
Recently, Credit Suisse conducted a survey and determined that Switzerland’s most expensive canton is Geneva, while the cheapest place to live is Appenzell Inner Rhodes, (AIR)

Analysis:
Demand is a curve showing the various amounts of a product consumers want and can purchase at different prices during a specific period of time. Supply is a curve showing the different amounts of a product suppliers are willing to provide at different prices. Equilibrium price and quantity are determined by the intersection of demand and supply. Price elasticity of demand (PED) indicates the responsiveness of consumers to a change in price, and is reflected in the relative slope of demand.

In the graph below, the markets for housing in Geneva and AIR are shown.

Demand for housing in Geneva (Dg), is high because of the many employment opportunities there. In addition, Geneva’s scarce land means supply of housing is low, resulting in a high equilibrium rent (Rg). Demand for housing in Geneva is inelastic, since renters in Geneva are less responsive to changes in rent compared to AIR, perhaps due to the perceived necessity of living close to their work.

Demand for housing in AIR (Da) is low, but supply is high due to the abundance of land. AIR is a rural canton with few jobs, therefore fewer people are willing and able to live there than in Geneva. Since living in the countryside is not a necessity, demand is relatively elastic, or responsive to changes in rent. The lower demand and greater supply make the AIR’s equilibrium rent relatively low.

The effect of a tax on property is a shift of the supply curve to the left and in increase in rents as landowners, forced to pay the canton a share of their rental incomes, raise the rent they charge residents.

In Geneva, property taxes are high, but this has little effect on the quantity demanded.

Geneva’s property tax shifts the supply of housing leftwards, as fewer landlords will be willing and able to supply properties to renters when the canton taxes rental incomes. However, the decrease in quantity demanded is proportionally smaller than the increase in the price caused by the tax, since demand for housing in Geneva is highly inelastic, or unresponsive to the higher price caused by the tax.

Renters in AIR are far more responsive to higher rents caused by property taxes, perhaps because living in AIR is not considered a necessity and there are more substitutes for rural cantons to live in. Renters in Geneva do not have the freedom to live in one of Switzerland’s many rural cantons, and are therefore less responsive to higher rents resulting from cantonal taxes.

Evaluation:
A tax decrease in AIR could lead to a significant increase in the number of people willing to live there, since renters are highly responsive to lower taxes. To some extent, housing in AIR and Geneva are substitutes for one another. Lower taxes in AIR would make living there more attractive, and subsequently the demand for housing in Geneva would fall putting downward pressure on rents there. People would move to AIR, attracted by lower rents, and commute to work in the cities. According to the article, this is already happening:

The disparity in the amount of disposable income… has increased the trend of people moving cantons for financial reasons… Economic necessities had led to an increase… of people moving address and opting to commute into work”.

There are many determinants of demand for housing in Switzerland, the primary one being location. High rents in Geneva are explained by the high demand for and the limited supply of housing. On the other hand, residents in AIR enjoy much lower rents, due to the weak demand and abundant land. Cantons should take into consideration the PED for housing when determining their property tax levels. Raising the tax Geneva will have little effect on rentals but could create substantial tax revenue. On the other hand, reducing taxes in AIR may attract many households away from the city to the countryside, drawn by the lower rents and property taxes.

Applying the basic principles of demand, supply and elasticity to Switzerland’s housing market allows households and government alike to make better decisions about where to live and how much to tax citizens.

Note: To see the full commentary including a cover page and highlighted article, click here

Related posts:

1. Sample IB Economics Internal Assessment Commentary – Understanding the ECB’s bond-purchasing program
2. Exports, good – Imports, ALSO GOOD!
3. When more tax is good tax…

Energy Roundup – WSJ.com : In Today’s Journal: Easing Back on the Gas

Here’s a great example of a market in disequilibrium:

“Amid an abundance of natural-gas supplies and soft prices, gas producers are starting to pull the plug. Chesapeake Energy Corp. said it will cut 6% of its gas production in September in response to low natural-gas prices. The Oklahoma City-based company will also reduce its capital spending by 10% in 2008 and 2009. Other natural-gas producers are cutting back their output as well, analysts said.”

We learn in IB and AP Economics that markets are generally efficient thanks to the signals that prices send from consumers to producers to determine where scarce resources should be allocated. We’ve also learned how supply and demand interact in a market (such as that for natural gas) to determine equilibrium price and quantity. In the above example, there exists a disequilibrium, where either the quantity demanded exceeds the quantity supply (a shortage), or the quantity supplied exceeds the quantity demanded (a surplus).

Based on the excerpt above, discuss the causes and effects of the disequilibrium in the natural gas market. Are resources being under or over-allocated towards gas production right now? What about in a month or two? On a piece of scratch paper, sketch a supply/demand diagram and illustrate the above scenario. Describe the shifts you would draw in such a diagram.

Discussion questions:

1. What is meant by “soft prices” in the natural gas market? Assuming output by gas producers remained constant, what must have changed to cause the soft prices?
2. How have firms responded to soft prices? Does the reaction of the gas companies support the law of supply? Explain
3. In the next month, what will happen to supply of natural gas?
4. What may happen in the natural gas market  if firms reduce capital spending in the next two years?

Once you’ve read this post, thought about the situation in the gas market, and commented below, read this for a clear, concise explanation of the situation from a college professor, or click here: Environmental Economics: A demand and supply example

Related posts:

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2. Beijing caves in to the indisputable power of the MARKET!
3. As Chinese planes take off, prices may be coming in for a landing

This article was originally published on May 12, 2008. It is being re-published since it relates to our current units in AP and IB Economics.

The Associated Press: Gas prices knock bicycle sales, repairs into higher gear

Greg Mankiw has an ongoing series of posts linking to articles illustrating the impact that rising gas prices have had on demand in markets other than that of the automobile.

One of the determinants of demand for goods and services is the price of related goods and services. As gas prices rise, drivers tend to switch from automobiles to alternative forms of transportation. A few days ago I blogged about the switch from tractors to camels in India, one illustration of the relationship between the price of one good and demand for its substitutes. Mankiw has so far linked to articles about the impact of high gas prices on demand for bicycles, small cars and mass transit.

These three “goods” are all substitutes for the most common form of transport among Americans, the private automobile (often times a gas-guzzler in “the bigger the better” America). When the price of a good like personal vehicular transport increases (in this case due to the price of an input required in private cars, gasoline), the demand for a substitute good will increase.

In the case of bicycles, evidence indicates that just such a change in demand is already underway in America today:

Bicycle shops across the country are reporting strong sales so far this year, and more people are bringing in bikes that have been idled for years, he said.

“People are riding bicycles a lot more often, and it’s due to a mixture of things but escalating gas prices is one of them,” said Bill Nesper, spokesman for the Washington. D.C.-based League of American Bicyclists.

“We’re seeing a spike in the number of calls we’re getting from people wanting tips on bicycle commuting,” he said.

Interestingly, the increase in demand for bicycle travel in response to high gas prices might be even more pronounced due to America’s sluggish growth, 4% inflation and rising unemployment. Real wages have seen little gain in the last couple of years as growth has fallen close to zero while prices have continued to rise. It may be possible that a fall in real incomes in America has spurred new demand for bicycle transportation, which could be considered an inferior good, meaning that as household incomes fall, consumers demand more bicycles for transportation.

Since bicycles represent such a drastically cheaper method of transportation, high gas and food prices, a weak dollar, and falling real wages accompanying the economic slowdown have had a negative income effect on American consumers, leading to increases in demand for inferior goods such as bicycle transportation

That said, having worked in a bike shop myself for two years in college, I can say that most consumers looking at new bicycles are not doing so because of falling incomes. Quite the opposite, in fact, indicating that new bicycles are normal goods (those for which as income rises, demand rises). However, the article states that in addition to increases in new sales, “more people are bringing in bikes that have been idled for years”.

It may be that while new bicycles themselves are normal goods, bicycle transportation as a whole is an inferior good. The increase in demand for new bicycles could be explained by the substitution effect (as the price of motor vehicle transportation rises, its substitute, bicycle transport, becomes more attractive to consumers) and at the same time explained by the income effect too (as real incomes have fallen, demand for the bicycle transport has risen).

This phenomenon is an excellent illustration of how the income and substitution effects work in conjunction to explain the inverse relationship between price and quantity demanded for automobiles (the law of demand), as well as the concept of cross-price elasticity of demand between two substitute goods.

Discussion Questions:

1. Both the price of substitute goods and income affect demand for a particular product. How have both the prices of substitutes for bikes and the income of bike consumers influenced the demand for bicycles in different ways?
2. What is the definition of an “inferior good” in economics?Do you believe bicycle transportation is an “inferior good”?
3. Are all bikes the same? Do you think demand for some bicycles responds differently to changes in income than demand for other bicycles?

Related posts:

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2. Supply and demand shifters and the price of pork in China
3. What does a good IB Economics Commentary look like?

Chocolate Sales: A Sweet Spot in the Recession – TIME

Living in Switzerland, I find an article featuring a local business from the town my school is in irresistible, particularly when it appear in TIME magazine. Lindt chocolate, the company featured in this article, manufactures its delicate treats right down the hill from the ZIS campus, which means that when the wind is just right, you can just catch the scent of fresh, creamy chocolate wafting up the hillside while walking to campus.

Lindt, as well as its global competitors in the chocolate business, is enjoying surge in demand even while countless other industries are forced to cut back production, lay off workers, and close their factory doors. From TIME:

While the credit crisis has slowed down sales of everything from cars to organic groceries, people seem happy to keep shelling out for chocolate. Last year, as the global recession was gaining ground, Swiss chocolate makers bucked the trend with record sales — nearly 185,000 tons, an increase of 2% over 2007, sold domestically and in 140 export markets…

“Switzerland’s image sells well abroad, and nothing says ‘Switzerland’ more than chocolate,” says Stephane Garelli, director of the World Competitiveness Center at the Institute of Management Development (IMD) in Lausanne, predicting that this comfort food will continue to sweeten the sour economy for months to come…

“Now that people don’t have a new television or a new car,” he noted, “they eat a bit more chocolate.”

“Chocolate is one of the more recession-resilient food sectors,” says Dean Best, executive director of Just-Food, a U.K.-based news and information website for the global food industry. “With consumers eating out less and eating at home more, there is evidence that they are still allowing themselves the occasional indulgence — and chocolate is a relatively inexpensive indulgence.”

But the question of why there is no meltdown in the chocolate business may be more a matter of psychology than economics. “There is well-documented evidence going back to Freud, showing that in times of anxiety and uncertainty, when people need a boost, they turn to chocolate,” says Garelli of the IMD. “That’s why when the economy is bad, chocolate is still selling well.”

Which goes to show that chocolate is more than a candy treat — it’s real food for the soul.

So does this mean chocolate is an inferior good, or one for which demand increases as incomes fall? I doubt many Swiss chocolate producers would consider their product inferior, but perhaps it does fit the definition.

On the other hand, perhaps the reason demand for chocolate increases during a recession has more to do with the substitution effect than the income effect. As people eat out less, they consume fewer expensive deserts at restaurants and instead fill their shopping baskets with more affordable dessert options for the home. I can say from experience that this is the case for myself.

Living in Switzerland, I find myself rarely going out to eat at restaurants, an activity reserved for special occasions in this country where a steak can set you back 75 dollars. Instead, I eat at home almost every night, and nothing is more appealing to me, especially during hard economic times, than a bar of delicious chocolate after a home cooked meal. Demand for chocolate may rise during recessions simply because the demand for one of its substitutes (restaurant desserts) falls.

Discussion questions:

1. Do you think chocolate is an inferior good or a normal good? What’s the difference? What types of goods do YOU consome more of when you find yourself faced with a tighter budget?
2. Does economics have a good explanation for the above situation? The article mentions Freud, a pioneer in  the field of psychology; do humans’ economic behavior always appear rational?
3. If chocolate were an inferior good, what would happen to chocolate sales when the global economy finally turns around and incomes start increasing? What do you think will happen to chocolate sales when the economy starts imrpoving? Explain.

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2. It may not be a recession, but it sure feels like one…
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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?

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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.

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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”.

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In  IB Economics, we are currently learning about how firms in imperfectly competitive markets differentiate their products in order to increase their market power and their price-making power.

In a market with a few large firms such as the laptop computer market, companies must do what they can to increase demand for their own products over those of their competitors. Apple Computer is an example of a company that has successfully differentiated its line of laptop computers in recent years, regularly improving the features of its line of MacBooks to attract consumers away from its competitors and into the world of Macs.

Last year Apple launched the MacBook Air, the lightest and thinnest laptop on the market, creating a huge buzz in the technology world and converting millions to Apple’s line of laptops. This year, Apple has launched yet another innovation in laptop computing, in the hope of once again increasing demand for its products, and making consumers think they cannot live without the sleek, shiny Apple computers. This year’s innovation? The “MacBook Wheel”… watch:

Apple Introduces Revolutionary New Laptop With No Keyboard

The goal of an imperfectly competitive firm like Apple is to increase its market power by increasing demand for its particular product through product differentiation, advertising, developing brand loyalty, and “hype”: all forms of non-price competition. If Apple were to simply charge a lower price than its competitors for its products, it would also succeed in increasing the amount of computers it sells to consumers, but may also end up accepting lower profits due to the lower prices it must sell for.

Through differentiation, which means making its products unique and attractive to consumers, Apple attempts to increase market demand for its computers, while simultaneously making demand less elastic. With higher, more inelastic demand, Apple gains price-making power over the laptop computer market, as can be seen in the graphs below, which show that after the successful launch of a new product like the MacBook wheel Apple is able to charge a higher price, produce a similar quantity, and earn greater economic profits.

In the video, one customer says that he’d buy “buy almost anything if it’s shiny and its made by Apple”. Such statements reflect that among loyal customers, demand for Apple’s products is highly inelastic. While the firm is certainly not a monopolist in the market for laptop computers, Apple has surely succeeded to increase its market power and thus its power over prices through product differentiation, brand loyalty, and the “hype” surrounding the launch of new products like the MacBook Wheel.

Discussion questions:

1. In the graphs above, the slopes of the demand curve increases after successful product differentiation by Apple. Why does this happen?
2. Assuming the market for laptop computers is monopolistically competitive, what will likely happen to Apples economic profits over time? What must Apple do if it wishes to maintain its profits in the long-run?
3. What are some real ways companies like Apple and its competitors have attempted to differentiate their products over the years? Would YOU buys a MacBook Wheel if it were real?

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Kite Powered Ship Sets Sail for Greener Futhre – Guardian.co.uk

A German engineer has given an old technology new life to help make trans-oceanic shipping greener and least costly.

A cargo ship pulled by a giant, parachute-shaped kite will leave Germany on Tuesday on a voyage that could herald a new “green” age of commercial sailing on the high seas.

The owners of the MS Beluga, a 462ft cargo vessel, will try to prove that modern steel ships can harness wind power and reduce their reliance on diesel engines.

During the journey from Bremen to Venezuela, the crew will deploy a SkySail, a 160 square metre kite which will fly more than 600ft above the vessel, where winds are stronger and more consistent than at sea level.

Its inventor, Stephan Wrage, a 34-year-old German engineer, claims the kite will significantly reduce carbon emissions, cutting diesel consumption by up to 20 per cent and saving £800 a day in fuel costs. He believes an even bigger kite, up to 5,000 square metres, could result in fuel savings of up to 35 per cent.

Here’s a thought… reduced fuel costs to trans-oceanic shipping companies should shift the supply of such services out, as the marginal cost of shipping falls. Greater supply will mean lower prices to customers demanding such services, moving downward along the demand curve, increasing the equilibrium quantity of trans-oceanic cargo journeys.

Question: Assume all cargo ships in the world eventually incorporate the sail technology, increasing the supply and reducing the price of shipping by an average of 20% and reducing the emission of greenhouse gases of vessels by an average of 20%. What would have to be true about the price elasticity of demand for trans-oceanic shipping in order for a 20% reduction in price to result in an overall reduction of greenhouse gas emissions by cargo ships? Depending on the answer to this question, this “green” technology could actually result in greater emissions of greenhouse gases by cargo ships.

Explain…

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