Are we asleep?

On Wednesday I was passing through Dublin Airport on my way back to New Zealand, when I saw poster ads promising people up to 150,000 euros as a reward, if they've been responsible for introducing a new foreign company as a direct investor in Ireland. You can see how the scheme works here.

It's a clever idea, and it comes on top of an already impressive track record in attracting foreign direct investment (FDI) into Ireland. The agency involved, IDA Ireland, is widely regarded as one of the best of its kind: as one example, in the 'Achievements' bit of its website, it says that "2013 was a record year for FDI in Ireland as IDA client employment reached its highest ever level at 166,184. FDI alone created 25,000 jobs in 2012 and 2013".

And it is quality investment. As a recent report from an IBM unit says:

For most countries it is not just the number of jobs created that is of interest, but also the type of investment projects and their value to the economy. Comparing countries on what
projects are attracted, and not just the number of jobs, is therefore an increasingly important metric for gauging inward investment performance. To this end, IBM-Plant Location International has developed an FDI value indicator that assigns a value to each investment project, depending on the sector and the type of business activity. This value indicator assesses the added value and knowledge intensity of the jobs created by the investment project. Using this measure, Ireland continues to be the top performer in the world, resulting from the country’s success in attracting research and development (R&D) activities in life sciences and ICT coupled with high-value investment in financial services. 

It's left me wondering whether we are doing anything at all in New Zealand to attract inward FDI, let alone anything comparably slick or substantial or successful. Quite the contrary: I can recall people arguing against the desirability of FDI in the first place (repatriated profits would supposedly weaken the balance of payments) and some crassly populist criticism of the cost of wining and dining potential investors.

While Ireland's got some unique advantages - it's a low tax, business friendly, English speaking base within the EU -  we have our own selling points. But when's the last time you saw any recent government making a serious attempt to capitalise on them? And why aren't we getting our share of the FDI that's creating those high value added and knowledge intensive jobs?

Monopoly Power

A Monopoly is a market situation where a single firm (or individual) is the sole producer and seller of a product or service in an entire market. It is characterized through a lack of competition. As a result the monopolist has the ability to affect market prices, which often results in an inefficient outcome for society. 

Monopolies typically emerge because entry into a particular market is restricted. Those restrictions may be effects of high entrance costs, government regulations, or other impediments. Due to the lack of competition, monopolies often cause higher prices, lower outputs and sometimes even inferior quality of the provided goods or services. Thus, to see why monopolies still persist in certain industries, we need to take a closer look.

Sources of Monopoly Power

As mentioned above, monopolies derive their market power from entry barriers to their markets. Those barriers can can be divided into four groups, according to their sources: specific resources, government regulations, natural monopolies, and deliberate actions.

Specific resources

If a company (or an individual) owns a specific and unique resource, it can already act as a monopolist. Imagine you live in a small village in the middle of the desert where there is just one well to provide water. If this well is owned by one individual, he (or she) can charge a lot of money, because there is no alternative supply and water is an absolute necessity. However, this source of monopoly power is not very relevant in practice, as resources can be traded worldwide today, which makes it easier for customers to find alternatives (even for seemingly unique products).

Government regulations

In many cases monopolies arise because of government regulations. This happens whenever the government grants a firm (or institution) the right to be the sole producer and seller of a certain good or service. Given that monopolies often cause inefficiencies, this may seem a little odd. However, government regulated monopolies are established specifically because they are viewed to be in the best public interest.

Just think of copyright and patent laws. When a pharmaceutical company creates a new drug, it can apply for a patent (i.e. the right to be the sole producer and seller of this drug for a limited time). This is attractive for companies because they can generate high profits during the patent period. Hence, the firms are given an incentive to engage in research and development of pharmaceuticals, which is beneficial for society.

Natural monopolies

Sometimes it is more efficient for one producer to supply the entire market than for two or more suppliers. Natural monopolies often occur in industries with the need for large and expensive infrastructures. In those industries we often see economies of scale for the relevant output range, which means that an increase in output reduces the average cost of production for the supplier. In other words, if there is more than one supplier, the output for each of them is lower, which results in higher average production costs (per supplier). 

An example of a natural monopoly is the railway system. To provide railway services, a company needs a large infrastructure (tracks, power lines, etc.). If there are two competitors in the market, both of them need to pay the fixed costs related to this infrastructure. Hence, it is more efficient for them to merge and thereby reduce the fixed costs.

Deliberate actions

Last but not least, some companies deliberately erect barriers to entry in their markets to prevent the entrance of new competitors. However, for this to be possible, the companies need to have a certain market power beforehand. As companies grow, they automatically become more powerful, since they control a bigger share of the market. The bigger (and more powerful) a firm becomes, the more the industry is at risk of limited competition.

Effects of Monopoly Power

Since a monopolist company is the sole supplier of its industry, it faces a downward sloping demand curve (unlike firms in a competitive market). As a result, the firm has to lower the price of its good or service to increase quantity sold. Therefore, a monopolist's marginal revenue (MR) is always less than the price (P) of its good or service. This is crucial for understanding monopolist behavior. 
To give an example, imagine you are the sole supplier of ice cream in your village. To keep things simple, assume you can sell 1 cone for a price of 1$, thus your revenue will be 1$. However, if you want to sell 2 cones, you have to reduce the price to 0.90$, which will result in a marginal revenue of 0.80$ and a total revenue of 1.80$. So, even though you can sell an additional ice cream cone, you earn 0.10$ less on each unit sold, therefore marginal revenue falls. 

The fact that marginal revenue is lower than the price of the good has several implications for the profit maximizing behavior of a monopolist. Those can be illustrated in a supply and demand diagram (see illustration 1).

Illustration 1: Profit maximization of a monopolist

As we just saw, a monopolist usually faces a downward sloping demand curve (D) and a marginal revenue curve (MR) that lies below the demand curve. In fact, whenever we face a linear demand curve (e.g. y= a*x - b), the marginal revenue curve will be twice as steep (e.g. y=a*x - 2b). Though, please note that this only applies to linear curves.
To maximize profits, the monopolist will produce up to the point where marginal revenue equals marginal cost (MR = MC). This results in an output quantity of QM, and a price of PM. In contrast, in a competitive market (where MR = D), the company would produce quantity QC, for a price of PC.

Hence, monopoly output is lower than competitive output, but prices are still higher. This results in a welfare loss for society (deadweight loss) which can be quantified as the shaded triangle DWL. The deadweight loss is the reason why monopolies are often not in the best interest for society.

Government Policy towards Monopolies

To react to the inefficiencies caused by monopolies, the government has different options to chose from. The most relevant ones are the following: competition law, price regulations, nationalization, or doing nothing.

Competition law

One way to prevent monopolies from arising is through competition law. In this case, government institutions primarily control mergers and acquisitions to make sure they will not result in an impediment to the competitiveness of an industry. In addition, the institutions enact laws to prevent collusive behavior and other activities that could restrict competition.

Price regulations

Alternatively, if a monopoly already exists, the government policy can confide itself to controlling the negative effects of monopoly power. Generally, this is done by prescribing the prices the monopolists are allowed to charge. However, it is rather difficult to set those prices appropriately, which makes it difficult to successfully implement this policy in reality. 

Nationalization

A rather invasive option is the nationalization of existing monopolies. This allows the government to directly control the firm's behavior and thus minimize its negative effects on society. However, since this kind of policy is diametrically opposed to the idea of a free enterprise economy, it has become extremely rare in practice.

Remain inactive

As we have seen above, there are certain occasions where monopolies are socially desired or even encouraged by the government (e.g. patents, copyrights). Furthermore, it is possible that the inefficiencies caused by a possible intervention would be more harmful than the effects caused by the monopoly itself. In those cases the monopoly outcome is more desirable for society and the government will remain inactive and not interfere in the market.

In a nutshell

A Monopoly is a market situation where a single firm (or individual) is the sole producer and seller of a product or service in an entire market. Monopolies can arise because of specific resources, government regulations, costs of production, or deliberate actions. They are characterized through a lack of competition, which results in lower production outputs and higher prices. The government can react to monopolies by enacting competition law, imposing price regulations, nationalizing the monopolies or, if the inefficiency is acceptable (or even desirable) for society, by not doing anything at all.

The way we live now

Today's release of the September quarter Consumer Price Index incorporated the latest three-year review (pdf) of spending patterns, and some other changes, notably using technology to capture the prices of many consumer electronic goods. Instead of Stats people visiting physical stores or browsing electronic retailers' websites, info will now be gathered from retail transaction data collected by market research firm GfK.

It's another fine example of how using data collected for one purpose can be cleverly used by Stats for another - something that Stats has become quite adept at (and from casual observation, rather better at than many other national statistical agencies). In this case, it's a rich data set: "The data includes price and quantity information, as well as information about the characteristics of individual products. This allows us to use sophisticated methods to measure price change". In areas like electronic goods, where the grunt of the microchip or the amount of RAM or the quality of graphics is changing all the time, it can be quite hard to figure out how much of an apparent price rise is down to quality changes in the goods being bought. A laptop might have gone up 10% in price, but could well be effectively cheaper if you're actually getting 20% more performance. With this rich data Stats can figure out the trade-offs.

The other interesting thing in the new improved CPI is the list of items being dropped from the CPI shopping basket. Here it is: it's an interesting squint at the way we live now. The common theme is how new technology is making once ubiquitous products obsolete, with smart phones and tablets in particular dealing to a variety of other products.

What's gone into the basket? Pets, mainly - not because we've all suddenly decided in the past three years to become petowners when we weren't before, but because Stats used to reckon that it couldn't get a good price series for puppies and kittens, and now it reckons it can. Here's the full list.

We're apparently drinking more cider (excellent), using ferries more (good), but grabbing an UP&GO or similar as we rush out the door (not my ideal breakfast, though Sanitarium say it's "a nutritious liquid breakfast range that's designed for people who live life on the go" and that "Not only does UP&GO taste great, it's also good for you", so what do I know). And then there's that damned post-Canterbury-quake nuisance, having to hire someone to get you an accurate fix on rebuild costs for your house insurance.

So it's another interesting peek into changing lifestyles. Stats has been doing this for just over 100 years now, and it's fascinating to look at the patterns. If you've never seen it, head over to '100 years of CPI', and in particular the link there to '100 years of CPI - Basket change', which is an "Interactive basket visualisation showing when selected goods and services were added or removed from the CPI". It's almost a complete social history in itself.

In food, for example, saveloys came into the basket in the drear 1970s (1974) but we progressively got our culinary act together, with fancier cheese (1988), avocado, courgettes, capsicums, fresh pasta (all 1999), and hummus and free-range eggs (2008), which is also when saveloys got ejected from the basket. And if you want a bit of "I don't know whether to laugh or to cry" reminiscing - press the 'Really?' button, where you'll see the rise and fall of the tinned herring, the waterbed, and, most poignantly of all, the Buzzy Bee toy.

Good news from charter schools

Radio New Zealand told me this morning that, according to copies of Education Review Office reports RNZ had been shown, two of the early group of charter schools have been found to be doing well ('Big ticks for charter schools').

I'm delighted to hear it. Charter schools have the potential to address what is one of our main educational challenges: the long tail of underachievers in our public schools. To be clear: our educational performance on average is pretty good, and we score well on international comparisons like the PISA ones. But there's a large group at the bottom who struggle. For one reason or another, the standard state school isn't working for them.

What's encouraging about the experience overseas is that the main positive impact of charter schools tends to be the improved performance of precisely those groups who struggle most in the traditional schools. Here's what the big (many would say definitive) study of charter schools in the US had to say (executive summary here, pdf):

Looking back to the demographics of the charter school sector in the 27 states, charter school enrollment has expanded among students in poverty, black students, and Hispanic students. These are precisely the students that, on average, find better outcomes in charter schools. These findings lend support to the education and social policies that focus on education as the mechanism to improve life chances for historically underserved students. Charter schools are especially beneficial learning environments for these students (p18)

Enrollment and persistence in charter schools is especially helpful for some students, particularly students in poverty, black students, and English language learners all of whom post significantly higher learning gains in both reading and math. Hispanic students are on par with their TPS [traditional public school] peers in both reading and math. For students with multiple designations (such as being black and in poverty), the impacts of charter schooling are especially positive and noteworthy (pp23-4)

It's interesting to see that on these early ERO findings the same thing is happening here. RNZ quoted the ERO report on Vanguard Military School as finding that "A significant proportion of students have not experienced success in their previous schools. At this school they are responding positively to adults' high expectations".

Just what you'd expect when you get a variety of options, where students have more opportunity to match up what they want with a school that provides it. As usual, greater choice, more competition and more innovation work, and they work most for those who had least choice previously - typically those on the outer, for one reason or another.

Neither of these two schools, by the way, would have worked for me or my wife or our kids - Vanguard, according to an earlier report by RNZ, has gone for "the ethos and training methodology of the military", and South Auckland Middle School for "project-based learning based on Christian philosophy and values". But then there are lots of people who'd have hated the school I did well at (and others did well there too, if they were either academic or rugby-playing - the rest, not so much).

And that's the whole point. Students need to be able to access the approach that best suits them. Vanguard and South Auckland are just the ticket for some kids who would otherwise have floundered.
More choice is an excellent idea: we shouldn't be lumbered with markets in important areas like education and health, where there are limited "one size fits all" options on offer, and especially when the losers from limited choice are towards the bottom of the social and economic ladder.

Money, Money, Money

For many people, money is equal to bills and coins. However, even though this is not wrong, it is only one part of the equation. Generally speaking, money is a set of assets that is commonly used and accepted as payment for goods and services in an economy. This suggests that anything can be considered money, as long as it fulfills certain criteria (i.e. as long as it is generally accepted).

To really understand what money is, we must therefore look at the relevant functions it performs within the economy. To keep things simple, we will focus on the three most important ones here: money as a medium of exchange, a store of value, and a unit of account.

1) Medium of exchange

Money can be used in exchange for goods and services. This reduces transaction costs by a huge margin, because people no longer need to barter. In other words, you can just walk into a store and buy a pair of jeans (or whatever you need) in exchange for your money. This only works as long as the seller is confident, that he will be able to use the currency he receives to buy goods or services of equal value later on.

2) Store of value

Money can serve as a store of value. That means, it can be used to transfer buying power into the future. If you sell your car for instance, you can keep the money for a while and use it to buy a new car later in the future. For that reason money needs to be durable and must not lose its value over time. 
Please note that this may not be perfectly accurate in reality, as money can actually lose some of its value due to inflation. However we consider this effect negligible for now (but we will cover it later).

3) Unit of account

Money is also a measure of economic value. Every good you can buy in a shopping center has a price tag on it. Thanks to that we can easily compare the value of completely different goods. To give an example, you may want to buy some ice cream for 2$ and a shirt for 20$. By comparing the prices you know that the ice cream is worth about 1/10 of a shirt. Using money as a unit of account is very convenient because it allows us to compare virtually everything. 

In a nutshell:

Money is a set of assets that is generally used and accepted as a medium of exchange for goods and services in an economy. Apart from its function as a medium of exchange, money also serves as a store of value and a unit of account. Everything that fulfills these three functions can be considered money.

Do we need some JOLTS?

...JOLTS being the Job Openings and Labor Turnover Summary that the American Bureau of Labor Statistics (BLS) publishes every month. You can find the text of the latest one here and it's on FRED (the St Louis Fed's economic database) if you'd like to download the data or create some graphs of your own.

Right now, the financial markets and the mainstream media have been heavily focussed on the big statistic that the BLS publishes - the monthly jobs report - and that's fair enough. So have I, in one of my day jobs as a tracker of the main macroeconomies.

But as I've got to know it a bit better I've found the JOLTS data actually gives you a much better feel for what's going on in the US labour market than the big headline jobs and unemployment numbers, and I'm beginning to think we could do with the same insight into what's going on in our own economy.

In the US, for example, in the most recent month there were some 4.6 million hires, offset by some 4.4 million 'separations', for a net employment gain around the 200K mark. 'Separations' were made up of 2.5 million 'quits' (people who voluntarily leave their jobs), 1.6 million layoffs and discharges (involuntary moves), and 0.4 million 'other' (retirements, deaths, disability etc). And yes, the numbers don't add up exactly, because of rounding, but that's the internal logic of the numbers. What the media mostly report - the net 200K gain - is actually the net resultant of giant (by comparison) gross flows, as I mentioned before in commenting on an excellent graphic display of some of these trends.

Looking at separations, here's the layoffs and discharges component. The shaded areas are recessions. There are always large numbers of layoffs, in good times and bad, because the US labour markets tend to be very flexible, but they're now way down on where they were during the worst of the GFC. Indeed they're down to the levels typically seen in pretty good times.

And here's what has been happening to quits. As you can see, quits drop sharply in tougher times: people are less prepared to risk leaving what they've got, plus there are fewer opportunities to move to. Interestingly, from this perspective, the US labour market hasn't yet got back to its buoyant pre-GFC level of quits.

And that's not because the opportunities aren't there. As the graph below shows, the number of job openings (red line) has actually just climbed back to its pre-GFC level. Actual hires, though (blue line), haven't quite got back there.

Overall, you'd say that this adds up to a positive picture. The haemorrhaging of layoffs has dropped to relatively low levels, and the number of job openings (which I'd take as the most forward-looking indicator in all of this) is back up at a robust level, though there seems to be some residual caution on both the employer (hires) and employee (quits) sides of the market. You don't get anything like the same degree of insight from the monthly new jobs number, or the monthly unemployment rate.

I think there's a good case for having the same sort of insight into our own labour market. I'm pretty sure that we don't have these American-style gross statistics (I did have a quick re-look at the Quarterly Employment and Household Labour Force surveys, and couldn't find them, but if I'm wrong, no doubt someone will put me right).

Yes, we know (say) what the total number of filled jobs was each quarter, so we know what the change in jobs was from one quarter to the next. But we don't know if a 10,000 increase in jobs was down to 10,000 hires, no quits, no sackings, or 100,000 hires, 60,000 quits and 30,000 layoffs. And I'm not sure you can make a good enough fist of either tracking the economic cycle or devising labour market policy without some clearer sighting of those gross flows.

We're even more in the dark on job openings (in US terminology) or vacancies (ours). That's not to knock MBIE's vacancies index (latest reading shown below), which is a useful macroeconomic indicator in its own right. But it's an index, of the main online job ads only, and not the sort of 'ask the employers directly' numbers the US collects.

I'm just about the last person who'd wish an extra or unnecessary burden on Stats - I've been up close and personal with them for a long time, and I know the pressures on resources - but I'm starting to think we could do with better tracking of the dynamics of our labour market. And we could probably do it cheaper than the Americans do, as we're more adept at re-using 'administrative data' (like the IRD's) that's been collected already for other reasons (the Americans use a separate standalone survey).

As it happens, it looks as if Stats think so, too. I dug out Stats' list of the important Tier 1 statistics (background here, list itself here as a pdf). 'Job and worker turnover' is listed as a currently produced Tier 1 statistic, though I'm not sure the 'turnover' part is comprehensive and I reckon this could usefully be expanded on JOLTS lines. MBIE's vacancies index was recently made a Tier 1 statistic, but is not yet anything like a full headcount of job openings. And layoffs, unfortunately, is on the long finger: 'redundancies' is at the research stage, with no decision thus far on how often the data might be collected, or when the exercise might start.

In sum, we know that the JOLTS data give us much better understanding of the US economy; we can be pretty sure they'd do the same for us if we had their equivalents; and we've agreed that they should be on the Tier 1 list. Maybe time to get on with it?

Positive Externalities vs. Negative Externalities

Externalities are often defined as the positive or negative consequences of economic activities on unrelated third parties. Since the causers are not directly affected by those externalities, they will not take them into account. As a result, the social cost (or benefit) of these activities is different from their individual cost (or benefit), which leads to a market failure.

There are different types of externalities. The definition above already suggests that they can be either positive or negative. Additionally, there is another (and maybe less familiar) distinction which should be made here: Both positive and negative externalities can arise on the productionor on the consumption side.

In the following paragraphs we will look at the different types of externalities in more detail.

Positive externalities

Economic activities that have positive effects on unrelated third parties are considered positive externalities. As we learned above, they may be present in the form of production or consumption externalities.

Positive production externalities are positive effects that originate during the production process of an economic actor. An example of this could be an orchard placed next to a beehive. In this situation both the farmer and the beekeeper benefit from each other, even though neither of them has considered the other one's needs in his decision-making.

Positive production externality

This can be illustrated by comparing social cost and social benefit based on a supply and demand diagram. In this case, individual demand (D) is equal to social benefit (SB) since there are no externalities on the consumption side. However social cost (SC) is lower than individual supply (S) because there is an external benefit (EB) that is not included in the individual supply curve. As a result the market equilibrium (E*) is different from the optimal market situation (O*) and there is an undersupply of both orchards and beehives.

Positive consumption externalities are positive effects on third parties that originate from the consumption of a good or service. A possible example could be your neighbor’s flower garden. She most likely cultivates the plants solely for her own pleasure, yet you can still enjoy the beauty of the flowers whenever you walk by.

Positive consumption externality

Again, this can be illustrated by comparing social cost and social benefit. In this case however, the individual demand curve (D) lies below the social benefit curve (SB) because the external benefit (the beauty of the flowers) is not included in the neighbor's demand curve. The social cost (SC) on the other hand is equal to the individual supply (S) because there are no externalities on the production side. Like in the first illustration the market equilibrium (E*) is different from the optimal market situation (O*) and as a result there is an undersupply of flowers. What is different from the previous illustration though, the optimal price (p2) in this example is higher than the equilibrium price (p1).

Generally speaking, for positive externalities the overall benefit to society is higher than the one that is taken into account by the actors during their decision-making process. This results in an undersupply of beneficial products (or activities) for society. In order to correct these market failures it is important to know whether the externality arises from the production or the consumption side, since this affects the desired optimal market equilibrium. 

Negative externalities

Analogous to the previous paragraphs, negative externalities are economic activities that have negative effects on unrelated third parties. They can be divided further into production and consumption externalities.

Negative production externalities are negative effects that originate during the production process of an economic actor. The most common example of this kind of externality is the pollution caused by a firm during the production of their goods. Pollution affects the entire population, however as long as companies are not held accountable for their activities, they have no incentive to reduce their economic impact (since that would be more expensive).

Negative production externality

To illustrate this, we shall compare social cost and social benefit again. Similar to the positive externality example, individual demand (D) represents social benefit (SB). The social cost curve (SC) in this case however is higher than the individual supply curve (S) because of the external cost (EC) that is not included in the firms supply decision. As a result the market equilibrium (E*) is different from the optimal market situation (O*) and there is an oversupply of harmful behavior. In this example the optimal price of the good (p2) is higher than its actual market price (p1).

Negative consumption externalities are negative effects that arise during the consumption of a good or service. To give an example, we can revisit your neighbor. If she likes to play loud music in the middle of the night, a negative externality on your part could be sleep deprivation. Once again, she may not take this into account since the consequences do not directly affect her.

Negative consumption externality

In this case, the individual demand curve (D) lies above the social benefit curve (SB) because of the external cost (your sleep deprivation) that is not included in the neighbor's demand curve. The social cost curve (SC) on the other hand is equal to the individual supply (S), because there are no externalities on the production side. Again, the market equilibrium (E*) is different from the optimal market situation (O*) and as a result there is an oversupply of loud music. In this example the optimal price of the good (p2) is lower than its actual market price (p1).

The major characteristic here is, that without any regulatory influence, neither the firm nor your neighbor will take the negative effects of their activities into account. They are not directly affected by the consequences and will thus produce more than in an efficient market (where externalities are taken into consideration). This results in an excess supply of harmful behavior.

In a nutshell

Externalities are the consequences of economic activities on unrelated third parties. They can arise on the production or on the consumption side and can be either positive or negative. In all cases however, they will result in market failures that can only be avoided by imposing some kind of regulation to internalize the externalities. 

Three decades later, still bonkers

Last week the Australian Productivity Commission came out with a couple of reports, on the Aussie dairy trade (pdf) and on Aussie retailing (pdf). I wrote up the dairy one because it had various angles relevant to us, notably some discussion of our Fonterra-centred industry structure, a good smackdown of the 'national champions' idea, and some useful analysis of the economics of the global dairy trade.

I've only just got round to taking a squizz at the retail report, and it's equally good. It points out, for example, that a lot of planning/zoning regulation can be both inefficient and anti-competitive, and that there's a reasonably straightforward path to fixing both problems:

Two reforms have been identified as being of particular importance: first, the need to
reduce the number of business zones and increase the permissible uses of land (to reduce
prescriptiveness) within these zones; and second, to remove consideration of the effects on existing individual businesses from the approval process for development applications (to avoid anticompetitive outcomes) (p11)

The Commission is strongly of the view that state, territory and local governments can
assist consumers and the retail sector by developing and applying zoning policies that
ensure the areas where retailers locate are both sufficiently large (in terms of total retail
floor space) and sufficiently broad (in terms of allowable uses, particularly those relating to business definitions and/or processes). This would allow new and innovative firms to enter local markets and existing firms to expand (p11)

As an example of how those reforms would work, the Commission had heard submissions about high rents being charged to retail outlet tenants by shopping centre owners, and while it noted that following best practice in leasing wouldn't be a bad idea, it also found that "the root cause of most retail tenancy lease problems are unduly restrictive planning and zoning controls that limit competition and restrict retail space, particularly in relation to shopping centres. Addressing the latter would also resolve many of the problems in the retail tenancy market" (p12).

More generally, the report got me thinking about how far Australia, and New Zealand, have got with pro-growth, pro-efficiency, pro-competition deregulation. Because, as this report found, despite years and years of economic reform, there are still thickets of regulation that are absolutely bonkers.

Three examples. I'll let them speak for themselves, other than to note the Aussie Commission comment (p113) that "In many cases, these [trading] rules are anachronistic and have no apparent rationale".

Here's a map of trading hours regulation in Western Australia (p7, repeated on p113).

And here's a decision tree on whether you're allowed to open for business in Australia on Easter Monday (p114).

And here's what Woolworths discovered about trading rules in Western Australia for its Masters Home Improvement Stores (which are like Mitre 10 or Bunnings Warehouse megastores):

in Western Australia, regulations prevent Masters Home Improvement stores from trading in line with the hours enjoyed by other hardware stores. To be eligible to trade as a ‘domestic development shop’ Masters must only sell those goods that are prescribed by the Retail Trading Hours Regulations 1988. The regulations prescribe a list of what a ‘domestic development shop’ can sell, which gives rise to all sorts of inconsistencies and anomalies. The regulations allow the sale of:
• light bulbs but not light fittings
• outdoor lighting but not indoor lighting
• kitchen sinks but not dishwashers
• wood-fire heaters but not gas heaters
• indoor television antennae but not outdoor television aerials (p10)

I suppose the good news is that both Australia and New Zealand now have Productivity Commissions that are able to turn over the flat stones and tell us what they're finding underneath, and there's the occasional one-off inquiry like Australia's recent Competition Policy Review that has been doing the same thing (have a read here in particular). It's good to know that there's still some kind of following wind to keep the momentum of reform going.

But isn't it strange, and a bit dispiriting, that after the best part of 30 years of progress in both countries, we're still lumbered with this kind of malarkey. And while I suspect we may not be as bad as the Aussies on most shop regulation (though I could be wrong about the  Easter trading, where our regime is probably as chaotic as theirs), I wonder what we'd find if, for example, we turned over some flat stones of our own. I wonder what's underneath the occupational qualifications one?

Did we lose the fiscal plot?

I've been engaged in a bit of tweeting to and fro about the rise in New Zealand's government debt in recent years, and what's behind it.

The background is that there's been a fair bit of political point-making going on about the large rise in debt on National's watch, with some people arguing that National seems to have got the kudos for responsible economic management while simultaneously presiding over a very large rise in government indebtedness.

Personally I don't care for or about the political point-scoring, and my take on it is that practically any New Zealand government, of virtually any political persuasion, would have ended up doing what National found itself doing - supporting the economy in the grim days after the GFC hit, and paying to rebuild the infrastructure destroyed by the Canterbury earthquakes. And there would have been a lot of completely appropriate questioning along the lines of 'have you forgotten the lessons of the Depression', and 'does the name John Maynard Keynes mean anything to you', if there hadn't been that support. I don't reckon there was a great deal of policy leeway for any incumbent government in these very unusual circumstances.

But it's kind of hard to make any kind of fact-driven argument in 140-character bursts, so I thought I'd take a bit of space to deal with one strand of the debate, namely how much of a fiscal boost did the government provide to the economy in the wake of the GFC.

Here are Treasury's estimates. They come from the 'Additional Fiscal Indicators' document which was part of the 2014 Budget Economic and Fiscal Update. The 'fiscal impulse' shown in the graph is the size of fiscal policy changes, measured by changes in the true underlying surplus or deficit, when you've taken out any cyclical effects affecting it. Bit of a mouthful, I know, but there you are.

What is shows is that there was a big boost to GDP, of the order of 3.5% of GDP, in the year to June 2009, and another fairly sizeable one, of about 1.75% of GDP, in the year to June 2010. In money terms, that's about $6.5 billion in the June '09 year, and about $3.4 billion in the June '10 year. Call it a round $10 billion or so for the whole package (you could probably add in a little more for another bit of fiscal support in the June '11 year). Formally, yes, $10 billion worth of fiscal boost occurred on National's watch over the two years, but I think it a very high probability that something similar would have happened - and should have happened - no matter who was at the helm.

But there's another way to see what might have happened if someone else's hand was on the tiller, and that's to look at what other governments did in exactly the same situation. So I've rounded up a bunch of the usual suspects and I've calculated the same 'fiscal impulse'. These data come from the IMF's World Economic Outlook database. Positive numbers are fiscal tightening, negative numbers are fiscal loosening.

You'll see that nobody was doing a lot in 2005, 2006 or 2007. Then fiscal policy gets loosened a good deal in 2008 (we're in the middle of the pack), even more again in 2009 (we're again in the middle of the pack), and generally was loosened a bit more in 2010, where we let it rip a bit more than the others. You'll note, incidentally, that at that point the UK took the 'austerity' route (a big fiscal tightening).

Over the three worst GFC crisis years, 2008-10, our cumulative fiscal boost was 6.7% of GDP, in the same ballpark as Australia's 6.1%, and a bit more than America's (5.6%) or Canada's (4%). The UK had chosen a completely different tack, and was taking back support in 2010, so its cumulative boost was least, at 3.1%.

Bear in mind that these numbers, while looking precise, are very spongy indeed (as even their creators will tell you), so they only tell a broad picture story, and the overall story is that everyone loosened fiscal policy, and everyone loosened appreciably, with us and Australia doing a bit more of it than the others. On the other hand we clawed back a good deal more than everyone else in 2012, so there's not a lot in it over a five year view (ex the UK). All of us took a distinctly Keynesian tack. So it's kind of hard to argue that there was something distinctively National about our absolutely typical response. Ditto if it had been Labour at the wheel.

Finally I came across a nice picture of US fiscal policy, for those of you who like graphs more than tables of numbers. It's from the Hutchins Center on Fiscal and Monetary Policy at the Brooking Institution. They call it their 'fiscal barometer', and you can see the original graph and read about the methodology here. It's a broader measure than the 'fiscal impulse' calculations mentioned thus far, so the numbers tend to be a bit bigger when it comes to measuring the fiscal impact. You want to look at the dark blue line.

You'll see that in 2007 US fiscal policy was not adding to GDP at all, shifted to a boost of around 1% of GDP by the end of 2008, to a boost of around 2.5% by the end of 2009, and peaked out at around 3% of GDP in 2010. That's a total of about 6.5% of GDP - pretty much identical to our cumulative fiscal impulse over the same period.

Look at it any way you like, the answer keeps coming up the same. A lot of countries, hit with the same sort of shock, responded in much the same way and to much the same extent, and appropriately so. The colour of the political rosette on the incumbent's lapel generally didn't matter a damn, except later in the piece in the UK. There was nothing unusual about our part in the proceedings.

Three strikes, and you're - still going....

In a previous post I mentioned that Australia's Competition Policy Review had put a torpedo into the side of 'national champions' - requiring or allowing mass consolidation of an industry to produce what will supposedly be a more internationally competitive player.

And last week, I'm pleased to say, the drifting hulk took another blow as Australia's Productivity Commission got it amidships with another one.

The occasion was the Commission's report on dairy manufacturing (pdf) - the latest in an industry series on 'Relative Costs of Doing Business in Australia'. There's lot of interesting stuff in the report, including the short but informative Appendix B down the back on 'Economics of dairy markets',  but for me the highlights were the bits where the Commission responded to submitters arguing that Australia should go the Fonterra route (these are all on p3):

the Australian dairy industry is a price taker on global markets and has no capacity to alter this, irrespective of the structure of the industry. A belief that any single Australian dairy company could exert market power is not consistent with market realities

the emergence of a dominant manufacturer is not a prerequisite for developing distinctive Australian branding for dairy products

there are potential risks associated with highly concentrated industry structures if the overall performance of the industry is linked with one company

Fonterra-like arrangements are not necessary to ensure that scale benefits at the plant level are realised — indeed, there is considerable evidence that Australian dairy manufacturers are taking advantage of scale benefits where it is profitable

And the Commission wrapped it up on p8 with this:

...industry participants are best placed to balance the various tradeoffs and commercial considerations they face (such as between scale and transport costs). Other than where legitimate competition concerns are relevant...the most beneficial dairy industry structure for Australia will be determined by the market place. Attempts by governments to ‘second guess’ market outcomes to achieve a particular industry structure are fraught with difficulty, and likely to impose net costs on the industry and the community more generally. It does not require much imagination — or experience with price setting by government — to envisage highly problematic judgements in setting an Australian price (or prices) for guaranteed domestic milk supply, as occurs today in New Zealand.

The Commission also quoted (pp115-6) from a recent speech by Rod Sims, the head of the ACCC, where he said:

We are seeing a return to calls for ‘national champions’ in Australia. It is, of course, terrific when companies out compete their rivals and take on the world. The concern is when they call for restrictions on competition at home so they can better compete on the world stage. The argument is a contradiction: if you cannot beat your rivals at home how can you hope to do so overseas? Firms involved in cosy oligopolies or oligopolies in Australia are unlikely to succeed on the world stage.

So it looks as if the old rustbucket SS National Champion has now taken three hits in a row. Unfortunately, if past experience is any guide, it will manage to struggle back to port, get patched up, and in due course set out again on another hopeful journey.

The Law of Supply and Demand

The principle of supply and demand is one of the most important concepts in microeconomics. It helps us understand how and why transactions on markets take place and how prices are determined. To learn more about supply and demand we mainly need to look at consumers and producers.

Consumers

In this case, consumers are all the economic units that are potentially willing to buy a certain good or service. The actual demand for said good or service depends on different variables (as we will see later). For now we will focus only on the most important one, the price. For most goods and services we can say that demand will increase as the price falls and vice versa. This actually seems pretty obvious: Just think about how many people would buy a Ferrari if they were not that expensive.

Producers

Producers on the other hand are the ones that are potentially willing to produce and sell a certain good or service. The actual supply again depends on multiple variables, yet as we did before we will focus only on the price for now. For most goods and services this implies that supply will decrease as the price falls and vice versa. Again the reasoning behind this is rather simple: If you were to sell ice cream you would probably try and sell as much as you could if prices were high, because you could make a good profit. However, if prices were to fall (maybe even beyond your production cost) it would not be profitable to sell ice cream anymore and you would produce less.

Illustration

Now these relationships are a lot easier to understand if we look at a simple illustration (see below). The x-axis of this graph represents quantity (Q) and the y-axis stands for price (P). 

Illustration 1: Supply and Demand

If we look back at the behavior of the consumers, we said they were willing to buy more (i.e. a higher quantity) of a good or service if the price falls. So for every price there is a quantity demanded, which will be higher the lower the price is. Now if we plot all these quantity-price combinations we get a graph called the demand curve (D).

Now we can do the same thing for the producers. But since they are willing to produce less (i.e. a lower quantity) as the price falls, the graph we receive is somewhat similar to a mirror image of the demand curve. We call this the supply curve (S).

The point where both curves (D and S) intersect is called the market equilibrium (E*). At this point (and price) the consumers are willing to buy exactly as much of a good or service as the producers are willing to sell, and the market clears. This is the best possible situation for all actors, thus they will always tend to get to this outcome. This means the two curves will keep shifting until the equilibrium quantity and price are reached. 

In a nutshell:

Consumers are willing to buy more of a good or service as prices fall, so they are represented by a downward sloping demand curve. Producers are willing to sell less of a good or service as prices fall, so they can be represented by an upward sloping supply curve. The intersection between the two curves is called the market equilibrium. It determines both the equilibrium price (p*) and equilibrium quantity (q*) and is the optimal outcome for all actors.

Do We Really Need Economic Growth?

The principle of economic growth has become quite controversial in recent years. While many economists perceived the necessity of growth almost as a dogma, critics have become increasingly numerous. Since the global economies are continuously overexploiting natural and non-renewable resources, the idea of unlimited economic growth seems to be doomed to fail at this point.

Before getting into more detail here, we need to define from what perspective we are looking at the issue. Since we want to explore overall economic growth (i.e. on a global scale), we will use a macroeconomic approach. However, please note that the issue of growth is at least equally important for firms on a microeconomic level (don't worry, we will look into that later). For the following paragraphs, we will define growth as the changes in overall real output (real GDP) of the entire economy over time.

So if we look at the issue, the most basic question is: Do we really need economic growth? To answer this right away: Yes, we do.

Now, let me explain. The conclusion above is mainly based on the following aspects.

1) "More is always better"

As we have discussed in an earlier post, peoples wants are essentially unlimited. They generally want to get as many resources as they can. This may not seem like a convincing aspect as it stands, but it builds the foundation for the upcoming arguments.

2) Standard of living

The economy needs to grow because population grows. If the economy grows at a slower rate than the population, the standard of living will decrease. To illustrate this you can think of wealth as a cake. If more and more people share this cake but the cake itself does not grow, everybody gets a smaller piece.

3) Distribution of wealth

Wealth is distributed amongst the population in a certain way. Some people have more of it and others have less. This is inevitable for the most part, but we should still try and shorten the gap between the rich and the poor. However since the rich generally will not want to give up part of their wealth, redistributing the cake will be easier if we can simply give a greater share of additional pieces to the poor (rather than taking existing pieces from the rich). Thus we need a bigger cake.

4) Technological Development

Last but not least, economic growth also correlates to investment and technological development. More efficient production and new technologies enable new growth opportunities. Furthermore, when looking at the overexploitation of non-renewable resources, new technologies can help improve the situation and lessen the impact of economic activities on natural resources. A good example of this are electric cars, they open up new business opportunities while lowering CO2 emissions of traffic.

Disclaimer:
It is important to note that this line of argumentation does not mean economic growth should be pursued at all cost. There are many other variables, that need to be taken into account. For instance, wealth and GDP do not necessarily reflect a populations well-being (see also Limitations of GDP as an Indicator of Welfare) and increased economic activity still often has a negative impact on the environment. We will cover some of these aspects in later posts.

In a nutshell:

Economic growth is necessary in our economic system because people generally want more wealth and a better standard of living. Furthermore it is easier to redistribute wealth and advance new technologies while an economy is growing. We must however be aware that after all economic growth is a means to an end and not an end in itself.

The Importance of Economic Models

Models are a very important tool when it comes to understanding economic principles. Yet they are often subject to criticism, mostly because many of them are said to be simplistic and far away from reality. Because of that the importance of economic models is often underestimated.

To be fair, the critics may have a point. The models are indeed simplistic and not always close to reality. But that is exactly what makes them great. To keep things short, they have two very important functions.

1) Models simplify reality

There is no point in creating a model that describes every detail of a certain object. For example, there is no need to build a model of a car that is 100% identical to the actual vehicle. In that case we could just look at the car itself.
Instead a good model will omit certain details and build on certain assumptions. This will make it much easier for us to examine it and actually learn something.

2) Models guide our attention to certain topics
The second function is very much connected to the first one. By omitting certain details while keeping others, the model automatically guides our attention in a certain way. Depending on what we are trying to learn, the model can put the focus on different topics. At this point it is important to note that including different details will dramatically change the quality and purpose of every model. 
Now that has implications for our car example. If for instance we are trying to figure out how an engine works, we need to include all the relevant rods, wheels and pins into the model. The bumper design however is not relevant and can be omitted. Naturally these relevant details are entirely different if we are trying to create a new design for our car and so on.

In a nutshell

Models are very powerful tools that help us comprehend economic principles by simplifying reality and guiding our attention to specific features of an object.

Looking at economic models the right way will come in handy as we are learning more about economics. Sometimes even looking at what is not included can help us understand what a topic is all about.

Macroeconomics vs. Microeconomics

The study of economics can roughly be divided into two branches: Macro- and Microeconomics. For the sake of completeness, there are certain other branches as well, but differentiating between those two will be good enough for us (for now).

The two disciplines look at the economy from different perspectives. While macroeconomics can generally be described as the study of the economy as a whole, microeconomics is often referred to as the study of small economic units (such as households, firms, specific markets, etc.). However, it is important to note that the two are still interdependent in many ways.

To see why we should not treat the two discipline completely isolated from each other we need to examine them in a bit more detail.

Macroeconomics
As the name suggests, the field of macroeconomics looks at the economy on a very broad scale. It analyzes the behavior of the entire economy. To do this it often makes use of aggregated variables, such as aggregated demand or aggregate production, and so on. The goal is then to find relationships and interdependences between those variables. 

Some of the topics that are covered in macroeconomics are:

• Monetary and fiscal policy and its effects
• Taxes
• Interest rates
• Economic trends (booms and recessions)
• Economic growth
• Trade and globalization

Microeconomics
Again the name implies that microeconomic studies look at the economy on a small, detailed scale. It analyzes the behavior and decision making of individuals and companies within an economy. By doing so, it builds the foundation for many macroeconomic studies, as it provides the data to calculate the aggregate variables mentioned above.

The topics that are covered in microeconomics include:

• Consumer behavior (decision making, utility maximization)
• Profit maximization of firms
• Supply and demand (for individual markets)
• Externalities
• Labor economics

In a nutshell:

Macroeconomics is the study of the economy as a whole (from a broad perspective) and microeconomics is the study of small units (from a close perspective). Even though they cover different areas of economics, they are still highly interrelated and should not be isolated from each other.