The Crisis of the Sterling

In an international sense, the 'Golden Years' weren't quite so great. Sterling had major problems. Although as a whole the world is booming, external problems in the British  economy were starting to show. The fastest area of trade growth between major economies was in manufactured goods, yet Britain's share of manufactured trade fell from 25% in 1950 to 11% in 1970. The balance of payments was also perceived as weak because of its volatility. Visible trade was constantly in deficit and invisible trade in surplus, but the magnitude of these fluctuated a lot meaning there was never a consistent surplus. It was weakened further by the Sterling balances.

Sterling balances is the term given to debts accumulated during the Second World War. This figure stood at roughly £3.5 billion by 1950. The gold and foreign exchange reserves covered roughly 1/5th of this, although this figure was increasing. In 1957 exchange controls were removed and there was a danger than holders of the pound would sell up. The government needed to strengthen their reserves in order to stop this run on the sterling from occurring. It needed to run a persistent balance of payments surplus.

The government needed to resolve Britain's balance of payments problems. It had three routes to go down: protectionism, devaluation or deflation and 'Stop-Go'. Protection would've been opposed by the US and other members of GATT and EFTA, therefore that option was ruled out. Devaluation took place in 1949 to $2.80 as a war adjustment, but any further devaluation was difficult because of being part of the fixed exchange rate system of Bretton Woods. It would also conflict with the Sterling Area. The Sterling Area was what laid behind and held together the Commonwealth. It also supported the City of London's position as a global financial centre. Devaluation of the sterling would cause a collapse of the Sterling Area and would be unfavoured electorally. The final choice was the route taken. Bouts of deflation would be implemented to cut imports to improve the balance of payments position. However, the way the government went about it ultimately failed. They were too timid with their squeezing of the economy because they wanted to protect their full employment objectives and therefore foreign currency reserves stayed low and the sterling crisis continued.

One of the main issues Britain had was that state spending abroad was offsetting all private sector surpluses in the 1960s. The state was spending nearly £200 million a year in aid to the Commonwealth and £313 million in overseas military spending. Without this being cut any attempt to improve the balance of payments would be in vain.

Eventually, the Sterling had to be devalued. The Balance of payments crisis just prior to 1967 was the last straw and the Sterling was devalued to $2.40. Military spending was also cut back. There was some short term success from this, the balance of payments was in surplus by 1969 but it didn't last long as inflation and wage rises meant any gains were soon wiped out. The Sterling Area gradually faded away after this. It just could no longer be maintained with the decline of Sterling as a global currency. The empire was also in the process of breaking up as Commonwealth countries were beginning to gain independence and demand their own currency to complete this process. The demise of Britain was in full swing.

To conclude, we can say that during the 60s and 70s it was realised that the British economy was no longer in a position to support a global currency. The balance of payments was a persistent problem for the economy because of a wrongly held belief that Sterling was still a major currency. The problems did not end with the 1967 devaluation. 

The Challenges of the 'Golden Age'

If you read my previous post you'll see that the 'Golden Age' is a very positive time if viewed in certain lights. It wasn't all plain sailing for Britain, though, as this post will explain. If we look at the growth rate from the 1950s to mid 70s, we see it averages around 2.8% per year. Pretty good, higher than during the industrial revolution. But, compare it to the growth rate of other advanced economies and it looks feeble.  In the 1950s we expected these other economies to grow quicker with their scope for 'catch up' growth, but in the 60s many of these economies had actually caught up with and overtaken Britain and were still growing faster.

This suggests there's a fundamental problem somewhere in the British economy. Could it be a problem of investment? We said investment was one of the reasons for Britain's low unemployment in this period, but it could also be part of the reason Britain was lagging behind. Our investment rates had grown since the 1930s, but they were still a way behind other advanced economies. Some blamed this on the policy of 'Stop-Go'. The poorly planned contractions and expansions of demand were too frequent, which left a level of instability that hindered investment. In reality, during the 'Go' phase the demand was pumped into the economy too fast. Prices rise quickly and the government has to quickly backtrack with a deflationary policy that chokes off investment. In the 'Stop' phase firms just help back on their investment, waiting for the next 'Go' phase. The uncertainty of the whole system meant lower investment.

The government needed some alternative methods to raise investment whilst still maintaining their very favourable employment conditions. They didn't want to devalue the sterling and they didn't want to deflate the economy for too long. The only option left was to return to a policy of state planning. A policy of 'Indicative planning' was working well in France so the governments of the early 60s tried to mimic it.

In steps the National Plan! Launched in 1964 by the Labour government with the aim of boosting long term growth up to 4%. A lot of effort was put in to the plan, production targets were set across the board which were needed to achieve the goal. It was all placed under the control of the new 'Department of Economics'. Sound good? It wasn't. It failed. There was no method given to meeting the targets and no penalties for those that didn't make them. It was a naive hope that workers would just cooperate. Well, they didn't. It potentially could have worked, but the whole plan stemmed from a misdiagnosis of the economy's problems. It all assumed that the 'Stop-Go' cycle caused the low investment which hindered growth. What if this wasn't the cause?

Was 'Stop-Go' really the problem? In a way, no. Large fluctuations in the economy that were persistent before 1939 and also occurred after 1973 didn't occur during the 'Golden Age' and a similar policy was used in other countries that were experiencing rapid growth. So was low investment the problem? Britain's investment rates were catching other countries by the 70s, but it was investment in private housing that was holding the rate back. It seemed that Britain was very unproductive compared to its competitors with the same equipment which could have been a deterrent for investment. Investment is seen more and more as a symptom of Britain's decline, rather than a cause of it.

The suggestion from this was that Britain was suffering from other supply side weaknesses. What could these have been? Bad industrial relations, restrictive practices, poor management, poorly aimed research and development and inadequate human capital formation.

Britain's bad industrial relations came partly in the form of strikes. Compared to Germany the strike rate was poor, but compared to the USA it was much better. Productivity was the real issue. Britain's steel productivity was a 1/3 of the EEC average. We were over-manning our factories with people putting in little effort. Top managers in large industry seemed to be completely oblivious to shop floor activities.

Research and development was one of the big problems too. Britain was spending more than all other Western economies bar the USA, with half of this coming from the private sector. The direction of this spending was an issue. It was being spent on defence, civil nuclear power and civil aerospace - three unprofitable and poor commercial areas. All of the most talented scientists and technical manpower were stuck in dead end projects not adding  much to the GDP of the country. Innovation was falling too.

Another one of the supply-side issues was education. We were a comparatively uneducated economy. Only half our factor directors had degrees, the figure was closer to 90% if you looked abroad. It was even worse at middle management level. Those managers that did have degrees tended to have them in arty subjects and not managerial subjects.

So, if these really are the problems causing low growth - why did they persist? You'd assume that market forces would create change and push the inefficient parts of the economy out. The explanation for this is put down to 'Institutional sclerosis'. Key power structures had been left undisturbed for such a period of time that they had become entrenched. Vested interests were created and these resisted change. A part of this can be put down to the little damage Britain took during war. If we compare it to Germany, who took a lot of damage, we see why. Germany's war damage forced them to rethink the whole economy, they kept their strengths and replaced their weaknesses. With Britain, this didn't happen and institutions were left entrenched. The world boom then further lessens Britain's incentive to change.

The government were also very reluctant to generate the required change. They didn't want to challenge the vested interests in competition policy and preferred to follow the path of 'Stop-Go' and not detailed economic intervention. Another reason the government didn't force change is perhaps the problems weren't as bad as first implied. This was the view of some historians. There were some positives: our research and development spending was similar to France and they were growing rapidly. We looked good in industries such as pharmaceuticals and food and drink. Globally, Britain's incomes were in line with the OECD average and the economy was still successful. The only real negative was the loss of global political influence.

To conclude, the 'Golden Age' is a period that can be argued to have been good and bad for Britain. The debate about the extent and causes of the failures I've detailed above will continue for many years to come. Britain does lose ground, but is still a successful economy.

The 'Golden Years'

Once World War 2 had come to an end, the government had a changed view on the economy. There was a unanimous agreement that the economy could not be returned to the conditions of the 1930s. A prime opportunity had presented itself for economic betterment to take place. The war experience could fuel this improvement along with breakthroughs in Keynesian economic theory.

In weighing up what exactly the government could do to improve the economy from the 1930 levels, three main areas appear. Firstly, could they try a policy of nationalisation? The short answer to this was no. Many key industries were already under national control, such as steel, coal and the railways and most other important industries were so highly regulated already that nationalising them completely would have been ineffective. So, the policy of nationalisation was crossed off the list. Could they try and raise public spending? Well, in reality - not really. Public spending was already high at 37% of GDP in 1948, most of this going on social safety nets rather than boosting the economy. Any further public spending would be unsustainable. There goes public spending off the list. The option that was chosen was macroeconomic management.

The 1950s was a period of breakthrough for Keynesian theory. It saw the policy of demand management come to flourish - or better known: 'Stop-Go'. The idea behind this policy was constant tweaking of the economy to keep it heading in the right direction and to avoid overheating or recession. When unemployment began to rise, the government would loosen policy and when the economy looked like it was overheating the government would tighten policy again. Did it work? Eh... In some senses, yes, in most other senses, not really. If you place a high priority on unemployment then it could be passed as a success - unemployment reached historically low levels and fluctuated around the 1.5-2.5% mark. Living standards also rose. However, this was at the cost of frequent balance of payment crises, slower growth than the UK's major competitors and inflation (although not runaway inflation).

The policy had a famous critic in the form of the economist RCO Matthews. He had his doubts about Keynesian theory. The basic thrust of his argument was that the reason unemployment was so low wasn't to do with the policy the government had implemented - this policy only affected unemployment at the margin. He claimed that demand was higher than pre-war levels, but not because of financial policy. Tax was higher than spending, budgetary policy tended to be deflationary and interest rates were consistently higher in the 50s.

So what could the other reasons for the low unemployment be? Some have put it down to high investment rates. Investment was especially higher than in 1939 and most of it was coming from the private sector. Investment is a fickle economic variable that depends a lot on confidence. From 1950-1973 there was a world economic boom which is the reason for this high investment. In Europe and Asia, war had hit harder than in the US. This left a lot of scope for 'catch up' growth to repair the war damage using the best practice techniques. Many workers also moved into more productive sectors such as services instead of agriculture. As well as this, world trade barriers come down and the Bretton Woods system begins to function efficiently as the USA pump the system with overseas aid and defence spending. Overall, world demand increases which fuels investment and productivity growth. This growth in world trade in a way drags the British economy along with it.

Another contributory factor for the higher investment comes from Broadberry. Productivity rises were higher than wage rises which favours job creation. As well as this, wage restraints continued through the 1960s, essentially increasing firms profits allowing investment to take place. The wage restraints were supplemented by cheaper imports of food and raw materials to keep living standards rising.

We can conclude the 'Golden Age' by saying that, yes, full employment was pretty much achieved, but it wasn't all down to the wonders of government policy. They were helped a great deal by very favourable conditions around the world. With hindsight, we can also see that this is only a temporary purple patch for Britain as problems begin to crop up. 

Macro-Economic Issues

The macro-economy refers to the wider economy - it's looking at an economy as a whole as opposed to individual firms or operators within an economy that micro-economics refers to. We come across macroeconomics on a daily basis: inflation and unemployment for example. The topic gets a lot of media attention and is the main cause of a lot of the criticism that politicians receive. The importance placed on macroeconomics by politicians can never be understated - they fully understand that voters want a thriving economy and therefore they strive to achieve this.

The four major economic issues are ones we will all have heard of: Economic growth, unemployment, inflation and the Balance of Payments/Exchange rate. The government aims to keep all four of these in check as part of their policy objectives. They want economic growth to be at a high, stable level. They aim to reduce unemployment because not only is it a drain on their finances in the form of unemployment benefits but it is a waste of resources. Inflation needs to be kept low and stable to make decision making easier on individuals and firms. The balance of payments wants to be in surplus, or at least balanced, so that the exchange rate isn't pushed upwards (this can fuel inflation as import prices will rise). The problem the government faces is that these policy objectives can conflict. If there's one thing you learn from this post, make it be this: The government are in a difficult position - they will struggle to achieve all four of these objectives at the same time.

At this point I am going to direct you to a previous post I've written about the circular flow of income as this will come in handy when looking at the next part. Click here to be linked to that post.

So, the macroeconomic goals of the government have a close relationship with the circular flow of income. If the withdrawals from the flow exceed the injections into the flow then we will see a case of aggregate demand falling. This subsequently will lead to a fall in economic growth, a rise in unemployment, lower inflation and a potential improvement of the balance of payments. With injections exceeding withdrawals we expect the opposite to happen. Here is a perfect example of the difficulties the government faces. A rise in aggregate demand has the potential to push the government closer to two of its goals (economic growth and a fall in unemployment) but at the same time it also pushes them further away from the other two goals (rise in inflation and a worsening balance of payments). The dilemmas of a politician. 

VampireStat: A Warning & Referrer Spam

This is completely off the topic of economics I'm afraid. It's a heads up to other bloggers - if you've been getting hits on your blog from a website called VampireStat then do not click on it. Please. I was always suspicious of it when I saw it was browsing my page and pumping up my hit counter so I never clicked on it to find out what it was - but from what I've heard its a potentially malicious site. There are other sites similar to it, trying to entice blog owners onto their page to spam them and potentially infect them.

So, this is a heads up to blog owners not to click on the link to VampireStat. I don't know anyway of blocking them from viewing your blog, but for now just resist the temptation to click. If you know the names of other similar sites please comment them and help out fellow bloggers.

A few other sites have come up that are essentially the same thing: 'Filmhill', 'current' and 'topblogstories'. Once again, DO NOT click on these links. I did some digging and these sites are known as referrer spam. There isn't actually someone viewing your blog, these sites are using bots to trawl through blogs to get you to click on their link. The only way to stop them is to not click on them. Clicking on them makes them do it more. So, to reiterate, ignore any hits from these sites and do not click the link. It's for the good of yourself as well as others!
Cheers guys!

Marketable Permits

Another market based instrument the government can use to try and internalise the externalities caused by the use of environmental goods and services is marketable permits. The authorities choose the amount of pollution they feel is acceptable for a particular pollutant. Then, they issue permits to firms, each one allowing the firm to emit one unit of pollution. The amount of permits they give out will be equal to the pollution limit they have set. A market has then been created - firms can buy or sell these permits when they need to, the price of the permits will depend on the demand and supply. These marketable permits leave the decision to the firm as to how many permits to buy and how much pollution to abate.

The firms marginal abatement cost and the cost of permits will influence the firms decision to cut their pollution. If the marginal abatement cost is greater than the permit price then the firm will keep its pollution as it is and buy permits to cover it. If the permit price is greater than the firms marginal abatement cost then the firm will cut its pollution because it will be cheaper than buying the permits to cover it all.

Marketable permits are a lower cost way of reducing pollution than command and control. Imagine we have two firms: Firm 1 and Firm 2. Firm 1's MAC is £100 and it is polluting 50 tonnes. Firm 2's MAC is £150 and it is also polluting 50 tonnes. Total emissions is 100 tonnes. If we wanted to cut pollution down to 80 tonnes using command and control methods we'd get each firm to cut pollution by 10 tonnes. This would have a cost of £1,000 to Firm 1 and £1,500 to Firm 2, a total cost of £2500 to cut the pollution.

Now, If the permit price was £130 and we were trying to get to 80 tonnes under marketable permits the cost would be different. 80 permits would be issued to firms, so Firm 1 and Firm 2 would both get 40. Firm 1 could cut pollution by 20 tonnes to reach a total of 30 tonnes emitted at a cost of £2000. They could then sell 10 spare permits netting them £1300, meaning the net cost was £700. Firm 2 could buy up 10 additional permits and keep its pollution at 50 tonnes - this would cost them £1300. So, pollution has now fallen to 80 tonnes (30 from Firm A and 50 from Firm B) but it has only cost a total of £2000 (£700 for Firm A and £1300 for Firm B). Therefore marketable permits is a more cost effective way of reducing pollution than command and control.

Marketable permits also have a benefit over the pollution tax system. Permits allow authorities to set the amount of pollution and then let the market choose the price. With taxes, the authorities choose the price and let the market choose the pollution level.

There are many technicalities to the system that I'll talk through now. The first of these is 'bubbles'. This is essentially a 'bubble' over a whole firms pollution - the aim is to make the aggregate level of pollution in the bubble stay the same. So, they can increase pollution from one of their outlets as long as they reduce pollution elsewhere in their firm by an equal amount. 'Banking' is an extension to this. It allows a firm to bank credits for later use if they reduce below the aggregate amount - it allows them to temporarily pollute more in the future by using these credits. 'Netting' is another concept. This allows firms to create a new source of emissions only if they generate equal reductions elsewhere in their firm - they cannot buy new permits from the outside to cover the new emissions they must internally trade the permits they already have.

In reality, marketable permits are a difficult concept to get going. An example of this is the EU CO2 Emissions Trading Scheme of 2005. It ultimately failed because too many permits were given out at the start and therefore nothing was achieved, but a lot of money was wasted. There are many other problems with the system. Firstly, the politics behind it make it difficult to impose and coupled with this the unethical-ness of actually permitting firms to pollute generates a lot of opposition. The system comes with massive administration costs that only get higher with more firms being included in the operation. The main problem is how to actually allocate the permits in the first place? One method used already is 'grandfathering'. Firms are given permits based on historical emissions data, the more the firm polluted in the past the more permits they get. This is, in essence, rewarding dirty firms. It also incentivises firms to increase production and therefore pollution when talk of a permit scheme being introduced starts so that the firm can gain more permits. 

In theory marketable permits are a great idea, currently in reality they don't work too well and there are many obstacles that need to be overcome. Maybe in the near future we will see these sort of schemes becoming more common and helping the pollution problem. What is your opinion? Cheers for reading.

Sam.

Government Failure

Sometimes we see governments intervening in markets in an attempt to make them more efficient. However, it is very often the case that they aren't any better at managing resources than the free market - this is known as government failure. We'll look at example involving land conversion and biodiversity loss.

Land conversion is the main reason for biodiversity loss around the word - both grassland and forest cover is declining rapidly in some parts of the planet. We use a diagram similar to the one used in the last post which looks at the interaction between a firm's marginal net private benefit and the marginal external cost of land conversion. The definitions in this case are as follows:

• Marginal net private benefit (MNPB) = the profit associated with a one unit increase in land conversion.
•  Marginal external cost (MEC) =  External cost of a one unit rise in land conversion.

The market for this looks as follows:

Let us describe the market. We have an initial over-conversion because of the market failure. Lp is converted when the socially optimal level would be L*. This is all explained in the last post I made. The government failure, however, comes in the form of the subsidy. The government may be subsidising farmers' incomes, or something of the sort, but this is encouraging more land to be converted. The subsidy increases the marginal net private benefit of land conversion for the firm and therefore the amount of land converted has moved further away from the socially optimal level. We have to remove the government failure before we can remedy the market failure.

We've assumed a constant upwards sloping marginal external cost curve here, but it may be a good time to mention other plausible curves. We could have a curve that increases at a constant rate and once a threshold point is reached it increases faster. Or, we could even have a downwards sloping MEC curve. How? Imagine a view being ruined by a factory. The first factory has a massive effect on the view but subsequent factories have a lesser effect because the damage has already been done by the previous factories.

Government failure occurs a lot in the real world. One example would be with the Common Agricultural Policy. It aimed to provide farmers with a steady income by offering a guarantee price for their goods. This meant overproduction was rife - farmers knew that the best technique was to farm as much as they possibly could to get the most revenue. Land was farmed more intensively and more land was converted to farming to expand production. This will/has caused degradation of the land and biodiversity loss.

Another example is subsidies in developing countries. Governments there tend to impose subsidies to keep prices below the market price so that food and the like is affordable. This encourages over use of the land once again and makes the economic activity look artificially appealing, attracting more firms in. It is also a waste of financial resources that are needed elsewhere.

As we can see government failure is something that is very real. It can occur fairly easily and it needs to be stopped before any market failure can be addressed. How do we stop it, though? I'll be going into this in later posts, stay tuned. Thanks for reading.

Sam.

Markets and Market Failure

When it comes to a firm deciding what output to produce, they generally take into account only two things: How much they can sell the good for and how much it costs to produce. Using this information, they set out to maximise profit by producing where the marginal costs are equal to the marginal revenue. This means there is a strong incentive for the firm to keep costs as low as possible to maximise profits.  

Many environmental goods do not come with a price tag, they are treated as being free by the firm. This 0 price tag means that firms put no effort into using these resources efficiently. The costs that the firm should incur when using these goods are known as the external costs. They do not get taken into account by the firm when making production decisions and therefore we experience over production. External costs are the difference between the social cost of an economic decision and the private costs (costs to the one making the decision).

Here we can clearly see that at the price P the optimal production would be Q*, if the social costs were taken into account. But production is actually at Q because only the firms private costs are looked at when deciding how much to produce. This is an obvious overproduction and it is due to environmental goods not having a price and therefore being treated as free.

Another way to map this out is using marginal external costs versus the marginal net private benefits of production. The marginal net private benefit is the additional benefit the producing firm gains from each additional unit of production. The marginal external cost is the cost to the third party of each additional unit of production. Each additional unit of production adds an increasing amount to the costs but a decreasing amount to the benefits, hence the shape of the curves you're about to see.

In the scenario here, the firm produces at the point Q. Why? Well, they do not care about the marginal external cost of their actions so we can ignore that curve for now. At point Q, benefit for the firm is maximised. Any more production past point Q and benefit to the firm will start to decline. Any point before Q will mean there is more potential benefit to gain. The socially optimal point of output/pollution would be at Q*. This is where the profit from producing the last unit of pollution equals the cost of producing it. Essentially, here, benefits = costs. The external cost has been paid for and the true value of the environmental good has been taken into account. The problem is getting firms to produce at this point. There needs to be a form of incentive to encourage firms to reduce production and therefore pollution to the socially optimal point. How to do this?

That's market failure in an environmental sense. Thank you for reading, comment if you have questions.. blah blah blah. Have a good day.

Sam.

Interactions Between the Economy and the Environment

The economy and the environment is a topic that divides opinion. There are groups of people that feel very strongly either way and a bunch sitting on the fence. One thing is for certain - it is an important issue that needs addressing. The interaction between the economy and the environment is vast, almost all economic action has some impact on the economy and vice versa.

The interaction can be summarised fairly easy. Environmental inputs are taken from the environment for use in the economy and are exchanged with waste created from their use. While this is going on the environment and the economy also operate independently. If the link was broken then both would suffer.

Where does this all come from then? Well, we assume the economy functions in a circular motion. (P)Production produces (C) consumer goods and (K) capital goods, which produce more (C). This yields societies (U) welfare:

So where does the environment come into this? Well, the environment starts off the chain. We can add (R) the flow of natural resources leading to (P) production. We can also add waste (W). At each stage of the process waste is created and fed back into the environment. Using the First Law of Thermodynamics that states we cannot create or destroy energy and matter, the amount of waste used in a time period must be equal to the amount of resources used. The start of the chain now looks something like this:

Now the final stage to convert this into the circular system is to add in recycling (r). This gives us the full circular system. Natural resources add to production which adds to consumer/capital goods. All three of these create waste which is fed back into the environment. Some of this waste is taken to be recycled and fed back into the system as a natural resource. Ultimately the consumer/capital goods lead to consumer welfare. The environment also adds to consumer welfare as it is.

This is how the system works, but can it be improved? Yes, yes it can. We can reduce R by using energy more efficiently. This will in turn reduce waste which is of course a good thing. We have to take care of the assimilative capacity of the environment. This is the ability for the environment to break down waste, it becomes more and more limited with higher amounts of waste. Therefore, the more waste we create, the less can be broken down naturally by the environment - a bad thing.

The question now might be why don't we recycle all waste? That way the assimilative capacity of the environment would never get strained and natural resources could remain very much intact. Well, we can't because of the Second Law of Thermodynamics. This states that energy can change states and become unusable. The word for this dissipation is 'entropy'. Unused resources have low entropy but once they've been used it becomes high entropy. This explains why we cannot recycle everything.

So, we've essentially covered the three main economic functions of the environment above: a supplier of natural resources, an assimilator of waste and a source of utility. Environment damage occurs because us as the consumer do not value these functions correctly. We treat them as free when in actual fact if they were marketable goods they would have higher prices.

The concept of sustainable development can be touched upon here. There are many different definitions for this phrase, you've just got to pick one. The one I like is "Development that meets the needs of the present without compromising the ability of future generations to meet their own needs".

How do we ensure that future generations can meet their wellbeing needs? We need to make sure we look at the ideas of intergenerational and intergenerational equity. This means providing for the most needy in today's society (intra) but also meeting the needs of the next generation (inter). A good way of doing this is to ensure that we leave a stock of capital at least as large as the current one. This comes in two forms: weak and strong sustainable development. Weak will involve maintaining the aggregate level of capital stock. A fall in natural stock can be substituted by a rise in man-made capital. Strong differentiates between the two types of stock, it understands that some natural stock is a necessity. It encourages the need to be cautions and beware of irreversibility.

Sam.

Externalities and Public Goods

Externalities are the effect on the third party of an action made by an individual or a firm - whether it be for the better or the worse. A lot of the time externalities are negative, pollution for example, and this is the example we will use here. We'll look at a firm in industry creating a good that means they are polluting the atmosphere.

With externalities being ignored, the firm will hire workers and capital according to the rule: (Marginal revenue product of labour = marginal cost of labour = wage = marginal cost of labour)

In Layman's terms, this means they'll employ labour up until the point where the marginal revenue product of labour is equal to the marginal cost of labour, meaning profits are being maximised. If the producer had to clean up the pollution as well then the amount they'd employ would become:

What has been added is a new Price, the price of cleaning pollution. This is taken away from the price of the product they're producing which will overall leave a lower figure. If we rearranged above we could achieve this:

The marginal cost of the good will now be the wage plus the marginal cost of cleaning up the pollution. This means the social cost of the firms actions have been taken into account. Previously, the marginal cost of production was below the marginal social cost - leading to an overproduction. Here it is graphically:

Q2 is the social optimum when the cost of clearing the pollution is taken into account. If MSC is greater than MC then there are external costs of production, if it's the other way round there are external benefits to production.

Now for a quick look at public goods, a fairly simple sub-topic. A public good is one that has the characteristics 'non rival' and 'non excludable'. What does this mean? It means that my consumption of the good does not stop other people consuming it (non rival) and I cannot be prevented from consuming the good once it is provided (non excludable). Street lighting is a good example. It's a good that generally has to be provided by a government because no individual or firm would pay for it - they'd just wait for someone else to buy and free ride. A good that has only one of the characteristics stated above but not both is known as a 'quasi-public good'.

That's all boys and girls! Comment if you need more help, share the blog if it has assisted you. Cheers!
Sam.

The 5 Minute Guide to the "Credit Crunch"

So, "credit crunch" is a phrase that has been tossed around way too much in the last few years. I find it tremendously cheesy and I'm not ashamed to say that it makes me cringe a bit when I read it. But, it seems to have reached that stage where it is now a socially acceptable term (ugh!) and therefore we have to roll with it. I'm taking a wild stab in the dark here assuming that a lot of people know what the "credit crunch" is but don't know how it came about, or how we ended up slap bang in the middle of it! Fear not, I am here to talk you through it in 5 minutes (don't hold me to that).

So, we roll back the clock to the early to mid 2000's. We are in America and looking at the US mortgage market. Around this time most things economical are going well, generally the world is in a stable position and growing well - meaning confidence is high. What is important to note is that, due to this, property prices in the USA were on the rise. High confidence and rising house prices put the mortgage lenders in a fairly arrogant position. We saw an expansion of what is known as the 'sub prime' mortgage market. These are essentially risky mortgages - mortgages given out to people who may have trouble meeting the repayment schedule. Why do this? Well, the banks felt safe because the rising house prices meant if the recipient of the mortgage couldn't make the payment then the bank would inherit an asset that was rising in value - increasing their profit.

Everything was all well and good until we reach 2007. Towards the end of the year inflation in the USA rises and this forces interest rates up (higher interest rates are a method of bringing prices/inflation down). The mortgage default rate begins to rise now because the low introductory interest rate of the mortgages start to come to an end. The mortgage recipients now have to pay the higher national interest rate on their repayments and many could not do this and were forced to default.

Coinciding with this, the housing boom collapses and house prices plummet. Now the banks are left with a defaulted mortgage and a worthless house - they have entered a very sticky situation and their balance sheets are severely hit. A key part of the finance sector is banks lending to each other when needed, they do this at special rates and it is the cheapest way of generating short term funds. This stops. Banks stop lending to one another because their balance sheets were hit by the defaulting mortgages and worthless properties.

This essentially is the problem. Some banks cannot afford to keep going due to the losses they've made and with no access to short term funding from other banks they have no option but to declare bankruptcy - Lehman Bros for example. It becomes a global crisis because of the integration of the world economy. Countries are so intertwined now due to trading, international agreements that something like this can spread around the world in a matter of months. It took roughly 3 months from when the USA entered recession for the UK to enter recession. In the space of a few months a crisis in one country has become a global financial crisis.

That's it. Sub-prime mortgages increase -> inflation causes interest rates to rise -> housing market collapses -> default rates increases -> banks stop lending to one another -> recession -> spreads around the world.
This is a very simple look at the credit crunch, of course there is a lot more to it. For the normal person, this is as much detail as you need to understand, essentially, what went on and why we are where we are now.
Cheers guys,
Sam.

Lorenz Curve and Gini Coefficient

These two concepts are used in conjunction with one another to measure the distribution of something you're interested in. The most used example is for the distribution of income, but it can be applied to anything.

The diagonal line is the line of complete equality between national income on the Y axis and population on the X axis. Area A on the diagram shows the inequality, the Gini coefficient puts a value on this area. The Gini coefficient is calculated by the following: A / (A+B). It takes the area of A as a proportion of the whole area under the line of perfect equality. The value of the Gini coefficient can range from 0 to 1. 0 Being complete equality and 1 being complete inequality.

If we have two Lorenz curves that do not intersect and the coefficient increases then we can see there has been an increase in inequality. If the two curves do intersect, even if there is a change in the Gini coefficient we cannot say for sure what has happened to inequality by just looking at the coefficient. We need to look at the shape of the curves and where they cross to get an accurate representation of the change. That is one limitation of the Gini coefficient.

Short but sweet. Cheers guys, over and out.

Sam.

Factor Markets

When discussing factor markets we are talking about the market for factors of production. Recall the circular flow of income (there is a post on it somewhere) - firms are demanders of factors of production and households are suppliers. Firms pay money to households in exchange for their factors of production - wages for labour, for example.

We'll be looking at perfectly competitive factor markets. Everyone in this market is a price taker, whether it be the firms, the workers or whoever. Freedom of entry and exit exists. It costs nothing for a person to leave the labour force and nor does it cost anything for someone to join it. We assume that the factors are homogenous. Everyone/everything in the market has the same level of skill and motivation. Finally, there is perfect knowledge. Workers know everything about the firm and firms know everything about the workers, for example.

Let us zoom in on the labour market more specifically. A perfectly competitive labour market looks as follows:

On the left we have the market as a whole. The wage rate is determined by the interaction of demand for workers and the supply of workers.  With this wage rate, we can look at an individual firm on the right. At wage rate W the firm would be willing to employ Q hours worth of labour.

We need to somehow ascertain how much labour would be supplied by people in the labour market. This figure is dependent on many factors. From the point of view of the worker, working involves disutility's such as sacrificing leisure time and it being tedious/boring.  The more they work the larger the disutility. The marginal disutility of work (MDU) will increase as people work more. Due to this, we see an upwards sloping supply curve of labour. To encourage people to work more hours, higher wages need to be paid in order to compensate for the higher disutility.

In general, an individual's supply of labour will look like this. The higher the wage rate, the more hours worked. However, there is a case where the shape of the individuals supply of labour actually bends backwards. This is the case when an individual feels that after a certain point they can afford to work less and have more leisure time. It looks like this:

Once wage reaches W the individual feels that they are earning enough and can afford to cut back on the amount they work should wages rise further.

The amount of labour a firm demands rests on the assumptions that firms are trying t maxisimise profits. The theory is known as the marginal productivity theory. We look at the marginal revenue product of labour in this piece of analysis (MRPL). We know that to maximise profits, marginal costs must equal marginal revenue, so therefore the firm will employ labour up until the point wages (the marginal cost) equal the marginal revenue product of labour. It looks like this:

The firm will hire Q hours worth of labour in order to maximise their profits. What about the demand curve for a firm as a whole? Well, because whatever the wage the firm will be producing where wages equal MRPL, this means that the demand curve for the firm is the MRPL curve. From the peak of the curve to the right is the demand for labour for a firm trying to maximise its profits.

There are some firms that are known as monopsomists. These firms are wage setters, not wage takers. They are a firm with monopoly power on factors of production in an area - say a single employer in a village. They have the power to restrict the amount of labour they employ to keep wage rates down. The firm faces an upwards sloping supply curve for labour, to employ more workers they need to pay a higher wage rate. This supply curve shows us what wage must be paid to attract a certain amount of labour. The wage is also the average cost of employing labour, therefore the supply curve is the AC curve. The marginal cost of labour will be above the average costs because to attract more employees the wage rate must be raised. The profit maximising point for the firm would be where MCL = MRPL with a wage of W1. If we were in a perfectly competitive market the wage rate would have been at W2 with a higher amount of labour employed. The monopsomist forces the wage rate down by restricting how many workers it employs.

Monopoly, Monopolistic Competition and Oligopoly

Before we look specifically at any of the three market structures in the title we should take a closer look at revenue as this will be important in the analysis. When price varies with output, which it does in all market structures bar perfect competition, the demand curve is downwards sloping. Average revenue equals (total revenue) / (quantity). This is the same as (price x quantity) / quantity. Cancel out the two quantities and we're left with average revenue being equal to price - hence it is equal to the demand curve.

So, the average revenue curve is sloping downwards because it is equal to price. Why the position and shape of the marginal revenue curve then? Well, as we know, marginal revenue is equal to the change in total revenue divided by the change in quantity. If we substitute in price x quantity for total revenue we are left with: 

If we use the product rule to differentiate this (Google this or find a text book, I'm not going to explain the pure math behind it) we're left with marginal revenue being equal to: 

The change in price over the change in quantity will give us a negative figure, so what we're left with is Price + something negative. Due to the "+ something negative" it will be falling below the AR curve, hence its position on the diagram above.

The total revenue curve interacts nicely with the marginal revenue curve we can see above. The total revenue curve increases at a decreasing rate. Why? Well, because to sell more the firm has to lower its price. Due to this, there will come a point when total revenue is maximised. This will coincide with the quantity at which marginal revenue is equal to 0. That quantity will be the revenue maximising quantity for the firm.

Now that we've understood the concept of revenue, let us hone in on the specific market structures. We'll start with monopoly. In a monopoly we have one firm that dominates the market. How do they do this? It is largely due to the barriers to entry into the market. They could be any of the following:

·         Economies of scale.

·         Legal restrictions.

·         Aggressive tactics.

·         Product differentiation.

...the list does go on. These all make it very difficult for new firms to break into the market and pose any sort of competition/threat to the existing monopoly firm. Graphically, a monopoly looks as follows:

They produce at the point MC = MR because this is where profits are maximised. At this point there is a difference between average costs and average revenue, revenue exceeds costs which means that the monopoly is making a supernormal profit. All pretty obvious thus far. Monopoly is probably the easiest of the market structures to master, all there is to remember is that supernormal profits are made in the long and in the short run. To the consumer a monopoly may seem to be a disadvantage - higher prices and lower output compared to perfect competition. This is true, but it does have its advantages. Firstly, supernormal profits fuel innovation which can lead to better, cheaper products in the long run. Secondly, if the economies of scale are big enough then through a monopoly some markets can exist that wouldn't be possible if monopolies weren't allowed. This is in the case of a natural monopoly.

Natural monopolies are markets that have very high, fixed  start-up costs. So high that it becomes unprofitable if more than one firm try and provide the good/service. An example would be the London Underground - massive start up costs in laying the foundations of the network. So, if there were two firms in the market a loss would always be made and therefore production wouldn't occur at all. See this diagram below.

If there was two firms trying to run versions of the Underground simultaneously then neither would be able to stay afloat only serving half of the market each - whereas one firm serving the whole market means it is affordable. With two firms, the demand curve above with slope down at twice the rate meaning it is always below the long run average costs curve, meaning a loss will be made. The scale of production that comes with a natural monopoly means that costs can be lower and therefore the market price can be something consumers will be willing to pay.

That's the low down on monopolies. Now to move onto monopolistic competition. Do not get the two confused - similar names yet totally different market structures. In a monopolistic market firms sell a different variety or different brand of the same product. There are many firms that all act independently of each other with freedom of entry and exit into the market. There is symmetry in the market - new firms entering the market effect all old firms equally.

1 = Firm demand. 2= Firm demand after new competitor enters.

Each firm has a share of the whole industry, but can only influence the price minimally, hence the inelastic demand curve for the firm. Every time a new firm enters the industry all existing firms will see their demand decrease and the influence they have on industry price fall. Every new firm that enters moves the market closer to perfect competition.

A firms profit in the short run looks strikingly similar to that of a monopoly. Supernormal profits are available. However, emphasis on 'short term'. Over the longer term more firms enter and prices are forced down. The quantity each firm supplies is also forced down and supernormal profits are quashed. Firms will keep entering until average costs equal average revenue, at this point no more supernormal profit is available. We haven't entered perfect competition because the demand curve/average revenue curve is sloping downwards meaning price is not constant across all firms.

On the left we have the firm in the short run. Supernormal profit is made. The new firm enters and we move to the situation on the right hand side. The firms individual demand has fallen, and thus its average revenue and marginal revenue have fallen too. This means that the amount of profit that is made has fallen. These firms will keep entering and this will keep happening until supernormal profit is wiped out completely.

The model is all well and good taken at face value - but it does have its limitations. In reality there is imperfect information about profits and demand, it doesn't take into account the effect non-price competition has and in reality it is difficult to identify an industry demand curve. Bar all of these problems it does give us a fairly accurate representation of a monopolistically competitive market. One problem with this market type is because of the downwards sloping demand curve - production will not take place at the lowest long run average cost. Therefore monopolistic competition isn't as efficient as perfect competition.

The final type of market structure to analyse is that of an oligopoly market. Oligopoly is when there are a few large, major players in an industry. 3 or 4, for instance. There are significant barriers to entry and firms are very interdependent. The firms have to look at the incentives to compete with the other dominant firms and the incentives to collude with these firms to determine their plan of action.

Now, to determine the total production of an oligopoly market we have to run through a little story. We start with an industry with one firm acting as a monopoly. The firms demand function is as follows: P = 200 - Q and its marginal costs are 0.From this, we can see that if quantity was 0 then price would be 200 and if price was 0 then the quantity would be 200. We can use this to draw an initial demand curve.

We derive the marginal revenue curve by differentiating total revenue. Total revenue = (200-Q) x Q, and that differentiated leaves us with: MR = 200-2Q. Profit is maximised at MC=MR, and MC = 0, so therefore the firm will produce 100 of the good. Half the market is supplied.

Now, the next part of the story is for a competitor to enter the market. Firm B spots that there is unfulfilled demand, 100 of it, and decides to enter the market. The demand curve for Firm B is going to be: P = 100 -Q. With that as the demand curve, and using the method in the paragraph above, firm B works out it's marginal revenue curve to be: MR = 100 - 2Q. The new market now looks like this:

Firm A is still supplying 100 of the market and now Firm B has entered and is supplying an additional 50 to the market. 150 of the market demand is satisfied.

But, the next day Firm A reacts to this new firm. They have to readjust and now see their demand function as: P = 200 - Q - 50, or P = 150 - Q.

Both Firm A's demand and MR curves have swung in, and now it finds itself supplying only 75 to the market compared to the 100 it was supplying previously. The new entrant has brought down Firm A's production. 125 of the market is now supplied.

Firm B has to react to this change from Firm A. It sees Firm A's new supply of 75 and recalculates its demand function to be: P=200 - Q - 75, or P = 125 - Q. From this it gets its marginal revenue to be: MR = 125 - 2Q. At this marginal revenue Firm B will now increase its production to 62.5. 137.5 of the market demand is now satisfied. You may have noticed some repetition here. The market will keep going back and forth between the two until an equilibrium is achieved. Firm B's production increases whilst Firm A's falls. So when will equilibrium occur? It will be the point when one firm reacts to another firms level of supply and achieves the same level of supply. In the example above this is when 66.66 is produced by each firm, leaving the 133.33 of the market demand being satisfied.

What we have described above is typical when the number of firms in an industry is small - it is known as Cournot competition, competing over market share. As we see above, with 2 firms in the market each firm supplies 1/3 of the total demand in equilibrium meaning 2/3 of demand is satisfied. With 3 firms in the industry, each firm will supply 1/4 of the total demand in equilibrium meaning 3/4 of demand is satisfied. Each additional firm added means more of the total demand is satisfied and therefore the market is moving closer to perfect competition.

What can we say about profits under Cournot competition? Well with the total demand function being P = 200-2(Q) we can calculate price to be 66.66 by substituting in the equilibrium quantity we derived earlier. We assumed costs are nothing, therefore total revenue in the industry will equal 2(66.66 x 66.66) = 8887.7. Sounds like a nice figure. However, what would it be under a monopoly? We saw Price and quantity equal to 100 when there was just one firm, so total revenue will be 100x100 = 10,000. Higher than in the oligopoly. This tells us that firms would be better off if they got together and agreed to limit the market - this is known as collusion.

Collusion can happen in many ways, one of these being price leadership by the dominant firm. In this scenario, the dominant firm makes an assumption that all the smaller firms in the industry will act like a firm in a perfectly competitive market once it has set the price and chosen its output.

The dominant firm has to decide the price it is going to charge. The price has to be between the range of P1 and P2 above. Any higher than P1 and there will be excess supply, any less than P2 and they won't be able to afford to supply anything. So, the demand curve for the dominant firm runs from P1 down to the point on the market demand curve that coincides with P2. So, the leader can choose a price, say P. Then, with a price decided the dominant firm has to decide how much it will produce at this point and therefore how much of the market is left for the other smaller firms.

So, Price P was decided by the leading firm. Therefore, at this price the dominant firm will supply QL to the market (Where P = Dominant firm demand). The following firms will supply QF to the market (Where P = S) and the total supplied to the market will be QT. QT should be QL + QF. That is one form of collusion between firms - a very subtle one and therefore very difficult to prove.

A few rules of thumb are used when it comes to tacit collusion - using an average cost mark-up when it comes to pricing, for example. Something like P = (1 + 0.1)AC would do the trick. Firms would agree on a certain rate of profit and then enforce this pricing mark up to achieve that. They also use benchmark pricing, £9.99 or £14.99 for example.

As far as collusion and the law goes it's a tricky one. It is illegal but it can be incredibly difficult to prove that it is actually going on. It is entirely up to the authorities to decide the difference between prices being set competitively and firms agreeing prices. Unless it is really bad or really obvious it rarely gets proved.

Phew, that is it. Cheers for reading guys. Same script - comment if you need any additional help or you spot mistakes, all feedback is welcome!

Sam.

Perfect Competition

Perfect competition is a very unrealistic market structure. We'll discuss the characteristics of it later, but for now we have to understand that it is a theoretical concept. If the world was perfect then in most cases we'd have markets operating 'perfectly'. The world isn't perfect and therefore actually seeing perfect competition in reality is a long shot. The major assumption we make is that firms are price takers. By this we mean that each firm alone has no influence over the market price because of their relative size. They take the price they can get as given and perceive it to be constant. Therefore the demand curve for a firm in perfect competition is horizontal - the can sell as much as they want but only at the market set price. Any higher and they wouldn't sell a thing, any lower and they'd make a loss in the long run.

Here we have a typical perfect competition scenario in the short run. On the left is the market where the market price is determined by the supply and demand for the good. The firm, on the right, takes the market price as given and as their price. Average revenue and marginal revenue is the same as the demand curve because we are looking at a constant price for the good. Production takes place at the point where MC = MR, anywhere before this point and more profit can be made, anywhere after this point and profit falls. If you look at the diagram, at the point MC = MR, the average cost is below the average revenue. This means profit is available, which is shown by the yellow area. In the short run the supernormal profit will be (AR-AC) x Qe.

Now, above I've just said that AR and MR are the same as demand because price is constant. You want proof I hear? Sure thing. Average revenue = Total revenue / Quantity. Total revenue is actually price x quantity. Therefore average revenue can be re-written as (price x quantity) / quantity. Quantity cancels out leaving price ~ average revenue = price. Marginal revenue = the change in total revenue / the change in quantity. Substituting in what total revenue actually is we have the change in (price x quantity) / change in quantity. The change in quantity cancels out leaving price ~ marginal revenue = price. Boom!

But, we have only discussed the short run. These supernormal profits don't go unnoticed - they attract new firms into the industry. Supply now shifts out.

The price falls due to the increase in supply. On the right diagram we can see that it's fallen to the point where MC = MR = AC. This means that supernormal profit is no longer being made, it has been competed away. At this point no more firms will enter the industry because there won't be the pull of supernormal profits. Therefore, in the long run there is no supernormal profit to be made in a perfectly competitive market.

It seems risky to the normal person, producing right on the point of breaking even. This is true to a certain extent. Shocks to the system could cause demand to fall, what would happen to the firm then?

Here we have the case of a fall in demand in the market causing a fall in price. The firm was initially producing where MC = MR = AC, but now the fall in price means that if they produce at MC = MR they will actually be making a super-normal loss. This point would be below average costs and therefore the enclosed area on the right hand diagram would be loss. Would they carry on producing? Surprisingly, yes, in this case the firm would. To understand this we have to look at the breakdown of the costs. In the short run we know capital is fixed and labour is variable. Therefore the average variable cost for the firm in a simple world would be labour costs / quantity. As long as the average revenue (demand curve) is greater than the average variable costs then the firm will continue producing. This means they can cover the costs of labour and make some contribution to the fixed costs. If they couldn't cover the average variable costs it would be better for the firm to stop producing, lay off all the workers and only lose the fixed costs.

Some other things we can state is that the short run supply curve for a firm in a perfectly competitive market is the marginal cost curve until the point where price equals average variable cost. As we said above, below that point the firm will stop supplying the market. In the long run the firms supply curve is horizontal at the minimum average cost.

All we need to do now is sum up whether perfect competition is a good thing. It definitely has its advantages, they are as follows:

·         It's efficient - production occurs at the lowest average cost which is the most efficient point.

·         Competition - competition in an industry forces firms to be more efficient.

·         Price is influenced by demand - the market is essentially run by consumers, it responds to their behaviour.

·         No supernormal profits in the long run.

It really has few disadvantages though. You could state the fact that it isn't realistic as a disadvantage, I guess. In real life it would be rare to find a market with freedom of entry/exit, identical products, price taking firms, etc. One point that could be made about the lack of super-normal profit is the lack of innovation. Innovation tends to be fueled by profit, without profit there is little room for firms to innovate. Innovation is one thing that can lead to a more efficient market, so in perfect competition once the efficient point is reached it will not be made any more efficient. Comprende?

Sam.