The visible hand in economics

Archive for August 2007

Yves Smith think so. His argument is that, even though we didn’t fully appreciate it at the time, Greenspan really really cared about equity markets. He was scared of them, and he didn’t want to go out there and nail them as much as he should have. By being ‘hostage’ to the equity markets, Greenspan surrendered some of the Central Banks integrity. He gave up the hard arse, anti-inflationary image of the Central Bank that Paul Volcker had created.

I’m not sure I agree completely, I mean Greenspan did have the ability to keep inflation in the bag for 19 years. However, his unclear style of speaking and his refusal to target a clear level of inflation did create unnecessary uncertainty in the marketplace, and to some degree, may have damaged the inflation fighting power of the Federal Reserve.

A Reserve Bank governor needs to be a clear speaker, who finds the mere idea of inflation repugnant. That is why Don Brash did such a good job.

I was having a discussion with my girlfriend yesterday on a blog post by Tyler Cowen. There are a lot of interesting points in the post, but the one that struck me and led to the discussion was:

“The median photograph of you is probably the best approximation of your physical attractiveness “

The reason Tyler gives for this is that there is a random sample of photos taken of a person, so on average a photo will show what you look like. Compare this to the method we actually use to judge how good we look; the mirror. In the mirror we make ourselves look as good as we can, so it gives us an upwardly biased sample of how we look. So based on this, we should use photos to tell how good we look, a scary thought.

This is where the discussion between my girlfriend and me appeared. She said that the sample of photos was biased, as people often know there photo is going to be taken and act appropriately. We interpreted this in two different ways:

Matt: So the sample of photos is biased upwards, since people pose when they are having their photo taken. As a result, I look even worse then my average photo!

Rosie: It depends on the person. When Matt knows a photo is going to be taken he makes stupid faces. As a result, the sample of photos is biased downwards.

I don’t know. I don’t think any of this bodes well for my attractiveness. At least I have economics ;)

Winston Peters has come to the rescue of the elderly by delivering a gold card. Now blah blah people are complaining that the discounts are not enough and blah blah people are annoyed they don’t get discounts on power. I don’t really care about that. What excites me the idea of why firms may be willing to get involved in this scheme.

Now there could be reputation effects, advertising etc etc. However, there is an even simpler solution, price discrimination. Generally, the elderly have more elastic demand for many goods, as they are on lower incomes then people that are in their prime working age. As a result, firms want to charge a lower price to the elderly, than they do to people who are still working full time. That is why there are all sorts of discounts schemes for elderly people already.

However, there is a cost to setting up these scheme, which may be sufficient to stop firms doing it. Suddenly the government offers to pay to set it up, and firms can price discriminate to their hearts desire. That seems cool, the elderly and the firms are better off, have we got a free lunch here? No.

Someone has to pay for this, and that is working people. They pay taxes, which get used to fund the scheme. Also as the firms can price discriminate, they will now charge a higher price to those with relatively inelastic demand, the people working.

As an intertemporal transfer, this seems ok, except for the fact that the current elderly never had to pay the higher prices and taxes associated with this scheme. As a result, they are getting a free transfer, and the generation that turns elderly once the scheme is scrapped is the generation that will have to pay for it. Still I don’t really care, I just like talking about price discrimination ;)

Hat tip: No minister 

So teachers want a pay rise.  This isn’t really surprising given the inflationary pressure in the economy.  Now I don’t know too much about teachers pay, but I did find it interesting that the teachers union is saying that teachers wages should increase by 7.5%, and that this would reduce the average size of the classroom.

We know why teachers are saying this, they want parents and students to support them, so they have to make it sound like it is in their interest.  However, this isn’t the way I understand the situation.  If teachers pay is increased, and the government does not completely fund it, then less teachers will be hired.  With less teachers and the same number of students, schools will ended up with more students per class.

One possible counter-argument is that we have a skill shortage for secondary school teachers, and as a result by increasing wages we can get more teachers into jobs.  This presumes that schools have the resources to hire more teachers, at a higher wage, which would imply that we have a shortage of secondary school teachers.  But we don’t.  We are on the border of having a shortage of teachers, schools can find the number of teachers they need, but it does take time (average fill rate for secondary teaching jobs is 70%).

As I doubt the government will be stump up all the cash for a 7.5% jump in teachers wages (there are other groups they have to bribe first and foremost), schools will be stuck trying to come up with more money to pay teachers.  Fewer teachers will be hired and class sizes will rise.

So that makes it six finance companies in 15 months. What does this mean for the NZ credit market?

NZ banks should not be significantly effected. Banks are in relatively good shape, and all the recent trouble in secondary, non-bank financial institutes, is likely to increase demand for low yielding, low risk bank products.

However, non-bank financial institutions are going to have one hell of a time trying to find funds in the current tight credit market. The failure of so many finance companies is likely to make thing more difficult for them, by increasing investors level of risk aversion. Without a steady stream of deposits, some efficient and well managed finance companies are going to be flushed down the toilet. That is what happened to Property Finance.

My concern is that this may make it difficult for firms to borrow money. NZ currently has a tight labour market, and NZ firms are making low margins. In this sort of situation, firms are unwilling to remove staff, and as a result need to borrow to stay afloat. Now, something will have to give, either the flow in the credit market will improve, unemployment will creep up, or firms will be run into the ground. Only time will tell I guess.

Update: A couple of finance companies say they are feeling good. They expect regulation to occur, but how should we regulate the non-bank financial sector?

Update II:  So Five star consumer finance has gone under.  Guess it wasn’t really five star ;) .  Look I’m an economist with no sense of humor I just had to say it.  But it didn’t deserve a new post, as the company was small and not that exciting.  It might scare people, but I suspect it was just dead wood.

Supply and demand, the economic scissors. This beautiful diagram explains a significant amount about how economists think:

supplydemand.gif

Now from what I understand, when the two curves cross we have equilibrium. This sets a price where demand and supply are equal. When the price is higher we have a surplus of goods, here some of the firms in the industry can’t sell all their produce, and so they cut prices bringing us to equilibrium. When the price is below equilibrium we have a shortage of goods. In this case competing consumers are supposed to bid up the price until we get to equilibrium.

However, in western society we don’t like to bid up the price, we just sit around. The best example I have of this is my daily pie. I want a chicken pie, I go to the store and they only ever have one, and half the time someone else has taken it. Now instead I buy a curry pie. If the store knew that I also wanted a chicken pie they could have put one more in the oven and I would have paid a higher price, and we would both be better off.   Instead, they think that I have revealed a preference for curry pies and they keep on cooking them.  There is imperfect information here.

How are we supposed to solve the case of the pie, given that western consumers aren’t fond of arguing up the price when there is a shortage. Well I think that firms realise this, and through a process of trial and error they try to increase information, so that they can set the equilibrium price.

The example of this is supermarkets. In a supermarket there always seems to be one type of toilet paper on special. The different manufacturers take turns, lowering there price and sometimes increasing it by more than they dropped it the next week. In this case the firms are trying to discover what the demand curve looks like, they are trying to find out if there is a shortage of their product. Through this process the firm discovers enough information bring us closer to equilibrium, all in the name of maximising profits. How convenient.

I have always been skeptical of open source software, if Microsoft and all of their highly paid programmers can’t get it right, how can a bunch of guys who work on projects for free in their spare time do any better? As a recent convert to Linux I now realize how wrong I was. In fact I now have absolutely no use for any Microsoft products.

As an economist I believe that there will always be a role for propriety software though. To see why I think it is useful to examine what proponents of free software are striving for. With that in mind I have pulled the definition of “free” software off of the Free Software Foundation website:

  • The freedom to run the program, for any purpose (freedom 0).

  • The freedom to study how the program works, and adapt it to your needs (freedom 1). Access to the source code is a precondition for this.

  • The freedom to redistribute copies so you can help your neighbor (freedom 2).

  • The freedom to improve the program, and release your improvements to the public, so that the whole community benefits (freedom 3). Access to the source code is a precondition for this.

As you can see they are referring to free as in freedom to modify and redistribute rather than free as in price. However this implicitly means that the software will be available for free as even if a price is charged for the software, the person who buys it is free to give it to all his friends for free and they can give it to their friends and so on.

When I put my economist hat on (let’s be honest, I never take it off) I think that if all software was free the quality of software would suffer. What does a developer of free software get for the time he puts into writing a new piece of software? Not really much more than kudos from the community. So there is a big trade off here, with free software the people are working on software use it themselves so they are able to detect problems and add new features very easily, but at the same time if there is no financial reward from developing software then people have the incentive to put their effort elsewhere. This problem is particularly bad for software that is extremely complicated or requires a lot of time to develop. In this case we either get a software that is no where near as good as the proprietary version or the amount of time required to develop the software means progress is very slow.

As an example I use a mathematical program called Mathematica for a lot of my work and haven’t been able to find anything anywhere near as good that is “free”. I am also an avid gamer and have noticed that the standard of open source games is pretty terrible which makes sense given the amount of time required to develop a game.

So while I am huge fan of Linux and open source software , I think that aiming for all software to be free isn’t a good idea as there are certain cases where this provides the wrong incentives.


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