A Level Revision: Contestable Markets

In the A2 course contestable markets is a popular essay question and is usually combined with another market structure.

What is a contestable market?

• One in which there is one firm (or a small number of firms)
• Because of freedom of entry and exit, the firm faces competition and might operate in a way similar to a perfectly competitive firm
• The threat of “hit and run entry” from new firms may be sufficient to keep the industry operating at a competitive price and output
• The key requirement for a contestable market is the absence of sunk costs – i.e. costs that cannot be recovered if a business decides to leave a market
• When sunk costs are high, a market is more likely to produce an price and output similar to monopoly (with the risk of allocative inefficiency and loss of economic welfare)
• A perfectly contestable market occurs only when entry and exit into and out of a market is perfectly costless
• Contestable markets are different from perfect competitive markets
• It is possible for one incumbent firm to dominate the industry
• Each existing firm in the market produces a differentiated product (i.e. goods and services are not perfect substitutes for each other)

There are 3 conditions for market contestability:

• Perfect information and the ability and or legal right to use the best available technology
• Freedom to market / advertise and enter a market
• The absence of sunk costs

Example
• Liberalisation of the European Airline Market in late 1990s
• Traditional “flag-flying” airlines faced new competition
• Barriers to entry in the industry were lowered (including greater use of leased aircraft)
• New Entrants – easyJet- Ryanair

Austerity = negative multiplier effect

In the NYT it was stated that Moody’s are predicting that a tighter fiscal policy – cuts in government spending and increased taxation – will slow economic growth for 2013 by about 1.2 percentage points and prevent the unemployment rate from falling to 6.1 percent by the end of the year. Where is the effect of QE on these figures?

Geoff Riley in New Zealand

Co-founder of Tutor2u and economics guru, Geoff Riley is in Auckland for this week. Currently on a Royal Society Fellowship Geoff is also heading to Melbourne and Hong Kong on his trip downunder.

He is doing a presentation to teachers from around the Auckland area at King’s College on Thursday at 2pm. Please email me if you would like to attend – address below. We are very lucky to have someone of Geoff’s calibre here in NZ.

m.johnston@kingscollege.school.nz

A Level Revision: Comparing living standards over time and between countries

National income figures, usually GDP at factor cost, are the man figures used to compare living standards. This is because most countries keep and publish detailed national income data.

However, care has to be taken in using national income figures to compare living standards both over time and between countries. It is important to use GDP at constant prices (i.e. real national income) so that a misleading impression is not given because of the effects of inflation. It is also important to take into account differences in population size. A country with a large population is likely to produce more than a country with a small population. However, this output has to be shared out among more people so living standards are not necessarily higher. This is why economist divide output by population and compare real GDP per capita. Even when adjustments have been made for inflation and differences in population size, national income figures as a measure of living standards have to be interpreted cautiously.

A rise in real GDP per capital may have resulted from an increase in the output of capital goods. In the longer run this will increase productive capacity and result in more consumer goods being produced. However, in the short run people may not feel any benefit from more capital goods being made. An increase in weapons will also increase GDP but, again, may not necessarily improve living standards. If more police are employed and crime is reduced, the quality of people’s lives will be improved. However, if more police are employed to keep pace with rising crime, people will be feeling worse off. So economists have to look not only at the amount of goods and services produced but also at the composition of those goods and why the quantity has changed. In addition, the quality of goods and services produced should be examined. The same quantity could be produced this year as last year or five years ago but if the quality of the output has risen, living standards will have improved.

The distribution of income also has to be taken into account. National income may rise but if it is concentrated in the hands of a few, the living standards of the majority may not rise. See graph below (The Economist – 2nd February) showing the Gini coefficient of income inequality.

National income figures also fail to take into account some items which affect the quality of people’s lives. A certain amount of economic activity is not declared, either to avoid paying taxes or because it is illegal. If there is an increase in, say, people providing home hairdressing services but not declaring them, people’s living standards may rise, although this increase will not be reflected in the official figures.

Differences in working hours and working conditions are also not taken into account. If output remains constant but working hours fall, people are likely to have a higher quality of life.

National income figures only take into account economic activities for which a payment is made. They do not take into account externalities and non-marketed activities. So, for example, an increase in pollution will reduce living standards while an increase in people decorating the homes of old people, on a voluntary basis, will improve the quality of life of the elderly. Neither of these will be recorded in national income figures.

All of these factors have to be taken into account in using national income figures to make comparisons both over time and between countries. However, some additional factors have to be considered when making international comparisons. Different statistical methods are employed in some countries and the degree of accuracy can vary. Tastes and needs can be different in different countries. For example, people living in a cold climate have to spend more on heating than those in warm countries, merely to enjoy the same standard of living. There is also the problem of selecting a rate of exchange to make the comparison. Exchange rate fluctuate and do not always reflect relative prices in compared using purchasing power parities which compare the cost of a given basket of goods in different countries.

Germany is the place to go.

Since the 1950′s the free movement of people has been one of the major goals of European integration. Broadly defined, this freedom enables citizens of one Member State to travel to another, to reside and to work there (permanently or temporarily). The idea behind EU legislation in this field is that citizens from other member states should be treated equally with domestic ones – they should not be discriminated against. With the current austerity measures in a lot of European countries and high unemployment there has been a movement to more bouyant countries in particular Germany. See graph below from WSJ Graphics.

It is the algorithms that outsmart humans not machines.

Whilst away on hockey tour in Malaysia I was able to avail myself of the ‘The Straits Times’ newspaper which is published in Singapore. One article that particularly caught my attention was that concerning the creativity of algorithms. Most are oblivious to their creativity yet highly sophisticated algorithms have created music based on the works of great artists but in a style that is personalised and therefore indicative of you the individual. They are also replacing writers – Professor Phil Parker of the Insead Business School in Paris has published more than a million reports on Amazon in just a couple of years. Using a proprietary algorithm that produces a report in 10 – 20 minutes instead of about 4 weeks. The algorithm pulls information from the web, performs econometric analyses, creates tables, formats the report and publishes it as a Word document. Professor Parker has also developed algorithms to produce poems, videos and video games.

Algo Trading
Although we could question the efficacy of algorithms on intangible dimensions such as “soul’ and “depth”, one area where they trounce human beings is stock trading. With up to 75% of trades on Wall Street done using computer programmes it is no wonder that algorithms execute trade at lightening speed and carry out numerous transactions every second. On the NYSE the average round-trip transaction time is 600 microseconds. To put into perspective if you blinked it takes you 300 milliseconds to complete the action – during that time NYSE executed 500 trades. This desire to improve efficiency in the market has led to extremely low costs of trading and very high stock liquidity. However it has also produced huge swings in stock prices. On 6th May 2010 – know as the ‘Flash Crash’ – the DJIA fell 9% in minutes but then recovered most of that loss in the subsequent few minutes.

The landscape of society was always made up by this uneasy relationship between nature and man. But now there is this third co-evolutionary force – Algorithms – and we will have to understand them as nature and in a way they are. Kevin Slavin Ted Talk

A Level Revision – Fixed, Dirty Float Exchange Rate Systems

For many years after the Second World War most countries operated a system of fixed exchange rates. The external value of a currency was fixed in terms of the US$ and the value of the US$ itself was fixed in terms of gold. In effect, therefore, the values of the currencies were fixed in terms of gold. The ‘fixed’ rate was not absolutely rigid. The value of a currency was allowed to vary within a narrow band of 1 or 2% on each side of the ‘fixed’ rate or parity. For example, if the value of the NZ$ were fixed at NZ$1 = US$0.50, a permitted deviation of 2% would allow it to vary between NZ$1 = US$0.51 and NZ$1 = US$0.49. These limits are often described as ‘the ceiling’ and ‘the floor’. Central banks were responsible for maintaining the values of their currencies within the prescribed bands. They are able to do this by acting as buyers or sellers of the currency in the foreign exchange market. For this purpose each central bank must have a fund containing supplies of the home currency and foreign currencies.

The way in which the Reserve Bank of New Zealand can use its funds of currencies to influence the exchange rate can be explained by making use of the diagram below. Let us assume that the value of the NZ$ has been fixed at A and, initially, the market is in equilibrium at this exchange rate. The permitted band of fluctuation is PP1 and the value of the pound must be held within these limits. A large increase in imports now causes an increase in the supply of NZ$’s in the foreign exchange market. The supply curve moves from SS to S1S1 causing a surplus of NZ$’s at the ‘fixed’ rate (A). If no intervention takes place, the external value of the
NZ$ will fall to B which is below the permitted ‘floor’.

The Reserve Bank will be obliged to enter the market and buy NZ$. In doing so that will shift the demand curve to the right and raise the value of the NZ$ until it is once again within agreed limits. In the diagram below intervention by the Reserve Bank of NZ has raised the exchange rate to C.

When the Reserve Bank of New Zealand is buying NZ$’s, it will be using up its reserves of foreign currencies; when buying NZ$’s it exchanges foreign currencies for NZ$’s. ‘Supporting the NZ dollar’, that is, increasing the demand for NZ$’s, therefore leads to a fall in the nation’s foreign currency reserves. In the opposite situation where an increased demand for NZ$’s tends to lift the value of the NZ$ above the permitted ‘ceiling’, the central bank will hold down its value by selling NZ$’s. This will increase the supply of NZ$’s and lower the exchange rate. When the Reserve Bank is selling NZ$’s it will be increasing its holdings of foreign currencies.

The main argument for a fixed exchange rate is the same as that against a floating rate. A fixed rate removes a major cause for uncertainty in international transactions. Traders can quote prices which will be accepted with some degree of confidence; buyers know that they will not be affected by movements in the exchange rate. The risks associated with international trade are lessened and this should encourage more trade between nations and more international borrowing and lending.