Concentration ratio of the Premier League, La Liga, Bundesliga and Serie A

Part of the CIE A2 syllabus deals with the concentration ratio and by good fortune a recent edition of The Economist schools brief looked at this area. The concentration ratio is the percentage of market share taken up by the largest firms. It could be a 3 firm concentration ratio (market share of 3 biggest) or 5 firms concentration ratio. Concentration ratios are used to determine the market structure and competitiveness of the market. The most commonly used are 4, 5 or 8 firm concentration ratios which measure the proportion of the market’s output provided by the largest 4, 5 or 8 firms.

Example of a hypothetical concentration ratioThe following are the annual sales, in $m, of the six firms in a hypothetical market:
Firm A = 56 – Firm B = 43 – Firm C = 22 – Firm D = 12 – Firm E = 3 – Firm F = 1

In this hypothetical case, the 3-firm concentration ratio is 88.3%, that is 121/137 x 100.

HHI and European Football
However, we can apply a similar calculation to measure the concentration of football league championships. The Herfindahl-Hirschman Index (HHI) was originally developed to measure the concentration of firms in an industry, but it has been used in football. To work out the HHI (see equation) you count the number of championships a team won (Ci) within a given time period, dividing by the number of years in the period (N), squaring the fraction, and adding the fractions for all teams.

If the HHI is a maximum 1 this indicates a perfect imbalance and one team has been champion for all years. The minimum HHI value is 0.1 and this means that there has been a different winner each year. Below is the HHI in various European leagues between 2012-13 to 2021-22.

Distribution of championships in European Leagues – 2012-13 to 2021-22 (10 years)

From the above table this to the big football leagues in Europe we see that the distribution of championships is high skewed toward a few dominant teams. In all four leagues one team has won at least 5 championships over the 10 years with Bayern Munich being totally dominant in the Bundesliga winning all 10 – HHI = 1. In a lot of cases the runner-up in these leagues is also featured as a championship winner. La Liga and the EPL had two teams that were 1st or 2nd in most years – Barcelona or Real Madrid, Manchester City or Liverpool. To the extent that teams can ‘buy championships’ because they have more revenue than their competitors, differences in market size and team popularity may be to blame. The EPL is the most balanced of the league with a HHI = 0.32 with La Liga HHI = 0.38. This lack of competitive balance combined with the extraordinary popularity of European football provides additional evidence that fans may be less concerned with the competitive balance that one might think.

Source: The Economics of Sport (2018) – M. Leeds, P. Von Allmen and V. Matheson

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What will higher unemployment figures in NZ mean for monetary policy?

Although still low New Zealand’s unemployment figures today registered an increase of 0.1% to be at 3.4%. The labour market is still tight but there are signs that the reduction in job ads and monthly filled jobs are putting less pressure on the market. This may mean that the RBNZ, who sets monetary policy, sees that aggregate demand is starting to ease indicating a less aggressive stance with interest rates. With inflation at 7.2% and still well above the policy target agreement of 1-3%. the RBNZ might increase the OCR this February by 0.5% which is a reduction on the the previous increase of 0.75% on 23rd November. That would leave the OCR at a peak of 5.25% by May. However if high inflationary expectations become the norm the RBNZ might have to become more aggressive in its policy. Below is a mindmap on monetary policy which might be useful for revision purposes.

Source: ANZ Research 1st February 2023

Adapted from: A Level Economics Revision – Susan Grant.

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The migration model and the theory of wages

The new prime minister Chris Hipkins stated that he wanted to make it easier for workers to come to New Zealand especially helping those sectors experiencing significant labour shortages but didn’t want to loosen immigration settings too much.

In economic theory the impact of migration we can assume that the supply of labour will shift to the right. This increase in labour supply makes labour less scarce and therefore leads to a reduction in wages. The lower wage means the level of domestic (local workers) employed is reduced. The blue area represents what local workers receive in pay whilst the green area is the immigrant wages. This will cause a transfer of surplus from domestic employees to employers – wage loss to labour but a gain to the employer. There is also a net increase in surplus from that before immigration called ‘Immigration surplus’ – see graph. However does this really happen? The impacts of immigration on the labour market critically depend on:

  • skills of immigrants, the skills of existing workers, and the characteristics of the economy
  • which areas of work are they involved in – skilled / non-skilled
  • immigration leads to more aggregate demand and competition for existing jobs in certain occupations but also create new jobs
  • the immediate impact on wages depends on the skills that substitute or complement existing domestic workers.
  • the extent to which an influx of workers to an economy increases unemployment is dependent on how domestic worker are willing to accept the new lower wages.
  • if skills of immigrants are complementary to those of domestic workers, all workers experience increased productivity which can be expected to lead to a rise in the wages of existing workers.
  • Immigration can also expand demand for labour as consumer demand for goods and services increases, and employers may increase production in sectors where migrant labour is used (e.g. agriculture or care sectors).
  • immigration may change the mix of goods and services produced in the economy and thus the occupational and industrial structure of the labour market. An example here would be the use of technology in the production process.
  • at which part of the business cycle the demand for labour occurs – downturn means slower demand.

With the immigration issue in NZ Shamubeel Eaqub, from Sense Partners, told Radio NZ Checkpoint programme:

“We kind of use it as a political tool to deal with whatever we want to at the time,”

“Currently it happens to be that it’s labour shortages, 10 years ago it was because we wanted population growth and economic growth, and I think it’s really unfair to … use immigrants as these little political chess pieces. We need to be a little bit more structured around what we want it for, that would create more certainty – both for the immigrants and for the businesses in New Zealand.”

Has China’s economy outgrown its economic blueprint?

Below is an excellent video from German state broadcaster Deutsche Welle (DW). It outlines the decline in China’s GDP which is now at historic lows. DW look at the problems that have been building in China as for the first time in two decades, its output fell behind that of the rest of Asia. It also addresses the history of economic rise and the mountain of debt that it has accumulated. Add to that the demographic change and international threats. Below are some points from the video:

The draconian measures to contain COVID has sapped domestic consumption crippled small businesses and kept China’s factories closed.

The Chinese government has shielded its economy for years with infrastructure projects – building roads, dams, harbours, rail networks etc. It is the latter that is a good example of excess capacity and mounting financial losses – the network keeps growing even less populated locations where there isn’t much demand and now maintenance costs and interest payments have overtaken the railway’s income.

With the working population declining it is hard to maintain dynamic growth. Less workers puts pressure on wages and for China to maintain its cheap prices it has to improve productivity. Demographic change is a long-term phenomenon so the Chinese government still has room to respond and it has already switched to a three-child policy.

Also the demand for China’s exports has decreased as the global economy goes through an economic slowdown with surging inflation. Exports declines from 36% of GDP in 2006 to 20% in 2021 – see graph. Therefore more domestic consumption is needed to maintain growth and an expansionary fiscal policy like that in western economies might be the way to go.

Argentina and Brazil currency union – pros and cons

Recently there has been talk of preparation for a currency union between the Brazilian ‘real’ and Argentina ‘peso’ which would create the world’s second largest currency bloc. The new currency, which Brazil suggests calling the ‘sur’ (South) would reduce the reliance on the US dollar and encourage greater regional trade.

To enter a currency union it represents one end of the exchange rate continuum whilst the other end is pure floating currency determined by market forces (supply and demand) – see Fig 1 below:

Reserve Bank of New Zealand: Bulletin, Vol. 68, No. 4

Costs and Benefits

By joining a currency union both Brazil and Argentina no longer have control over managing inflation, attaining full employment and use interest rates to respond to different stages of the business cycle. One of the benefits of a floating rate is that it acts as a shock-absorber – a downturn in the economy leads to a depreciating exchange rate and therefore more competitive exports and more expensive imports – however a lot depends on the elasticity of demand for both exports and imports. Remember the Greek experience in the EU when their economy was in a dreadful state financially and they had the Euro as their currency. If Greece still had its old currency the drachma it would have depreciated and maybe have led to some sort of export recovery. The concern was that the strength of the Euro was determined by the Germany economy and this impacted the poorer members of the currency union like Greece, Portugal and Spain. When asymmetric shocks occur they effect economies differently as they can be due to different production and consumption structures, trade exposure and varying levels of inflation between the two countries. This is apparent with Argentinian inflation hitting 95% in 2022 compared to 5.79% in Brazil. Furthermore, central bank interest rates in Brazil are 13.75% compared to the central bank in Argentina of 75%. It seems here that the Argentinian economy is in real trouble and add to this they are on the brink of another default on their debt – 5th in 40 years. So who is to benefit here – it seems that Argentina is in the worst predicament and might welcome currency union to try and improve the economic conditions in their economy. However will a full currency union actually happen? Table 1 below summarises some of the pros and cons.

eLearnEconomics – Natural Monopoly

Below are some notes from the eLearnEconomics site. For more information click on the link.

A natural monopoly is when one firm has the ability to supply the entire market at lower prices than two or more firms. A natural monopoly faces downward-sloping average cost (AC) for the entire range for which demand is applicable. The reason for its downward-sloping AC curve is usually that the initial investment in the infrastructure of the firm is large, but once it is in place, the marginal cost (MC) of production is low, for example hydro power. This high establishment cost is a strong barrier to entry and a natural monopoly could undercut any would-be competitor so they could not survive. Natural monopolies often involve some kind of network, for example water, gas,phone, rail.

Equilibrium Output-Natural Monopoly

The rule for maximising profit or minimising a loss (the equlibrium) for a natural monopoly is the same as any other firm. The most profitable output or smallest loss is where marginal revenue (MR) equals marginal cost (MC). Any other position will result in a smaller profit or greater loss. Therefore, the equilibrium output is at a price of Pe and quantity Qe (determined from the intersection of the marginal cost and marginal revenue curves). At the equilibrium output Qe the natural monopoly is making a supernormal profit (of $100m) and produces less than what society or consumers desire. Operating at the equilibrium output position creates a deadweight loss of BFG because consumer surplus and producer surplus are not maximised. The natural monopoly is charging a price in excess of marginal cost (P > MC), this is called mark-up pricing. At the equilibrium output in perfect competition, price and marginal cost are the same. Sellers cannot charge higher prices because they would immediately lose sales to competitors. This is called marginal cost pricing and occurs in perfect competition where at the equilibrium output position price equals marginal cost (P = MC). A natural monopoly charges more and produces less than would be the case if the firm operated as a perfect competitor.

Policies concerning natural monopoly

One way a government can regulate a monopoly is by administering price controls that do not allow a natural monopoly to operate at its preferred equilibrium output position where marginal revenue equals marginal cost. For this monopoly the equilibrium output is at a price of $7 (Pe) and quantity of 50m (Qe). The aim of price controls is to benefit the consumer with lower price and a greater quantity. Average cost pricing is a way that the government can improve resource allocation because it increases total surpluses in the market and reduces the deadweight loss that would be associated with a natural monopoly operating at its equilibrium position (MR = MC). Average cost pricing regulates the firm to charge a price equal to average costs (P = AC). In this instance the price would be $4 (Pn) and the quantity would be 80m units (Qn). The natural monopoly would no longer be maximising profits because the marginal revenue is less than marginal cost, the firm is making marginal losses on the increased output. The firm would make a normal profit instead of a supernormal profit. Normal profit is a return to the entrepreneur sufficient to keep them in their present activity. A natural monopoly regulated to a situation where price equals average cost is able to earn a fair rate of return. The net deadweight loss to society is reduced but not eliminated, the deadweight loss is now the area HKG. The natural monopoly is making a normal profit so they may lack the funds to do R & D and be less innovative, this could be viewed as a negative impact on resource allocation of fixing the price. A price set to equal average cost is more socially desirable than the equilibrium output position because consumers experience a significant increase in consumer surplus due to the lower price and higher quantity consumed. Average cost pricing has the advantage over marginal cost pricing of not having to provide a subsidy to a natural monopoly to keep the firm operating.

Read more at: elearn Economics – https://www.elearneconomics.com/

Most Premier League clubs make as much money as a branch of IKEA

With the recent World Cup in Qatar I thought I would share this post again on the Economics of Football. The David McWilliams podcast entitled ‘The Economics of Football’ in which he interviews Simon Kuper of Soccernomics fame, is particularly insightful. What he basically says is that the vast majority of clubs are not businesses and are not trying to make profits. They are pursuing trophies and with this intention spend what money they do make on buying the best players. If you look at the teams in the four English Divisions in 1921 there has been little change even when some clubs go bankrupt. As they are fan based institutions they seem to be unaffected by things like debt in a normal business. For example if a club (limited company) goes bankrupt you discard the old company and form a new limited company changing the name of the club (ABC City to ABC United) but playing at the same ground with the same strip etc. To put it in perspective a typical Premier League club is the size of a branch of IKEA.

Football clubs are huge emotional brands but not very big businesses. For example in 2019 Barcelona was the first club to made over $1bn in revenue but that equates to 0.02% of what Walmart made that year. The problem that football clubs have is how to monetise that passion for the club without affecting their fan base.

Bundesliga should be the richest league in Europe?
When you look at the economic indicators of the German economy – population size, income levels, GDP growth etc – it should be the league with the most money. Why is this not the case? The German FA doesn’t want foreign money coming into their clubs like Chelsea, Manchester City, Paris Saint-Germain etc. Also the German Bundesliga has a rule that over 50% of a club must be controlled by its supporters.

New breed of foreign owners and European Super League
The owners of Manchester United, Tottenham and Arsenal are more focused on making money out of the football club compared to others – Man City, Chelsea, PSG – whose owners want success at the expense of profit. This new breed of owner has come under a lot of pressure from the club’s supporters in that some are borrowing money to buy the club and then taking money out. Take for instance Man United – in the 5 years up to 2020, no owners in the Premier League have taken out more money than Man Utd £133m (dividends £112m, share buy back £21m). In stark contrast, some owners have put in significant funds: Everton £348m, Aston Villa £337m and Chelsea £255m – see graphic.

Source: SwissRamble

You can therefore see why some owners were keen on the European Super League. The proposed ESL was all but free-market capitalism with an American style franchise system with 12 teams guaranteed a place in the competition – significant barriers to entry and not conducive to competition. So much for Joseph Schumpeter’s creative destruction with a group of elite clubs protecting their market and the owners being rentier capitalists. The ESL’s proposed move is similar to what has been happening in the market place – a structure of businesses taking huge debt and taking little interest in competition as long as they are making money. Manchester United, probably the most famous club in the world, got knocked out of the Champions League in the group stage in 2021 but are still making a lot of money for the owners. It seems that the desire to win trophies has been superseded by profit – the proposed ESL avoids competition as member clubs are protected against the risk of failure. Not to say this is not already happening as the EPL and many other leagues in Europe are dominated by a small number of clubs which have significant funds available.

Strong US dollar a concern for developing countries

From CNBC – some good graphics in this presentation and an interview with Eswar Prasad, an economist at the Brookings Institution and professor at Cornell University. Quote below:

“So here’s the paradox. The rest of the world despises how dominant the dollar is, yet they go to the U.S. dollar, because there really isn’t much of an alternative,”

Some facts about the US Dollar –

  • 60% of the world’s central banks’ foreign exchange reserves in US dollar-denominated assets.
  • 40% of consumers use the US dollar as a payment currency worldwide.
  • 60% of international debt and 50% of loans globally is in US dollars.
  • US dollar – still the main currency to buy and sell commodities such as oil.

“This is ultimately going to entrench the dollar’s dominance even further,” Prasad said. “That is certainly a serious problem for low-income countries that have high levels of foreign debt, especially dollar-denominated debt.”

eLearnEconomics – tour of site and new feature

Below is a short video showing features of the eLearnEconomics site. Since 2008 eLearneconomics has provided a comprehensive and concise insight into understanding a multitude of economic concepts, ranging from the central ideas of demand, supply and markets, to the complexities of microeconomics and macroeconomics. The sites covers Cambridge International Exams A2, AS and IGCSE material, IB as well as the NCEA Level 1, 2 and 3. The site has key notes, flash cards, written answers and multiple-choice questions, all with immediate feedback that provides student-centred learning to improve student’s results and grades.

New feature

The most recent written answers (nearly 5000 questions and answers over 145+ topics) will now be saved and can be viewed under results for students with a premium access. The written answers allow students to recall information and apply it to exam style questions. Immediate feedback allows for student-centred learning and identifying areas that are not fully understood.

https://www.elearneconomics.com/

2022 HDI – Switzerland #1

Below are two very good videos by Geoff Riley of Tutor2u. They cover the 2022 HDI figures and an explanation of the 3 main indicators that make up the index. This topic is part of the A2 Economics course and the videos great for revision purposes. Switzerland comes in at #1 with New Zealand and Belgium 13th=. The second video covers the limitations of HDI which can be part of an essay questions. Click here to find more economics revision videos from Tutor2u.

Economics for the future

With the summer holidays and more time to read, I came across a very informative journal paper, which was tweeted by @KateRaworth , in the Ecological Economics Journal entitled “Economics for the future – Beyond the superorganism” by N.J. Hagens – full paper can be found here. I have attempted to summarise part of the journal paper below.

—————————————————————————

Hagens addressed the concern that are environment and economy are at a crossroads with the current model of:

Human behaviour + finance + energy + the economy + the environment = catastrophe

Most economies aim to grow at around 2-3% each year – hopefully maintaining inflationary targets and keeping apace with foreign competition. However in order to achieve this growth rate they will consumer as much energy in the next 30 years (approximately) as was consumed cumulatively in the last 10,000 years. Growth is now being driven in unsustainable ways with consumers in the developed world trying to satisfy unlimited wants and needs (which are not normally affordable) by debt.

Hagen articulates how a social species self-organising around surplus has metabolically morphed into a single, mindless, energy-hungry “Superorganism.”

Background – the industrial revolution and the discovery of fossil fuels (energy) influenced most aspects of daily life and heralded unprecedented growth. It also created new jobs with steel making processes, mass-production assembly lines etc – the high levels of agricultural productivity facilitated the labour required to run these new industries. How economies have developed – see table below.

Human behaviour -today status is an important aspect of life and although people are a lot better off than those 50 years ago it is where they rank in today’s society which counts and not absolute income. A trait of the consumer today is the stimuli and addiction to consumption. There appears to be no instinctual ‘full’ signal in modern brains and we are constantly looking for the next reward – episode on Netflix, the latest car, a new iPhone etc.

Modern economics assumes the rational brain is in charge, but it’s not. Our in-group nature facilitates fake news works and makes people doubt the belief about climate change and energy depletion. There is a strong tendency to care about the present rather than the future – the discount rate. Most of our challenges are in the future – recognition that the future exists and that we are part of it springs from a relatively new brain structure, the neocortex. Emotionally, the future isn’t real.

Energy – ecological economics recognises that real economies are completely dependent on energy. Energy = the currency of life. It is the ‘net energy’ after energy costs have been subtracted that is the enabler and driver of natural – and human – systems

Most economic theory suggests that if the price of one input is too expensive the market will develop a cheaper alternative. This is not the case with energy as alternatives have differences in quality, density, storability, surplus, transportability, environmental impact, and other factors. We can (for now) readily print money but we can’t print energy to give it value. We can only develop new sources or extract what exists faster or learn to use it more efficiently. Fig 3 below shows that fossil fuels are the foundation of the modern economy and are currently imperative to industrial development and growth.

Synthesis
Fig 8 below is a conceptualisation of the last few and next few hundred years (not to scale).
Green line = sustainable flow levels available to humanity which reached technological and geographical limits in the 19th century.
Red line = the one-time pulse of non-renewable natural resource inputs to human economies (oil, gas, copper, etc.).
Black line = financial markers (money, credit, etc.) of the underlying primary capital.

Point A – pre-Industrial era using relatively simple technology such. as sails and animal labour.
Point B – industrial revolution – humanity added the condensed stocks of hydrocarbons to previously flow-based human economies. Solow residual = the economic growth not explained by labour or capital was absent during this time because the black line and red line were tracking together.

Between B and C = energy crisis in the 1970s. Solved by using debt to pull consumption forward in time and globalisation and outsourcing to the cheapest areas of production

Point C = GFC 2008. New system – too-big-to-fail guarantees, artificially low interest rates quantitative easing, central bank balance sheet expansion and various GDP-friendly rule changes.

Point D, where our global monetary representations of reality continue to decouple from the underlying biophysical reality (red curve)

Humans to superorganism – a Tibetan monk might seek comfort by sitting alone on a wooden bench meditating but for the modern consumer achieving comfort means eating at a better restaurant, buying a better car, air conditioning or heat, fast internet, faster transportation, etc. For most people these preferences have a strong correlation to devices and processes requiring energy. Our ancestors didn’t live with Instagram, Fortnight, Teslas, sushi or Netflix. Furthermore, the hedonic treadmill, that is addictive consumption, is linked to energy use.

The consumer today doesn’t seem to have a sense of delayed gratification – waiting for something builds up you utility / satisfaction. Therefore we have a present bias in that, to quote the band Queen, ‘we want it now we want it all’. This pursuit of ‘stuff’ by consumers also explains the motivation for debt, which pulls energy and material consumption to the present.

Implications – Gross domestic product (GDP) → gross world burning (GWB)

Economic growth can only experience ‘absolute decoupling’ if we increase GDP while decreasing primary energy consumption. US senator Robert F Kennedy pointed out 50 years ago that GDP traditionally measures everything except those things that make life worthwhile. Dr Mike Ryan’s (WHO) agreed with this in his recent speech about how Covid 19 is a wake up call to how we live our lives and the fact that we can’t keep just focusing on economic growth. Yet economies still pursue the GDP carrot, often toward facetious endeavours that assure the significant financial return over the shortest time period. Although the COP27 addressed some issues to do with climate change in giving money to those developing countries that had suffered from climate change impacts, there was no agreement to reduce fossil fuel usage.

In the same way that ants pursue individual tasks for the growth of the colony, humans have outsourced our individuality to the ‘cloud’, which is itself devoid of an actual brain. N.J. Hagens

The risks associated with the reduction in energy and material well-being are two-fold:

  1. Economies need to prepare for an environment with less credit, energy limitations and the changing nature of work.
  2. The Great Simplification might emerge – a new economic system based on biophysical reality. Taxes on rapidly depleting resources, a reduction in risky lending and regulated incomes.

Whatever we’ll call it, we are desperately in need of a set of guideposts and principles that include not only ecology but also biology, psychology, physics and emergent behaviours. This discipline will focus at least as much on ‘what we’ll have to do’ as on ‘what we should do’. N.J. Hagens

Source: Economics for the future – Beyond the superorganism by N.J. Hagens.
Ecological Economics Volume 169, March 2020.

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Business cycle or volatile booms and busts? The four stages of the bubble.

I blogged on this topic last year but below is a useful video from the Wall Street Journal (WSJ) on how bubbles are so difficult to predict with some examples from Gamestop to Tulips. A graphical explanation follows after the video.

I picked up this graphic and explanation from The Geography of Transport Systems by Jean-Paul Rodrigue (2020)

It is apparent that business cycles aren’t those smooth ups and downs as depicted in a lot of textbooks but more volatile with booms and busts. Central banks appear to play their part in this process with the low cost of borrowing feeding the boom phase of the cycle. Instead of economic stability regulated by market forces, monetary intervention creates long-term instability for the sake of short-term stability.

Bubbles (financial manias) unfold in several stages, an observation that is backed up by 500 years of economic history. Each mania is obviously different, but there are always similarities; simplistically, four phases can be identified:

  • Stealth – emerging opportunity for future prize appreciations of investments. Investors have better access to information and understand the wider economic context that would trigger asset inflation. Prices tend to increase but are unnoticed by the general public.
  • Awareness – many investors start to notice the momentum so money starts to push prices higher. There can be sell-offs but the smart money takes this opportunity to reinforce its existing positions. The media start to notice that this boom benefits the economy.
  • Mania – the public see prices going up and see this a great opportunity to invest with the expectations about future appreciation. This stage is not so much about reasoning but psychology as money pours into the market creating greater expectations and pushing prices up. Unbiased opinion about the fundamentals becomes increasingly difficult to find as many players are heavily invested and have every interest to keep asset inflation going. At some point, statements are made about entirely new fundamentals implying that a “permanent high plateau” has been reached to justify future price increases; the bubble is about to collapse.
  • Blow-off – everyone roughly at the same time realises that the situation has changed. Confidence and expectations encounter a paradigm shift, not without a phase of denial where many try to reassure the public that this is just a temporary setback. Many try to unload their assets, but takers are few; everyone is expecting further price declines. Prices plummet at a rate much faster than the one that inflated the bubble. Many over-leveraged asset owners go bankrupt, triggering additional waves of sales. This is the time when the smart money starts acquiring assets at low prices.

For more on the Business Cycle view the key notes (accompanied by fully coloured diagrams/models) on elearneconomics that will assist students to understand concepts and terms for external examinations, assignments or topic tests.

Taylor rule and New Zealand interest rates (OCR) at 8%

The Taylor Rule is a specific policy rule for fixing interest rates proposed by the Stanford University economist John Taylor. The rule is a formula for setting interest rates depending on changes in the inflation rate and economic growth.

A simplified formula is: r = p + 0.5y + 0.5 (p – 2) + 2
r = the short term interest rate in percentage terms per annum.
p = the rate of inflation over the previous four quarters.
y = the difference between real GDP from potential output.
This assumes that target inflation is 2% and equilibrium real interest rate is 2%

Taylor argued that when:

  • Real Gross Domestic Product (GDP) = Potential Gross Domestic Product
  • Inflation = its target rate of 2%,
  • Federal Funds Rate (FFR) should be 4% (that is a 2% real interest rate).

If the real GDP rises 1% above potential GDP, then the FFR should be raised by 0.5%.
If inflation rises 1% above its target rate of 2%, then the FFR should be raised by 1.5%.
He stated that the real interest rates should be 1.5 times the inflation rate.

This rule has been suggested as one that could be adopted by other central banks – ECB, Bank of England, etc for setting official cash rates. However, the rule does embody an arbitrary 2% inflation target rather than, say 3% or 4%, and it may need to be amended to embody alternative inflation targets at different times or by different central banks. The advantages of having such as explicit interest rate rule is that its very transparency can create better conditions for business decisions and can help shape business people’s and consumers’ expectations. Central banks prefer to maintain an air of intelligent discretion over the conduct of their policies than to follow rules, but to some extent they do unwittingly follow a Taylor rule. This makes the rule a useful benchmark against which actual policies can be judged.

New Zealand and the Taylor rule
When the Taylor Rule is applied to the New Zealand economy it suggests an optimal, OCR of more than 8% – see graphic from live gross domestic product (GDP) tracker. A rate as high as this would do significant damage to the economy even if inflation did get down to the 2% target for inflation. Households and businesses would find it particularly hard with incomes being squeezed. An OCR of this level would have an unwieldly impact on households and businesses, squeezing incomes. 

Criticisms of Taylor rule
The theory assumes that only the central bank can affect the equilibrium real rate of interest and there is a closed economy with households that have identical consumption patterns and the same declining marginal utility. However, an economy is a much more intricate machine which aims to allocate scarce resources to satisfy the utility of economic agents such as individuals, firms and government. The dominant model for many years has been “Dynamic Stochastic General Equilibrium” (DSGE) and it takes all the characteristics of an individual (this person is typically called the representative agent) which is then cloned and taken to represent the typical person in an economy. These agents make supposedly perfect decisions by optimising, working out the kinds of mathematical problems in an instant. This almost rules out any fluctuations in the natural rate that might arise from alterations in how individuals discount the future, from how consumption preferences may differ among individuals or alter over time for one individual, or from differences in the distribution of wealth.

Source: Live GDP tracker

How well do we understand inflationary expectations?

In looking at the causes of inflation, textbooks will cover demand-pull and cost-push but not go into much detail about inflationary expectations. If the consumer believes that prices of goods are going to increase this will have an impact on future price levels and the wage demands – a self-fulfilling prophecy.

Higher wages = Higher labour costs = Higher prices

Jerome Powell, US Fed Chairman, has made four 0.75 percentage point hikes in a row is an aggressive monetary policy to reduce inflation. Yesterday’s increase of 0.5% takes the bank’s benchmark lending rate to 4.25% – 4.5%, a range that is the highest since January 2008. He also alluded to inflationary expectations:

“We can’t allow a wage-price spiral to happen,” he said. “And we can’t allow inflation expectations to become unanchored. It’s just something that we can’t allow to happen.”

So how do you measure inflationary expectations? Policymakers use surveys at different times to monitor households’ and firms’ beliefs about prices. Furthermore, in order to try and shape consumer expectations central banks are very transparent as to their forecast of inflation and future interest rate changes.

How well do we understand households’ expectations? An article in the IMF Finance & Development (September 2022) looked at a deeper understanding of how consumers think about inflation. There seems to be a disagreement between consumers and policy makers with the former relying on the price change in a few products like coffee and petrol as an overall indicator of a country’s inflation rate. Past experiences —such as living through events such as the 1970’s oil crisis, the stagflation years of the late 1970’s, the Global Financial Crisis 2008, stock market crash of 1987 (Black Monday) etc, can influence peoples understanding of inflation for years to come. For instance if you lived through the stagflation years you are you more likely to be less optimistic about controlling inflation?

Andre et al (2022) recent research set out to see if economic policy (fiscal and monetary) and economic events result in the same expectations by laypeople and experts. They focused on unemployment and inflation and distributed surveys to 6,500 households and 1,500 experts. The survey asked respondents to consider four hypothetical shocks to the US economy:

  • a sharp increase in crude oil prices
  • a rise in income taxes,
  • a federal government spending increase,
  • a rise in the Federal Reserve’s target interest rate.

All respondents were given the current figures for inflation and unemployment and were asked to give their forecast of their movement over the following year after being given news about one of the four shocks. Interestingly laypeople believed that an increase in interest rates and income taxes would increase inflation which is contrary to what economics textbook models show – see Chart 1. The difference of opinion seems to stem from the interpretations of demand versus supply models see Chart 2. The experts used theoretical models and economic toolkits whilst the laypeople were more likely to rely on personal experiences, political views and a different interpretation – i.e. they look at supply-side issues:

higher interest rates = higher costs for firms = increase in prices to maintain profit margins = inflation↑

Experts take the view that it is a demand-side issue:

higher interest rates – higher cost of borrowing for consumers = less borrowing = inflation↓

Central Banks look to make communication more accessible

Central banks are now trying to, not only make communication accessible, but also much easier to understand. For example the European Central Bank (ECB) has built a presence around social media platforms using simpler language to explain the impact of interest rates on inflation.

Economic models depend on ‘rational expectations’ according to which households base their individual decisions—on how much to save, consume, and work—on expectations about the uncertain future state of the economy.

Source: Hall of Mirrors: How Consumers Think about Inflation by Carlo Pizzinelli
IMF F&D September 2022

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World Cup 2022 action bias and penalty kicks – is it best if the goalkeeper does nothing?

With the World Cup approaching the semi final stage and games being decided on penalties I thought it would be appropriate to look at the psychology of penalty kicks. Would goalkeepers be better not moving when facing a penalty?

Action bias is a situation where we would rather be seen doing something than doing nothing. This has been the case in numerous government elections as the voting population like to see some action from politicians when in some cases the best option is to let the economy run its course. President Nixon (US President 1969-74) was a great one for doing something even though it would have been better to do nothing – I refer to the wage and price controls introduced in 1971 – the controls produced food shortages, as meat disappeared from supermarket shelves and farmers drowned chickens rather than sell them at a loss. So when the economy is doing badly the government maybe tempted to intervene, even if the risks associated with the changes not necessarily outweigh the possible benefits. Furthermore if an economy is doing well policy makers may feel that they shouldn’t do anything even though the changes could improve the economy further.

According to classical assumptions in economics, when people face decision problems involving uncertainty, they should choose what to do according to their utility from the possible outcomes and the probability distribution of outcomes that follows each possible action. Bar-Eli, Azar, Ritov, Keidar-Levin, & Schein, 2007

In a 2007 study, Michael Bari-Eli at the Ben Gurion University of the Negev, Israel, analyzed 286 professional soccer penalty kicks. They discovered that goalkeepers almost always jump right or left because the norm is to jump — a preference for action (”action bias”). The goalkeepers jumped to the left 49.3% of the time, to the right 44.4% of the time, but stayed in the centre only 6.3% of the time. Analysis revealed that the kicks went to the left 32.2%, to the right 39.2% and to the centre 28.7% of the time. This means that the goalkeepers were much more likely to stop a kick if they had just stayed put – see table below.

The table above suggests that the decisions taken by the kicker and goalkeeper are made roughly simultaneously. The fact that the directions of the kick and the jump match in 43% of kicks rather than in 0% or 100% of the kicks suggests that neither kicker nor goalkeeper can clearly observe what the other chose when choosing their action.

A goalkeepers’ decision making.

In order to suggest a best option for goalkeepers it is necessary to examine the probability of stopping the ball following each combination of kick and jump directions. The table below presents the average saving chances using the formula

Number of penalty kicks saved ÷ Number of penalty kicks x 100

Jumping left = 20 ÷ 141 x 100 = 14.2%
Staying Centre = 6 ÷ 18 x 100 = 33.3%
Jumping right = 16 ÷ 127 x 100 = 12.6%

The research conclusions state that goalkeepers jump to the right or the left during penalty kicks more than they should. In analysing the 286 kicks Bar-Eli et al show that while the utility-maximising behaviour for goalkeepers is to stay in the goal’s centre during the kick, in 93.7% of the kicks the goalkeepers chose to jump to their right or left. This non-optimal behaviour suggests that a bias in goalkeeper’ decision making might be present. The reason that they suggest is ‘action bias’. However you also need to look at the psychological aspects of a goalkeeper. Former Arsenal and Chelsea goalkeeper Petr Cech said that he never liked to stay in the centre as it might look to the fans that he wasn’t trying. Although he would be in a good position to save a penalty that was kicked down the centre, he would feel a lot worse if he stayed in the centre and the ball went into the goal either side of him.

Sources:

Bar-Eli, M., Azar, O. H., Ritov, I., Keidar-Levin, Y., & Schein, G. (2007). Action Bias Among Elite Soccer Goalkeepers: The Case of Penalty Kicks. Journal of Economic Psychology, 28(5), 606-621.

https://workplacepsychology.net/2018/09/02/an-action-bias-can-be-counterproductive/

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Globalisation and geo-political tectonic plates

Below is another very good CNBC video which tackles the issues of globalisation and can it bring countries together? It goes right back to the 15th century and the Age of Discovery and mentions when globalisation really began in 18th century Britain with the industrial revolution. However more recently with more populist governments countries has become more protective of their industries of which the US China trade war being an example. This year the war in Ukraine has pushed international relations to breaking point.

2023 will most likely see a significant slowdown in the global economy and the reliance on global trade to function. IMF Chief Economist Pierre Olivier Gourinchas talks of ‘geo-political tectonic plates’ where rising commodity prices, supply chain problems, a refugee crisis and higher central bank interest rates have all pushed the plates (countries) further apart to form trading blocs.

The rise of China and other emerging markets has been the success of globalisation but it has also led to protectionist measures and rebalancing of power. Therefore as a country’s power increases there is a need to adjust the way we deal with this imbalance i.e. some countries economic development has not been matched with their financial and global institutional firepower which is patly due to the dominance of the US dollar. This is ironic as the US economy’s share of global output has declined. Worth a look especially when teaching trade and protectionism – see also the table on pros and cons of globalisation.

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The Paradox of Aid – dumping in developing countries.

Although a few years old now the video below is a good example of dumping – where the exporting country is able to lower its prices below that of the domestic price in the market it is selling into. Useful to show when teaching barriers to trade.

The U.S. spends approximately $37 billion dollars a year on foreign aid – just under 1% of our federal budget. “The Foreign Aid Paradox” zeroes in on food aid to Haiti and how it affects American farming and shipping interests as well as Haiti’s own agricultural markets. The fact that the US dump rice exports on the Haitian market below the equilibrium price severely affects the revenue of local farmers. Should there be a trade-not-aid strategy for developing countries? Below is a very good video from wetheeconomy

The trade-not-aid strategy is based on the idea that if developing countries were able to trade more freely with wealthy countries, they would have more reliable incomes and they would be much less dependent on external aid to carry out development projects. International trade would raise incomes and living standards as poor countries would be able to export their way to economic development.

Climate change: who is helping developing countries

Poor nations, which have contributed the least to climate change are among the most vulnerable to climate change today. They need some financial commitments from the developed world who have grown their economies by polluting the atmosphere. For instance Pakistan emits under 1% of global emissions but it is the eighth most vulnerable country – see graphic. It is estimated that Pakistan has had $22 billion in material damages with up to 12,000 people losing their lives with 60 million affected – 2022 saw extreme monsoon rains and the worst flooding in a decade.

It is the developed world that is most responsible for climate change – since 1850 the US has emitted more than 500 billion tonnes of CO2 which is approximately twice that of the next largest emitter China. It is vital that the richer countries assist the developing world combat extreme weather. They have the finance to do it but don’t seem to rich their target of $100bn per year year since 2020. There is a pay back here in that those got countries got rich on the problem that we now have.

1992 UN Framework Convention of Climate Change was approved and at the Conference of Parties (known as COP) and in 2009 15 developed nations committee to $100 billion each year – see graphic – to support developing countries with reducing emissions and adapting climate change. The $100 billion goal was “carefully crafted” to be deliberately vague. As a result, there’s no requirement that specific countries contribute a certain proportion of the funds. Multiple analysis have calculated that the United States, which contributed less than $3 billion of the $83.3 billion in 2020, is under delivering by tens of billions of dollars when considering its relative emissions, population size and wealth.

The IMF has also provided long-term affordable financing. The money so far has funded mitigation projects, which help developing countries transition away from fossil fuels, like building a zero-emissions transit system in Pakistan. Money has also gone toward adaptation projects, which help countries build resilience against climate risks, like restoring vegetation and reducing the risk of flooding.

Source: New York Times. Who will pay for Climate Change. Nov 7 2022

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Globalisation to regionalisation and its impact.

With the global economy experiencing supply chain pressures, inflationary problems, higher interest and geopolitical tensions are we seeing a move to more regionalisation rather than globalisation?

Part of this change has come about from the decoupling of the American, European and Japanese economies from China. This ultimately alters trade and investment flows around the global economy and will mean lower economic growth and less liquidity. For instance consider the restrictions on technology including complex microchips being placed by the US on China. Janet Yellen the US Treasury secretary referred to ‘friendshoring’ which means relocating production to countries that fall within the US economic sphere of influence. Apple’s recent announcement that it would begin sourcing sophisticated chips from North America is the signal that many global firms have been waiting for to begin reducing their exposure to China.

Furthermore as well as the impact of decoupling of trade with China, a shortage of labour will also add to production costs and will result in slower rates of growth. Labour force participation rates have dropped as there have been less migrant workers coming into countries. This scarcity of labour will put further pressure on wages and ultimately inflation. To counteract the latter interest rates will continue to climb and this will lead to further problems:

  • The cost of financing economic expansion will become more expensive.
  • Firms that have lived off 0% interest rates and negative real rates (nominal interest rate – inflation) will face increasing problems on their balance sheets

In the medium term interest rates are determined by inflationary expectations and rates tend to move lower in periods of disinflation and higher in periods of inflation. The risk for all central banks and policymakers is if the rate of inflation goes above that of expectations there can be a further tightening cycle.

Response to shocks – GFC and COVID-19

The GFC and COVID-19 saw the primary policy response of an expansionary monetary policy (near 0% interest) due to insufficient aggregate demand. The result of this policy has changed the economic landscape. Today things are quite different:

  • insufficient aggregate supply,
  • persistent supply shocks,
  • higher inflation,
  • higher interest rates
  • slow growth.

After years of loose fiscal, monetary, and credit policies and major negative supply shocks, stagflationary pressures are now putting the squeeze on a massive mountain of public- and private-sector debt. Recession (negative GDP for two consecutive quarters) seems on the cards.

Source: The Real Economy Blog

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