New to the A2 CIE syllabus is indifference curves and my A2 class recently had a multiple-choice question concerning indifference curves and giffen goods. A giffen good occurs when a rise in price causes higher demand because the income effect outweighs the substitution effect.
Suppose you have a very low income and eat two basic food stuffs rice and meat. Meat is a luxury and is much more expensive than rice. If rice increased in price, your disposable income is effectively reduced significantly therefore, you buy less meat, to compensate for less meat you buy more rice to gain enough calories. Source: www.economicshelp.org
Griffen good and indifference curves
- Good B falls in price – hence budget line moves from: 50 A – 30 B to: 50 A – 60 B.
- The move from point J to point K is the substitution effect which = +16
- The move from point K to point L is the income effect which = -20
- These make up an overall move from point J to point L is the price effect (substitution effect + income effect) = -4
As income effect is negative, substitution effect positive and overall price effect negative Good B is a giffen good.
Summary of income and substitution effects of price changes
Go to eLearn Economics for more notes on Indifference Curves.
In 1894 New Zealand made history by being the first developed nation to introduce a minimum wage. The Economist had an article on minimum wages and the fact that they might in fact be good for an economy. Most economists believe that a higher minimum wages = the artificial increase in labour costs and therefore lower demand for labour.
Some economists have suggested that minimum wages can increase employment and obviously pay. However if employees have monopsony power as buyers of labour and are able to influence wages they can keep the wages lower below its competitive rate – see graph below.
Two economists (David Carr & Kruegger) found out in New Jersey that when the minimum wage was raised employment in fast-food restaurants actually increased. The Economist suggests that if firms are not reducing the number of their employees with higher minimum wages they must be employing a number of strategies such as raising prices of their goods/services or saving money from reduced revenue. The IMF state that a moderate minimum wage (30-40% of the median wage – see graph) doesn’t have a significant negative effect on employment numbers and may do some good.
Monopsony in the Labour Market
A monopsony occurs in the labour market when there is a single or dominant buyer of labour. The buyer therefore is able to determine the price at which is paid for services. Unlike other examples we have looked at, in this situation we are now dealing with an imperfect rather than a perfectly competitive market. The monopsonist will hire workers where:
Marginal Cost of labour (MCL) = Marginal Revenue product of labour (MRPL)
From the perspective of the monopsonist firm facing the supply curve directly, if at any point it wants to hire more labour, it has to offer a higher wage to encourage more workers to join the market – after all, this is what the ACL curve tells it. However, the firm would then have to pay that higher wage to all its workers so the marginal cost of hiring the extra worker is not just the wage paid to that worker, but the increased wage paid to all workers as well. So the marginal cost of labour curve (MCL) can be added to the diagram.
If the monopsonist firm wants to maximise profit, it will hire labour up to the point where the marginal cost of labour is equal to the marginal revenue product of labour. Therefore it will use labour up to level of Eq which is where MCL=MRPL. In order to entice workers to supply this amount of labour, the firm need pay only the wage Wq. (Remember that ACL is the supply of labour). You can see, therefore, that a profit-maximising monopsonist will use less labour, and pay a lower wage, than a firm operating under perfect competition.
In this situation the power of the employer in the labour market is of overriding importance and the employer can set a low wage because of this buying power.
I cover the endowment effect as part of the Behavioural Economics course that I teach. The example that I use was aired on the PBS TV channel and was an experiment at the University of Chicago where students are told to work out how much they would be prepared to pay for a travel mug – they offered an average price of US$6 per mug. Then some of the students were given the same mug for nothing and an hour later, asked how much they’d be willing to sell it for. In rational economics, the price should be exactly the same but when asked they now wanted US$9 for the mug. The emotional pleasure of owning something for just an hour pushed the price up by 50 percent. It’s an unexpected outcome, suggesting we are unaware of the emotions that drive this behaviour.
Endowment effect in the Indian stockmarket
Recent research (Endowment effects in the field: Evidence from IPO lotteries in India Santosh Anagol, Vimal Balasubramaniam, Tarun Ramadorai – 2016) use a real life experiment in the Indian stockmarket to study the endowment effect. It focuses on the floatation of new companies on the Indian stockmarket referred to as initial public offerings (IPOs). When the Indian IPO’s are oversubscribed issuers use a lottery to ensure that winners received a fixed number of shares of the IPO stock whilst the losers in the lottery receive zero shares.
- Winning investors are allocated shares on the floatation of the company
- Losing investors can buy only after the issue of the IPO’s start trading.
The researchers tracked the behaviour of 1.5 million winners and losers in the lottery following the random endowment of the stock in lotteries in 54 IPOs occurring between 2007 and 2012. What they are tracking is the propensity of winners and losers to hold IPO stock following random allocation. The randomisation ensures that winners and losers are (based on forecasts) identical in terms of their information sets, beliefs, and preferences. Moreover, they have equal opportunities to trade once the stock is listed in the market. If endowment effects do not exist in this setting, holdings of the randomly allocated stock amongst winners and losers should converge rapidly over time.
The authors also find that the estimated endowment effect has little relationship with listing gains on the first day – the average IPO increase in price is 52% suggesting among other things that these effects are not driven by a wealth effect accruing to lottery winners. However, after 12 months the IPO price falls by 54% so you would expect lottery winners to off load their shares after the first day’s trading and for the losers to buy stock which is much cheaper.
Another finding is that when IPO returns are substantially greater than a winner’s previously experienced returns they are more likely to sell the IPO stock, and losers are more likely to buy the stock. That is to say, the endowment effect reduces considerably when past personally experienced returns are taken into account, suggesting that experience-based learning plays an important role in individual decision-making.
The Economist has suggested that the inertia effect could be present as investors are too busy to make time to buy or sell shares once they have been successful or unsuccessful with the lottery issue. However the authors shows that the endowment effect is still present when they study investors who make more than 20 other stockmarket trades in the month of the IPO floatation. The research also looked at those experienced investors who have taken part in 30 IPOs and found there was still a significant endowment effect with winners being four times more likely than losers to hold shares at the end of the first month of trading.
Winning the lottery seems to make investors more likely to hold onto shares regardless of profit or loss.
With the Cambridge A2 exam coming up here is a revision note on Keynes 45˚ line. A popular multi-choice question and usually in one part of an essay. Make sure that you are aware of the following;
1. C and S are NOT parallel
2. The income level at which Y=C is NOT the equilibrium level of Y which occurs where AMD crosses the 45˚ line.
1. OA is autonomous consumption.
2. Any consumption up to C=Y must be financed.
3. At OX1 all income is spent
4. At OB consumption = BQ and saving= PQ
5. Equilibrium level of Y shown in 2 ways
a) where AMD crosses 45˚ line
b) Planned S = Planned I – point D
Remember the following equilibriums:
2 sector – S=I
With Govt – S+T = I+G
With Govt and Trade – S+T+M = I+G+X
Below is a very good short video by Martin Wolf of the FT on Globalisation. He discusses the following and uses graphs to illustrate the decline of global trade and other related variables.
- Global trade has stalled in volume
- Cross border financial assets have declined
- Global foreign direct investment has fallen
- Trade liberalization has stopped and the DOHA round of trade talks has failed
Household debt in New Zealand is now equivalent to 163% of annual household disposable income – see graph below. Record low interest rates has seen credit growth rising at a pace not seen since 2008. How do low interest rates contribute to this?
Household debt as a share of disposable income (including investment housing)
Low borrowing rates have made it easier to purchase property with bank funds especially as the supply of housing hasn’t matched the increase in demand. The strong growth in property prices has meant that those who already own a house are using that security to purchase additional property. According to the IMF New Zealand has the highest ‘House Price-to-Income Ratio’ – see graph below.
Other parts of the world are experiencing high household-debt to income levels (see graph below) but does high debt levels mean that the economy is going to hit a major recession? Since the credit crisis of 2008 the global financial system has seen tighter regulations put in place to improve stability with banks limiting access to credit so there is less exposure to the risks associated with highly leverage lending.
Growth in house prices and household credit 2011 – 2015.
However debt servicing remains tolerable with low interest rates and much of the debt secured against investment housing. Also debt-to-asset ratios have fallen to levels that were experienced in 2007 but this has eventuated from low interest rates which have boosted house prices. Ultimately with a fall in house prices, and depending on its severity, those who recently entered the property market would suffer some degree of hardship whilst those already well established in the market might have a financial buffer.
Debt and future growth in New Zealand
Household debt still has implications for the long-term growth of the economy.
- With larger proportions of their income being allocated to debt consumers have less disposable income for other goods and services which creates less aggregate demand.
- High debt levels mean households have more exposure to unfavorable economic conditions that could lead to rising unemployment. In this case they have less money to fall back on.
Source: Westpac Economics Overview – August 2016
From her Jackson Hole speech US Fed Chair Janet Yellen used the Taylor Rule to suggest that the Fed Funds rate today should already be around 1.33% – currently at 0.50%. She also used the Taylor rule to explain how US interest rates should have been negative after the Global Financial Crisis. This same rule suggests that the rate should already have been 1.25% in June – see Chart below.
Source: National Australia Bank: Australian Markets Weekly – 5th September
What is the The Taylor Rule?
This is a specific policy rule for fixing interest rates proposed by the Stanford University economist John Taylor. Taylor argued that when:
Real Gross Domestic Product (GDP) = Potential Gross Domestic Product and
Inflation = its target rate of 2%, then the 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 0.5%.
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.