The 1983 movie ‘Trading Places’, staring Eddie Murphy and Dan Aykroyd tells the story of an upper class commodities broker Louis Winthorpe III (Aykroyd) and a homeless street hustler Billy Ray Valentine (Murphy) whose lives cross paths when they are unknowingly made part of an elaborate bet.
There is a great part in the movie when they are on the commodities trading floor that explains price and scarcity. Winthorpe and Valentine are up against the Duke Brothers in the Frozen Concentrated Orange Juice (FCOJ) futures market.
How a futures market works
As opposed to traditional stock/shares futures contracts can be sold even when the seller doesn’t hold any of the commodity. For instance a contract of $1.30 per pound for a 1000 pounds of FCOJ in February indicates that the seller is compelled to provide the produce at that time and the buyer is compelled to buy the produce.
Here’s how it worked in the movie
The Duke Brothers believe they have inside knowledge about the crop report for the orange harvest over the coming year. They are under the impression that the report will state the harvest will be down on expectations which will necessitate greater demand for stockpiling FCOJ – this will mean more demand and a higher price. Therefore at the start of trading the Dukes representative keeps buying FCOJ futures. Others saw they were only buying and wanted in on the action, those that had futures were not willing to sell so the price kept rising. However the report was fake and Winthorpe and Valentine had access to the genuine report which stated that the orange harvest had not been affected by adverse weather conditions. Knowing this they wait till the the price of FCOJ reaches $1.42 and start to sell future contracts.
Then when the crop report is announced and it indiates a good harvest investors sell their contracts and the price drops very quickly. The Dukes are unable to sell their overpriced contracts and are therefore obliged to buy millions of units of FCOJ at a price which exceeds greatly the price which they can sell them for. In the meantime Winthorpe and Valentine for every unit they sold at $1.42 they only have to pay $0.29 to buy it back to fulfill their obligation. This results in a profit of $1.13 per unit.
The Organisation of Petroleum Exporting Countries (OPEC), is a cartel of 12 countries made up of Algeria, Angola, Ecuador, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, the United Arab Emirates, and Venezuela.
Recently OPEC countries have proved skeptics wrong by deciding to cut oil production. Previously OPEC seemed quite content maintaining oil supply levels even with low oil prices – maybe with the intention of driving prices down and putting companies with high costs of extraction out of business. But the collapse in oil prices since June 2014 – see chart – has battered the economies of oil-producing nations as some investment projects are no longer financially feasible and this could result in a new supply shortage within a few years.
However a deal signed in Algiers in September has seen OPEC countries will reduce production for the first time since 2008 by approximately 1.2 million barrels per day (bpd) which means its production is around 32.5 million bpd – see table below:
Agreed crude oil production adjustments and levels*
* Reference base to crude oil production adjustment is October 2016 levels, except Angola for which September 2016 is used, and the numbers are from Secondary Sources, which do not represent a quota for each Member Country.
From the table the big cuts in production are from Saudi Arabia, Iraq, UAE and Kuwait. Iran is allowed to raise output by 90,000 barrels as they have sought special treatment as it recovers from sanctions. It is unclear whether the Opec cuts were wholly contingent on the planned 600,000bpd cuts by non-Opec members, including a 300,000bpd cut by Russia. Mr al-Sada of OPEC said the agreement would “definitely help rebalancing the market”, enabling the industry to “come back and reinvest” in new production capacity to ensure future security of supply.
In simple economics this reduction in supply of a very inelastic product should, in theory, increase the price of oil and on the news of the cuts oil prices surged as much as 10pc to hit $52-a-barrel – see graph opposite.
Brian Fallow of the New Zealand Herald wrote a very informative article on the inflationary target that the Reserve Bank of New Zealand keeps missing – the CPI has been below the bottom of the bank’s 1 to 3% target band. Some will say that the RBNZ has been too tight with its monetary policy stance – maintaining high interest rates for too long. Assistant Governor John McDermott has defended the bank’s position for the following reasons:
- Nearly half the CPI consists of tradables where the price of goods is impacted by competition from outside New Zealand. For the last four years the global economy has been in a disinflationary environment caused by excess supply and in particular low commodity prices especially oil. Year ending September 2016 Tradables = -2.1%. This offset almost all of the +2.1% rise in non-tradables prices. See graph below.
- The recovery form the GFC has been quite weak and with the NZ$ strengthening (imports cheaper) accompanied by lower world prices has meant that import prices have been very low.
- The growth of the supply-side of the economy has been particularly prevalent which again has led to less scarcity and lower prices.
- Recent years has seen immigration boost the demand side of the economy but because the age composition is between 15-29 rather than 30-40 in previous years, the former has a much less impact on demand as they don’t tend to have the accumulated cash for spending.
- The RBNZ reckon that the output gap is now in positive territory (actual growth being higher than potential growth) which will start to put pressure on prices as capacity constraints become more prominent.
- Statistically with a weak inflation rate in the December 2015 quarter the December 2016 quarter is most likely to be higher as the percentage change is taken on the CPI of the previous year.
The spectre of deflation hitting the New Zealand economy does not seem to be a concern at this stage especially with the longer-term inflationary expectations being in the mid range of the target bank i.e. 2%.
We discussed Contestable Markets in my A2 class today and I used this clip from Commanding Heights to show how regulated the US airline industry was during the 1970’s. Regulations meant that major carriers like Pan Am never had to compete with newcomers. However an Englishman named Freddie Laker was determined to break this tradition and set-up Laker airways to compete on trans-atlantic flights. He offered flights at less than half the price of what Pan Am charged. Alfred Kahn was given the task by the then President Jimmy Carter to breakup the Civil Aeronautics Board (the regulatory body) and he wanted a leaner regulatory environment in which the market was free to dictate price. There is a piece in the clip that shows how ludicrous some of the regulations were:
When I got to the Civil Aeronauts Board, the biggest division under me was the division of enforcement – in effect, FBI agents who would go around and seek out secret discounts and then impose fines. We would discipline them. It was illegal to compete in price. That means it was illegal to compete in the discounts you offer travel agents. So we regulated travel agents’ discounts. Internationally, since they couldn’t cut rates, they competed by having more and more sumptuous meals. We actually regulated the size of sandwiches. Alfred Kahn
When the CAB was closed down competition was the rule and the industry had vastly underestimated the demand for air travel at lower prices – a very elastic demand curve – see graph below.
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
• Liberalisation of the US Airline Industry in the 1970’s and 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
Michael Cameron – Waikato University Economics Dept – wrote an interesting piece on his blog about Economics and the war on drugs. He refers to an article by Tom Wainwright in the Wall Street Journal on “How economists would wage the war on drugs”. Essentially, the war on drugs is being lost. Badly. As Wainwright notes:
The number of people using cannabis and cocaine has risen by half since 1998, while the number taking heroin and other opiates has tripled. Illegal drugs are now a $300 billion world-wide business, and the diplomats of the U.N. aren’t any closer to finding a way to stamp them out.
This failure has a simple reason: Governments continue to treat the drug problem as a battle to be fought, not a market to be tamed. The cartels that run the narcotics business are monstrous, but they face the same dilemmas as ordinary firms-and have the same weaknesses.
El Salvador – a leader of one of the country’s two gangs has a human resource issue with high turnover of employees.
Mexico – the Zetas cartel franchises its brand like McDonalds which in turn has led to arguments over territory.
Rich countries – street corner dealers are struggle to compete on price and quality with the ‘dark web’. It is a similar scenario with Amazon.
To combat the drug trade governments have focussed on restricting the supply. Each year acres of coca plants and manufacturing activities are destroyed but the price has remains around $150-$200 per pure gram for the past 20 years. How have the cartels managed to keep this price?
However, supply of drugs might not even be appreciably reduced when drug crops are targeted. Wainwright points out that:
- Drug cartels are a monopsony – they are a single buyer of Andean coca leaves, so they have market power over the price of leaves (i.e. the cartels have the ability to strongly influence the market price of coca leaves). So if some crops are wiped out, the price is unlikely to rise because of the cartels’ market power.
- The price of cocaine is so much higher than the crop input costs that even a large increase in crop prices would have little effect on the market price of cocaine (i.e. even a big increase in the price of coca leaves would lead to only a small shift in the supply curve for cocaine).
Also because of its addictive nature demand for drugs is relatively inelastic – the decrease in quantity demanded is less than the percentage increase in price. Therefore reduced supply and a higher price doesn’t change demand that much.
Demand-Side interventions seem to be a better option and they are also a lot cheaper. Weighing up reducing supply by destroying coca crops in remote areas against drug education in schools and you find the latter is a much more plausible option.
A dollar spent on drug education in U.S. schools cuts cocaine consumption by twice as much as spending that dollar on reducing supply in South America
Bigger loses have be inflicted on cartels with some US states making marijuana legal.
Tom Wainwright also has written about this in his new book “Narconomics: How to Run a Drug Cartel”
Businesses have always altered their prices to different customers. Special prices for the movies on a week day, half-price drinks for those who are in the bar before 7pm, increased train fares for those traveling before 9am, reduced prices for students and pensioners etc.
However some companies are now employing dynamic pricing which means prices change by the minute and are influenced by a persons income, location and the spending history of on a particular site. You’ll no doubt have come across certain websites where they recommend certain items/books that you might be interested in – this is generated by an algorithm. Furthermore competitors can be monitored constantly, and their prices matched – Amazon updates its prices on average every 10 minutes based on activity on its website and the characteristics of people browsing on its website.
Physical stores are now holding sales for hours rather than days as they can established certain times of the day that lower prices are needed to increase sales. Toll roads in Texas change prices every 5 minutes to try to keep traffic moving at more than 80kph. Sports teams and even zoos have embraced dynamic pricing to stimulate demand for hot tickets and those that have not been sold.
Are Apple users richer than Microsoft users?
Some companies have assumed that Apple users richer than Microsoft users and have therefore been pointing them in the direction of more expensive options. Some airlines have been charging frequent flyers more as they are assuming that because they are traveling regularly that it must be work related and their employer will be paying for it.
Where dynamic pricing can go wrong – a book on Amazon for $23,698,655.93
The use of algorithms to set the price can be very effective for business but things can go wrong. An example was shown at a TED talk by Kevin Slavin (see previous post) in which a paperback book “The Making of a Fly” was priced at $1,730,045.91 which was a bargain because if you had bought the book a few hours later the price had gone up to $23,698,655.93. The issue here is that nobody was buying or selling anything but it transpires that two algorithms got locked in loops with each other without any human intervention.
Customers are switching on.
With dynamic pricing the customer is learning to play the game as some are searching for low fare flights from an internet cafe therefore not displaying any history from the computer they use at home. Others are piling up goods on the online basket and not clicking ‘buy’, hoping this will prompt the algorithm to give them a cheaper price.
Following on from my previous post, the increase in the supply of oil is starting to cause problems with regards to storage. According to The Economist (see graphic) US petroleum stocks rose by 4m barrels last week which is an 80 year seasonal high. Add this to the anticipated increase in supply from Iran after the sanctions were lifted and you have a significant increase in supply. However with reduced demand where is the supply going to housed? At this time of year, with the Northern Hemisphere winter, oil stocks usually dwindle but supply actually increased in Q4 2015 by a record 1.8m barrels a day according to the International Energy Agency. It wasn’t so long ago that investors were buying oil and keeping it in oil tankers waiting for the price to rise.