Causes of recessions and how do you manipulate the economy for a ‘soft landing’?

Below is a very good video from CNBC that covers the main causes of recessions – overheated economy, asset bubbles and black swan events. Good analysis of soft and hard landings as well as the wage price spiral effect.

“History teaches us that recessions are inevitable,” said David Wessel, a senior fellow in economic studies at The Brookings Institution. “I think there are things we can do with a policy that makes recessions less likely or when they occur, less severe. We’ve learned a lot, but we haven’t learned enough to say that we’re never going to have another recession.” As the nation’s authority on monetary policies, the Federal Reserve plays a critical role in managing recessions. The Fed is currently attempting to avoid a recession by engineering what’s known as a “soft landing,” in which incremental interest rate hikes are used to curb inflation without pushing the economy into recession.

Are we actually in recession and is a wage-price spiral on the cards?

For the majority of textbooks a recession is defined as two consecutive quarters of negative GDP. Whilst a lot of economies might technically go through this objective measure in the next year it is a rather strange economic environment that we live. I don’t recall a recession that coincides with record level unemployment, high consumer spending and a huge number of job openings which in turn has led to wage increases. Recession is usually associated with the opposite – high unemployment, low to nil wage growth and little spending. Therefore the economy isn’t in the usual boom-bust cycle but more of an intentional slowdown. Central banks need to get inflation under control by reducing aggregate demand through higher interest rates. Consumer prices, especially in food and energy, rising faster than wages but with wages rising there is a risk of a wage-price spiral. In order to get the inflation down most central banks only have the tools of interest rates and bank liquidity with both currently in the tightening phase.

New Zealand Employment Data – 3rd August 2022

Today’s figures labour data statistics in New Zealand were interesting to say the least. Although unemployment went up 0.1% to 3.3% against expectations it was wage growth of 7% that really stood out and reflected a really tight labour market almost matching the CPI of 7.3%. This is a major concern for the RBNZ the labour market appears to be the major driver of inflation and the threat of a wage-price spiral is very real. A self-perpetuating inflation cycle could cause domestic inflation in New Zealand to remain high, even if global pressure start to ease. In previous periods of inflation the RBNZ got help in the form of redundancies that forced numbers of consumers to cut their spending. This is unlikely in such labour market conditions and what can be sure is that the OCR will be on the rise again and is likely to increase to 4% by the end of the year.

Theory behind the wage-price spiral

As from previous posts, the Phillips Curve analysed data for money wages against the rate of unemployment over the period 1862-1958. Money wages and prices were seen to be strongly correlated, mainly because the former are the most significant costs of production. Hence the resulting curve purported to provide a “trade-off’ between inflation and unemployment – i.e. the government could ‘select’ its desired position on the curve. During the 1970’s higher rates of inflation than previously were associated with any given level of unemployment. It was generally considered that the whole curve had shifted right – i.e. to achieve full employment a higher rate of inflation than previously had to be accepted.

Milton Friedman’s expectations-augmented Phillips Curve denies the existence of any long-run trade off between inflation and unemployment. In short, attempts to reduce unemployment below its natural rate by fiscal reflation will succeed only at the cost of generating a wage-price spiral, as wages are quickly cancelled out by increases in prices.

Each time the government reflates the economy, a period of accelerating inflation will follow a temporary fall in unemployment as workers anticipate a future rise in inflation in their pay demands, and unemployment returns to its natural rate.

The process can be seen in the diagram below – a movement from A to B to C to D to E

Friedman thus concludes that the long-run Phillips Curve (LRPC) is vertical (at the natural rate of unemployment), and the following propositions emerge:

1. At the natural rate of unemployment, the rate of inflation will be constant (but not necessarily zero).

2. The rate of unemployment can only be maintained below its natural rate at the cost of accelerating inflation. (Reflation is doomed to failure).

3. Reduction in the rate of inflation requires deflation in the economy – i.e. unemployment must rise (in the short term at least) above its natural rate.

Some economists go still further, and argue that the natural rate has increased over time and that the LRPC slopes upwards to the right. If inflation is persistently higher in one country that elsewhere, the resulting loss of competitiveness reduces sales and destroys capacity. Hence inflation is seen to be a cause of higher inflation.

Rational expectations theorists deny Friedman’s view that reflation reduces unemployment even in the short-run. Since economic agents on average correctly predicted that the outcome of reflation will be higher inflation, higher money wages have no effect upon employment and the result of relations simply a movement up the LRPC to a higher level of inflation.

Strong US dollar is a problem for other economies

This year the US dollar has appreciated by 10% against other major currencies. The main reason behind this is the US Fed increasing interest rates in tackling the inflationary pressure in its economy – since the beginning of the year the Fed Funds rate has increased from 0% to 2.25-2.5%. This increase in interest rates has been quicker than other major economies which has led to the strengthening of the US dollar. This stronger dollar makes US exports less competitive and imports cheaper as the US dollar buys more of the other currency. However even if a country doesn’t trade with the US it can still be impacted by the US dollar when pricing goods and services. The problem lies in the invoicing of fuel and food which is usually quoted in US dollars – an IMF paper suggested that approximately 40% of invoices are in US dollars – see Figure 4 below. Furthermore they also found prices for businesses doing trade between two distant countries can be much more sensitive to the value of the US dollar than the relative levels of the tow local currencies.

With the US Fed focused on inflation further interest rate increases on the cards which could lead to further strengthening of the US dollar. To counter this action other countries central banks could increase their interest rates ahead of time to protect their currency.

IMF – July 2020

The graph above reveals that the share of global exports invoiced in dollars is much larger than the share of exports destined to the US. This difference indicates that the dollar plays an outsized role in the invoicing of global exports; the patterns for imports are quite similar. The right panel of Figure 4 establishes that the dollar’s leading role reflects more than its use for the invoicing of commodity exports: once exports of commodities are removed from both the invoicing and export shares, the dollar share of invoicing (23%) still exceeds – by a sizeable margin – the share of exports destined for the US (10%). Figure 4 also reveals that the euro’s share in global export invoicing is an impressive 46%. While this appears as a very large number, recall that a currency’s vehicle currency role can be gauged only by comparing its share in global invoicing to the share of global exports that involve the jurisdiction issuing the currency. This comparison reveals that the euro’s share in global export invoicing is not much larger than its share, 37%, of exports destined to EA countries.

Sources:

Strong dollar is a major headache for other countries. FT 30th July 2022

IMF – Patterns in Invoicing Currency in Global Trade. Emine Boz, Camila Casas, Georgios Georgiadis, Gita Gopinath, Helena Le Mezo, Arnaud Mehl, Tra Nguyen. July 2020

A2 Economics: Micro – Long-Run Average Cost – Envelope Curve

Another post geared towards the A2 exam next week. Long-run and short-run average costs curves are part of economies of scale and market structures essays.

In the short run at least one factor of production is fixed but In the long run the firm can alter all of its inputs, using greater quantities of any of the factors of production. It is now operating on a larger scale. So all of the factors of production are variable in the long run. In the very long run, technological change can alter the way the entire production process is organised, including the nature of the products themselves. In a society with rapid technological progress this will shrink the time period between the short run and the long run.

The long-run average cost (LAC) curve shows the least costly combination of producing any particular quantity. The graph below shows short-run average costs (SATC) and the LAC. The LAC forms a tangent with the SATC and it is therefore the lowest possible average cost for each level of output where the factors of production are all variable – it is formed from a series of SATC curves. The diagram shows:

From the diagram A is the least-cost way to make output Q1 in the short run. B is the least-cost way to make an output Q2. It must be more costly to make Q2 using the wrong combination of factors of production, for example the quantity corresponding to point E. For the combination of factors of production at A, SATC1 shows the cost of producing each output, including Q2. Hence SATC1 must lie above LAC at every point except A, the output level for which the combination of factors of production is best

The LAC is a flatter U-shape than the SATC curves and can be explained by economies of scale and diseconomies of scale. However it is really important to note that the firm does not necessarily produce at the minimum point on each of its SATC curves. Thus the LAC curve shows the minimum average cost way to produce a given output when all factors can be varied, not the minimum average cost at which a given plant can produce.
Note:

The Long-Run Average Cost is sometimes abbreviated to LRAC
The Short-Run Average Cost is sometimes abbreviated to SRAC

This LAC is also know as the envelope curve (looks similar to the back of an old style envelope) – see image.

Source: Economics by Begg 7th Edition

Will inflation stay above pre-pandemic levels?

With inflation above double figures in many economies and central banks tightening monetary policy will consumer prices fall? Some economists believed that the inflation figure is transitory and that the surge in prices would quickly decline with the increases in commodity prices falling out of the year-on-year comparison. The US Fed expects inflation to fall from 5.2% at the end of this year to 2.6% by the end of 2023. Predicting the effects of shocks and monetary policy on the inflation rate has become very difficult.

Alternative Macro Signals construct a “news inflation pressure index” which measures how frequently price pressures are mentioned in the news media. In the US and EU the index is still well above 50, indicating that inflationary pressures are continuing to rack up. There are those who believe that inflation will not return to pre-pandemic norm of low stable price growth – 3 indicators suggest this:

  1. Rising wage growth: Bank of Spain suggest that half of the collective-bargaining deals signed have clauses which tie wages to the level of inflation. Other examples of high pay demands include IG Metal in Germany and rail workers in Britain. The G10 group of countries has had a very steep rise in wages increases from the previous year. Minimum wages are increasing in both Germany and the Netherlands. Australia’s industrial-relations agency has increased the minimum wage by 5.2%.
  2. Public expectations: with higher wages there is an expectations of higher prices – Canadians are predicting 7% inflation whilst Japan 20% (previously 8%) believe prices will go up significantly.
  3. Company expectations: retailer inflationary expectations are on the rise. Bank of England suggest clothes prices will be 7-10% higher than a year ago but are customers willing to accept such price increases.

However there is some hope with supply chain pressures easing – cost of shipping from Shanghai to Los Angeles has fallen by 25% since March. Retailers have stocked up on inventory and cutting prices to sell stock. In the US car production has increased which should ease the pressure on the highly inflated used vehicle market.

Source: The Economist – Why inflation looks likely to stay above the pre-pandemic norm. July 2nd 2022.

Inflationary Expectations – Households v Economists

In recent years more attention has been paid to the psychological effects which rising prices have on people’s behaviour. The various groups which make up the economy, acting in their own self-interest, will actually cause inflation to rise faster than otherwise would be the case if they believe rising prices are set to continue.

Workers, who have tended to get wage rises to ‘catch up’ with previous price increases, will attempt to gain a little extra compensate them for the expected further inflation, especially if they cannot negotiate wage increases for another year. Consumers, in belief that prices will keep rising, buy now to beat the price rises, but this extra buying adds to demand pressures on prices.

At a recent press conference US Fed chair Jerome Powell expressed concern about 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.”

A recent IMF blog post by Carlo Pizzinelli looked at the inflationary expectations of consumers against those of policy makers. When monetary or fiscal policy are in the news how do consumer expectations for inflation change? Additionally how do economic events influence expectations? Can we say that consumers form the same expectations as those who deliver policy decisions? The researchers asked consumers to consider four speculative shocks and then make predictions about their impact on inflation and unemployment. The four were as follows:

  • a sharp increase in crude oil prices as a result of falling world supply,
  • a rise in income taxes,
  • an increase in government spending,
  • a rise in the US Federal Reserve’s interest rate.

It is an assumption that these shocks are generally understood by consumers. Researchers provided current figures for the rates of inflation and unemployment and asked them to give their forecasts for the two variables over the following year. They then provided news about one of the four speculative shocks and asked them to make new predictions for inflation and unemployment.

Results show that there are large differences in expectations from consumers and experts. Of note is consumers belief that an increase in income tax and interest rates would increase inflation which is contrary to what experts predict – see Chart 1.

In order to look into why there is a disagreement between two groups consumers were asked as to what they were thinking when they made their predictions – a focus was on demand side v supply side theory. Experts drew on their technical knowledge whilst consumers rely on personal experiences. Consumers believe that higher costs (interest rates up) for firms are then added to the price of the good or service. Experts predict a decline in prices as consumers spend less and save more – see Chart 2

It is important that central banks make their statements in a simple language so that there is clarity for the general public – e.g. when a central bank raises interest rates unexpectedly households are under the assumption that this action will lower inflation and their actions will ultimately lead to a reduction in inflation.

Full employment doesn’t mean all workers benefit

Michael Cameron in his blog ‘Sex, Drugs and Economics’ wrote a piece on full employment and the fact that it doesn’t benefit all workers. It was based on his published article in The Conversation.

Full employment has normally been the concept that has been used to describe a situation where there is no cyclical or deficient-demand unemployment, but unemployment does exist as allowances must be made for frictional unemployment and seasonal factors – also referred to as the natural rate of unemployment or Non-Accelerating Inflation Rate of Unemployment (NAIRU). Full employment does suggest that the employee has a lot of bargaining power as the supply of labour is scarce relative to the demand. In theory a tight labour market should lead to higher wages and improved conditions of work as the employer has less labour to chose from. We have seen in the labour market incentives for employees in recommending potential candidates for vacancies in the company. Other incentives for potential employees include shorter working weeks, hiring bonuses and special leave days.

However this doesn’t apply to all workers as Michael Cameron alludes to. A lot depends on the bargaining power of the worker and the elasticity of supply of labour. If the supply is very inelastic for a particular job (higher skilled) it is harder and most likely more expensive for the employer to find an alternative worker. This is evident when unemployment is low as the worker can easily look around at other job opportunities. On the contrary if the supply of labour is more elastic (lower skilled jobs) the worker has less bargaining power and the employer will have more potential workers to chose from. The graph below shows the elasticity of supply of labour – high skilled has a steeper curve (inelastic) whilst low skilled as a flatter curve (elastic)

Source: Economicshelp

Cameron writes in The Conversation:

Many low-income workers are in jobs that are part-time, fixed-term or precarious. Low-wage workers are not benefiting from the tight labour market to the same extent as more highly qualified workers.

Nevertheless, a period of full employment may allow some low-wage workers to move into higher paying jobs, or jobs that are less precarious and/or offer better work conditions. That relies on the workers having the appropriate skills and experience for higher-paying jobs, or for increasingly desperate employers to adjust their employment standards to meet those of the available job applicants.

Add to this the increase in the cost of living and those in low skilled jobs with little bargaining power are under pressure to accept whatever is available. The alternative is welfare benefits which are always playing catch-up

BoJ still buying bonds as other central banks reverse asset purchases.

Within the OECD are annual inflation has been rising at an average of 9.6% – its ranges from 2.5% in Japan to 73.5% in Turkey. The US and the UK has inflation of 9.1%, Australia 6.3% and NZ 7.3%. Most of the bigger economies target a 2% inflation rate and in response to these higher rates the US Fed increased its interest rates by 75 basis points to 1.5-1.75% with a potential 50 or 75 basis point rise in July. The Reserve Bank of Australia also lifted its interest rate by 50 basis points to 1.35% in July.
In order to tackle this inflationary pressure it is normal for central banks to sell bonds / assets back into the market which is turn reduces the money supply and raises interest rates. This should depress aggregate demand as there is now less money in the circular flow and the cost of borrowing goes up. However, the Bank of Japan (BoJ) is out of kilter with accelerating interest rates as it has committed to its policy of yield curve control intended to keep yields on 10-year bonds below 0.25% by buying as much public debt as is required – see graph below:

FT – Investors crank up bets on BoJ surrendering yield curve controls

How to Bond Yields work?
Say market interest rates are 10% and the government issue a bond and agree to pay 10% on a $1000 bond = annual return of $100.
100/1000 = 10%
If the central bank increase interest rates to 12% the previous bond is bad value for money as it pays $100 as compared to $120 with the a new bond. The value of the new bond is effectively reduced to $833 as in order to give it annual payment of $100 a year the price would have to be $833 to it a market based return.
100/833 = 12%

Yield curve control
Yield curve control (YCC) involves the BOJ targeting a longer-term interest rate by buying as many bonds as necessary to hit that rate target. It has been buying Japanese Government Bonds (JGB) at a monthly rate of ¥20trn which is double its previous peak of bond buying in 2016. Although there is no theoretical limit on its buying ability it has impacted the currency which has fallen to a 24 year low against the US dollar. This will push up the price of imports and inflation although the BOJ is confident that the price rises in its economy are transitory. If inflation does start to consistently hit levels above the BOJ’s target of 2% will they reverse their bond purchasing policy and shift to a higher yield cap?

Shorting JGB’s
A lot of investment banks are looking to short JGB’s. In this situation the trader suspects that bond prices will fall, and wishes to take advantage of that bearish sentiment—for instance, if interest rates are expected to rise. This will likely happen if the Japanese relax their YCC with interest rates rising and bond prices falling – see image below for a simple explanation of shorting.

Source: Online Trading Academy

Sources:

  • The Economist: – BoJ v the markets. June 25th 2022.
  • Financial Times: Investors crank up bets on BoJ surrendering yield curve controls. June 23rd 2022

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Africa’s resource paradox and market failure

I have blogged a few times on the resource curse that affects some developing countries but it seems that in Africa a lot of resources go unused when they are actually demanded in an economy. There seems to be a lack of planning for supply and demand and build an infrastructure linking the two. The Economist came up with some good examples of this:

  • Ghana – generation vs distribution. The country produces too much electricity as Ghanaian usage per year equates to what someone in the US uses a fortnight. More than 25% of households in Ghana are not connected to the grid and 25% of electricity is lost due to derelict distribution infrastructure and theft. With regard to oil, Ghana spent over $4.7 billion on importing petroleum last year, despite having domestic petroleum refineries which are lying idle – they could produce 30% of its petroleum needs.
  • Uganda – like Ghana supply is greater than demand as capacity if nearly double peak demand. Trucks wait on the side of roads even though traders can’t find vehicles to transport their goods.
  • Ethiopia – largest livestock in Africa and tanneries to turn hides into leather but shoe and glove makers import leather from China. Local tanneries are concerned with how the leather is treated.
  • Nigeria – tomato-processing plant to make tinned paste but closed down due to crop failure caused by a voracious moth

Another issue is the completion of infrastructure projects – according to McKinsey approximately 80% of African infrastructure projects fail in the cost benefit analysis stage whilst fewer that 10% get the stage of acquiring funding. For Africa to further development there has to be some acknowledgement of market failure and a willingness to separate commercial power and political power amongst its government officials.

Source: How market failures are holding Africa back. The Economist 5th May 2022

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Ireland’s first win against the All Blacks in New Zealand – Behavioural Economics

You maybe aware that the rugby game tonight between Ireland and the New Zealand All Blacks in Dunedin created history. It was the first time that Ireland have beaten the All Blacks in New Zealand. Remember they did beat the ABs in Dublin and Chicago.

Irish supporters, including myself, will take great pleasure in talking about such a result – I was at Eden Park last Saturday and disappointed at the number of mistakes Ireland made. What all this alludes to is the fact that as part of this entertainment comes without the public paying for it, the public benefits from an externality.

Those Irish supporters who traveled to Dunedin for the game will have no doubt spent a significant amount of NZ dollars tonight in the bars and restaurants around town. Nevertheless the satisfaction (utility) derived in NZ dollars from the game would have been much greater than the price Irish supporters would have paid for the ticket. This suggest that there is a lot of consumer surplus present – the difference between the price that a consumer WOULD BE WILLING TO PAY, and the price that he or she actually HAS TO PAY. The success of the Irish team will boost merchandise sales and interest for the World Cup next year in France but more importantly it has been good for rugby in general with throwing the World Cup wide open. When the All Blacks play overseas there are significant externalities whether it be the revenue generated in hosting the match or the social benefits to society.

Furthermore the lead up to the game brings about a sense of delayed gratification (Behavioural Economics). Looking ahead the fact that people have paid for tickets to the World Cup means that they can reap the pleasures of anticipation of being there. Research (Smarter Spending – see previous post) shows that owning material things from expensive homes to luxurious cars turn out to provide less pleasure than holidays, concerts or even witnessing Ireland beating the All Blacks – where were you when Ireland beat the All Blacks in Dunedin? With Ireland’s win national pride increases, along with patriotism and people feeling better about themselves. This is turn brings people together and boosts well-being of the nation. As for the All Blacks they will learn from this defeat and it makes for a great game next week in Wellington. Go Ireland!

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Finland tops happiness rankings in 2022

The World Happiness Report for 2022 was published in March and it is interesting to see what data is used to generate their rankings. The colour-coded sub-bars in each country row represent the extent to which six key variables contribute to explaining life evaluations. These variables (shown in Table 2.1) are:

  • Healthy Life Expectancy: Life expectancy at birth based on data from WHO.
  • Social Support: Someone to help you in times of trouble. National average of binary responses either 0 or 1.
  • Freedom to make life choices: Yes of No to “Are you satisfied or dissatisfied with your freedom to choose what you do with your life?”
  • Generosity: national average of response to the Gallup World Poll (GWP) question “Have you donated money to a charity in the past month?”.
  • Corruption Perception: “Is corruption widespread throughout the government or not” and “Is corruption widespread within businesses or not?” The overall perception is just the average of the two 0-or-1 responses.
  • GDP per capita: purchasing power parity (PPP) at constant 2017 international dollar prices.

You will notice Dystopia as a variable. This is an imaginary country that has the world’s least-happy people. The purpose of it is to have a benchmark against which all countries can be favourably compared (no country performs more poorly than Dystopia) in terms of each of the six key variables. This permits the calculated contributions from the six factors to be zero or positive for every actual country. The happiness rankings are not based on any index of these six factors—the scores are instead based on individuals’ own assessments of their lives, as revealed by their answers to the single-item Cantril ladder life-evaluation question below:

“Please imagine a ladder, with steps numbered from 0 at the bottom to 10 at the top. The top of the ladder represents the best possible life for you and the bottom of the ladder represents the worst possible life for you. On which step of the ladder would you say you personally feel you stand at this time?”

Finland remains in the top position for the fifth year running, followed by Denmark in 2nd and all five Nordic countries among the top eight countries, joined by Switzerland, the Netherlands and Luxembourg. France reached its highest ranking to date, at 20th, while Canada slipped to its lowest ranking ever, at 15th, just behind Germany at 14th and followed closely by the United States and the United Kingdom at 16th and 17th.

Among the six variables used to explain these levels, there has been general growth in real GDP per capita and healthy life expectancy, generally declining perceptions of corruption and freedom, declining generosity (until 2020), and fairly constant overall levels of social support.

Source: https://worldhappiness.report/

Teaching MC=MR with M&M’s

Having just completed Perfect and Imperfect Competition with my Year 13 NCEA class I used a couple of packets of M&M’s to drum home the concept of marginal analysis MC=MR. It has always been something that students have struggled with but I am hoping this experience of creating graphs with M&M’s might help their understanding and when to use the concept.

Profit is maximised at the rate of output where the positive difference between total revenues and total costs is the greatest. Using marginal analysis, the firm will produce at a rate of output where marginal revenue equals marginal cost. Below are a few of the graphs done using M&M’s.

Perfect Competition – Supernormal Profit
Monopolistic Competition – Normal Profit

A2 Revision – Oligopoly and the kinked demand curve – download

Getting onto market structures with my A2 class and here is a note on the kinked demand curve. I alluded to in a previous post that one model of oligopoly revolves around how a firm perceives its demand curve. The model relates to an oligopoly in which firms try to anticipate the reactions of rivals to their actions. As the firm cannot readily observe its demand curve with any degree of certainty, it has got to estimate how consumers will react to price changes.

In the graph below the price is set at P1 and it is selling Q1. The firm has to decide whether to alter the price. It knows that the degree of its price change will depend upon whether or not the other firms in the market will follow its lead. The graph shows the the two extremes for the demand curve which the firm perceives that it faces. Suppose that an oligopolist, for whatever reason, produces at output Q1 and price P1, determined by point X on the graph. The firm perceives that demand will be relatively elastic in response to an increase in price, because they expects its rivals to react to the price rise by keeping their prices stable, thereby gaining customers at the firm’s expense. Conversely, the oligopolist expects rivals to react to a decrease in price by cutting their prices by an equivalent amount; the firm therefore expects demand to be relatively inelastic in response to a price fall, since it cannot hope to lure many customers away from their rivals. In other words, the oligopolist’s initial position is at the junction of the two demand curves of different relative elasticity, each reflecting a different assumption about how the rivals are expected to react to a change in price. If the firm’s expectations are correct, sales revenue will be lost whether the price is raised or cut. The best policy may be to leave the price unchanged.

With this price rigidity a discontinuity exists along a vertical line above output Q1 between the two marginal revenue curves associated with the relatively elastic and inelastic demand curves. Costs can rise or fall within a certain range without causing a profit-maximising oligopolist to change either the price or output. At output Q1 and price P1 MC=MR as long as the MC curve is between an upper limit of MC2 and a lower limit of MC1.

Criticisms of the kinked demand curve theory.
Although it is a plausible explanation of price rigidity it doesn’t explain how and why an oligopolist chooses to be a point X in the first place. Research casts doubt on whether oligopolists respond to price changes in the manner assumed. Oligopolistic markets often display evidence of price leadership, which provides an alternative explanation of orderly price behaviour. Firms come to the conclusion that price-cutting is self-defeating and decide that it may be advantageous to follow the firm which takes the first steps in raising the price. If all firms follow, the price rise will be sustained to the benefit of all firms.

If you want to gradually build the kinked demand curve model download the powerpoint by clicking below.
Oligopoly

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The Supply Chain explained

The supply chain has been stretched to the limit over the last two years and there have been a number of reasons for that. From a lack of containers to surges in global economy activity, as consumers shifting from buying services to buying goods, the freight time and cost have increased significantly.

From the IMF – good video explaining how the supply chain works and the problems faced after two years of lockdowns. Has the supply chain got too complicated?

Inflation and the Base Year Effect

A price index is a means of comparing a set of prices as they change over time. Index numbers allow for a comparison of prices with those in an arbitrary chosen reference (base year), a year that current values can be compared against. This base year is usually given a numerical value of 100 or 1000. The index number allows for percentage changes to be calculated between various time periods.

If we look at the last few years some of the current inflation increases has been exaggerated by what are known as base-year effects. What has happened is that annual inflation has been measured against a time during the COVID-19 pandemic when economies were locked down and prices slumped. Therefore the inflation figures around the world have been increasing quite rapidly but soon they will be measured against the current higher prices which should mean a lower inflation figure. Regions such as Europe that rely on imported energy may see a greater fall in inflation than others if the price of fuels like oil and gas were to quickly cool. But that doesn’t seem likely in the current climate especially with the war in the Ukraine and come October the northern hemisphere heads back into winter with greater energy use. The graph above is a little out-of-date in that inflation in the UK is now 9.1% and the Bank of England expect it to exceed 11% in October. The USA has an inflation rate of 8.6% and it is expected to reach 9%.

Central Bank rate increases in 2022
Below are the central bank rate hikes this year and the big question is have they got their timing and rate increases right.

  • With the threat of inflation should banks have increased their rates earlier?
  • If they tighten too quickly will that tip their economy into recession and a hard landing?
  • What is the right rate increase for the current inflation figure?
  • How long (pipeline effect) will it take for interest changes to impact the inflation figure?
  • These are the challenging questions that central bankers face in today’s environment.

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The economics of transfer deals – Sevilla FC

A colleague forwarded me link to the BBC sport website concerning the work of Ramón Rodríguez Verdejo aka Monchi. Monchi spent 11 years as player at Sevilla (goalkeeper) but is recognised more for his role at Sevilla’s sporting director. When appointed Sevilla were in the Spanish second division and Monchi studied clubs like FC Porto and Lyon who won titles but were able to sell top players and replace them with similar quality players for less money. His first signing was Dani Alves who six years later went to Barcelona for £30m a profit of £29.7m – other signings by Monchi are listed in the table below which equates to and overall £189.75m profit.

Sevilla was relegated from the top flight at the end of the 1996–97 season but returned to La Liga in 1999 with a policy of sell and grow. Since then they have won the following:

  • Copa del Rey in 2007 and 2010;
  • Uefa Cup in 2006 and 2007;
  • Europa League in 2014, 2015, 2016 and 2020.

Monchi pulled off another profitable transfer last season which saw Ivan Rakitic return to Sevilla for a second spell. Originally the Croatian was signed for £2.1m from Schalke in 2011 and then sold to Barcelona for £15.3m in 2014. In September this year Sevilla resigned him for £1.36m and still playing very good football at 32 years of age.

Do the new signings perform?

The website ‘Total Football Analysis’ looked at how well Monchi’s signings performed – this included five years at Sevilla (2012/13 to 2016/17) and two years at AS Roma (2017/18 to 2018/19) – he returned to Sevilla in 2000. His time at AS Roma was not as successful as at Sevilla.

How ‘Total Football Analysis’ judged the success of his signings was by using the metric: the percentage minutes played versus the price that was paid in the transfer market – see graph below. So logically the more expensive the signings the greater the minutes played. The players in red are AS Roma and those in blue are Sevilla FC.

Upper-left quadrant – poor signings as they are players with an above-average price (more than 7.63 million euros) who played below average minutes (39.24%).

Even if we are taking five seasons at Sevilla and only two at Roma, most of the players in the upper-left quadrant are Roma players. Only Ciro Immobile, Joaquín Correa and Paulo Henrique Ganso could be considered very bad signings for Sevilla in this period, while Roma in only two seasons had Patrik Schick, Javier Pastore, Grégoire Defrel, Rick Karsdorp, Cengiz Ünder, Davide Santon and Juan Jesus in the same list. 

Lower right quadrant – excellent signings. Those are players with a below-average price who played a higher than average percentage of minutes. This time, plenty of Sevilla players make the list, but only three Roma players: Aleksandar Kolarov, Federico Fazio and Nicolò Zaniolo.
Lower left quadrant – cheap but didn’t play much, which could mean they were supposed to play that role or were bad signings
Upper right quadrant – expensive signings who played a lot of minutes as there were high expectations.

The correlation between price and percentage of played minutes is represented with the green line. Curiously, the correlation is very low for Monchi’s signings, showing the price is a very bad predictor of players performances in his case. Part of this is because of his high spending at Roma on players who couldn’t make an impact. This reinforces what we suggested before: Monchi proved to be much better at signing lesser-known players for cheap fees than at making high-profile signings.