Marginal Cost and Benefit

It's about value received for the cost (not just the price). Airline costs, airline mergers and airline travel in generally have been in the news for the past several months. The industry is being hammered by rising fuel costs, and many companies have recently chosen to place charges on checked baggage or even get rid of in-flight snacks in coach, all in the name of reducing costs and improving profit margins.

But providing less service is not the only answer. Airlines could also find a way to provide more value for the price. Lack of service may be driving down revenue as travelers are beginning to either find alternative ways to travel, or alternatives to travel. This piece at airport-int.com would seem to indicate that flyer frustrations with the hassle and lack of service is a contributing factor to declining revenue. And as I've commented on another blog, simple honesty when dealing with the public at the point of interface could go a long way to reducing frustration. Add to that a pairing of authority with responsibility for front-line employees could reduce the problems that accompany planes stuck on runways for extended periods of time. (It's one thing to have responsibility - it's another thing to have the authority to do something about the problem for which you have responsibility.)

We often forget that competition can be done in a qualitative (value of product) way as well as quantitative (price). If the consumer gets more for the same price; it makes the product more attractive. And if quality improves enough, the consumer may be willing to pay more.

I understand that airlines put a lot of effort into providing high quality for the first-class experience, but the first-class passenger is subject to many of the same frustrations as coach-class when the flight is delayed or cancelled. And frankly, on most of the planes I've been on, the coach seats outnumber the first-class seats by a wide margin. The overall number of flights is falling because of reduced passenger demand across the board.

The alternative to applying marginal cost/benefit analysis and looking for ways to improve product quality is, I'm afraid, a return to the early days of the airline industry, when there were few flights (and few airlines) and only the rich flew. And I doubt you'll find enough rich people to fill a 777 flight from NY to LA on a daily basis.

I look forward to your comments.

There's a Reason They Call It the "Dismal Science"

While you're thinking about food prices, here's one more from The Big Picture to worry about. I questioned the source of the data - not because I think the projections are wrong (or right for that matter), but because I would like to know how credible the data is.

I do think resource use is an economic problem, with an economic answer. But as several of the people leaving comments to the post inferred, much of the concern may actually be about use vs. availability.

As always, I look forward to your thoughts.

Linkages....

There's an interesting story about gasoline prices in today's issue of USA Today. It does a good job of explaining how prices can differ between stations in close proximity, and the choices that a station owner may want to make, but often will find outside of his or her control. As I said, the article is interesting, but here are two others from the same issue that you can use with your students to see whether they can make some connections -- simple ones, to be sure, but there to be grasped.

The first story speaks to the idea that many retailers are stocking their stores. They believe that people are planning "staycations" instead of vacations. This decision makes sense in light of the rising price of transportation (i.e., fuel). The link here is clear. Higher fuel prices should translate to more people staying at home. People consequently will want to make that "staycation" as comfortable as possible.

The second story takes another step. If people are staying at home, they may be doing more backyard barbeques. And that means a shift in demand for all the accoutrements thereof, from hot dogs and buns to charcoal. The connection is simple, but your students should be able to see and explain how one change in the economy trickles through and affects a number of other decisions, choices and, subsequently, other prices.

And the retailers choices may represent a risk if they guess wrong and the American consumer just moves blithely ahead with more elaborate vacation plans.

I look forward to your comments.

Markets and Information

A basic premise in economics is that markets are more efficient when both parties have similar information. This allows competition to work and for the market to reach an efficient match of quantity supplied and quantity demanded. Now, rightly or wrongly, many people assume that the supplier or seller is generally presumed to have superior knowledge. One can argue whether or not this is a valid assumption, but I'm going to go with it for purposes of this post.

If the supplier does have superior information, then a tool that provides the demander or consumer with more information about the market should make for better competition a more efficient market. Such a tool can be seen at this site.

The site collects gasoline price information from volunteers around the nation and provides recent gasoline prices to help consumers determine where the "best" price might be. The most interesting portion is "below the fold" in the left hand column of the site. It's the gasoline temperature map and compares average gasoline prices, by county, across the nation. You can zero in and even find information by city or zip code. I've browsed around and the information is by no means complete. Outside of larger metropolitan areas, the information seems spotty at best, and totally absent in many cases. Nevertheless, it might be an interesting tool to demonstrate with your economics classes when discussing the value of information in the local market. It could also be used when teaching comparative shopping in a personal finance or consumer education course.

I've got a family road trip coming up this summer. I might even put it to the test.

I'd be interested in your thoughts about this as a teaching tool, and if you're a contributor to the site.

Access to Capital

As the year winds down the class tends to find it harder to focus on new material. For those of you teaching AP or IB economics, you may even face a situation where your semester has ended. After all, with the exams done there may be little real incentive for the students - aside from sharing your passion for the subject.

This brings us to today's topic of interest - microfinance. Economic development is one of those topics often left to the end of the text, and frequently the idea of building economies can be less than interesting. But the idea of microfinance - lending small amounts to people to start a small business is interesting. It was even good enough to garner the 2006 Nobel Peace Prize.

If you check out the video, you'll see that the Grameen Bank was formed as a not-for-profit organization. Another group that does similar work is Kiva.org. The story is quite consistent. Access to small amounts of credit can make a huge difference in the lives of the poor, allowing them to pull themselves out of poverty into situations of relative comfort or even affluence (by local standards).

Now here is a controversy. A Mexican bank has gotten into the microlending business, and has found the arena to be quite profitable. Is that "right?" Some would say "no" because the stockholders/owners of the bank are making money from the poor. It's one more instance of the poor paying their precious resources to people who already are "rich." Others say "yes" because a commercial financial institution can bring more resources to the poor than a not-for-profit can. This means more of the poor benefit. And isn't bringing them out of poverty the real goal?

I can see both sides. What do you and your students think? Please share.

What I'm Reading

I'm going to start this review with an excerpt.

"Economic slumps would be associated with financial crises by means of the loss of discipline. Through the boom, banks would overreach and extend loans to riskier clients. The buoyancy of economic booms causes riskier creditors to approach banks for loans - a problem of adverse selection. Some banks succumb to the temptation to make loans to these creditors, perhaps in the belief that luck or a bank clearing house will see them through - this is a problem of moral hazard. Adverse selection and moral hazard ultimately earn their just reward. Decline in asset values causes a decline in the collateral for loans; therefore, banks tighten their lending practices. As the slump worsens, the banks with the riskiest clients turn illiquid and then insolvent."

Sound familiar? I was struck by how well this seemed to describe the run up to and unraveling from the sub-prime mortgage situation. What made it doubly impressive was that it was in the closing chapter of the book, The Panic of 1907: Lessons Learned from the Market's Perfect Storm by Robert F. Bruner and Sean D. Carr. Later in the same section, Bruner and Carr cite research that indicates

"financial crises will occur where 'financial markets are opaque, when regulation and supervision are poor, and when lending is based on collateral rather than expected cash flow...' "

The parallels between the Panic of 1907 and the credit crunch of 2007 are certainly there if one is looking for them. If one digs into the sub-prime market as it existed in the period leading up to August 2007, one could easily make the case that market was opaque (due to the innovative nature of some of the products), that regulation and supervision were poor (in part because no one was specifically charged with oversight of the mortgage origination industry), and lending was based on collateral (expected housing prices in what had been, up to that point, a rising market) rather than expected cash flow (the income of the buyers).

And while this book did not cover some aspects of the Panic that I had hoped would be covered, it was interesting and a quick read. The structure of short chapters, focused on actual people (J. P. Morgan plays a huge role in the tale), makes it fast-moving and personal instead of a treatise on macroeconomics and finance.

For those of you who teach American History or economics, or who are interested in the monetary history of the United States (the Panic of 1907 led directly to the formation of the Federal Reserve System), you could do worse than pack this in your travel bag as you head out for summer break.

I look forward to other views and comments.

China, Myanmar and Adam Smith

I love it when the "old ideas" have current relevance. Read what Adam Smith has to say about how we react to news of earthquakes in China. (Or monsoons in Myanmar?)

"Let us suppose that the great empire of China, with all its myriads of inhabitants, was suddenly swallowed up by an earthquake, and let us consider how a man of humanity in Europe, who had no sort of connection with that part of the world, would be affected upon receiving intelligence of this dreadful calamity. He would, I imagine, first of all, express very strongly his sorrow for the misfortune of that unhappy people, he would make many melancholy reflections upon the precariousness of human life, and the vanity of all the labours of man, which could thus be annihilated in a moment. He would too, perhaps, if he was a man of speculation, enter into many reasonings concerning the effects which this disaster might produce upon the commerce of Europe, and the trade and business of the world in general. And when all this fine philosophy was over, when all these humane sentiments had been once fairly expressed, he would pursue his business or his pleasure, take his repose or his diversion, with the same ease and tranquility, as if no such accident had happened. The most frivolous disaster which could befall him would occasion a more real disturbance. If he was to lose his little finger to-morrow, he would not sleep to-night; but, provided he never saw them, he will snore with the most profound security over the ruin of a hundred millions of his brethren, and the destruction of that immense multitude seems plainly an object less interesting to him, than this paltry misfortune of his own. To prevent, therefore, this paltry misfortune to himself, would a man of humanity be willing to sacrifice the lives of a hundred millions of his brethren, provided he had never seen them? Human nature startles with horror at the thought, and the world, in its greatest depravity and corruption, never produced such a villain as could be capable of entertaining it. But what makes this difference? When our passive feelings are almost always so sordid and so selfish, how comes it that our active principles should often be so generous and so noble? When we are always so much more deeply affected by whatever concerns ourselves, than by whatever concerns other men; what is it which prompts the generous, upon all occasions, and the mean upon many, to sacrifice their own interests to the greater interests of others? It is not the soft power of humanity; it is not that feeble spark of benevolence which Nature has lighted up in the human heart that is thus capable of counteracting the strongest impulses of self-love. It is a stronger power, a more forcible motive, which exerts itself upon such occasions. It is reason, principle, conscience, the inhabitant of the breast, the man within, the great judge and arbiter of our conduct. It is he who, whenever we are about to act so as to affect the happiness of others, calls to us, with a voice capable of astonishing the most presumptuous of our passions, that we are but one of the multitude, in no respect better than any other in it; and that when we prefer ourselves so shamefully and so blindly to others, we become the proper objects of resentment, abhorrence, and execration. It is from him only that we learn the real littleness of ourselves, and of whatever relates to ourselves, and the natural misrepresentations of self-love can be corrected only by the eye of this impartial spectator. It is he who shows us the propriety of generosity and the deformity of injustice; the propriety of resigning the greatest interests of our own, for the yet greater interests of others, and the deformity of doing the smallest injury to another, in order to obtain the greatest benefit to ourselves. It is not the love of our neighbour; it is not the love of mankind, which upon many occasions prompts us to the practice of those divine virtues. It is a stronger love, a more powerful affection, which generally takes place upon such occasions; the love of what is honourable and noble, of the grandeur, and dignity, and superiority of our own
characters."
HT to Russell Roberts at Cafe Hayek. Have a good weekend.

Economic History, Institutions & Choice

I was watching this story on CNBC's Worldwide Exchange this morning and I was reminded how decisions are shaped by institutions and institutions are shaped by policy choices. What triggered the thought was a comment by Simon Nixon regarding the reluctance of banks to finance big deals unless they are convinced there are investors to buy the Collateralized Loan Obligations (CLOs) - the packaged loans that allow financial institutions to transfer default risk to other parties, who may themselves be financial institutions.

This interdependence is at least partially responsible for the global reach of the credit crunch here in the U.S. It explains how mortgage-based securities can contribute to significant losses at British, German and other banks. The history of this interdependence goes back, at least in part, to the last major financial institution crisis in the U.S., the Savings & Loan (S&L) crisis of the late 1970s and early 1980s. As that industry tottered toward failure, financial institutions (particularly S&Ls) were allowed to invest in non-traditional areas. S&Ls had always been more or less restricted to home mortgages, banks specialized business loans, etc. And the institutions would generally live on the spread between what they paid depositors and what they received from loans or investments.

The S&L industry ultimately collapsed with a lot of questionable activity on the books of many individual firms. Financial regulators, under pressure from legislators and the public at large, basically told financial institutions that they had to find a way to reduce risk in their loan portfolios. One option was to invest in strictly safe securities (Treasuries, etc.), but this meant businesses and individuals found it hard to borrow. The second option was to make the loans, repackage them and sell the new product to others who would basically bear the risk of default. Financial institutions could continue to service the loan for a fee, and the risk would not appear on their books.

The products and industry have evolved beyond that simple format. But the idea remains the same. Originate loans, package and transfer to other parties. The other parties may be hedge funds, financial institutions, or even wealthy individuals. This brings us to the present. Banks and other financial institutions see demand for loans, and with recent monetary policy actions, they should have access to reserves that will allow them to lend. But they will remain reluctant to lend if they can't find other parties to accept the new loans as repackaged obligations.

The evolution of credit markets and banking has been, in my opinion, generally a good thing. But this market depends on supply and demand on both ends. There may be demand for loans, and banks may have access to supply. But unless there is demand for the repackaged debt instruments, banks will remain reluctant to go through with the loan process.

I look forward to your comments.

***UPDATE***
You can find another great discussion on institutional change in our economic history in essay by Chicago Fed President Charles Evans from their most recent annual report. While it doesn't speak directly to the period I mentioned, it does a good job of explaining how financial market change or innovation affects the economy.

AP Econ Teachers Conference

Every other year, the Powell Center for Economic Literacy in cooperation with the Federal Reserve Bank of Richmond co-sponsors a national conference for Advanced Placement Economics Teachers.

This year's conference is scheduled for November 2 - 4, 2008, and features an excellent program, as always. For more information and to register, check out this page on the Powell Center site. I look forward to seeing you there.

Free Day

How many of you got your free iced coffee at Dunkin' Donuts or your free chicken biscuit/sandwich at McDonald's today? You may be asking "How can these firms afford to give away food in a period of rising costs?" Your question provides an opportunity to discuss some basic ideas in economics and personal finance courses.

For economics classes, you might want to focus on the idea of complimentary goods. The demand for one product may be closely linked to demand for another product. In this case it can be amplified depending on the location and terms. In the case of DD, you may go for the coffee, but since you're there and the donuts smell so good...

One other factor is that by getting the iced coffee free, your perception is of a reduced cost for the complimentary good. In the case of McD, the free biscuit/sandwich offer is contingent on the purchase of drink. Again, there is a perception of reduced cost because you're receiving two items for the price of one (with a relatively high profit margin). But there's the smell of other food in the air. Maybe an order of hash browns or french fries..

For the personal finance course, you may want to discuss the idea of complementary goods or loss-leaders. Retailers often use loss-leaders (in this case the free products) to draw the consumer into the store, depending on the sale of higher priced or higher profit margin complimentary goods to offset the loss. (Is there a reason why peanut butter and jelly usually aren't on sale the same week?)

These two concepts are compatible and offer an opportunity to teach both econ and personal finance with the same example. I encourage your thoughts, and I give a HT to fellow Collegiate colleague Rob Wedge for this post.

Choices, Choices, Choices

For those of you interested in the area of behavioral economics, I have an interesting lead. The new issue of Capital Ideas, published by the University of Chicago Graduate Business School is devoted to research on how we make choices.

As you know, a basic assumption of economics is that individuals are rational. As you also know, it doesn't always seem that way. The area of behavioral economics has evolved to try and reconcile this seeming contradiction.

While I've not read the entire issue, the article summaries look very interesting. And given the popularity of a recent book, Predictably Irrational by Dan Ariely, this should make interesting parallel reading. (By the way, if you are looking for an interesting debate on the question of how irrational we are, check out this site featuring a discussion between Ariely and Tim Harford, author of The Logic of Life.)

I look forward to your comments.

***UPDATE***
I'm not sure how I missed this interview in yesterday's Real Time Economics blog with Richard Thaler, one of the authors in Capital Ideas. Anyway, the oversight is corrected.

Jack Sparrow as Economist?

The Powell Center for Economic Literacy has a list of Keystone Principles for building economic understanding. One of the principles is "economic systems influence choices." From my experience, the study of economic systems generally is framed in a large context – nations and civilizations. The discussion of market, command and mixed economies is applied to larger groups. The discussion of traditional economies frequently gets relegated to either historical or small aboriginal groups. Only rarely is an effort made to examine how smaller groups within a larger social context create their own system – their own institutions and procedures for making decisions.

In Sunday’s issue of The Boston Globe, there was a review of a forthcoming book by Peter Leeson, an economics professor at George Mason University. The book, partially titled The Invisible Hook, is about pirates and their economic system. Judging by the review, pirates were a notoriously democratic (lower case d) lot, instituting checks and balances and even a rudimentary workman's compensation plan.

This book will bear investigating once published, if for no other reason than it provides a smaller view; showing how groups "outside" the main stream, establish systems to help with economic choice-making.

Maybe this makes sense. Jack Sparrow was given life by Johnny Depp. Mr. Depp evidently modeled the character on Keith Richards, Richards plays in a band with Mick Jagger, Jagger attended the London School of Economics (albeit studying accounting and finance, and for less than one year).

Please share any other reviews of the book you may run across. (HT to Cafe Hayek.

Economics and Ethics

When you're discussing economic systems with your students, how often do the students bring in issues of ethical behavior? And when they do, how do you integrate their interest into the discussion? One option is to dismiss the concern because the "focus is on economics." Another option is mention Smith's Theory of Moral Sentiments as well as The Wealth of Nations, and discuss both of his works. However, many of us are not familiar with both, or may only be passing familiar with one. And it still may not answer the question "How does ethical behavior play in the marketplace?"

While not an academic study, a survey done by The Wall Street Journal may give you a starting point. It provides some insight on how consumers reward and/or punish producers based on perceptions of ethical production. According to this article, consumers are willing to "reward" perceptions of ethical behavior, but not as much as they will "punish" perceptions of unethical behavior. In short, ethical behavior pays, but not as much as unethical behavior costs.

This raised a further question in my mind: why the asymmetry? Is it possible that it makes us feel better to "avenge" the wronged than to reward what we feel should be normal behavior? I don't know. But I think human behavior is such that the feeling of "superiority" in punishing an unethical producer could well outweigh the feeling from rewarding someone who may actively do more than we do.

What are your thoughts? Or your students?

Another Resource for Teaching about the Food Crisis

The American Public Media program, Marketplace, has been doing a series called Food Fight. I've not caught all of the installments, but those I have heard have usually been informative and interesting. You might want to check out the series. This also has use for those who teach current events and world studies, as it offers a number of international perspectives.

You and your students can listen on-line, download for MP3 or read the transcripts. I hope this is helpful.

Food Prices and Policy

A few days ago, there was an interesting exchange about the politics of U.S. farm subsidies between Richard Posner and Gary Becker on their blog. In both cases, there was discussion about how political pressure results in a benefit for a small group at the expense of a larger group. The posts were worthy of note by this blog, given other recent posts on the economics of food. Unfortunately, there have been other demands on my attention so I didn't
post on that exchange.

Now, I'm glad I didn't. Since reading the Posner-Becker posts, the topic has been on my mind and, as a result, I've been running across other posts on other sites that provide more information for you. You may have run across any or all of the sites yourself, but on the chance you haven't...here are some pointers.

The International Herald-Tribune posted a discussion between Jagdish Bhagwati and Jeffrey Sachs about short-term and long-term policy implications of the current food crisis. It's more general than the Becker-Posner discussion but raises some good fundamentals.

The You Think! student site, operated by The World Bank, is focusing on the price of food as its current theme. The article is good and provides a variety of links to other sites, including this one (link no longer available) featuring an excellent interactive graphic by The Financial Times. It allows students to examine issues of commodity production, trade barriers, and inflation in an interesting way.

I recommend all of these to your attention. And I look forward to your comments.

***UPDATE***
And now you can think about milk. Seriously, this article courtesy of The Wall Street Journal has some excellent charts about other commodities, as well.

Production Possibilities...A Better Example

Guns vs. butter is so last century. How about school lunches vs. military spending? Or food vs. gasoline? Jason Welker makes a good point on the first. (Link no longer available.) But our quest for renewable energy generated the second. There seems to be a growing consensus that the drive to add ethanol to the fuel mix has impacted commodity markets. That was our choice. Now we face the cost.

But lets move the question to the local and bring forward the issue of opportunity cost. I wonder how many schools will cut sports budgets because of team travel costs before reducing the quality of their school lunch programs? (And what would be the response if they did?) I don't know. But Jason's post got me wondering. Your thoughts?

Understanding Real Income

One of the interesting results of "thinking economically" is learning to put things in "real terms". Whether I'm analyzing an effect, or helping my youngest understand his choices with his allowance, translating monetary income into something substantial can often lead to changes in decision-making.

When teaching personal finance or economics, I spend some time developing the idea of "real income". This is your income adjusted for inflation. Another way of looking at it is your income measured by what it will actually purchase. When developing this idea, I try to explain that focusing on nominal income (the wage you receive in monetary terms) may be deceptive. An examination of real income (what can be purchased with the wage) may be a better measure of personal and national economic progress. To do this, I try to develop the idea of personal basket of goods. This is not unlike the "market basket" that is used to define and measure the Consumer Price Index (CPI) which is the headline measure of inflation. One can spend a lot of time explaining why the CPI is a good index, but a less good measure of inflation. But the very thing that makes it a good index is helpful in developing the idea of real income.

There was an article in the Saturday (May 3) edition of The New York Times that explained the components of the CPI. The title of the article is deceptive, because it implies that if the item is not in the chart, it doesn't count for inflation. I don't want to go there. Rather I encourage you to examine the chart, using the interactive components to get a good sense of the market basket. Because once that's clear, your students can more easily understand how price changes (up or down) affect their real income.

For purposes of explanation, you can have the students look at all the components and then ask them, what has to happen if the price of one component rises (or falls). Given the assumption that the external boundary (nominal wage) is more or less fixed, the choice is consumer less (or more, respectively) of the product with the changes price. This will keep the proportion the same. But if the amount of the product is not changed to reflect price, the difference will have to show up as changes in other consumption. This is helpful in a number of ways, even in explaining what happens to personal budgets when food and gasoline prices rise.

Play around with this and consider bookmarking it. I think it's a keeper. What are your thoughts?

(HT to Mark Perry at Carpe Diem.)

Happy Birthday...

Jane Jacobs. Jacobs was a pioneer of urban theory, and an enemy of bad central planning. She saw cities as the fundamental building block of modern economies, and wrote a number of influential works. Find out more about her here.

HT to The Library of Economics and Liberty.

Happy Birthday...

Jacob Viner. Viner was an eminent historian of economic thought and an excellent trade theorist. He was also, according to this site, a rather reticent member of the Chicago School.

HT to The Library of Economics and Liberty.

Expectations....

If this is true (and I have no reason to suspect it isn't), and if it's been going on for a while (which may or may not be a valid assumption), say three to six months; how do you think this shapes consumer expectations? This is important because expectations shape decision-making both in the immediate term and - to a lesser extent - in the longer term. After all, expectations help determine supply and demand.

I look forward to your thoughts. To what extent do expectations shape activity? Do you think information of this type (either prior to correction or after) is helpful, harmful, or neutral?

Wants vs. Needs

One of the first things taught in financial literacy courses is budgeting. And in constructing the budget, we tell students start with income; only then should they move to spending. Once the students are addressing the spending side of their budgets, it's important to get them to differentiate between wants and needs. There are a number of ways of differentiating. One of my favorite rules of thumb is "needs are general (clothing, food), wants are specific (Nike, steak)." But another aspect of building the expense side is learning how to control spending. And a key part of that can be controlling what some people call "emotional spending." That is spending that we do that is mood-related: depressed, disenchanted, ecstatic, etc. Emotional spending almost always falls under the category of want as opposed to need. And while you may claim that your emotional state needs to seek release by spending; there are usually other ways that won't mess up your financial plan.

There is a good article on Investopedia.com on this topic. It has a good explanation of what constitutes emotional spending, as well as offering some good suggestions on how to control it. For those of us teaching a basic personal finance course or a unit on personal finance within another course. It's worth a look. What do you think?