Modern business cycle theory (updated)

The Kids Prefer Cheese blog has a short posting on The evolution of modern business cycle theory. If you are into macro it may be interesting. They argue that modern business cycle theory is built around two ideas.

First was the audacious idea that the observed business cycle was not a problem but actually Pareto optimal in the sense that the economy was fully competitive, there were no externalities, and all agents were operating on their supply curves at all points in the cycle. This was the original real business cycle (RBC) theory of Prescott that the cycle was just the result of optimal responses to real shocks.

Second was the insight that the macroeconomics of imperfect competition was fundamentally different than that of perfect competition. Specifically, if firms face a downward sloping demand curve, then deviations from their optimal price are not infinitely costly and perhaps small nominal barriers to changing prices (menu costs) could deter rational profit maximizing firms from always immediately adjusting their price in response to a nominal disturbance. This was the original new Keynesian economics (NKE) of Mankiw and Blanchard & Kiyatoki.

It is also argued that the downside of the early RBC and NKE models was that they just didn't work. These two initially competing strains of business cycle research have gradually merged over time. More recently things have gotten better for a number of reasons.

First is the work estimating the models rather than calibrating them, often using Bayesian computational methods, and testing the models in a more rigorous way. Second is the new attention being paid to regime switches in monetary policy. Third is work that allows for real state dependent pricing in the model. Fourth are new theoretical ideas being applied, like the paper I referenced yesterday that explores the public good aspect of a firm's price change.

Update: The visible hand in economics asks What is modern business cycle theory.

Airline ticket prices

One of the big economic question of the age is

Why do most airlines charge substantially more for a one-way ticket than a round-trip ticket on the same route?

At the Austrian Economists blog three possible answers have been put forward:

1. It's price discrimination - one-way fliers might need specific times and flights in a way that makes their demand more inelastic.
2. Some people might pay a premium for a one-way ticket in order to leave their return open-ended.
3. It's a matter of not wanting an empty seat coming back the other way given the low probability of a "double coincidence of one-way tickets."

None of which seem totally convincing.

Boudreaux on the Cato Daily Podcast

Donald J. Boudreaux talks about the "Big Visions for Energy and the Fatal Conceit" in this Cato Daily Podcast.

The NZ petrol market

This report from Newstalk ZB tells us that the NZ petrol market "fundamentally competitive". The news report says

An independent review of petrol pricing has found the New Zealand market is fundamentally competitive.

It says price fluctuations have been driven by increases in taxes and the price of crude oil, while retail prices are not as fast to rise and as slow to fall as consumers have feared. It says the New Zealand market is more transparent than the Australian market, because buy-sell contracts are not used and New Zealand does not have the same price cycles.

The report also says

UBS senior economist Robin Clement says the New Zealand dollar cost of crude oil is roughly where it was at the start of June. He says the price was just below $2.00 so there is scope for another cut. Mr Clement says the effects of declines in the global oil price seem to flowing through to New Zealand quite quickly.

This does raise a couple of issue with me. First, what are we to make of the kinds of comments at the consumer.org.nz website:

Oil companies led by BP - New Zealand's largest - have given motorists a hard time since the New Year. They've raised prices at the pump as soon as crude oil prices rise and then failed to pass on savings from falling prices and the high New Zealand exchange rate.

Does Consumer NZ really know so little about the NZ petrol market? Or do they know something the "independent review" doesn't? What is the basis for their comments?

And, second, if these finding are correct what does it say about the nature of the New Zealand petrol market? Given the research I commented on earlier which suggests there is an asymmetry in price adjustments, for the US at least, Why don't we see such an asymmetry here? This research argues that their is a consumer search asymmetry. When retail petrol prices are rising, consumers search harder for the best price; when prices are falling, consumers ease up on search. This “reference price” consumer search model assumes consumers’ expectations of prices are based on prices observed during previous purchases. The model predicts that consumers search less when prices are falling. This reduced search results in higher profit margins and a slower price response to cost changes than when margins are low and prices are increasing. Do New Zealand consumers just search more than those in the US?

Below is a graph from the MED website which shows the make up of the retail price of regular unleaded petrol. The graph breaks the retail price down into taxes and levies, importer cost, and importer margin.

The importer cost is based on the Singapore benchmark petrol price plus an estimated quality premium and an assessment of the importation costs of freight, insurance, losses, and wharfage. The importer margin is calculated by the Ministry as the retail price less taxes and levies, and less the importer cost. That is, it is the margin available to the importer to cover domestic transportation, distribution and retailing costs, as well as wholesalers' and retailers' marketing margins. The importer margin is lagged by one week, i.e. it is assumed that retail prices this week are based on the importer costs of last week.

Book club: Capitalism and Freedom

There are more postings over at the Free Exchange blog in their Summer book club on Milton Friedman's Capitalism and Freedom. Read here, here and here.

State workers overpaid (updated)

This is what we are told by this NZPA article at stuff.co.nz. The article reports on research by Dr John Gibson, Professor of Economics in the Management School at Waikato University.

The research was published in the New Zealand Journal of Employment Relations and used the New Zealand component of the International Social Survey Programme Work Orientations Survey. It compared like-with-like work.

The article quotes Gibson as saying

"The average pay differential between the public and private sector was between 17 percent and 21 percent,"

The article also notes that

The study was based on 2005 data, so given the faster rate of public sector pay rises recently, the premium was likely to be even higher now.

The stuff report goes on to say

"In addition, public sector workers appear to benefit much more from a `warm glow' belief that in their job they can help others and that their job is useful to society.

"In competitive labour markets people would be willing to work for less to feel so good about themselves and their jobs.

"So the fact that public sector workers actually get paid 20 percent more is evidence of how out of line wage setting has been in the public sector."

It is also noted by Gibson that given that the study was able to compare like jobs with like jobs, it suggests that the higher pay levels for the public sector had little to do with needing to pay more to attract more skilled workers. In addition Gibson could find no justification for the pay premium in the public sector in terms of job conditions.

So we are left to wonder, Why are government salaries so high? I'm sure its got little to do with productivity. This article from Infometrics argues

Public sector wages have also been boosted by the promotion of collective bargaining via the Employment Relations Act 2000. A key justification for the promotion of collective bargaining is a perspective that there is an “inherent inequality of power in employment relationships”.

There is no provision within the Act for addressing circumstances where the inherent inequality favours employees. Yet public sector employment relations are such a case. To begin with, governments’ statutory powers to raise taxes mean that they do not face the same type of immediate financial pressures that inhibit wage rises in most private firms. In addition, it is difficult for citizens, the ultimate employers of public sector workers, to ensure that they are well represented in the wage negotiation process.

The article goes on to make the point

There are natural conflicts of interest between each of these parties and their ultimate employers, the citizens. Using public sector wages to illustrate: high wages improve the wellbeing of employees at the expense of taxpayers, yet the threat of unemployment to public sector workers from excessive wage demands and industrial action are negligible compared with the private sector. In addition, the political fall-out of industrial actions are potentially more serious to politicians than the cost of higher wages, which can be spread thinly across all taxpayers.

Infometrics also adds,

Promoting collective bargaining in the public sector seems a recipe for excessive public sector wage growth. Although a key purpose of government activities is to redistribute incomes from the wealthy to the less fortunate, it is not obvious that public servants, teachers, and medical practitioners are the “unfortunates” most of us have in mind.

Updated: NotPC comments on The "warming glow" of bureaucracy and adds links to more discussion of the issue while Kiwiblog notes 20% higher pay in the public sector.

How an economist thinks

Alex Tabarrok at Marginal Revolution on How an Economist Thinks. He writes

Over the weekend a crew came round my neighborhood offering to paint house numbers on the curb. Large bold curb numbers, they pointed out, make it easier for emergency service workers to find houses in the dark. Good argument. The price was good too. Then I noticed my neighbors were having their numbers painted. So of course, I declined.

Make trade not war?

In this short audio from VoxEU.org, Philippe Martin talks to Romesh Vaitilingam about his research with Thierry Mayer and Mathias Thoenig on the ambiguous relationship between globalisation and war – both civil war and war between states. They find that trade deters severe civil conflicts but fosters less severe ones. And trade created by regional trade agreements is pacifying in terms of wars between states, but greater overall openness has the opposite effect.

Now not to deal with inflation

This report, by Angus Shaw of the Associated Press, from the SFGate tells us that

Zimbabwe announced Wednesday that it is knocking 10 zeros off its hyper-inflated currency - a move that turns 10 billion dollars into one.

The report goes on to say

President Robert Mugabe threatened a state of emergency if businesses profiteer from the country's economic crisis, a move that could give him even more sweeping powers to punish opponents in the event that political power-sharing talks fail.

"Entrepreneurs across the board, don't drive us further," Mugabe warned in a nationally televised address after the currency announcement. "If you drive us even more, we will impose emergency measures. ... They can be tough rules."

The report also notes why the zero have been dropped.

Gono, the central bank governor, acted because the high rate of inflation is hampering the country's computer systems. Computers, electronic calculators and automated teller machines at Zimbabwe's banks cannot handle basic transactions in billions and trillions of dollars.

Inflation, the highest in the world, is officially running at 2.2 million percent in Zimbabwe, but independent economists say it is closer to 12.5 million percent.

Will this reduce inflation? No, as it does not deal with the real cause of the problem, but only a symptom. As the report says

Economist John Robertson said the new bills will soon be worthless, because the inflation rate continues to skyrocket. What costs $1 at the beginning of the month can cost $20 by month's end, he said.

"This is attending only to the symptoms of the problem. The real problem is the scarcity of everything driving up the prices. ... The government has not only caused the scarcities but damaged our ability to fix the problem."

At the root, he said, is the damage to the farming sector, along with government raids on the state pension fund and foreign currency bank accounts of businesses.

This report from the Washington Post tells us

Zimbabwe's money shortages, inflation and chronic shortages of food, gasoline, medicine and most basic goods have brought many businesses in Harare to a standstill. Smaller shops and at least four main restaurants have shut down.

State media reported Saturday that nightclubs were canceling music shows because audiences dried up after a 2,000 percent increase in prices for beer and soft drinks in the past week. Several bars and clubs were openly accepting U.S. dollars, even though that is against the law

No one should be surprised that this is happening. With the Zimbabwe dollar worthless, it is sensible for people to move to another median of exchange. The new notes will do nothing to change this. It is impossible to believe that people will assume that the government will stop printing money money just because it issues new notes and coins.

The law of unintended consequences: again

At the Spectator's CoffeeHouse blog, Fraser Nelson looks at Taxing alcopops: the Australian experience.

Australia made the decision to raise the tax on alcopops. As to the consequences of this decision Nelson writes

Jacking up pre-mixed drink prices by 70% cut their consumption by 30%, but pushed bottled spirit sales up by 46% as kids mixed their own. And - surprise, surprise - the people pour far more generous measures than they were getting with the Bacardi Breezers. Result: a sharp 10% hike in the amount of alcohol consumed in Australia, the precise opposite of what was planned.

Nelson also points out

But there is some consolation for its government. The extra boozing means some A$600,000 a month extra in duties.

Working conditions in the foreign operations of multinational enterprises

One of the many thing some people dislike about multinational enterprises are their foreign labour practices. But what is the evidence on this issue? In a column at VoxEU.org, Alexander Hijzen (Employment Analysis and Policy Division of the OECD) presents new evidence on how foreign takeovers affect workers’ wages and non-wage working conditions. The basic result is that foreign investment is worth encouraging.

Hijzen's column is Working conditions in the foreign operations of multinational enterprises. The column is based on OECD (2008).

Hijzen points out that

... OECD (2008a) adopts a “local standard” to evaluate the social impact of FDI in the host country. This involves comparing the wages and working conditions of employees in the foreign affiliates of MNEs and their supplier firms to the wages and working conditions that they would have received had they not been employed by a foreign firm or one of its suppliers. The difference may be interpreted as the contribution of MNEs to improving wages and working conditions in the host country as employment conditions in comparable domestic firms provide a plausible approximation (“counterfactual”) of the conditions that would have been offered to individuals had they not been able to work for MNEs (directly or indirectly).

An often asked question to do with MNES is, Do foreign multinationals pay higher wages than domestic firms? Hijzen writes

Simple comparisons suggest they do. Moreover, wage differences between MNEs and local firms tend to be larger in developing countries, presumably reflecting the larger productivity advantage MNEs over local firms in those countries. Simple comparisons between MNEs and local firms, however, overstate the contribution of FDI to improving pay, because FDI is typically concentrated in the most advanced sectors and largest firms in the host economy, which would pay above-average wages even if they were locally owned. Even after correcting for this bias, it is still the case that MNEs offer better pay than domestic firms, particularly in developing countries where their productivity advantage is greatest.

Hijzen looks at evidence on the effects of foreign takeovers on average wages within firms for two emerging economies (Brazil and Indonesia) and three OECD countries (Germany, Portugal and the United Kingdom). He explains

It shows that foreign takeovers raise average wages in the short-term, particularly in emerging economies. Wages rose between 10% and 20% following foreign takeovers in Brazil and Indonesia, and between 0% and 10% in the three OECD countries. While these figures show the effect on average wages, they do not tell how the change is distributed across workers within firms and, particularly, whether the increase in average wages reflects wage gains for incumbent workers or instead changes in the skill composition of the workforce. To the extent that foreign takeovers lead to skill upgrading, the evidence overestimates the positive effects of takeovers on individual wages.

Hejzen than looks at the effects of foreign ownership on individual workers.

Foreign takeovers of domestic firms have a small positive effect on the wages of existing workers in Brazil, Germany and Portugal in the short-term, ranging from 1% to 4% and no effect in the United Kingdom. While the short-term impact of takeovers on incumbent workers is modest, the role of foreign ownership is more substantial for new hires. This is indicated by the relatively large wage gains of workers who move from domestic to foreign firms. They range from 6% in the United Kingdom to 8% in Germany, 14% in Portugal and 21% in Brazil. The differential effect of foreign ownership on incumbent workers and new hires may reflect more competitive conditions in the market for new hires that allow new employees to more widely share the productivity advantages of MNEs. In the longer term, however, one would expect the positive effects to spread across the entire workforce, as large pay disparities between new and old workers within firms are unlikely to be sustainable.

Whether multinational enterprises also promote improvements in other aspects of workers’ employment conditions, such as training, working hours and job stability, is a more complex question, and the existing evidence is scarce. Studies that have looked into this issue suggest that MNEs have a low propensity to export non-wage working conditions abroad. New analysis by the OECD suggests that, in contrast to wages, non‑wage working conditions do not necessarily improve following a foreign takeover. Even when they do, it is not clear whether these effects derive from a centralised policy to maintain high labour standards or merely reflect the optimal responses by MNEs to local conditions.

In addition to having direct effects on workers, FDI may also have indirect effects on workers’ employment conditions in domestic firms when there are knowledge spillovers associated with FDI. The effect on workers in domestic firms, however, is considerably weaker than the direct effect on employees of foreign affiliates of MNEs. While it is true that FDI typically has a strong effect on average wages in local firms, this largely reflects the competition between foreign and domestic firms for local workers. Positive productivity-driven wage spillovers do not necessarily arise. They are likely to be more important when there are strong links between local firms and foreign MNEs, such as through the participation of local firms in the supply chain or through worker mobility.

In summary Hijzen says

The potential of multinational enterprises to contribute to economic development in host countries provides a case for encouraging inward foreign direct investment. For a start, removing specific regulatory obstacles to inward FDI could be important. Under certain circumstances, it may also be appropriate to provide specific incentives to potential foreign investors. Such targeted policies should not, however, become a substitute for policies aimed at improving the business environment more generally. By contrast, lowering core labour standards in an effort to provide a more competitive environment for potential investors is likely to be counter-productive. It does not appear to be effective in attracting FDI and is likely to discourage investment from responsible MNEs, anxious to ensure that minimum labour standards are respected throughout their operations.

• OECD (2008), “Do Multinationals Promote Better Pay and Working Conditions?”, OECD Employment Outlook, Paris.

EconTalk this week

Robert Barro of Harvard University and Stanford University's Hoover Institution talks about disasters--significant national and international catastrophes such as the Great Depression, war, and the flu epidemic in the early part of the 20th century. What do we know about these disasters? What is the likelihood of a catastrophic financial crisis in the United States? How serious is the current economic situation in the United States? The conversation also includes discussions of economic stimulus, tax policy, and the recent worldwide rise in commodity prices.

Aleksandr Solzhenitsyn dies at 89

For something a little different on Solzhenitsyn, here is a piece on the economics of Solzhenitsyn (pdf) by Cecil Bohanon.

(HT: Marginal Revolution)

Book club: Capitalism and Freedom

There are more postings over at the Free Exchange blog in their Summer book club on Milton Friedman's Capitalism and Freedom. Read here and here.

Shooting Ourselves in the Food

Ernesto Zedillo (Director, Yale Center for the Study of Globalization, and former president of Mexico) says we are Shooting Ourselves in the Food. Zedillo opens his Forbes.com piece by noting

Rising food prices are eroding the real income of people all over the world, undoing some of the last decade's progress in combating poverty.

Zedillo then makes the point

Protectionists haven't missed the opportunity to blame free markets for the crisis. The absurd goal of "food sovereignty" has made a comeback in a number of countries both poor and rich and is being used as an argument to resist and cancel the liberalization of agricultural markets. This position--most clearly exemplified by France--is ironic because agricultural protectionism, not freer markets, is what has aggravated the problem.

Zedillo goes on to say what nearly all economists have been saying, that the problem is not with markets but with government policy. He writes

Increasing demand for grains in emerging countries such as China and India and two successive years of severe drought in Australia, an important contributor to world supply, could never in and of themselves have caused the huge price hikes we're experiencing.

and he adds

Consequently, one must look at other factors to understand the spike in food prices: high energy costs, increased fertilizer prices and the weakening of the U.S. dollar. But to get the complete picture, one cannot ignore the severe protectionist distortions, both new and old, that have crippled the much needed supply response in world food markets.

By reducing the incentive for domestic farmers to increase production, controls over grain exports in some developing countries have worsened shortages instead of alleviating them, thus contributing to higher world prices. This has been the case, for example, with the recent restrictions in rice exports by China, India and Vietnam and wheat exports by Argentina and Kazakhstan.

Zedillo then joins the chorus of those making the point that the most damaging distortions in agricultural markets originate with polices in the rich countries.

There's little doubt that the present spiral in grain prices is closely linked to U.S. and EU policies enacted to boost production of biofuels. The American and European governments subsidize the production of biofuels, limit their import and mandate their use. The exact extent to which these policies have impacted food prices is still a matter of contention, but not even the most enthusiastic proponents of ethanol can deny that by inducing a greater allocation of agricultural resources toward biofuel production, the amount of grain available for food has been reduced. According to the World Bank, while global production of corn increased by 51 million tons from 2004 to 2007, biofuel use of corn in the U.S. alone increased by 50 million tons, thus leaving no margin to satisfy the increase of 33 million tons in global consumption for other uses during the same period. This explains why some respectable experts, such as the former chief economist for the U.S. Department of Agriculture and a top World Bank agricultural economist, have imputed a large proportion of the rise in food prices to the growing use of food crops for fuel.

Again we see biofuels as the major villan in the food price story. So why do so many governments, including New Zealand's, want to go down the biofuels route?

Politicians understanding of economics

What is it about economics that politicians just don't get? This is a letter from Donald J. Boudreaux to the Aurora (Illinois) Beacon.

Barack Obama proposes to deal with rising gasoline prices by giving a $1,000 "emergency rebate" to consumers - a rebate to be paid for by taxing the so-called "windfall profits" of oil producers ("Obama pitches $1,000 energy rebate checks," August 2).

In other words, a critical part of Sen. Obama's strategy for reigning in high gasoline prices is to subsidize gasoline consumption and more heavily tax its production. This plan - which increases the demand for gasoline and reduces its supply - makes as much sense as trying to put out a fire by dowsing it with jet fuel.

E. Frank Stephenson at the Division of Labour blog writes

Earlier this year, much was rightfully made of McCain's call for a gas tax moratorium and how no economists thought it was a sound idea. For example, here's Mankiw: "I don't know any prominent economist who favors this McCain-Clinton proposal."

What I'm wondering now is if there are any prominent economists who support Obama's tax/rebate scheme? Any takers? Anyone?

I'm sure there will be no takers but this does raise the question as to why did Obama put this idea forward in the first place? I'm sure he's too smart to believe its a good idea and even if he did he has advisers who would tell him its a stupid idea, so why say it? The reason must be political, that is, he thinks its a vote winner. Or in other words he thinks voters are really stupid.

So either Obama doesn't understand the economics of what he said or he does, but doesn't care as long as he thinks it will win him votes. Neither of which look like good options.

Interesting blog bits

1. Dwight R. Lee on Economic Protectionism.
2. Laura LaHaye on Mercantilism.
3. Jagdish Bhagwati on Protectionism.
4. Alan S. Blinder on Free Trade.
5. Douglas A. Irwin on GATT Turns 60
6. Jagdish Bhagwati on Globalization (Word doc.)
7. Douglas A. Irwin on why 'Outsourcing' is Good for America.
   

Quote of the day

Like Dracula, protectionism never really dies, and we who support free trade must always keep our intellectual wooden stakes sharp and ready.

Bob McTeer
President and Chief Executive Officer
Federal Reserve Bank of Dallas

Glaeser interview

Edward Glaeser, an economics professor at Harvard University, talks with Bloomberg's Tom Keene about the impact of oil prices on urban economies, the outlook for the U.S. housing market, and the relationship between urban diversity and economic growth.

Asymmetric price adjustment and petrol prices

Petrol prices are in the news more often than not these days. One particular point that has been made is that when retail petrol prices are going up, they tend to go up quickly, but when the same prices are heading down, they tend to go down slowly. This asymmetry leads some critics to berate oil companies for not passing along the savings when crude oil or wholesale petrol prices fall. For example the consumer.org.nz website writes

Oil companies led by BP - New Zealand's largest - have given motorists a hard time since the New Year. They've raised prices at the pump as soon as crude oil prices rise and then failed to pass on savings from falling prices and the high New Zealand exchange rate.

This is just? May be not. It turns out that the pricing phenomena may be more appropriately pinned on petrol consumers. When retail petrol prices are rising, consumers search harder for the best price; when prices are falling, consumers ease up on search.

Matthew Lewis of the Ohio State University has a paper on the Asymmetric Price Adjustment and Consumer Search: An Examination of the Retail Gasoline Market (pdf). The abstract reads

It has been documented that retail gasoline prices respond more quickly to increases in wholesale price than to decreases. However, there is very little theoretical or empirical evidence identifying the market characteristics responsible for this behavior. This paper presents a new theoretical model of asymmetric adjustment that empirically matches observed retail gasoline price behavior better than previously suggested explanations. I develop a “reference price” consumer search model that assumes consumers’ expectations of prices are based on prices observed during previous purchases. The model predicts that consumers search less when prices are falling. This reduced search results in higher profit margins and a slower price response to cost changes than when margins are low and prices are increasing. Following the predictions of the theory, I use a panel of gas station prices to estimate the response pattern of prices to a change in costs. Unlike previous empirical studies I focus on how profit margins (in addition to the direction of the cost change) affect the speed of price response. Estimates are consistent with the predictions of the reference price search model, and appear to contradict previously suggested explanations of asymmetric adjustment.

The outcome is that if consumers are diligent about seeking out the lowest available price, maybe retail petrol prices will drop more more quickly when wholesale prices fall.