Friday, October 31, 2008

Why Productivity Growth Is So Important?

Despite UK economic growth is enviable by its major rivals such as France, Germany & US, there is still one area where UK consistently lagged behind them. That is non-other than low productivity

Definition: Productivity is output per worker

Why productivity growth is important?

(1) Determines standard of living
. If productivity is significantly increased, it will cause a large rightward shift in AS curve. By that time, UK economy can generate more output & more income per worker. This acts to increase standard of living on 2 bases. First, UK people get to consume more goods. Second, increase in income can help to reduce poverty & income inequality

(2) Lower inflation. If productivity growth is impressive, on average each worker can produce more & this helps to lower down the cost per unit of output. This is because the total costs (fixed costs + variable costs) are spread over a larger range of output. Businesses will be able to pass on these in the form of lower price to consumers. This will also help to ease cost-push inflation

(3) Attraction to foreign MNC
. MNC here means multinational companies. These large firms often consider large variation of factors before deciding to invest in a country. Normally factors they look at are productivity of workers or we can say costs per unit of labor, level of education, facilities, and government regulations on MNCs etc. If UK is competitive on this, it may be able to at least compete with low cost Asian economies such as China, India, Malaysia & Vietnam to attract investors

(4) Narrowing the deficit on BOP. Balance of Payments is an account that summarise the transactions between UK & the rest of the world. By experiencing high productivity growth thus driving down the costs per unit of good, UK will be more competitive in terms of international pricing. Demand for UK exported goods will grow over time, especially from its major trading partners like US, France, Germany, Netherlands & Italy as it could be relatively much cheaper than buying elsewhere. Although this will not solve the large deficit in BOP which is mainly due to trade in goods, it will at least narrow it

Counter arguments

(1) How to measure productivity? Some economists argue that it could be quite a tricky task in measuring productivity of workers as it has a lot to do psychological behaviour in work place. Also, productivity could be easier to measure if we consider manufacturing industry where workers deal with machineries, but how about in services sector which varies in nature like banking, teaching, hotel etc? Therefore the usage of real GDP per capita & HDI (Human Development Index, which we will learn next term) is a more appropriate measure in determining standard of living

(2) Inflation may not be lowered
. It could be too early to say that higher productivity will necessarily lead to lower inflation. Inflation is driven by many other factors. If there is a cut in interest rates it will cause UK people to remortgage their property or a phenomenon which is called as mortgage equity withdrawal. This causes an increase in consumption (C) which will drive up AD. Business will expand their operation. Governments may increase their spending on healthcare, education, infrastructures, social services which they always do. These combined can possibly caused an upward pressure in inflation. Also we need to consider external shock such as high oil price which once reached $147 per barrel in July

(3) Not sufficient to attract foreign investors. The main argument is that, costs per labour in developing Asian economies like Vietnam & China are far much cheaper than UK. I personally don’t think that UK will be able to do so even when abolishing the National Minimum Wage. Compared to China, UK has stronger labour laws & also their workers are more represented by labour unions. In China, working conditions are bad & most of the time the employees are less educated & not aware of their basic rights. These enable the employers to exploit them by paying low salary which overall lead to lower costs of production. Large MNCs will definitely be attracted to China given that labour costs are large % of total production costs

(4) BOP may not narrow. Pound has appreciated against many other major currencies since 1996. This means Britons have large purchasing power & it is cheap for them to buy from any other countries. The people in UK has large marginal propensity to import & that is they have tendency to spend large proportion of their income on imported goods. This explains why the trade deficit in goods has widened over the years even though UK began to close down the productivity gap with its major rivals

Wednesday, October 29, 2008

Why The Dollar Strengthened Despite Economic Woes?

(1) Calling for loans. As credit begins to dry up, US banks started to call in loans lent out to brokerage, securities firms and banks outside the greenback. Call loans are loans that are repayable immediately upon call & its interest rates are calculated on daily basis. Therefore to repay those banks, the borrowers will have to supply home currency & demand for dollar. This explains why dollar gains strength

(2) Growing unattractiveness of UK & Eurozone. UK economy is now in a mess. Unemployment had risen to a level we have not seen for years. More firms are cutting output. Meanwhile its economy will inevitably fall into recession for the first time in 16 years given the 3rd quarter’s GDP had contracted by 0.5%. To refresh your memory, recession is defined as 2 successive quarters of negative economic growth.

Eurozone economy doesn’t fare that well either. Its economy is much exposed to the threat of collapsed in Eastern European economies such as Hungary, Ukraine, Belarus, Russia etc. This is accrued to 2 reasons. First, European banks especially Germany & Austria had lent heavily to financially ill countries like Ukraine & Hungary which had turned to IMF recently. Second, Western & Eastern Europe have strong tie via trade. It seems that their economy will really slow down for some time. Therefore investors flee pound & euro denominated assets & demand for dollar

(3) Issuance of debts. Interestingly, the yen has appreciated against dollar. But this will not be long. US will soon issue debts to finance its budget deficit & bank bailouts. Many countries especially Japan will buy more of those debts to artificially keep yen lower than dollar, so that Japan can export itself out of depression. China is also likely to buy those debts, possibly causing the Chinese renminbi to be further lowered against dollar

(4) Possible lower interest rates. Many cash rich businessman & institutional investors from States begin to withdraw monies from UK & European banks due to the anticipation of further cut in interest rates to boost economic growth. This is a sign that savings in these banks are less attractive now due to lower yielding rate. At the moment of writing, interest rates is 4.5% in UK & 3.75% in Euro (which means much space for further cut)

All That You Should Know About An Oligopolist

(1) Few large firms. The oligopoly market structure is characterised by the dominance of few big firms. Few here mean less than 10. It can also be as low as 2 firms. In this case we call it as duopoly. Good example will be firms for personal care product such as Proctor & Gamble and Unilever. Here they dominate almost entirely the market for these products

(2) Highly interdependent. Some may think that just because the industry is dominated by few large firms, therefore competition is less intense. This is untrue. Any action by an oligopolist, will have a large impact on its rivals. For instance, say there are 4 firms. If firm A reduce prices, its rivals will likely follow suit. If not, they will lose all their customers to firm A. Likewise if B comes up with a new product, very likely others will come up with a similar or improved version of products

(3) Prefer non-price competition. Since price war will actually lead to lower profits in the long run for oligopolists, therefore they prefer to engage in non-price competition such as effective advertising & branding. Furthermore, this form of strategy is difficult to be modelled by its rivals. For price cutting, there is a limit as further cut will entail firms to losses.

(4) High concentration ratio. Concentration ratio is defined as the percentage of total sales contributed by the top 3 to 5 firms. In oligopoly market structure, concentration ratio tends to be very high as each firm actually command a large portion of market share. Normally, we classify a market as oligopoly if the concentration ratio of 4 largest firms is above 60%. However, different industry may have different nature of concentration ratio. For instance, telecommunication industry in Malaysia which is heavily dominated by Maxis, Digi & Celcom, could have concentration ratio as high as 90%

(5) High barriers to entry. Barriers to entry are defined as obligations created by the government or existing firms to make the entrance of new firms into the industry difficult. Factors like patents, control over key inputs, control over distribution network, high upfront expenditure, high & continuous advertising expenditure etc can insulate existing firms from competition. Due to that, we can therefore say that the market is less contestable. Also its sunk costs are very high. Sunk costs are costs that are not retrievable upon exiting the industry. Good example will be specialised equipments or machineries used in production. It's extremely difficult to resell these for other usage unlike some e.g. van, lorries etc

(6) Economies of scale (EOS). Defined as fall in long run average cost curve (LRAC)associated with an increase in output Oligopoly firms do enjoy great EOS such as purchasing EOS, managerial EOS, technical EOS etc as they produce in large scale although not to the extent of natural monopolies. This can give them further competitive edge as they are able to pass on the lower costs to customers. Newer firms are unlikely to be able to do so.

(7) Pricing strategy. Large dominant oligopoly firms may also practice predatory pricing & that is the practice of lowering down the price of their goods to the extent of loss making in order to drive out their competitors. Once successfully in doing so, their will gradually increase the price once again. Also they may practice limit pricing, a strategy of lowering down the price of their goods to the level where new firms find it unprofitable to join the industry. The primary reason for them to be able to do so, is due to their strong cash reserves since they already earned substantial supernormal profits

Thursday, October 23, 2008

Barriers To Entry...Something You Might Want To Know About Business

Barriers to entry

Definition: Obstacles that make it difficult or impossible for new firms to enter an industry

Barriers to entry is very much synonym to monopoly & oligopoly market structure. On the other extreme, perfect market is assumed to have no barriers to entry & exit causing the market to be flooded with sellers

Types of barriers:

(1) Globalisation. At the international level, trade restrictions such as tariffs & quota are also considered a form of barrier into the market of another country. The common one is the Common Agriculture Policy (CAP) which is argued to have hurt millions of farmers in developing countries. Due to the CAP, surpluses of agriculture produce in Europe are dumped into the Third World countries & simultaneously preventing those farmers to export themselves out of poverty by erecting various barriers

(2) Vertical integration. Some large firms may have some control over key inputs of production especially raw materials. Good example will be Bridgestone (tire manufacturer) that had acquired some rubber plantations in Malaysia & Indonesia. By having access & control over important source of inputs they can place existing rivals & potential ones at a disadvantage. In this case will be difficulty to obtain inputs & even if rivals can, it may not be at a low price. This is because Malaysia has comparative advantage in producing it, resulting in lower costs of production. This is called backward-vertical integration

Another is forward-vertical integration. By having good ties or agreements with key retailers & distributors, they can also prevent or limit the ability of rivals or potential firms from getting access into certain market. Example, most of the time Nestle brand product would dominate supermarket & hypermarket shelves & they are placed in a strategic way where it’s easier for in-store shoppers to see. Rival goods may be placed say at the bottom. Also, some may fixed an agreement with distributors to store only their brands, thus totally eliminate the chance of entry by other firms. Coca-Cola had done this before

(3) Predatory pricing & limit pricing. The first refers to the practice of selling at a loss making level to force an existing competitor out of the market. Normally the existing rival is one which is smaller, relatively new & does not enjoy as much supernormal profit as the large one does. Upon successfully doing so, the incumbent firm will then raise the price of its goods or services once again. The ability to do so, lies in the strong cash reserves position of the monopolist or oligopolist

Meanwhile, limit pricing is the practice of selling at a price where new firms find it unprofitable to join the industry. These 2 types of pricing have very much to do with the significant EOS & supernormal profits enjoyed by established firms

(4) High advertising expenditure. Established large firms can afford to spend heavily in advertising to create brand loyalty, by persuading the consumers to think that the goods or services they produced are slightly different from the others. In other word, their goods are not easily substituted by the goods from existing or potential rivals. Also, it can cause demand for their goods to be more inelastic (PED lower than 1)

In such situation, new firms will have to spend much heavier to break the customers’ loyalty towards existing brand & to create powerful household names. In reality, new firms are very much reluctant to take the gamble as there is no guarantee over the success. All those costs will be sunk costs at the end of the day

(5) Economies of scale (EOS). It is defined as fall in the long run average cost curve associated with an increase in output. Large established firms enjoy all sorts of EOS such as financial, managerial, marketing, technical etc because they produce in large quantity owing to the large customer base that they have. This results in cost saving which can be passed on to the customers. New firms tend to be more inefficient as their average costs (AC) will be greater than those realised by large firms. Therefore they lose out in terms of pricing competitiveness

(6) High set up costs. Normally those businesses in oligopoly or monopoly market structure required large upfront investment such as specialised machineries & technologies. This is very obvious in car manufacturing, jet manufacturing, telecommunication industry, IT related business, information news dissemination such as Reuters & Bloomberg etc. In other word, high ratio of fixed to variable costs. All these are considered as sunk costs, as they are not easily converted to other form of usage shall a firm consider to exit the industry. Therefore we say high sunk costs act as a barrier to entry & exit

(7) Legal barriers. Often created by government policy. One good example is patents. It is actually meant to encourage invention & technological progress. Once the good obtains patents, the incumbent firm has the sole right to produce that particular good for a certain period of time. Within that period, the firm which made the discovery can reap supernormal profits as there are no rivals that come up with similar goods. Even if there is, that firm can be sued. One good example will be the legal tussle between Polaroid Corp & Eastman Kodak. Polaroid Corp made the discovery on instant camera. Observing the supernormal profits reaped, Kodak then enter the market with its version of instant camera & this caused Polaroid to suffer from falling profits due to falling price. Kodak was taken legal & asked to pay Polaroid compensation

Wednesday, October 22, 2008

Does Anyone Benefits From Recession?

I know fellow readers may think that I’m crazy to write such posting. In fact I believe that if you ask anyone on the street, no one will ever like recession & of course not any of them I know will support my statements.

However in economics, I truly believe that there are always 2 sides to everything. When oil price increased dramatically to USD $ 147 per barrel in July most if not all consumers & firms suffer. But there are some that benefits such as oil company like Exxon Mobil, Shell & Petronas. Smaller firms like natural gas tank installer benefits too.

When we talk about inflation, borrowers who are on fixed rate mortgages benefit too, but not the bankers. The money those lenders received actually worth lesser, given that inflation erodes its buying power. Here the redistribution of income is from lenders to borrowers

So who benefits anyway in the case of recession?

(1) Opposition party. This is the best opportunity by the opposition to topple the government. Excuses being used are often the government has mismanaged the economy causing high unemployment, prices of goods rising, increasing income inequality etc. This is also the period where voters have strong swing in their confidence towards the government, & more often than not they easily buy words & promises by oppositions

(2) Book authors. Those authors, usually an economist who wrote about credit crunch issue seems to be cheering about this. Book companies are very willing to sign contracts with these authors & personally I predict that in 2009 there will be mass of books all talking about sub-prime lending.

(3) Economics lecturer. Being an Economics teacher, my realm is pretty much to do with jargons like real GDP, monetary & fiscal policy, national debt, currency etc. But thanks to the recent subprime mortgage crisis, my finance vocabulary has improved a lot. Why? The issue arouse my curiosity to find out what really is CMO (Collateral Mortgage Obligation), credit default swap, how bonds are rated, annuity & many others. I believe other Economics lecturer would definitely agree with me on this

(4) Students taking economics. There is no other time better than now for students to learn Economics especially Macro. I got to realise that students love for Economics grew in the classroom recently. More questions were being raised regarding the financial meltdown even though I have finished teaching that topic. Part of it is because, they are able to see things they learn in textbooks such as unemployment, recession, real GDP, national debt etc appear in major newspaper. It arouse their curiosity too in wanting to know how to apply theories in real life

(5) First time property buyer. This is not really a significant event in Malaysia. But in UK, some area had witnessed prices of property fell to more than 15%. Arguably this is the best time to hook on the property ladder, especially young for young working people. However one could also argue that this is valid provided they are able to secure loan from banks, which now seems to be much frugal in lending

(6) Stock investors. Many stocks had fallen to an unprecendented level & their PE (price to earnings) Ratio has gone down a lot. Last week, the world’s richest investor Warren Buffett said in major newspaper that this is the best time for bargain hunting. I still recall his famous quote- “ Be greedy when others are fearful, and be fearful when others are greedy”. From investment point of view, it is always the best period to invest when prices of stocks had fallen to record low so that you can dispose it off with a much higher price later & reap those profit. Anyway, I’m looking to jump into my unit trust investment. Yes, I had make lots of losses but I feel that by jumping in now, I’m able to lower down my cost of investment & hopefully I can breakeven faster. This strategy is called dollar cost averaging

(7) Hypermarket. In the period of recession, many poor people on the street turn poorer. Income is falling everywhere. There will be fall in numbers of retail sales & those who shop along high streets. Most if not all will likely turn to the most famous household name, Tesco for household goods & other appliances. There will be an increase in its profit, so long as it does not engage in aggressive & damaging price competition at the moment. Others such as Carrefour & Giant will benefit too. In UK, other household brands are like ASDA (owned by Walmart), Sainburys & Morrisons

(8) Manufacturer of inferior goods. Inferior goods are those goods with negative income elasticity of demand (YED lower than 1). In layman, it means if one’s income increases, he will consume lesser of that good. Of course it works vice versa. Here it’s actually kind of difficult to distinguish inferior goods as it may differ from an individual to another. For me, instant noodles, Tesco brand bread, biscuits in tins are considered as inferiors. But I believe I’ll be consuming that a lot (I just bought 5 packs of instant noodles, & I didn’t realise the economic rationals of doing so until I write about this)

(9) The Economist. This really gets on my nerves. I normally went to Borders a day or two after the arrival of weekly magazine The Economist, & I can still see those magazines on the shelves. But in the recent 2 weeks, I failed to get a copy of it. This is an evidence of how the America meltdown actually helps to advertise The Economist, although in a very indirect way causing an increase in its demand even though the price has not changed (Remember in Unit 1 where I mentioned price constant, only demand curve shifts rightward? The same principle applies here)

Monday, October 20, 2008

Will The Dollar Collapse?


(1) Lower interest rates. Finally US had decided to slash interest rates by 50 basis points to become 1.5%. The intention is to revive the US economy by the way of greater household spending. However, with lower interest rates on top of the current financial meltdown will further cause US to be a less attractive destination to save money. Wealthy foreigners & large fund management companies may look around other countries that offer better yields. With falling demand, dollar will fall

(2) Diverting to other growing economies. This has much to do with the loss of confidence on how the Congress is managing the crisis. Debt has been ballooning to more than $ 10 trillions lately, near to 70% of its GDP & there is a fear that US will run into repayment problem. Monies borrowed were not injected into the economy by developing infrastructures & human capital, but to buy toxic debts & part to finance previous debts. Economic confidence we have seen in earlier days has not return. Current account deficit is still large. Recession if not depression seems to inevitable. Investors may see US as a less attractive destination to park their money.

Existing investors could pull out by selling the holding of dollar assets. Meanwhile potential investors will shy away. Increasing supply of dollar accommodated by the fall in its demand are likely to cause dollar to suffer a free fall. There is a growing evidence that countries like China, Japan, South Korea, Russia etc had slowly diversified their portfolios away from dollar

(3) Current account deficit. The large deficit is caused by heavy imports while at the same time US' export is not growing much. Fortunately this trade imbalances is financed by the strong inflow of capital from OPEC oil-rich countries & emerging Asian economies. If this capital were to dry up as these countries no longer interested to hold dollar denominated securities, it means demand for dollar will fall. Dollar will depreciate

(4) Ballooning debts. US national debt is actually much larger than all of us thought, that is if we were to include all those future obligations such as pension funds, social insurance, Medicare, Medicaid etc. At the same time there is an immense pressure onto Congress to boost spending onto healthcare given the increasing number of retirees from the baby boomer generation

All this require huge spending too. So that means, in the future US are likely to borrow more to finance all these. The current crisis has already spark fear on the possibility of US to default on its debt. If it does materialise, there will be no countries that are willing to buy US debt & it may cause the dollar to fall. The impact will be exacerbated if in such a situation US begin to print more money to finance that debt (since they can’t find buyer). This will send the dollar to a free fall

Not likely,

(1) Self interest. China & Japan will definitely not let the dollar & therefore US economy to go collapse. Both have about the equal 20% share of exports to America, which means American consumers are important to them. Letting the greenback collapse, likely means sending Chinese manufacturing sector to recession & we may witness large scale of unemployment. To Japan, fall in demand for their exports will even give them more difficulty to bail themselves out of depression.

In fact, they are more interested to get hold of dollar by pumping in more Yuan & yen to make the dollar artificially high relative to their currency so that US will continue to buy from them. As for some claims of Asian currency shifting away from dollar, it could be argued that countries like China which is so cash rich are just diversifying their portfolios of investment, given that they already hold so much of US debts & securities

(2) Other currencies are likely to fall too. No doubt US economy is facing many problems due to sub prime lending & is on the verge of moving into a recession (or maybe another depression). Debt is standing at all time high. This somehow lowered the investors’ confidence on the prudent of holding dollar assets.

But don’t forget, Eurozone faces the same problems too. Many financial institutions are on the shaky ground. Government in each euro country has announced a series of measure to pump in more money to increase liquidity in their financial system. For instance, of the largest real estate companies in Germany such as Hypo was being bailed recently. To make things worse, Euro is also on the brink of recession. Their debt is high too & the interest rates had been slashed as well. This could mean that holding the dollar is as good as holding the euro. Other economy like Japan has high national debt standing at 195% of their GDP. The yen could be in problem too. However one can also argue that situation in Japan is much different, since their country has high savings rate

Friday, October 17, 2008

Forecast Of UK Economic Outlook In 2009

If the current economic woes continue,

(1) Inflation will further fall (9/10).
At the meantime there will be no threat of high oil price. On the other hand, consumption will likely fall given the unsettled housing market woes. Firms will deter or even cancel their investment spending as they are worry that they can’t recoup their capital or operate profitably. There is limited space for fiscal expenditure, as UK’s national debt is getting higher. Export will likely fall given that main UK trading partners such as France, Germany, Italy, Spain, US etc are facing various economic uncertainties. There will be no demand pull or cost push inflation

(2) Interest rate cut (7/10). UK’s interest rate is still high at 4.5% & this gives Monetary Policy Committee (MPC) much flexibility to further reduce it. There could be another round of 25-50 basis points (0.25%-0.5%) slashed to stimulate household spending & investment into the economy

(3) Pound is set to fall (7/10). Lower interest rates will mean those rich foreigners or large institutional investors will withdraw their savings from UK & look for another country which offer attractive yields. Furthermore the current guarantee by UK government for the first £50, 000 of savings will not help to restore savers confidence. News of banks being rundown from time to time will cause these savers to withdraw their money causing pound to further fall when they convert it back to home currency. Also investors are now eyeing on the safe haven, investing in gold & silver

(4) Unemployment increasing (8/10). The manufacturing sector which is already in such a mess will run into a deeper recession as demand for exports will likely weaken. More job cuts will be reported. Figures of unemployment will be much higher when we sum this up with those retrenched workers from the financial institutions

(5) Lower property prices (7/10).
People do not dare to take financial commitment e.g. financing new assets due to fear over job losses. Banks on the other hand are now more stringent in lending due to credit shortage, high interbank lending rate (LIBOR) & fear over the same problem will repeat itself. This automatically means lower prices for property as demand for housing is likely to be weak throughout 2009

(6) Increase government borrowing (7/10). UK government will continue to pump in more money to increase the liquidity in the banking system. Also it’s part of an effort to restore confidence in the financial institutions so that they can start lending once again

Does Stock Market Crash Often Followed By A Recession (or Depression)?


(1) Falling wealth. In most countries, people generally store their wealth in property market & stock market. With market crash, it means consumers’ wealth is wiped off & this could undermine their willingness to spend into the economy & this leads to fall in consumption. Fall in AD will cause real GDP to fall.

However the situation could be unique in UK, as most Britons store their wealth in property market. People there even view shares as speculative investment. This means when share prices go up, people do not spend more & when share prices go down, they do not cut their spending. It’s also worth to note that only small % of populations have significant savings in shares. At the moment, wealth crisis in UK wasn’t stemmed from falling stock index, but rather a series of falling house prices which has to do with high default rate of subprime mortgage loan

(2) Falling investment. In the period of falling share prices, firms may find difficulty in raising capital through the issuance of shares. Therefore this may prompt them to defer or cancel an investment project causing a fall in AD. Real GDP will decline & this causes negative economic growth

(3) Fall in confidence. This depends on how long & how severe is the crash. Most notably was the October 1929, Great Depression where share prices suffer from such a large fall & is prolonged that it causes a general decline in economic confidence & collapse of financial institutions. Consumers cut their spending & firms continue to hold back their investments, causing a large scale of unemployment & fall in economic growth. These effects were magnified by a negative multiplier effect, when things happen in a cycle


(1) Market correction. In many occasions, stock market crash does not lead to recession. Those share prices are falling because they are overvalued whereas economic fundamentals remain intact. A good example will be the notorious October 1987 crash, where the market crashed by as much as 25% in a single day of trading, but didn’t cause any significant economy problem to both UK & US economy. Share prices began to recover in late 1980s & UK enjoyed a high economic growth that time (refer diagram below)

October 1987 crash in UK

October 1987 crash in US

In a nutshell, whether the economy will run into a recession due to crashing stock market depends on what causes the stock market to crash. If it is a correction, the fall will likely be short-lived & it will not harm the level of confidence.
However if prolonged, people may think otherwise & this cause them to overreact & run into panick. This further exacerbate fall in stock prices. Also it depends on economic fundamentals. Like now, many banks have problem with their balance sheet due to over-exposure to subprime lending. This causes the valuation of their stocks to be bad. Furthermore, given these banks are heavyweights in the construction of Dow Jones & FTSE index, the fall in their market capitalisation will defnitely pull down those indexes a lot

Thursday, October 16, 2008

Should Malaysians Cheer For The Recent Lower Oil Price?

Is there anything to cheer for cheaper oil price?


(1) Less burdening. In Malaysia, demand for car is inelastic (PED< 1) given the poor condition of public transport e.g. irregular bus, sardine-packed LRTs & KTMs etc. As such Malaysians rely heavily on it as a main form of transport to travel from one place to another. This translates to high expenditure on fuel consumption. Now with lower price, public especially those on lower income bracket can set aside more money for various purpose e.g. saving, children school fees, household goods etc

(2) Lower price of other goods. High oil price is the main cause for sudden hike in the prices of most other retail goods. This is because, goods need to be transported from factory to the shop, restaurant or distribution outlet. Manufacturers will not hesitate to factor in the cost of logistics. As a result, retailers will too pass on the increase in costs to end consumers to protect their profit margin. Since oil price has went down again recently, it is hope that consumer goods will be much cheaper


(1) Cut in allowance. Some companies do pay their employees COLA (cost of living allowance) to ease the burden of unsustainable living cost. With oil price downward spiraling, companies are likely to review whether COLA should be continuously given or stripped. Given the outlook of worldwide economy continues to be gloom, the profitability of companies are likely to be affected too. This further strengthen their justification to reduce or strip COLA

(2) Congestion. As driving is now less burdening, those who once car pool & use public transport to work will resume to travel at their comfort once again. This cause negative externalities. Existing congestion will be worse. People will be late for work & productive time is wasted just like that. Also, increasing number of cars lead to more road accidents.

(3) Pollution. More cars mean pollutants released. Air quality will worsen & in the long term it is not surprising that more people will suffer from respiratory ailments

(4) Lower revenue for government
. Price elasticity of demand for oil is very low (PED < 1). Therefore, as world oil price decrease, total revenue for oil producing country such as Malaysia will decrease too. In the near future, government may find it tough to conduct expansionary fiscal policy e.g. spending on development projects to awaken the economy from its slumber to recession. Our government does rely heavily on revenue from Petronas as source of funding. In fact, from today’s newspaper The Star, 16th October, government had already planned to shelve some of the development projects

(5) Lower profit for transportation firms. Bus & LRT operator will definitely see a fall in the demand for their service after the height of RM2.70 per liter. More & more people will switch back to cars. Cost of operating will now be higher given that the fixed costs are thinly spread over the smaller number of passengers. Small reduction in price of diesel will not be sufficient to offset this

(6) Prices of other goods stay the same. History has proven that business people are very fast to response to high oil price by raising the price of their goods. But when there is a fall in oil price, they are sort of ‘reluctant’ to lower the price of their goods, as it mean lower profits for them

Wednesday, October 15, 2008

Will Increase In Fixed Costs Increase Both MC & AC?

This is another interesting issue to look at regarding the theory of costing. Most textbooks & economics websites do not provide sufficient information on this. It normally provides only the curve.

Before I explain, I hope that readers understand what is FC, VC, TC, AC & MC is. Brief definitions:

Fixed cost (FC): Costs that do not vary with amount of output produced. E.g. even though I may not be doing business that month, I still need to pay for rental or loan from banks etc

Variable cost (VC): Costs that vary with number of output. The more a firm produce, the more raw materials it need

Total cost (TC): Sum of both FC & VC

Average cost (AC): TC/ Q (cost per unit of output)

Marginal cost (MC): Additional increase in cost, due to extra one unit of output produced

Source of diagram:

Try to look at it mathematically. Look at the calculations below

5th unit, FC = RM 10, VC = RM 30, therefore TC = RM 40 and AC = RM8

6th unit, FC = RM 10, VC = RM 32, therefore TC = RM 42 and AC = RM7

Marginal cost (MC) from the 5th to 6th unit is (42-40) RM2

But when fixed cost increase, say to RM 15

At 5th unit, new TC = RM 45, therefore and AC = RM9

At 6th unit, new TC = RM 47, threfore and AC = RM7.83

BUT marginal cost (MC) from the 5th to 6th unit is (47-45) RM 2

Therefore when fixed cost increase, it will pull AC up, but has no effect on MC. This is because mathematical logic tells us that the similar increase actually cancels out each other

Monday, October 13, 2008

Relation Of MC & AC curve

Source of diagram:

Student’s question: What is the relation between the marginal cost (MC) curve & average cost (AC) curve?

This is one of the most popular questions that students ask me. It is under Industrial Economics for those who are taking Edexcel examination & under Business Economics for those taking Cambridge. The following analysis, is based on diagram above. Our concern is on MC & AC only. Ignore AFC & AVC (so difficult to find diagram with only MC & AC)

Let me illustrate. Say there are 9 students & coincidentally each of them has RM 20. This means average amount of money that each student has also RM 20. When the 10th student which has only RM 10 joins the group, total amount of money is RM190 & of course the new average is RM19. Here, the average went down because the amount he added to the total which is the marginal was actually less than the average

That’s why when MC < AC, AC will go down (pull the average down)

On the other hand, say the 10th student carries with him RM 100, the total amount of money is RM 280 & the new average is RM 28. Here the average went up because the amount he added to the total which is the marginal (increase of RM 100) was far higher than the average of RM 20.

Therefore we conclude, when MC > AC, AC will go up (pull the average up)

If the tenth student brings with him only RM20 just like the others, then there is no change in average amount of money. This is because marginal increase equals to original average. That is new total amount of money is RM200, divided by 10 students & still each is RM20.

So, when MC = AC, AC will not change (does not affect the original average)

Learning Economics Through Cartoons

The big man represents large US economy. The cushion beneath there refers to the stimulus package offered earlier such as tax rebates to increase consumer confidence & therefore spending. Another man is best referred as President Bush that hopes that his plans work out to prevent the US economy from crashing

These are the problems that haunt US economy: high unemployment, previously high oil price which breached US $100 per barrel, high cost-push inflation, falling house prices, ballooning consumer & national debt, many other financial institutions on the brink of collapse, factories shutting down, & depreciation of US dollar

What Happens If GM succesfully merged with Chrysler?

Benefits for GM if acquisitions of Chrysler materialise

(1) Economies of scale. EOS is defined as fall in the long run average costs curve associated with an increase in output. GM may enjoy purchasing EOS, technical EOS, financial EOS etc. Purchasing EOS is when GM purchase inputs in huge bulk, thereby giving them advantage of negotiating for lower price. Financial EOS is achieved when it borrows in a big sum. This gives them an edge over negotiation for lower financing rates. Furthermore banks would not hesitate to borrow given that larger firm is perceived as more stable & more cash-rich. Technical EOS is when production plant is used to the maximum capacity, thereby spreading over large fixed costs

(2) Enlarge its market base. The resulting company will conquer larger US market share. This is because GM is the leading car manufacturer & Chrysler is the third. Having more monopoly power, may enable it to charge higher price in the future once the economic woes settle back. This leads to greater supernormal profits

(3) Greater R&D. Earning supernormal profit in the long run, enable the resulting larger firm to invest larger portion of its retain profit into R&D. By doing so, it may lead to discovery of better production techniques or innovation e.g. more fuel efficient cars. Consumers are the biggest beneficiaries on this

(4) Less need for advertising & branding. Chrysler has strong brand equity & large customer base. GM does not need to engage in heavy promotion or advertising to push for more sales

Disadvantage of the acquisitions

(1) Allocative inefficiency. Having monopoly power, the new firm will charge customers the price where MC = MR, rather than P = MC or MC = AR resulting in allocative inefficiency. By charging higher price there is also a loss of consumer surplus

(2) Productive inefficiency. The new firm having monopoly power will not produce output where LRAC is minimised rather output at MC = MR

(3) Diseconomies of scale. DEOS is increase in the costs of production associated with the increase in output. As size of operation increase, more bureaucracy will be involved when layers of management/ department added. This adds to cost. Also it will be more difficult to monitor large number of workers. Failure in communication often leads to strike that increase the costs of operation (depending how long). For big firms, these are normal problems

(4) Easier for collusion. As number of firms shrinks, this causes the car industry to be more concentrated. In other words, having high concentration ratio (normally we use CR3-5). This gives the new resulting firm more space to practice collusion with other firms, practice of selling cars at higher price

(5) Job losses. As the mergers will involve restructuring of operation, more workers will be retrenched as part of the plan to cut costs. This will add to the gloom of US economy which is already on the brink to Great Depression

(6) Lower price to suppliers of inputs. The resulting new firm can pressed suppliers to supply raw materials or inputs at much lower price as it has monopsony power. The same argument goes for Tesco that pressurised farmers to supply to them those vegetables at a very low price. However, GM may argue that this is for the benefits of consumers too as lower costs may translate to cheaper car

Sunday, October 12, 2008

Finding Out About Foreign Exchange Rate

Click this link:

How Effective Is Demand Management Policies To Avoid Another Great Depression In US?

What are demand management policies?

Policies to influence the movement of aggregate demand (AD) & therefore overall level of economic activity. Here we meant the fiscal policy & the monetary policy. Fiscal policy involves the manipulation of government expenditure & level of taxation, while monetary policy involves manipulation of the interest rates & also the money supply

How does fiscal policy work to reverse recession (or worse depression)?

(1) Increase government spending. The government should spend more money onto public works such as transportations, infrastructure, health & education sector, communication etc. Direct government spending (G) moves AD to the right. Along the way, more contractors will be engaged to construct all these. Here it positively affects investment by firms (I). Don’t forget that massive spending will help to reduce unemployment in the economy. As more people are employed, consumption (C) will increase. The latter two will also cause AD to shift rightwards.

As real GDP increase, it will help the economy to rebound. Spending onto infrastructures does have positive supply side effects too as it increase the productive capacity of the economy. It is argued that in the long run, economic growth will be much larger

(2) Slashing tax. Reducing income tax will help to boost the economy via two channels. First, paying lesser tax automatically means an individual having higher disposable income. This helps to increase (C) & therefore pushing AD to the right. From supply side argument, lower tax will increase the incentives to work harder & longer hours as bulk of the income belongs to that individual. AS curve will shift rightwards. The same argument goes for corporation tax. Increase in I will positively affect AD & AS

How does monetary policy work to reverse recession (or worse depression)?

(1) Lower interest rates. Interest rates cut, means borrower paying lesser to the bank & therefore having higher income for other forms of consumption. Also lower rates will induce people to spend into the economy by the way of credit. This is what the Fed did during the Greenspan regime that went on until somewhere in 2005. As a result, the economic boom then after the dotcom burst & terrorist attack took place due to higher household spending. AD increase

The same argument goes for private firms spending. Financing projects & expanding business will be cheap & feasible. More will be expected to take it up. Increase in I will lead to increase in AD too

Lower interest rates will cause US dollar to depreciate. As such, buying from US will be cheaper & this will boost its export market. X increase. To Americans, falling dollar means fall in purchasing power. This discourages imports. M fall. Net effect will be increase in net export (X-M). More foreigners will spend money into US causing economic growth


(1) G is not on public works. It could be a little bit too late for US officials to realise that they should follow the movement of UK government. There is difference between UK & US bailout. In UK, government spends monies to recapitalise the banking system & to improve the balance sheet of the bank with the hope that they are able to lend money as usual. In US, monies are spent on buying toxic debts that nobody wants.

It is a big waste as that huge sum of monies could be better off spent elsewhere especially to redeveloping the economy & generates employment opportunities for those retrenched from the private sector

(2) Little space for G in the future. US’ debt is already ballooning at 70% of their GDP. If were to include those pension funds, social insurance etc, national debt would tantamount to 400% of GDP. It will be a painful procedure to be President Bush’s successor. There is very little space to manipulate G in the future, & most of the task I firmly believe would be focusing on reducing the burden of debt, something we last seen under the administration of Clinton

(3) Tax should not be increased. I believe this is the largest factor that hinders the success of both monetary policy & fiscal policy. Fear over job losses is gripping all Americans (last week itself, more than 160, 000 job losses were reported). Level of wealth gone down together with the falling value of houses & stock prices. Those who were lucky, still hang on to their job perhaps with pay cut & no increment. Increasing tax is killing the man on the street! This is countering expansionary fiscal policy

(4) Interest rate cuts is futile without consumer confidence. With the ongoing credit crisis, banks are more reluctant to co-operate with the Fed. Lower interest rates were not passed on. Also banks are now more stringent in lending. Number of loans approved dropped drastically. Consumers on the other hand, are fearful on taking financial commitments over the insecurity of their jobs. Firms do not borrow over insecurity of future profits. All these lead to fall in C & I.

To worsen the C & I, Dow Jones fell for 7th consecutive day of trading. This shows one thing, if consumer confidence is not restored, NOTHING the government or the Fed do will prevent us from witnessing another onslaught of October 29, 1929 Great Depression (we are now in October too)

Besides, how low can it go? Fed rate is now standing at 1.5%. The depression in Japan throughout 1990s to early 2000s is good evidence. Even though interest rates was 0%, still people & firms are reluctant to spend.

Saturday, October 11, 2008

Impact Of Depreciating Pound

Several months ago, the exchange rate was about £1 to US $2. In the recent, pound has depreciated & with £1 UK people can only get US$ 1.75.

Weakening pound is good news for UK’s manufacturing sector which is already in a deep recession. Falling pound means much cheaper to buy from UK. As such this will boost export market. For Britons, weaker pound translates to fall in purchasing power & this should automatically means falling import. The overall effect will be increase in net export (X-M). This will lift AD & raise real GDP

Disadvantage of depreciating pound

(1) Fall in standard of living. As imported goods are now more expensive, British people get to buy lesser goods with the same amount of money they have. Another way to look at it will be, needing more pound to buy the same amount of good. Demand for luxury imported goods will fall, foreign travel will decline etc

(2) Causes inflation. Two ways it can happen. First is imported inflation. Weakening pound causes imported raw materials & intermediate goods to be expensive (although in real term they are not). This hike in costs of production will be passed on to consumers by the way of higher prices. This could be exacerbated if the country where UK import from suffers from high inflation. Second, is demand-pull inflation. As UK goods become cheaper, demand from overseas market will increase & this will boost the export market causing economic growth when AD moves upward

(3) Less incentive to cut costs
. It is argued that some firms may be over relying on the weakness of pound to stay competitive. Yes, UK goods are cheaper now but not because of the lower costs involve in producing them, but rather the structural short-term weakness of pound that artificially makes them look cheap. To maintain long term competitiveness, it is best for those manufacturers to look at issues like lacking R&D, sluggish productivity & other forms of efficiency

What determines exchange rate?

(1) Interest rates. In short term interest rates are important. Many investors, wealthy individuals, large fund managers are shopping around to decide where to save the money. If MPC decides to increase rates, it will attract hot money flows. To save in UK’s financial institutions, they will need to buy pound & this cause pound to appreciate.

In the recent month, pound has been falling due to worsening economic situation in UK. In current period, price level tends to fall. As such people expect MPC to cut interest rate to meet the inflationary target of CPI 2% +/- 1% & also to revive confidence in the economy so that people will begin to spend. This will cause investors to flee pound denominated assets causing pound to depreciate

(2) Speculation. Movement of exchange rate may not necessary follow economic fundamental at least in short term. This is because people are betting on changes in US economy from time to time & this may give rise to demand or fall in the dollar against pound

Thursday, October 9, 2008

Great Depression Revisited

There is no other time better than now to revive the issue of Great Depression, given that the world largest economy is imminently moving towards that direction. It an Armageddon & a day that all those who went through it will not forget.

What is Great Depression?

The greatest worldwide economic downturn that began in 1929 & lasted for about 10 years in US. It is often associated with the memorable date of October 29 or the Black Tuesday, the day where stock market suffered the biggest blow. Since then, this event has been used in the 21st century as a benchmark on how far world’s major economy can fall

What happen that time?

US’ GDP fell from $103 billion to $55 billion as industrial production slows down significantly. Unemployment rose from 3% to 25% & this was partly exacerbated by the world trade that plummeted by 65% around that time. Suicide rate increase from 14 to 17 per 100, 000

Major causes

(1) Restrictionary monetary policy. All thanks to the tight monetary stance instituted by Federal Reserve at that time. To prevent inflation, interest rates were raised several times & unfortunately the financial market did not positively digest this. This led to the stock market crash in October 1929. As the market was not performing, investors turn their money onto currency markets. That time, dollars were backed by gold. Speculators began heavily selling dollars for gold, & this caused major depreciation of dollar.

The Fed then raised interest rates again to preserve the value of dollar & this deepened the crisis. Further restrictions in availability of money for businesses lead to more bankruptcies. Industrial production fell by 9% between October & December 1929 & this instantly led to large scale unemployment. More people began to default in their loan. In the same period stockholders lost more than US$ 40 billion

(2) Fall in spending across economy. Closely related to the first point. With the fall in wealth & declining economic confidence, people & firms immediately cut their spending into the economy. This led to reduction in number of goods produced & thus a further cut in employment. As more people lost their jobs, more ran into bad debts & this hurt the balance sheet of their company. Fall in profitability forced those existing firms to cut employment again (cycle repeat itself). Unemployment rose to 25% at the height of the Depression

(3) Failure of banks. In the 1930s, more than 9000 banks failed. That time, there were no such thing as guaranteeing the deposits. Therefore as banks collapsed people simply lost their savings. Surviving banks surrounded by pessimism began to tighten the condition for lending & this exacerbate the situation by the way of falling consumption expenditure & investment

(4) Smoot-Hawley Tariff. The government created this act with the intention to insulate & revive American companies from competition outside. Also it is hoped that it will generate employment opportunities once those industries get back on their feet. Under this act, higher tariffs will be imposed onto imported goods that come into US causing them to be more expensive. Consumers will be forced to consume local goods

Unfortunately, others also retaliate by imposing high tariffs on US good. Exports fell. Manufacturing sector was sent to recession. Therefore the intention to create jobs failed

(5) Unbalance concentration of economic activity. It is argued that the government should diversify the economic activity. The Federal government that time favoured new modern industries than agriculture. Somehow during World War I, they had taken bold move to subsidise farm, paid absurdly high prices for wheat, encouraged more of them to buy land, equip those farmers with modern production techniques etc. This was all part of the food security program. After the war end in 1918, these farmers were treated like ‘step-son’. Price paid for farms’ output fell tremendously. Many were in left great debt.

Too much of concentration were given to rising industries such as automobile & radio. As such when those two collapsed during the wrath of Great Depression, the whole US economy follow suit (Like I said in class, never put all eggs in one basket!)

Is There Anything To Worry Over The US Ballooning Debt?

The national debt clock in Times Square is unable to sustain additional zero

What is national debt?

National debt is the amount of money that US government owed to holders of its debt instruments such as treasury bills (maturity is 1 year or less), treasury notes (maturity period between 2 years to 10 years), treasury bonds (longest, around 30 years) etc. The creditors can be Americans or foreigners. Few days ago, the US government announced that this debt has surpassed US $ 10 trillion (up from $ 9.5 trillion) & is currently standing at about 70% of its GDP. Not even can the national debt clock contains the additional zero

Why national debt increases?

(1) Financial bailout. This is the main argument. Bulk of the money is wasted to bail out those inefficient banks which ran into the sub prime mortgage crisis which stemmed from reckless lending. Also it is argued that US government is buying over worthless assets or some called it toxic debts. These monies is better off if spend onto education, infrastructure & healthcare sector which have positive long term supply side effects

(2) Increasing number of elderly people. Over the years, life expectancy had increased. Along the way, with growing number of old people, there is an intense pressure onto the US government to continuously pump money into the healthcare sector

(3) Tax cuts. There were several tax cut measures earlier on to revitalise business & to encourage people to spend. Somehow this fall in tax revenue is not matched by the massive increase in government spending. As such it ran into budget deficit

(4) Military spending. This has got to do with the financing of military operations in Iraq

Is there anything to worry about the ballooning national debt?


(1) Higher tax. If the debt further increase, it means the US government is liable to pay higher interest repayments. As such income tax & corporation tax may increase gradually over the years just to finance the debt. This is certainly a bad news for consumers & firms

(2) Crowding out effect. Increase government borrowing from the private sector will cause a competing demand for money. As such interest rates will be bid up & this will crowd out households’ spending & firms’ investment. Another way to look at this is, if private firms buy the bond they will in return have lesser funds for investment

(3) Inflationary pressure. If the debt is growing out of hand, very likely US government will struggle to find sufficient number of buyers of the bond. To fill the gap, they may be tempted to start printing money & this will cause inflation as money supply increase. This also explains the events of hyperinflation in Germany in 1922-23 & the case in Zimbabwe

(4) Borrowing is not to finance economy. If the US government borrows to finance investment onto infrastructure such as new & more efficient roads, communication etc, then we may witness a long term US economic growth due to the supply side. That time, the government may be able to collect more tax revenue to reduce its debt burden. In the present state, the monies borrowed are not meant for productive use e.g. bailing out failing banks, paying pensions etc. This will not contribute to economic growth

(5) Not inclusive of other debts. It is argued that the actual national debt is much larger if we were to include social security & other form of social insurance which the government is obliged to pay. Adding this together, the figure of debt will amount up to US$ 59.1 trillion (wikipedia) & that is about 400 % of its GDP

(1) Worse debt in the past. During the World War II, US’ national debt is standing at a much frightening figure of 150% of GDP (same like UK). This is an example, how a country can borrow during the period of crisis & gradually paying it back over the time.

(2) Economic growth. If the US government plan is successful in lifting the fear among consumers, very soon the US economy will rebound with falling unemployment, better performance of the Dow Jones, business expansion, increasing retail sales etc. That time, government can raise taxes to part finance the debt & the rest to reinvest onto the economy particularly on infrastructure spending. Technically speaking, if the increase in real GDP is faster than accumulation of the debt it should be fine.

Sunday, October 5, 2008

Events That Can Worsen The Subprime Mortgage Crisis

What can worsen the current crisis?

(1) Further fall in consumer confidence. If US consumers totally lose confidence with the way government is handling the current subprime mortgage crisis, they will further cut their consumption into the economy. They are afraid to make credit commitments over the fear of job losses. Retail sales will further fall. House prices will also fall thus worsening the negative equity

(2) Increase in savings. Closely related to paradox of thrift, an economic theory propounded by J.M. Keynes. It states that if everyone thinks that by saving money during recession will do them good, then they are wrong. Fall in consumption will lead to fall in AD, therefore economic growth falls too. In the end, everyone is worse off

(3) People rushing to withdraw money. All due to imperfect information. News about giant insurer like AIG or even banks on the brink of collapse will cause everyone to rush to the bank to withdraw money, even from financial institutions that have healthy balance sheet. The further constrain in liquidity will cause the whole financial system to collapse

(4) Stringent lending. Remaining banks are now more stringent in lending. Interest rates had been increased to recoup previous written off debts. People & firms find it more difficult to get financing. Consumption & investment will further fall

(5) Further decline in business confidence. Economic uncertainties will discourage firms ranging from corner shops to large corporations from investment. There is fear of bankruptcy or they can’t recoup their capital. In such period, even with investment tax credits given government may prove futile. Major newspaper are not improving the situation, as news of companies filing for bankruptcy often serve as headlines

(6) Oil price increase. Again there is another talk recently to cut production of oil given that there is overproduction. By cutting the supply, oil price will increase once again & this will further hamper economic growth. Currently, oil price falls below US $100 & this is not a good news for major oil producing countries. As demand for oil is inelastic, fall in price means fall in total revenue.

(7) Bailout at the expense of taxpayers’ money. Bad news for working people. They will have lesser money to spend. AD will fall followed by economic growth. From supply side of argument, people will be discouraged from working hard knowing that the bulk of it goes to government. Output will fall

(8) Increase in interest rates. Nevertheless, inflation is creeping although at a smaller rate. This may trigger the Federal Reserve to raise interest rates. However one can argue that, for now US is concern of another Great Depression. Therefore the emphasis is on economic growth, not so much of combating inflation

Saturday, October 4, 2008

Should US & UK Government Intervene In The Mortgage Crisis?


(1) Strategic industries argument. Banking, finance, insurance & investment are backbone to both UK & US economy. It is also the home to tenths of thousands of employees. If there is no contingency plan such as nationalisation, strategic mergers & acquisitions or capital-pumping to increase liquidity, these banks & institutions will be dragged onto their knees. As a result there will be mass scale of structural unemployment once all of them go bankrupt

(2) To prevent another depression. If banks & financial institutions are left bankrupt, it will trigger another round of credit shortage as not many banks are left standing. The liquidity bottleneck, will force remaining banks to increase the cost of mortgage products by the way of higher interest rates. Of course one can also argue that this is to increase its profitability & covering up the bad debts that have been written off previously.

As interest rates increase, consumption will fall, investment will fall, output will fall & unemployment will rise. If all these happen simultaneously, it will exacerbate recession then depression. Furthermore, banks are now more stringent in their lending. Numbers of loans approved dropped significantly. This causes further fall in house prices due to fall in demand for houses. Again this carries negative wealth effect

(3) Restore confidence in financial system. If banks like Halifax risked bankrupt, savers would rush to get their money out, just like Northern Rock last year. Somehow, it will not be able to meet savers demand in such a short notice as most of the deposits will be lent out in the form of mortgages & loans. The widespread news of people being unable to withdraw money will spread across economy & causes panic. Soon people will want to withdraw their money even from those banks that have healthy balance sheet. The repercussion will be the collapse of financial system. Therefore bail out is important as it restores confidence

Should not

(1) Moral hazard. Recall about moral hazard in my previous postings? It means with insurance, often it can change the behaviour of one or more party & often for the worse. We can’t rule out the possibility of another risky engagement in future e.g. reckless lending since these banks know that the government is always there to bail them out

(2) Prevail of free market system. Some economists argued that inefficient firms, in this case the banks should be left to perish. The working of free-market force is the best way to distinguish those incompetent firms from the competent ones. However one can also argue that financial institutions are unique in the way that they are heavily interdependent e.g. through interbank lending. As such, a collapse of one institutions will negatively affect the others

(3) Worthless assets. The US government is spending massively buying over worthless assets e.g. credit default swaps that is high above market prices. Furthermore nothing is being addressed about home repossessions, falling house prices, worsening national debt that is standing at $9.7 trillion currently etc. Some economists argue that the government should take the bottom-up approach & that is solving the fundamental problems in economy e.g. measures to ease burden of public

(4) Burden to taxpayers. At the moment, US national debt is about 65% of its GDP. Somehow it is estimated that this figure will mount up to 85% in nearest time, given the huge government expenditure of $700 billion to bail out those inefficient banks & the committed $85 billion to the insurance giant, AIG. Of course, we must also take into consideration the decision to possess worthless assets owned by Freddie Mac & Fannie Mae, through the nationalisation deal. To finance such large expenditure, is non other than through the taxpayers’ wallet

Interesting facts:
How large is US$ 700 billion bailout in terms of a country's GDP?

(a) 103.86 times Namibia's GDP
(b) 35.88 times Iceland's GDP
(c) 5.41 times New Zealand's GDP
(d) 4.34 times Singapore's GDP
(e) 3.39 times Hong Kong's GDP
(f) 2.85 times Thailand's GDP
(g) 0.60 times India's GDP
(h) 0.21 times China's GDP
(i) 0.16 times Japan's GDP
(j) 0.05 times US' GDP (can you imagine size of US economy!)

Source of data: The EDGE, October 6, 2008

Thursday, October 2, 2008

What Can Be Learnt From Subprime Mortgage Crisis?

The moral lessons from sub-prime mortgage crisis:

(1) The free-market system fails. US especially the Wall Street pundits are once a strong believer of the mechanism of free market forces in allocating resources. In 1980s to 1990s many of them preached that there should be more deregulations in the banking system & financial market. Deregulations mean allowing more market forces & lesser government intervention. But now, the same pundits are crying for the biggest government bailout in the history.

This shows that although free market economy is favourable in most cases, it cannot stand on its own. Mixed economy is the best. So is US a pure capitalist? Definitely not. To some extent it’s mixed as from time to time there will be government intervention. Just that it’s minimal

(2) The payoff for greediness. Any firms operating in free-market system have strong lust for profits. Because of this, they are willing to make reckless lending without even considering the credit background of borrowers. The bankers creatively design loan packages such as interest only mortgages & 100% mortgages just to put themselves into more ‘trouble’. They continued to do so as they bet that the housing market boom will go on ‘forever’ & borrowers will have no problem on repayment later. Unfortunately they have forgotten about the past. Everything that goes up, will eventually come down one day

(3) No one can time the market. It’s somehow incredible that not even the best economist or Wall Street experts can tell whether the market is already on its peak or bottom. This is accrued to two main reasons. First & foremost great length of imperfect information has made estimations difficult. Second, the herd mentality of many analysts. When a single prominent experts point for an upward trend, all other mediocre will eat that up & tell layman investors that the market is still not at its peak.

In fact I do understand that many investors as in this case property & stock market hunters, cannot resist the temptation to make quick bucks when they see continuous upward trend in house prices & share prices

(4) Banks should get back to traditional lending. Here it means, collecting savings from customers & lend it out. Of course at the same time, they must scrutinised the income & capability of the borrowers. For all that happens now, is because the banks has departed from traditional business model & involved in risky way of raising money. They borrow from other sources so that they can lend out more & make more money. But when more borrowers went into default, the banks’ collapsed will be followed by their financial sources

(5) UK & US people must increase their savings ratio. In UK, savings dip below 0% in September 2008, the first time since 1958. This reflects low level of savings & high personal debt in the economy. The same goes for US. The people there have high tendency to store ‘all’ their wealth in property market without even considering other options such as paper assets & banks. This is because they felt that property prices will always be more stable & the boom will continue ‘forever’. We often hear financial jargons such as diversification in stocks, now it seems that UK & US people must also learn how to diversify their sources of savings

Why Is Coca-Cola Expanding Outside US?

Why Coca-Cola seeks expansion outside America?

(1) To further increase its market share & continuously earn supernormal profit

(2) To look for benefits such as increasing purchasing & managerial economies of scale (EOS) through horizontal integration. Besides, relatively labour wages in developing countries are much lower than US itself. Very often the labour law is very weak too, allowing those workers to be fully exploited

(3) To stay competitive & ahead of close rivals like Pepsi & Dr. Pepper Snapple. One of the common strategy is to acquire dominant firms in growing market so as to set a strong foothold there before any rivals do.

(4) Sales in home country begin to decline as more US people begin to switch to healthier drinks such as bottled water & tea

(5) The business in US has reached saturation level & there is not much space for further expansion as most markets had been tapped into

(6) Market outside US is growing rapidly especially from the BRIC economy (Brasil, Russia, India & China). In fact 78% of Coca-Cola sales is contributed from abroad

For further reading, refer