Monday, August 24, 2015

Is the Airline Industry a Carel?

The following is an article from the Independent Institute written by Abigail Hall.  It is outstanding.

According to the U.S. Bureau of Transportation Statistics, an astounding 649 million domestic flights were booked in 2014. Whether for business or pleasure, roughly half of all Americans flew round-trip last year. With such a volume of customers, the U.S. airline industry posted nearly $30 billion in profits in 2014.

These seemingly sky-high profits have raised red flags for some consumer advocates and government agencies. A recent subpoena from the Department of Justice revealed that United, Southwest, American and Delta airlines are all being investigated for “possible unlawful coordination” and allegedly participating in collusive activities. Some have pointed to a string of mergers within the industry and airlines’ annual profits as proof that the industry is acting like a cartel, arguing that this collusive behavior raises prices unfairly to customers. Indeed, many have praised the investigation, suggesting the government should further regulate the industry to increase competition.
Without a doubt, the airline industry is highly concentrated, with fewer firms operating today than even five years ago. In fact, 14 mergers have taken place since 2000, the most recent being the 2013 merger of U.S. Airways and American Airlines. Today, the four largest U.S. airlines control approximately 85 percent of domestic air travel, compared to 60 percent in 1999.
But perhaps we shouldn’t hit the streets with torches and pitchforks to protest the “airline cartel” just yet. In fact, the existence of fewer firms in the industry may be a good thing—for producers and consumers alike.

Economics teaches us that the presence of only a few firms in a market does not mean competition is absent or consumers are being preyed upon. In fact, the very opposite may be true. Take, for example, what economists call “natural monopolies.” Due to the cost structure of certain industries, a single firm could produce a product more cheaply than could many small firms. In such instances it’s actually better to have only one firm in the market than many. Multiple firms would mean higher costs and, ultimately, higher prices for consumers.

It follows from this logic that the mergers cited as a breakdown of competition may actually be a good thing in the airline industry. Bankruptcy has been cited as the primary reason for many recent mergers. This would imply that much of the industry’s consolidation is not due to firms colluding to grow their profits, but rather to attempts to preserve businesses and improve efficiency.

The idea that airline profits indicate collusive or monopolistic behavior falls apart on further inspection. Although $30 billion may seem lucrative, profit margins for airlines have been dismal over the last 60 years—less than 1 percent on average. Those are some of the lowest reported in any domestic industry. If airlines were effectively colluding, we’d expect higher profits.

There is yet another reason to question the allegations of collusion—ticket prices. They have actually fallen about 50 percent since the 1970s. In 1974 a flight from New York to Los Angeles, for example, cost more than $1,400 in today’s dollars. Today, the same flight can be found for as little as $278. Since 2000, ticket prices have decreased 18 percent.

Those concerned about airline competition may want to advocate less government regulation, not more. Although this may seem counterintuitive, economics and history teach us that collusion is exceedingly difficult to begin and maintain—unless government protects it. Absent government protection, colluding firms are constantly threatened by outside competitors that will chip away at their market share.

Moreover, firms trying to collude face strong incentives to renege on their deals with their co-conspirators. If the major airlines agreed to fix prices, for example, each airline would face an incentive to drop its prices to draw away competitors’ customers and increase its bottom line. Taken together, these factors mean collusive agreement tend to fall apart.

It’s easy to look at industries like the airlines and accuse them of the worst. But before we assume that firms providing a valuable service to millions of people are being unfair, we must examine the facts. Otherwise, we all may wind up grounded.

AP Resources

If you are a teacher looking for classroom resources, here's a link to classroom posters.

Sunday, August 23, 2015

Real Interest Rate

Here is a link to my lecture on real interest rates.  It is a powerpoint.

Here is the text:

Directions:  follow the steps below to learn about the real interest rate, and then answer the questions that follow.
1.        What is the “nominal interest rate”?  The nominal interest rate is the interest rate expressed as a percent.  The nominal interest rate is printed on a bond, savings accounting passbook, mortgage, or other financial instrument.  For example, Juan may have a loan at Hill’s National Bank that is charging 8% interest.  Won may have a savings bond that pays 10%.  Greg Mankiw defines the nominal interest rate “as the rate the bank pays.”  The nominal interest rate is not the purchasing power.  Sometimes the interest rate is described as the cost of using money.  Answer this question as “true” or “false” by circling the letter.  T  F  Greg is thinking about buying a new car.  The sticker posts an APR of 1.9% interest.  The 1.9% is a nominal interest rate.
2.       If Maggie borrows $100 for 1 year at 10% interest rate, how much is the nominal interest rate?  The nominal interest rate is 10%.  Fill in the blank with the correct word or words to complete the sentence.  William wants a student loan to attend Buffoon University.  First National Bank of Buffoonia will loan William tuition at 6% per year.  The nominal interest rate is ______.
3.       How much will Maggie have to pay back in dollars if she borrows $100 for 1 year at 10%?  Maggie will have to pay back $10.  (Multiply the principal, $100, rate of interest in percent, 10%, and the time in years, 1, and you will arrive at $10.  That is, $100(.10)(1) = $10.  To generalize the concept, 1 + i represents the nominal interest rate.  So I could have multiplied $100(1.10) to see that the total amount Maggie would have to pay back is $110.  Subtracting $100 from $110 would be $10.  Calculate the amount of nominal interest for Won I Chang.  Won loans Christie $500 at 12% for 1 year.  How much interest in dollars will Won receive when the loan is due? ______.
4.       Suppose that Juan loaned the $100 at 10% for one year to Maggie.  How much will Juan receive from Maggie on the due date in nominal terms? $10.  Suppose that Juan loaned the $100 to Maggie at 15% for the year.  How much would Maggie pay on the due date? ____
5.       What is the “real interest rate”?  The real interest rate is the buying power of the interest in dollars.  The real interest rate is the amount of purchasing power after interest is paid or collected after adjusting for inflation.
6.       How do I calculate the “buying power” after a loan has been paid or collected?  To find the purchasing power of the amount of nominal interest collected or paid, simply divide the amount of interest in dollars, by the price level.  Assume that the economy uses the GDP deflator to gauge prices.  Look at the table below to see how the purchasing power of the interest collected or paid changes with different price levels.
Price Level
Purchasing Power
7.        How did the purchasing power change as the price level changed?  When the price level was high, 2, the interest collected lost buying power.  This is good for the debtor but bad for the creditor.  When the price level was low, the purchasing power of the interest collect increased.  This is bad for the debtor and good for the creditor.  So when people say that inflation is “bad” they are not seeing the whole picture.  Inflation as reflected in the price level distorts the purchasing power of the interest collected and redistributes wealth in ways unintended.
8.       What is a change in the price level called?  A change in the price level can either be called inflation or deflation.  A positive change in the price level is inflation.  Such a change might be a change from 1.04 to 1.06.  A negative change in the price level is deflation.  Such a change might be a change from 1.06 to 1.02.  There are two price levels used in AP Macro.  What is the price level called that uses a fixed market basket? _____________  The other price level divides nominal GDP by real GDP.  This price level is called ____________________.  If an economist wanted to see how much production was growing, which price level would she use? ______________.
9.       Now let’s generalize the concepts so we can move on to application. 
Let 1 + i be the nominal interest rate
Let 1 + π be the inflation rate
Let 1 + r be the real interest rate
10.    What is the equation I use to find the real interest rate?   r = i - inflation rate
11.    How much does the real interest rate equal in each of the following cases?  1.10/1?  1.1/1.05?  1.1/.95?  Using the formula from step 10 and subtracting 1, the answers are .10, .048, and .16.
12.   How can I approximate those values?  You can get approximately the same values by simply subtracting the numerator and the denominator.  For example, 1.10 – 1 = .10.  1.10 – 1.05 = .05.  and finally, 1.10  - .95 = 15.
13.   What is the Fisher Equation?  The Fisher Equation which is: r = i - inflation rate (pi)
where r is the real interest rate, i is the nominal interest rate, and π is the inflation rate.  The Fisher Equation approximates the nominal interest rate.  In step 12, I found the real interest rate.  I subtracted the inflation rate from the nominal interest rate.  In step 13, I rearranged the equation into the Fisher Equation.  The Fisher Equation states that the nominal interest rate equals the real interest rate minus the inflation rate for small changes in the inflation rate.
14.    What is the real interest rate?  The real interest rate is the amount of interest the creditor receives or the debtor pays after subtracting inflation.

15.   Why is the real interest rate important?  The real interest rate is important because inflation may catch lenders off guard.  These lenders will receive less interest in terms of buying power than they would have if they fully anticipated inflation.  Inflation can help the debtor when inflation isn’t fully anticipated.  The debtor is helped because the debtor repays the interest will dollars that don’t buy as much as when the dollars were loaned.  The real interest rate is important when performing cost-benefit analysis, indexing bonds to the Consumer Price Index, or making monetary policy.

Thursday, August 13, 2015

Price Discrimination at Sherwin-Williams

While waiting for the Sherwin-Williams associate to ring up a simple purchase, I began to wonder what was taking so long.  Although I like the men who work there, I hate going to the store because it can be as much as 20 minutes to buy a gallon of paint.  Finally, the associate quoted me a price which was different than the retail price printed on the sticker.  Sherwin-Williams isn't the only the paint store in town, but for me it is.  I believe that this paint store price discriminates all of its customers.  My evidence is in how they charge me exorbitant prices on tools.  For example, a scrapper is four times higher at SW than at Menards.

Price discrimination eliminates all consumers surplus.  Price discrimination is necessary for a business to capture as much profit as possible to stay competitive.  I have found going to this store so annoying that I have switched to Hill Paint Store, a local competitor.  I don't think I'm alone.

For historical stock prices, click here. The stock seems to pricey for me.  For a review of price discrimination, click here.

Friday, July 10, 2015

Labor Force Participation Rate

As this cartoon suggest, when workers drop out of the labor force, they are not counted in the unemployment rate calculation.  Most of the workers who are dropping out are men who use this "hands" to perform work.  The work that men perform is being replaced by robots and capital goods.

Monday, July 06, 2015

Income Inequality

Here are eleven charts that begin to show income disparity.

According to Mother Earth, 10% of the population controls 67% of the income in the United States.  As the cartoon suggests, those in the top 10% are able to influence the laws to favorably allow them to retain their wealth.  In economics, this is called rent seeking.

I became interested in income inequality after the release of Thomas Piketty's Capital.  I bought Joesph Stiglitz' book on inequality too.  Both of these books are wonderful, intense reads.

Sunday, June 07, 2015

MRUniversity: The Solow Model 1 – Introduction

MRUniversity: The Solow Model 1 – Introduction

This tutorial is from the authors of Marginal Revolution.  I have found that Tyler Cowen explains the Solow Growth model better than anyone else.

Monday, June 01, 2015

Fisher Effect

Write writing test questions on aggregate demand, I found this graphic.