What Does Inflation have to do with Stock Prices?

When the BLS released its inflation data, stock prices fell. Why does the stock market react to inflation fears?

Tim Schilling at the Chicago Federal Reserve Bank says, "The standard rule of thumb is that if the Fed increases short-term rates, longer term rates also rise. This makes holding bonds more attractive and people will sell stocks to buy bonds at the higher yield." Bond prices and interest rates move in opposite directions so if bond prices are falling, yeilds are increasing. If investors can earn more in bonds than in stock, it's rational to invest in bonds. So, how much should a share of stock cost?

Say you know for sure that HNI is going to pay a $1 dividend this fiscal period. If interest rates are 5% then you should pay $20 for a share. I calculated this number by using the formula: I=PRT. Assume that T equals 1, then 1=$P(.05). Dividing by .o5 means that a price of the office furniture maker should sell for $20 a share. Assume that inflation is a worry and the interest rate pops to 10%. Now, HNI only is worth $10. The value of alternate investments makes the financial markets unstable when investors are worried about what the Fed will do to interest rates.

Ultimately, investors know that the monetary authorities have the situation under control and shake off the jitters. As Mr. Schilling says, "However, I have been around long enough to know that a hike in interest rates can be reassuring to the financial markets. It reassures them that the Fed has the long-term inflation situation under control, thus long-term rates actually fall and stocks remain a viable investment."

Face the Music, UMG

Last week I redeemed my iTunes gift card online. With my $25 on account, I went shopping for music. With the June Rolling Stone, I listened to Nine Inch Nails, Amy Winehouse, a lip gloss song, and R. Kelly. I didn't buy a single song. With so much music in the store, I wanted to find the "BEST" songs for my iPod. I sampled songs from each artist only to find that the 30 second clip wasn't enought to satisfy my curisousity or wasn't to my taste. I felt like I had filled up on appetizers and clicked off wondering why I can't find new music to expand my tastes. I recently filled up on Credance Cleerwater Revival after watching Die Hard 4. I'm not the only one who goes to the buffett only to return with the same favorite entrees. The music industry has to find a new delivery system to meet the needs of all users not just old users like myself.

With the number of labels contracting through mergers and acquisitions, coordination on delivery methods and pricing should be easier to coordinate for Sony/BMG, EMI, Warner, and UMG. Piracy is threating the old music business marketing. However, more music is sold today than ever. Piracy is telling the music industry that it's price is too high in the manner in which it is purchased. For example, I would pay more for a glass of water in the desert than at a lakeside resort. The outmodeled practice of signing long-term contracts with artists and retailers has locked the music industry into rigid pricing. The music business isn't agile. It's no wonder that the industry is described as a dinosaur. As those contracts begin to expire, I think the industry should look at how people listen to music.

Listeners use music to accompany studying, driving, having sex, and shopping. Music has a low cost of consumption. Like breathing air, hundreds of activities can be engaged in without sacrificing any consumption of music. I contend that the price of music has to be lower to match the manner in which listeners consume their music. Since air is virtually free, music should be nearly free.

Making music almost free would help eliminate piracy AND increase sales for the ailing music industry. Because of the huge cost advantages of mass production, the average cost of replicating a CD is close to a dime. The delivery mechanisms are more than iTunes and the internet. The industry must look at a business model like Netflix in which listeners subscribe to a service that delivers unlimited amounts of music for a small fee. Anyone who doubts that this model will be profitable only has to look at the bottom line for the DVD distributor of 1.08 billion.

Using a subscription-based marketing system, the music industry working in cordination can eliminate the winner-take-all marketing that crowds shelf space at Wal-Mart with only the "best" artists being mass marketed. An excellent review of the Rolling Stone article is given at: http://oligopolywatch.com.

I Can't Shop At Elder-Beerman at 11 AM

The Muscatine Journal had an insert for a sale at Elder-Beerman for Wednesday only from 10 am until 5 pm. I work during those hours. How can I take advantage of the sale during that time?

I offer that the ad targeted those people with a low opportunity cost in time and those shoppers most sensitive to price. The store was practicing price discrimination by charging different prices to different customers. Many of the ads read "Save 60% to 70% off the retail price." Elder-Beerman can still add to its total revenue by selling items above the marginal cost which is what I believe to be the case here. By tempting customers into the store with promises of more than half off, the store is finding the highest price each customer is willing to pay and surrender their surplus.

iPod and the Production Possibilities Curve

The idea for today's blog comes from David Mayer, Winston Churchill HS in San Antonio, Texas. Dave's idea was to show how opportunity cost, scarcity, and trade offs relate to the PPF in microeconomics. I hope I have captured his idea. Thanks mucho, Dave.

Suppose that Juan Sanchez, a rational and utility maximizing student buys an iPod with his earnings from Burger King. Juan buys the iPod nano with a maximum capacity of 250 songs. Juan either listens to Classical or Hip Hop music. The accompanying graph shows the various choices Juan can make with the limited storage space (click on graph to enlarge). Juan has thousands of choices he can make. If he puts 250 classical songs like Yo-Yo Ma on his iPod, then he can't put on any Hip Hop without giving up some classical. Efficiency infers that one can not get more of one thing without giving up something else. Notice that at point E, Juan can add more music of either genre without incurring opportunity cost.

Say Juan is currently at point B and moves to point C. Juan then gives up 50 classical songs. What would need to happen for Juan to be able to move beyond PPF curve ABCD to point F? If Juan is using the maximum capacity of his iPod, what is the opportunity cost of classical songs he must give up to get one more Hip Hop song? (Answers are in the next paragraph.)

If Juan would buy an iPod with greater storage space, he would be able to reach point F and satisfy more wants. Juan faces a constant opportunity cost of "1" whenever he choose another point along the curve.

What Does Shelf Space Have to do with CD Prices?

Big box retailers like Wal-Mart stock their shelfs with the music most listeners want to hear. Chris Anderson, Long Tail of Economics, writes, "20% of Wal-Mart's inventory accounts for 80% of sales." So big box giants like Best Buy stock the CDs that most everyone will buy. Since space is limited, the super stores make choices. These stores with over 100,000 square feet of shelf space stock the shelves with the most popular music. Although there are many talented musicians in the world, the "best" are signed with UMG, EMI, Sony/BGM, or Warner.

A market structure that is dominated by a few firms is an oligopoly and the music industry has such a structure with a four-firm concentration ratio greater than 80%. Suppose these four firms were able to supply 80% of the market for music. What music would you find on the shelves? I propose that you would find artists who have signed with a major label such as those that make up the oligopoly. Few artists can compete with the big labels on price or quality and lose shelf space. In losing shelf space, the major firms dominate the market and dictate the price that maximizes the most profit. Those in the industry find it's better to take the market price and the $15 price prevails.

Why are Compact Disks $15?

The music industry is dominated by four major recording firms. Universal Music Group, EMI, Sony/BGM, and Warner control over 80% of the market. The remaining 20% experiences competition for resources resembling a perfect competitor. The four major firms have every incentive to keep the price high and not enter into a price war with its competitors since the price of CDs could approach zero. It is my contention that the Bull Moose Looney, the dominate firm, sets the price tacitly and the rest of the firms take it. The dominate firm has all of the clout to enforce the price using economies of scale so the rest choose to accept the $15 price. The market share among the big four firms is roughtly equal but the dominate firm has the leadership that has gained the mutual respect of the industry.

On the graph, Qf represents the firms on the fringe who compete as perfect competitors. The oligopoly knows that Qf cannot be changed and makes its pricing decision on the residual market share. The oligopoly acts like a monopolist and takes the amount of the market represented by the difference between Qmrkt and Qf. The oligopoly sets the price where marginal revenue equals marginal cost. Everyone takes the price. One explaination for the price taking behavior is the tit-for-tat reproach from the dominate firm.

In oligopoly behavior, a Nash equilibrium often explains behavior. Notice that the dominate firm does take its rival's behavior into its stategic behavior. Because of economies of scale, it's possible for suboptimal equilibria to result. For example, if the dominate firm increases the quantity, the price will fall and many competitors will exit the market. Also, as long as price is above ATC, the firm can make a profit. The competitiors in this market don't want a price war because everyone will lose so the price remains rigid at $15.

In the last three years, firms have been consolidating into comglomerates. This makes tacit collusion easier for the oligopoly. At point Qf, the price is high and equal to ATC. This begins to explain why many local bands lose money on their work and the problematic nature of pricing an information good characterized by zero marginal cost.

My full lecture on this price leadership model will be presented in Muscatine on Monday, July 2, at the Howe Commons at 7 PM and in Las Vegas at the National AP Convention. As technology breaks down barriers to entry into this industry, many questions about efficiency and social welfare arise not just in entertainment, but software, communication, and information good. I welcome your comments.

How Come the New Guy Gets Paid More Than Me?

Tess has been working at Sweet Temptations for two years. A friend of hers was looking for a summer job so Tess helped get Connor a job where she works. While working, Tess found out that Connor gets paid almost a $1 more than her. Why does Connor get paid more when he's the least experienced worker?

Both Tess and Connor serve scoops of Gelato, the Italian ice cream. I believe that their MRP are the same since there's no productive differences in ability. My first answer is that the supply of labor curve slopes upward and to the right so hiring an additional worker requires the employer to increase the wage rate. Since just about anyone can scoop Gelato, I believe that the market supply is perfectly elastic.

The source of wage differential has to be employer discrimination. In the graph Connor gets paid more than Tess. Sweet Temptations acts like Tess is less productive than Connor and devalues her output in a manner that is a manisfestation of personal prejudice. From an econ 101 viewpoint, Sweet Tempatations doesn't maximize profits either. Employing Tess nets the business area AEG as profit and hiring Connor only nets the area ACB. (The area under the MRP is total revenue. I subtracted the area under the wage curve for the net.) The fact that the business chooses to indulge their preferences by earning less profit smacks of discrimination.

The owner of the store should resist temptation to indulge in discriminatory practices not only because they will make more money, but it's the right thing to do.

Why Did The Waiter Bring Too Many Breadsticks?

The Olive Garden has a company policy that requires servers to bring a certain quantity of breadsticks to the table. If there are three in your party, then the waiter should bring four breadsticks. While dining at the Davenport store, I predicted to my financee that the waiter would bring three breadsticks to the table. When the waiter brought five, I wondered why would a waiter violate the company policy and bring too many breadsticks?

The waiter said that he was super busy that night and he did not want to be running back and forth to the kitchen for more breadsticks. The econ 101 answer is that he wanted to reduce transaction costs and increase efficiency. The waiter also said that he could tell I was a big tipper. Since he had to be the one who gets the sticks and bring them out to me, he knew he could increase his tip at little or no extra cost to Olive Garden. The waiter weighed the costs and benefits of breaking the bread law at Olive Garden and made more on his tip. You can observe this same behavior at Red Lobster who the same breadstick policy.

Galesburg High School Graduation

Should parents and family members be allowed to hoop it up at graduation ceremonies? Let's say I'm receiving my diploma and my parents blow air horns, throw beach balls, and make a huge celebration while I walk across the stage. Should schools allow this celebration?

Tom Chiles, Principal at GHS in Galesburg, Illinois, didn't think so. GHS has a graduating class of 400 students. Mr. Chiles did not award dipolmas to four graduates whose parents went overboard. This was kind of like the penalty that the NFL gives athletes who celebrate in the endzone. His reasoning is a clear application of a negative externality--an econ 101 topic.

When the costs of behavior are felt by those who are neither buyers or sellers, a negative externality results. Some in attendance at the GHS Graduation could not hear the name of their graduate because of the excessive noise. There were multiple examples of costs that bystanders had to bear in order to attend such as throwing hats, streamers, stomping on the bleachers, and parents leaving as soon as their son or daughter received their diploma. Although these parents were working in their own self-interests, the market was failing to guide the graduation ceremony smoothly. How would you remedy this situation?

Mr. Chiles, an ex-wrestler who'd never back down from a fight, chose to deprive kids of their diploma for the actions of their parents. The action landed Tom on Good Morning America and CNN and the Galesburg Reporter quoted students as saying "Mr. Chiles is racist." If Mr. Chiles would have arrested the parents, I think the noise would have stopped. To penalize the kid for the parent's action is akin to having a son inherit a father's debt upon the father's passing. It doesn't align costs with actions.

Keith Pogemiller, a counselor at MHS, has a Coase remedy. Pogge wants the class valdictorian at the beginning of the ceremony to ask rowdy parents and students to behave in a manner that will facilitate a smooth graduation. The costs are largely internalized this way.

GHS is a large high school. Many of the students commute from Chicago to attend. I'm sure some of the teachers don't even know all of their colleagues or even all of their students. At MHS we used to search parents as they entered the gym and allow only five tickets per family. People will always say their rights have been stomped on whenever you attempt to make them act respectable. In the case of GHS, I would move the ceremony to 10:00 am then arrest parents who contribute to the externality problem.

I also think that graduation attendees view the ceremony as a common resource. Econ 101 predicts that a common resource will be overconsumed to the point that it's worthless. Common examples are public fishing pools where the fish are caught until there are no more fish. At GHS, Tom could limit the amount of tickets that each student gets much like a fishing license. In this way, only those who value the occassion the most will attend.

Mr. Chiles was assistant principal of the year when he was at Muscatine High. We often ate breakfast and discussed wrestling. I can say that Tom acted in the best interests of the most people at the GHS ceremony. I'm sure by next year, he'll have a solution.

Can a Hospital Sign Doctors to a Noncompete Contract?

Wayne McCaffery mentioned that the hospital in his town makes employees sign a contract that they won't compete within a 30-mile radius. Since monopolies are illegal, how can the hospital do this?

I would consider the hospital to be a natural monopoly and thus the marginal cost would slice through the demand (price) curve at a lower point than the average total cost. Thus, increasing competition to the hospital would drive the price to the competitive ideal and require subsidies or regulation to remain open. The hospital can only survive if it is monopolized. This is the best for society too.

Why Do People Pay To Tan in the Summer?

The Tan Shack is a spa where young girls go to tan. Today the temperature was in the 90's and the sun was so bright that I wore my dark sunglasses. When one could sun tan for free, why would anyone pay the Tan Shack?

I think the econ 101 answer is there are consumers who still find it convenient to stop on their way home from work and receive the known and constant benefits of the shack. To go home to tan might take more time and more inconvenience with the effects of ultraviolet rays that are uncertain. So most still use the Shack. But there's more.

Let's say that the worker at the Shack makes $6 per hour and it costs $15 per session. As long as the marginal revenue product is greater than the marginal resource cost, it pays the business to remain open even if there's only one customer. In other words, the price of the tan is greater than the wage, a variable cost, so the Tan Shack should stay open.

Some might argue that the rent on the Shack might warrant the spa to shut down. I argue that the rent is a sunk cost and should not be considered in the decision to stay open after the rent has been paid.

Is a Cigarette Tax Like an Illegal Download?

Iowa recently added a $1 tax per pack of cigarettes. The Des Moines Register reports that robberies of cigarettes have increased. According to the story, in the last four days there have been three armed robberies. Since a tax increases the price that is paid to obtain a pack, is it fair to say that the high price of cigarettes has created preverse incentives?

According to the Register, the robbers expected to resell the cigarettes as well as smoke them. I think the price is too high and the high price has encouraged illegal activity. Is the music industry any different?

Most high school students file share songs or "rip" them from friends. Music in the form of a CD is excludable but is nonrivalrous in consumption. I don't blame the music industry for earning a fair return on their investment, I just wonder if the price for a CD or a download is too high. As the graph that accompanies this blog suggests, the socially optimal price is zero. At price P and quantity Q, most of the market is excluded and would benefit from illegal sharing. (Click on graph to enlarge.)

Like cigarettes, music prices seem to be too high. As long as prices remain high illegal activity will continue.

Raspberries

The jogging path around the Community Y is laden with raspberries. Whenever I'm tempted to stop jogging to snatch one, I can never find a ripe one. The jogging path is about a half mile long, how come I can never, or seldom, find a ripe raspberry if there are so many bushes?

The jogging path is a common resource which anyone can use. I often see families picking raspberries as early as 5 am every morning. In the econ 101 language, the path and raspberries are nonexcludable.

The raspberries are picked by so many people that often there are only green berries left by the time I jog by. Economics has a name for this too. The consumption is rivalrous. In other words, when someone picks a berry, I have less. Economics predicts that a common resource will be consumed to the point where the price equals the marginal cost. Since the price of raspberries are free, economics predicts that the berries will be consumed until there's nothing left. This is what I observe when I look for berries.

Sometimes I notice that two pickers will often argue over who gets a bush. This happens when it gets really crowded. I offer that the actions of these pickers exert a cost on joggers who are not interested in berries at all. The pickers who argue and fight over a bush suggests the existence of a negative externality. If you are a fan of a Pigouvian tax, then the price of the berries is too low. Would a berry license help define property rights? Should the Community Y pick the low laying fruit and maximize their profit by charging an entrance fee?

There's A Hole In My Sidewalk

Why does the price of cocaine keeping falling? In a June 7, 2002, article in the WSJ, The Informed Reader, the paper reports falling prices of the street drug known for a quick rush and as status symbol for the rich. How does economics explain the drop in the price of a gram of coke from $600 in 1980 to as low as $25 a gram in 2005? The econ 101 answer is lower costs have shifted the supply curve to the right increasing the supply and lowering the price.

The WSJ reports that lower labor costs, more efficient distribution channels, and the willingness of suppliers to earn less in profit have moved cocaine closer to its competitive ideal. As the price of a street drug moves closer to the P=MC price a society will see an unexpected consequence of lower crime in nonviolent robberies. In Freakonomics, Steven Levitt reports that most crack cocaine street dealers live with their moms and earn a wage less than the minimum wage. This implies that profits have been competed away in the crack market. Levitt's research shows that the number of users stays the same, however.

In the poem, "There's A Hole In My Sidewalk" an addict becomes aware of her tendency to make the same mistake and chooses the path to recovery by accepting the blame and taking a different sidewalk home. As the quantity of coke increases, let's hope that those who have the propensity to choose coke as their drug of choice, take a different sidewalk home.

Where Demand "MEATS" Supply

On the front page of the Des Moines Register today, editorial cartoonist Brian Duffy, has a simple analysis of how an increase in the demand for steak to grill out increases the price of steak. From the cartoon, it looks like our griller is the one who gets burned. You can check out all of Duffy's work at www.desmoinesregister.com

Renting or Buying Boston Legal

Bob Long shares an office with me. We both love Denny Crane from Boston Legal and thought about buying season one on DVD. I found out that Bob had been renting it from Blockbuster. Why would Bob rent instead of own?

When video tape recordings of Snow White and Cinderella were released by Disney, I remember the price for a VHS format tape as being over $150.00. You would need to watch one of the tapes many times to get your money's worth from investing in a VHS tape at those prices. If you were going to entertain children, you might have bought a tape at those prices. But what if you were only going to watch the tape one time?

High rental costs of VHS tapes spawned the rental industry for people who only wanted to watch a movie one time. The industry fround that they had two types of buyers and needed two prices. When the price of VHS tapes fell to $30, more tapes were sold as one might expect. A movie like Cinderella is an information good that I define as a good that is excludable but nonrivalrous in consumption. For example, if bob rents Boston Legal, I can go over to his house and watch it. Unless I'm standing right in front of the television, my watching Boston Legal does not rival, or reduce, Bob's ability to enjoy the show.

If Bob and I would go to the library and checkout Boston Legal, then the DVD might be a common resource. In this case, checking out the DVD would be nonexcludable and nonrivalrous in consumption since we both have library cards.

Whether we buy, rent, or checkout Boston Legal both Bob and I will consume the good until the marginal benefit equals the marginal cost. Competitive markets drive the price of a good down to its marginal cost. Since the costs of producing a DVD are sunk costs, the marginal cost is zero or close to zero. This infers that the price of Boston Legal should be zero assuming that the DVD is sold in a competitive market. Since the DVD is excludable but nonrivalrous in consumption, any price greater than zero will rationally cause consumers like Bob Long to obtain Boston Legal at or as close to its socially optimal price. So Bob rents Boston Legal for five nights for $5--a buck a night.

Mr. Long might think he's saving money. I might call him cheap. But Mr. Long is simply reacting to competitve market forces as if guided by an invisible hand.

Does a Scholarship Prove the Income Effect?

At a graduation party among purple balloons and gold table clothes, a student told me that a friend had won a substantial scholarship and he was happy for him. "My friend had taken a job this summer working 14 hours a day to pay for college," Griffen said. "Now he won't have to work as hard. Does this prove the income effect?

According to Ehrenberg, the income effect is a function of the change in hours worked divided by the change in income that takes place when wages are held constant. So suppose you win a scholarship and now your income increases by $50,000. As a result, you now work 40 hours a week instead of 80. The income effect is equal to -40/+50,000. Assuming that your wage rate didn't increase, you worked less as your income increased exongenously. The same effect might be observed if you inherit money or win a lottery.

In this case, the student who won the scholarship might "bend over backward" to increase the amount of time he spends on leisure proving the income effect in his case.

When I heard Nobel laurate Robert Solow speak at Cornell College this past fall, he expressed some skepticism of the income effect. In this econ 101 blog, I simply say that the income effect is one of the many factors that influence behavior of scholarship winners.