Oil Prices–Price Elasticity Friday, Mar 13 2009

Well…my last serious post on oil prices can be found here. Back then, oil was at $80 a barrel. Since then, oil went up to $147 and is now at the mid forties after dropping all the way down to $30. Does economics explain this phenomenon? Well, lets have a go with that most amazing of tools, hindsight.

The total demand drop from 2006 to today ranges between 2 and 2.5% . Assuming that the predictors were expecting a gain of 1.2% yoy (a reasonable prediction), the notional demand drop would then be about 5%.

At the same time,  production has increased by about 1.5% over the same period.

In this period, oil prices have risen to $140 a barrell from about $40 and have come back down to about $40 a barrell. Can conventional price Elasticity explain this?

Even assuming the widest variations in demand and supply, we have about a 6% variation in demand and supply. This ^% variation has led to a price change of almost 300%. This would mean that demand and price have a multiple of 50. By my previous calculations, the multiple  was closer to 10 than 50.

So economics does not seem to completely explain this massive change in price. But what if the underlying multiple of 10 was also leveraged?

The theory behind perfect marketplaces is that more players there are, the more clearly the price in the marketplace would be provided. However, in oil, the actual deliveries are fairly small compared to the speculators who trade in oil contracts. In theory, these speculators are supposed to provide liquidity to the market thereby enabling it to find true price without distortions introduced by large market participants.

The problem here is that sometimes speculators themselves distort the market. In a bull market,  every speculator went long on oil, which distorted market price and ensured that the real price soared well above the price that the oil sheikh needed to purchase his private A-380.

However, the reverse also occured. When the bubble burst, the speculators had leveraged their positions, and now had to sell at any price in order to exit the market. This led to an equally dramatic price drop which has seen oil drop back down to $40 a barrell again.

Of course not all of this is due to the evil speculators. The US Dollar has been appreciating against almost every currency due to a flight to safety. A rising USD means that the Arab Sheikhs (who sell their oil in dollars) can now buy those English Football Clubs cheap. This also tends to drop the prices, and cannot be ignored.

Notes: The data is approximate but the base from which it was taken was the  International Energy Agency report of February 2009.  Any mistakes and incorrect assumptions are my own however.

Note 2: The strong dollar affects other things than prices of Football Clubs. 

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The Productivity View — better is good? Tuesday, Sep 2 2008

Well, its been a VERY long time since my last post, but never fear loyal readers, I am back!

Today I was looking at a ragpicker on the road, and thinking that it would be really simple to make her life a bit better by giving her a pushcart in which she could push higher loads of stuff collected and thereby earn a higher income. This is what is called a productivity tool, which is supposed to make the world a better place.

And surely, improving that ragpickers productivity might make it better for the ragpicker, thereby helping society! But a bit of thought brought some counterpoints.

Now economic theory states that if the ragpicker got a a huge competitive advantage by having a cart, a lot of people would have jumped on and bought/rented carts in order to improve their own productivity as well. This would make the entire ragpicker population even more productive than it used to be. Surely, that is a good thing?

Well…maybe not. You see, although the amount of garbage that the 17 or so million people in Mumbai produce is monumental, its not infinite. At the end of every day, the ragpickers of Mumbai, however unproductive they are, have sifted their way through the morass of dross, and have found their little pieces of gold. So improved productivity would therefore mean that the ragpickers would merely be done faster….not produce more gold from dross.

Well, even then, that would be a good thing undoubtadly. A ragpicker who is done by mid afternoon could attend evening school, get a mechanics job, move up in life, and then improve economically. But lets consider for a moment that the current system is a level playing field…mostly. The late wakers are not shut out, as they would have been if the early birds grabbed eveerything. So, although the total wealth out of picking through garbage would be the same, its distribution would now go to those who woke up earlier, and scouted out the best piles.

This greater inequality in wealth distribution would be accomplished by those with access to better information on which localities are putting out good garbage, or who can anticipate which garbage will yield better returns. Previously, even if people held this information, they could not corner the market, as the information flow filtered down before they could grab it.

This seems to show something strange. Improved productivity does not lead to better conditions for all. Infact, in this case, it leads to much greater inequality. And this is what I would call the productivity trap. In a place where productivity improvements do not lead to increased sales/offtake as well, it only would lead to inequality.

Of course, there is always a silver lining. If you are a nimble company (or a person) and can see that the existing players are unproductive, you can move in and quickly make yourself a number 1. However, be warned that your advantage depends on you having a productivity too that can’t be copied….and no one seems to have come up with one as yet!

So there you go….another rambling post, but my tale is done for now. I will post on slightly less garbage like topics sometime later. Till then… Ta Ta!

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Fed Cuts Rates — Much ado about nothing? Thursday, Nov 1 2007

The US Federal Reserve has cut interest rates. And of course, I wanted to pontificate on this. But before that, lets answer a question that no one seems to have asked. Exactly what interest rates did the Federal Reserve cut anyway?

Federal Funds Rate –Overnight Targets?

The Federal Funds rate is the one over which all the hoopla is raised. Stripped off its jargon, it is the overnight interbank lending rate. As always, an example to explain.

Banks borrow and lend money everyday. In order to give money to withdrawing depositors, or to loan takers, they have to keep some cash which we will call daily cash requirement. The daily cash requirement is estimated by the bank at the beginning of each day. But at the end of the day, some banks have more money, and some banks have less money than they budgeted for. The banks that have more money can lend the money to the banks that don’t have enough overnight. Of course, banks charge interest. And it is this overnight interest rate that the federal reserve can control.

The overnight interest rate can be thought of as a penalty for banks that lend (give away) more money than they budgeted for. By lowering the penalty that the banks have to pay, Ben Bernanke and the Federal Reserve hopes to increase the lending amounts of banks, which leads to more money in the market.

Its November and all is not well!

The Markets (which is a nice way of saying Stockbrokers)  expected the Federal Reserve to lower interest rates following rumours that the Sub-prime imbroglio had yet to run its course. The Fed did not disappoint in this. But what is interesting is reading the fine print in the text of their report.

The Fed says that they are rather worried about inflation, and don’t really have any plans of any further interest rate drops. With commodity and oil prices at all time highs, they believe that people are rapidly going to be faced with increasing costs on everything, from food to steel.

Why must the US Economy Grow?

Most economists expect that the United States Economy will not grow at all in this quarter, while the pessimistic types even expect a small contraction in the economy.  But a question that can be asked is, “Why should the economy grow. After all, sometimes you have to be satisfied with what you have!” The answer to this is simple. If the United States population was constant, then there would be no real pain if there was no growth. It would be status quo, with the resources of the country being split equally amongst its people. However, with immigration, new births and everything else, the number of people in the United States of America is increasing. If the economy does not grow, a constant amount of resources will now have to be distributed across a larger number of people. This will make everyone (on average) a bit poorer. And this is NOT acceptable.

The problem of course is that this growth should be in real value. Its actually rather easy for the Fed to print more notes and make everyone richer. But the problem is that more money would be chasing after less resources. So the hard reality is that the Federal Reserve must increase production of goods(by encouraging investment) or must make it cheaper to import things (reduce import duties, Free trade and all that stuff).

Interest rates are one way to increase investment. And unfortunately for the Fed, its the only tool in its armoury at the moment. By lowering interest rates, they are hoping that people will be more inclined to invest in production/trade, thereby kickstarting the economic engine again.

But is it really needed?

That is a question where the answers are not quite so clear. The belief amongst most people is that the sub prime crises is a real dampener for the economy. However, I see that the whole housing market is only about 5% of US GDP. So is this 5% really going to drag down the remaining 95% down that badly?

The most popular answer is…YES. Like self fulfilling prophecies, the more people hear they are in trouble, the less willing they will be to spend and invest, which would drag down the whole economy. This is what the Fed is afraid of.  And most people (laymen and economists) think that this is the reason why the Fed is lowering rates. Its to increase confidence.

A more scary reason!

But there could be another reason for the Fed to lower interest rates. And this is a much less comforting one. It has everything to do with capital movement across borders and the US Dollar.

Up to now, the United States has been running a whacking big trade deficit. This trade deficit is basically imports from other countries. They include oil, Software services from India and Chinese Toys. Ideally, imports should manage exports. So, in theory the Coca Cola that the US sells should make up for the Chinese toys. But this has not been happening. And it has not been happening for a VERY long time now.

The reality of the trade deficit

Its quite simple. Because it is importing more Chinese toys than its exports of Coca Cola, the US is giving away dollars to China (and the rest of the world). China (and the rest of the world) keeps these dollars in a special fund called a currency reserve. But if the US keeps doing this, the amount of dollars in the Currency reserves of countries will become so large that they might start asking uncomfortable questions like “What in Heck can we do with all these dollars that no one really wants to have? I would much rather have Chinese Yuan and Indian Rupees than dollars that the US is not going to take back”

What does the Fed lowering interest rates have to do with this? A lowering of interest rates actually increases the capital flow out of the US. More dollars flying away to be put in Indian and Chinese stock markets. But such huge flows of capital would put the currencies of these countries under immense pressure. A case in point is India, which has seen its currency rise over 10% in the last year. IF the Chinese Yuan were to appreciate similarly, in the long term, this would make Chinese exports to US less competitive, and will (hopefully) lower the trade imbalance between the two countries.  At the same time, cheaper local interest rates in USA would mean that companies would be tempted to invest in business rather than merely hoard their money in savings deposits. So the domestic economy would be more inclined to grow, thereby making the USA a more resilient economy.

But….all this is contingent on the US citizen investing money rather than buying more Chinese toys. If he goes out to buy more Chinese toys with the money the banks are lending him, the capital flight out of the USA will only increase. And while the world economy would continue to grow, it will be interesting to see at what point the countries holding US dollars would start thinking of dumping them. And that would be an uncomfortable time for one and all

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RBI Credit Policy Update — Minor Tweaks only! Tuesday, Oct 30 2007

 

Today, the RBI issued its credit policy update. A few months ago, I had put out an article outlining the central Banks rather unenviable position. This credit policy update seems like the RBI is still trying to juggle too many of their financial balls around.According to the traditional economists who run the Federal Reserve and the ECB, banks should not worry about their actions impacting exchange rates. The RBI governors and economists would just laugh at those deluded Americans and Europeans who don’t know better. One of the RBI’s many targets is a desire to keep the Indian currency at a certain price band versus the dollar. This is called a currency peg. In order to keep the currency reasonably weak, the Central Bank has decided to raise the Cash Reserve Ratio (CRR), which is the percentage of cash deposits that the banks have to keep with the Central Bank.

Raising the CRR: How does it help?

Well, the concept is simple. Any money the banks don’t have access to, they cannot lend. If banks cant lend money, there will be less money floating around the system. If there is less money floating around, then inflation can be controlled.

Are there any other consequences?

The answer to this is not quite so simple. The RBI would love to say, heck NO! But they know better. The central bank has in this case kept the basic lending and deposit rates on hold. By doing this, they hope that banks will keep their interest rates constant. But for a bank, things look a little less nice. Any money that is not being lent has some interest being paid out on it, and the bank therefore loses money. Now, RBI has told the banks, “Lend less money, but keep your interest rates the same.” This would translate to lower profit margins for banks, which is never a good thing for those money minded bankers. So what banks are actually likely to do is keep the borrowing rates constant, but start hiking rates on what they see as easy targets. For banks, the easy targets are Consumer Durable loans, auto finance, and personal loans. And of course, the lower margins also mean that they cannot undercut each other in offering easy liquidity, and will be a bit more choosy in whom they give money too.

So, why CRR…why not Interest rates and other things like that?

That is the big question, isin’t it? The answer is a little bit complicated, but here it goes. If the RBI raises interest rates, international money will be attracted by the better yields, and start pouring in money. This money that comes into India will be converted into Indian Rupees, which will in turn raise inflation, which devalues the currency. Now, because the Indian economy is rather strong right now, a case might happen that the foreign in flows will not cause inflation (which is somewhat the case now), but will instead cause the Rupee to strengthen…weakening the ability of India to export its goods. All in all, raising interest rates is a signal to foreign investors to come and put their money here; which is what they are doing right now as it is.Right now, the RBI is handling the foreign inflows by selling rupees madly to buy dollars. Since the RBI prints its own money, it does not really have a shortage of rupees. But the problem is that all these rupees end up in the Indian Bazaars, and the central bank is terrified of the bogey of inflation. So, by making the banks hoard more money (raising the CRR), it is hoping that it is taking money out of the system in the same proportion as the foreign funds coming in. And if timed well, it might well work.

The Catch: Mundel and Fleming have their revenge

Of course, the Mundel-Fleming model of economics (described here) states that in an open economy it is impossible to control interest rates, inflation and exchange rates. But the RBI is seemingly managing this impossible juggling act. But Mundel and Fleming have their revenge. In reality, the RBI is able to maintain all three only by making the banks hoard money. In other words, they are no longer as competitive as they would like to be. Thus, the economy is not truly open. In the long term, if the Central Bank continues to increase the CRR, it will no longer be profitable for banks to stay in business, and the economy might well nosedive.Analysts (nameless up to now) believe that one way of reducing the liquidity is strangely enough; to reduce interest rates. (conventional economics states the opposite). This is because currently, huge foreign inflows are happening due to the interest rate arbitrage that exists due to the low US rates and the comparatively higher Indian rates. If this differential is reduced, foreign money will no longer be flowing into India at the current high rate, and the amount of money that RBI will print to keep the exchange rate constant will naturally reduce.I am not so sure. While the RBI will have to eventually drop interest rates, another way out could be to let go of the currency ball. IF the Indian currency were to find its own natural level, the money supply in the Indian Bazaars would remain constant. The worry for India is that the favourable exchange rates might well prompt increased imports, and hit Indian exporters hard. But in the long term, this might be the only real option available to the RBI.Of course, like most economist solutions this is not perfect. The real worry that Indian industry cannot really cope with lean mean Chinese manufacturers and others of their ilk cannot be ignored. Making imports cheaper with a stronger currency could well decimate India’s advantages in cheap labour and hit our exports so hard that they may never recover. But my belief is that the Indian corporate is now ready to take on the rest of the world. If we free the Indian corporate, he will also be free to take over his foreign competition with the stronger Indian currency.

Summary

Well, that is all hypothetical though. In reality, the RBI has raised Cash Reserve rates in order to reduce the money floating around in the market while keeping interest rates constant. All this is just to keep balancing the tightrope that the Indian rupee is walking. And of course, to fight the demon of inflation, which is hovering at a comfortable 3% today.

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Price Elasticity in the real world — Oil Prices Monday, Oct 29 2007

What better way to test price elasticity with that most insanely difficult commodities to price, oil. Most people say that oil price is determined by the whims of local dictators rather than by the laws of supply and demand. But lets have a slightly closer look, and see how it goes. Maybe we can get some trends.

First lets look at the price of oil. For our analysis, which is hardly going to be in depth, we will only bother about the last 2 decades or so.

Year	Prices	Consumption (million barrels/day)
1988	18.53	65
1989	14.91	66
1990	18.23	67
1991	23.76	67
1992	20.04	66
1993	19.32	65
1994	17.01	67
1995	15.86	69
1996	17.02	71
1997	20.64	72
1998	19.11	74
1999	12.76	75
2000	17.9	77
2001	28.66	78
2002	24.46	79
2003	24.99	81
2004	28.85	83
2005	38.26	85
2006	54.57	86
2007	65.16	87

The data above is a little detailed, but anyone will notice that as the price goes up, the consumption of oil is increasing. This is rather silly, is it not? After all, the price elasticity thing says that if the price of a commodity goes up, the demand for it will go down. Yet, oil consumption has gone up rather than down. Not at all as per theory, is it?

Well, there is a reason for that. While the overall consumption of oil has gone up, a breakup of regions tells an interesting story. While global demand has gone up by about 22 million barrels a day, North America has only risen by 4 million barrels, and Western Europe is even worse, with practically no change in consumption. It is in Asia where consumption has shot up, with Asia accounting for an increase of almost 13 million barrels a day, which is an incredible 60% of the global increase in consumption. Africa and the middle east account for the remaining rise.

Now, the reason why prices have gone up and consumption is still moving up is becoming a bit clearer. The problem is that a previous zero consumer has entered the market, and the production of oil must catch up. Until then, the prices will just keep going up. In the case of oil, while global consumption today is about 85 million barrels a day, the spare capacity in the world is only about 2-3 million tonnes a day. One attack in Nigeria, or one storm in the Florida Keys would lead to a shortage in supply.

And like I pointed out, elasticity is not just about price setting the supply. Sometimes, supply sets price. As there is no feasible substitute product for oil, the elasticity of oil is very low, maybe as low as 0.1. Let us now evaluate a hypothetical situation, where the supply oil drops by 1%. And lets see what happens to price.

Now, from the formula, Price Elasticity (0.1) = Percentage change in supply (0.01)/Eq. Change in price

Cross multiplying Eq. Change in price = 0.01/0.1 = 10%.

Now, we see the problem. The smallest supply disruptions lead to a HUGE change in price. Now, over the last 20 years, oil demand has increased by about 20%. Even if supply rose by 10%, the gap in demand and supply is still 10%. With a price elasticity of 0.1, you can see that the resultant change in price is at least double. If you add an inflation rate of about 5%, you can see that a rise in oil price from $18 to about $ 70 dollars seems reasonable.

Of course, oil is ruling at quite a bit more than that. Its at close to $90 today. And this is where I inject caution. It would be tempting for me to lower the price elasticity of oil still further and get the required $90 per barrell as the price that oil should be at. But that would not be accurate. In reality, the additional 20 odd dollars is the risk premium of oil owing to the Very small amount of spare capacity and low price elasticity of oil. The market knows that if oil supply just drops by 5% the price of oil could well go up 1.5 times. And disruptions to supply are rather high probability events these days! Some amount of the oil price today is therefore exaggerated to take into account this risk. But to assume that prices will drop to the levels of the early to mid 90’s once the security risk is removed is to live in a fools paradise. Unless substitute products are discovered, or far more reserves than are currently available are discovered and utilised, high oil prices are here to stay.

So there you have it. How price elasticity can be used in the real world with oil prices. This pretty much completes the Price elasticity section that I had. Hopefully, next section onwards will be on some other topic!

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Economics 102: Price Elasticity…What is it? Friday, Oct 26 2007

Well, first things first. I have forgotten to point out one of the assumptions behind economics. Its a rather basic one. It basically says that the actions of an individual are perfectly rational and are motivated by the desire to maximise gain.

Now most of you will jump the gun and say “What Tosh!”. And while it is true that most of us do not behave terribly rationally most times, as a group we are much more predictable. Besides, we do things for gain at all times. It may not be monetary or measurable…but sometimes peace of mind may be more important than money (or the other way round).

Ok…now that that is done, lets move to our topic for the day. Today’s topic is Price Elasticity.

Egads: Yet another dull topic?

I hope not. But you never can tell till a topic is done! But without waiting for any more fanfares, lets start!

How is demand dependent on price?

Price elasticity attempts to quantify changes to demand if there is a change in price. There is a bit more to it than that, but we will save that for later. First a definition.

Price elasticity is the ratio of the change in quantity bought of something,  versus a corresponding change in price of that something.

An Example

Confused? Well, lets explain it with an example. I will go with a practical problem that I faced. When I was a kid, the Price of Maggi ™ Noodles was Rs. 5. And I loved Maggi Noodles. We used to have it every Sunday for lunch (my sister and I). Then one fine day, the Price changed from Rs. 5 to Rs. 7. And suddenly, instead of buying 2 packets of Maggi every week(about 8 packets a month), we had Maggi Noodles once every 2 weeks, which dropped our demand down to 4 packets a month.

The change in Price of Maggi was Rs. 2 on a base of Rs. 5. At the same time, the quantity demanded dropped from 8 to 4. So elasticity of demand is now seen to be (4/8)/(2/5) or (4×5)/(8×2)=1.5.

Now…what the heck is this 1.5? What does it really mean? Well, basically it means that every time you increase the price of Maggi by 1 unit, my demand for the Maggi will fall by 1.5 units. (oversimplification here, but it suffices). Even this does not impress you, oh fine reader!

Revenues and Profits now

Ok…lets do a revenue calculation and now you may be able to see how Price elasticity is cool. Before, I used to spend about 8×5=Rs 40 on Maggi. Now, after the price increase, I spend 4×7=Rs  28 on Maggi. Let us also assume that it takes only Rs 2 to actually produce and sell the Maggi Noodles. Thus, previously, the company was making a profit of 3×8=Rs 24. Now, they would make a profit of 4×4=Rs 16. So the poor company has shot itself in the foot. By increasing price, they would have imagined, they would increase profits. But because of elasticity of demand, they have actually lost money! So when you have pricing decisions, you better worry a heck of a lot about how elastic the demand for your product (or service is).

So, what is elastic, and what is not?

That is a 64 million dollar question indeed. If you have an elasticity more than 1, it basically means that your product sales are extremely sensitive to price. A change in price of 1% will alter the demand for your product by more than 1%

If you have elasticity between 0 and 1, it means that the demand will change less slowly than the price change. So a 1% change in price would lead to a change in demand of less than 1%.

Factors affecting Price Elasticity

1. Can you do without? : If the price of maggi doubled, my consumption would drop pretty drastically, because i dont really think Maggi is worth Rs. 20. But the same cannot be said of electricity. If the price that the company doubled, I might be able to cut back a bit. Maybe a couple of cold showers instead of the hot bath, or Switch off the lights while sleeping. But, I cant really cut electricity consumption by too much. So, if a product is essential, its elasticity will be low.

2. Are there substitutes?: If tomorrow, Maggi prices doubled, I would go and buy Top Ramen instead, which would drop Maggi sales drastically. A more practical example. Lays has reduced the quantity of its chips packets (or increased the price). But I continued to buy Lays chips, because there was no acceptable alternative. But then ITC came out with Bingo Chips, which is cheaper (and crispier too). So, I switched to Bingo, which is practically the same as Lays, and cheaper too.

3. Is it a huge part of your income?: Now, the price of sugar can double. Is it going to change my consumption of sugar too much? Not really. Its not that the sugar has no substitute (i could use sugar free). Its just that if I earn 20,000 a month, and spend Rs 50 a month on sugar, I dont really care whether I spend Rs. 50 or Rs. 100. Its still a negligible amount of my total funds. But the situation would change completely if my 3 bedroom house rent doubled from Rs. 10, 000 to Rs. 20,000. Now there is no way I could live there and survive. So my demand for a 3 bedroom house would plummet!

So, there you have it. Price Elasticity of Demand explained. I just hope it made some sense. For further entertainment on elasticity of demand, we will take a live case, which is going to be oil consumption and prices. Lots of fun and frolic promised.

p.s: All Trademarks belong to their respective owners, whosoever they may be.

p.p.s: I did not like Bingo Chips too much…even if they were crispier than Lays!

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Applied Economics: Currency appreciation! Wednesday, Oct 24 2007

 

 

Ok. Today, we try to analyse currencies from a pure economic demand and supply perspective, and will try to explain why the US of A is so pissed off with China, and how the RBI is imposing controls to ensure that the Rupee does not suddenly become more valuable too!

Demand and Supply: Market determines Price…Or is it the Chinese Government?

A really quick intro first. China is exporting more than it is importing. This in economic parlance is called a trade surplus. What does this mean for china in Demand and supply terms.China is making $110 of sales to the world, and is ending up only buying about $80 worth of things. So, China is netting a profit of $30 (oversimplifying a bit). But there is only one problem. China does not use dollars! It uses Remnebi, or Yuan as its local currency. So, this $30 is actually worthless to a common Chinese guy on the street. He cant buy anything with it in China, and since he does not buy anything from the outside world, the mystery is…what happened to that missing $30?Now standard economic theory says that if someone has $30 that they don’t want, they will try selling it cheaper. Now, one dollar buys about 7.5 Yuan. But now this guy has excess dollars, and he is quite desperate to buy some new Chinese Toys for his kid. So he shouldbe willing to pay a bit less for the Chinese Yuan. Maybe he will pay one dollar to get only 6 Yuan. And if he does that, then the Chinese currency is said to strengthen, which will make its exports a bit tougher, and its imports a bit more expensive, thereby eliminating that pesky Trade surplus.But the Chinese Government is a ways smarter than that. They want to keep that trade surplus going (don’t ask why). So what they do is simple. They go to this Chinese guy who holds the $30 of the trade surplus and tell him…”Hey boy, we will give you 7.5 Yuan for every dollar you got. Just hand over the money to us.” Of course, Mr. Chinese dude is overjoyed at getting a good rate, and hands over the cash to the chinese government. The Chinese Government in turn puts this in a special place, which it calls the Currency Reserve, and as you can imagine, this is like a bank vault for American dollars that the Chinese People cant really spend. This explains how the Chinese dudes have a currency reserve of $ 1 Trillion. Its simply because they can’t find any Chinese guys who want to buy American goods!

What about India?

Yup. What about India? India is getting huge amounts of money coming in to it via foreign investments and surely our software firms are making American dollars just take wing and fly down here. So we should be in a similar situation to China. Well…sort of. India has this wonderful thing called invisibles, which is where the software sector is defined. IF you take out invisibles, India has a whacking big trade deficit. But if you add investment and other such things then we are similar to China, with a comfortable trade surplus. This of course means that the Rupee is getting more valuable, as the demand for Rupees from foreigners increases. The problem for the RBI is that there are simply too many foreigners with cheap dollars now wanting to enter India. IF the RBI tried to do a Chinese Government and give every person with 1 dollar Rs. 44 (Which is what the Indian Rupee used to be), you would be left with a heck of a lot of rupees floating around in the country, which increases inflation inside the country. But letting the rupee become more valuable would mean that the software industry (and textiles and half a dozen others) would raise a stink to the high heavens and claim that they cannot pay taxes ever again. So, this strengthening of the Rupee now has to be blocked by telling the foreigners to go slow

Enter the P-Note…Err…Exit the P-Note

Upto now, there was this thing called the P Note. What was it? Basically, it was a magic wand by which any person could invest in India, and no one would know who. Now, RBI wants to block this P-Note. Thus only identified individuals would be permitted to trade in India, which would (hopefully) reduce the amount of dollars flowing in. Is this likely? In the short term, certainly the stock markets reacted with fear that the dollar tap would be shut off. But in the long term, with the Indian economy growing at 9%, you might well find that it does not (unless Indian Bureaucracy manages to hobble applicants). There will be a hoard of people registering themselves to trade in India, and the RBI will have to find a new way to slow down the arrival of cash.

So there you have it. Why the US thinks that the Chinese Government is distorting the world economy…and why the Indian rupee might rise…or not!

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Economics 101: Diminishing Marginal Returns Friday, Oct 12 2007

I was told that while I have given lots of economic posts, I have neglected basic economic theory. I have to admit, “Guilty as charged”. To recompense for this, I am finally going to start from a little further back, hoping that my own concepts are good enough to give some insight into economics.  So…lets begin with one of the pillars of Economic Theory, “The law of Diminishing Marginal Returns”

 An Example with Chocolate:

The big name should not intimidate people. In reality the law is something that most people intuitively know…2+2=3.5!

Let me illustrate it with an example. Let us say that the pleasure you get from eating 1 piece of chocolate can be quantized, say as 1 joy per piece.

The first piece of chocolate you have will give you 1 joy. Maybe the second piece will give you 1 joy worth of return as well. But the third piece might only give you a return of 0.9 joy. And the fourth piece will give you only 0.8 joy. By the time you get to the end of a 1 kg pack of chocolate, I am pretty sure even the most die-hard chocolate fan would actually rather pay someone some money rather than eat any more chocolate.

So, the law of diminishing marginal returns says that the return you get on an item reduces as you have more of that item with you. With money, lets look at Bill Gates. I am sure that his first million was worth a lot to him…but his 50th Billion was probably not really important…and he should not care too much if his wealth is 51 billion or 52 Billion. While you bet that I would care if i got even $1000 more…after all, i have no billions at all!

So there you have it…the Law of Diminishing marginal returns. The next economics post shall cover Price Elasticity, and other such pretzel like quantities!

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Interest Rates — Oil Prices and Software Firms! Wednesday, Sep 19 2007

The recent decision by the US Fed to drop interest rates down to 4.75% seems to indicate that the economic heads think the Housing problems in the US are far from over. But I am no expert on housing markets in the US so will leave that for others.

Now 0.5% change does not sound like too much. But that is one of the problems of the absolute scale. Consider that 0.5% chopped off from 5.25% is an almost 10% drop in price. Essentially you could say that the variable rate loan you take is now 10% cheaper. This is what has everyone convinced that this is a very big deal for the US Markets.

But my point is not about proportions and percentages. I am going to be talking about the impact this drop in rates is going to have on Inflation. Now, the theory is ridiculously simple. Even George W Bush would be able to explain it. Interest Rates Go down –> Inflation goes up. I have explained the reasons for it in a previous post, but will put them out again. Simply put, people have less incentive to save, so will draw money out of banks to spend. More money in the system means that the value of money drops, which means that things get more expensive…hence Inflation.

Exchange Rates–The weakening Dollar

But Unites States of America is a slightly more complicated story. Here we have a double- whammy lined up. First is of course the impact of people having more money in their pocket to spend. This will raise inflation. But the hidden danger is coming up. With the lower interest rates offered, the American Dollar has just lost some value. Bond yields will drop, which mean that people will be less interested in buying dollars. This means that the value of the dollar with respect to other currencies drops.

The Consequence — Even Higher Oil and commodity prices.

Oil prices are already at all time highs at $80 dollars a barrel as of September 17th 2007. The lower value of the US dollar will mean that the Arab Sheikhs would need even more dollars to buy their LearJets and Ferrari’s. Hence the price of oil, and commodities that are benchmarked by the dollar (almost every commodity) is therefore going to go up by approximately the same amount that the dollar will weaken.

How Much will prices go up by?

Of course, the amount prices will go up is not going to be directly related only to the weakening of the US Dollar. It is also dependent on the elasticity of demand…which I will try to explain simply. Elasticity for a commodity is how price sensitive it is. for example, if intel increases its processor prices by 50% and AMD did not do so, Intel would find that its sales would collapse because people would switch to AMD. But there is no such problem for Oil. Whether the prices go up by 5% or 20%, the consumption is not going to change much because there is no real substitute available. So we can expect the prices for Oil to shoot up by an equivalent amount. Is this 10% or more….probably not. $88 dollars is a lot. But you cannot discount that the price might well be going in that direction. The same of course goes for all other commodities…in varying degrees.

Software Firms: What about them?

For Indian software firms, things are lousy. The RBI seems to be more hands off about the Rupee, and a 0.5% drop in interest rates in the US might well see the Indian Rupee appreciate.  And the appreciation might not be as low as 0.5%. Luckily for India, Inflation is down from a few months ago, so interest rates may not rise immediately…but the increased oil and commodity price increases that are likely to occur worldwide will certainly put pressure on Indian Inflation rates. So we might be faced with a situation where the RBI might actually raise rates again in India (not immediately, thankfully), which would raise the value of the Indian rupee further. This would mean that the exchange rate differential that Software firms survive on is going to be slashed. There is still some headroom available, but it looks as if the Software Industry’s margins and spectacular growth may well be under significant pressure.

 Impact for the US

So what does this mean for the US. Obviously, they believe that in the short term, its better to have higher inflation than to confront a possible recession due to lowered spending from American customers. The Policy makers are operating under the impression that even though the dollar yields will drop, people will still have demand for US Treasury bonds and this will prevent the dollar from completely collapsing. So far, China has been busy buying up dollars that ensure that demand is going to be met. They are now beginning to invest this money in the US Equity markets, which is going to make things….interesting. Keep watching this space.

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Of overcharging Taxi Drivers, and all of their ilk — Sub optimal Economic Equilibrium Friday, Jul 20 2007

Yesternight, a friend of mine was attempting to hail a taxi at Salt Lake in Kolkata. Of course, no taxi guy seemed to be willing to take him for anything under 10 times the actual price, so he had to walk in the end.
But this got me thinking. According to definitions, perfect competition would exist when it is very easy for people to enter and exit the market. By that definition, taxi drivers in Salt lake should exist in perfect competition. But clearly, because prices have not fallen, it seems as if there is no perfect competition here. Why is that so?
Now, at first I thought it could be cabals or unions that distort the free market…but that did not make enough sense. So here is an alternative explanation for why taxi and auto guys charge so much…even though due to competition they ought to offer cut rate prices.
Let us take a hypothetical case where there are 1o taxi drivers. In most places, such as Bangalore, or bombay, there would be a plethora of customers, and the taxi driver would have choices, as does the customer. Also, because most of the customers are locals, knowledge of the locale is also assumed. In this case, it seems to me that the perfect competition model ensures that the lowest prices will be guaranteed.
However, in a place like Salt Lake and Gurgaon, the case would be slightly different. Firstly, the local populance is unlikely to travel by taxi. In salt lake, this is probably due to familiarity, and lack of places to go to. In the case of gurgaon, it is because those who live there are likely to have their own private means of transport like a car or a bike. Therefore, the only people who are likely to hail a taxi-cab are going to be people who are not locals. Also this subset is definitely smaller than the superset of all the people living in the area.
So to summarise, problem is
1. Information Asymnetry
2. Finite customer base.

So, let us take a hypothetical case of 10 taxi drivers, and only 2 customers. While it seems counterintuitive that the prices should go up, here is why they will. In order for the taxi driver to make ends meet, he will have to get revenues of say Rs. 200 a week. Whether he gets it by taking 1 fellow 5 times or taking him once is immaterial to him. Therefore, now these 2 customers will now pay 400 between them. Now, while only 2 taxi drivers benefit, averages say that the next day, another 2 taxi drivers will get 200 and the first 2 will go without clients at all. So, all in all, in a 5 day week, all the taxi drivers will get paid, and the total income would be Rs. 2000. (200 a week per taxi driver)
What would happen now if 1 guy undercuts to a more realistic fare…say Rs. 30. Remember, this is a price inelastic market, so the number of customers won’t really go up. So he might get 2 more passengers added to the market. Now, by perfect competition laws, every other taxi driver should also lower his prices down to 30. So now, the total revenue made by all the taxi drivers now is 4×30x5= Rs. 600. This means that every taxi driver now gets only Rs. 60 in a 5 day week.
So we have a perfectly logical explanation for why taxi guys overcharge in certain places. Its market demand a and supply based, after all!
But there is a neat little corollary here. This is in reality a vicious cycle, because the assumption that is made for this to work is that the demand is inelastic with respect to price. This assumption was made with respect to mobile phones when they first came to India. The rates were incredible, with prices going as high as Rs. 27 per minute. Obviously there were not many takers for that sort of price. But once TRAI mandated changes to pricing, companies were busy complaining that they were going to make huge losses. But to their surprise…they did not…the market got them new customers….and that began the price war that led to perfect competition (practically).
The analogy of course with autos and taxis is this….someday, someone will cut the price and address a market of locals as well…then the traditional elastic demand and supply economics will triumph!
But till then, if you live in Salt Lake or Chennai…prepare to get fleeced by the local private transport providers!

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