September 8, 2017

Stock You Like a Hurricane - When Price Gouging Won’t Fly under Severe Weather Conditions

In the wake of the devastation caused by Hurricane Harvey, many on the East Coast are watching closely to see where another powerful hurricane, Irma, will make landfall in the continental United States. These back-to-back catastrophes have created a unique situation in which many items considered necessities for surviving during and after such a storm are in short supply. In fact, in the wake of the devastation left by Harvey in the Houston area, many trucks in the southeast are being loaded up with water, diapers, food, and other items to help in the relief effort in Texas, further straining the supply of essential goods to the area that is about to be hit next. While shortages of essential goods have developed in many areas, there has been no shortage of articles written by economists describing how laws prohibiting price gouging lead to or exacerbate many of these shortages. For informational purposes, I’ll describe why this is in the following paragraph. What is even more interesting, is when we find examples of other economic forces at work that are largely being ignored in the other articles. In particular, this week several airlines announced that they would be doing quite the opposite of price gouging, by voluntarily capping the prices they are charging on flights to and from Florida during the evacuation effort.
Hurricane Irma Threatens Florida as People in its Path Prepare
(Photo credit: NASA/NOAA GOES Project)
Before we discuss the scenario with voluntarily capping airline flight prices, let’s first briefly examine the reason economists are so interested in price gouging laws to begin with. The reason most economists will argue against price controls of this sort that limit the maximum price that can be charged for a good, is that it prohibits the market from working to set the price that “clears the market” in a competitive equilibrium. That is to say, sometimes the price of a good needs to be very high before quantity supplied equals quantity demanded. If the price is below this point, people will want to buy more of the good (because people find it to be relatively pretty cheap) than is supplied (because many suppliers don’t find it profitable to sell a good for so few dollars). This inevitably leads to a shortage, and determining who gets the limited available quantity must be done in some other way than raising the price. One method of distributing goods in such a scenario is “queueing”, which is distributing the resource to whomever shows up first in line. If you’re worried about one person buying a lot of the good (stocking up on many cases of bottled water), instead of many people buying one case each, you could also try imposing limits on how many each person could purchase.

If you do limit the ability of prices to rise through anti-price gouging laws, most economist argue, you create two problems. The first is that people may overindulge in the artificially cheap good (stocking up on as much bottled water as possible), leaving very little or none for others (who may value it more) to purchase. The second problem is that the price gouging laws remove or decrease the incentive for entrepreneurs to transport much needed supplies to the affected areas from areas where they are more plentiful. Absent these laws, someone from Virginia may be tempted to purchase several generators and drive to Houston or Florida to sell them to people who are in great need of them, albeit at a higher price to cover their investment/expenditures.
Price Gouging Laws lead to Shortages of Many Essential Goods
(Photo credit: By Maksym Kozlenko via Wikimedia Commons)
What I want to discuss in this article, however, is not the typical price gouging scenario. Earlier this week, as predictions of Irma’s landfall somewhere on the Florida peninsula became increasingly more certain, evacuations began to take place. Then, something interesting happened. Airlines began advertising that they were doing two things. First, they were attempting to add as many extra flights as possible to get people out of Florida. Second, and somewhat surprisingly to many economists, most airlines announced that they were voluntarily capping the prices of their Florida flights at relatively low levels. While this may seem like an odd phenomenon to many, I would argue that the unique circumstances of these flights make the voluntary price capping a unique exception, and unlike other necessities like plywood, bottled water, and gasoline.

First, despite economists’ general agreement that prices should be able to rise (for the reasons discussed above), the general public tends to view large hikes in prices negatively. Thus, you may not expect many companies to raise prices by much during disasters, even if there is no law prohibiting it, due to the potential decrease in customer satisfaction. This doesn’t apply much to the entrepreneur who chooses to drive to an area to sell more generators, but it can be pretty damaging for larger companies whose reputation is on the line. Airlines have received a lot of negative P.R. already this year, and probably aren’t looking to add to it, even if they’re otherwise justified in their actions.

Second, while airlines are increasing the number of flights (and size of planes) to transport more people, there’s actually little room to temporarily increase the supply of seats flying out of Florida. One large barrier to increasing supply is the limited capacity of airports to have more planes at their gates. This means that even if the airlines charged several thousand dollars per seat, there just aren’t enough flights for it to have much of an impact on profits. When the airlines weighed the lop-sided risk of the costs of a potential P.R. disaster with a small bump in profits versus making a positive impression on the public and forgoing those profits, the choice is pretty obvious. When viewed in this light, it’s easy to see why airlines would publicly impose price restrictions on themselves.
Larger Planes and More Flights are Being Added to Help with Florida Evacuation
(Photo credit: Carla Thomas  via NASA)
The problems associated with price gouging laws are clear when applied to goods like plywood or generators, but don’t fit as well when applied to flights. It is much more plausible that someone would be incentivized to drive a truck full of supplies to Florida than to fly their small plane down, find a runway with available space, and find customers to fly out of harm’s way a few at a time. The limited ability to expand “production” of flights, coupled with the fact that a few large companies with a lot to lose control most flights, means that in this instance there’s no need for a price gouging law to limit prices. The major airlines have made a competitive and economic decision that, at least for them, price gouging just won’t fly.

August 20, 2017

Total Eclipse of Supply - Why are Solar Eclipse Glasses Impossible to Find?

America is gearing up for its first total solar eclipse in well over a quarter century, and there’s something strange going on near the path of totality. No, I’m not talking about the possibility of Lizard Man sightings during the eclipse, but rather the fact that there appears to be a shortage of the cheap disposable solar eclipse viewing glasses that are essential to wear if you want to look at the sun without permanently damaging your eyes. This article, from Denver, describes the difficulty that people from Oregon to South Carolina are experiencing in finding the glasses in the waning hours before Monday’s eclipse. I’ve discussed shortages before on this blog, so why is this one so strange/unexpected?
A total eclipse over the United States is a once-in-a-generation phenomenon
(Photo credit: NASA  via Wikimedia Commons)
The shortage of solar eclipse glasses is interesting because it should qualify as a relatively competitive market (many buyers and sellers; free entry/exit; etc…), and the product is relatively inexpensive and quick to manufacture and distribute. In addition, science allows us to predict future eclipses far into the foreseeable future, so it’s not like this event suddenly snuck up on everyone. Thus, despite there being no specific laws placing a price ceiling on solar eclipse viewing glasses (some states’ general price gouging laws could potentially apply, but I’m not aware of any being applied at this time), a shortage of eclipse viewing glasses has emerged. So, you may be asking yourself, what kind of factors would contribute to such an economic anomaly?

When a competitive market experiences a shortage, it usually adjusts for the disequilibrium created (quantity demanded > quantity supplied) by increasing prices until the market reaches equilibrium. This occurs because, as prices rise, more suppliers are willing to produce more eclipse glasses, and at the same time some consumers stop demanding pairs of glasses because the price gets too high for them. We expect this to take a bit of time to occur, but even if there were no additional time to produce more pairs of glasses the price of glasses should increase a lot until enough consumers drop out and there is no longer a shortage.
The path of "totality" stretches from coast to coast!
(Photo credit: Wikimedia Commons)
There are two interesting things that appear to be occurring with eclipse glasses. First, it appears that both producers and consumers may have underestimated the Demand for these glasses. This is likely do in large part to the rarity of total solar eclipses in the United States. It’s hard to predict the level of Demand without much historical data, especially due to the lack of eclipses that could be hyped up by so many internet and 24/7 news stories. When stores that don’t typically sell eclipse glasses (hardware stores, gas stations, etc…) were deciding how many pairs of glasses to order to stock their shelves, they seem to have preferred erring on the side of underestimating Demand. This makes sense; while eclipse glasses are relatively cheap to produce and store, their value drops to almost nothing after the eclipse on 08/21/2017. The next total solar eclipse in the US is not until 2024, and only overlaps with this year’s path around southern Illinois/southeast Missouri. That leaves a lot of stores across the nation that would have to store any excess glasses with very few potential buyers after Monday.

The second complication, that may be the most interesting to an economist, is that many groups began advertising several weeks before the event that they would be handing out eclipse glasses for free. Some were schools, museums, and other government institutions who may have been seeking to promote the “public good” by helping protect people’s eyes while encouraging people to pay attention to this scientific phenomenon. Others were retail establishments, including many optometrists, who used the free glasses as a form of advertising and a way to get potential customers in their doors. No matter their reasons, these free glasses seemed to have two effects. First, many suppliers knew they’d be trying to sell glasses against others who were giving them away for free, and so they logically ordered fewer than they otherwise would have. Second, many consumers (like me) heard that there were free glasses available, and chose to pass by those that were for sale in the store a few weeks before the eclipse.
Were you able to snag a pair of these stylish and necessary frames?
(Photo credit:
By the time everyone realized that Demand was much higher than expected, it appears to have been too late. No longer being able to find free glasses around town, consumers turned to the stores selling the glasses. Prices appear to have been a bit “sticky”, with the high Demand not being fully revealed to the stores selling the glasses until they had almost sold out. If they had raised their prices immediately only to find that Demand was low, consumers would have only bought from their competitors, and they would have been left with a large excess of glasses with no buyers.

One additional complication in this ordeal was the emergence of “fake” solar glasses sold on Amazon and elsewhere. Many people purchased glasses for themselves and their families only to be told that they may not be fully protected from the solar rays after all, and that they would need to find the “approved” version of the glasses. Whole counties even ordered and distributed these unapproved glasses! As any given person only needs one pair of approved glasses to view the eclipse, many people who would have otherwise been satisfied and not purchased more glasses at any (positive) price were now thrust back into the market to try to buy a pair of glasses in time.

We typically expect a market to self-equilibrate over time, unless some sort of barrier (such as a price control) keeps it from doing so. With the Great Eclipse of 2017, we can see that a confluence of unique circumstances has created a shortage of eclipse glasses that it appears will persist through the end of the phenomenon. With a little economic insight, we can “shed some light” on this mystery, just in time for Monday’s darkness.

July 25, 2017

Credit for Trying - Is Banning Transactions Fees a Win for the Consumer?

Take a second and think back to the last time you bought something that was on sale. How great did it feel? It’s easy to recognize and appreciate deals when you get a better price for something you were going to buy anyway. But how do you feel when the tables are turned, and you’re charged extra to buy something?

For example, when you go to the gas station to fill up your SUV, do you pay with cash or credit? At most stations, the price that you pay per gallon when using cash is different than the price per gallon for using credit. Either way, you’re getting the exact same gasoline, so how do you perceive this difference in price? If you see it as a mark-up or extra fee for using credit, you’re probably not a huge fan of the price differential. On the other hand, if you see it as a discount for using cash, you may view it favorably, and would be unlikely to want to see the discount removed.
When you purchase something, you often weigh 
the cost and benefits of using cash vs. credit
(Photo credit:
It is with this in mind that this article from The Telegraph, across the pond in the UK, caught my eye. The article was written by The Telegraph’s Consumer Affairs Editor, who chalks up a new law banning charging many credit card fees as a clear victory for consumers. If the title of the article, “[e]nd to rip-off credit card fees…” doesn’t make this position clear, the description of these “rip off” fees as being “used by shops, restaurants and travel firms to make extra profit at the direct expense of customers choosing to pay by card” should remove all doubt. But is the removal of these fees truly a clear “win” for consumers, at the expense of the greedy shops, restaurants, and travel firms?

Let’s begin by considering a portion of the quote above. These fees are charged to customers who are “choosing to pay by card.” This implies that the customers have other options (usually cash), but find paying by card to be preferable for some reason. Presumably, either they find using credit more convenient, or they may receive some cash back or points for using their credit cards. No matter the reason, some citizens chose to pay in credit despite the fee, and others chose to avoid the fee by paying in cash. Essentially, you’re free to sort into the group (cash or credit) that you feel is the best deal for you, after taking the fees into account.

Now what happens if you ban the ability to charge credit card transaction fees? If you’re a consumer, perhaps you’re hoping that the cash price will stay the same, and the credit price will be lowered to match it. Those who previously paid in credit would now be better off, since they still get the perks (convenience, points, etc…) of using credit, but for a lower price. If this scenario were to play out, even those previously using cash would be as well off, if not better off. Some of them may even choose to switch over and begin using credit cards for their purchases! Consumers would clearly be better off, and the costs would fall on either credit card companies or those greedy shops, restaurants and travel firms. The problem is, this scenario has some assumptions that aren’t likely to play out in the real world.
How do you view the price difference in
paying for gas with cash vs. credit?
(Photo credit: 127driver via Wikimedia Commons)
The issue with the scenario above is that it assumes the cash price will stay constant. It’s like assuming that if gasoline is currently $2.00/gallon when using cash, and $2.10/gal when using credit, that all gas would be $2.00/gal after the fees were banned. But it’s costly for gas stations and other stores to offer the payment option for credit cards. They even have to pay fees to the credit card companies for facilitating these transactions. If gas stations can’t pass along these fees to consumers, they have to find some other way to not lose money on the transaction. In this example, gas stations will do one of two things. First, they may increase the price of gas for everyone, let’s say to $2.05/gallon. While those consumers using credit cards are now better off, those who still use cash are clearly worse off, as they are helping subsidize the purchases of their credit using neighbors. The other possible result of the ban on fees is that vendors may choose to cease offering credit cards as a payment option all together. In this case, those who previously used credit cards are clearly worse off, as they used to have to choice to use either cash or credit and chose credit, but now must choose their second best option.

The lessons in the example above could easily be extrapolated to apply to all sorts of shops and firms. It’s easy to see that a law which essentially limits the choices of the consumer is not necessarily a clear “win” for all consumers, or even the average consumer. Viewing the issue as a discount for using cash rather than a penalty for using credit allows us to see more clearly the true costs and benefits of such a regulation. Perhaps The Telegraph is giving lawmakers more credit than they deserve.

July 18, 2017

Prognosis Negative - The Dual Drivers of Electricity Price Variability

How great would it be if someone paid YOU to consume their goods or use their service? For instance, what if instead of having to pay to go see a new hit movie, you not only got into the theater for free, but were even given a few dollars in compensation?

People love to complain about their power bills being too high, 
but what if you actually got paid for using power!?
(Photo credit: Max Pixel)

This is exactly what would occur if prices were negative for a good, but it’s a fairly rare occurrence. Why? For most goods, the Supply curve doesn’t cross below zero (or even marginal cost (or even minimum average cost for a given firm)). This means that even in the most competitive markets, suppliers are free to either leave the market or just not sell their goods to you, if they can’t get a high enough price to make selling them worthwhile. A negative price doesn’t usually satisfy this condition, so you may wonder if it is ever something we would observe in a real-life marketplace.

It would be unexpected for movie theaters to pay 
consumers to go see new blockbuster films.
(Photo credit: LuisJ3000 via Wikimedia Commons)

As it turns out, we do observe negative prices for goods from time to time. As you may have guessed from the title of this article (unless you were thrown off by the Seinfeld reference), the market for electricity will at times end up supplying electricity for negative prices. A few unique characteristics of this market lead to such an occurrence. These characteristics include:
  •          The inability to store the good for long periods of time
  •          Markets that are often segmented and closed-off from other parts of the country
  •          Varying levels of subsidy to different types of electricity generation
  •          The impracticality of shutting down or scaling back electricity generating operations for short time-periods

When considering all of these peculiarities together, it is not surprising that at times more electricity will be generated than people want to consume, resulting in a negative price. What is most interesting, however, is how fittingly electricity generation provides a “powerful” example of how there are always two sides to a market.

I first learned of the negative prices in this market while reading an article in 2015. At the time, it was fascinating to see prices below $0 for a good, but for the particular scenario described it was easy to figure out why it had occurred. In this instance, the supply of electricity in the short-run was relatively fixed and inelastic (due to the reasons outlined in the bullets above). As such, and price changes would likely come about due to shifts in demand. This was exactly the case. During periods of extremely low demand for electricity, the inability to store or substantially reduce the production of electricity at low cost meant it was cheaper to take a loss by selling it for a few hours at a negative price than it would have been to completely stop generating power.

What made this story even more interesting, is when I came across this article recently discussing the upcoming total solar eclipse. The article is all about how the eclipse is a very rare event, but will still have a large impact on the amount of power being generated that day, due to the drop in ability of solar panels to convert the sun’s rays to energy. What I found most interesting in this article, is the following:

“The onslaught of wind and solar resources is already regularly contributing to wild swings in power supplies across grids, sending wholesale electricity prices below zero on some days.”

I was struck by this particular sentence, because it is describing negative prices in the electricity market for completely different reasons than the article discussed above. That is to say, even if demand is stable, the type of technology used to produce and supply power (e.g. renewable energy sources like solar and wind) can have such inherent variability in productive capacity that supply can shift in substantial ways. In this case, it is the supply-side of the electricity market that is sometimes leading to negative prices.

The important takeaway from all of this is that there are two sides to a market, and it is the unique characteristics of the market you are looking at in space and time that will determine the degree to which supply and demand work together to determine prices. People often have the tendency to focus on one or the other, but it’s best to remember to stay “plugged-in” to information about both.

July 14, 2017

Who Watches the Watchmen? Rick Perry, CBS, and Basic Economics

Life would be pretty boring if we were only allowed to form opinions on and discuss matters that we had studied extensively. Often times, part of learning about a subject entails making somewhat shaky declarations on how you think something works, and then having others with more knowledge explain through gentle nudges how and why you weren’t quite right. However, it takes a fair amount of confidence to not only make a statement on a subject you’re only tangentially familiar with, but to try to actually explain the concept to others. It takes even more confidence to be willing to publicly correct whoever made the statement, calling him or her out on the misinformed opinions that were presented. All of that being said, a large part of why I created was specifically to point out misinformation in the news, as it pertains to economics. So while it’s difficult to try to correct someone’s claims, I usually won’t fault someone for trying. This past week presented a glaring exception.

Last Thursday, the internet was abuzz with pretty much everyone who has ever taken an introductory economics course (and as you’ll see, maybe some who haven’t) calling out Secretary of Energy Rick Perry for an incorrect explanation of economics principles that he delivered while visiting a coal plant in West Virginia. The quote in question was in Secretary Perry’s misapplication of a fundamental building block of economics; Supply and Demand.

(Photo credit: Gage Skidmore on Flickr)

According to reports, Perry stated “Here’s a little economics lesson: supply and demand. You put the supply out there and the demand will follow.” This statement does not agree with traditional economic theory. It implies that anything that is supplied in larger quantities will invoke larger quantities being demanded. If this were true, you would find that when your business was having trouble finding buyers for your huge warehouse of fidget spinners, and sales had stagnated, you should just produce many more fidget spinners to solve the problem.

(Photo credit: Pexels)

When I first became aware of this statement, I wondered if it had flown under the radar enough to be featured in a story of its own on this blog. Fortunately, when you’re in a high profile position like the Secretary of Energy, many people appear to be watching to point out when you don’t get your ‘little economics lesson’ quite right.

(Photo credit: Wikimedia Commons)
One such outlet that was quick to jump on the story was CBS News. The site featured this article, which correctly pointed out that Perry’s explanation of the concept of Supply and Demand was pretty far off. The author of the article, unfortunately, did not stop there. The journalist went on not only to point out that Perry’s explanation of this economic concept was incorrect, but to try to explain this concept in her own way, as follows:

“The gist of the theory is, if the supply for a product is low but its demand is high, the product’s price is likely to increase. If a product’s supply is high and the demand for a product is low, however, the product’s price is likely to drop.”

While attempting to point out one person’s blunder, the journalist makes a mistake of her own. The problem is, the price for a product is determined (in general) by the equilibrium reached at the point where Supply and Demand intersect. At this price, the Quantity Supplied = Quantity Demanded, and the “market clears”. It would be correct to say that a product with relatively high demand or relatively low supply would have a relatively higher equilibrium price, and vice versa. However, the only way to get a change in price (to have the price “increase” or “decrease”) would be to observe a shift in Supply, Demand, or Both.  Thus, if a product’s supply is high and the demand for a product is low, the product is likely to have a relatively low price, but the price wouldn’t be expected to “drop”, as Supply and Demand aren’t changing.

It’s important to call out blatant misinterpretations of bedrock economic principles. However, as we learned this week, if you’re going to go further by trying to explain the concept for yourself, it helps to be sure you got it right.

February 10, 2017

Do You Really Own Your Home? Fix It Up With Some Property Rights!

If you’re anything like me, you spend 30% of your day sleeping, 10% cooking, and approximately 60% watching people renovating and selling houses on HGTV. What’s better than sitting back on your functional but not-so-pleasing to the eye sectional sofa in your cramped house to watch people create the open floorplans and tile patterns of their dreams? Many of the channel’s hit shows feature people searching for or creating their dream house, and who better to make that dream come true that the quirky and lovable Chip and Joanna Gaines. The show’s hosts introduce prospective buyers to two or three homes that are well below their maximum budget, leaving plenty of room for renovations. After a bit of cajoling, the family chooses one home and design plan, and the work begins in earnest; breathing new life into a house that has otherwise been neglected. At the end of the show, the remodeled house is revealed, and that episode’s featured family is given a grand tour of the house that is now theirs to enjoy! However, as these families are quickly discovering, the house might not be as much “theirs” as they thought.
How much work would you put into this Fixer Upper?
(Photo credit: chumlee10 on Flickr)
This recent article details how many of the people featured on the show thought they were designing their dream home, but are now sharing that dream with frequent visitors. A large proportion of the homes remodeled on the show are now being featured as vacation destinations on websites including Airbnb and VRBO. The reasoning for this is pretty simple; the homes have become immensely popular with viewers of the show who want a first-hand look at how the house came together, and the rentals provide extra income for the home’s owners. While the home owners from those first seasons aren’t breaking any rules or laws by renting their houses out, the producers of the show aren’t exactly thrilled. Two questions arise out of this disagreement. First, can the producers actually forbid these homeowners from renting out space in their own homes; and as an extension, what other things might you not be allowed to do to your own property? Lastly, how does all of this play out in terms of the incentive to improve your home in the first place?

The producers of Fixer Upper can easily prohibit families from renting out the houses featured on the show, simply by adding a clause in the contract. As mentioned in the article, they have begun doing exactly that. It’s likely that the main reason they’ve chosen to do so is to protect the brand of the show. The show is based around the Gaines family helping other families create a dream home at a price they can afford. It takes away from the mystique of the show if viewers start thinking too much about how those families then have to rent their dream homes out to strangers, renovate additional rooms, and generally not live ‘happily ever after’. On the ‘flip’ side (pun intended), homeowners wouldn’t be willing to sign-up for the show at all, if the contract were to become too overbearing. Plus, there’s literally no way to contract over every single thing that could ever be done or not done to a house. As a result, those things which were not explicitly controlled for in the contract are in what’s known in the property rights literature as the “public domain.” The rights, such as whether the house can be rented our, remain in a sort of limbo until one side or the other claims the right for themselves. In this case, homeowners from the earlier seasons began claiming this right, but the show’s producers decided to take it back by working it into future contracts.

If you sit down and think about it, there are a lot of things that you can’t technically do to your own house/property, at least not without getting explicit approval. For example, most places require you to meet minimum codes of safety to prevent accidents such as fires. Even if you have fully paid off your house, you may not be allowed to add on an addition, add a fire pit, or even paint the house a different color if you belong to certain homeowners’ associations. In fact, there are many different groups, from public to private, that can limit your ability to remodel or even sell your own house. Generally, these rules and laws are put into place using the argument that making these changes have external benefits or costs to your neighbors or others. They are intended to nudge you in the direction of making the ‘socially optimal’ decision of how much to renovate. In some cases these rules are worthwhile, while in others they may be excessive. To examine this further, let’s consider how these restrictions could have a real impact on your decisions when fixing up your dream home.

Deciding to renovate a house is a large undertaking, but it’s not an all or nothing proposition. The couples on Fixer Upper are presented with a plan to make several large changes to improve the livability and design of the house they are purchasing, but there simply isn’t enough budget to fully renovate every room of the house. These un-renovated rooms aren’t featured on the show, since they aren’t new and stylish like the rooms that are fixed up. The interesting thing to think about is, how much more would people invest in their renovations, if they had more rights over their property. For instance, in most places in the U.S. you can be forced to sell your house under the rule of eminent domain. You are required to be compensated, but perhaps not as much as the minimum you would actually accept if you were to engage in voluntary negotiations. Knowing that your property could be bulldozed in order to create a highway for public benefit alters your calculation of how many long term investments you really want to make. It’s harder to justify putting on a new roof that should last 30 years, or renovating a spare bedroom. It’s possible that the optimal level of renovations is something more than what people are currently undertaking. People would almost certainly make more investments in their homes if their property rights were more secure. However, detailing and providing those rights comes at a cost itself, which may mean that we’re already having housed ‘fixed up’ the efficient amount. Although, if Chip and Joanna Gaines are the ones doing the remodeling, I think we can all agree that having more wouldn’t be such a bad thing. 

February 7, 2017

What do Donald Trump and Germans Have in Common? More than You’d Expect!

Unless you live in tornado alley, there’s probably a pretty small chance of a powerful windstorm causing downed limbs and fallen trees on your house or surrounding property; a small chance, but not zero. If you estimate the probability of such an occurrence to be high enough, you may even find it worthwhile to take some precautions and prepare a few items in case you are affected. Maybe you purchase a chain-saw or even a generator, to be ready in the event that a storm does strike. What happens though, if one day your neighbor drops by looking to borrow your chainsaw to cut down some trees on his property? If you think the chance of you needing the saw soon is small, you’ll probably be happy to let him borrow the saw. But what if you happen to catch the weather report on the news, and they're airing a special segment on the devastating impact of past storms. If a statement like that causes you to increase your estimate of a storm’s likelihood, would you change your actions and decide that lending out the saw is just too risky? You may be asking yourself, what does all of this have to do with Donald Trump and the German government? The answer is, both Donald Trump and the German government have made some interesting statements in the previous year that warrant some discussion of how they may cause people to change their actions.

Image: Donald Trump's statements on the probability 
of default may have interesting effects.
(Photo credit: Gage Skidmore on Flickr)

In the case of Trump, he made statements in May of 2016 to the effect of saying that the U.S. can’t default on its debt, because it has the ability to print more money to pay off those debts. How does this statement affect expectations? In order for the U.S. to borrow money and take on debt, it has to find people who are willing to lend the money. The interest rate that those lenders require in order to agree to lend their money depends on how likely it is for them to be fully paid back. For instance, if I were offered the opportunity to purchase a U.S. Treasury Bond today that was worth $100 one year from now, two things would affect how much I would be willing to pay for it; the interest rate and the likelihood of default.

First, I’d factor in how likely it was that I would actually be paid the $100 next year; that is to say, the probability that the borrower (U.S. government) would default on the loan. If you’re lending money to your sketchy neighbor, you might say it’s pretty likely he’ll default. If you’re lending money to Mother Theresa, you may be less skeptical. Here Donald Trump is reinforcing the perception that the probability of the U.S. defaulting on a loan should be approximately zero. This is good from the perspective of the borrower, since it should lead to a lower interest rate that the U.S. has to pay to borrow the money.

Image: What determines your willingness to lend money?
(Photo credit: quazie on Flickr)

The interesting portion of Trump’s statement, however, is how it affects the interest rate in a different way. If you’re lending money, you want to be sure that the money you’re paid back in the future will be able to buy more goods than you could buy with it today. This is the compensation for you delaying your purchase. You’ll therefore decide the minimum amount of interest you must be paid by examining how the rate compares to expected inflation. Trump’s statement seemed to indicate that the U.S. would be willing to print money to pay off current debts. While this makes it cheaper to pay off previous debts in the short-run, it means previous lenders aren’t getting as much buying power as they expected. In the long-run, printing more money unavoidably leads to inflation. Printing a lot of money leads to a lot of inflation. This devalues the currency, meaning you need to trade more dollars for the same number of goods. If you announce intentions to potentially print a lot of money in the future, then lenders will require a higher interest rate now in order to maintain the same amount of purchasing power after the value of the dollar decreases.

In the case of Germany, the German government advised citizens last August to stockpile food and water for ‘civil defense’ purposes. The statement was urging citizens to have 10 days of food and water in reserve, in case of a national emergency that temporarily cutoff supply lines. If people take this statement seriously, it could create some economically interesting short-term adjustments. The demand for stockpile-able items, such as canned food and bottled water, would increase as more people entered the market for these goods. As such, we would expect both the price and quantity sold of these goods to increase, in a short-term bump. However, this increased demand would presumably return to normal levels after the stockpiles were accrued. What would be even more interesting to observe is how producers of these goods read the signals of the higher demand, not knowing that it was only temporary. If suppliers misinterpret the short-term increase in demand as a permanent shift, then they may invest in long-term capital expenditures (such as new machines, larger plants, etc…) to try to keep up with the heightened demand. Unfortunately, these investments would soon prove unprofitable, as demand fell. All because people’s perceptions were changed by a simple statement.

Image: Germans were encouraged to stockpile food and water.
(Photo credit: Julie & Heidi on Flickr)
As you can see, it is not only concrete actions which can have a profound effect on an economy. Mere statements on a topic can alter people’s perceptions and expectations, and expectations form an extremely important part of our decisions on what actions to take today. As always, it’s important to think before you speak, and consider the ramifications of information you convey.

What’s your take on the impact the statements discussed above may have had? Have you recently changed your actions based on a change in expectations (perhaps you purchased a new car or television after your expectation of a raise or promotion at work increased)? Feel free to discuss in the comments below!