Economics help blog – Page 163

Scotland post referendum

18 November 201719 September 2014 by Tejvan Pettinger

An independent Scotland would have made an interesting economics case study. How would Sterlingisation or a Currency Union have affected the Scottish economy? Now we may never find out. There were undoubted risks involved, though I’m not sure how much the issue affected the outcome. The Eurozone is also an interesting economics case study, but …

Currency substitution – Dollarisation / Sterlingisation

3 April 201915 September 2014 by Tejvan Pettinger

Currency substitution occurs when a country uses another currency without any official backing and without a Central Bank – instead of using its own currency.

For example, Panama uses the US Dollar as its currency. Even though it has no formal currency union with the UK. Jersey uses Sterling unofficially too.

The advantage is that a country like Panama gets to use a currency which has a stable value and international respect. The disadvantage is that it has little control over monetary policy and doesn’t have a Central Bank to act as lender of last resort to print money during periods of liquidity. Also, you lose the ability to devalue the exchange rate (which some may argue has advantages too)

Sterlingisation for Scotland

If Scotland vote for independence, Sterlingisation is seen as the best outcome for an independent Scotland. (Possibly as a precursor to a second stage where Scotland creates its own Central Bank and print its own ‘Scottish Pound’)

Sterlingisation would mean Scotland continues to use the Pound, but without a Central Bank as lender of last resort. It also means monetary policy would be set by the Bank of England.

Does it matter if Scotland doesn’t have a lender of last resort?

Given the problems of the Eurozone in recent years, there is an unfortunate precedent of countries being severely damaged by a lack of a Central Bank willing to act as a lender of last resort. However, there are two possible factors which could help Scotland.

Firstly, some argue that having no Central Bank encourages banks to act more responsibly and avoid taking on excess risks. The Adam Smith Institute have produced a paper which is optimistic about the potential of ‘Adaptive Sterlingisation’ arguing that the period of free banking in Scotland in the eighteenth century was largely successful – with banks secured by shareholders. – How sterlingization and free banking could help Scotland flourish at Adam Smith – Institute.
Would the Bank of England want to allow banks in the British Isles to fail? If Scotland gained independence, the Bank of England would have no compulsion to act as lender of last resort, but the UK banking systems is closely integrated; a collapse in confidence north of the border would have implications south of the border too. Would the Bank of England want to allow a failure of our near neighbour – when the financial and economic fortunes of the two countries are so closely tied together?

Difficulty in switching from fossil fuels and oil

18 November 201715 September 2014 by Tejvan Pettinger

Question and answers on the difficulty of switching from non-renewable energy sources, such as fossil fuels. (from – finding alternatives to fossil fuels)

Readers Question: Why is it that on a global scale, alternative fuels are somewhat being ignored?

Firstly, fossil fuels are still cheaper. However, the gap is narrowing. For example, see how solar panels are coming down in costs.

There can be a reluctance to switch from one mode of production to another. Even if an alternative became cheaper, it requires significant investment to switch from one mode of power to another. For example, the UK kept steam trains running into the mid 1960s. Diesel was more efficient and cheaper many years previously, but it required a lot of investment in infrastructure to buy new diesel trains. Often it’s easier to keep going with old technology out of habit and merely because it is what has been used in the past. In some parts of the world, steam power is still used.

But, on the other hand, if we look back in history, we can see that a dominant technology can quite quickly lose its position. America quite quickly switched from steam trains to the petrol powered car. Once a tipping point is reached the momentum can swing to the new technology.

Also, a factor is that oil and petrol companies are very profitable and it is in their interests to keep oil based industries strong. If they can delay a switch to alternative fuels they might try. How much ability they have to delay an energy switch is open to question. But, there are powerful lobbyists to support the US coal and oil industries.

Readers Question: If it is not being ignored, Why is research and development is somewhat slow?

Alternatives to fossil fuels are generally not profitable in the short term. Therefore, private enterprise has limited incentives to research alternatives. This is an example of market failure, because the market ignores:

The long term importance of developing alternatives to fossil fuels, which will one day run out.
The external benefits of developing alternatives to fossil fuels, e.g. improvement in environment and reduced pollution.

Scotland in the UK

18 November 201713 September 2014 by Tejvan Pettinger

Generally I try and remain politically uncommitted. But, in the past few weeks, I’ve been surprised at how much the issue of Scottish independence has affected me. Despite a mental desire to feel nationalistic identity as unimportant, I feel deep down it really means a lot – and I hope Scotland votes to remain part …

EU inflation and deflation

18 November 201712 September 2014 by Tejvan Pettinger

The Eurozone inflation rate is 0.4% (ECB database) (Sept 2014) Eurozone HCIP inflation rate HCIP (Harmonized consumer index prices) Source:| (ECB Inflation graphs, sometimes a few months outdated) Food inflation Food inflation is currently negative. Food inflation tends to be one of the most volatile components. This negative food inflation is one factor reducing the …

The problems of a Scottish currency union

17 January 201810 September 2014 by Tejvan Pettinger

If Scotland gains independence, the Yes campaign has argued that their preferred option is to keep the Pound Sterling and enter into a currency union with the rest of the UK.

This means sharing the same currency Pound Sterling, and having the same monetary policy. Monetary policy would continue to be set by the Bank of England. There would be no exchange rate between the two countries.

Currency Union with the rest of the UK

However, currency unions are problematic. The Eurozone has been a disaster for many European countries who have been saddled with high unemployment and stagnant economies. See all problems of Euro here.

A big problem with currency unions is that in the absence of a lender of last resort, you face pressure to limit budget deficits. Since the Euro was created, Southern Europe has been pushed into more austerity than is desirable. It has left their economies vulnerable and with limited options to deal with trade imbalances and economic downturns.

The Bank of England governor, Mark Carney insisted a currency union with a sovereign, independent Scotland was impossible. “You only have to look across the Continent to look at what happens… A currency union is incompatible with sovereignty.” (Guardian)

Paul Krugman has stated there are great risks of sharing a currency.

Economists (starting with my late colleague and friend Peter Kenen) have long argued that sharing a currency without fiscal integration is problematic; the creation of the euro put that theory to the test. And the results have been far worse than even the harshest critics of the euro imagined, with euro Europe doing worse at this point than Western Europe did in the 1930s:

Krugman goes on to argue that Scotland’s position could be worse than the Eurzone because there is no guarantee that the Bank of England will be interested in acting like Mario Draghi in his support for debtor countries.

An independent Scotland would be dependent on the kindness of the Bank of, um, England, with no say whatsoever in that bank’s policy. (Scotland and the Euro omen)

Currency unions also exacerbate political tensions. People in southern Europe feel let down by economic policy of the ECB and northern Europe. Germany on the other hand is not happy with the perceived need to bailout its profligate neighbours. Currency unions have not been an effective system for encouraging harmony amongst nations – in fact the opposite. There is a real fear that after independence – Scotland could feel exacerbated and frustrated at being at the mercy of English monetary policy.

But could a currency union between Scotland and the UK work?

There are some reasons to believe that a currency union between Scotland and the UK would work better than the Eurozone.

Firstly, there is much better labour mobility between Scotland and England than say between Greece and Germany. If the Scottish economy is relatively depressed, workers could move south and vice versa.

A big problem of the Eurozone was the divergence in wage costs and relative prices. This left southern Europe uncompetitive but without the option of devaluation to restore competitiveness. This is perhaps less likely to be a problem between Scotland and England. If there is a significant divergence in wage costs, readjustment is easier because of the greater capital and labour mobility.

Reasons firms invest in very competitive markets

18 November 20174 September 2014 by Tejvan Pettinger

Readers Question: Why invest capita in purely competitive industries with equilibrium margins that are razor thin and entrants that erode quasi profits? Suppose volume is not exceptionally large, why then?

Economic theory suggests that firms will invest in industries where there is supernormal profit being made. Investment will be more attractive in industries where there is a degree of monopoly power and higher profit margins.

However, in the real world, firms can make decisions based on other factors and decide to enter an industry with low profit marigins.

Why might a firm invest in a very competitive market with low profit margins?

Self belief. An entrepreneur may have great self-belief that it can do better than all the incumbent firms. For example, the coffee shop market may be very competitive in a certain town, but someone with great passion for coffee may feel he can still do it better than all the incumbent firms. Therefore, even though the market is already competitive, they may still enter. This is something that economic theory may not give too much weight to – personal ambition, pride and self-belief – but it is a quite common that people think they can just be better than the competition. This self-belief may even be a motivation for a firm to enter a loss making industry. It’s not quite the same, but recently restructuring specialist Hilco tookover HMV – a record shop making a loss. But, Hilco had the confidence to turn the firm around; initial reports suggest they have been successful.

Expand the market. An entrepreneur may see a very competitive market with low profit margin, but feel they can still expand the market. For example, in the 1990s, the coffee shop industry was probably quite competitive with a low profit margin. But, Starbucks still saw a gap in the market and opened a lot of new coffee shops (often right next to existing coffee shops). They felt they could grow the market, sell extras and increase profit margins. That industry has expanded and become more profitable in recent years.

Multinational companies can afford low profit margins. Many entrepreneurs would be reluctant to risk entering a market with very low profit margins. However, some big companies can afford to enter an industry even if they don’t expect to make much profit. For example, big supermarkets entered the petrol retail industry. They drove down already slim profit margins. Petrol retail is not there core business. They are probably happy for petrol to be a ‘loss leader’ to attract customers to the store. In other words, people come to fill up with petrol at Tesco, and then spend £80 to do their weekly shop. The profit on petrol maybe zero, but if Tesco gain more customers spending £80 on groceries it is a good business decision. It wouldn’t make sense for someone to set up an independent petrol station because profit margins are so poor (in fact many independent petrol retailers have closed down in recent years) There may be many other examples where multinationals feel there is strategic benefit to entering a competitive market with low profit margins.

Competition in the seafood industry

18 November 20173 September 2014 by Tejvan Pettinger

Readers Question. I came across a company recently which farms mussels of the coast of a small town in Bulgaria, and I started thinking about its structure in the economy. I know since it produces a homogeneous product along with hundreds of other mussel farmers, it must be in perfect competition, however this mussel company also sold locally on top of selling to suppliers. This means it was the only mussel supplier (locally) in the town, and as far as I know that’s a monopoly. My question is, what would this company’s graphs look like? Would it be more like a perfect competition, or a monopoly? Although it is the only supplier in the town, it sells the mussels at the same price if not cheaper to locals as it does to suppliers, which I know unlike monopolies. Would there be any deadweight loss in a company like this? Is it inefficient or is it more efficient than normal? Consumers can buy mussels from the supermarket, but local supermarkets all get their supply of mussels from this one local company. Please help me understand!

Firstly, this is the first time I’ve been asked about the Bulgarian mussel market so I can’t claim any specialist knowledg.

But, Selling mussels does look like it exhibits features of perfect competition.

There are many farmers (sellers)
It is an homogeneous product
Buyers are likely to have good information about the product and price.

The market price is likely to be determined by a simply supply and demand curve

Selling locally – Is it inefficient or is it more efficient than normal?

If the local mussel farm sells to a local town, I don’t think makes it a monopoly. I’m sure that local restaurants and supermarkets could choose to buy from other distributors. But, local restaurants probably find that the local mussel farmers can undercut distributors because effectively they are cutting out the ‘middle man’ and transport costs

If the local mussel farmers sold above the nationwide price, restaurant owners would buy from the more traditional distributors. So there is still a degree of competition.

In this sense it is more efficient than normal because you can go from supply direct to retail, and cut out transport costs and the efficiency loss of selling on to a distributor.

In one sense the mussel farmer may have local monopoly power, but this is far outweighed by the lower costs and greater efficiency of being able to supply direct to the local market.