Currency Devaluations

For students in my advanced macro class, a real life example of the effects of currency devaluation on an economy:

http://www.nytimes.com/2011/10/06/world/europe/belarus-silent-protests-outlawed.html?partner=rss&emc=rss

We will talk more about this in the next class and the experience of The Gambia during the mid 80s.

On Prices and Price Control

In a free market economy like our own, few things as underappreciated as the prices of the products we buy. Very few people in our society understand how complex and subtle prices are. The price of a product is not just a number on a sticker attached to the cover of an item we want to buy, but rather a number that sums up a whole lot of information about that product, where it comes from, what it is made of, who made it, who wants to buy it and among a host of other information how much of it is left. Without a proper appreciation of the importance of prices, people in society tend to ask for policies that, on the surface seem legitimate, but upon closer inspection are deeply flawed.

The strength of prices lies in their ability to signal to both producers and consumers about the relative scarcity of a product. Since both parties (consumer and producers) are sensitive to price, price changes will affect their purchase (supply) of a product. Each morning we wake up and go to the shop to buy any number of items, bread, sugar, milk, gas to name just a few. And each time we go to the shop, we find those items there, waiting for us. We do not need to make a special order nor do we have to wait in an hour long queue. All we need is money and desire for the product and it is ours. Have you asked yourself how the rice farmer in Thailand knew you would want a 50 Kg bag of rice, or how the baker knew you would need a loaf of bread at 7 am every morning, when neither of them knows you? The answer to these and similar questions is that they do not need to know you or your need for rice and bread. Both of these producers are responding to price (and profit). For producers, a rise in the price of their product, along with constant production costs, means that their profit per unit increases. This increase in profits spurs producers to produce more and in some cases other producers to enter the market and start producing the good. The price rise could be due to any number of factors, but the outcome in this case should be an increase in supply by producers. The increase in supply should now reduce the scarcity of the product. On the other hand, rising price of goods leads to people cutting back on how much of it they buy, the law of demand. By cutting back on their purchase of an item, the scarcity of the product falls.

When a society does not understand the role prices play in their economy, then the society tends to demand certain policies from its government. With regards to prices, people demand their governments to control the price of goods, in essence to shackle the free market. It is not at all time that people demand price controls from their governments, but rather at times they perceive to be difficult for them. When prices start to rise (for most products) people start to feel poorer, for good reason since their incomes can now buy less than it used to. Price rises can happen for a number of reasons and the solution to the problem lies in the cause of the price rise. Price control is never a solution to rising prices but rather a cause for more serious problems.

When there is a general rise in the price level, those most vulnerable in society (the poor) ask for help from their government. They ask to be protected from “greedy” businessmen who are “out to exploit the common man”. If the pressure from this group is strong enough, a government usually bows to its demands and institutes price controls for a particular product(s). Price controls are of two types, price ceilings and price floors. In this post I will focus on price ceilings since it is the more common form of price control in our country.

Price ceilings

A price ceiling is a type of price control for a product wherein the government sets a maximum price, above which the product cannot be sold. We usually see this in the food market, for example rice, flour, meat etc. When the ceiling is set by the government, no one in the country can sell above that price. Doing so would lead to that person or the people engaged in that transaction to be jailed. The problem with price ceilings is that the ceiling is set at a price which is below the equilibrium market price. At the equilibrium market price, demand for and supply of the product are equal. If the price is set below the market equilibrium, then what ensues is a shortage. A shortage occurs due to the relationship between price and quantity (supplied and demanded). As mentioned earlier, a rise in price leads to producers having higher profits and supplying more of that product whilst consumers demand less due to their being able to afford less from their income. When a ceiling is introduced, the price of the product falls. The fall in the price leads to lower profits for suppliers which in turn lead to a reduction in the supply of the product by suppliers. On the other hand, consumers, now ecstatic due to the lower prices increase their purchase of the product. The simultaneous effect of falling supply and rising demand leads to there being a shortage at the new price.

The problem does not end with the shortage; rather this is only the first stage. After a shortage takes place, it occurs to people that there isn’t enough of the product to go around, but since price cannot adjust. It can no longer signal to producers that “people want more of your product, so produce more”. Therefore something else has to adjust to serve as a form of rationing. Along with providing us with information about a product, a price also serves as a form of ration where only those who can afford to buy the product at the market price get it. With our price control now on, sellers now have to find a way to sell the limited product they have among so many people. The most common form of rationing is first come first served. This type of rationing by sellers would lead to long queues around the country. Another way seller could ration is to sell to only their relatives, friends and neighbours. Yet another form could be their selling only to those in their ethnic group.

Following a shortage and the long queues, a black market for the product grows catering to those able to afford buying the product at above the government controlled price. Black markets are illegal and therefore anyone caught in that transaction would be arrested and imprisoned.

From the outcomes explained above, we can see that a policy once instituted to help the poor and vulnerable in society only ends up hurting these people more. With price controls, two markets would develop, the first a regular market which has little of the product and therefore very few will get it, and the second a black market where the product is sold at price above even the initial equilibrium market price. In both markets, poor people will find it extremely difficult to obtain the product. The irony is by setting a price ceiling to help the poor, society is in fact making it harder for poor people to buy the product.

Monetary Policy in the Current Environment

Central Banks have the unenviable job of trying to achieve conflicting goals, price stability, economic growth, low unemployment etc. In some cases, the economic environment is favourable and conducting monetary policy is fairly easy. In other cases the environment could be termed as hostile, where conducting monetary policy is tricky and the outcomes uncertain. Currently we are facing the latter. Although GDP has been forecast to rise by 5.5 percent, we are still faced with a fragile economy and rising commodities prices. The rise in commodities is not caused by an increase in domestic aggregate demand but rather world aggregate demand. This means that regardless of how much or little we demand, we will be faced with the same rising prices. In situations of rising prices, central banks raise the interest rates to slow down demand and ultimately inflation. The higher rates lead to higher cost of borrowing funds. The higher price of borrowing leads to businesses demanding fewer funds for investing from banks than before which in turn leads to slower output growth. In our current environment, with weak output growth, lowering interest rates should be the answer. Unfortunately lowering interest rates to spur growth might lead to demand pull inflation. This coupled with our imported inflation would just lead to more problems. On the other hand, raising interest rates to slow down inflation will be ineffectual at best and disastrous at worst.

In an ideal world, fiscal policy would be used to complement monetary policy. But if government is faced with budget constraints and interest payment equal to 20 percent of the budget, either raising government spending through debt issues or lowering taxes is not an option. In this case, there’s no short term solution. A currency appreciation would be a short term solution, although this would have a negative impact exports. In short, there is no quick fix to this problem and the job of a Central Banker would be termed as difficult as best.

Taxes

There are few things people hate more than taxes. It ranks up there with death and annoying relatives. Unlike the latter, taxes do have an important use. They serve as a form of income distribution, passing wealth from the wealthy to the poor. Taxes are also used to fund government activities such as regulation and investment in public goods. Regulation is needed in situations where market failure exists. Market failure is any situation that prevents a market from delivering an outcome similar to that which would exist in a perfectly competitive market. Market failure does not mean that the market has failed, only that the equilibrium output produced is below that which would have been produced had the market been perfectly competitive. Public goods are goods that have at least one of two properties, non rivalry and non excludability. I will get into that on another post

Although taxes have an important use, they are also distortionary. This means that they have an effect on the amount of goods and services we demand. In the presence of taxes, less goods are demanded by consumers and less labor is supplied by workers (although lower labor supply might not always be the case). In economics, we are taught that lump sum taxes are better than proportional taxes. Lump sum taxes do not have an effect on the ratio between the amount of goods and services we demand. Proportional taxes on the other hand act as if there is an increase in the price of a commodity, in this case altering the price ratio between two or more goods (or labor and leisure).

Higher taxes have the effect of lowering a person’s disposable income, the amount of money they take home after taxes. The lower disposable income means that spending by that person has to go down, or saving has to fall or both fall. The reduced spending extends to everyone in the country that has been hit by the higher tax rates, as a result, spending goes down in the economy. With people spending less than they did before the taxes rise, businesses will now be faced with goods that are not being sold. This would not be the case if the tax rise was anticipated well in advance. If businesses did anticipate the tax rise, they would reduce production knowing that aggregate demand would be weaker. On the other hand, if the tax rise comes as a surprise or with little time for businesses to adjust, then inventory will pile up. With inventory pilling up, firms will demand less good from their suppliers, and the suppliers will demand less from theirs and so on and so forth. The end result of this process is that less goods and services will be produced than were before the increase in taxes. The lower production by firms means that profits will be down and costs have to be cut. The typical response from firms when faced with cost cutting is to lay off staff. Keeping the staff would lead to the firm having too many workers. This in turn leads to lower aggregate income and lower consumption which leads to lower aggregate demand.

There is an upside to lower aggregate demand although it might not be seen as that by firms. Lower aggregate demand means that firms will invest less in capital than before, which leads to lower costs of capital and lower interest rate from banks. It also means that price rises (inflation) will slow down. If the economy is faced with imported inflation, then lower aggregate demand will not reduce inflation.

Imported inflation refers to the rise in the price of goods and services that are imported. The rise in price of these goods means that even with a stable exchange rate, these goods will cost more to buy at home. If that good is an input to production, say oil, then the rise in price will affect any good that uses it as an input in production. The goods using that input should also see an increase in their price. This pushes up prices at home as well, since imported goods are part of the basket of goods that people will buy. The more open a country is, the more imports and exports make up a large portion of GDP, the larger the pass through of import price inflation to domestic prices.

If an economy, as mentioned above is faced with imported inflation, then the result will be lower aggregate demand, slower (or even negative) GDP growth and higher inflation eroding people’s income even more. If people are faced with this situation, assuming they are rational, they must adjust their preferences to the new conditions they face. With disposable income being less than it was, workers are faced with two options, either reducing work hours because work does not pay as much as it used to or finding other ways to met the shortfall in income.

The first option seems more likely when taxes are extremely high and inflation is fairly moderate. The latter option seems more like when taxes are fairly high, inflation also high and people think what they earn is not enough to meet their needs. For those whose income is proportional to the amount of time or effort they put into the work, working more hours will help to raise income to meet this short fall or keep up with rising prices. For those in business (small and medium), raising prices to increase profits is an option, although they can’t raise prices indiscriminately since they are faced with a weaker aggregate demand. Those who’s wages are fixed by contract have less options. Negotiating for higher wages in a slowing economy is very difficult even with inflationary pressures pushing down real wages. Being rational individuals, these people will seek to find ways of increasing their take home pay without directly asking for higher wages. Moonlighting or shirking at work to run “personal businesses” are just some of a few things they will do to maintain their take home income.

This shirking will mean that less time will be devoted to formal work and more time to informal activities that generate income. The end result will be more distortion in the labor market.

An Old Piece I Once Wrote

Yesterday in class, I referred to a piece I wrote about a year ago on trade rules. I think I was talking about taxes and subsidies, can’t remember, but I promised to post the piece up for those interested. Here is the piece.

“Brikama direct” as Rationing

Gomadi Yalla, nyaka hel and bugay (Atheism, Stupidity and Greed) are just a few words used to describe the decision of drivers to take certain passengers and leave others. For those who still do not have a clue as to what I am talking about, below is a concise explanation of the situation.

Taxi drivers, especially those plying the Westfield Brikama route have taken it to only take passengers either going to Tabokoto or Brikama. There are a host of towns and villages between Tabokoto and Brikama; Lamin, Banjulnding and Yundum to name just a few. This has caused a lot of stir amongst people and a number of reasons for why drivers are doing this have been given. The first is that drivers are no longer God fearing and hence are taking advantage of desperate passengers. The second is that they are not smart and do not know that they would make more money if they took Lamin and Banjulnding passengers. The third is that they are greedy and want to make more money than they should.

Each of these theories has a flaw. Taking the first, I find it hard to believe that drivers have always been motivated to do good for us. That they engage in driving for the good of the nation. That has never been the case nor is it now. I firmly believe they are as self interested as are we all are. The prospect of making a decent living is what has driven them to well... drive. On the second point, it would be a mistake to think that we know more about the business of driving than drivers. If we agree that an accountant knows more about book keeping and financial statements than a non accountant and carpenter knows more about making furniture from wood than someone who isn’t a carpenter. Why do we believe that we as a people know more about the business of driving than drivers? Another point that goes against this theory is linked to self interest. Drivers want to make more money. If they knew that they would make more money by switching their strategy (i.e. taking from Lamin and Banjulnding) then they would. If not every single one of them, most would.

The third theory, greed looks to hold up. The problem with this point is similar to that of the first. To claim drivers are greedy now is to claim that they were either not greedy before or less greedy. I won’t bore you with arguments about changes in population characteristics over time and the like, but to think that drivers alone of all Gambians have become greedier independent of all Gambians is quite hard to believe. As if there was a strange disease called greed that infects only Gambian drivers making them act in such a way, leaving the rest of us non drivers sounds a bit implausible.

Two thirds of the Gambia live on 17 percent of the country. That means that almost 1.2 million Gambians live between Banjul and Brikama. Imagine that more than half of these people have to either go to school, work or the market every morning. They also have to go back home every evening as well. Imagine also that there are not enough cars to move all these people at the same time. What does one do? In a free market, the price of entering a van would rise to the point that supply equated demand. Prices are a form of rationing and if prices do not adjust, then some other form of rationing must be done. This is where the Brikama direct comes in.

Drivers know that demand exceeds supply yet they cannot charge a higher fee. They also cannot increase capacity, meaning they cannot take more than their legal limit (in most cases 14 passengers). The aim of the driver would be to pursue a strategy that would minimize costs and or maximize revenue under this new environment. Given the nature of the passengers on the journey, the strategy that would reduce costs would be to take the passengers that would require the least stops. More stops would mean a longer journey and more fuel consumed. In terms of maximizing revenue, a driver would make more money by taking a passenger directly from Westfield to Brikama (D12) than by taking two passengers, one from Westfield to Lamin and another from Lamin to Brikama (D10).

During peak hours, i.e. morning and evening, drivers pursue this strategy of taking only “direct” passengers. This does not last all day as drivers return to taking passengers that are stopping en route during off peak hours.

This explains why drivers refuse to take certain passengers during rush hour whilst taking those same people when it is not rush hour. Someone would be tempted to interpret the driver’s decision to maximise profits by taking only direct passengers as greed, but the thinking of the driver is no different in rush hour than when it isn’t rush hour. This strategy is called profit maximization, and it is what every business tries to do. The excess demand has given drivers the power to choose who they will take. The inability of fares to rise means that another form of rationing must take place. In this case the rationing is “Brikama direct”.

Transportation in The Gambia Part 1

The other day, on my way to work, I had a lift. I live at Banjulnding and for those who live after Tabokoto, the site of throngs of people standing on the road early in the morning waiting for a van is nothing new. Not for the man giving me a lift- more used to using the Kombo Coastal road to work. His first reaction upon seeing all those standing at NTC Lamin was to ask “Are all these people waiting for a van?” I was fairly amused when I heard that question for it wasn’t something I expected to hear. To me it was so obvious that I barely even noticed it, it was a part of what one had to put up with to get to work.

Later that day I couldn’t help but think of the causes and possible solutions to that problem. As an economist, I thought to look at theory for an initial starting point. Two causes sprang to mind, Government regulation and Agency problems. Imagine to my surprise reading a news story a few days later online about a company being setup in The Gambia to deal with the latter problem. Here is the story about Fangsoto Transport Services. The basic idea of this company is to solve the agency problem that arises from vehicle owners hiring drivers to drive their vans.

Agency problem refers to a situation where the owner of an asset hires someone else to use that asset to make money. The owner of the asset Is the Principal and the one using the asset, the Agent. A classic example of a principal agent relationship is the limited liability company. The shareholders (agents) who do not run the company, own it, whilst the managers (agents) run the company but do not own it. In this relationship, there is a clear conflict of interest between the two parties. Both would like to have as much of the profits generated from the assets as possible. For every Dalasi the principal takes from the profits, there is D1 less for the agent and vice versa. This problem is further compounded by another problem, Moral Hazard. In using the assets of the Principal, the Agent knows that it will be very difficult for the principal to monitor him. He can therefore take more risk than he would otherwise take knowing that higher risks yield higher returns. The best part of it for the agent is that he will be taking risks with someone else’s asset. If it succeeds, he gains more, if it fails he loses nothing. This problem of the agent taking on more risk than he otherwise would have taken had he been monitored properly is called a Moral Hazard problem. The conflict of interest that occurs between the principal and the agent is called the agency problem.

In the case of the transport industry in The Gambia, the agency problem and moral hazard are closely intertwined. The inability of the owner of the van to observe the driver means that the driver can declare to have less income than he actually made, or work less hours. This has led owners to now hire apprentices that they trust to oversee the driver- this also has its own problems which I will talk about in another piece. There is no incentive for a driver to take proper care of the van knowing that it is not his. If the care breaks down, the cost of repairing it does not come from his pocket, therefore he can push the van to its limit in order to make more money for himself at no risk to him (although one can argue he is risking his life).

The Fangsoto Transport Services tries to solve these problems by being an intermediary. An intermediary is a person or institution that stands between two parties. In this case the principal and the agent.

“Once you sign an agreement with us, we take proper care of your vehicle, appoint a driver and will be responsible for maintenance services, and as the owner, you can collect your money on weekly, monthly

“Drivers do not have the trust and confidence in vehicle owners, which result to care free driving and carelessness in the manner to control such vehicle

They try to solve these problems- agency and moral hazard- by taking being able to select good drivers and to monitor them whilst they are working. Their ability to do these two at a lower cost than vehicle owners allows them to make a profit. I failed to mention earlier that monitoring is possible in a principal agent relationship. It is only that monitoring is prohibitively expensive and it eats into profits.

It’s great to see that the things we learn in class also apply to the real world. Something I have been trying to get my students to appreciate for some time now. Economic theory tells us that there are a number of ways that the agency problem can be solved. Making the incentives (in this case profit) of the principal and agent compatible is one way. Another is through the use of government regulation. It is great to see someone coming up with an idea to solve the problem whilst using the free market mechanism. I wish more people looked to solve society’s problems using market mechanisms instead of government intervention

Site Move

The University of The Gambia is now using Google apps (Google sites included). I have decided to move my work related posts to that site. For those students taking my courses, you can access the site here. I will still be maintaining this blog, but most of the posts will not be related to my UTG work but rather my personal writing and observations. I made a new year's resolution to write more, so I hope to post something at least once a week.