Four Types of Industry Structure

If you're an aspiring business person, the level of competition is one of the most important things that you should look at in choosing a business or market since more intense competition among players in an industry typically results in lower profit margins; the reason why astute business persons like MVP aggressively seek dominant market positions and less competition is to be able to have greater control over pricing and profits. 

Industry or market structure is primarily defined by the number of competing firms or sellers, and to a lesser degree, the types of products offered by the firms. In this post, I will discuss four main types of market structure; hopefully, this post will be able to help you better evaluate businesses that you are thinking of pursuing in the future.

Number of firms	Type of product
	Identical products	Differentiated products
One firm	Monopoly	-
Few firms	Oligopoly
Many firms	Perfect competition	Monopolistic competition

1. Perfect competition

A perfectly competitive market has the following characteristics:

• There are many buyers and sellers (i.e., firms) in the market
• The goods offered by the various sellers are largely the same
• Firms can freely enter or exit the market

Because of these characteristics, the actions of any one buyer or seller in the market would have very little impact on the market price and firms just take price as given. Also, in perfectly competitive markets prices and margins tend to be low since, in theory, the only way for a seller to attract more buyers and generate more sales is to reduce prices (particularly if there's no effective way of using marketing strategies to differentiate the product).

2. Monopoly

A firm is considered a monopoly if

• It is the sole seller of its product
• Its product does not have close substitutes

The fundamental cause of a monopoly is barriers to entry. Barriers to entry have three primary sources:

• Ownership of a key resource. Although exclusive ownership of a key resource is a potential source of monopoly, in practice monopolies rarely arise for this reason.
• The government gives a single firm the exclusive right to produce some good (or render a service). Governments may restrict entry by giving a single firm the exclusive right to sell a particular good in certain markets. Patent and copyright laws are two important examples of how government creates a monopoly to serve the public interest.
• Costs of production make a single producer more efficient than a large number of producers. An industry is a natural monopoly when a single firm can supply a good or service to an entire market at a smaller cost than could two or more firms. A natural monopoly arises when there are economies of scale over the relevant range of output.

The most important advantage of being a monopolist is that it can set prices without regard to how other firms respond. Thus, while a perfectly competitive firm is a price taker, a monopoly firm is a price maker. 

3. Monopolistic competition 

Monopolistic competition is a market structure where many firms are selling products that are similar but not identical. A monopolistically competitive firm’s products may be differentiated due to factors like geography (when consumers prefer stores that are convenient to reach) or the idiosyncratic preferences of buyers (that is, if tastes differ markedly from one person to the next). These slight differences enable firms to charge higher prices and still attract buyers. This opportunity to profit in the short run encourages new firms to enter monopolistically competitive markets, which may eventually lower profits and move the industry closer to perfect competition.
4. Oligopoly 
An oligopoly market is characterized by few sellers offering similar or identical products. While it's possible for competition to be intense even when there are only a few or a couple of players, which places the industry closer to perfect competition (think the local telco industry prior to PLDT's acquisition of Digitel), sometimes firms realize that it's in their best interest to cooperate, and even collude when the law explicitly requires them to compete. When sellers in an oligopoly act in concert, the market becomes a quasi-monopoly since firms are able to set higher prices for greater profitability.

So, given these types of industry structure, as a prospective (or already practicing) entrepreneur these are some things that you have to keep in mind:

• Choose monopolistic or oligopolistic businesses for greater profitability. You do not have to have MVP's resources to achieve this--just remember Porter's Five Forces and choose industries with high barriers to entry (for other entrants) and a low threat of substitute. 
• While it's easier said than done, the best way to achieve monopoly profits is to innovate and create a business that can't easily be emulated. While intellectual property laws in the Philippines may still be limited (or maybe just the enforcement of these laws?), still always try to use them to protect your business.
• Or if you're already in a particularly competitive industry, try to differentiate your product and not just compete based on price. Enter unexplored geographic markets or be a niche player and change the product enough to suit particular tastes.
• If you think it's easy to copy your business but no one is doing it yet, you can enjoy "first mover" advantages and command higher margins for a while. But be ready for an exit strategy and execute this as soon as the market becomes saturated (innovating/improving your product may be considered one such strategy)
• Avoid perfectly competitive markets at all costs! Ask yourself this question: Why would a customer buy this product from me? If the only answer you can think of is "because my price is lower," then in all probability you'll just be wasting your capital, effort, and time if you start this business.

Why Do We Spend So Much Money on Stuff?

STUFF I LEARNED FROM Robert and Edward Skidelsky's How Much Is Enough? Money and the Good Life

In investigating why people seem to have lost sight of the quest for the "good life" (as articulated by Keynes in his 1930 essay "Economic Possibilities for our Grandchildren"), the authors look for explanations for insatiability and conspicuous consumption. This search leads to the pioneering work of Harvey Leibenstein more than half a century before credit cards and online shopping: "Bandwagon, Snob, and Veblen Effects in the Theory of Consumers' Demand." Here, Leibenstein posits that apart from the "utility" that a good or commodity directly provides--a concept which is at the heart of classical consumer theory--buying decisions are also affected by external effects on utility which the author refers to as the "bandwagon" effect, the "snob" effect, and the "Veblen" effect.

The bandwagon effect pertains to how demand for a good is increased because other people already have it. It is borne partly of conformity--"keeping up with the Joneses"--and partly of envy. Both mechanisms are strong in children, which may cause parents to work harder to satisfy this want, and in individuals and households with limited means or of lower socio-economic standing. Examples include everything your neighbor has which you don't have and makes you salivate.

How do we begin to covet, Clarice?

The snob effect, of the other hand, is the exact opposite of the bandwagon effect: it refers to the extent to which the demand for a commodity is decreased because other people (or too many of them) already own it. It follows, of course, that "snob goods" are desired because others do not have them; they are not necessarily the most expensive, but mark their possessors as having superior taste. This effect represents the desire of people to be exclusive and to stand apart from "the crowd." Examples include everything marketed by Apple.

Despite being polar opposites, snob goods can easily transform into "bandwagon goods," leading to their abandonment by the snobbiest of the snobs.

The Veblen effect (named after American economist and sociologist Thorstein Veblen) overlaps the two effects above: it pertains to the extent to which the demand for a good is increased because it is expensive and known to be expensive. Like bling on your favorite hip hop artist, Veblen goods are simply advertisements of wealth. Examples include everything you don't need and cannot afford.

"I Am Rich." Remember this?

To clarify, there's an important distinction between the snob and the Veblen effect--the former is a function of the consumption of others, the latter is a function of price.

I know how hard it can be to avoid or even just lessen the above effects on our spending decisions: after all, the opinions of people we interact with do matter to some (or a great) degree. Just remember that continuously succumbing to bandwagon, snob, or Veblen effects will just compromise our financial capabilities and delay our journey towards the good life.

A Lesson in Economics from Calvin and Hobbes

This comic was made by Bill Watterson some 20 years ago. I said it once, and I'll say it again: Calvin and Hobbes was way ahead of its time.

18 Nobel-Worthy Insights from My Conversation with Dr. Joseph Stiglitz: Asian Financial Forum 2012, Part 3

ASIAN FINANCIAL FORUM 2012 SPECIAL

Dr. Stiglitz and veteran news personality Lorraine Hahn. Photo taken with my crappy cellphone camera which doesn't give Ms. Hahn's extraordinary beauty justice

A quick run through for insights 1 to 9:

1. Everyone's spooked because China's growth in 2011 was just 8% to 9%.

2. All eyes on Asia.

3. What a 0% savings rate really means.

4. What is saved in Asia should stay in Asia.

5. What "savings glut"?

6. Breaking something that ain't broke.

7. A case of diversification making things worse.

8. The problem with too-big-to-fail banks is that they are too big to fail, and everyone knows it.

9. The reason why we still haven't achieved transparency for complex financial products like credit default swaps and other financial derivatives is that that is how these people make money from these things.

And now for the much awaited continuation of this special series...

10. Restoring confidence in the US economy is a matter of green shoots turning brown. Economic recovery cannot be achieved with just a speech--especially if the facts disagree with what you're saying. For example, one oft-cited statistic is how unemployment has gone down from 9-point-something to 8-point-something percent the last time someone counted. Experts have interpreted this "dent in unemployment" as a sure sign of US economic recovery. But if you take a closer look at the numbers, the main reason for the decrease in the metric is that some people gave up looking for a job, so technically they don't count as unemployed anymore. The sad reality is that one out of every six Americans who want a job cannot find one...

11. One way to bring about economic recovery in the US is to restructure the economy and focus on increasing real productivity. That is to use less resources for the same output, particularly in agriculture and manufacturing.

12. Debt should be the least of the US's worries, if only because interest on US debt is very low at almost zero for short term debt and 3% for long term debt.

13. Austerity is to the economy as "blood letting" is to a sick person in the middle ages (or in Westeros, just ask the Boltons - IJ); as blood is drawn from the sick person, he or she gets worse, and medieval doctors respond with, wait for it--more blood letting! In other words, "austerity" or slashing spending will only make things worse for the American economy. At least until the poor soul finally dies. What the US should do instead is take advantage of low interest rates and invest in more value-creating projects, which are often just right under everyone's noses. Also, raising taxes and increasing spending actually increases GDP more than any austerity plan--if only it weren't for some genius politicians...

14. The end of the euro? Maybe we should not be so surprised. When the Eurozone was formed, economists were skeptical of whether or not it will prosper. Why? There's actually some sort of checklist for when it's appropriate for a group of countries to adopt a single currency. Guess what? These Eurozone countries did not satisfy these criteria.

15. Ratings agencies only contribute to the woes of Europe and the rest of the world. It is their moral responsibility to ensure that complex financial products are as transparent as possible. Unfortunately for all of us, in this case the "less moral" has outbid the "more moral", as is almost always the case.

16. Asia is in a good position to play an important role in the drive for global economic recovery. We cannot insulate ourselves forever; fortunately, when there's a need, we are capable of responding with policy in a timely manner. Also, since there's still a vast, undertapped domestic market in many parts of the region, growth is still possible. It definitely won't be easy, and it would only work with constant vigilance.

17. Where's China in all of this? Domestic spending should increase, and savings go down. Not for households, though. With higher wages, they should be able to maintain an ample savings rate and spend more at the same time. The Chinese should not go overboard with consumption, though. If China follows the US's patter of consumption (recall: a whopping 110% of income spent), then we are all doomed.

18. The issue of income inequality is not the politics of envy, as what many right-wing politicians declare in their speeches. More and more Americans are getting worse off year after year. One would find income inequality on other parts of the world, yes, but different. China may have more inequality if one uses a measure like the GINI coefficient, but for many Chinese poverty has been greatly reduced--and that's a good thing. And this difference suggests that the "degree of inequality" may not be as important as the "equality of opportunity", which is very lacking in the US where there are now very few opportunities for a great majority of the population to move up in the world. 

If only all economists were like Dr. Stiglitz... or, at least, if only world leaders listened to economists who think and reason as he does... We would be living in a very different world, where green shoots grow and bloom and don't turn brown very quickly--I think.

18 Nobel-Worthy Insights from My Conversation with Dr. Joseph Stiglitz: Asian Financial Forum 2012, Part 2

ASIAN FINANCIAL FORUM 2012 SPECIAL

Photo courtesy of Val Roque

Well, if you want to be strict about it, it wasn't really a conversation, although I'd like to think of it as one.

Dr. Joseph E. Stiglitz is a Professor of Economics at Columbia University and former Chief Economist of the World Bank. In 2001, he received the Nobel Prize for Economics for his pioneering work on the consequences of information asymmetries (the basis of a popular capital structure theory, if my finance students would recall). He was the keynote speaker for the second day of the 2012 Asian Financial Forum, where he talked about a diverse range of topics--from how the "slower" growth of China in 2011 is not really so bad if you think about it to the Occupy Wall Street movement and inequality in the US. After his address, there was a one hour "open dialogue," which was basically just a Q&A, where I got to have "a conversation" with him (I fielded the first question from my front row seat :)). In this post, I will share some Nobel-worthy insights from Dr. Stiglitz, ideas that are definitely worth hearing and will hopefully make us think deeper about things that are going on around us.

1. Everyone's spooked because China's growth in 2011 was just 8% to 9%. Thirty years ago, people didn't even think that that kind of growth was possible. Get a grip, people, there's no need to worry. First of all, a big part of that "decrease" in growth was just caused by a change in the way things are measured, so it's not really a decrease. And even if China's growth has indeed slowed, it's all well and good because at least now this growth is more sustainable.

2. All eyes on Asia. In the 1820's, Asia's share of global GDP was 45%. Since then, with the onset of colonialism and unfair trade agreements, that share plummeted to under 10%. So we can just interpret the recent rise of Asian economies as a "rectification" of a 200-year anomaly.

3. What a 0% savings rate really means. Yeah, so that's the current average savings rate in the US. But take note that that's an average figure, and that rich Americans--the so-called "1%"--actually do get to save a bit, somewhere around 5% of their income. So how do we get to zero? The gap is accounted for by how the "bottom" 60% of Americans spend 110% of their income, which is basically a savings rate of negative 10%. That means around 190 million Americans spend more than they earn and live off debt, which may make sense if you take into account that debt in the US is actually very cheap (at least up to 2014, if the Fed is to be believed). Sadly, that "cheap" debt is actually financed by the savings of hardworking Chinese and other Asians...

4. What is saved in Asia should stay in Asia. The average savings rate in China is 50%. China is the world's largest saver and second biggest economy. Doesn't it make sense then that we manage these funds in Asia instead of anywhere else? Before 2008, Asian savings were "transferred" to the US and Europe and placed in the care of big multinational financial institutions for professional risk management, and just transferred back to Asia whenever there's a need for the funds (at a hefty commission, of course). 2008 happened, and everyone now knows how good these US and European institutions are at managing risk. Not.

5. What "savings glut"? That's what the Fed says, that's its explanation for what's been happening since 2008. But how could there be a savings glut when we see a lot of savings needs around the world, particularly in Asia. If you want to point fingers, point to how these these funds were mismanaged, particularly at how Asian savings were basically just used to finance a housing crisis and two expensive wars in the past decade.

6. Breaking something that ain't broke. For four decades after the Great Depression, financial regulation worked in the US. Then these geniuses who were supposed to overlook financial institutions for the general public came up with the idea of deregulating financial markets. So all the finance talent focused on developing "innovative" financial products that made a lot of money, yes, but led to no real productivity whatsoever.

7. A case of diversification making things worse. Diversification is supposed to make things safer by spreading risk among many "baskets": when one basket falls, at least there will still be some eggs left. Maybe this was the rationale behind letting financial institutions spread their reach to various continents around the world. Unfortunately, instead of spreading risk among a bunch of baskets and making things safer, everything just became connected to everything else, forming one global electric grid where if one part fails, everything goes out.

8. The problem with too-big-to-fail banks is that they are too big to fail, and everyone knows it. And this distorts financial markets since everyone now would bend over backwards to accommodate these banks, even if their demands are unreasonable or at least not supported by market forces.

9. The reason why we still haven't achieved transparency for complex financial products like credit default swaps and other financial derivatives is that that is how these people make money from these things: by making everyone, sometimes even themselves, completely ignorant and unaware of what's really going on.


I still have pages and pages of notes to make sense of, so I guess insights 10 to 18 will have to wait till Part 3 on Tuesday.

Decision Making According to Economists, Part 2: Diminishing Marginal Utility

Let's go back to where we left off in Part 1.

In a game of chance, you pay a fixed fee to enter, and then a fair coin will be tossed repeatedly until a tail first appears, ending the game. The pot starts at 1 peso and is doubled every time a head appears. You win whatever is in the pot after the game ends. Thus you win 1 peso if a tail appears on the first toss, 2 pesos if on the second, 4 pesos if on the third, 8 pesos if on the fourth, etc. In short, you win 2^(k − 1) pesos if the coin is tossed k times until the first tail appears.

What would be a fair price to pay for entering the game?

We can estimate the "fair price" of this game using expected value, for which we need the payoffs and probabilities that correspond to each state of nature.

The game could end after the following number of tosses:

1   2   3   4  5   ...   k   k + 1   ...

Please note that it is possible (although, of course, very improbable) that the game would go on indefinitely.

The payoffs for these possible outcomes are as follows:

1   2   4   8   16   ...   2^(k -1) ...   2^k   ...

Now we turn to the probabilities. For the first outcome, the probability of getting a tail on the first toss is 1/2. For the second outcome, you'll need to toss heads then tails, for which the probability is 1/4. The third outcome consists of heads, heads, and tails, and the probability is 1/8. So now, we should see that the pattern of probabilities is:

1/2   1/4   1/8   1/16   1/32   ...   1/(2^k)   ...   1/(2^(k + 1))   ...

The expected value of an alternative is just the weighted average of the payoffs, using probabilities as weights. Therefore, the expected value of playing the game is:

1*1/2 + 2*1/4 + 4*1/8 + 8*1/16 + 16*1/32 + 2^(k - 1)*(1/(2^k)) + 2^k*(1/(2^(k + 1))) + ...
= 1/2 + 1/2 + 1/2 + 1/2 + 1/2 + 1/2 + 1/2 + ...
= infinity

(Kudos to reader "Maykee" for getting it right, and thanks to everyone who tried.)

So, would you pay that much to play the game? How about something significantly less than infinity, like say, 1 million pesos? It does not sound so attractive, right? In fact, I'll bet that you'll even have trouble finding someone who's willing to play the game for 100 pesos (how many tosses would it take to win more than this?). This is why people have referred to this game as a paradox--the St. Petersburg Paradox, to be precise.

The game was invented by Nicolaus Bernoulli, nephew of the Bernoulli that we encountered in Part 1. "St. Petersburg" does not pertain in any way to Nicolas, however, but very interestingly to the work of another famous Bernoulli, his cousin Daniel. According to Daniel Bernoulli, it is not appropriate to use expected value to solve the problem since

The determination of the value of an item must not be based on the price, but rather on the utility it yields…. There is no doubt that a gain of one thousand ducats (some form of ancient money) is more significant to the pauper than to a rich man though both gain the same amount.

Daniel Bernoulli

What is utility? In its most basic sense utility is the satisfaction or benefit that one gets from choosing or doing something. Economists want to play safe, however, and just say that utility is that something which makes decision makers choose one thing over another. And Daniel Bernoulli's simple idea--that of diminishing marginal utility--revolutionized the study of economics and decision making in the next couple of centuries.

Diminishing marginal utility means that the utility that one gets from receiving or consuming one unit of something--be it pesos, ducats, fame, or beer--decreases as one amasses more and more of that something. It explains why the first bottle of beer tastes oh-so-much better than your fifth, and why receiving a 5,000 peso bonus when you're just earning 10,000 pesos a month is more satisfying than receiving the same amount when you're already a millionaire.

This concept is also very important in finance because it defines a decision maker's attitude towards risk. An individual for whom a particular reward has diminishing marginal utility is risk averse with respect to that reward: he or she is the stereotypical decision maker in economics, someone who is willing to pay to avoid a very small probability of a big loss (e.g., someone who buys insurance)--that is, how most of us usually are. Someone for whom the same reward has increasing marginal utility, on the other hand, may be seen as risk seeking, like someone who will pay just to have even a small chance of winning something big (e.g., someone who plays the lottery)--that is, how most of us are in certain situations, sometimes.

Going back to the game, if we assume that for a typical player the game's prize has diminishing marginal utility and that this utility is a slowly increasing function of the player's initial wealth plus his winnings, then the utility of the additional payoff from a toss of heads will be smaller than the utility of the one that came before, which should result in a finite fair price.

I know a lot of you have already had your fill of theoretical mumbo jumbo this past month, so we'll get back to more practical matters in the next post. :)

Decision Making According to Economists, Part 1: The Expected Value Criterion

In a previous post, I introduced two approaches in studying how people make decisions. In this post, I will discuss the first of these approaches in greater detail: normative decision making.

The normative or prescriptive approach deals with how people should make decisions: it looks at decision making from the point of view of an ideal decision maker--one who is fully informed, able to compute with perfect accuracy, and fully rational--in a environment where information about all available alternatives are known. The normative approach is generally quantitative and involves formulas that range from the basic to the insanely incomprehensible, and thus usually falls within the exclusive purview of economists and mathematicians. The first important normative decision making criteria--expected value--shall be the focus of this post.

Making decisions using expected value

The scenario below illustrates a typical decision problem

ABC Realty has recently purchased land for the development of a new luxury condominium complex. ABC is in the process of selecting the size of the project that will lead to the largest profit given the uncertainty of the demand for condominiums.

Using the four steps in making good decisions that we discussed previously, let's take a closer look at the details of this problem.

1. Identify all available alternatives. ABC needs to choose the size of the condominium project. Let's say the following alternatives are available:

d1 = a small condominium complex

d2 = a medium condominium complex

d3 = a large condominium complex

3. Identify uncontrollable or unpredictable circumstances that may affect the payoffs of alternatives. The project's profits will be affected by the demand for condominiums. Since these possible occurrences, referred to as states of nature, are beyond the control of the decision maker, they are just assigned likelihoods or probabilities. For example, let's say that according to ABC's analysts, there is an 80% chance that demand for condominiums in the foreseeable future will be strong and a 20% chance that it will be weak, or

probability of strong demand = P(s1) = 80%

probability of weak demand = P(s2) = 20%

It should be pointed out that since s1 and s2 cover all possibilities for the demand for condominiums, P(s1) and P(s2) should sum to 1 or 100%.

2. Determine the costs and benefits of alternatives. Both ABC's choice for the size of the project and the demand for condominiums would affect the project's profits or payoffs, which are presented in the following table

We see from this payoff table that the decision is not straightforward since the best alternative--the one with the highest payoff--changes with the demand for condominiums: whereas a large complex would take advantage of strong demand, it would lead to losses if demand turns out to be weak because of (presumably) the higher cost of construction.

4. Evaluate alternatives using some criteria or rule and make a decision. One commonly used criterion in making a decision given the information presented above is the expected value criterion.

The expected value of an alternative is the weighted average of its payoffs under different states of nature, using the probabilities as weights. 

This concept was first formalized in Jakob Bernoulli's groundbreaking work, Ars Conjectandi, published in 1713.

Jakob Bernoulli

We compute for the expected value of each alternative as follows

According to this rule, since alternative d3 or building a large condominium complex results in the highest expected value, ABC should choose this alternative.

While the expected value rule does make a lot of practical sense, we should be careful in interpreting the numbers that result from our analysis. An expected value of 14.2 million does not mean ABC will earn that much if it decides to build a large complex: ABC will either earn 20 million or lose 9 million depending on what demand for condominiums will be. 14.2 million is ABC's average profit if it faces this scenario several times and makes the same decision to build a large complex each time; in other words, it's what ABC stands to earn in the long run.

Expected value in practice

The most common practical application of the expected value concept that I can think of is in gambling, particularly in poker. If you play the Texas Hold'em variety or any similar variant, you may have heard of this strategy rule: join the game if the probability of making one of your outs (i.e., your number of outs divided by the number of cards remaining) times the pot is greater than the required bet. The first part of this rule--the probability of making one of your outs times the pot--is the expected value or payoff of joining the game, so if this is higher than the cost of joining, then it makes sense to call the bet.

Something to think about

We'll end this post with something that has puzzled the greatest minds for the longest time until it led to another groundbreaking concept in the study of decision making, which will be the topic of Part 2 of this post.

Think about this scenario for a while.

In a game of chance, you pay a fixed fee to enter, and then a fair coin will be tossed repeatedly until a tail first appears, ending the game. The pot starts at 1 peso and is doubled every time a head appears. You win whatever is in the pot after the game ends. Thus you win 1 peso if a tail appears on the first toss, 2 pesos if on the second, 4 pesos if on the third, 8 pesos if on the fourth, etc. In short, you win 2^(k−1) pesos if the coin is tossed k times until the first tail appears.

What would be a fair price to pay for entering the game? Read Part 2 to find out.

The Economics of Beauty

It seems that some of you should just stop whatever it is you're doing: it is all for naught. It turns out that beauty and good looks are a significant determinant of happiness and success. According to this study by economist Daniel S. Hamermesh, "plain people" earn less than the average-looking people, who in turn earn less than the good looking ones, regardless of gender. What's more, unattractive women are more likely to be unemployed and marry "men with less human capital" (economist-speak for poor, lazy slobs). Here's Dr. Hamermesh in the flesh, as he discusses this prevalent form of employer discrimination on The Daily Show.

Of course, all this is related to Dr. Hamermesh's other study that shows how more attractive university instructors and professors are rated significantly higher by students. Should I show you how highly my students rated me when I was still teaching? :P

3 Common Myths of Capitalism

1. Being "pro-capitalism" is the same as being "pro-business"

The point of capitalism is that business should be able to freely compete against one another, and that benefits consumers in the long run. It's not good for businesses per se because they have to work really hard to come out on top. That's why many businesses hate capitalism and spend a huge amount of money to convince the government to implement rules and restrictions that will favor them, even if these rules are not in the interest of consumers. So "pro-capitalism" really is "pro-consumers."

2. Capitalism generates an "unfair" distribution of income

True capitalism rewards people who are productive, people who work a lot of hours, people who are talented, and people who come up with good ideas; people who don't do these things get less. The one negative that people might be concerned with is that some people have very little skill and so are not able to earn that much left on their own. This is why some people support anti-poverty spending, but that's completely different from interfering with capitalism. Regulating prices, limiting quantities, and imposing all sorts of restrictions on business--these make the economy less productive, give us a smaller pie, and make it even harder to implement programs that help those who are less fortunate.

3. Capitalism was responsible for the recent financial crisis and the recession

In so many words, it's not capitalism's fault that what happened happened: the government interfering with capitalism--with its regulations, subsidies, and bailouts--is clearly to blame. Oh yeah, the private sector was also involved (a bit).


Lesson learned: The less straightforward a statement is, the more likely that it is bull shit.

A 4-Minute Animated History of Economics

My favorite line: 1867, Das Kapital goes to press without Karl Marx ever visiting a factory (LOL!)

Competition Schmompetition

This post is a response to the comment of one of our readers to the previous post about Cebu Pacific:

Anonymous said...

The only way to improve service is competition. If we have this "open sky" policy the local airline industry will shape-up. This is what Tourism Sec Alberto Lim was pushing and was also the cause of his early political demise.

The same is true for the local shipping transport industry this should be opened up to foreign investors to improve service and safety. The more competition the less we hear of poor safety standards . As MVP have said the limited local capital will not be sufficient to improve Philippine infrastructure.


Dear Sir/Ma'am,

Let me start by saying that additional capital does not necessarily mean more competition, so I don’t really  get the point of quoting what MVP supposedly said.

Now for the meat of the matter.

I understand how--given our love for democracy, capitalism, and all things American--many of us can believe that free markets and unfettered competition is the panacea to the world's multitude of woes. After all, it's what introductory economics taught us: perfect competition is always best for consumers.

Unfortunately, this can't be farther from the truth. I'll give you two examples that support this admittedly contentious stand. First, let's take a look at the 2008 global financial crisis. While there may be no single factor that caused that shitfest, the deregulation of the US's financial system should be at the top of the list. Arguably, what happened happened because the financial experts that have surrounded the past two American presidents--ex-Wall Street people, all-- pushed for industry-wide deregulation, which essentially told banks and other financial institutions that they could freely compete and do whatever they want. And do what they want, these greedy motherfuckers did. How’s that for laissez-faire economics?

Want something closer to home? Since we’re talking about the local transportation industry anyway, why don’t we take another look at that? Ever noticed how there’s no jeep, bus, or taxi whenever you desperately need one and there’s a glut of them whenever you don’t? That’s free competition at work. Things are as shitty as they are because anyone with enough dough to buy a second-hand Toyota Vios and who knows the right people can get a taxi franchise and run his or her own mini-taxi empire, despite “regulation” from the LTFRB and even if our streets simply don’t need another taxi. Things are as shitty as they are because whatever regulation is in place is either unwilling or powerless to shape capacity and supply--by requiring operators to retire or replace their aging vehicles or by setting a strict schedule based on a thorough study, for example--to meet demand.

People say that the surest sign of economic prosperity is a healthy and efficient public transportation system: you only need to go as far as Hong Kong and Singapore to see the truth in that statement. And an efficient transportation system can only be achieved with a tightly regulated monopoly or oligopoly. Here in Hong Kong, there are only two bus operators (and their routes don’t overlap), one taxi service, and one privately-operated subway system (MTR); regulation is there to serve the public’s interest by controlling the profits of these operators. The only competition there is is intermodal in nature: when people decide to ride a bus or taxi because they’re too lazy to walk to the nearest MTR station.

So is competition--from a foreign player or otherwise--the answer to Cebu Pacific’s deteriorating service? Why don’t we all give that another thought before we say yes.

The World Economy in a Nutshell

Re-posted from Greg Mankiw's Blog

On Consumption and Savings

DEAR INVESTOR JUAN

I have just arrived in Manila from my China trip. I haven't had much free time in the past two weeks to work on articles, so I have to work doubly hard in the coming weeks to catch up. Fortunately, I was able to gather enough material for three to four articles about the nuances of Chinese financial decision making and the Chinese ecomony. I'll start by answering this comment from Hap about consumption and savings in the Philippines.

Dear Investor Juan

Hi Sir! Always good reading from you. Maybe you could find time to write a post about the "ideal" distribution of expenditures and savings in the Philippines. I've been reading how it differs between East and West, but I can't figure out which one has a better model. Thanks!

Hap

Dear Hap,

Before we talk about the “ideal” mix of consumption and savings in the Philippines, we must first understand how these two variables interact and how they affect economies, in general, and an individual’s well-being, in particular.

Macroeconomics Crash Course

Gross Domestic Product (GDP) in terms of inputs to the economy can be expressed with the following equation:

GDP = C + S + T

Where C is consumption, S is personal savings, and T is taxes. What this means is that citizens contribute to the economy by buying stuff, by saving a portion of their income, and by paying taxes to the government.

So where does everything go? C goes to businesses and is used to produce goods and render services for the consumption of individuals; S supplies capital to these businesses for investment, I; T is used by the government to spend for infrastructure and government services. When we have an open economy that can trade with other countries, we also have to account for exports (X) and imports (M). So GDP in terms of an economy’s output may also be stated as:

GDP = C + I + G + X – M

So equating the two equations for GDP above, we get:

GDP = C + S + T = C + I + G + X – M

Using this model, let’s try to determine the underlying reasons behind the significant gap between the consumption and savings mix of Western and Eastern economies, particularly in the US and China.

US Consumption

In the US, people are basically net consumers rather than savers: from the Bureau of Economic Analysis figures above, personal savings in the US have ranged from 1 to 5% in the past five years, which just amounts to just $1,000 to $5,000 on an annual salary of $100,000. Americans love to spend their income on anything and everything, from essentials like food, clothing, cars, and houses to the not-so-essential like gadgets, video games, and entertainment items. So, is having a high consumption rate and low savings rate bad for the economy? Well, at least from the example of the US, it does not seem so: remember, the US is still the largest economy in the world with Japan only at a far second (which China is poised to overtake in the near future). In fact, it is this remarkable appetite for consumption that has driven the US economy in the past decades; a high consumption level (high C) drives the demand for products and services upwards and boosts the profitability of businesses, which in turn leads to overall economic growth (high GDP). The danger of having a low personal savings rate, though, may be seen more clearly from the perspective of the individual; an American with low personal savings, or does not have anything invested in valuable assets like real property or securities, runs the risk of financial ruin in times of recession or economic crisis. What will you do if you get laid off and you don't have enough money in your bank account for your basic needs? You first try to live on whatever asset you have; if you are a home owner, you try to borrow against the value of your home (so you see how this gets worse when real estate prices plunge, as what also happened last year). And once you've used all of your assets up, where else can you go?

China Savings

Americans are fortunate in the sense that they have a relatively well-developed welfare system that citizens can turn to in case of dire need, especially with the recent passage of the Patient Protection and Affordable Care Act. In China where the health care and education infrastructure is still very much undeveloped for around 90% of the population, especially in rural areas, saving has become a matter of survival. To prepare for the future, something which the Chinese government can't help with, the Chinese are saving anywhere from 20 to 30% of their income (I've actually spoken to two Chinese nationals in Beijing who are able to save as much as 40% of their disposable income religiously), a far cry from the experience in the US. With the low consumption level this very high savings rate implies, how has the Chinese economy been able to grow at a staggering rate of 8 to 10% per year in the last 10 years? Even with this low consumption level, the Chinese economy is still able to grow at a fast clip because of high government spending, G, and high exports relative to imports, X - M.

The Effects of the Financial Crisis on Consumption and Savings

During the financial crisis of 2008 and 2009, what happened, happened: people in the US were either laid off or demoted, leading to lower disposable incomes; Americans reacted by saving a bit more and consuming less; since China's exports go mainly to US markets, the depressed US consumption lowered the demand for China's exports; to make up for this, the Chinese government tries to motivate its citizens to buy more, which leads to saving less; all of this leads to China experiencing a trade deficit, its first since 2004.

The Better Model and What This All Means for the Philippines

One of our China trip speakers, Dr. Men Ming, a finance professor at the University of International Business and Economics in Beijing and a Fulbright scholar, mentioned something very insightful about the ideal savings rate in China. When people save their income, the money most often just goes to savings deposits, which the banks, in turn, lend to individuals and businesses, and use for other financial services. In China, the predominant banks are those which are owned by the state; according to Dr. Men, decisions made by these banks are sometimes questionable and are often tainted by allegations of corruption. So, for both the economy as a whole and the welfare of the individual, he proposes to lower savings and increase consumption so that: (1), the consumption increase can help boost local demand for Chinese products and drive GDP growth, and (2), shift the decision-making applied to funds from banks back to the individual.

So what does this mean for us? I don't have exact savings figures for the Philippines, but I believe we save only a little more than Americans, probably from 7 to 8% of our income. We have the same appetite for consumption as Americans (ya gotta love those iProducts) even if our welfare, health care, and educational systems are probably just as bad as (if not more so than) China's. On the good side, our banks, in general, are more transparent and trustworthy than the state-owned banks in China (except those small, under-regulated rural banks, of course). Personally, I still advise that we save more than 10% of our income, if just to prepare for a rainy day; I think the government still has not reached that level of political maturity and will to pull off something like what Obama did for health care, and it would be stupid to solely rely on what government can provide.

But as we've discussed in several articles in the past, we have to remember that saving should just be the start; once we are able to accumulate enough capital, we should start looking for ways to earn better returns than those provided by savings accounts. More on this on the next post!