Tuesday, 4 December 2012

Economics of nationalisation versus privatisation.

MC= Marginal cost
MR= Marginal revenue
MRC= Marginal revenue for a firm under competition
AC= Average cost
AR= Average revenue
ARC= Average revenue for a firm under competition

The profit maximisation diagram is used by economists to explain how firms determine the level of output that leads to the highest level of profit for the firm, specifically the point where total revenue exceeds total costs by the highest amount and hence profits are maximised. This is where the yellow and blue lines cross. Not the gap shown by the black lines in between the average cost and average revenue indicates the profit per unit.

However, if we were to assume that the firm instead opted to produce at the “Highest non loss-making point” (HNLP), which is where the green and orange lines cross and hence the firm makes zero profit as costs equal revenue, then the societal benefit of the firm would be greater. This is because, as we can see, it produces a higher level of output with a lower unit price. Therefore in this diagram the social optimum level of production and the incentivised level of production differ. It is also impossible to incentivise the firm to produce at this level other than subsidising the firm to such an extent that this level of output becomes the most profitable. This tactic is unattractive as it simply everyone, including those who do not wish to consume the product, paying via taxation for the product to be sold at a lower store price and to drastically increase the firms profits.

A different option would be to simply nationalise the firm, turning it from a private enterprise to a state run firm. Since the profit maximisation incentive would be replaced by an “electorate pleasing” incentive. While the electorate may at first like the idea of a large state enterprise turning a profit to pay for public services, they would quickly realise that they would themselves just be paying for the public services through higher prices, a somewhat more regressive manner than income taxation. Furthermore a lower level of output, which is necessary to generate profits, would mean lower demand for inputs. This translates directly into a higher level of unemployment. Because of this, the “electorate pleasing” incentive results in the HNLP.

The diagram shown, however, assumes a monopoly, and while it can be stated with some confidence that in a choice between government monopoly and a private monopoly, the former is preferable, often in reality the choice is not so simple. The choice is often between private competition and government monopoly.
In order to model both monopoly and competition within the same diagram we must use the formula: (ARcn =ARmn*F). This means: The average revenue for a single firm producing quantity “n” in a competitive environment is equal to the average revenue for a monopoly producing a quantity of “n” multiplied by the number of firms. This is because whether 5 firms each produce 20 of a product or a single firms produces 100, the quantity is still the same and hence the effect on price is still the same.

With this formula we can create a new graph incorporating competition. The following example assumes there are 4 firms. It assumes this because that is the number of firms that results in a level of output at the lowest point on the marginal cost curve, any level of output above this, in the long run, will lead to new firms entering the market and any level below will lead to firms buying others.
As we can see, the firms in a competitive produce at a lower price and although they produce a lower quantity, this quantity multiplied by 4 would clearly exceed the level produced by a private monopoly. From this diagram then we can state that private competition is preferable to private monopoly. However if we compare it to the HNLP we can see it produces a lower price, though cannot say simply from looking at the diagram say that it produces a higher level of output, in order to properly compare private competition against state monopoly in this context we must look at the figures behind the graph.

State monopoly

As the table demonstrates, in this incidence the competitive market produces a higher total output at a lower price, for this industry then it can be said that, with measures to ensure competition, society is best served by the sector being in private hands. It is also possible however for the state monopoly to produce more at a lower price. When either the state or the private sector can produce superior results in both price and output, then the choice is obvious. However when there is no absolute superior option then a trade off must occur. The government must decide if they prioritise the price level or the level of output, and to what degree they prioritise it. For example a government may have to decide whether a 5% increase in the level of output is worth a 4% increase in the price level.

Since the optimal form of organising the industry is determined by their relative equilibrium outputs and price levels, but this data is sometimes difficult to accurately measure, we must look at what determines the cost and revenue curves, namely the intricacies of supply and demand respectively.

The main determinates of the cost curve are the “Economies” and “Diseconomies” of scale. These refer to the benefits and problems gained by a firm gaining size, respectively.

An example of an economy of scale is the division of labour. If a firm produces more, it will have to hire more staff, this means they can divide the number of tasks between more people. Where a person may have done three tasks five times a day, now they can do one task all day. Because the person is focused on this single task they become better at performing it and gain experience faster. Also having each employee doing less tasks makes training faster, as well as filling temporary vacancies easier.

An example of a diseconomy of scale would be communication channels. With some companies communication between employees is vital, and the best way to do this is one-on-one communication channels. However as the number of employees increases the number of communication channels this requires increases quickly.

Communication Channels

Economies and diseconomies of scale determine the optimum size of a firm, with higher diseconomies and lower economies of scale making the optimum size smaller. The smaller the optimum size of a firm, the more likely that it suits private competition rather than state monopoly.

The determinants of the shape of the revenue curve are the variety, volatility and intangibility of demand.

A monopoly attempting to meet a wide variety of demand will suffer, as can be seen by poor quality of cars in the Soviet Union. Since the automotive industry has a large variety of demand, attempts by a monopoly to meet all these demands will struggle, leading to a “one size fits all” while a large number of firms can each engage in specialisation, some making “luxury sports cars”, while others can provide “cheap utilitarian transport for the masses”, to quote Giorgetto Giugiaro.

Another determinant of the revenue curve is the “intangibility of demand” for certain products. Before a movie is released to the general public, a film company can assess it and come up with a number of demonstrably true figures; length, budget, a list of the actors, production time, CGI expenditure. However, none of these are real indicators of the films quality as a product, nor the demand for it, the audience does not judge a film based on these figures, but rather their enjoyment from the film. Their enjoyment from the film is derived not from these figures, but from a set of characteristics that are based partly on these. A film can be too long or too short, it can be too low budget to allow for decent suspension of disbelief or it can have so much in terms of special effects that the audience is reminded they are watching a movie. This type of demand is difficult for a monopoly to produce for, since it can not set easy targets for its products. Other products however have a less intangible demand, for example televisions. When people are considering buying a television they have certain characteristics in mind; size, features, clearness of sound and picture, inputs, power consumption. These are all measurable and demonstrable. Another good example of tangible demand comes in the form of refined materials and components. Since the aesthetics of a good are often dealt with by the manufacturer, the materials and components bought by the manufacturer are free to focus on tangible characteristics such as size, weight, strength etc. It is because of this that while car manufacture may be best left to private firms, the production of steel and aluminium for the cars may be better suited to a state monopoly.

Another factor that determines the optimum method of organising an industry is the size of the barriers to entry. Barriers to entry refer to the start up costs of a business, such as acquiring the land, buildings and machinery to produce the goods. The lower these are, the easier it is for firms to enter the market and hence the optimum firm size is reached quicker if there are too few firms. The less barriers to entry there are, the more desirable a private enterprise approach is.

To summarise, the traits which indicate a superiority for the private enterprise approach or the state monopoly approach are as follows.

Economies of scale
Diseconomies of scale
Variety of demand
Intangibility of demand
Barriers to entry

From this list we can work out a variety of sectors that are best served by private or state control

Better off nationalised
Better off private
Utilities; power, water etc
Public transport
Natural resources
Corner shops

Monday, 1 October 2012

Mad Max economics, or why the invisible hand "run Bartertown"

After watching the Mad Max trilogy again, sadly with the American dubbed version of the first, I found myself noticing something. Bartertown is a clear example of the benefits of a market economy over a planned economy, at least when rebuilding after a nuclear apocalypse.

In order to compare the two approaches, we need a clear example of a post-apocalyptic planned economy, which we can find in the form of the oil refinery settlement (ORS) from Mad Max 2 for the planned economy and the aforementioned Bartertown from Mad Max 3 for the market economy.
From what we can tell of the ORS, they pump and refine oil which they then use to fuel their vehicles so that they can then gather the other things they want/need. While it doesn't fit exactly the notion of a planned economy as we know it, it is the closest we will find in the series.

The superiority of the market approach of Bartertown over the planned approach of the ORS comes in three key points.

First there is the fact that while setting up a town on top of a resource will give you access to that particular resource, and any resources you and your people can gather, setting up a town based on trade gives access to all feasible resources in the area. People with water will come with water, people with food will come with food etc. Your people don't need to go out looking for these things to the same extent. These people who bring food, water and other things will trade with each other and also pay either a fee to Bartertown and/or partake in the local entertainment, both of which will provide Bartertown with resources it didn't have. Indeed we see this in the film. Furthermore some traders set up permanent bases to produce and sell their goods in Bartertown, such as Master-Blaster and his “underworld”.

Secondly, when you have a resource situated economy like the ORS, anyone with greater strength can roll into town and take over and not lose much operational capacity. Indeed this was the plan of The Great Humongous. But there would be little point in invading Bartertown, aside the methane production facility “underworld”, most of Bartertown's value comes from its use as a trading site. Anyone who invaded such a place would clearly not value property rights and hence the traders that make Bartertown the location it is would be reluctant to operate under the new management. Hence there is little incentive to invade Bartertown. Also since a large number of traders would be in Bartertown, likely more than work in whatever resources the town may have, the level of defenders relative to the resource would be greater than in a resource focused town.

Finally a somewhat more cynical point, but in a post-apocalyptic society, people would be far more brutal in their outlook, benevolence would give way to survival-focused behaviour. In a trading town, people pursuing their own interests is what allows the town to function. It is in each persons interest to sell their goods to each other to get the goods they want, any short term gain from stealing or breaking a contract is immediately outweighed by the fact they cannot return to Bartertown, or if captured “the wheel”.

Granted there is the problem that in such an economy there is potential for one trader to get too powerful and control too much of a valuable resource, the obvious example being Master-Blaster, who's monopolist position allows to him to cause much embarrassment to Auntie, but at the same time he is still subject to her laws. He cannot simply kill at will in Bartertown, when he tries to he quickly finds himself surrounded by guns. He is as much bound by the laws as anyone else and for all his talk that he "run Bartertown" he is only really capable of causing annoyance, he cannot leverage his monopoly position into any tangible control. 

So in conclusion, while the free market approach is not something one should pursue with dogmatic enthusiasm, it is however useful if you need to rebuild post apocalyptic Australia. To summarise, once the bombs come down, grab a book by Milton Friedman.

Monday, 11 June 2012

On a UK space programme

As anyone unfortunate enough to be within 5 feet of me in the last month has undoubtedly gathered, I have recently become somewhat enamoured with space. Because of this I have decided to do a blog about why the UK should have a space programme.

In order to consider the merits of such an endeavour we must first look at the cost. The total, inflation adjusted, lifetime budget of NASA between its creation and 2008 was $851.2 billion. Dividing this by 50 we get $17.02 billion, NASA's current funding is about $18billion. A quick google reveals these to be around £11 billion and £11.6 billion respectively. This is of course quite a large amount of money. For the sake of safety I often overestimate costs, so for the sake of example we shall assume that a UKSA, after start up costs, would cost about £12 billion a year. This would represent 1.7% of total government spending and 0.005% of GDP.

So here I shall present the various benefits of a UK space programme.

1. Moon Silver
There's silver on the moon so lets go get it. Furthermore, there is also the notion of asteroid mining which is already receiving attention. Both of these present examples of resources in space that we could sell here on Earth.

2. Being the "Silicon Valley of Space"
Firstly this argument assumes that there will one day be the commercialisation of space, with various companies doing various things across the solar system. If we take that to be inevitable then we must ask, where will these companies be based? Where will these companies set themselves up? The answer is wherever the experience and technology for going into space is, so if we want the worlds space entrepreneurs to set up companies in Britain, we need to be showing that we can go into space and the best way to do that is to just go into space. This is also an argument for a space elevator, if we build one then this removes the main obstacle to private firms operating in space, specifically that escaping Earth's orbit is hard. If we build a space elevator, which estimates suggest would cost $40 billion or £25 billion for a one off investment, then we will make Britain the place to launch stuff into space from.

3. Attracting investment.
Other investment could also be attracted by the British space programme, not just space relevant investment. This is because it would create give an impression of a technologically advanced country, on the cutting edge of scientific advancement, hence attracting firms that are technologically sensitive.

4. Inspiration.
This is a point stolen from Neil DeGrasse Tyson. Specifically it refers to giving public presence to science and promoting a sense of wonder in young people. Space is something children find cool and if we make space travel something that exists rather than the preserve of science fiction, then we are more likely to have people wanting to grow up to be engineers and scientists. Engineers and scientists create new technology, new technology leads to economic growth, economic growth leads to lower unemployment, lower unemployment leads to an improved government budget as they will have higher tax revenues and lower unemployment benefit expenditure.

5. Beating China to it.
Not strictly an economic argument, but I don't much like the idea of humanity being represented outside of Earth by the "People's Republic of China" for reasons that should be plainly obvious to anyone with a shred of humanity.

6. It's awesome.
Yup. It is. Deal with it.

Also this probably won't be the last I talk about space and economics, though I will try to keep in confined to the blog. Although a bunch of people don't read my blog, so I'll have to tell them in person. So to conclude if I'm talking about space and you're bored by it, just say "I've read your blog about it" and I'll shut up.

Thursday, 15 March 2012

The whats and whys of nationalisation

I'm back, not that you missed me or anything, but regardless of your lack of appreciation of me I have returned yet again to bestow my knowledge upon you. To this end I intend to write about the economic arguments for the nationalisation of certain sectors of the economy and while many economists go on and on and on about how the free market can solve everything, they are what we call "bad economists" and should not be listened to under any circumstances.

Also note that I am not advocated total nationalisation of everything, there are some things which I feel work best when left to market forces, the difference between sectors of the economy that should be nationalised and those which shouldn't lies in the incentive structures and the effects of competition as I shall demonstrate throughout this blog.

1. Pharmaceuticals.
There are, according to the ever reliable wikipedia, three hundred and sixty nine pharmaceutical manufacturers in the United Kingdom. After giggling at the fact that number ends with sixty nine, you may noticed that this means that the pharmaceutical resources of the United Kingdom are divided three hundred and sixty nine ways. This strikes me as something that is likely detrimental to the medical research sector.
Also note how the incentive structure for a pharmaceutical company is contrary to the common good. If a firm produces a treatment that has be done constantly for the rest of the patients life, this is likely to create much higher profits than a cure. Hence it has been demonstrated that the pharmaceutical industry is one where a state-owned monopoly is preferable to the free market.

2. Farming
This is a more tricky one but this is another sector which would be better under state control. The reasons for this are thus. Firstly, it allows for the circumvention of the glorified ludditism that is "organic farming" which the existence of is frankly embarrassing, if the state controlled agriculture then we could have proper investment in superior GM crops and new farming capital, which is sometimes unavailable due to the low profit nature of the agricultural sector. Also, it will allow for the production of a "food surplus" for emergency stores as well as for various humanitarian projects and as a foreign policy tool, its much easier for oppressed people to overthrow their dictators if we provide them with food as well as weaponry.

3.Scientific research in general
This one is rather straight-forward for some of the same reasons as the pharmaceutical industry, such as the merging of resources and the allowing of them to work in unison as opposed to in competition, but there is also the avoidance of "tech-killing" whereby a company could invest in research in areas that would harm its profits, thereby enabling them to patent it and then not use it. It would also allow for more UK firms to benefit from technological advancements, as opposed to simply the firm that patents it, as the government could license the tech to any and all UK firms. Finally it would enable research into areas that aren't deemed profitable, but that could provide benefit to humanity.

Theres a few arguments for taking a few sectors into state ownership, I may do a few more later but right now I don't want to and its my blog so I'll do what I want, get off my back.