John Nash, the american mathematician whose work with game theory earned him the Nobel prize in Economics, was the subject of the Oscar winning movie A Beautiful Mind (and was portrayed by none other than our very own Russel Crowe). The movie focuses both on his remarkable advances in mathematics and his struggle with paranoid schizophrenia.
A short clip from the movie: a trip to the pub can lead to a revolutionary 28 page doctoral dissertation:
This week we focus on oligopoly markets where interaction between the large firms means that strategy, which was absent in competition and monopoly, plays an important role. In fact because analyzing strategic situations is complicated, we need to introduce a new tool to understand the forces in an oligopoly market. That tool is called game theory and is the main topic discussed in class this week. There are two things to keep in mind when studying game theory. One is the basic technique of analyzing each game – identifying the outcome of the game given the payoffs and the players involved. The other thing to keep in mind is that game theory provides insight into any situations facing oligopoly firms, from pricing decisions, to market entry, capacity building, advertising, and so on. It is important to remember the insights from the theory as well as being comfortable with the mechanics of analyzing a game.
The Sydney Morning Herald article discussing the Deutsche Bank survey on prices and price indices is available here. The price comparisons make the case Australia is more expensive than the rest of the world. Is this due to costs? Taxes? Price discrimination?
What questions does this raise in the context of the strong Australian Dollar?
The latest consumer price index figures were released yesterday and are available from the Australian Bureau of Statistics (see the Consumer Price Index, Australia, March 2013). They show that the Australian consumer price index (CPI) rose 0.4 percent in the March quarter 2013.
What do you think the Reserve Bank should do given the numbers?
We continue this week with the analysis of the profit-maximizing firm, switching our attention to the monopoly firm – a firm without any competitors. Owing to the lack of competition, a monopoly has great degree of power in the marketplace. This power can be exploited in several different ways, one of which is to charge different customers different prices in a practice known as price discrimination. (Can you think of an example of price discrimination?) We will also use the model of the market to investigate the social implications of various market structures and in the process identify one of the most important properties of the free market – it’s ability to maximize “economic efficiency.”
We also discuss the important concept of market failure, which arises when part of the costs (or benefits) of a market transaction are paid by people who do not directly participate in the transaction. We will illustrate market failure in the case of electricity generation that also causes environmental damage and discuss ways to resolve the market failure.
There has been a lot of discussion in the news lately around Bitcoins (see for instance this article in The New York Times and this on in the Sydney Morning Herald).
Can we classify Bitcoins as money? We defined “money” in class as having 3 functions: as a medium of exchange, as a unit of account, and as a store of value. Bitcoins satisfy the medium of exchange function, which is to say people will accept Bitcoins as payment, in a very limited number of markets. Bitcoins might help if you want to buy something on Silk Road. But try buying your groceries at Woolworths with a Bitcoin. Bitcoins are really not that good as a medium of exchange, at least at the moment, because they are accepted by only a tiny fraction of people and businesses in the economy.
In terms of serving the unit of account function, Bitcoins could in principle serve this function quite well, as indeed can any numeraire (i.e., a standard by which values are measured). In the past, societies have used shells and cows as money, so Bitcoins can fulfill this function as well as any other.
The main problem with Bitcoins, as I see it, is that it doesn’t perform the last function of money very well – it is not a very good store of value. The fact that Bitcoins have fluctuated widely in value over the last few weeks (from $27 to $230, according to bitcoincharts.com) gives you an idea of the problem. (In fact just today, April 16, 2013, the value of Bitcoins has fallen from $80 to $60.) Would you hold your wealth in an asset that fluctuates that widely in value? It would be very risky. Of course Bitcoins can increase in value as well (and make you a tidy profit if you time the market right). But the point is, people hold money because they know the amount of goods and services it will buy from one day to the next. Something that fluctuates widely in value does not serve this function very well – one day a Bitcoin might buy you a mean at a fancy restaurant (assuming you could find one that would accept it for payment), another day you might be lucky to buy a loaf of bread with it. I suspect most people would prefer to store their wealth in Australian dollars (or other major currency) because they know what the currency will buy them from one month to the next. In all, Bitcoins don’t serve the store of value finction very well.
But Bitcoins are also fundamentally flawed in a macroeconomic sense – Bitcoins have programmed in deflation. The reason is simple: the supply of Bitcoins is set to decrease over time. This means they will become more expensive (due to market forces) over time, which is another way of saying that the goods and services a Bitcoin can buy will become cheaper over time. As we discussed in class, an economy in which prices are continually falling is one in which everybody puts off buying until tomorrow when the prices are lower. This means that an economy with Bitcoins operating as the money supply will suffer from continual deflation and as a result suffer from recessions, falling incomes and rising unemployment.
A related issue is who (or what?) is the central bank for Bitcoins? The current design of the Bitcoin currency hardly has the same level of credibility or transparency that, for example, the Reserve Bank of Australia has built up over many, many years. How do we know that the Bitcoin system won’t suddenly increase the supply of the currency (perhaps to ward off the deflation mentioned above)? If that happened, the Bitcoin would instantly become worthless and Bitcoin-denominated wealth would be destroyed. History tells us we can trust that the RBA won’t suddenly inflate. Do we have that level of trust in the Bitcoin system? Not at the moment and I suspect it will take a long time to establish.
This week we turn to microeconomics and focus on the economic theory of the firm. This means we have to go through some foundational material linking the concept of a demand curve to a firm’s revenue as well as covering the difference between accounting costs and economic costs. The main purpose is to illustrate the firm’s profit maximizing decision about how much to produce and sell to its customers. We will then use the model of the firm to start talking about how market structure affects the firms’ behaviour. The series of slides with commentary below show how price and profit dynamics play out in a typical market in the economy.
The following 2 minute video from Reuters discusses how the falling Japanese yen could impact businesses. Watch the video and consider the impact of Japan’s on-purpose devaluation of its currency. Could we start to see “currency wars” with countries like South Korea? What export related policies could you expect to see? What abut Australia? Which industries do you think would be affected by Japanese products becoming less expensive?
Like most countries, the Australian banking system comprises a central bank, the Reserve Bank of Australia (RBA), and several large private banks (Westpac, ANZ, etc.). In essence, private Banks take deposits and use the deposits to make loans. The main source of their profit is the interest rate differential between the interest rate they pay to the depositors and the higher interest rate they charge on loans. This means that to maximize profit, the private banks will lend out as much of their deposits as they can, subject to having enough on reserve to serve the needs of their account-holders. The RBA manipulates the amount of deposits in private banks by buying or selling government bonds in a process referred to as open market operations. The following short video explains how open market operations are used by the RBA to manipulate deposits in private banks and ultimately to control the level of interest rates in the economy.
Firms, Markets and Business Management 