May 19, 2009

Swine Flu Makes Cancun Struggle

A recent phone call from a good friend of mine – an owner of a night club in Cancun, Mexico - made me aware of the following situation and post this blog:

The announcement of the swine flu in Mexico has brought panic and uncertainty to several countries. The disease has greatly affected Mexico City and generated a huge uncertainty about this country and the disease itself. Furthermore, Mexico's main airport is located here and many flights to Mexican cities have layovers in Mexico City.

Therefore, Cancun - a city based on tourism – has experienced a great loss of its customer base. As soon as the swine flu had been announced, the tourists have cancelled their vacations, the streets have become empty and the city has resembled a ghost town.

The fear of an infection has decreased the demand in tourism dramatically and the prices have declined. The supply has also changed as a response to the decrease in demand and the night clubs and some hotels have closed for a certain period. Lacking the critical amount of customers, they have been forced to this decision, since the production costs such as personnel expenses cannot be offset. (The decrease in supply prevents the prices from falling to zero, so there is still at least little supply and demand for hotel rooms).

Even though the swine flu is not as dangerous as predicted and there have not been any cases in Cancun yet, tourists would rather choose different locations for their vacation. The downturn of the tourism still goes on making Cancun struggle by the fear of the swine flu.

Agency Problems for Firms and Banks

On April 2nd, 2009, the leaders of the G20 group of developed and emerging economies gathered in London to combat the economic crisis.

Their goal was to “rewrite the rules of global finance and reshape the world’s financial institutions” because since their last meeting last November, “the global economy has fallen off a cliff. Consumers have cut back their spending. Companies have slashed production, postponed investment and laid off workers in their millions. The financial system remains dysfunctional. Trade flows are shrinking at the fastest rates since the second world war.”
(Retrieved from the article “Be Bold”, April 2nd, 2009, from The Economist Website:

Representing member states from 5 different continents, the G20 faces challenges from the start to create a common solution for the economic crises. The most difficult to combine, were the soltuions of USA/Great Britain and France/Germany.

The US/UK solution includes the call for more stimulus spending. According to the Washington Post, U.S. President Obama statet in his international debut that the "voracious" U.S. economy can no longer be the sole engine of global growth. Major European powers are firmly resisting calls to further open their coffers and cut taxes to spur the global economy. Obama and Brown suggest a higher government spending for each of the member countries to boost the sales and therefore the economy. Higher spendings result in higher investments and reflect a growth potential for both, consumer and financial markets.

On the other hand, Europe and Asia do not agree with the US/UK stimulus package. France and Germany consider it a big mistake for the governments to spend more on the economy without stabilizing the financial system.
”German and French leaders have shunted aside the president's call for increased government spending to stimulate their economies. The Czech Republic's prime minister even characterized the U.S. proposal as charting "the road to hell.” Instead of more stimulus spending, European and Asian leaders want more government regulation of the financial system. And they have been openly skeptical of Treasury Secretary Timothy F. Geithner's regulatory plans, suggesting they don't go far enough.”
(Retrieved from the article “Obama at G20 Summit”, March 30th, 2009, from The LA Times Website:,0,
“President Nicolas Sarkozy and Chancellor Angela Merkel said Europe had done a lot already to provide economic stimulus. What was needed was far tougher regulation, whose targets would include banking transparency, hedge funds, traders’ pay, rating agencies and tax havens. Another problem for firms and banks arises out of the interactions between the owners and managers.”
(Retrieved from the article “Be Bold”, April 2nd, 2009, from The Economist Website:

Since all of the other arguments basically involve macroeconomic analysis, I would like to describe the last one within a microeconomic context. According to the principal-agent-theory, there is a conflict of interest between the owners and managers. In economics, the principal-agent problem treats the difficulties that arise under conditions of incomplete and asymmetric information when a principal hires an agent. The theory is concerned with resolving two problems that can occur in agency relationships.

The first is the agency problem that arises when (a) the desires or goals of the principal and agent conflict and (b) it is difficult or expensive for the principle to verify what the agent is actually doing. The problem here is that the principal cannot verify that the agent has behaved appropriately. Therefore it is likely that the manager tries to achieve short-term profits to maximize his outcome while the company’s interest focuses on long-term success and survival.
The second is the problem of risk sharing that arises when the principal and agent have different attitudes towards risk. The problem here is that the principle and the agent may prefer different actions because of the different risk preferences. Because managers benefit from the firm’s short term profits by a premium and still receive their full salary even with bad decisions, they are less risk-averse than the owners.

These problems can lead firms into a crisis and contribute to the current economic downturn.Therefore I think it is important, that this argument was mentioned and that firms generate solutions for this problem. Various mechanisms may be used to try to align the interests of the agent with those of the principal, such as incentives like piece rates/commissions, profit sharing, efficiency wages, the agent posting a bond, or fear of firing. In my opinion, these do not prevent the short-term orientation of managers. I would rather suggest the concept of a bonus bank. An instrument that pays managers only a certain percentage of their incentives, leaving the remain in their bonus bank account and distributing it over the next few periods. However, if the target achievement of the managers in the following year is lower or even negative, a negative credit can offset their credit account in the bonus bank. This way the interests can be aligned and the managers have incentives for long-term orientation. It would help the company’s efficiency and long-term success which could stabilize the economy.

This was an analysis of only one out of few arguments mentioned, to solve the global economic crisis with the hopes that the G20 group can compromise and develop a common and successful stimulus package.

May 8, 2009

offshore tax havens

President Obama presented proposals in order to crack down on overseas tax havens. Obama claims that these oversea tax havens are costing tax payers “tens of billions of dollars a year." One of the key changes would restrict companies from deferring the payment of taxes on profits earned overseas. Administration officials stated, “The plan also would keep firms from taking deductions against their taxes by inflating the amount of foreign taxes they paid.” Obama also claims he is aiming to take away the competitive advantage for companies that invest and create jobs overseas, working to replace their tax advantages with incentives to produce jobs in the U.S. He plans to rise of 200 billion dollars in 10 years.

Double taxation to US global business is only going to benefit our foreign competitors. If Obama continues on with this he could put many American corporations at a strong disadvantage. American corporations use global strategies (offshore tax havens) in order to remain competitive in the industry. Tax foreign profits of our corporations and you just cut our ability to compete. By changing these rules, Obama will again be putting US companies at a greater competitive disadvantage.

May 4, 2009

Powers struggle

According to this local paper, our fair town of Colorado Springs, USA, is divided into two main parts, as far as restaurants go: the downtown area and the Powers Boulevard area. In the downtown area, franchises really struggle whereas on Powers, local restaurants are losing lots of money. Now the franchises might have to just take the fact that they cannot compete, but I think that the locals have opportunities that they might not be taking advantage of.
According to the article, “One of the biggest threats to independent restaurateurs is food costs” (Schniper, Matthew. “Powers struggle.” independent April 30-May6, 2009: 22). These threats can be separated further into four categories: 1. Wage wars from “bulk-buying chains” 2. An explosion of competitors 3. A dramatic increase in rent 4. A strong susceptibility to troughs in the business cycle.
Notice anything in common about these categories? If you realized that they all reflect greater costs for smaller restaurants, give yourself a cookie. In economics, this is referred to as positive economies of scale, and means that much greater profits can be had by growing larger. How much larger? The company should ideally try to produce the quantity that will result in the lowest average cost. In a perfectly competitive market (which should provide a good approximation in this case), this will also be the point in which marginal revenue equals marginal costs of the industry; the profit maximizing point.
One might conclude that this implies that the large companies are guaranteed to corner the market around Powers, but this is not so. According to Mr. Link, an owner of Eastside Grill and ex-owner of a Ruby Tuesday franchise, the flexibility of his new restaurant menu went a long way toward covering the gap because now he can react to what his customers are asking for, which buys him consumer loyalty and is more in tune with customer preferences. In fact, many of the restaurant owners that were interviewed in the article felt that two companies would definitely flourish, simply because their offerings were unique and authentic to their ethnic heritage.
To me, the obvious solution is that this dilemma is to consolidate. Cartels may be illegal, but two shops might find that they can peacefully share a larger building in order to cut down on costs and to cause some advertising due to the novelty. After all, several larger restaurants have done so successfully (such as the Pizza Hut/ Taco Bell that lies down the street from me). If lots of restaurants started “buddying up,” they could reduce the competition; share the cost of rent; and support each other through the lean times. If they share ingredients, they may even be able to cut down on their food costs by buying in bulk and cutting back on spoilage and waste.

May 3, 2009

Gas Tax

This article suggest imposing a higher tax on gasoline due to the fact the prices have dropped from the $4.00 per gallon to $2.30 and Americans are using this price fall to consume more. As Americans consume more gas it drives the demand up resulting in higher gasoline prices. This article also introduces the idea that if the government raised the gas tax it would reduce consumption and prices would likely fall also with greenhouse gasses.

In the economic times of today this gas tax would pose many negative threats. First off this tax would attack the poor more than the rich and as unemployment raises this tax would place a burden on the many families affected by this economic downturn. Also with Chrysler and GM failing this tax would aid in destroying these companies as they are known for their trucks and SUVs. With this raise in gas prices GM and Chrysler would see a drop in demand for their vehicles.

There are many other solutions to reduce the use of gasoline. Auto makers continues to invest in making care more fuel efficient also with focusing more on alternative fuels such as natural gas, bio fuels and electricity. If more Americans have access to alternative fuel vehicles the gasoline consumption is reduced more than if a high tax is imposed.

May 2, 2009

"It'll be the domino effect."

This article suggests that with the declared bankruptcy, and subsequent closing, of Chrysler, other auto manufacturers might have to face shutting down as well. This is because the plants in charge of supplying Chrysler with parts will suddenly be losing a lot of money, possibly closing down, leading to a shortage in parts in the auto industry.

Looking at the situation as if the car manufacturers are in monopolistic competition, it can easily be seen that one firm leaving the industry could allow other firms to increase production, possibly even bringing them out on top of this economic recession. However, the article is right to look at the parts manufacturers.

Parts manufacturers, with the exit of Chrysler, suddenly find themselves with a decreased demand for their product. Again using the monopolistic competition model, this would result in a sharp decrease in quantity produced, with an increase in price. This demand shift occurs due to two reasons: first, the firms that produced Chrysler-specific parts no longer have any sellers; second, the firms had already been giving the auto manufacturers as many parts as they needed.

With the price increase on one of their inputs, auto manufacturers may find it difficult to continue production at current levels, at least as far as the short run. Lowering production means lowering already low profits, which could force auto manufacturers to close plants or even declare bankruptcy themselves.

It is possible that the closing of Chrysler would increase demand for other types of vehicles, because people who would have bought a Chrysler would eventually no longer be able to do so. But Chryslers aren't going to simply disappear overnight, and a manufacturer declaring bankruptcy could shake consumer confidence in all auto manufacturers, decreasing demand even further. It's difficult to say which shift will be observed until it actually occurs.

Can Toys "R" Us Sell Toilet Paper?

In today’s market, many businesses are struggling to stay afloat and many have been forced to close because consumers do not have the money to spend. What do you do when people cannot afford to spend money on luxuries and your business specializes in such things as electronics or children’s toys? Toys “R” Us seems to think they have the solution to that problem. They have announced that they are going to open a new convenience section, called the “R” Market, where they plan on carrying items like toilet paper, paper towels, laundry detergent, food and baby supplies. Sounds like a good idea to me. If you cannot stay afloat in your own market then move to one that is not doing so poorly. That is the way a market works. You stick with it as long as you are making an economic profit. However, Toys “R” Us is no exactly changing markets. They are just branching out in efforts to recover. I don’t see this working. They may get the occasional last minute shopper that forgot to buy toothpaste while they were at Wal-Mart, but that will probably be it. Parents that cannot afford luxuries are not going to take their children to the toy store just to but toothpaste. That is a tantrum waiting to happen. You take your kid to the toy store to buy toys not essentials. This is what Toys “R” Us is overlooking, peoples preferences. People prefer convenience, but not at the expense of there pocket book. They are still going to have to buy that toy they cannot afford. The demand for luxuries is low and simply offering something else of higher demand is not going to raise the demand for the luxury. Essentials and luxuries are two different markets and offering essentials in a market for luxuries does not affect the demand for luxuries.

May 1, 2009

Life's Certainties: Death and Taxes

Ben Franklin’s adage finds relevance in an April 22nd WSJ article bringing up Obama’s proposal to increase corporate taxes on overseas profits. Written by Jesse Drucker, the article stresses the administrations proposal to generate a “potential 20 billion dollar tax revenue” to combat the fiscal recklessness seen by critics in its first 100 days. Drucker states that currently, “U.S. companies can defer taxes indefinitely on the profits they say they have earned overseas until they repatriate that money back to the U.S.” Corporations that will most likely be hurt include, global corporations like Phizer, Hewlett Packard, and Coca Cola. But these companies have benefited immensely as well, for example Phizer due to the current law, cut its effective tax rate by 20.2 percent. While the complete repeal of the law that allows for such benefits is unlikely a restructuring is a valid proposition. In defense of corporations, America’s corporate tax is amongst the highest in the world--around 35%, on the other hand critics point out the number of loop holes in the tax code and the fact that a lot of these larger corporation hold profits in shell offshore companies to stem off taxes. Accordingly, the administration “is committed to reforming deferral to improve the overall efficiency and equity of the tax code by reducing incentives to divert investment from the U.S. in order to avoid taxation.”

While the argument possesses a populist sentiment, it undermines several economic ideas. First, the idea of diverting investment from the US, suggests that the idea of trade being a zero sum game, contradicting classic economic thought. Acquiring comparative advantage through trade and competition, progresses all participants. While the spokesperson for the administration might equate money as investment, and thus divestment, wouldn’t it make more sense that a lower corporate tax to begin with would attract more foreign investment into the US? Higher corporate taxes hinders US companies to compete and taxing profits hinders them substantially, in a global economy it is essential that we are able to grow our corporations to benefit not only ourselves but the world. How are US companies able to compete overseas where domestic companies are being taxed at a considerably lower rate and have an advanatge in their business model. By removing incentives like these laws, it only inhibits competition globally. As the article states these “titans” of industry aren’t going down without a fight, with significant lobbying power, Round 1 of this fight will be bloody.