Quiz #2 week of Feb 22, on lectures 3 (Economic
Change) and 4 (Finance, Cycles, etc).
Study the PowerPoint and use the Study Guide that will
be on the website.
Questions are taken from the visible PowerPoint slides.
More detail is on the hidden slides or slide notes but no
questions are taken from them.
Data questions: No specifics required unless I say so in
lecture but you need to know ‘greater than,
increase/decrease’ type answers.
Date questions: I give you dates/periods and you have to
know what went on.
Booms and Busts
Evolution of spatial economic systems is marked by
periods of prosperity and periods of decline.
In the vernacular, they are labeled as booms and busts
and have distinct cyclical periodicity.
We are going to explore four types of economic
periodicity that have been identified:
Kondratieff Cycle
Inventory Cycle
Product Cycle
Keynes Cycle
But before that we will look at the financial/banking
system and how it (didn’t) work.
CONTAGION
CONTAGION - INTRO
2008
…three years later…
INTRODUCTION
…now
INTRODUCTION
Global Connectivity & Finance
The 2008 Financial Crisis (a.k.a. Sub Prime Mortgage Affair)
Complex cause and effect between:
Sub Prime Mortgages
Housing bubble
Credit derivatives market and bubble
Real trouble started in the U.S. with the 1999 GrammLeach-Bliley Act (GLBA).
GLBA repealed the 1933 Banking Act called the GlassSteagall Act.
The Glass Steagall Act was designed to prevent the
financial speculation that caused the Great Depression.
The Financial System
A Simple Overview of the Financial Sector
Financial sector has four primary actors:
Retail banks – your savings and credit.
Private (investment) banks – trade in stocks, bonds, derivatives.
Credit Rating Agencies – who assess risk.
Insurance companies – who buy risk.
Bank Acts in various countries (prompted by the Great
Depression 1929) separated these four players, legally
preventing them from trading in each others products.
This was done to partition risk and prevent what would later be
called “cascade failures”.
THE FINANCE SYSTEM
A Happy(‘ish) Retail Banking Place
Equity (your money) protected
to some extent by government
deposit insurance and bank
reserve requirements.
Retail bank pays you
interest.
Difference between
interest paid and
interest earned is
profit, out of which…
Banks’ money protected by
insurance companies who
buy risk.
Retail bank takes your
savings and pays you
interest.
Retail bank lends your savings to
mortgages and credit purchases,
and secured investments
and makes interest.
Small risk due to defaults on secured
mortgages, loans, credit cards and
THE FINANCE SYSTEM
bonds.
A Risky(‘ish) Private Banking Place
Equity (investor’s money)
not protected.
Private bank takes
investors’ money and
pays a ROI.
Private bank pays you a
ROI.
Difference between money
invested and ROI earned is
profit (or loss), out of which…
Banks’ money protected by
insurance companies who
buy risk.
Private bank buys all
types of investments
and makes/loses money.
Large risk
equivalent with risk
of investment.
THE FINANCE SYSTEM
Risk is
assessed by
credit
agencies.
The Happy-Risky’ish Banking System 1933-1999
Equity (your money)
protected to some
extent by CDIC and
bank reserve
requirements.
Retail
Banking
Retail bank takes
your savings and
pays you interest.
Retail bank pays
you interest.
Difference
between interest
paid and interest
earned is profit,
out of which…
Retail bank lends your
savings to mortgages and
credit purchases, and
secured investments and
makes interest.
Small risk due to defaults on secured
mortgages and loans, and on credit cards.
T
H
E
B
A
N
K
A
C
T
THE FINANCE SYSTEM
Private
Banking
Equity (investor’s
money) not
protected.
Private bank pays
you ROI.
Difference
between
money
invested and
ROI earned is
profit, out of
which…
Banks’ money
protected by
insurance
companies
who buy risk.
Insurance
Companies
Private bank
takes investors’
money and pays
ROI.
Private bank
buys all types of
investments and
makes/loses
money.
Large risk
equivalent
with risk of
investment.
Risk is
assessed by
credit
agencies.
Rating
Agencies
The Unhappy-Very Risky Banking System
Equity (your money)
protected to some
extent by CDIC and
bank reserve
requirements.
Retail
Banking
Private
Banking
Equity (investor’s
money) not
protected.
Retail bank takes
your savings and
pays you interest.
Trade in
unsecured
instruments
Retail bank pays
you interest.
Difference
between interest
paid and interest
earned is profit,
out of which…
Retail bank lends your
savings to mortgages and
credit purchases, and
secured investments and
makes interest.
Trade in
CDO and
MBS
Retail banks
instruments
invent Sub Prime
Mortgages
Small risk due to defaults on secured
mortgages and loans, and on credit cards.
High risk due to defaults on unsecured mortgagesTHE FINANCE SYSTEM
and loans, and on credit cards.
Private bank pays
you ROI.
Difference
between
money
invested and
ROI earned is
profit, out of
which…
Private bank
takes investors’
money and pays
ROI.
Private bank
buys all types of
investments and
makes/loses
money.
Rating
Insurance
agencies
companies
buy (high
Banks’ money
Risk is
Large risk
buy
protected
by (high
risk)
CDO
assessed by
equivalent
insurance
risk) CDO with risk of and credit
MBS
companies
agencies.
investment.
and
who buy
risk. MBS
and rate
Rating
them lower
Insurance
Agencies
risk!
TheThe
Unhappy-Very
Risky
System
Largest Failure
ofBanking
Unregulated
Retail
Private
Capitalism
Since
1929
Banking
Equity (your money)
protected to some
extent by CDIC and
bank reserve
requirements.
Banking
Equity (investor’s
money) not
protected.
Retail bank takes
your savings and
pays you interest.
Trade in
unsecured
instruments
Retail bank pays
you interest.
Difference
between interest
paid and interest
earned is profit,
out of which…
Retail bank lends your
savings to mortgages and
credit purchases, and
secured investments and
makes interest.
Trade in
CDO and
MBS
Retail banks
instruments
invent Sub Prime
Private bank pays
you ROI.
Difference
between
money
invested and
ROI earned is
profit, out of
which…
Private bank
takes investors’
money and pays
ROI.
Private bank
buys all types of
investments and
makes/loses
money.
Rating
Insurance
agencies
companies
buy (high
Banks’ money
Risk is
Large risk
buy
protected
by (high
risk)
CDO
Mortgages
assessed by
equivalent
insurance
risk) CDO with risk of and credit
MBS
companies
Small risk due to defaults on secured
agencies.
investment.
and
who buy
risk. MBS
mortgages and loans, and on credit cards.
and rate
Rating
them
lower
Insurance
High risk due to defaults on unsecured mortgages
CONTAGION - WHAT HAPPENED
Agencies
and loans, and on credit cards.
risk!
The Effects…
CONTAGION - THE RESULTS
Who Gets Affected?
Financial companies who directly participated lose
billions directly and quickly.
Financial companies who did not participate but still held
loans and insurance policies to banks who did also lost
billions.
Private individuals who had deposits in bankrupt banks
lost billions.
Manufacturing that relies on credit to keep production
going could not get it so went out of business.
Nations (taxpayers) who had to bail out the banks to
break the cycle lost billions, whether they were involved
or not.
CONTAGION - WHAT HAPPENED
Where Gets Affected?
Everywhere:
Developed world economies that:
started the problem;
held debt from other developed economies;
needed credit to keep their manufacturing going;
needed customers to keep their economies going.
Emerging economies that:
held debt from the developed economies;
needed credit to keep their manufacturing going;
needed customers to keep their economies going.
CONTAGION - WHAT HAPPENED
The Lead Up…
CONTAGION - THE RESULTS
A small sample of US bank mergers 1990 to 2009
(Think ecology here – the more complex ecosystems are, the safer.
Gramm-Leach-Bliley
37
U.S. FDIC had 8,430
banks registered in
August 2008. By
Feb 2014 there
were 6,799 left.
Citigroup bailout $25 billion
JP Morgan Chase bailout $25 billion
4
Bank of America bailout $15 billion
Wells Fargo bailout $25 billion
CONTAGION - WHAT HAPPENED
Global Growth in Derivatives, 1998-2013
Nominal value invested in
OTC derivatives in 2nd half
2013 = $710 trillion.
Gramm-Leach-Bliley
This is about an 8-fold
increase in
value since 1998.
49 times US annual GDP.
775 times Ontario’s GDP.
$99,000 for every person
on earth.
THEMES - CONTAGION
1: Adjusted for inter-dealer doublecounting.
2: Share refers to the percentage of
semiannual reporters in the global total.
Source: Bank for International Settlements,
OTC Derivatives Statistics November 2013
The derivatives bubble is clearly seen in these data. It is over
13 times global market capitalization - the global value of all
stocks.
At their peak in June 2008, total
derivative value was almost $700
trillion – ten times global GDP and
seven times what they were in 2000.
Trillions of dollars.
THEMES - CONTAGION
Share by Type of Derivative, 1998-2013
1998
2007
Credit derivatives are
CDO and include MBS.
Gramm-Leach-Bliley
They barely existed in
1998.
By 2007 their nominal
value was $51.1 trillion
(@9% of all derivatives).
In 2013 it was still $24.4
trillion.
THEMES - CONTAGION
1: Adjusted for inter-dealer doublecounting.
2: Share refers to the percentage of
semiannual reporters in the global total.
Source: Bank for International Settlements,
OTC Derivatives Statistics November 2013
Trillions US$
Credit
Derivatives,
2007-2013
CONTAGION - WHAT HAPPENED
The boom
and then
bust of CDO
pre- and
post 2008 is
evident.
1: Adjusted for inter-dealer
double-counting.
2: Share refers to the percentage
of semiannual reporters in the
global total.
Source: Bank for International
Settlements, OTC Derivatives
Statistics November 2013
Trillions of Dollars
Beginning in 1999 MBS issuances begin to grow rapidly, the
majority being issued by government mortgage agencies.
Gramm-Leach-Bliley
CONTAGION - THE RESULTS
The Results…
CONTAGION - THE RESULTS
The Bubble Begins to Burst………….
Foreclosures 1st quarter 2008
In the U.S. …
Gramm-Leach-Bliley
Foreclosures 1988-2007
CONTAGION - THE RESULTS
Foreclosures
1988 to 2008
Housing Prices
Annual Change in
Home Prices
CONTAGION - THE RESULTS
Industrial Output
CONTAGION - THE RESULTS
Employment
Job Openings
Unemployment
Rate
CONTAGION - THE RESULTS
Discretionary Retail Sales
CONTAGION - THE RESULTS
UK Housing Prices Adjusted for Inflation
2008
And the offshore loop
wired in European
nations, in classic
contagion fashion.
2008
1975
1999
CONTAGION - THE RESULTS
Spain
Housing Prices
2008
1999
CONTAGION - THE RESULTS
Ireland - Housing Prices
Dublin
Eire
2008
1999
CONTAGION - THE RESULTS
Canada - Housing Prices
140.00
120.00
100.00
80.00
60.00
40.00
20.00
0.00
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
Index Number (2007 = 100)
160.00
Canada
Toronto
Edmonton
St. John's
Winnipeg
Vancouver
Montreal
Calgary
Victoria
Canada - Housing Prices 2007-11
150
Index Number
140
130
120
110
100
90
80
2007
Canada
St.John's
Toronto
Calgary
Victoria
2008
2009
2010
2011
Major Metropolitan Areas
Montreal
Winnipeg
Vancouver
Edmonton
The Co$t…
CONTAGION - THE COST
Cost of TARP (Well
known bailout
program):
$750 billion
Cost of 50 other US
federal government
programs, guarantees
and write-downs:
$14.4 trillion
CONTAGION - THE COST
Annual value of US
GDP:
$14.2 trillion
A Reprise on Global Dollars
Global GDP in current dollars, 2012 = $72.9 trillion.
Global market capitalisation 2012 = $53.2 trillion.
U.S. GDP in current dollars, 2012 = $16.2 trillion (22%).
U.S. market capitalisation 2012 = $18.7 trillion (35%).
Cost of 2008 financial crisis by 2012 = $22 trillion (US alone).
33% of global capitalization value lost = $17.6 trillion.
US bank bailouts = 734 ($204,808,576,320)
Current notional cost of global derivatives: $600 trillion.
Amount spent on cancer research by Nation Cancer Institute:
@$2.5 billion
CONTAGION - THE COST
Sources: http://www.gao.gov/assets/660/651322.pdf. http://data.worldbank.org/data-catalog/world-development-indicators.
In 2009
Robert
Rubin, Alan
Greenspan
and Larry
Summers
formed to so
called
“committee
to save the
world” that
developed
the finance
sector
bailout plans
in the U.S. to
the tune of
$14 trillion.
THEMES - CONTAGION
In 1999
Robert
Rubin, Alan
Greenspan
and Larry
Summers
fought for
and won the
repeal of
the GlassSteagall Act
thereby
deregulating
the financial
sector that
allowed the
2008 crisis
to occur.
Contagion and Cascade Failure
The 2008 CDO/MBS crisis is example of the cascade
failure that results from a contagion.
Triple A financial securities considered almost risk
free - “as good as cash”.
Risk estimate on the CDOs and MBSs was evaluated
by credit rating agencies at about 1% - they might
lose 1% of their value. They lost 20%.
But credit agencies were underestimating risk on the
very derivatives they were buying.
AND THE LEGACY?
CONTAGION - THE COST
CONTAGION - THE COST
OVERALL DEBT AS A % OF GDP
EU & Japan, Korea most indebted
With China & India holding that debt
http://www.economist.com/blogs/buttonwood/2010/06/indebtedness_after_financial_crisis
Top Ten Debtor Countries by Volume
External debt
Per capita
Country
% of GDP
US dollars
US dollars
World
$56,900,000,000,000
$8,422
98%
United States That is,$13,450,000,000,000
US$13.45 Trillion $43,758 94%
United Kingdom
$9,088,000,000,000
$147,060 416%
Germany
$5,208,000,000,000
$63,493 155%
France
$5,021,000,000,000
$80,209 188%
Netherlands
$3,733,000,000,000
$226,503 470%
Spain
$2,410,000,000,000
$52,588 165%
Italy
$2,328,000,000,000
$39,234 101%
Ireland
$2,287,000,000,000
$515,671 1004%
Japan
$2,132,000,000,000
$702,714 205%
Luxembourg
$1,994,000,000,000
$4,028,283 3854%
Canada 13th $833.8 Billion
GDP Growth
Growth just now beginning to climb back to
2007 levels in the worst affected countries.
U.S. Housing and Labour Markets
Both are leveling off, albeit at low and
high levels respectively.
The other downside of capitalist democracies.
In the 2000 presidential election, 80% of the $314 million contributed to the
Bush campaign and the Republican National Committee, came from
corporations or individuals employed by them. The WSJ investigated how
many industries were lobbying for policies and concessions as a return on
their "investment."
http://www.wsj.com/articles/SB983833353790355901
Have we finally learned a lesson?
Perhaps not…
In December big US banks succeeded in getting parts of the
Dodd-Frank Act2 repealed, especially the Volker Rule that
stopped them from trading in the more speculative
derivatives – such as CDOs.
The “big US banks” in question (and their 2008 bailouts) were:
Citigroup ($25 billion)
Bank of America ($15 billion)
J.P.Morgan Chase ($25 billion)
Goldman Sachs ($10 billion)
Morgan Stanley ($10 billion)
2A
final irony: the full name of the Act is the Dodd Frank Wall
Street Reform and Consumer Protection Act (neither of which
it appears to have done).
Have we finally learned a lesson?
Perhaps not…
According to the Bank for International Settlements, the
global derivatives market is now at $710 trillion – 20% higher
than in 2007.
The “big US banks” hold about 30% of that amount, with
Goldman Sachs holding about $48 trillion and Citibank about
$62 trillion.
Only 5% of those holdings are in what are considered “safe”
instruments: regulated, transparent, exchange-traded
products.
The rest are in what the NYT1 calls “…far more lucrative,
opaque over-the-counter products.”
1http://dealbook.nytimes.com/2014/05/13/derivatives-markets-growing-again-with-few-new-protections/?_r=0
THEMES - OTHER
Economic Cycles - Models
The Kondratieff (or long wave) Cycle.
Forty to sixty year cycle.
Schumpeter’s Innovation-Invention cycle.
Mensch’s causal mechanism.
The Inventory Cycle.
Four year cycle.
Relationship between supply & demand, and
inventory to sales ratios.
The Product Cycle.
Based on process of bringing products to market.
The Keynesian Cycle.
Less a cycle and more a macro-economic system.
ECONOMIC CYCLES - INTRO
ECONOMIC CYCLES - KONDRATIEFF WAVES
The Kondratieff Long Wave
(a.k.a. K-Waves, super-cycles)
Industrial revolutions not smooth but comprised of:
A succession of innovations.
Occurring at roughly fifty year intervals.
Punctuated by major economic depressions.
Characterised by the collapse of the former growth industries
that:
Had overshot needs and were overbuilt.
Were overprotective.
Were hostile to innovations that threatened their status quo.
Russian economist Nicolai Kondratieff postulated (1925) that
the industrial nations experienced successive cycles of growth
and decline of about fifty years periodicity.
ECONOMIC CYCLES - KONDRATIEFF WAVES
Stock
index
line
Wholesale
Price
index
line
1789-1844
1845-1896
1896-1949
ECONOMIC CYCLES - KONDRATIEFF WAVES
1949-2010?
A fifth
Kondratieff?
Electrification
Chemicals
Autos/Oil
Stock Steam
indexTechnology
line
Autos/Oil
ITC
Rail/Steel
Technology
Bio
Nano
Environmental
Technology
Robotics
Price
index
line
17891844
18451896
18961949
ECONOMIC CYCLES - KONDRATIEFF WAVES
19492010?
2010?-2070?
How Do Kondratieff Waves Work?
Kondratieff Waves are well accepted in financial
economic analysis but not in mainstream economics but
hasn’t stopped them from trying to figure out a process
for them.
Two main causal mechanisms exist to explain them:
Schumpeter’s invention/innovation cycle.
Mensch’s metamorphosis model, based on…
… the Product Cycle, and…
… the Inventory Cycle.
ECONOMIC CYCLES - KONDRATIEFF WAVES
ECONOMIC CYCLES - INNOVATION AND INVENTION
Schumpeter’s Invention/Innovation Cycle
Schumpeter (one of the great economists) said that
K-Waves coincide with long periods of invention
accumulation followed by bursts of innovation.
That is, inventions are made into new and different
products or innovations.
For example, the bright idea (invention) gets made
into the light bulb (innovation).
These are adopted and produced, and go on to
replace the previous similar innovation (e.g.
gaslights).
Each peak in the K-wave coincides with these new
innovations on the market.
ECONOMIC CYCLES - INNOVATION AND INVENTION
Production and Adoption
Replaces
ECONOMIC CYCLES - INNOVATION AND INVENTION
Schumpeter’s Invention/Innovation Cycle
Percent of Peak Development
E.G. POWER SOURCES
Various types of increasingly more efficient power sources
replace one another.
Water Power
Coal
Oil/Petroleum
Spatial Constraints on Location Loosen
1800
Kondratieff Periods
?
1850
1900
ECONOMIC CYCLES - INNOVATION AND INVENTION
1950
2010
Schumpeter’s Invention/Innovation Cycle
Percent of Peak Development
E.G. TRANSPORTATION
Various types of increasingly more efficient transportation modes
replace one another.
Inland waters
Railroads
Motor vehicles
Surfaced
Roads
Spatial Constraints on Location Loosen
1800
Kondratieff Periods
?
1850
1900
ECONOMIC CYCLES - INNOVATION AND INVENTION
1950
2010
Mensch’s Metamorphosis Model
ECONOMIC CYCLES - MENSCH METAMORPHOSIS
Mensch’s Metamorphosis Model
Why should the invention/innovation cycle
work at all?
Based on capital seeking best places to invest,
which leads to…
The Product Cycle
and
The Inventory Cycle
Both of which supply these opportunities
because the invention -> innovation cycle
requires production and inventory.
ECONOMIC CYCLES - MENSCH METAMORPHOSIS
Growth in investment & prosperity
Mensch’s Metamorphosis Model
Capital shifts to paper investment,
companies maintain product status
quo, marketing ‘innovations’
prevail, company value based on
growth, risk avoidance increases.
Capital shifts to safe
assets (e.g. gold),
companies contract &
maintain profit though
decreasing costs, bubble
valuations prevail, risk
Causal
Mechanisms:
avoidance high.
Other
Possible Coincident
Capital seeks
Saturation
accumulated
Demographics
– Spans
Two Generational Periods
Stagnation
inventions to
War
– Saturation
Level Coincident With Conflicts
innovate
into
Acceleration
products,
companies are
undervalued, risk
avoidance low.
Inventions
Decline
Rapid growth
Initial entry
Capital seeks accumulated
inventions to innovate into
Innovations
products, companies are
undervalued, risk avoidance low.
ECONOMIC CYCLES - MENSCH METAMORPHOSIS
<KONDRATIEFF
WAVELENGTH>
Initial entry
TIME
ECONOMIC CYCLES - PRODUCT CYCLE
The
Product
Cycle
Four stage cycle in the development and decline of a product. Length
depends on the product and/or product group (e.g. T.V.s versus autos).
Nested consecutive sets of product cycles typify the rapid growth,
acceleration, and saturation stages of the K-Wave – the so called spring,
summer and autumn stages.
Sales & Profits
Monopoly
Competition
Sales
Profits
R&D Introduction
Growth
ECONOMIC CYCLES - PRODUCT CYCLE
Maturity
Saturation
The Product Cycle - Consumers
Four types of consumers, one each for the product market
periods. Will explore this more in Diffusion lecture.
Sales
Monopoly
Competition
Late Majority
Early Majority
Early Adopters
R&D Introduction
Laggards
Growth
Maturity
ECONOMIC CYCLES - PRODUCT CYCLE
Saturation
ECONOMIC CYCLES - INVENTORY CYCLE
The Inventory Cycle
Has two phases – growth and decline.
Length depends on the type of product and/or product
group (e.g. clothing, T.V.s, autos).
Cyclical interplay between production & inventory,
demand, competition and, especially, investment.
Investment is the mechanism that starts the cycle of
growth again, after product saturation due to
competition stalls it.
Therefore the inventory cycle is meshed intimately with
the product cycle.
ECONOMIC CYCLES - INVENTORY CYCLE
The Inventory Cycle
Jobs created so more
demand follows.
Growth creates
demand.
Inventory increases to cope
with increased demand.
Production increases
to supply inventory.
Increased competition
leads to oversupply and
market saturation.
Sales decrease, production
continues, inventory increases,
imbalance occurs.
Jobs lost, demand
Investment in
decreases.
inventory increases…
Production decreases as growth
then decreases.
decreases due to saturation,
inventory is used up and not
replaced.
Under utilization of
INVESTMENT IN
Bleeding off of capital to carry
production capacity leads
UNDERVALUED
inventory leads to declining
to declining stock prices.
STOCK.
dividends and stock prices.
ECONOMIC CYCLES - INVENTORY CYCLE
Investment in company leads to jobs and growth in demand starts again.
ECONOMIC CYCLES - PEAKES, TROUGHS, LAGS
Peaks, Troughs and Lags
Peaks:
Occur when a cycle reaches its zenith.
Not always a good thing - precursor to trough.
Happen in later stages of product and
inventory cycles.
Market is hot - people invest unwisely in
overvalued stocks causing bubbles.
ECONOMIC CYCLES - PEAKES, TROUGHS, LAGS
Peaks, Troughs and Lags
Troughs:
Occur when a cycle bottoms out.
Not always a bad thing – precursor to growth.
Happens in earlier stages of product and
inventory cycles.
Market is cool – people invest wisely in
undervalued stocks and new products.
ECONOMIC CYCLES - PEAKES, TROUGHS, LAGS
Peaks, Troughs and Lags
Lags:
Occurs when effect is slower than cause.
Occurs always, but sometimes get elongated.
Is the root of synchronization issues:
Remedies for an effect are too slow and happen too
late, making cycles ‘stumble’ over one another.
Remedy for cause of one problem may exacerbate
cause of another.
Good example is Keynesian model.
ECONOMIC CYCLES - PEAKES, TROUGHS, LAGS
ECONOMIC CYCLES - KEYNES
John Maynard Keynes - 1936
Macroeconomic model involves complex interplay of the
product and inventory cycles and how they affected
national economies by generating peaks and troughs of
economic growth.
Cyclical interplay between production, inventory,
demand, competition and especially investment,
generated periods of inflation during peaks and
unemployment during troughs.
Government investment or taxation could be used to
control inflation or unemployment.
Model was used in the late 1930s and in the post war
years providing governments with a tool for controlling
unemployment and inflation.
ECONOMIC CYCLES - KEYNES
How The Keynesian Model Works
STABLE CLOSED SYSTEM
INCOME EARNED = INCOME SPENT
Money is spent on
local goods by
Employees work to
Entrepreneurs
workers, investors,
make products,
invest and produce
governments.
earn and spend
goods to satisfy
AGGREGATE
income.
demand.
DEMAND
INJECTIONS:
LEAKAGES:
Investment from abroad.
Investment to abroad.
Government spending.
Government taxes.
Export earnings.
Import purchases.
EFFECTS:
EFFECTS:
Spending power rises.
Spending power falls.
Aggregate demand rises.
Aggregate demand falls.
Excess money but same stock of goods.
Factories close.
RESULT:
RESULT:
ECONOMIC CYCLES - KEYNES
INFLATION
UNEMPLOYMENT
UNSTABLE OPEN SYSTEM. INCOME EARNED ≠ INCOME SPENT
Fiscal Policy and Monetary Policy
Key to Keynesian macroeconomic model is aggregate
demand - the name given to how much capital is
floating around in an economy.
Producing and selling stuff drives employment and
prices, so…
Do too little, aggregate demand falls and you get
unemployment.
Do too much, you get too much money chasing too
few goods and you get inflation.
The two approaches to controlling an economy are
called fiscal policy and monetary policy.
ECONOMIC CYCLES - FISCAL AND MONETARY POLICY
Fiscal Policy and Monetary Policy
Fiscal policy tries to influence aggregate demand by controlling
leakages and injections through (e.g.):
Investment in public works (puts capital in).
Raising taxes (takes capital out).
Encourage/discourage exports/imports (in and out).
Done by government departments.
Monetary policy tries to influence aggregate demand by
controlling the money supply:
Interest rates (encourage/discourage spending).
Create/remove money itself (increase/decrease available capital).
Done by a nation’s central bank.
ECONOMIC CYCLES - FISCAL AND MONETARY POLICY
Keynesian Model Uses Fiscal Policy To Control Economy
STABLE CLOSED SYSTEM
INCOME EARNED = INCOME SPENT
Employees work to
make products and
earn and spend
income.
Money is spent on
local goods by other
workers, investors,
governments.
AGGREGATE
DEMAND
Entrepreneurs invest
and produce goods
to satisfy demand
INJECTIONS:
LEAKAGES:
Investment
abroad
Investment
abroad
POLICY to
TOOL:
POLICYfrom
TOOL:
Government spending
Government taxes
Export earnings
Import
purchases
Control leakages by:
Control
injections by:
EFFECTS:
EFFECTS:
MoreSpending
government
LessSpending
government
powerspending.
rises
power spending.
falls
Reducing
taxes.
Increasing
taxes.
Aggregate
demand
rises
Aggregate
demand
falls
Excess money
but same
stock of goods
Control
Control
exports.
Factoriesimports.
close.
RESULT:
RESULT:
ECONOMIC CYCLES - KEYNES
This is called
fiscal policy
INFLATION
UNEMPLOYMENT
Monetarists use Monetary Policy To Control Available Capital
STABLE CLOSED SYSTEM
INCOME EARNED = INCOME SPENT
Employees work to
make products and
earn and spend
income.
Money is spent on
local goods by other
workers, investors,
governments.
AGGREGATE
DEMAND
Entrepreneurs invest
and produce goods
to satisfy demand
INJECTIONS:
LEAKAGES:
Investment
abroad
Investment
abroad
POLICYtoTOOL:
POLICYfrom
TOOL:
Government spending
Government taxes
Export earnings
Import
purchases
Control leakages by increasing
ControlEFFECTS:
injections by
EFFECTS:
money
available
decreasing
money
Spending
poweravailable
rises
Spending
power through
falls
lowering
rates,
through
raising
interest
rates,
Aggregate
demand
rises
Aggregate interest
demand falls
Excess
money butmoney
same stock
of goods
increasing
money
decreasing
supply.
Factories
close.supply.
RESULT:
RESULT:
This is called monetary policy
INFLATION
UNEMPLOYMENT
The Keynesian Model Stumbles
Injections >Leakages=Inflation
Leakages>Injections=Unemployment
Therefore inflation and unemployment are inversely
related.
They supposedly cannot happen together.
But they did, starting in the 1970s with a phenomena
called stagflation.
Stagflation of 1970s occurred due to the increasing
complexity of leakages and injections…
ECONOMIC CYCLES - KEYNES
The Keynesian Model Stumbles
But the Keynesian model has one fatal flaw, if
it can be called that.
The model relies on sufficient lag times to
separate the effects of injections and leakages.
Each of these either alleviates or exacerbates
the problems they are designed to solve,
depending on when its effects are felt.
The 1970s saw several factors that decreased
the required lag times…
ECONOMIC CYCLES - KEYNES
The Keynesian Model Stumbles
Increasing size of financial sector and its invisible
leakages, along with…
IT advances and speed/volume of financial decision
making, along with…
Increasing complexity and porosity of territorial and
aspatial regulatory boundaries though which leakages
and injections occurred.
Oil crisis & decline of U.S. and Euro industry and with
it the loss of employment and thus demand.
Cheap products distort supply and demand
relationships.
ECONOMIC CYCLES - KEYNES
ECONOMIC CYCLES - SUMMARY
STABLE CLOSED SYSTEM
Growth creates
Capital shifts to
paper investment,
Capital shifts to safe
INCOME
EARNED
= INCOME SPENT
demand
companies maintain product
status
assetsincreases
(e.g. gold),
Inventory
to cope
Money
is
spent
on
Jobs created, more
with increased
demand
quo, marketing
contract
&
Employees
work to ‘innovations’
local goods by othercompanies
demand follows
Entrepreneurs
invest
prevail,
company
based oninvestors,maintain
profit though
make
products
and valueworkers,
Production increases
and costs,
produce
goods
growth
avoidance increases
decreasing
bubble
earn
and risk
spend
governments.
to
supply
inventory
Monopoly
Competition
Increased
competition
to satisfy
demand
valuations
prevail,
risk
income.
AGGREGATE
Capital seeks
Railroads
Motor
leads
tovehicles
oversupply
and
Inland
waters
Stock
avoidance
high
Sales
decrease,
production
DEMAND
Saturation
market saturation
indexinventions to
continues, inventory increases,
Stagnation
line innovate into
INJECTIONS:
imbalance occurs
Jobsproducts,
lost,
demand
Investment
in
Sales
Surfaced
Acceleration
Investment
from
abroad
Decline
Vietnam
Civil War
decreases
inventory
increases,
WW
1
companies
are
War of 1812
Roads
Government spending
Profits riskProduction
then decreases
decreases as growth
undervalued,
Late
Majority
Early
Majority
Export
earnings
Price
decreases
and
inventory
is
used
up
Rapid growth
Initial
entry
index avoidance low
EFFECTS:
up and not replaced
line
0 Under utilization of
Spending
power
rises
Capital
seeks
accumulated
INVESTMENT INAggregate
Inventions
Early Adopters
demand
risesinto
Laggards
Bleeding
off
of capital
to carry
inventions
to
innovate
production
capacity
leads
WW
2
UNDERVALUED
Innovations
Cost
Revenue Excess
Profit
inventory
leads
to declining
money
but same
stock
of goods
to declining
products,
companies
are
Initialstock
entryprices
STOCK
dividends
and stock prices
RESULT:
undervalued,
risk
avoidance
1949-2010?low
1789-1844
1845-1896
ECONOMIC CYCLES - SUMMARY1896-1949
TIME
INFLATION
of Peak
PercentSales
Profits
&Development
YES THIS WILL BE ON THE TEST
Spatial Constraints Loosen
Kondratieff Periods
<KONDRATIEFF WAVELENGTH>?
ECONOMICES OF SCALE - INTRO
Economies of Scale
Definition:
The reduction in unit costs of
production realized when more
units are produced.
I.E.
The more units you make the
cheaper each unit is to make.
Definition:
The reduction in costs of production
realized from clustering together
with other economic activities.
I.E.
The more economic activities gather
together, the cheaper it becomes to
produce things.
BUT ONLY TO A POINT.
BUT ONLY TO A POINT.
ECONOMICES OF SCALE - INTRO
Economies of Scale
Economics of ISE:
Localization effects:
• Cost per unit reductions.
• Effects of like industry clustering.
• Productivity increases.
• Reduced cost of inputs.
• Revenue enhancements.
Urbanization effects:
Limitations of ISE:
• Effects of shared resource pool.
• Indivisibility thresholds.
• Effects of shared infrastructure.
• Matching inputs to scales.
• Linkages.
• Mass consumption required.
• More demand.
• Downtime.
ECONOMICES OF SCALE - INTRO
Goal: Increase profits by reducing unit costs of production
• Economics of ISE:
• Cost per unit reductions.
• Production function, diminishing returns, marginality.
• Productivity increases.
• Capitalization, bulk buying, specialization of production process.
• Revenue enhancements.
• Control of market share/price through volume.
• Limitations of ISE:
• Indivisibility thresholds.
• Matching inputs to scales.
• Mass consumption required.
• Downtime.
ECONOMIES OF SCALE - INTERNAL
The Production Function
A production function is the relationship between
quantity of inputs and quantity of outputs, & is given by:
Y = f(x1, x2, .., xn) Factors of production
Where:
Y is the output
x is the quantity of various inputs
And the function is defined as:
Y = f(x1 | x2, .., xn)
varies | fixed
That is, only one variable is allowed vary in quantity while
the others are fixed.
The production function gives rise to the law of
diminishing returns.
ECONOMIES OF SCALE - INTERNAL
The Law of Diminishing Returns
OUTPUT
If every unit of input produced the same unit of
output the production function would be a 45
degree line. But…
INPUT
ECONOMIES OF SCALE - INTERNAL
The Law of Diminishing Returns
OUTPUT
A production function is affected by the law of diminishing
returns to scale, which states that as the quantity of one
variable of input is increased while the others are held
constant, the output or total product will…
then at a diminishing
rate (<450)…
reach a maximum (=00)…
then at a constant rate (= 450)…
first increase at an increasing rate (>450)…
INPUT
ECONOMIES OF SCALE - INTERNAL
then
decline.
Marginality
Important concept in economics because it
demonstrates that “best” and “most” are not the same.
Marginality is a measure of the output you get from
the last unit of input.
In other words, why invest more input than you need
to in order to produce output.
Most of us think of reward as getting the most we can
but marginality thinks of reward as getting the most for
the least.
ECONOMIES OF SCALE - INTERNAL
MEASURE OF INPUT
Total production
millions of units
0
0
1
2
3
4
5
6
7
DIMINISHING RETURNS
Inputs of labour in
millions of person
hours
100
250
375
476
550
MEASURES OF OUTPUT
Marginal product in
millions of units
(difference between
each new unit of
output for each new
unit of input)
100-0=
250-100=
375-250=
Highest
marginal
production
Average production
millions of units per
million person hours
(total
production/input)
0
100
100
150
125
125
125
101
74
50
600
Highest 119
average 110
production.
100
30
630
90
-6
8
624
ECONOMIES OF SCALE - INTERNAL
Maximum amount of production.
78
Internal Economies of Scale – Margins of Production
700
Quantity at which
maximum output
Quantity at which
is reached and
marginal returns
marginal returns
to inputs begin to
to inputs reaches
internal
is not
declinescale economies
zero.
600
500
400
300
200
Point of
to
produce as much as you can get.
Quantity at which
It is to produce as much
asreturns
you can
average
to get for as
to
little as you inputs
havebegin
to give.
decline
100
0
0
1
-100
Total output
2
3
4
5
6
7
Units of Input
Marginal output
Average output
ECONOMIES OF SCALE - INTERNAL
8
The Cost Curve
COST
A cost curve is produced by the way fixed and variable
costs combine
Total cost curve is
the sum of the
fixed and total
costs.
Fixed cost is constant
with quantity
produced. E.G. rent of
factory.
Variable cost increases with
quantity produced. E.G. raw
materials.
QUANTITY PRODUCED
ECONOMIES OF SCALE - INTERNAL
Cost Curve Data
But when we consider unit costs, the lines become curvilinear.
A
B
C
D=B+C
B/A
C/A
D/A
Units of Fixed Costs Variable Total Costs Fixed Unit Variable Total Unit
Output
of
Costs of
of
Cost of Unit Cost of Cost of
(millions) Production Production Production Production Production Production
1
2
3
4
5
6
7
8
9
10
10
10
10
10
10
10
10
10
10
10
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
ECONOMIES OF SCALE - INTERNAL
10.00
5.00
3.33
2.50
2.00
1.67
1.43
1.25
1.11
1.00
1.00
1.00
1.00
1.00
1.00
1.00
1.00
1.00
1.00
1.00
11.00
6.00
4.33
3.50
3.00
2.67
2.43
2.25
2.11
2.00
COST CURVES PLOTTED
20
18
16
Costs
14
12
10
8
6
4
2
0
1
2
3
4
5
6
7
8
9
Output
Fixed Costs
Variable costs
ECONOMIES OF SCALE - INTERNAL
Total costs
10
UNIT COST CURVES PLOTTED
20
18
16
NOTE:WHEN COSTS ARE AVERAGED OVER NUMBER OF UNITS,
UNIT COSTS DECREASE AT A DECREASING RATE OVER NUMBER
OF UNITS PRODUCED.
Unit Cost
14
12
10
8
6
Effect of diminishing returns seen
here in the different unit cost curve
slopes.
4
2
0
1
2
3
4
5
6
7
8
9
Output
Fixed Costs
Fixed unit cost
Variable costs
Variable
unit
cost
ECONOMIES OF SCALE
- INTERNAL
Total costs
Total unit cost
10
Average Unit Cost
Internal Economies of Scale
Unit Cost Curve
Diseconomies
of scale
Economies of
scale
Costs per unit
decrease but at
different rates
C1
Q1
Quantity of Output
ECONOMIES OF SCALE - INTERNAL
Effect of
diminishing
returns
seen here.
The ability to produce many units at lower costs per
of theDiseconomies
unit gives aEconomies
manufacturer
opportunity to reduce
scale the profit
prices, increasescale
demand, and soof
maintain
margin per unit. But profits increase and decrease to
scale as well.
Increasing Decreasing
profit to
profit to
scale
scale
Profit Per Unit
Maximum Profit Per Unit
Quantity of Output
ECONOMIES OF SCALE - INTERNAL
Revenue per Unit
Average Unit Cost
Internal Economies of Scale
Profit Generated Per Unit
Example - Assembly costs of various small cars in E.U.
At 15,000 units produced, assembly
cost per unit = @$870
At 45,000 units produced, assembly
cost per unit = @$400
At 195,000 units produced, assembly
cost per unit = @$220
ECONOMIES OF SCALE - INTERNAL
http://www.tms.org/pubs/journals/JOM/0108/Kelkar-0108.html
Example – Parts fabrication cost of various small cars, EU
At 12,000 units produced,
fabrication cost per unit =
@$2,100 for Audi and
Lupo Hybrid and @$1,250
for Lupo Steel.
At 195,000 units produced, fabrication cost per unit =
@$950 for Lupo Hybrid & Audi, & @$500 for Lupo.
Steel
ECONOMIES OF SCALE - INTERNAL
http://www.tms.org/pubs/journals/JOM/0108/Kelkar-0108.html
Parts cost breakdown for small cars, EU
60,000 cars annually 95,000 cars annually
Largest returns to
scale found in
tooling costs
ECONOMIES OF SCALE - INTERNAL
http://www.tms.org/pubs/journals/JOM/0108/Kelkar-0108.html
Restrictions on Internal Economies
Indivisibility threshold:
To be cost effective, machines must produce at their
maximum output.
Large scale operations require large scale inputs:
Upstream, instream, and output bottlenecks always
appear as scale increases.
Mass consumption required:
Large scale mass output requires mass consumption
that can absorb the output.
Downtime:
The unit cost curve for machine downtime is infinite,
the reason why retooling is expensive.
ECONOMIES OF SCALE - INTERNAL
Ford Motor Company, Rouge River Plant
Largest integrated factory in the world in 1928.
93 buildings, 16 million square feet, 100,000 employees.
Had its own dock, electrical plant, and steel smelting
plant, a glass making plant, and over 160 kilometers of
internal railroad.
Ran into issues daily with supplying the plant, getting
output off the site, and with mechanical problems.
A classic example of scale diseconomies.
ECONOMIES OF SCALE - INTERNAL
Definition:
The reduction in costs of production realized from
gathering together with other economic activities.
I.E.
The more economic activities gather together, the
cheaper it becomes to produce things.
Localization effects:
Effects of similar industries clustering.
Urbanization effects:
Effects of shared resource pool.
Effects of shared infrastructure.
Linkages.
More demand.
ECONOMIES OF SCALE - EXTERNAL
STORES
URBANISATION
ECONOMIES
Logistics
Forestry
Packaging
HR
consultants
LOCALISATION
ECONOMIES
Upholstery
Automakers
Light bulbs
Metal
fabricating
Finance
Janitorial supply
Paper air
filters
Wood
veneer
Electronics
Batteries
Transportation
Glass products
Rubber products
Labour pool
ECONOMIES OF SCALE - EXTERNAL
PEOPLE
Wiper blades
Localisation
Economies
The jewelry and
gun quarter,
Highgate,
London
ECONOMIES OF SCALE - EXTERNAL