Economics #8: Cost Disease


In economics, there is a simple idea called the Cobb-Douglas production function that tries to explain the relationship between labor (the total number of person-hours worked), capital (the real value of all machinery, equipment, and buildings), total factor productivity (the ability to produce more output with less input), and the total output of an economy. The idea is that since labor and capital are relatively fixed, economies grow by increasing their productivity, which technology is the main driver of.

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Economics #7: Rent vs Buy

Lately and frequently, the topic of homeownership has been popping up in my life. I don’t know if this is a result of my age or current economic trends, but I figured I might as well organize my thoughts on the subject.

Generally, the renting vs buying debate goes something like this: renting is essentially throwing money down the drain, while buying builds equity and sets you on the path to financial freedom. Throw in some narratives about the American dream and some wishful thinking about home price appreciation, and owning is just always better.

This post will explore this argument through the economics of renting vs buying. Of course, there are non-economic factors that come into play. For example, buying a house might just make you happier or vice versa. Buying can provide the stability of knowing you can’t be kicked out by a landlord or have your rents raised dramatically. Buying allows you to customize your house the way you want it. Renting can provide the freedom and flexibility to change your life up at a moments notice. Renting can be less stressful, no headaches from repairing a roof or a water heater. These factors might even be more important than the by-the-numbers analysis. To each their own.

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Economics #6: Fiscal Policy

In 2009, as economies around the world faced the prospect of economic collapse, massive packages of tax cuts and spending were enacted to halt the decline. In the United States, President Barack Obama signed the American Recovery and Reinvestment Act, which over three years would spend about 6% of the countries GDP split between tax cuts and infrastructure projects.

The idea was simple, if there is slack in an economy (idle factories and workers), then the Government can borrow and spend to close that gap. Flash forward to 2011, at the height of the euro crisis, when a similar economic contagion was spreading throughout Europe. This time, the response was a packageĀ  of bail-outs contingent on imposing strict fiscal discipline in the troubled countries. The idea was also simple, recklessness had brought about the crisis, so discipline should help fix it.

If these responses seem contradictory, they should. In both cases, some economists argued for fiscal stimulus, some for fiscal austerity, and each side had their own evidence which ultimately boiled down to how they modeled something called a “fiscal multiplier”.

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Economics #5: Monetary Policy

Ever since the panic of 2008, the federal reserve has been working overtime to patch up holes in the economy. There was QE1, ZIRP, QE2, Operation Twist, QE3, and most recently, an interest rate hike at the end of 2015. In his book The Only Game in Town, Mohamed El-Erian argues that these monetary policy band-aids have reached the limits of their efficacy. El-Erian believes that a pivot to real structural reform is long overdue.

But since the political will to enact real reform is in short supply, it looks like the federal reserve, and the monetary policy that it sets, will continue to be front and center on the world stage. This post will break down how monetary policy works.

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Economics #4: Economies of Scale

What are some industries are characterized by many small firms in fierce competition (retail, restaurants, etc) while some industries are characterized by a few large firms with market power (telecommunications, railroads, etc)?

What is it about the restaurant industry that allows competitors to open up a shop across the street. What is it about the telecommunications industry that often limits competition to one or two providers in a city.

That answer these questions we will start with the concept of economies of scale and then apply that to industrial organization.

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Economics #3: Comparative Advantage

In 1776, Adam Smith popularized the idea of specialization:

If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of the produce of our own industry employed in a way in which we have some advantage.

For example, if we are good at brain surgery and bad at making shoes, it makes sense to focus on brain surgery and trade for shoes. Same goes for legal work, accounting work, landscaping work, etc. If they guy down the street can do my taxes better than I can, I should ask him to do them. But what happens if we are better at everything? We can perform brain surgery, make shoes, practice law, file tax returns, and mow our lawn better than anyone else could. Do we just do everything ourselves?

In 1817, David Ricardo sought an answer to this question in the context of international trade. Why would a country that was better at producing everything, trade with a country that was worse at producing everything?

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Economics #2: Financial Instability Hypothesis

On January 13, 2010, the chief executives of four top Wall Street institutions gathered together in Washington to testify on what went wrong in the years leading up to the great recession. Jamie Dimon, the CEO of JPMorgan Chase, noted that:

In mortgage underwriting, we somehow missed that home prices don’t go up forever.

Lloyd Blankfein, the CEO of Goldman Sachs, added:

Whatever we did, it didn’t work out well. We were going to bed every night with more risk than any responsible manager would want to have.

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Economics #1: Information Asymmetry

Imagine you’re in the market for a new car. The used car you purchased last year is still fresh in your mind – it broke down every other day – so you decide to buy new. You sign some papers and drive-off in your new car. An hour later, for whatever reason (maybe you remember you’re allergic to automobiles), you decide to sell your car. To your dismay, you find that you can only get about 75% of what you originally paid for it.

Part of that 25% reduction is simply due to the dealership mark-up. Best case, a dealership would repurchase your car at wholesale. But the dealership may also wonder what happened in that hour which you owned the car. Maybe you discovered something that they don’t know about. Maybe the car is haunted (or more boringly a lemon).

This gap in knowledge – the same gap that stopped you from buying used in the first place – is known as information asymmetry and it’s the subject of today’s post. In our example, information asymmetry caused us to lose a couple thousand dollars. Taken to the extreme, information asymmetry can cause complete market failures.

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