Why is the UK making interest rates so low?

 

On 11 March 2020, the Bank of England cut the interest rates to 0.25% from 0.75%, and a week later it was reduced further to 0.1%. But why does reducing interest rates help limit the economic impact from coronavirus?

An interest rate cut is a monetary policy, which us used to increase aggregate demand (which is made up of consumption, investment, government spending and net exports. There are many reasons why a decrease in interest rates increases aggregate demand:

·       Reduces cost of borrowing: This can act as an incentive for consumers to take out mortgages and for firms to take out loans to finance greater spending and investment.

·       Deters individuals and firms from saving: A decrease in interest rates means you get a smaller return from saving. This encourages consumers and firms to spend money rather than saving it.

·       Exchange rate depreciation: Reduced interest rates mean that it is less attractive to save money in the UK as you would make more money from saving in other countries. This means there would be a decrease in demand for Pounds causing the exchange rate to fall. This leads to people in the UK buying less from abroad and exporting more because it is cheaper for other countries to buy our goods. This leads to net exports (Exports – Imports) decreasing.

Overall, a cut in interest rates leads to an increase in consumption, investment, and net exports, causing an increase in aggregate demand. Therefore, the UK cut interest rates to a low level to stimulate economic growth, after aggregate demand fell during lockdown.

How worrisome is the UK’s national debt?

 

At the end of May 2020, UK’s national or government debt was just under £2.0 trillion which is nearly 100% of its  gross domestic product (GDP). National debt is the total the government owes to the private sector. The national debt arises when the government spending each year is more than its income through taxes, and it accumulates every month. In the month of June 2020, the government’s borrowing figure was just below £30billion.

National debt is financed by selling government gilts, Treasury bills and bonds to the private sector in return for an interest on the bond. Debt can also be financed by the Bank of England printing money and buying bonds itself. One positive thing in the current borrowing situation is that interest rates is so low that the government is actually spending less on servicing its debts than what was originally planned during this period.

National debt is not necessarily a bad thing, if it is in balance and enables expansion of the economy. For example, the economy needs a small inflation of 2-3%  which will need the additional debt every year. Similarly government needs finance for its commitments such as pension payments to the retired, financing infrastructure and other expenditure which is required to drive growth.

However, the impact of the pandemic slowdown and emergency policy measures have caused the debt to reach these levels and are likely to see an unprecedented rise over the rest of 2020 and 2021. GDP is expected to fall at least 30% because of a nationwide shutdown which will result in fall in tax revenues - income tax, VAT, corporation tax and excise duties. Besides the government will have to spend more on benefits – for the unemployed, housing benefit, sickness benefit (Universal Credit). The borrowing is expected to fall after a few months when different schemes are wound down.

There are countries which have similar or higher debt, for example, Japan has a National debt of 225%, Italy is over 120% of their GDPs.  Also, the UK has had much higher national debt in the past, e.g. in the late 1940s, UK debt was over 200% of GDP. However, the sheer size of the current debt means that the Treasury will try and ensure that things don’t get worse. The common fear is that there will be austerity measures put in place and there will be less economic support for ordinary people in the future. Such measures taken from 2010 onwards did quite a lot of damage to the society – from increase in homelessness, stalling life expectancy and a general rise in poverty of working families.

It’s probably time to see alternative mechanisms to reduce the debt coming from the income side - introducing progressive tax rises and growth through investment. Corporation tax in the UK has been reduced to 19% and is the lowest rate in the G20. There is also room to revise property and land taxes upwards. On the income tax front, increasing the top rate of income tax from 45% would bring in the rich to share the load of the reducing the borrowing. The reliefs currently allowed in capital gains tax can also be revisited. Investments in infrastructure and housing also remains a priority and if this can be done by channelising towards new green projects, it would help in creating jobs, supporting businesses as well as driving the sustainability agenda. While the recent pandemic is unprecedented in its impact, the government has the opportunity to do a reset and re-prioritise initiatives to bring the debt to the desired levels.

PRICE DISCRIMINATION

Peter is a used car dealer and is known to charge higher prices for his cars to affluent clients, while he is known to reduce his price if he sees that a customer is not too well-off or unlikely to pay a high price. What Peter is indulging in is the most basic form of price discrimination.

Price discrimination is a selling tactic that charges different prices to customers for the same service or product. Here, the seller charges different prices to different groups of people, based on certain attributes.

For a price discrimination to be legal, the different price charged to a different group of people must be justified by the amount of effort required. At a wholesaler manufacturing level, it is more complicated to ascertain if a seller isengaging in price discrimination. To protect themselves from any unfair price discrimination, many purchasers ‘most favoured nation’ clauses in their purchasing contracts that protect them from any price discrimination by wholesalers and manufacturers. These clauses guarantee that the seller is offering their goods/services at the same price as they are giving to their other buyers.

There are three kinds of price discriminations in the market:

·       First degree discrimination is where the company charges the maximum possible price for each unit they sell.

·       Second degree discrimination is where customers are charged different prices depending on what they choose. For example, loyalty cards reward frequent buyers with discounts on future purchases. Or when coupons by fast food companies reward customers with a discount.   This is indirect price discrimination because the seller is allowing the consumer to choose what price they will pay.

·       Third degree discrimination is where an entire group is charged differently from the others. For example, student discounts at restaurants, travel/oyster cards for school children which are sold at a lower price or off-peak travel rail tickets being cheaper. This is also known as direct price discrimination.

Another way that firms practice price discrimination is when they offer slightly altered products, depending on a consumer’s ability to pay. For example, offering priority boarding ticket where consumer gets a shorter queue and better service within the same flight. Or when an airline charges higher price for seats which offer extra legroom on their flights. This is a kind of indirect segmentation when consumers who are willing to pay more are offered better choices.

Say that Sarah charges £7 for every music CD that she sells. If she has 100 customers and if she offers the same price to all, she will earn £7 * 100 = £700 revenue. With price discrimination, she can charge two different prices where students can buy the CD at £4 while adult would need to pay £10. Thus, her revenue would then be:

£10 * 35 = £350

£4  * 120 = £480

Total revenue= £830. Thus, the firm makes more revenue under price discrimination.

One can maximise profits under price discrimination if the seller sets output of products and price in such a way that MR=MC. If the market has two subsets with different elasticity of demand, then the firm can increase their profits considerably by setting different prices for both subsets, depending on the slope of the demand curve. Thus, the PED Price Elasticity demand for adults is inelastic and thus price is higher, while for students, prices will be lower as their demand is elastic.  Profit is maximum when MR=MC.

Link between marginal cost and price discrimination:

When the marginal cost of an additional traveller for a flight is very low, the airlines feels motivated to use price discrimination to sell all the tickets. Once a flight is soon to fly, the MC of an extra customer is very low. This validates price discrimination for the airline.

Some examples of price discrimination:

·       Discounts for buying train tickets in advance

·       Student discounts on rail journeys

·       Mobile phone deals which allow 100 text messages free

MINIMUM WAGE AND ITS EFFECT ON EMPLOYMENT

 

If Alice has a cake business, she will need to hire people to help her bake, decorate and deliver her cakes to her clients. In the resource market, Alice becomes the demander and her workers become the suppliers. When the supply of labour is equal to the demand for labour, the market can be said to be at equilibrium at the intersection between supply and demand curves. This is the stage when wages are at the current market rate. In other words, the person hiring is willing to pay what is agreeable to the worker.

Let us assume that is £7 pounds an hour. The government then passes a law that says that there has to be minimum £8.72 an hour for these workers, as anything less than that is not sufficient to give them a good life. Minimum wage is also called the price floor in the market. One would think that having a fixed minimum wage would bring clarity in the market. Surprisingly, it doesn’t happen that way. If the minimum wage /price floor is higher than the actual clearing price, it will end up distorting the market. Employers will have to reduce the number of hours that it can hire labour as they have a fixed amount of money that they can spend on their workers.

However, the workers see the increased rate at which they can be hired and thus more of them will be willing to work. A worker who made £7 an hour and worked 40 hours a week will now feel that he is eager to work more hours, say 45 , as he will now earn nearly £9 an hour. The supply of labour will increase. What will happen now is that the demand is limited. Thus, there will be an over supply of labour. Hence, we see that before the introduction of minimum wage, there was a surplus below the demand curve and above the supply curve. The producer surplus was the benefit of the individual workers, which was above and beyond the benefit they would now get after the minimum wage. The consumer surplus was the advantage that the employer was getting before the minimum wage. Overall, the market gets dead weight loss. Minimum wage works to the advantage of those who have employment in hand. However, it works to the detriment of the employer for the labour he has employed already.

Minimum wage affects unskilled labour markets where the workers do not have specific training or relevant experience for the work they are applying for. In the labour market, demand comes from employers and not from individual consumers. Similarly, the supply is not coming from big corporations, it is coming from individual workers.

Milton Friedman, Free market economist,  had argued ,’A minimum-wage law is, in reality, a law that makes it illegal for an employer to hire a person with limited skills’. His argument was that if you were willing to hire a teenager for a dollar fifty an hour, the law won’t let you as it would be illegal to hire someone for less than minimum wage. The law would say that you must hire him at a dollar sixty. If you didn’t want to pay that, or couldn’t afford to pay that, you would just end up not hiring him. As a result, this would produce unemployment among people with low skills.

The National minimum wage rate is currently £8.72 for workers over 25 (from April 2020). The minimum wage was introduced in April 1999 (at £3.60) and is the legal minimum that employers can pay.

The Profit Maximising Rule

Janet runs a stall in the local market where she sells burgers. One assumption we can safely make for any business is that it aims to make a profit. It is the same for Janet. She is wanting her stall to do well so that it earns a tidy profit for her.

Janet knows that maximum profit is earned when the total revenue earned by the stall exceeds the total cost of running the stall by the largest possible amount. When Janet raises the price of her burgers, she starts getting less customers. When she reduces the price of her burgers, she gets a lot more customers which leads to Janet dropping the prices further. Customers further increase but at this stage, Janet realises her business is running in a loss.

Janet’s friend Barbara explains profit maximising rule to her. Barbara tells her that the marginal revenue in Janet’s Burger stall is the addition to total revenue that results from selling one additional burger, while marginal cost in her stall is the cost of making the additional burger. Her cost of burger is constant and hence her marginal revenue remains constant no matter how many burgers she sells. However, Janet’s profit would be maximised at a point where marginal cost equals marginal revenue. This is the golden rule of profit maximisation: Maximum profit occurs at a point where marginal cost is equal to marginal revenue. This is considered the optimal level of production.

Why does profit maximise when MC=MR? This is because if marginal revenue was higher than marginal cost (ie if Janet earned more per additional burger than she spent on making that additional  burger), Janet would happily decide to make more burgers as it increased her profit directly. Conversely, if marginal cost was higher than marginal revenue (ie if Janet spent more on making an extra burger than she earned by selling it), she would decrease production as expanding her output was having a negative impact on her profit. However, the optimum level of production for Janet would occur when marginal revenue equalled marginal cost, which would be the point of maximum profit.

Keeping the Profit Maximising rule in mind helps a business to set the right price for their products. Thus, if Janet chooses to maximise the profits of her burger stall, she must choose that level of output where Marginal Cost (MC) is equal to Marginal Revenue (MR), and the Marginal Cost curve is rising. In other words, she must produce at a level where MC = MR.

 

At A, Marginal Cost < Marginal Revenue, then for each additional burger made, revenue will be higher than the cost so that Janet will make more burgers.

At B, Marginal Cost > Marginal Revenue, then for each extra burger produced, the cost will be higher than revenue so that Janet will make less burgers.

Thus, Janet’s optimal quantity of burgers produced should be at MC = MR

The MC = MR rule is quite adaptable so that Janet can apply the rule to many other decisions for her business. For example, she can apply it to hours of operation. She can decide to keep the burger stall open as long as the added revenue from the additional hour exceeds the cost of remaining open another hour.

 

 

 

LAW OF DIMINISHING RETURNS

 

Alice has an acre of land where she grows courgettes. Besides the land, she needs seeds, fertiliser, water and labour to ensure a good growth of courgettes. Alice realises that if she increases the amount of fertiliser, her output of courgettes will increase. However, there will be a point where too much fertiliser will reduce her courgette crop.

At this point, the additional courgette output from additional unit of fertiliser will be smaller than the additional output of courgette from the previous increase in fertiliser. The point at which the yield of courgette is highest after which it starts to decline is the point where the law of diminishing returns has kicked in.

So, what is the law of diminishing returns? At some point, employing an additional factor of production causes a smaller increase in output than expected.

Peter’s Cafe

Diminishing returns happen in the short run when one factor is fixed (eg capital). Take the example of a busy café run by Peter. Peter decides to hire extra workers. As his capital is fixed, he cannot expand the space in the café. Although the extra workers will increase production (number of cups of coffee made in a day), they will jostle into each other’s way as space will be limited. At some stage, the marginal increase in Peter’s income will stop or reduce. All this is true only if considered in the short run as all factors become variable in the long run. Thus, law of diminishing returns applies only in the short run.

Let us assume that each worker’s wage is £10 in Peter’s café. Thus, hiring an extra worker will cost an additional wage of £10. The Marginal cost MC of a cup of coffee will be the cost of the worker divided by the number of extra cups of coffee produced. If Marginal Product MP is the output by the extra worker, as MP increases, MC will decrease. And vice versa. Let Total Product TP be the total output by the workers.

 

 

 

CAFÉ WORKERS	Total cups (TP)	MP	MC
1	5	5	2
2	11	6	1.7
3	18	7	1.4
4	26	8	1.25
5	33	7	1.4
6	38	5	2

 

We can see that, at the addition of the fifth employee, diminishing returns set in. This is because as extra employees produce less, MC increases.

A very relatable example for students would be the amount of revision hours they put in for studying for an exam. If they study for three hours a day, they will improve their knowledge considerably. If they study for six to seven hours a day, they will gain knowledge exceedingly well. However, if they study into the late hours up to early morning, sacrificing their sleep, their gain in knowledge will be hardly noticeable as their exhaustion will not let the brain work to its full capacity.

The Prisoners' Dilemma

 

What is The Prisoners Dilemma?

It is a hypothetical situation ( of a game analysed in game theory) which shows that two rational individuals might not cooperate even when it is in their best interest to do so. Here,  two prisoners Jack and Jill are arrested for a minor crime and believed to have committed a major crime. Both are detained in separate holding rooms and questioned. They have 4 possible options:

·       Admit that your partner committed the crime and you can go free. The partner would get 3 years in prison.

·       If you stay silent and the partner says you did the crime, you get 3 years and the partner goes free.

·       If both stay silent, they will both get one year in prison each for the minor crime.

·       If they both betray each other, they will both get two years each in prison.

Basically, each of them can do one of two things: stay silent or betray. Staying silent would be cooperating while betraying would be defecting.

What should they ideally do? Looking at it from Jill’s perspective, if she thinks Jack will stay silent, she should betray as then she will go free. If she thinks Jack will betray, she should definitely betray as otherwise she will get 3 yrs and Jack will go free. Jack will think exactly the same thing. Ideally, they should have both cooperated but the safer option when they don’t know what the other will do is to defect. Hence, most likely that both will defect to save themselves.

In real life marketing examples, let’s say that two cola companies Happy Cola and Joyous Cola are deciding how much to spend on their advertising campaign. Since both their products are identical, advertising would make a considerable difference to their sales. Lets imagine that they have to choose between advertising a lot or not at all. Also to simplify further, lets imagine there are a total of 100 customers who would drink cola. If both don’t advertise, then by random chance, 50 people would select Happy cola while 50 would select Joyous Cola. At £2 a can, they would each make £100. Lets say advertising costs £30. If Happy Cola advertises and Joyous Cola does not, then 80 people will buy Happy Cola and 20 will buy Joyous Cola. Happy Cola will spend £30 on advertising, after which it will make £130.

80 cans of Happy Cola X £2 -£30 =  £130

Joyous Cola will make:

20 cans of Joyous Cola X £2 = £40

 

If they both advertise, again half will buy Happy Cola and half will buy Joyous Cola. Each will make :

50 cans of Cola X £2 - £30 = £70

Results are similar to the Prisoner’s dilemma. Both cooperating and not advertising is the most preferable situation but both know that advertising will make more money for them. Unlike the prisoners though, these Cola companies can talk to each other and influence decisions.

 The label ‘Prisoner’s dilemma’ is given to situations where even though two entities could benefit from cooperating or suffer losses by not doing so, they still find it difficult or expensive to coordinate their strategies.

Defection always results in a better payoff than cooperation, when we don’t know the competitor’s choice, it is a dominant strategy. The only result from which both players could only do worse by unilaterally changing strategy is mutual defection. Thus, it is the only strong John Nash equilibrium in the game. Hence, cooperating mutually yields a better outcome than defecting mutually but it is rarely the rational outcome as one is always hesitant to cooperate as one is looking out for one’s self interest. This is counter intuitive, really.