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The Winner’s Curse: An Economic Anomaly

May 27, 2013 Leave a comment

My grandfather, William Campbell (1927-2013), played a large roll in theorizing the Winner’s Curse by applying physics equations to economics. The winner’s curse, in simplest terms, is the idea that the winner of a common value auction tends to overpay. Within competitive bidding, the winner’s chances of overbidding increase as the number of bidders, or consumers demanding the item, increases (Investor words).  Each bidder estimates a certain price; some overestimate and others underestimate. The one who overestimates usually wins, and therefore is “cursed” with an item that is not truly worth what he or she estimated for. Such a curse can occur in two similar, yet slightly different ways: the winning bid exceeds the value of the tract, so the firm loses money; or the value of the tract is less than the expert’s estimate so the winning firm is disappointed (Anomalies: The Winner’s Curse).

ImageWhile working for the Atlantic Richfield Company, otherwise known as Arco, my grandfather was summoned to his boss’s office and asked a simple question with a complex answer: how can we save money? After strenuous research and collaboration, the team of engineers and physicists discovered that competition within bidding creates an atmosphere that does not usually allow the winner to truly win. In order to understand such a concept, consider an auction of a piece of land that has five million barrels of oil beneath it. No one actually knows the value of the land; so, some engineers will overestimate the value of the property and others will undervalue it. Most likely, the company that overrated the property will be willing to pay more and thus win the auction. So, we can conclude that within “competitive bidding, the winner tends to be the player who most overestimates the true tract value” (Competitive Bidding in High-Risk Situations). The variable cost of oil does fluctuate as supply and demand increase and decrease, which creates even more risk in an already dicey oil business.

At the same time, the winner’s curse does not necessarily apply to an auction marketplace like eBay. The winner’s curse only applies to competitive lease sales, or an auction with limited supply and excess demand. Marketplaces like eBay and Craig’s List have more supply than demand, allowing consumers to search for the lowest possible price before purchasing an item; thus, producers compete and lower prices. The prices approach equilibrium. Within competitive bidding for a single item, the price cannot approach equilibrium because excess demand disallows such a balance.

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Not so fast

By no means is the winner’s curse a bid strategy; it is a mere analysis on what not to do. However, three simple rules can be followed to avoid being that guy who enthusiastically wins an auction only to watch his property slowly diminish in value: the less information one has compared with what his opponents have, the lower he ought to bid; the more uncertain one is about his value estimate, the lower he ought to bid; and the more bidders (above three) that show up on a given parcel, the lower one should bid.

Opportunity Cost of Doing My Homework

Opportunity Cost of Doing My HomeworkRight now I could be playing with my chickens because they’re so cute but instead I’m doing my homework; the ‘opportunity cost’ of me doing my homework is not being able to play with my chickens. But I do choose to do my homework instead of playing with my chickens because I think it’s ultimately the better choice.

Goober by Smuckers

Goober by Smuckers

Goober is a product created by Smuckers which combines the two complements, peanut butter and jelly, into a single product. Smuckers utilized the economic term of complements in creating this product. -Catherine G

Keynesian in Nixon’s Insanium Cranium

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Richard Nixon (conservative)

British economist, John Maynard Keynes, developed a new theory of economics that dominated macroeconomic thinking in the postwar era. Keynes presented his ideas in 1936, in a book called The General Theory of Employment, Interest, and Money.  He desired to develop a comprehensive explanation of economic forces. An explanation like this could give politicians and economists insightful information on ways to get out of economic crises like the Great Depression. This form of demand-side economics gained the favor of President Richard Nixon as he proudly declared himself “a Keynesian in economics,” on January 4, 1971. This was a rather unusual statement for the arch-conservative president because Keynes was viewed as being well to the left, both politically and economically. Regardless of his political party, the president aimed to balance the budget on a “full employment” basis, a Keynesian idea. Conservatives viewed this “as a license to run budget deficits forever,” according to the New York Times.

A key component to Keynes’s ideas is to see the economy in a broader view and focus on the economy as a whole. Keynes looked at the productive capacity of the entire economy, which is the maximum output that an economy can sustain over a period of time without large increases in inflation. The British economist attempted to answer a question concerning the Great Depression: why does the actual production in an economy sometimes fall short of its productive capacity. The answer Keynes proposed included the fact that neither consumers nor businesses had an incentive to spend enough to cause a rise in production. It did not make sense for a company during that time to spend money to increase production when no one else had enough money to buy the products. Also, unemployed consumers could not spend money that they did not have. Nixon became the first president to balance the budget based on “full employment” which meant the United States would “spend as if it were at full employment to bring about full employment, thus justifying an acceptable amount of deficit spending.”

According to the Congressional Budget Office, the “recent economic downturn has increased the budget deficit by about 2.5 percent of the gross domestic product annually since 2009.” The Congressional Budget Office also calculates that “if the economy were operating at its potential based on its productive capacity” (what used to be called “full employment”), gross domestic product would be $1 trillion larger this year.

John Keynes

John Keynes

“Conservatives do not like calculating the deficit any way except literally,” says Bruce Bartlett. “All of the adjustments to the deficit are assumed to be tricks to make it look smaller, they believe.” But back in 1971, having a Republican president adopt a left winged idea such as an expansionary budget policy and balancing the budget on a “full employment” basis was radical stuff indeed.

When Nixon first took office, he tried a conservative method to tighten the money supply, however this method did not work and the economy appeared to be heading into a recession.  With the American federal budget deficit totaled at $23.03 billion, combined with Nixon’s failure of obtaining more revenue through tax reform legislation in 1969 and rising unemployment (4.9 percent) and inflation (5.7 percent) rates in 1970, Nixon decided it was time for a change and proudly proclaimed himself to be a conservative Keynesian, hoping to turn things around. The administration then turned to fiscal policy solutions.

Nixon’s new Keynesian methods turned out to be a short-term domestic success.  His New Economic Policy “attempted to balance U.S. domestic concerns with wage and price controls and international ones devaluing the dollar.” N.E.P. worked so well that by early 1972, the output rose sharply and unemployment fell, however inflation increased. Nixon became the only president since World War II to bring about an economic upturn in a presidential election year. This astonishing fact contributed to his landslide re-election in 1972.

When President Nixon resigned in 1974, inflation was at 11 percent and unemployment rates increased to 5.6 percent; however the deficit was down to $6.14 billion. Although he was a conservative president, he adopted more liberal Keynesian methods and succeeded in his attempt to balance the budget on a “full employment” basis.

Categories: A3, Learning

Payroll Tax Ending Possible Effect On GDP

May 16, 2013 Leave a comment

Congress passed a payroll tax which was in effect in 2011 and 2012 was not renewed this year.  After the tax was passed it lowered the amount taken from people’s paychecks from 6.2% to 4.2% and thus the average family earning $50,000 a year was given an extra $1,000 to spend and put back into the economy.   After the fiscal cliff deal this January this act was not renewed and taxes were raised for higher-income families as a part of the compromise.

With the full tax rate back families are being forced to once again cut back on their spending by $720 reported by the New York Fed’s survey.  They also reported that during the tax cut families ended up spending $380 of the money they saved from the tax cuts.

ImageFamilies that are lower-income are going to be forced to cut back on their spending even more.   While higher-income people will cut back 64% while lower-income reduce it by 77%.  The New York Fed stated that they considered lower-income families to have an annual income of $75,000 or less.  People who were earning more than $75,000 were reported to have spent the money that they saved from the tax cut whereas they lower-income tended to spend that money paying off debt.

No one is able to really tell how the new increase in taxes will affect people’s spending it can be inferred that the average family is likely to cut back on how much they spend.  But if families do decide to cut back on spending it is likely to only have a negative effect on the United States GDP.  Forcing the government to either spend more to help improve the GDP or to lower taxes and hope that citizens will go out and spend the money they would have given the government in taxes to help improve the economy.

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The Evolution of the Peanut Butter and Jelly Sandwich

PB & J: America’s go-to lunch, snack, dinner, whenever sandwich.  It never goes out of style.  Jerome Monroe Smucker jumped on the PB&J wave at just the right time and has been riding the wave ever since.  J. M. Smucker first started Smucker’s in 1897 from the “back of a horse-drawn wagon”. Since it’s humble beginnings, Smucker’s  has grown and thrived, to say at the least. Now, Smucker’s company brands include Pillsbury, Jif, and many more. The giant success of Smucker’s proves that obviously Jerome must’ve known something about making sandwich spreads that all of his competitors didn’t.  Or, maybe he just knew something about economics that his competitors didn’t.  

The economic concept of complements is one of my favorite because it highlights a very positive aspect of capitalism, making it seem a little less cut-throat.  Complements are described as “Two goods that ‘go together,’ either in consumption or production”.  This concept outlines the relationship between two goods, and unlike with most products, they actually aren’t in competition.  An increase in sales for one product also means an increase in sales for the other.  So one company can actually benefit from the success of another company if their goods are complements.  Two things that people buy together are considered complements, like hot dogs and their buns, or more importantly: peanut butter and jelly.  Smucker’s realized the important economic relationship between peanut butter and jelly and utilized it.  For years, jars of peanut butter and jelly were sold separately as compliments so, yes, Smucker’s had success selling jelly, but this wasn’t enough for Jerome.  When consumers bought his jelly, they also bought another company’s peanut butter, so it was a win for both companies.  But Smucker’s decided that if people were buying their jelly anyway, they should also be buying their peanut butter; they could take over the entire PB&J industry.  And they did. In 1968 the world of PB&J changed forever.  Smucker’s hit the PB&J market with a curveball, something never done before; both peanut butter and jelly together in one jar.   They called it “Goober”.  By acknowledging the unique economic relationship between peanut butter and jelly, Smucker’s managed to acquire even more sales and become an extremely competitive player in the PB&J market.  Jerome Monroe Smucker

Studying economic terms and the patterns in the market has revealed to me that the success of one company or another is not simply due to luck or having a good product; but is a result of the company’s utilization the laws of economics.  As proven with Smucker’s success in the peanut butter and jelly market, knowing the patterns of the market and how to manipulate them can help a company thrive.  The idea of complements is particularly interesting to me because it explains how two companies can actually benefit from the success of each other instead of relying on the failure of other companies for their own success.  Smucker’s realized the relationship between peanut butter and jelly in the market and took advantage of it by starting to produce Goober: peanut butter and jelly in the same jar.  Because Smuckers utilized the laws of economics, they were able to excel as a company and basically acquire a monopoly over the peanut butter and jelly industry.

Supply and Demand in Depth

May 16, 2013 1 comment

The law of supply and demand is a theory explaining the interaction between the supply of a resource and the demand for that resource. The law of supply states that at higher prices, producers are willing to offer more products for sale than at lower prices. It also recognizes that the supply increases as price increases, and decreases as price decreases. Furthermore, it declares that those already in business will try to increase productions as a way of increasing profits. The law of demand says that people will buy more of a product at a lower price than at a higher price, if nothing changes. It additionally states that at a lower price, goods are more affordable and people can, and will, buy them more frequently. Lastly, the law of demand states that at lower prices, people tend to buy less expensive goods as substitutes for more expensive versions; this is also known in economics as the substitution effect. The law of supply and demand presents the effect that the availability of a particular product and the desire (demand) for that product has on price. If there is low supply and a high demand, the price will be high for that good. In contrast, the greater the supply and the lower the demand, the lower the price will be.

An example of the law of supply and demand is the price of oil. According to an article from MPR dated May 16 of this year,

Image“The price of oil has been dropping and the law of supply and demand has boosted gasoline prices to record levels.” The raised price of gasoline, partially caused by the “temporary” shut down of two oil refineries in Illinois, comes from a supply problem. The Chicago Daily Herald explains that “if the price goes up in China, we export our oil. It helps make us richer as a nation but the price goes up and we pay a lot more.” Although we pay more for gas because of this, the bottom line is that there is more money to be made by sending oil overseas. Furthermore, the exporting of oil is what is creating the supply issue. In another article, “U.S Oil Boom to Help Meet New Global Demand” by CNBC, the IEA states that “the shockwaves of rising U.S shale gas and light tight oil and Canadian oil sands production are reaching virtually all recesses of the global oil market.” Despite the high gas prices, the global oil demand is expected to rise 8 percent between 2012 and 2018, further raising the already elevated gas prices. Because America is a growing industrial economy, the rate of oil consumption rises simultaneously with the rate of industrial progression in our economy. New discoveries and improving technologies have increased the amount of oil that can be produced. This innovation could present the idea that it may indirectly raise the prices of gas yet again. Because more oil can be extracted at once, business could use more oil at once, therefore decreasing the supply of oil. However, an article by Floyd Norris of the New York Times states that although demand for oil is rising, “American consumption of oil is expected to be as much as one-third less than it was the last year,” by 2035. This predicted decline of oil consumption depends on how much conservation is encouraged in the years to come. The article goes on to say that the U.S promises include “increasing fuel economy in cars and trucks and at least a small increase in the use of natural gas to fuel trucks.” Furthermore, according to the IEA, if these promises are kept, “oil prices in real terms are likely to be only a little higher than they are now,” but if current policies are continued we will not be so lucky (gas prices would continue to rise rapidly).

In conclusion, the law of supply and demand plays a major role in our economy. It is the strength of a market economy. Because economics is based on the idea that people make choices by comparing the benefits of each option and choosing the most beneficial, the law of supply and demand is a necessary element in determining the price that an item should be. Goods that have a high demand are goods that people believe are the most beneficial options. However, the goods that appear most beneficial may become less beneficial if the demand of them becomes excessive. If there is excess demand of a good, the price of that good is then raised, motivating people to substitute that good for a less expensive option. This less expensive option then becomes the more beneficial one because of scarcity (people wanting more goods than are available) and because of the substitution effect. The law of supply and demand assists the understanding of basic economic ideas and is a crucial theory.

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