Matt Nolan

Import substitution, good or bad?

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Free exchange and Dani Rodrik have both made intelligent posts on the issue of import substitution. Free exchange sticks to the common line that import substitution is bad, Dani says that there is evidence that it is good.

I know very little about any of this, but I’m going to say something anyway. As far as I can tell, trade policy should work off the idea of comparative advantage, implying that each country should make what the good they are ‘relatively’ better at making (specializing in goods with the lowest opportunity cost). As a result, government policy should react in ways that take advantage of this concept.

This might imply to some people that government should not intervene in trade, and just let the free market choose the most efficient industries, which will in turn trade with the rest of the world. However, I’m not sure I fully agree.

It is possible that an industry that would have a comparative advantage in trade terms may not have been founded given high fixed costs and the requirement of skilled and experienced labour which will only be created when the industry exists (infant industry type argument). If the government can recognise these industries, it can subsidise their creation until they become fully efficient, by which times they will be net exporters.

Now this form of intervention isn’t the same as import substitution (although it is often placed as a subset of it). Import substitution involves creating the goods you import at home, now if this is a good where another country has a comparative advantage then all you are doing is hurting yourself and the other country. Import substitution is a bad idea (unless there are security of supply or political issues), but government policy to develop domestic industries does have some potential.

Matt Nolan

Image does make a difference

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So food with a McDonalds wrapper does taste better. Now I’m sure many people will take this as a sign that advertising is evil, as it can lead to children being overweight, however I think it is an awesome service provided by McDonalds. You see McDonalds advertising makes food taste better, they increase the value of the product to an individual by advertising it, and getting all your senses excited. Although two otherwise identical products might seem homogeneous to you, the fact that the McDonalds wrapper is on one and not the other implies that one has the value associated with advertising while one doesn’t. As all McDonalds is doing is increasing the value of their product, thereby increasing demand I don’t have a problem with it.

However, there may be a role for government intervention yet. If McDonalds is an addictive good, and the consumer had no a priori knowledge that it was addictive, then the increase in future consumption (and the associated negative effects) of McDonalds is not taken into account when the person purchases a product. By advertising, they can increase demand and make more people fast food addicts. Now to do not know the degree with which fast food is addictive. However, government regulation, such as education or limits on advertising could be useful.

Update: Hehehe a cartoon.

Matt Nolan

There is no such thing as a free lunch

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A column in the Sunday Star Times actually discussed an interesting issue this weekend; how the biofuel revolution will lead to higher food prices. They are exactly right, you increase the demand for corn, and the price of corn will increase. Now corn is a substitute for other foods, so the demand for other foods rises, increasing their price. Furthermore, corn is an input in the production process of milk, beef, chicken etc – so you shift the supply curve left, and the price goes up. Anyway you think about it, biofuels will push up the price of food.

Furthermore, when the government enforces regulation, what happens? The government makes petrol stations sell biofuels. As they aren’t already, they must be uneconomical, implying that they will be more expensive than normal fuel. As the government is saying that petrol companies have to sell a minimum amount of biofuel, they will have to cross-subsidise the price of biofuels with petrol, leading to an increase in petrol. Now, biofuels should reduce world demand for fuel, so the world price of petrol must fall, however I’m not sure which factor will be dominant when the price of fuel is determined.

It might be annoying that the price of food (and maybe fuel) will rise. We know that the most heavily affected will be the poor. Third world countries will face highly escalating prices for agricultural products, now even though some third world countries are food exporters, many of the poor in these countries have to pay the world price for food (in the same way we pay the world price of milk). As a result, rising food prices will make life even more difficult for the very poor in the age of biofuels.

Given this, it is difficult to know what would be optimal for the global community. The US is subsidising biofuels in order to provide a substitute for/reduce dependence on foriegn fuel. As oil is a non-renewable resource, we should be interested in finding substitutes. However, food is a necessity. Rising prices for food will affect outcomes, especially for the very poor.

The reason the price of food is rising, is that their is a limited supply, and governments are trying to use it as both food and fuel. Now you may argue that the supply of food will rise, and the price will again. This is a fair argument, however it is important to realise that the price of agricultural goods will be set such that the MC=MB for the least efficient plot of land. If the marginal cost of production on new land is significantly higher than on currently used land, we can expect prices to be a lot higher.

Ultimately, we have to realise that there is some tradeoff between these, and accept the consequences of the choice we make.

Matt Nolan

Floating GST rates?

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So supposedly, the RBNZ has suggested a floating GST rate as a way of controlling inflation. Now this seems silly too me for two reasons:

1) GST is a tax, as a result this would either have to be implemented through fiscal policy (and so would not work, as governments cannot commit to just focusing on inflation), or you would have to give the Bank the right to tax (as the Bank is not elected by the people this is uncomfortable)

2) The level of GST affects the price level, so if the economy is running strongly and you prop it up, you push up the price level.

Now the first criticism is self-evident, however it is a normative problem with the scheme, implying that there might be some theoretical merit. The second criticism is positive. Now, I am not saying that changing the GST tax will cause inflation, as inflation is the rate of change in the price level. Changing the GST tax will change the price level, but not change the rate at which the price level grows, in fact increasing GST will take money out of the economy, slowing growth in the price level and thereby slowing inflation.

So a floating GST tax would slow inflation, however lets think about why we want to slow inflation. We want to reduce volatility in the price level, to give people certainty. Volatility in the price level is bad as the majority of people cannot properly hedge against it. Now by having the GST tax increase and fall we are adding volatility to the price level, causing one of the problems that monetary policy is supposed to solve. It just seems a bit silly.

Matt Nolan

The week in numbers

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  • Household borrowing accelerated to 13.6%pa in June
  • Non-residential consents softened in June, but the June quarter was relatively strong, with Factory and commercial consents elevated
  • Residential consents lifted strongly in June, on the back of robust house price growth.  Wellington was a top performer

Most of this weeks data was expected.  However, after the RBNZ said household borrowing was easing, the continued growth in borrowing came as a surprise.

Matt Nolan

Immigration and inflation

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I have just been flicking through the NZX submission on monetary policy, thanks to a link kindly provided by Lucy.

While I disagree with most of the submission (for the reasons I gave yesterday about higher interest rates being structural), I was happy to see that they discussed immigration.

Now immigration is an interesting issue, ignoring any social issues (i’m an economists after all), I’m going to focus on the link between immigration and inflation. According to Rebus legal perth lawyers, one of the main reason why the overall economy could have a massive downfall and the country could go into the state of depression is due to lack of immigrants. A recent study showed that most of the top CEOs of the county are not the originals of the land but are the descendants of on immigrants who came to the country and got it to a great position where it now stands on.

Some people say immigration causes inflation, as it increases the demand for goods and services, driving up the price. Other people say that immigration drives down inflation by increasing labour supply, and thereby driving down real wage demands, preventing wage inflation.

Now the way I see it is that immigration increases demand and supply. After all labour is an input to production, but once labour has been paid they turn into consumers, who purchase the goods. As a result, whether inflation rises or falls with immigration depends on the productivity of the immigrants. If we bring in a whole lot of untrained, unproductive workers it will cause inflation. If we bring in workers that have the highest marginal product (so in the places where firms are begging for labour) then it should decrease inflationary pressures.

It seems incredibly simple, the difficult issue is actually identifying and bringing in skilled, hard working labour. However, i’m not sure that cutting immigrant numbers when we have shortages of unskilled and skilled labour is a good idea. I’m sorry RBNZ, but I think the NZX is right on this one.