Saturday, February 16, 2013

Playing to the weakness of retirees in the annuity market costly

When the working of the markets creates problems, when undesirable social results arise from market operations, especially when unrestrained, it is usual that people call for the government to intervene. Take the case of pollution. If a community cannot claim property rights, there is nothing they can do when a firm pollutes the environment except to call for government intervention. Economists and analysts describe this as a market failure situation.

Market failures can also arise when firms or agencies seek to conceal information, or what some may say “monopolize information.” There are some market interactions between consumers and sellers where because of the high cost of information gathering and other factors, both sides will never act with complete information; one side will always have more reliable information than the other side. One of those markets is the annuity market. You can buy an annuity with your pension savings so that it gives you an income until your death. If you desire to cover yourself against retirement during your old age, then you should meet a pension provider and ask for one.

Like pollution, undesirable social results can be the outcome when pension providers seek to influence the choice of retirees or hide necessary information that can impact on their making a decision. It has been reported that some pension providers go the length of putting pressure on their customers rather than giving them the information necessary for them to make an informed decision on annuities in the market, the market situation and the state of competition.

Also, it could be possible that the market is skewed in such a way that retirees do not know that a system of revealing important information about annuities exist and are made to depend on their pension providers. This system of information retrieval is called the open market option. Market failure would result if pension providers mask this system from their customers. Consumers lose out on benefits that must accrue to them from their investment, pension providers receive negative goodwill and the market eventually shrinks.

One solution to this problem is to make pension providers and other players in the market agree to a set of generally accepted practices. This is what the Association of British Insurers (ABI) in England, is proposing. Such self-regulation could be possible when all providers are under one umbrella body or when enforceable even for non-members of the ABI. Another solution is government regulation. The government can step in by providing a reporting system where consumers can complain if they believe a pension provider is not acting professionally. Several countries have one form or the other of financial services regulation. Where a pension provider can assert that it was acting in the best interest of the consumer, the problem could be if they are not asking enough questions of their customers, the retirees, who demand their professional services. This situation occurs often in the health insurance industry.

Whatever the situation is, making sure the market works efficiently is to the benefit of everyone. Market failures create social costs that raise the prices of goods and services; in such a situation, everyone loses.

Friday, February 8, 2013

Evolution of complex division of labor the secret behind globalization and increased standards of living.

When Adam Smith published his famous work, “Wealth of Nations”, he foresaw the replacement of a guild-regulated system of artisanal manufacturing by factories. Underpinning his prediction was division of labor, or the specialization of workers in tasks that compose the sequence of tasks that make up the production process. He realized that division of labor was factored on the extent or reach of markets which depends on population density and transportation costs to either shrink or expand. What Adam Smith foresaw was the evolution of economic networks of cooperation from reciprocal and redistributive networks to large, complex but flexible networks of cooperation that depend on impersonal markets and the forces of competition.

Extend the reach of your market and network. One man is not dreams
Division of labor and worker specialization has since been instrumental in the Industrial revolution and contributed greatly to the enormous wealth enjoyed in many developed nations today. As it evolved, it created a system of complementarity between inputs at various stages of the production process which complementarity is difficult to disengage by producing smaller units of factories based on those inputs because of the lack of alternative supplies or alternative consumers of the intermediate goods in the process. Therefore, in its evolutionary history, division of labor has seen the emergence of large manufacturing firms who can by becoming more efficient due to increasing returns to scale enhance their market power and assume monopoly rent but which powers can be short-cutted by government regulation through mandating a climate of competition, therefore transferring this power from producers to consumers through enhancing consumer surpluses.

That is the story of the evolution of the markets and capitalistic societies, according to a work published in 2007 by Axel Leijonhufvud. I thought it was worth writing upon here because the evolution of markets and the capitalist system has resulted in enormous evolution in our social systems, has changed considerably the way we earn income, the way we work and has encouraged the emergence of robots who today are replacing humans at brain-numbing tasks.

Some one thousand years ago, life expectancy was short, workers were uneducated, tied to their feudal lords who controlled much of the land and productive resources and had to undergo hard physical labor. The economic network of cooperation, a system whereby people, directly or indirectly, cooperate on producing output, earning income both through market and non-market work, was narrow both in time and space. The much there was of international trade was sparse. Today, our economic networks of cooperation are large, elaborate, complex but flexible. We are dependent on people we might never have seen, met or been aware of and sometimes earn income from entrepreneurs who do not even know we exist.

Axel Leijonhufvud argues that these complex networks of cooperation is made possible by division of labor through increasing the functional differentiation of the male and female who make up its elements and of the implements and artifacts that they use. Increased functional differentiation or specialization has resulted in increased standard of living although political risks, monetary instability, trade protectionism, high taxation and bureaucratic obstacles have sought to shrink these networks. Over the years, man has designed means of innovating and inventing to resolve this shocks, hence the evolution of his networks of economic cooperation.

Axel states that at the start, man innovated exchanges, starting with barter exchanges which eventually culminated in money exchanges, in order to make transactions voluntary, increase freedom of the individual to choose what to buy, how to work and what to produce, and all these at terms acceptable to all parties involved in the economic interaction. Monetary exchanges and impersonal markets have considerably contributed to the complexity of his networks and also to the increasing complexity of division of labor.

Within firms, he states that workers are now faced with specializing at tasks that serve as a vertical hierarchy, were one task in the production process is complementary to another in the process that a stoppage in one could lead to zero output. Workers hence do not need to learn a wide range of skills, leading to worker-product alienation when compared to artisanal production and increased emphasis on worker discipline. He has also seen a tendency for labor to hire capital, where capital hiring labor is the norm, due to the problems of bargaining over the increased profit resulting from the increasing returns to scale and monopoly rent further evolving complex division of labor network.

An outstanding result of the increasing complexity in economic interactions due to the increasingly complexity of division of labor is that firms no longer seek monopoly power but rather they seek to increase consumer surplus by evolving the inputs to the production process but this eliminates the small companies and retailers who cannot compete. Also, service industries are now favored before manufacturing and gradually, robots will be another factor in the move towards increased mechanization of the production process, replacing humans more and more in several occupations. He foresees that the next industrial revolution might be a “trade in tasks”.

If you do desire to read the article, you can download a pdf copy.

Journal Reference:
Leijonhufvud, Axel (2007) "The Individual, the Market and the Division of Labor in Society," Capitalism and Society: Vol. 2: Iss. 2, Article 3.DOI: 10.2202/1932-0213.1025.

Developing country status? Comparative advantage is a prerequisite for industrialization.

There are things we take for granted, like computers assembled in Asian factories, shoe imported from Italy, corn and sugar imported from the United States and CNN beaming the news into millions of homes. Have you asked yourself: what made all these possible? Why do some nations fail to copy the success of other nations, who decade after decade have specialized in producing particular products to the exclusion of other countries? If you come from a developing country background, why are you not getting industrialized like America, France, Germany and the BRIC countries?

Low standards of living are why children enter the labor force.
One concept behind these huge movements towards industrialization is comparative advantage. I was surfing the Internet when I found this article by Steven Hinson on I thought he did a disservice to the concept for the layperson, so I decided to reword it for the beginner reader who I presume are part of my readership.

His aim was to explain the concept of comparative advantage which was first proposed by David Ricardo (1772 -1823) in his “Principles of Political Economy and Taxation” (1817) . It has been used to explain mutual gains from trade, why specialization and division of labor works when workers are efficient and that the least cost of production is based on opportunity cost.

I’ll use Steven Hinson numeric examples.

Specialization and the division of labor in relation to comparative advantage

Imagine Sarah owns a small law firm. She is an accomplished attorney who earns $200 dollars per hour and she can type extremely fast at 120 words/hour without errors. Sarah believes she needs an assistant. She hires Andrea. Andrea is paid $20 per hour. He types at 60 words/hour without errors.

You can see that on every count, Sarah can do better than Andrea. She can type better than him and earns more. She has an “absolute advantage.” Does it mean she should do all the work and keep Andrea idle, but still receives his $20 at month’s end? According to the principle of comparative advantage, Andrea should be assigned a task between either typing or assisting in office filing and research, etc. Which would it be?

That is where the concept of opportunity cost comes into play. Opportunity cost, in simple terms, is the cost of the best foregone alternative. In this trivial example, if Andrea is assigned to typing, the best foregone alternative is office work. If he is assigned to office filing and research, the best foregone alternative is typing.

Since Sarah does 120 words/hour and earns $200 per hour, in simple terms, her 3 words of typing stands before $5 of earnings. Andrea does 60 words/hour and earns $20 per hour, therefore, his 3 words of typing stands before $2 of earnings. So, taking 3 words of typing as base, who has the lowest opportunity cost? You calculated rightly – Andrea. He will only be losing $2 for every 3 words of typing. We can rightly assign Andrea to typing while Sarah concentrates on office work like filing, researching etc and still carry out her duties as an attorney.

Efficient use of resources in relation to comparative advantage

Steven Hinson also made use of another example, Accountants and Attorneys. In an office, let there be two accountants and two attorneys. They have to specialize and divide between themselves the work of either producing tax returns or creating trusts. Accountants can produce 0.5 trusts per hour and 1 tax return per hour. Attorneys can produce 1 trust per hour and 0.5 tax returns per hour. Logically, accountants are better at doing tax returns and attorneys are better at creating trusts when absolute advantages are considered. I decided to simplify the relations; let us use the task of creating trusts as base. Accountants can, when the maths is simplified, produce 1 unit of trust for every 2 unit of tax return per hour while attorneys can produce 1 unit of trust for every half (1/2) unit of tax return. So, according to opportunity costs, attorneys have a lower opportunity cost of producing trusts while accountants have a lower opportunity cost for tax returns.

What happens if we let the accountants do all the tax returns and the attorneys all the trusts? Between them, there would be a maximum of 4 trusts per hour and 2 tax returns produced per hour. Remember the ratio of units!

Let’s play around a little. We think that there could be a way of rearranging tasks amongst these professionals so that they do not get redundant in either tasks while specializing and doing division of labor. Repeated tasks can result in boredom, can affect productivity and worker efficiency. Recall that for every 1 unit of trusts, accountants can exchange 2 units of tax returns while for every 1 unit of trusts attorneys can afford to give up half-a-unit (1/2) of tax returns. So, we’ll ask them to switch tasks once in a while based on comparative advantages. When the two accountants are asked to give up tax returns on the margin, they end up with two tax returns and one trust while if the attorneys give up trusts on the margin, they end up with 1 trust and half of a tax return making for a total of 2 trusts and two-and-a-half (21/2) tax returns on the margin.

The concept of giving up objects for another on the margin is behind the mutual gains nations receive by international trade. The casual reader can check up any good economics textbook for an in-depth understanding.

Why is comparative advantage very important?

These three reasons are what made Ricardo’s concept of comparative advantage ground-breaking.

  1. Necessary for industrialization.
  2. An economy with self-sufficient agents will produce within the constraints of the possible production boundaries taking into consideration its resources and manpower and for their own consumption. Economies that operate with comparative advantage can extend their productive possibilities by trading with other nations using least cost production methods, more efficient processes and highly specialized labor.
  3. Production using most efficient methods.
  4. Two prerequisites for industrialization is specialization and division of labor. This was well expounded by Adam Smith, the father of economics. Thus by trading based on comparative advantages, production is maximized much more than without comparative advantage. This is done using least opportunity cost.
  5. Increased standard of living.
  6. Specialization and efficiency translates into quality products, best use of resources, lower priced goods and services, high Gross Domestic Product (GDP) etcetera.

The concept of comparative advantage might seem trivial but it played a very important part in the industrialization process of many nations.

Sunday, February 3, 2013

The sharing economy, an exchange systems that is making barter popular.

The global financial crisis is a bug that has left no country unscathed. Most businesses have innovated different ways to surviving the crisis. In order to reduce the cost of excess inventory and improve cash flow, some have taken to barter. Firms who make use of barter as a form of exchange cut across the entire business world. From libraries ready to barter old books for booze, to fashion houses who want to swap your old clothes for equalized items. If one has to do a count the list is immense.

The sharing economy: new hands trying out old tricks.
Barter cannot replace money. Barter cannot be as efficient for our modern world, yet she does have her advantages. Mathew Winn, the owner of Molasses knows that too well, so he is ready to trade your used books for coffee . Or even, for more books. Or take the tale of another consumer, Johanna Lassonczyk, 31, who will be turning her back on the fashion industry. Interviewed by Spiegel Online Magazine, she has resorted to swapping things instead of buying new clothes because the fashion industry is in pretty bad shape . She is amongst many Germans who have started attending swap parties to exchange the old stuff in her closet with other items.

Nationalities are not left out of the trend. Threatened by American sanctions since June of 2012, Iranian companies, cash strapped and threatened by the sanctions, have resorted to bartering their produce for food. The News, a Pakistani online newspaper, reports that cash-strapped Pakistan Steel Mills (PSM) and the Government Trading Corporation (GTC) of Iran have, in principle, agreed to arrange barter trade between themselves to make their survival possible.

Social status is attached to the trend.

The idea might be great, a brain child to the green movement that is presently sweeping the corporate world after years of hiatus. It offers poor people, especially the younger generation, the opportunity to buy goods where their disposable income cannot be adequate, and the opportunity to enhance their social status. Some might call it the sharing economy. People share living space, clothing and cars. It might be a new form of consumption, a response to troubled financial economies. Only time will tell if the trend will sustain its current momentum.

The platform that makes all these possible is the Internet. Barter exchanges who serve several roles, especially that of connecting people with similar wants and needs, are springing up on the Internet. Thousands of businesses are availing themselves of this opportunity to improve their cash flow, acquire clients who usually would not have thought of trying out their products, and those who are not price sensitive because money is not at stake, but their wants and the equivalent goods they can exchange it for. The Internet makes the sharing economy profitable. It has been dubbed “the relationship economy,” driven by the principle of reciprocity. In Canada, the Trade school , a school that is based on barter, catering to people who love practical wisdom, mutual respect and the social nature of exchange, just launched on January 19 in Vancouver. Rather than ask for money, teachers ask for items from their students. The new sharing economy is all about giving back to the society, to your community, and has been enhanced by the spate of Web 2.0 social networking sites that have sharing as their main themes.

Not limited to National borders.

Bartering is not limited to national borders. Some exchanges cater to international clientele, like the Ormita Commerce Network. Although headquartered in Italy, its network of 220,000 members operates in many major cities around the world. Tough times call for tougher measures. If a business has enough resources, the lack of money should not hinder it from carrying out production. It should only be a transactional problem. Networks like Ormita reduce those costs.

Iranian companies like the GTC which was mentioned earlier have seen security in bartering due to factors which lie in the realm of politics and not economics. The economic sanctions from the United States has bitten her hard that International trade in money currencies has become very difficult.