Question from a teacher about the elasticity of supply

Question:  My students are currently studying demand, supply, and price.  When we were discussing the elasticity/inelasticity of demand and supply, a question arose regarding if any good/service exists which possesses both perfectly inelastic demand and supply.  I've given it considerable thought and the only goods/services I could think of which would fit the criteria are utilities (ie. electricity), water, waste water treatment, etc.  I believe demand for these goods/services is inelastic as would be supply (no substitutes, few suppliers, oligopolistically competitive market structures, etc.).   This line of reasoning would apply to their stock as well.  Are there any other examples?  Am I correct or totally off-base?   

Response:

You are not totally off-base but your question mentions a common misunderstanding when it comes to the determinants of the elasticity of supply.

In your question you state "perfectly inelastic supply and demand".  To that question the answer is no, both functions would be vertical and I know of no good that is perfectly inelastic in demand and supply.   One often cited example of perfectly inelastic demand is insulin.  Yet insulin is relatively elastic in supply.

Are there goods that are highly inelastic in demand and supply? Yes, but also keep in mind that the usage of elasticity you are referring to is a general, relative measure where one good is compared to another.  Examples would be goods that have very few substitutes on the demand side and are very difficult to produce on the supply side (technologically intensive, raw materials are difficult to get quickly, production techniques cannot be modified easily).  A good example is gasoline relative to, say, cigarettes or insulin.  All are highly inelastic on the demand side but gasoline producers are not able to respond as quickly to a price increase as cigarette or insulin producers.  Therefore gasoline has a more inelastic supply than cigarettes or insulin.

The difficulty for students when it comes to the elasticity of supply is to explain the concept without using an elasticity of demand determinant (like available substitutes, time frame for purchase, or proportion of budget).  Elasticity of supply is the responsiveness of the producer to a change in the good's price and is therefore determined by production flexibility -ability to quickly and easily/cheaply increase or decrease quantity supplied.  The fact that a product is elastic or inelastic to consumers does not necessarily mean anything when it comes to the elasticity of supply.  Hence substitutes, few suppliers, or oligopolistic market structures are not determinants, by themselves, of inelastic supply.  A monopolist could produce a good that has an elastic supply... think of Google's near monopoly over internet advertising.  If the price for internet ads were to increase, it would be relatively easy for Google to respond with an increase in the quantity supplied.

Utilities are inelastic in demand but depending on time of year or day, may be fairly elastic in supply.  Again, what's important is that elasticity is a relative concept.

The Rhetoric of "Class Warfare"

In the middle of my morning routine of flipping back and forth between Sports Center and Squawk Box on CNBC while nursing my second cup of coffee, I listened to Wilbur Ross and Joe Kernan discuss the pros and cons of the Bush tax cuts.  This wasn't the first time I heard the argument from wealthy conservatives that allowing the Bush tax cuts to expire was akin to starting a new "class warfare" pinning the so called rich against the very people they help by creating jobs - but something about the way it was being discussed this morning made me mental.

What is debatable about this issue is the effect the change in tax rates might have on an economic recovery.  But because economists and policy makers are uncertain about the effects, given the already uncertain state of the economy, the discussion has disintegrated to guilt, blame, and fear - things our politicians and news media outlets are good at creating and disseminating.  I'm not surprised, just depressed.

It truly amazes me to hear wealthy business owners, like Wilbur Ross, argue the class warfare angle as the reason to extend the tax cuts when the majority of the people who helped him become a billionaire make less than $20 per hour.  In fact, income inequality has never been higher in the US.  The Bush tax cuts actually created a significant amount of the inequality we have today.  Ending the tax cuts for the wealthy won't create class warfare, the class warfare started in 2001 and 2003 with the tax breaks for the wealthy (see "How Progressive is the U.S. Federal Tax System? A Historical and International Perspective" by Emmanual Saez and Thomas Piketty in the Journal of Economic Perspectives; Winter 2007, Vol. 21 Issue 1).

Let's get back to debating the economic merits of tax cuts but if, as many economists are saying, the expiration of the tax cuts will have little effect on the pace of the recovery, then maybe we should look at this issue as an argument for improving equity instead of projecting the decision to end the Bush tax cuts as a personal attack on "freedom, free enterprise, and success".  

Comments on Illegal Immigration

The following are my comments to questions presented by a local reporter for a story on illegal immigration. 

--Companies that hire undocumented workers pay them roughly half of what legal workers earn. Companies that do not hire illegal immigrants say they cannot compete because they pay their workers fair wages. Yes, in general, companies that hire mostly illegal immigrants will have a competitive advantage, all other things being equal.  But the comparison is not that simple.  Economic research suggests that illegal immigrants are as much as 30% more productive than similar legal workers of the same age and education (See William Ford's research in Economic Education Quarterly, 2007).  Often, the lack of competitiveness argument due to illegal workers partially masks other inefficiency or demand problems facing firms or industries.

--The unemployment rate for construction workers is double the overall rate. Some people say this is due in part to companies using illegal labor. Unlike farm or other unskilled, low-paying jobs, unemployed, legal workers covet construction jobs, which are generally higher-paying.
It is clear that the unemployment rate for construction workers is high due to the current global economic slowdown and the current housing crisis.  It would seem logical that if unemployment is high for legal construction workers, it is also high for illegal construction workers.  There is no evidence that the ratio of legal to illegal construction workers is any different than it would be during better economic conditions.  In order to support the above statement, one would need to know what the unemployment rates are like for legal and illegal construction workers during better economic conditions.

--If companies using undocumented workers build a house, it can translate into lower prices for home buyers. In this economy, would consumers pay more for a house if they knew it was built by legal workers? Some consumers may be willing to pay more for a house based on the type of labor used to build the house.  This behavior is similar to consumers paying more for "Buy American" products or products that are "green".  Unfortunately during tough economic times, demand for these higher priced alternatives is low.  In addition, I'm not sure we would benefit from encouraging this behavior.   If people have to spend more to buy a home, then it is reasonable to assume that many will cut back on new furnishings and appliances or may have to tighten the family budget.  Hence, one group's benefit, legal construction workers, is another group's loss.  In order generate net benefits for society from a tightening of labor laws, the gains for legal construction workers would have to outweigh the losses from home buyers and other business that cater to new home owners. 

--Many people say that illegal immigrants are necessary to do low-paying jobs, such as farm work. What could happen to the economy if all illegal immigrants were forced to leave the country? I don't beleive there is much debate among economists that eliminating illegal immigrants from the labor force will slow down the growth of the economic pie. It is also likely to increase the prices of many goods and services which will result in a change in how families and businesses allocate their budgets.  These changes will have unintended consequences in other parts of our economy that may result in greater costs than the benefits to workers in those industries that compete with illegal immigrant labor.

--Illegal workers do not pay taxes but use schools, roads and health care. What is the impact on the local, state and national economy? How much potential tax revenue is lost? For specific numbers on net tax revenue implications, I'd suggest researching the economics literature.  One place to start might be the Center for Immigration Studies.
As for a general comment, illegal workers pay more taxes than most people think.  Studies by the Social Security Administration indicate that a relatively large number of illegals pay payroll taxes and income taxes using fake social security numbers or by obtaining an individual tax identification number from the IRS just to avoid being detected as an undocumented worker; and many don't file for a refund even if they are owed one for the same reason.  This is an interesting phenomenon since illegal immigrants cannot collect social security.  Also, let's not forget many illegal immigrants pay property taxes and taxes on utilities indirectly when they rent, sales taxes when they consume goods and services, and excise taxes on gasoline, utilities, telecommunications, liquor, and tobacco products.  Although illegal immigrants may still create a negative net tax burden, part of that is due to the relatively low wages they earn, not the taxes they do not pay.  If illegals were made legal, their tax burden on society would likely be larger as they would qualify and take advantage of more government assistance as well as those who are currently paying income taxes to avoid detection would likely pay no income tax under current rules.

The Effects of a Changing Chinese Labor Market

I realize that my posts to this blog tend to be focused on the merits of free trade.  I've spent time discussing price ceilings and floors, and the disincentives produced by trade quotas, tariffs, and price gouging laws.  However, it is an idea that many Americans just don't seem to grasp, or they choose not to, or are even coaxed into ignoring the facts by political pundits and opinion makers promoting their agendas. 

With that said, we are beginning to see how the growth of China is reversing the global trade dynamic.  We already benefit from cheap manufactured goods, but I believe that the world is on the verge seeing China's growth bear a different kind of fruit for the rest of us.  This sentiment is supported by an article in the July 29, 2010 issue of The Economist magazine.  The cover article explores The Rising Power of China's Workers . 

The article, at once, reveals that China's working class is pressing for better conditions, higher wages, and better benefits, while reminding Americans of our own history.  It was only a century ago that American workers were fighting for the same goals.  We reap the benefits of the struggles of our ancestors.  We are able to enjoy a high standard of living, one that allows us to purchase inexpensive manufactured foods produced in emerging markets.

But, it is our penchant for a good deal that is allowing those Chinese workers to fight for rights of their own.  What are the inevitable results?  With higher wages, Chinese-made products will become more expensive.  Traders will look for alternatives and domestic producers will seize a new opportunity to compete.  Chinese workers will use their deeper pockets to purchase products that might have been previously unattainable.  That money we spent on cheap Chinese goods will begin to make its way back to us.  

Now, conservative political leaders, and supporters of American manufacturers will continue to argue that "Buy American" is the best policy.  While it is true that type of policy can have immediate positive impact on a failing economy, the long run consequences are too much to bear.

Update: Ten Reasons to be Bullish

by Matt Malick

Since the summer of 2009, analysts and strategists of all stripes have been looking for a “correction” to the historic stock rally that started in March of 2009.  It seemed that every major player on the Street - bull and bear alike - had been predicting a 10% to 20% market adjustment.  Throughout history, short-term market declines have been commonplace during multi-year bull markets.  Unfortunately, theorizing about a normal correction and actually living through a gut-wrenching drop in stock prices are different stories altogether. 

In late April, the Standard and Poor’s 500 index hit its near-term high of over 1200.  A 10% correction from that level would put the index at 1080 and a 20% correction would take the index to around 960.  The S&P 500 presently stands at about 1125.  While there is no guarantee that we are now experiencing the much-anticipated 10% to 20% correction, these figures indicate that further short-term losses would be exactly what most market experts have been predicting.  

The added market volatility over the last several weeks is doing its job.  It is bringing intense fright  and discomfort to investors.  The confidence that was building in the market is evaporating.  The major financial news networks are tripping over themselves to line-up interviews with all of the prominent bears.  Fund managers have turned bearish, individual investors have reaffirmed their unwillingness to enter equity markets, and bullish investors have begun to second-guess their theses . . .

Remember, sentiment has historically been an effective contrarian indicator, i.e. the crowd is normally wrong.  In early 2000, everyone was heralding a new technological revolution that was going to increase productivity and send stocks to the moon.  In early 2009, the consensus held that the U.S. was on the verge of a depression and that stocks would pile-up ever greater losses.  In both of these extremes, the consensus was wrong.

Despite the endless stream of negative headlines over the past several weeks, here are ten reasons to be bullish about the intermediate-term prospects for the stock market:

1. The Standard and Poor’s 500 and the Dow Jones Industrial Average are still more than 20% below their all-time highs of October 2007
2.  The yield on the 10-year U.S. Treasury Bond is 3.46%
3. The estimated earnings yield (2010 estimated corporate earnings divided by price) on the S&P 500 is 7.25% .  The estimated 2011 earnings yield on the S&P 500 is 8.55%
4. Gold has reached another all-time high (over $1,210 per ounce), even as countless television commercials tout the opportunities available to individual investors to avail themselves of “cash for gold” (the greater the percentage of a population that is involved in a mania, the less chance it is sustainable)
5. The overwhelming consensus - from Ph.D. economists to the shoeshine man – is that government sovereign debt is the crisis du jour (you are rarely bitten by the snake that you see)
6. In April, the government reported that payrolls rose for the 4^th straight month, posting the best month for employment in 4 years
7. In the fourth quarter of 2009, U.S. GDP growth reached 5.6% and in the first quarter of 2010 U.S. GDP growth hit 3.2%
8. Well over 80% of S&P 500 companies that have reported 1^st quarter 2010 earnings have once again surpassed analysts’ earnings expectations
9. In April, U.S. retail sales climbed for the seventh straight month
10. U.S. consumer spending has increased for six straight months through March

As you well know, it is impossible to predict day-to-day stock market moves.  Right now, the “headline risk” in the market is extraordinary.  Recently, it has been difficult to find a positive report anywhere.  However, over the intermediate-term, we continue to believe that stocks are out of favor, especially when employing a buy-and-hold strategy.  The recent market turmoil is decreasing enthusiasm and will thereby likely prolong the sustainability of market gains over the next few years.