Saturday, December 31, 2011

Costs of Inflation

I just read a great article, published by Slate here, about the role that money has in creating and  recessions.  Its a good overview of how money, for all of its benefits, also results in some issues.  I do not believe the Keynesian theory that inadequate "aggregate demand" results in recessions would exist in a barter economy.  Of course, a barter economy brings about so many transaction costs that any benefit from consistent aggregate demand would be dwarfed by these costs.

According to the Slate article, the solution is to eliminate paper money.  Requiring only electronic money would allow negative interest rates to exist.  I think its quite a thought, and do believe providing a mechanism for negative interest rates could be useful.  One of the less radical alternatives to a currency-less society mentioned in the article is to increase inflationary expectations.

The benefits of low--but some--inflation is not a new concept.  It led me to thinking about the costs of elevated inflation. After all, if inflation reduces the incentive to hold money, people will replace monetary holdings with investments and goods.  Interest rates on investments should factor inflationary expectations into the assets' yields, leaving the real yields unchanged.  So why is inflation bad?

Common cited costs of inflation include:
  • Menu costs:  Costs of changing prices listed online, in advertisements, and other materials (such as menus).
  • Shoe leather costs:  Costs of seeking the best prices as prices keep moving upward.  Not all prices move in in a coordinated manner.
  • Tax bracket implications:  Unexpected inflation can move taxpayers into higher tax brackets in a progressive tax system, without the taxpayer earning more in real terms.  As a result, additional wealth shifts from taxpayers to Uncle Sam.
  • Managerial time and attention:  When costs are changing, firms have to decide how often and by what amount prices should be updated.  This requires managerial decision making.
To me, these costs seem small unless serious inflation is underway.  If the inflation rate moves to around 10-15% annually, I don't see these costs as serious drawbacks of inflation.

I've thought about some other implications of inflation, two of which I describe below.  The first I've seen discussed many times.  The second, I have not seen raised.  To me, these seem more persuasive as real costs of moderate and elevated inflation.
  • Contracting difficulties:  The ability to contract allows firms and individuals to reduce risk and transaction costs. A negotiated long term contract is generally more efficient from a transaction cost perspective than repeated short term negotiations. The ability to contract in nominal terms facilitates economic activity.  Inflation makes nominal contracting difficult as the real contract value changes over time in an inflationary environment.
  • Real costs of capital increases:  Because many investors pay taxes, they are concerned with after-tax real returns on their investments. Taxes must be paid on nominal returns, however.  As a result, taxable investors must demand a larger pre-tax real return in an inflationary environment to achieve the same after-tax returns.  For example, consider two different scenarios.  In both scenarios, a taxable investor requires a 5% after-tax real return and the applicable tax rate for the investor is 50%.  In scenario 1, the inflation rate is 0.  In scenario 2, the inflation rate is 10%.  The investor would find an investment paying a pre-tax 10% nominal (and real) return acceptable in scenario 1, as it results in a 5% after tax real return.  In scenario 2, the investor would require a pre-tax 30% nominal return.  The after tax return nominal return is 15% (given the 50% tax rate), and the after-tax real return is thus ~ 5% (15% after tax nominally - 10% inflation rate).  Importantly, the real cost of capital to the firm in such an example is twice as much in scenario 1 as scenario 2.*  The firm's real cost of capital is equal to its nominal cost of 10% in scenario 1.   In scenario 2, the firm must pay a 20% real cost of capital (30% nominal -10% inflation).  Such an elevated real cost of capital is likely to reduce the capital stock and overall GDP in the economy.
I still think there are many other factors, not described above, that cause inflation to be harmful to our society.  With so much discussion in the financial media about inflation concerns and considerations, it is surprising to me that discussion of why inflation is such a concern is not addressed more often.  Any updates will be shared as I learn more on this topic...

*The cost of debt capital differs from the cost of equity capital in that debt capital is paid with pre-tax dollars.  This reduces the effects of inflation on debt capital transactions, provided both the issuer and investor are taxable entities and the applicable tax rate is same for both.  This difference between debt and equity capital costs is amplified in high inflationary environments and can thus distort the use of debt vs. equity capital in such environments.

Friday, December 23, 2011

Liquidity and Asymmetric Information

I've been reading a bit on the financial crises recently. One paper by John Taylor, here, describes an endeavor to decipher whether frozen credit markets were a result of liquidity risk or counterparty risk. The discussion of liquidity risk brought up an old nuisance of mine -- the meaning of liquidity across the various contexts in which it is used.

The term liquidity is thrown around in the financial press quite often. Some common examples heard often:

  • The fed is adding significant liquidity to the market 
  • There's a significant liquidity premium for those assets 
  • Banks are facing a liquidity crisis 

I've thought quite a bit about what the term liquidity actually means, and wanted to share my conclusions to date.

First, a few preliminary matters:

Investopedia defines liquidity as "The degree to which an asset or security can be bought or sold in the market without affecting the asset's price. Liquidity is characterized by high levels or trading activity. Assets that can be easily bought or sold, are known as liquid assets."

Multiple types of liquidity exist. The definition above is used in the context of market liquidity. Another liquidity, funding liquidity, refers to a company's ability to meet obligations as they become due.

These separate meanings offer the first insights into why some confusion exists (at least on my part) when liquidity is used in economic discussions.

Both of the definitions above appear to be static characteristics of assets (market liquidity) and companies (funding liquidity), at least in the short term. Given these definitions, certain questions remain unresolved. How can central banks "create" liquidity? How could central bank purchases of low-risk assets, such as US treasury obligations, affect liquidity in markets for risky assets?

In contemplating these questions, I came to believe the existing definitions noted above are incomplete with respect to critical characteristics of liquidity. Below I propose revised definitions, and then explain why I believe these create a more useful understanding of the term.

Market liquidity -- the degree to which market participants believe asymmetric information between buyer and seller exists with respect to assets offered for sale.

Funding liquidity -- the degree to which asymmetric information costs prohibit companies from meeting debt obligations without incurring significant value impairment.

Both of these liquidity definitions are premised on the role of asymmetric information in the market. When an asset owner knows more about the asset than a potential buyer, asymmetric information may prevent the transaction from occurring at fair value. This can occur for two reasons:

1) The classic "lemons" problem: The potential buyer believes the seller would only part with an asset at a price above its fair value. Therefore, the buyer requires an extra discount to mitigate such risk.

2) Owner dependent values: Some assets become more valuable with more informed owners. Loans to customers with whom a bank has an extensive relationship can be one example--such loans may be substantially less valuable to an investor less informed and less effective at responding to any delinquency situations.

Given these considerations, assets require greater risk premia as the available buyers are less informed.

When shocks hit markets or certain market participants must withdraw from trading activities (say a hedge fund experiences significant investor redemptions) fewer informed buyers exist. Central banks can respond to this problem by buying assets, such as US treasuries. You might wonder how buying US treasuries for cash could assist in added liquidity to risky investments. The answer lies, in my opinion, in how such central bank activities affect asymmetric information in the marketplace.

When central banks inject "liquidity" in the market, some investors previously holding US treasury securities now have available cash. Also, the central bank's buying activities has pushed prices of low-risk assets higher, lowering their related yield.  At the margin, investors now have greater ability (i.e. cash available) and incentive (i.e. less attractive yields in low risk assets) to become more informed regarding higher risk assets. 

As an example, consider an economy with three types of assets--cash, low risk treasury bonds, and high risk stocks. For simplicity, assume cash earns zero interest. As the central bank purchases treasury bonds, the economy experiences an increase in cash and a decrease in low risk bonds.  High risk stocks remain unchanged.  The yields of the low risk bonds also decrease due to central bank purchases.  These shifts result in two important observations:

1) Cash represents a larger percentage of assets held by investors. Since cash does not earn any income in this economy, it is reasonable to assume these investors are "looking" for ways to effectively deploy their cash holdings into income-earning assets.

2) high risk stocks become more attractive relative to low risk bonds--simply due to the decreased yields from the bonds.  

As a result of these observations, investors have more incentive to research the high-risk assets in search of income.  Said differently, central bank asset purchases encourage investors to lower the asymmetric information existing for risky assets. As investors perform research and asymmetric information declines, market liquidity and funding liquidity improve.

Sunday, December 4, 2011

Barriers to Entry and Fixed Costs - Part II

In my prior post, I described some thoughts on how fixed costs borne by customers (both monetary and temporal) affect industry barriers to entry.  Here I'd like to discuss barrier to entries resulting from fixed costs borne by the company.

My overall theme across these posts is that fixed costs drive barriers to entry.  Despite this theme, I also want to explain how the presence of fixed costs within a company's cost structure do not translate into barriers to entry.  That is, certain characteristics of a company's fixed costs enable those fixed costs to create barriers to entry, while other characteristics prevent fixed costs from becoming a barrier to entry.

Fixed costs enable economies of scale.  As more units are sold, the fixed costs are spread over more units.  Profitability per unit increases as the unit sales increase.  Economies of scale exist only to a point, however.  For example, flight crew and fuel costs are fixed once an airline schedules a flight.  As more travelers are added to the flight, profitability (loss) per passenger increases (decreases). A flight only half filled is unlikely to be profitable for the airline, as the costs per passenger are significant. This is why airlines adjust prices in attempt to fill their flights.  There are capacity constraints on economies of scale per flight, however.  Airlines must limit the passengers on a given flight to the seats available.

This brings me to an important term known as minimum efficient scale.  This is the smallest size of operations that will allow any firm to have a competitive cost structure.  Other firms may be larger, but the additional size beyond the minimum efficient scale does not translate to economies of scale.

When minimum efficient scale is large relative to the market size, economies of scale translate into barriers to entry.  Consider a market with a size of 100 units given existing costs of production (i.e. if companies set price so that they could just recover their costs of material, labor, rent and costs of capital, demand at this price would be 100 units.).  For convenience, we'll say the price at a market size of 100 is $10 per unit.  The minimum efficient scale to serve this market is 40.  Two companies operate at the minimum efficient scale, produce 80, and hence enables them to charge a higher price.  At a market size of 80, the market price is $12.  Hence, each firm earns "extra profits" of $80 (40 produced * $2 elevated price per unit)

A potential new entrant could spot these extra profits and consider entering this market.  If the potential new entrant thought carefully, he or she would realize that two options exist:

a) Enter at a scale of less than 20, so that prices elevated above $10 could persist.  Lets say that the new entrant chose to produce 10, and the market price at a total supply of 90 was $11. If the entrepreneur chose this option, his or her firm would operate at a competitive disadvantage to the incumbent firms, given the minimum efficient scale in the industry of 40 units.  This means the new entrant will have a higher cost structure, possibly even higher on a per unit level than the market clearing price.  In addition, incumbents would be able to lower prices to the $10 minimum price, and still cover all their costs.  The new entrant could not cover all costs at a $10 price, as we know that the minimum efficient scale is greater than scale chosen by the entrant for production.  As a result, a $10 price would result in losses for the new entrant, and persistent pricing at this level would drive the new entrant from the market.

b) Enter at a scale of 40 to achieve competitive parity with the incumbent firms.  Total production would be 120 units.  At 120 units, the market clearing price is $8 per unit.  We know that total costs per unit (including cost of capital) is $10 at the most efficient scale.  Therefore, all three companies would operate at a loss due to excess capacity.  None of the three companies would be willing to reduce capacity, because it puts them at a competitive disadvantage relative to the other two (see a, above, for discussion of this situation).  The most likely situation is that one of the companies exit the industry or go out of business, enabling the other two companies to begin profitable operations again.

In both scenarios above, the profit opportunities for a new entrant appear unlikely.  This prevents new entrants in the industry, despite incumbent profitability.  Here we have true barriers to entry.

Contrast the situation above with an alternative situation where the minimum efficient scale is small relative to the size of the market. Lets say another market had a total size of 10,000 units given existing costs of production, and the minimum efficient scale for operations was 40 units. Price at a total production of 10,000 is $10 per unit. In this case, there are likely to be 250 firms operating at minimum efficient scale*, and each earning only enough to cover total costs.  Lets put aside this likelihood and consider what would happen if there were only 200 firms, each operating at minimum efficient scale.  Production would be 8,000 units, the price charged exceeds $10, and incumbent firms all make extra profits.

How does a potential new entrant evaluate the industry above?  In this case, the entrant realizes he or she can enter at the efficient scale and take some of the extra profits.  Incumbent firms will not possess competitive cost advantages necessary to drive out new entrants.  In this market, new entrants should arrive quickly, until all excess profits are eliminated.

Examples:  I think its helpful to provide specific examples two industries that each have high fixed costs, but one with large minimum efficient scale relative to the market size and the other with small minimum efficient scale relative to the market size.

Large minimum efficient scale - utility (power) companies.  The cost of generation and creating the infrastructure to serve a market are largely fixed.  Power companies generally serve a limited market size as well.  The barriers to entry are so significant in power companies they are often labeled as "natural monopolies", which is another way to say that the minimum efficient scale is the entire size of the market.  Why aren't utility companies wildly profitable then?  Because of the huge barriers to entry, the government has identified the potential for monopoly pricing and regulates prices in these industries.  So although barriers to entry do not translate into high returns on capital for utility companies, this is a result of government intervention in response to existing barriers to entry in the industry.

Small minimum efficient scale - airline industries.  Airline costs exist at the flight and airport level.  Only minimal costs exist at the passenger level, which would be considered variable costs.  An extremely important aspect of the airplane industry is that the capital used in the industry (i.e. airplanes) are mobile, making the relevant market for assessing fixed costs as the global market for flights.  For example, because airplanes can be redeployed to other airports, any profitable routes that emerge will immediately see additional flights offered until profitability is eliminated.  Due to the fixed costs that exist for flights and airport service, airlines seek maximum capacity on flights.  Prices are lowered to gain additional passengers to help recover the costs for flight crew, ground crew, fuel, and airplane leases.  With the number of airlines in the market (remember the relevant market is global due to the ability to redeploy airplanes, even if individual airlines choose to operate only domestically or regionally), price competition erodes all extra profits.  The recent merger between Continental/United and the bankruptcy filing of American indicates just how difficult the airline industry is, despite cost structures for each company that largely consist of fixed costs.

*There of course could be fewer than 250 firms, because individual firms could operate at any scale that is a multiple of 40 and still be operating at an efficient scale.