Falling Share Prices – Causes and Effects

This week has seen major falls in share prices across the world with $6 trillion being wiped off world share values.  America’s Dow Jones index dropped 5.2%, Japan’s Nikkei index fell 8.1% and the UK’s FTSE index fell 4.7%, the lowest it has been for 15 months, while in Japan and America the falls broke records for the size of their drop since October 2008.

The initial reason for the fall was, paradoxically, good US economic data as their service sector boomed and wage levels grew at the fastest rate since the start of the decade. This good news meant that it is now more likely that US interest rates will rise sooner and by more than had previously been anticipated. Mark Carney reinforced this view when he expressed similar sentiments about the future of UK interest rates.

Although a rise in interest rates has been expected for some time as the world economy’s growth accelerated, the reminder that it might occur soon has come as an unpleasant shock. The scaling back of QE by central banks is expected to reduce the ability to borrow cheaply, some of which has financed recent purchases in shares. Financial investors expect that the forthcoming rise in interest rates will reduce company profits, therefore reducing the demand for shares. Simultaneously existing shareholders might be encouraged to sell quickly before prices fall further, thereby increasing the excess demand. In addition, the economic uncertainty was increased by the fall in the value of bitcoin by approximately 50% since the state of the year.

Economists are trying to decide whether we are currently experiencing a “correction” or  are entering a bear market, where prices fall by more than 20%. The “correction” proponents believe that shares are over-priced in terms of their price compared to their earnings – the price:earnings ratio – and therefore the fall was due. However there is concern that the behaviour of investors, whether in shares, currencies or commodities, sometimes leads to markets over-shooting since falls (increases) in price encourage selling (buying) which further reduces (increases) the price.

According to economic theory, the fall in share prices might lead to a negative wealth effect (the idea that consumption is determined by one’s wealth as well as one’s income). However, given that many shareholders are in the upper income brackets, their marginal propensity to consume will be low and therefore the effect will small. More significant might be the general impact on consumer and business confidence from the media reports about the falling share prices. As Keynes wrote in his General Theory,  “animal spirits” outweigh the  “weighted average of quantitative benefits multiplied by quantitative probabilities.”.


A Little Nudge

The Government’s Nudge Unit (or, to give it its correct title, the Behaviour Insights Team) has been in the news again recently. Their latest investigation involves an attempt to reduce the number of inappropriate calls to the 101 number (the number where one can report crimes, traffic accidents and minor offences). The problem which they are addressing is that 20% of calls to this number are classed as inappropriate and involve matters which are not of police concern, such as failure of the local council to empty the bins, or the high price of a restaurant meal. They found that delaying answering for 6 seconds reduced inappropriate calls by 75%.

Nudging people to behave takes many forms but one of the most successful is to make things easy for people. Thus healthy options are at the front in the cafeteria, many streamed TV programmes automatically go on to the next episode and, more importantly, British workers are automatically enrolled in work-place pensions unless they opt out.

The Nudge Unit was established in 2010 to help government departments improve their success rates in diverse areas by taking account of the way people behave. For example an experiment in vending machines in Australia resulted in a 20% switch from the most sugary drinks to alternatives simply by labelling the most sugary ones in red. Writing letters to the GP surgeries prescribing the most antibiotics, telling them that neighbourhood surgeries prescribed less, resulted in a 3% fall in prescriptions.

Port Talbot & A’level economics

A’level economics students frequently moan  that what they have been taught is not relevant to what is going on around them while economics teachers complain that students do not relate what they have been taught to the real world!

The recent events at Port Talbot provide an ideal example to use economics concepts.

The multiplier can be used in assessing the costs to the area should Port Talbot close since not only will steel jobs be lost if the plant closes, additional jobs will also be at risk as steel workers suffer lower disposable income and cut back on expenditure,  particularly in non-essential areas.

In considering the type of unemployment created, one can use the idea of structural unemployment since many of the steel workers affected will not have the skills needed in newer, growing industries.

The possible closure of the plant is relevant to the arguments about the benefits of free trade and the theory of comparative advantage whereby UK steel purchasers benefit from cheaper steel imports from China which need to be set against the  job losses among UK steel producers. This aspect can be expanded to consider whether the Chinese are dumping steel on the world market and, if so, what action should be taken, especially in the light of the tariffs on Chinese steel imposed by the USA and those imposed by China on imports of steel from the EU and elsewhere.

A final example is in the  field of market failure where Tata have complained that the UK Government’s environmental policies have raised energy prices and helped make UK produced steel (and heavy industry generally) uncompetitive. UK electricity prices are almost double those in the rest of the EU and more than double those in China and while these high prices help to subsidise renewable forms of energy, they make life difficult for UK firms.

The market for legal advice in the UK – competitive market or cozy cartel?

A report in today’s Independent newspaper suggests that the cost of legal advice from one of small number of well known firms in the UK, collectively known as the “Magic Circle”, has risen by around 100% in real terms since 2003.  The market structure for this industry seems to display all the hallmarks of an oligopoly, and one which might tend towards some form of collusion; demand is inelastic, there are a small number of interdependent firms and customers have difficulty collecting good information about substitutes.

In addition, beyond these largest firms a form of price leadership structure may be in operation.  As these large firms ratchet up their charges smaller firms outside the Magic Circle take the opportunity to increase their fees in a clear example of what is commonly referred to as Stackelberg equilibrium.  The economic rents enjoyed by these firms in the form of supernormal profits may be quite considerable.

The question is, as economists should we care, and if so, what can be done?  The availability of good legal advice at a reasonable price may well have positive externalities as it protects the functioning of a market economy and also allows smaller firms to compete in all markets with larger ones as they do not face the barrier to entry in any market of very high legal costs associated with operating in the market.  In short, high legal costs may make a host of markets much less contestable.

This suggests some government action is necessary.  Everyone with a knowledge of economics should be able to recommend lots of policies to make any given market more competitive, and the market for legal advice is no exception.  A reduction of barriers to entry, a requirement for transparency in pricing, an investigation into possible anti-competitive practices and the use of large fines for those found guilty might all be relevant.  However, as we have seen in the energy market action by consumers may also be needed.  A willingness by customers to shift their business to cheaper firms and an attempt to make firms move to a fixed price model by supporting those firms which do will certainly give the Magic Circle something to think about.

Ultimately, a combination of government action and consumer action will be needed but nobody should be under any illusion; the legal profession generally and the “Magic Circle” will fight against it tooth and nail.  Economic history suggests that those enjoying economic rent seldon give it up easily.

Paying for flood defences – an example of the public good problem?

At some point during each year everyone studying microeconomics will come across the idea of public goods, usually in connection with market failure.  The concept is pretty simple; a public good is non-excludable.  This means that people can benefit from the product or service whether they have paid for it or not.  This means that nobody pays for it as they will wait for everyone else to do so, allowing them to benefit for free.  This is known as the free-rider effect and means that the product or service is never provided.

So much for the theory.  Examples of public goods tend to revolve around things such as national defence, lighthouses and flood defence.  As you may have noticed, flooding is very much in the news and large numbers of people have recently been adversely affected by flooding, in some cases very adversely.  Understandably they are keen that more flood defences are provided, but who should pay for them?

As a public good it is clear that taxes need to have a key role in this.  If individual households are asked to voluntarily pay then each will refuse, reasoning that if all the other households in the flood risk area agree to pay then they can benefit from the defences for nothing as the defences are non-excludable.  As everyone thinks this then no money will be collected and no defences will be built.  Some kind of tax is needed, but who should it be extended to?  Just the people in the flood risk area?  Everyone in the country?  The government has considered this problem and come up with an idea related to council tax, which is a tax paid to local authorities by residents of an area based, very roughly, on the value of their houses.  This article from the Daily Telegraph explains:


The question which the government needs to consider is simple.  Who pays for the flood defences and how much?  It will be interesting to see how this develops.