A Renewable Boom means more Expensive and Less Reliable Electric Power

Posted by PITHOCRATES - October 20th, 2013

Week in Review

The news on our green energy initiatives sounds good.  We’re importing less oil.  And adding more and more wind power.  If you’re a proponent of green energy you no doubt are pleased by this news.  But if you understand energy and economics it’s a different story.  You’ll think the country is moving in the wrong direction.  Ultimately raising our energy costs.  Without making much of an impact on carbon emissions.  And just because we are exporting gasoline doesn’t mean we’re on the road to being energy self-sufficient (see The Renewable Boom by Bryan Walsh posted 10/11/2013 on Time).

Earlier this year, the U.S. became a net exporter of oil distillates, and the International Energy Agency projects that the U.S. could be almost energy self-sufficient in net terms by 2035.

This is not necessarily a good thing.  Being a net exporter of oil distillates.  It means that US supply exceeds US demand at the current market price.  That’s an important point.  The current market price.  The US has been in an anemic economic recovery—though some would say we’re still in a recession—since President Obama assumed office.  During bad economic times people lose their jobs.  Those who haven’t are worried about losing theirs.  And they worry about the uncertainty, too, about the cost of Obamacare.  So people are driving less.  And they are spending less.  Because they have less.  And worry about how much money they’ll need under Obamacare.  So they’re not taking the family on a cross-country vacation.  Some are even spending their vacation in the backyard.  The so called ‘staycation’.  No doubt the 10 million or so who disappeared from the labor force since President Obama assumed office aren’t driving much these days.  So because of this US demand for gasoline is down.  And, hence, prices.   Even though gasoline prices are still high and consuming an ever larger part of our reduced median family income (also down since President assumed office), gasoline prices are higher elsewhere.  Which is why refineries are exporting their oil distillates.  To meet that higher demand that has raised the market price.

But the biggest source of new electricity in the U.S. last year wasn’t a fossil fuel. It was the humble wind. More than 13 gigawatts of new wind potential were added to the grid in 2012, accounting for 43% of all new generation capacity. Total wind-power capacity exceeded 60 gigawatts by the end of 2012—enough to power 15 million homes when the breeze is blowing.

These numbers do sound big for wind.  Like it’s easy sailing for wind power to replace coal.  But is it?  Let’s look at the big picture.  In 2011 the total nameplate capacity of all electric power generation was 1,153.149 gigawatts.  So that 13 gigawatts though sounding like a lot of power it is only 1.127% of the total nameplate capacity.  Small enough to be rounding error.  In other words, that 13 gigawatts is such a small amount of power that it won’t even be seen by the electric grid.  But it gets even worse.

We used the term ‘nameplate capacity’ for a reason.  This is the amount of power that this unit is capable of producing.  Not what it actually produces.  In fact, we have a measure comparing the power generation possible to the ‘actual’ power generation.  The capacity factor.  Which measures power production over a period of time and divides it by the total amount of power that the unit could have produced (i.e., its nameplate value).  Coal has a higher capacity factor than wind because coal can produce electric power in all wind conditions.  While wind power cannot.  If the winds are too strong the wind turbines lock down to protect themselves.  If the wind is blowing too slowly they won’t produce any electric power.

The typical capacity factor for coal is 62.3%.  Meaning that over half of the installed capacity is generating power.  Some generators may be down for maintenance.  Or a generator may be shut down due to weak demand.  The typical capacity factor for wind power is 30%.  Meaning that the installed capacity produces no power 70% of the time.  And it’s not because turbines are down for maintenance.  It’s because of the intermittent wind.

So coal has twice the capacity that wind has.  Does this mean we need twice the installed capacity of wind to match coal?  No.  Because if you tripled the number of wind turbines in a wind farm they will still produce no power if the wind isn’t blowing.  In this respect you can say coal has a capacity factor of 100%.  For if they want more power from a coal-fired power plant they can bring another generator on line.  Even if the wind isn’t blowing.

You could say wind power is like parsley on a plate in a restaurant.  It’s just a garnishment.  It makes our electric power production look more environmentally friendly but it just adds cost and often times we just throw it away.  For if coal provides all our power needs when the wind isn’t blowing and the wind then starts blowing you have a surplus of power that you can’t sell.  You can’t shut down the coal-fired power plant because the wind turbines don’t produce enough to replace it.  You can’t shut down the wind turbines because it defeats the purpose of having them.  So you just throw away the surplus power.  And charge people more for their electric power to cover this waste.  Like a restaurant charges more for its menu items to cover the cost of the parsley the people throw away.

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There is Great Income Inequality on the Set of the Big Bang Theory

Posted by PITHOCRATES - September 21st, 2013

Week in Review

It is hard to explain economic fundamentals to the public.  To explain how free market capitalism made this country great.  And how supply and demand set prices.  How unskilled workers are in less demand than highly skilled workers.  So highly skilled people earn more money than unskilled workers.  Which is why doctors earn more money than those working in fast-food.  Because there always seems to be a shortage of doctors.  While there is no shortage of minimum wage jobs.  So doctors are worth more because they are in greater demand.

Those on the left want a living wage for everyone.  Regardless of their skill level.  Unions are trying to unionize fast-food workers and Wal-Mart employees.  So they can force these businesses to pay them more than the market price for their labor.  As determined by the laws of supply and demand.  Like they do everywhere else.  Computer programmers were in high demand during the dot-com bubble.  Raising the salary of computer programmers.  And people went to college to learn how to be computer programmers to get those high salaries.

But try to explain this to the layperson when the left demonizes Republicans.  Calls them greedy.  Saying they want to take food away from children and the poor.  And throw Grandma off the cliff.  That they’re in the pockets of the big, evil corporations.  And that unfettered capitalism is corrupt, unfair and just plain mean.  What makes it especially difficult to explain these economic fundamentals is that the left controls the public schools and our universities and colleges.  And the entertainment industry.  So they’re teaching our children to hate free market capitalism.  And Republicans.  While the entertainment industry mocks and ridicules anyone who tries to advance sound economic policies instead of expanding the welfare state.  Instead they preach egalitarianism.  Where everyone should get a living wage regardless of their skill level.  And where we treat people fairly and with dignity.  Transferring and distributing wealth fairly.  From those according to ability to those according to need.

It sounds nice.  Caring.  And kind.  Despite every country that has ever tried that became a horrible place to live.  For that’s what they did in the former Soviet Union.  The People’s Republic of China.  The former East Germany.  North Korea.  Cuba.  Nations that had to use a brutally oppressive police state to prevent their people from escaping the kind of egalitarianism the left is constantly trying to bring to the United States.

Perhaps the most frustrating thing in trying to teach economic fundamentals to lay people is that their heroes in the entertainment industry are always campaigning for the left.  They attend fundraisers for the left.  Help them win elections.  And they constantly mock and ridicule those on the right.  Despite indulging in some of the most unfettered free market capitalism themselves (see ‘Big Bang Theory’ Stars Seeking Hefty Pay Raises by Lesley Goldberg, The Hollywood Reporter, posted 9/17/2013 on Yahoo! TV).

Sources tell THR that Emmy winner Parsons (Sheldon), Galecki (Leonard) and Cuoco (Penny) will negotiate together — as they did in 2010 — and are looking for a considerable bump in pay from their current deal. According to a TV Guide Magazine report, the trio currently earns $325,000 per episode and may seek up to $1 million an episode…

The new deals for Bialik and Rauch, who joined the series midway through its run and were promoted from recurring to regulars, will see their salary jump from $20,000-$30,000/episode to the $60,000 ballpark, with increases each year taking them to $100,000 per episode by the end of their new contracts.

One million an episode versus $100,000 an episode?  Wow.  Talk about your income disparity.  There is no egalitarianism on the set of the Big Bang Theory.  There’s no fairness.  And just think how much food this could have bought for the children.  And the poor.  If these people were corporate officers they would be hated and despised for their greed.  Especially when the median household income (the income that supports an entire family) has been languishing around $53,000.  And here are actors making more than that each episode they film.  Is that fair?  When others have so little?

Yes, it is unfair.  But is it wrong?  No.  This is free market capitalism.  This is the top-rated comedy on television.  It has great writing.  And great characters.  Which the writers created.  But if you watch an early episode and then a later one you will see how these actors have evolved these characters.  In the first episodes Penny was the pretty neighbor Leonard was smitten with.  But watch her now.  And all the things she doesn’t say.  Her body language and facial expressions.  The little nuances that have transformed Penny into a real life person we look forward to seeing every week.  Kaley Cuoco has made Penny into what she is today.  As Jim Parsons has made Sheldon into what he is.  And Johnny Galecki has made Leonard into what he is.  The rest of the cast is probably the best ever fielded on a sitcom.  But it is the interactions they have with these three that make this show the number one comedy on television.

So, no, we don’t begrudge them from getting these unfair contracts.  More power to them to get as much as they can get.  Sure, it’s unfair to the actors that came before them.  When things were very egalitarian.  Where the actors made far less than they do today.  Even if that show went on forever in syndication.  Like Gilligan’s Island.  Making a lot of money for the owners of that show.  But not the actors.  No, they didn’t get a dime from that syndication.  Worse, none of them made close to a million dollars an episode.  They didn’t get paid a lot.  But everyone made closer to what everyone else made.  Because back then actors were more equal.  Unlike today.  Where there is great income inequality between actors.

So there is nothing wrong with Parsons, Galecki and Cuoco making these huge sums of money.  Or anyone else in the entertainment community.  It would be nice, though, if this community wasn’t publically against the very thing that they benefit so handsomely from.  Free market capitalism.  Which has been very good to them.  As it is very good to everyone.  But yet the entertainment community generally endorses the left.  And attacks the right.  Which helps the left raise taxes and burden business with more costly regulations.  Things that hurt the economy.  And keeps the median household income from rising.  Harming the middle class.  But making no impact on these superrich.  This is the problem we have with the entertainment community.  They’re hogging all the free market capitalism for themselves.  While forcing us to live in the miserable social democracy they helped to create with their endorsement of the left.

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China raises the Price of Cotton and Chases the Textile Industry out of China

Posted by PITHOCRATES - June 9th, 2013

Week in Review

Communists think they are smarter than capitalists.  They think they can manage an economy better than market forces.  Despite the failure of the Soviet Union, China (under Mao), North Korea, Cuba, etc., there are many Western nations with activist governments.  Believing like the Chinese that smart bureaucrats can make the economy operate better than those market forces can.  But the problem is they can’t control all market forces.  So when they intervene there are always unintended consequences that usually make things worse after their intervention.  As this example in China shows (see China’s cotton procurement policy hurting textile industry by Staff Reporter posted 6/9/2013 on Want China Times).

China has jacked up the domestic price of cotton to 20,400 yuan (US$3,325) per tonne as of May 13, 4,500 yuan (US$730) higher than the international price, reports Shanghai’s First Financial Daily.

Industry insiders said that the current procurement policy does nothing to benefit cotton farmers and will have a serious effect on the domestic mid-stream textile industry, forcing many firms to move their operations overseas, the paper said…

The government has justified its cotton procurement at prices higher than international levels, by arguing that the policy can protect the interest of farmers and stabilize domestic cotton farm acreage and output, which assures the domestic supply…

The high cost has forced textile firms to abandon orders, with a growing number of firms relocating to Vietnam, Bangladesh, and India. Downstream firms, in dyeing and printing, have also been affected.

China expanded their cotton production when international cotton prices rose.  Then international prices fell.  Leaving them with a surplus of cotton selling at a price that did not recover the costs of that expanded production.  So these wise bureaucrats decided to raise the price of cotton.  And restrict imports.  Problem solved.  They forced the domestic textile industry to buy the higher priced domestic cotton.  Which, of course, raised the price of the textiles they sold.  Above the prevailing international price.  Pricing them out of the international markets.  So this economic reality forced them to relocate to a country that did not force them to purchase cotton above market prices.  Allowing them to produce textiles and sell them at prices the international markets would pay.

This is the same reason why the U.S. doesn’t have a domestic textile industry anymore.  Only it wasn’t government forcing textile manufacturers to buy cotton at above market prices.  It was the unions forcing them to pay labor at above market prices that increased the price of their textiles.  And priced them out of the international markets.  Because there are always unintended consequences whenever we interfere with market forces.  Always.  And the end result is always worse after the intervention.  Always.

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Venezuela may put People before Profits but they have no Toilet Paper

Posted by PITHOCRATES - May 18th, 2013

Week in Review

The American left wants to have the economic system they have in Venezuela.  Where they put people before profits.  To prevent evil corporations from getting rich.  While exploiting their workers.  And overcharging their customers.  You see, that kind of thing just doesn’t happen in Venezuela.  Because they put people before profits (see So, Venezuela Has a Toilet-Paper Shortage (Don’t Laugh. Seriously.) by Jordan Weissmann posted 5/16/2013 on The Atlantic).

Venezuela is now suffering from a government-induced toilet paper shortage. The situation has become politically dire enough that the government has promised to import 50 million rolls to calm shoppers.

For those familiar with the Bolivarian Republic’s less-than-sterling economic record of late, this won’t come as a surprise. The country, while relatively wealthy by developing-world standards, has been suffering through a chronic shortfall of everything from groceries to asthma inhalers, resulting in desperate lines of shoppers and a healthy black market trade in kitchen staples like flour.

In the United States about the only toilet paper shortage people are familiar with is when they drop trou in a public restroom without looking to see if there was toilet paper first.  Why do people do this in the United States?  Because we take toilet paper for granted.  And always expect it to be there.  Because we are not socialists.  We’re capitalists.  And being a capitalist means you never have to see an empty shelf when buying toilet paper.

So why do socialists have such a difficult time buying toilet paper?  Because they put people before profits.  Which sounds good but is only code for dictatorship.  Where the dictator lives well.  As there is always enough for the privileged few.  But to sustain this privileged position a dictator has to steal from his people.

In 2003, then President Hugo Chavez slammed currency controls into place to prevent money from fleeing the country while government seized land and corporate assets. Those rules have made it harder to buy imports. Meanwhile, price caps meant to make basic staples affordable to the poor are so low that, for many products, they don’t pay for the cost of production.

Nobody’s going to make toilet paper if they’ll lose money selling it.

Price caps make things cost less than the prevailing market price.  Which encourages people to over consume.  Just as Nixon’s price controls led to gas shortages in the United States.  While at the same time the price caps force suppliers to sell below the prevailing market price.  Which is often below their costs.  So while people are clearing shelves off suppliers are not replenishing those shelves.  Leading to shortages.

To buy imports you have to first exchange your currency for the currency of the country you’re buying from.  For U.S. companies accept the U.S. dollar for its exports.  Not the bolívar fuerte.  Venezuela’s currency controls prevent Venezuelan businesses from exchanging their currency.  Making it impossible for them to buy the imports they need.  So they have to throttle back production.  Making it more difficult to restock those empty shelves.  Forcing the people to go without toilet paper.  While Hugo Chavez died a billionaire.

This is what happens when you put people before profits.  You make it possible for a charismatic dictator to impoverish the people he champions.  Which is impossible under laissez-faire capitalism.  For businesses can buy the imports they need.  And they can sell at a price that covers their costs.  Which keeps the shelves in capitalist countries overflowing with the goods people want to buy.  While wannabe dictators can’t seize land and corporate assets.  But have to work for a living.  Like everyone else.

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How a 12-Year Old Canadian and U.S. Unions see Business Differently

Posted by PITHOCRATES - May 12th, 2013

Week in Review

Advancing technology has greatly increased productivity.  Allowing fewer workers to do what workers a generation earlier did.  Causing our workforce to age.  Fewer workers are entering the workforce than are leaving it.  And costly union contracts paying pensions and health care to those who have left the workforce has decimated union membership.  For the costs they place on business have made these businesses uncompetitive in the market place.  Chasing manufacturing jobs out of the country.  Leaving union membership in the private sector at its lowest rates since the heyday of the labor movement.  To understand why let’s take a business lesson from the Canadians.  Who are trying to encourage their kids to become entrepreneurs.  Unlike in America.  Where business and profits have become a 4-letter word (see Canadian entrepreneurs: Born or made? by BARRIE McKENNA posted 5/10/2013 on The Globe and Mail).

[Entrepreneurial Adventure] pairs students with local business people to create a business, design a product, sell it and then give the profits to charity.

Why?

Evidence suggests Canada suffers from a weak entrepreneurial culture. While it’s relatively easy to start a company, the record of turning start-ups into fast-growing and successful enterprises is less convincing.

A 2010 study by Industry Canada…

… found that Canada generates a lower proportion of fast-growing companies than other developed countries, that relatively few small companies export and that the age profile of business owners is getting older…

Many business schools, including McGill University and the University of Toronto, now offer special entrepreneurship programs.

This is a problem.  For the number one job creator in any free market economy are small business owners.  People who go into business for themselves.  Taking great risk.  And hiring people as they grow.  This is the entrepreneurial spirit.  People who start out small.  And become someone like Steve Jobs.  Most people don’t understand the entrepreneurial process.  And the importance of having a business-friendly environment to encourage entrepreneurialism.  To create jobs.  To grow a healthy economy.  Creating new products that make our lives better.  And to do that one of the first things an entrepreneur must learn is what this 12-year-old learned.

“Some things work and some don’t,” acknowledged Alim Dhanani, 12, who worked on project management and Web design for the company. “To sell something, you have to have the right price. Not too small, so you have a profit, but not too big, so people will buy it.”

A 12-year-old can understand this.  The role of prices in the economy.  They have to be high enough to pay the bills.  But low enough to encourage people to buy from you.  Often times it’s not a matter of a business owner determining the price he or she wishes to charge.  They have to figure out how to pay their bills (and earn a profit) at the prevailing market price.  Something labor unions don’t understand.  Or they simply don’t care (see Fast-food workers in Detroit walk off job, disrupt business by Steve Neavling and Lisa Baertlein posted 5/10/2013 on Reuters).

Hundreds of fast-food employees in Detroit walked off the job on Friday, temporarily shuttering a handful of outlets as part of a growing U.S. worker movement that is demanding higher wages for flipping burgers and operating fryers.

The protests in the Motor City – which is struggling to recover from the hollowing out of its auto manufacturing sector – marked an expansion in organized actions by fast-food workers from ubiquitous chains owned by McDonald’s Corp, Burger King Worldwide and KFC, Taco Bell and Pizza Hut parent Yum Brands Inc.

Fast-food workers, who already have taken to the streets in New York, Chicago and St. Louis, are seeking to roughly double their hourly pay to $15 per hour from around minimum wage, which in Michigan is $7.40 per hour…

“People can’t make a living at $7.40 a hour,” said Rev. Charles Williams II, a protest organizer. “Many of them have babies and children to raise, and they can’t get by with these kind of wages.”

Those workers face high hurdles in their fight for better pay. Low-wage, low-skill workers lack political clout and face significantly higher unemployment than college graduates…

The Detroit action was put together by the Michigan Workers Organizing Committee, an independent union of fast-food workers, that is supported by community, labor and faith-based groups such as the Interfaith Coalition of Pastors, UFCW Local 876, SEIU Healthcare Michigan and Good Jobs Now.

The unions want to do to fast-food what they did to the automotive industry.  In this case the union basically gave unskilled workers the wages and benefits of skilled workers.  Sounds great if you’re an unskilled worker.  But the UAW priced the U.S. auto manufacturers out of the market.  The Big Three are a shell of what they used to be.  With both General Motors and Chrysler requiring taxpayer bailouts to avoid bankruptcy.  And pay for their crushing pension and health care cost obligations.  For GM was paying for more people not working than they were paying to work.  Even a 12-year-old can understand that this is a business model that just won’t work.

So what will happen in fast-food restaurants if you raise the labor wage from $7.40 per hour to $15 per hour?  That’s a labor cost increase of 103%.  In the restaurant business the rule of thumb for calculating your selling prices is as follows.  You calculate your food cost then triple it.  For in general one third of a menu price goes to food.  One third goes to labor.  And one third goes to overhead (utilities, rent, insurance, etc.) and profit.  Now let’s take a typical combination meal (sandwich, fries and beverage) price of $7.50.  One third of this price is $2.48 which represents the labor portion of the price.  The increase in labor is 103%.  So we take 103% of the $2.48 ($2.54) and add it to $7.50 to get the new selling price of the combo meal.  Bringing it to $10.04.

What will customers do?  Now that the combo meal will cost $2.54 more will they just continue to eat fast-food like they once did?  Will they stop adding an extra item from the dollar menu?  Will they just buy a burger and eat it with a beverage from home?  Will they just buy from the dollar menu instead of buying combos?  Of course, with the increase in labor costs that dollar menu will have to become the $2.03 menu.  Will people stop going to fast-food as often as they once did?  Some may decide that if they’re paying for a $6 hamburger the may go to a diner or bar for a $6 hamburger.  Worried about the lost business would fast-food owners try to cut their costs elsewhere to try to continue to sell fast-food at the market price?  By hiring fewer people?  Pushing current workers to part-time so they don’t have to give them costly health insurance?  Or will they just close their restaurant.  As people just won’t pay fancy restaurant prices for fast-food.

That 12-year-old in Canada would understand how the higher labor costs would affect business.  Causing changes in buying habits.  And changes in business practices.  He would not start up a fast-food franchise if labor prices were 103% higher than they are now.  For he would have to raise prices high enough to pay the bills.  But when he did they might be too high to get people to come in and buy food.  Causing a fall in business.  And a loss in revenue.  Making it more difficult to pay the bills.  That 12-year-old would see this as bad business.  Because he understands that a business owner can’t charge whatever he wants to charge.  He has to figure out how to stay in business while selling at the prevailing market price.  And though he may love fast-food he knows that his allowance won’t be able to buy as much as it once did.  So he would reduce his purchases at fast-food restaurants.  Just as his father will probably take the family out less often because of the higher prices.  Just as single mothers struggling to pay their household bills will, too.  But the unions don’t understand this.  Or simply choose not to.  Instead they just tell the workers that their employers are greedy.

It’s a sad day when a 12-year-old has better business sense than our unions.  Then again if unions cared about business they wouldn’t have bankrupted two of the Big Three.

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Thales of Miletus, Olive Oil, Tulip Mania of 1636 and the Chicago Board Options Exchange

Posted by PITHOCRATES - April 30th, 2013

History 101

Thales of Miletus was able to Predict a Bumper Crop of Olives

Italian restaurants will have a bottle of olive oil on the table.  The more authentic restaurants.  That give you a taste of old Italy.  Where they give you bread to munch on while you wait for your food.  We pour a little olive oil on a plate.  And dip our bread in it.  And enjoy that Mediterranean flavor.  Something that some of us may believe the Olive Garden brought to the dining experience.  But olive oil actually predates the Olive Garden.  We probably started eating olives for the first time around the 8th millennium BC.  When our Neolithic ancestors were still using stone tools.  Someplace in ancient Greece.

Olive trees grew all around the Mediterranean Sea.  And the Mediterranean people probably started using olive oil around the 4th millennium BC.   That’s 4000 BC.  Awhile ago.  We began to produce olive oil commercially somewhere around 2500 BC.  And began trading this luxury good.  We ate it.  Used it in religious rituals.  In medicines.  And fuel for oil lamps.  Among other uses.  As demand grew we planted more trees.  And brought in large harvests at the end of the growing season.  And took the olives to the olive presses.  And waited for our turn.  To pay the pressman to press our olives into oil.  And during a good growing season you could find yourself waiting quite awhile.

But who has time to wait?  If only we could figure out some way to avoid that long line.  Well, as it turned out, if you were smart you could.  As Thales of Miletus did.  A Greek astronomer, philosopher and mathematician.  As well as a pretty good weather forecaster.  For he was able to predict a bumper crop of olives one year because of favorable weather.  Which would make those olive presses busy at the harvest.  So he went to the olive press owners and reserved time on their presses for a nominal down payment.  So when the harvest came in he would be at the front of the line.  If he was wrong about his forecast he would give up his nominal deposit.  And walk away.  As the press owners didn’t care whose olives they were pressing they were glad to take his money for this right to buy press time later.  They had nothing to lose.  And when Thales prediction proved true and there was a bumper crop of olives those options to buy time on those presses became very valuable.  Those anxious to get their olives into the presses were glad to pay him for those options.  To buy his right to be first to buy press time.  Which he did.  Getting quite wealthy in the process.  As well as proving a point.  Rational thinking had real value.  They could use philosophy to make life better.

As Tulip Prices continued their Meteoric Rise the Speculators entered the Market to Get Rich Quick

And the option was born.  You can use them to speculate about the price of something in the future to make a lot of money.  And you can use them for hedging risk.  Such as farmers do.  They enter contracts with people to sell their crops at a set price.  Which protects the farmer if there is a bumper crop and prices fall.  Those who didn’t enter an options contract will only get the market price for their crops.  And have an unprofitable season.  While those with options contracts will be able to sell their crops above the market price.  And have a profitable season.  But if there are droughts that reduce the harvest prices will rise.  Which protects the buyer.  As he is able to buy below the market price.  At the price in the options contract.  While those buyers without options contracts will have to pay the higher market price.  Thus entering a contract hedges risk for both buyer and seller.  One party may do better than the other if there is a large swing in price.  But neither party will suffer a bad loss.  So whatever happens in that growing season they will be around for the following growing season.  But the speculators, on the other hand, can suffer great losses.

Tulips were big in the 17th century.  The affluent adorned their homes with these beautiful flowers.  And they soon became a sign of affluence.  Today people go to the affluent shops on Rodeo Drive and buy the latest in high fashion to show off their wealth.  In the 17th century they planted tulips.  People were impressed with what they saw.  And soon had to have these wonderful flowers themselves.  Causing a great surge in demand for tulips.  Which tulip growers rushed in to meet.  But the supply couldn’t keep up with the demand.  So tulip prices soared.  Soon, growers (sellers) and wholesalers (buyers) start entering options contracts to hedge their risks in the volatile tulip market.  As tulip prices continued their meteoric rise the speculators entered the market to get rich quick.  This speculation grew into such a frenzy that people would even mortgage their homes to raise money to buy tulip options.  Waiting for the big payday when they could exercise those options.  And buy tulips at one price.  Then resell them at a higher price.  A much higher price.  The demand for options grew so great that an options market opened.  And people bought and sold tulip options.

All good things must come to an end, though.  As must speculative bubbles.  And that happened in the Netherlands in 1637.  For there comes a time where buyers simply refuse to buy anymore tulips at those high prices.  And when they stopped buying people with vast amounts of tulips to sell began to panic.  And started lowering their price.  As other sellers started doing.  When interest in buying tulips fell supply began to exceed demand.  Sending the tulip price into a freefall.  With falling tulip prices no one was buying options contracts.  Because the market price was falling so fast that it would fall below the price in those options contracts.  And when they did ‘fall out of the money’ those options contracts became worthless.  And all that money the speculators poured into the options market was lost.  People lost everything.  Even their homes.  Sending the Dutch economy into a nasty recession.

With the Advent of the Internet it’s Never been Easier to Buy and Sell Options

Stock options were a way to get rich quick.  And what made them so attractive to speculators was leverage.  A small investment could turn into great riches.  But that leverage worked both ways.  And it could take that small investment and turn it into a great loss.  Should the price move in the wrong direction and fall when you have a contract obligating you to buy at a higher price.  And with the tulip mania of 1636 investors were getting a little gun-shy of options in general.  Causing the volume of options trading to fall in London.  Concerned of the speculative nature of options London made options trading illegal in 1733.  A ban that remained until 1860.

Russell Sage inaugurated options trading in the United States in 1872.  These were over the counter (OTC).  There was no central stock exchange.  Or standardized options format.  Which made the trading difficult to say the least.  Brokers placed ads in financial journals for their respective buyers and sellers.  And waited.  For someone to read the ad.  And call.  Then haggled over the price a bit.  Signed a contract.  And then waited until the expiration date of the option.  Or placed another ad in some financial journal.  To find someone else to buy the option.

Then things started changing in 1935.  The SEC granted a license to the Chicago Board of Trade (CBOT) as a national securities exchange.  And in 1968, CBOT finally did something with that license.  They created the Chicago Board Options Exchange (CBOE).  Which standardized and organized options trading.  One Nobel Prize later to Fischer Black and Myron Scholes for their “The Pricing of Options and Corporate Liabilities” we had a ‘scientific’ way for valuing stock options.  And with the advent of the Internet it’s never been easier to buy and sell options.  Allowing some to hedge risks easily.  While others live dangerously.  And speculate.  Trying to score big.  Before they lose everything trying to get rich quick.

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Economies of Scale

Posted by PITHOCRATES - December 31st, 2012

Economics 101

Employers are very Reluctant to hire Additional Employees because Labor Costs are their Greatest Costs

When it comes to running a business there is nothing more costly than people.  Employee salaries and wages.  Payroll taxes.  And benefits.  People need a large paycheck to live on and will go to the employer that offers the highest pay.  Government has imposed costly taxes and regulatory costs.  And to further entice good workers employers have to sweeten the deal with some fringe benefits like health insurance, paid vacation time, holiday pay, paid sick days and retirement plans.  It adds up.  Something like this:

As you can see the amount of pay employees are familiar with (the working pay above) is far less than the total cost to the employer.  The employee doesn’t see the 63.1% markup on their working pay that their employer has to pay in addition to paying the employee.  As a business hires more employees these costs add up.  A small factory with 15 workers on the factory floor can cost the employer $1.6 million.  Which is why labor costs are the greatest costs of most businesses.  And why employers are very reluctant to add additional employees.

The more Productive you are the Lower your Unit Cost and the Lower the Selling Price in a Store

Besides labor costs a business like a factory will have material costs, too.  These are variable costs.  They’re variable because they vary with varying levels of production.  The more production there is the more variable costs there are.  In addition to variable costs businesses have fixed costs.  Often simply called overhead.

Factories make things.  Like things you can pick up off a store’s shelf.  Things with low prices on their price tags.  But when it can cost a small manufacturer $1.6 million JUST for its labor costs how can they sell things with such low prices?  By making a lot of those things to sell.  As much as they possibly can with their variable and fixed costs.  What we call economies of scale.  And the more they can make for their given costs the lower the unit cost is for each thing you can buy off a shelf at a store.   As you can see here:

Assuming a factory can produce anywhere from 1,250,000 to 2,750,000 units with a given labor force operating the same production equipment in a factory you can see how the unit cost falls the more they produce.  Which is why there is so much talk about productivity.  The more productive you are (the more you can produce for a given cost) the lower your unit cost.  And the lower the selling price in a store.  Increasing productivity could mean moving an assembly line a little faster.  Or replacing some people with machines.  Things that workers don’t like.  But things consumers love.  For they like low prices when they go shopping.

Employers are very Reluctant to Hire New Employees and Prefer Increasing Productivity with Automation

If you crunch these numbers for the labor costs of 16 and 17 workers you can see how unit costs rise as an employee or two is added to the production floor.  At an annual production of 2,000,000 units the unit cost increases $0.05 (4.6%) going from 15 to 16 workers.  Adding two workers increases the unit cost $0.11 (10.1%).  Doesn’t seem like a lot.  But we notice when something we once bought for $0.99 now costs $1.04.  And we don’t like it.  But business owners like it even less.  Here’s why.

Business may be booming.  Those on the factory floor may be working a lot of overtime to produce at a rate of 2,000,000 units per year.  And are growing unhappy with all of that overtime.  They keep demanding that the owner hire another person.  The owner does.  Increasing unit costs by $0.05.  But the owner hopes the booming economy will continue.  And that they can even increase the production rate.  For if they can sell an additional 250,000 units the unit cost can actually fall $0.07 to $1.02.  Making the addition of a new worker on the factory floor not increase costs.  As the increase in production will make costs fall greater than that increase in labor costs.

But it doesn’t always work like that.  Economic booms don’t always last.  When too many factories increase production to meet booming demand they bring too much supply to market.  Causing prices to fall.  And forcing factories to cut back on production rates.  So instead of increasing the production rate they may find themselves cutting back.  Perhaps going from 2,000,000 to 1,750,000.  A fall of 250,000 units.  Increasing the unit cost $0.21 (19.3%).  Which could very well raise the unit cost above the prevailing market price.  Requiring layoffs.  To get the unit cost back down to $1.09.  Allowing them to sell at the prevailing market price.  And at a production rate of 1,750,000 units that may require letting go more than just one worker.  Maybe even more than two.  Which is why employers are very reluctant to hire new employees.  And prefer increasing productivity with automation.  For it is far easier to make machines increase or decrease production rates than it is to hire and lay off people.  Making it easier and less costly to reach great economies of scale.  Which makes low prices.  And happy consumers.

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Product Pricing

Posted by PITHOCRATES - December 10th, 2012

Economics 101

The First Thing a Business has to do to Determine their Selling Price is Determining their Costs

Did you ever think about how businesses price their products?  Do they just pull numbers out of the air?  Do they just charge as much as they want?  No, they don’t.  Because they can’t.  For if one gas station charges $12 for a gallon of gasoline while the station across the street is only charging $3.50 guess where people are going to buy their gas from.  So free market competition prevents businesses from charging whatever they want.  So how do they determine what to charge?

Well, some look at what their competitors are charging and match it.  Or charge a little less.  To steal customers away from the competition.  Which can work.  But it can also bankrupt a business.  For if a business owner doesn’t know his or her costs selling at the market price could fail to recover all of their costs.  The market price limits what they can charge.  But if their costs are too great to stay in business selling at the prevailing market price they have to do something about reducing their costs.  Which they can’t do if they don’t know their costs.  So the first thing a business has to do to determine their selling price is determining their costs.  Like this.

This is an abbreviated fictional income statement showing last year’s results.  And forecasting next year’s results.  EBT stands for earnings before taxes.  Income taxes for this year are based on the 2011 federal tax tables.  Income taxes for next year are based on the proposed Obama tax rates (increasing the top marginal rate from 33% to 39.6%).  The business is a subchapter-S where the business earnings pass through to the owners’ personal income tax returns.  The owner does not draw a salary but draws $125,000 from retained earnings to support him or herself, his or her stay-at-home spouse and their 3 children. The percentages show each number as a percentage of revenue.

You need to Sell at the Right Price and at the Right Volume to Pay all of the Bills

The difference between this year and next year is the rise in costs.  Obamacare and other business regulations increase the cost of sales (direct labor, benefits, direct supplies, etc.) by 2%.  And they increase fixed overhead (rent, utilities, administrative labor, benefits, etc.) by 2%.  They will have to recover these higher costs in higher prices.  Which will likely reduce unit sales.  But because each unit will sell for more we assume sales revenue remains the same.

The higher costs cause EBT to fall.  A lower EBT means lower federal income taxes.  But it also means less retained earnings to invest back into the business.  The reduction in retained earnings is $36,604.28.  Which limits investments to grow the business.  And leaves a much smaller cash cushion after some of those retained earnings are reinvested into the business.  To pay for the unexpected.  Like a new piece of equipment that fails and halts production.  Things worked well in the current year.  The business owner would like to have things work as well in the following year.  Which means not exposing themselves to such a dangerous cash position.  And how do they do that?  By raising their prices to make next year’s retained earnings as large as this year’s.  By recovering those retained earnings in higher prices.  Like this.

Let’s assume these numbers are for a coffee shop that sells only one type and size of drink (say a large espresso-based drink) to simplify this discussion.  If we subtract this year’s cost of sales from revenue we arrive with the markup on our direct costs.  Dividing this number into cost of sales we get a markup percentage.  For this year it was 72%.  In the current year let’s assume they sold 302,406 cups of coffee.  Which comes to about one cup a minute.  Dividing the costs of sales by the number of cups of coffee sold gives a unit cost of $2.58 for a cup of coffee.  Adding the 72% markup to this cost brings the selling price to $4.45.  Coffee sold at this price and at this volume produced enough revenue to pay all the bills, provided an income for the owner and his or her family while leaving enough left over to invest back into the business.  And provide a cash cushion for the unexpected.  As well as paying state income taxes, city income taxes, etc.

A Business must bring their Cost Structure in Line to be able to Sell at the Prevailing Market Price

To arrive at the new selling price we added the loss of retained earnings to next year’s revenue.  And re-crunched all of these numbers.  Because we are raising the price we can expect a small fall in revenue as customers buy less.  The higher costs and lower unit sales volume raised the unit cost.  The markup percentage is 1 percentage point lower but because the unit cost is higher so is the markup amount in dollars.  Which raises the selling price by $0.32.  Increasing the price of a cup of coffee to $4.77.  But is it enough?  As it turns out, no.  Because the new price raises revenue enough to push the business into a higher tax bracket.  Taking the business owner back to the numbers.

Because of the higher tax bracket, and the higher top marginal tax rate, this higher price still results in a loss of retained earnings.  About another $30,000.  So going through the whole process again brings the selling price up to $4.87.  Adding a total of $0.43 to this year’s price.  As long as the prevailing market price is around $4.87 for a large espresso-based drink this business owner should be able to keep his or her cost structure in place and stay in business.  However, if this exceeds the prevailing market price the business owner will have to make some spending cuts to bring his or her cost structure in line to sell coffee at the prevailing market price.  Make some assumptions.  And some adjustments.  Then crunch these numbers again.  And again.  For getting this price right is very important.  Too high and people will go elsewhere to buy their coffee.  To low and they won’t be able to pay all of their bills.

This may not be how all businesses determine their selling price.  But however they do it they have to bring their cost structure in line to be able to sell at the prevailing market price.   Because if their price is too high no one will buy from them.  If it’s too low everyone will buy from them.  Making them happy.  Until they realize they can’t pay all of their bills because their prices are too low.  The above example was complicated.  And that was with only one product.  Imagine a store full of products to sell.  And trying to calculate new prices on numerous products to cover the costs of new taxes and new regulations.  It’s not easy.  Which is why business owners don’t like big change coming from Washington.  For this change requires important decisions to make.  And if they get these decisions wrong and don’t find out until 6 months or so later they may dig themselves into a hole they won’t be able to get out of.  Putting them out of business.

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Iron, Steel, the Steam Engine, Railroads, the Bessemer Process, Andrew Carnegie and the Lucy Furnace

Posted by PITHOCRATES - November 21st, 2012

(Originally published December 14, 2011)

With the Steam Engine we could Build Factories Anywhere and Connect them by Railroads

Iron has been around for a long time.  The Romans used it.  And so did the British centuries later.  They kicked off the Industrial Revolution with iron.  And ended it with steel.  Which was nothing to sneeze at.  For the transition from iron to steel changed the world.  And the United States.  For it was steel that made the United States the dominant economy in the world.

The Romans mined coal in England and Wales.  Used it as a fuel for ovens to dry grain.  And for smelting iron ore.  After the Western Roman Empire collapsed, so did the need for coal.  But it came back.  And the demand was greater than ever.  Finding coal, though, required deeper holes.  Below the water table.  And holes below the water table tended to fill up with water.  To get to the coal, then, you had to pump out the water.  They tried different methods.  But the one that really did the trick was James Watt’s steam engine attached to a pump.

The steam engine was a game changer.  For the first time man could make energy anywhere he wanted.  He didn’t have to find running water to turn a waterwheel.  Depend on the winds.  Or animal power.  With the steam engine he could build a factory anywhere.  And connect these factories together with iron tracks.  On which a steam-powered locomotive could travel.  Ironically, the steam engine burned the very thing James Watt designed it to help mine.  Coal.

Andrew Carnegie made Steel so Inexpensive and Plentiful that he Built America

Iron was strong.  But steel was stronger.  And was the metal of choice.  Unfortunately it was more difficult to make.  So there wasn’t a lot of it around.  Making it expensive.  Unlike iron.  Which was easier to make.  You heated up (smelted) iron ore to burn off the stuff that wasn’t iron from the ore.  Giving you pig iron.  Named for the resulting shape at the end of the smelting process.  When the molten iron was poured into a mold.  There was a line down the center where the molten metal flowed.  And then branched off to fill up ingots.  When it cooled it looked like piglets suckling their mother.  Hence pig iron.

Pig iron had a high carbon content which made it brittle and unusable.  Further processing reduced the carbon content and produced wrought iron.  Which was usable.  And the dominate metal we used until steel.  But to get to steel we needed a better way of removing the residual carbon from the iron ore smelting process.  Something Henry Bessemer discovered.  Which we know as the Bessemer process.  Bessemer mass-produced steel in England by removing the impurities from pig iron by oxidizing them.  And he did this by blowing air through the molten iron.

Andrew Carnegie became a telegraph operator at Pennsylvania Railroad Company.  He excelled, moved up through the company and learned the railroad business.  He used his connections to invest in railroad related industries.  Iron.  Bridges.  And Rails.  He became rich.  He formed a bridge company.  And an ironworks.  Traveling in Europe he saw the Bessemer process.  Impressed, he took that technology and created the Lucy furnace.  Named after his wife.  And changed the world.  His passion to constantly reduce costs led him to vertical integration.  Owning and controlling the supply of raw materials that fed his industries.  He made steel so inexpensive and plentiful that he built America.  Railroads, bridges and skyscrapers exploded across America.  Cities and industries connected by steel tracks.  On which steam locomotives traveled.  Fueled by coal.  And transporting coal.  As well as other raw materials.  Including the finished goods they made.  Making America the new industrial and economic superpower in the world.

Knowing the Market Price of Steel Carnegie reduced his Costs of Production to sell his Steel below that Price

Andrew Carnegie became a rich man because of capitalism.  He lived during great times.  When entrepreneurs could create and produce with minimal government interference.  Which is why the United States became the dominant industrial and economic superpower.

The market set the price of steel.  Not a government bureaucrat.  This is key in capitalism.  Carnegie didn’t count labor inputs to determine the price of his steel.  No.  Instead, knowing the market price of steel he did everything in his powers to reduce his costs of production so he could sell his steel below that price.  Giving steel users less expensive steel.  Which was good for steel users.  As well as everyone else.  But he did this while still making great profits.  Everyone was a winner.  Except those who sold steel at higher prices who could no longer compete.

Carnegie spent part of his life accumulating great wealth.  And he spent the latter part of his life giving that wealth away.  He was one of the great philanthropists of all time.  Thanks to capitalism.  The entrepreneurial spirit.  And the American dream.  Which is individual liberty.  That freedom to create and produce.  Like Carnegie did.  Just as entrepreneurs everywhere have been during since we allowed them to profit from risk taking.

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Iron, Steel, the Steam Engine, Railroads, the Bessemer Process, Andrew Carnegie and the Lucy Furnace

Posted by PITHOCRATES - December 14th, 2011

Technology 101

With the Steam Engine we could Build Factories Anywhere and Connect them by Railroads

Iron has been around for a long time.  The Romans used it.  And so did the British centuries later.  They kicked off the Industrial Revolution with iron.  And ended it with steel.  Which was nothing to sneeze at.  For the transition from iron to steel changed the world.  And the United States.  For it was steel that made the United States the dominant economy in the world.

The Romans mined coal in England and Wales.  Used it as a fuel for ovens to dry grain.  And for smelting iron ore.  After the Western Roman Empire collapsed, so did the need for coal.  But it came back.  And the demand was greater than ever.  Finding coal, though, required deeper holes.  Below the water table.  And holes below the water table tended to fill up with water.  To get to the coal, then, you had to pump out the water.  They tried different methods.  But the one that really did the trick was James Watt’s steam engine attached to a pump.

The steam engine was a game changer.  For the first time man could make energy anywhere he wanted.  He didn’t have to find running water to turn a waterwheel.  Depend on the winds.  Or animal power.  With the steam engine he could build a factory anywhere.  And connect these factories together with iron tracks.  On which a steam-powered locomotive could travel.  Ironically, the steam engine burned the very thing James Watt designed it to help mine.  Coal.

Andrew Carnegie made Steel so Inexpensive and Plentiful that he Built America

Iron was strong.  But steel was stronger.  And was the metal of choice.  Unfortunately it was more difficult to make.  So there wasn’t a lot of it around.  Making it expensive.  Unlike iron.  Which was easier to make.  You heated up (smelted) iron ore to burn off the stuff that wasn’t iron from the ore.  Giving you pig iron.  Named for the resulting shape at the end of the smelting process.  When the molten iron was poured into a mold.  There was a line down the center where the molten metal flowed.  And then branched off to fill up ingots.  When it cooled it looked like piglets suckling their mother.  Hence pig iron.

Pig iron had a high carbon content which made it brittle and unusable.  Further processing reduced the carbon content and produced wrought iron.  Which was usable.  And the dominate metal we used until steel.  But to get to steel we needed a better way of removing the residual carbon from the iron ore smelting process.  Something Henry Bessemer discovered.  Which we know as the Bessemer process.  Bessemer mass-produced steel in England by removing the impurities from pig iron by oxidizing them.  And he did this by blowing air through the molten iron.

Andrew Carnegie became a telegraph operator at Pennsylvania Railroad Company.  He excelled, moved up through the company and learned the railroad business.  He used his connections to invest in railroad related industries.  Iron.  Bridges.  And Rails.  He became rich.  He formed a bridge company.  And an ironworks.  Traveling in Europe he saw the Bessemer process.  Impressed, he took that technology and created the Lucy furnace.  Named after his wife.  And changed the world.  His passion to constantly reduce costs led him to vertical integration.  Owning and controlling the supply of raw materials that fed his industries.  He made steel so inexpensive and plentiful that he built America.  Railroads, bridges and skyscrapers exploded across America.  Cities and industries connected by steel tracks.  On which steam locomotives traveled.  Fueled by coal.  And transporting coal.  As well as other raw materials.  Including the finished goods they made.  Making America the new industrial and economic superpower in the world.

Knowing the Market Price of Steel Carnegie reduced his Costs of Production to sell his Steel below that Price

Andrew Carnegie became a rich man because of capitalism.  He lived during great times.  When entrepreneurs could create and produce with minimal government interference.  Which is why the United States became the dominant industrial and economic superpower.

The market set the price of steel.  Not a government bureaucrat.  This is key in capitalism.  Carnegie didn’t count labor inputs to determine the price of his steel.  No.  Instead, knowing the market price of steel he did everything in his powers to reduce his costs of production so he could sell his steel below that price.  Giving steel users less expensive steel.  Which was good for steel users.  As well as everyone else.  But he did this while still making great profits.  Everyone was a winner.  Except those who sold steel at higher prices who could no longer compete.

Carnegie spent part of his life accumulating great wealth.  And he spent the latter part of his life giving that wealth away.  He was one of the great philanthropists of all time.  Thanks to capitalism.  The entrepreneurial spirit.  And the American dream.  Which is individual liberty.  That freedom to create and produce.  Like Carnegie did.  Just as entrepreneurs everywhere have been during since we allowed them to profit from risk taking.

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