Sunday, September 28, 2008


Someone mentioned needing a workbench while I was busy getting ready to mow the lawn, and I thought about it while pushing the mower back and forth over the damp and uncooperative grass. Pretty sure that I had everything that a workbench might require in the garage, I set to work after lunch, and was finished well before dinner. There are three 1x3s, a 2x3 stud, a 2'x4' piece of 3/4 plywood and a 2'x4' pegboard piece in there, plus some scraps made into shelves and cubbies. Tools will come later. My amazingly capable spouse said later that this is the sort of thing that would make a good Christmas present, but it's a bit late for that now.

And if you're wondering, why, yes, there is a lot of random wood in my garage. Isn't there in yours?

Monday, September 22, 2008

On the Theoretical Effects of a Minimum Wage: Brushing up on Econ 102: Microeconomics

(This is more retro-blogging of some stuff I wrote up a couple of years ago to try to explain how economists think of minimum wages in fairly simple theoretical terms. I'd say enjoy, but that might not be the first feeling that comes to mind when you read it.)

Supply and Demand

In a market in goods and services, sellers usually come in with some
price that they're willing to sell at, and buyers come in with some
price they're willing to pay. Buyers will happily pay less, and
sellers will willingly accept more, and different buyers and sellers
all probably have different prices in mind. When the sellers price
their goods and services, or the buyers post their bids, some buyers
will find things at prices they think are acceptable, and some that
are too dear; some sellers will find buyers willing to pay their
price, and others won't. When everyone who can find a deal has done
so, then the remaining buyers and sellers can either adjust their
price to find another match, or they can go home. When everyone has
done a deal or gone home, we say that the market has cleared.

When the market is large enough for a single good or service that is
essentially identical from all providers, we call it a
commodity. In this market, there are enough sellers and enough
buyers that a single price will emerge, called the market clearing
, at which every willing buyer and every willing seller will
find a match. Sellers who price their product above this price will
find no takers, because the buyers can find it available elsewhere for
less. Likewise, buyers who are looking for a deal will go away empty
handed, because all the sellers can get a better price from other

When the market gets an influx of buyers who want more stuff, or
alternatively the number of things for sale drops, the price of the
goods available will be bid up until the number of buyers willing to
pay matches the number of sellers willing to provide. If for some
reason, there are fewer buyers, or the buyers just don't want that
much of the product, or if more sellers appear with more goods, the
sellers will have to drop their prices to find buyers, since all the
buyers at the old, higher price will be gone, having already done a

Labor as a Commodity

In general, the service provided by a person as labor is not a
commodity, since each person typically brings unique skills and
productivity levels to bear on the work they perform. Considered
broadly over lots of people with similar skill and productivity
levels, a market will form the outlines of a commodity market in some
particular specialty, but this doesn't really apply to the entire
category of "Labor." One area where it comes close, however, is in the
unskilled or minimum training required labor category. On the seller
side, practically every able-bodied adult can supply this kind of
labor, and most will do so if the price is right. Some will do so even
if the price is minimal. At some price, then, the number of hours of
labor people are willing to supply will equal the quantity demanded,
and the market will clear. Once again, an influx of sellers (laborers)
or a drop in the quantity or labor demanded will tend to push the
price (wage) down, and an influx of buyers (employers) or a rise in
the quantity of labor demanded will tend to push the price up.
Markets with Price Controls

The idea that there should be a minimum or maximum amount that any
particular good or service should cost or that should be made
available doesn't seem intuitively obvious to most people, but when
the service is labor, we bring some other opinions to the table.

In the case of commodity labor, we call a minimum price restriction a
minimum wage. When the minimum wage is less than the market
clearing price, it has little effect. All of the sellers can find a
better deal, that is, a higher wage, and all of the buyers, or
employers, must satisfy their labor demands at the higher price or
leave their jobs unfilled. However, if the minimum wage is higher than
the market clearing price, then more people are willing to sell labor
at that price than employers are willing to buy. As shown in this
diagram, the quantity purchased will be less overall at the higher
price. The difference between this quantity and the quantity that
would be purchased at the market clearing price is the lost employment
opportunity, or the employment gap.

Note that at the higher price, sellers are willing to supply more
labor than at the market clearing price, mostly because more sellers
enter the market. The difference between the number of labor hours
made available and the number purchased is the apparent unemployment,
but this value is larger than the employment gap. One way to interpret
this is that raising the minimum wage above the market clearing price
will artificially inflate unemployment numbers, when the actual effect
on the number of people employed is smaller.

Markets with Supply Controls

The other kind of restrictions that are commonly applied to commodity
labor markets affect supply. Any given seller has only so many hours
of labor available to sell in a week. At a high enough price, some
sellers may be willing to place every waking hour in the market. Once
again new sellers may also enter the market at the high price to sell
a few additional hours of labor.

If a restriction is placed on the number of hours any given seller may
put on the market in a week, then the quantity supplied can only be
increased by adding more suppliers to the market. Sellers lose the
opportunity to sell extra hours at the market price, but an increase
in demand for labor hours will tend to push up the price for the hours
a seller does sell by a small amount, and will bring new sellers some
employment, as the market clearing price for labor hours rises with
the increased demand.

An overtime restriction that allows the supply but increases the price
will have a combination effect. To the extent that marginal cost of
additional labor hours supplied in the labor market is low (in
commodity markets, this cost is typically negligible compared to the
cost of goods) then purchasers will tend to hire more labor from the
less expensive unrestricted market. In the labor market however,
legal, contractual, and physical limits that raise costs to employ a
marginal labor hour are common. These may include a head tax, minimum
employment hour requirements, restriction to hiring from a particular
set of suppliers such as a union, and the costs involved in training
or providing a worker with tools or supplies. These costs are the ones
that can push an employer into purchasing expensive overtime instead
of less expensive regular labor hours.

The Big Fish Market

In a market, pricing power comes about when one party, or group
of parties, comes to the market with the bulk of the supply or the
bulk of the demand. This is when the marginal effect of the remaining
suppliers or purchasers isn't enough to change the price of the bulk
of the goods or services sold. If a seller has pricing power, then to
an extent, that seller may charge more than the net market clearing
price, even if other sellers will sell for less, because even when the
entire amount available at a lower price is purchased, there is still
some significant demand for the remaining amount supplied at the
higher price. In this case, the market may not clear at a single
price; the supplier with pricing power may accept the risk of selling
something less than all the available stuff for sale at the set price.
Other suppliers may go along with the higher pricing and also risk not
selling all of their goods; behavior in this case is mostly determined
by what pricing will maximize profit on the net amount sold.

Similarly, when a buyer has pricing power, other buyers may be willing
to pay more, but only a few suppliers are lucky enough to sell to
them, and the remainder must sell at the lowered offering price of the
buyer with pricing power or not at all, leaving some supply that would
have sold at the net market clearing price. The buyer asserting
pricing power accepts the risk of not getting all the quantity they
wish at the price offered; pricing is generally determined to maximize
the value obtained on the amount purchased.

In a commodity market, goods in one location are interchangeable for
goods in another location; the market may state its price "FOB
Chicago" for instance, and the price between other locations for
buyers and sellers may be adjusted relative to the cost of delivering
the goods elsewhere. Commodity labor tends to be a little less mobile
as well as less interchangeable. For any given person, the cost of
supplying labor hours close to home may be small, but providing it in
the next town or city may be prohibitive.

Pricing Power in Action

Let's consider that in Potterville, adult population 1000, there may
be one employer in town with commodity labor needs, Potter's Mill,
Inc. Being the sole commodity labor buyer gives them some pricing
power relative to all of the potential suppliers of labor hours in
Potterville. Lets say someone with a lot of time on their hands did a
survey, and found all thousand potential workers in Potterville will
provide forty hours of labor a week for ten dollars an hour, but only
five hundred will for five dollars an hour; another hundred people
change their minds for each dollar an hour difference. Now let's say
the mill offers five hundred forty-hour week positions at six dollars
an hour. (Apparently no one at the mill read the survey.) Six hundred
Potterville residents apply, and one hundred are turned away. They
were willing to work, some of them for even less than six dollars an
hour, but the mill only needs so much labor, so they must look

But what if the mill has six hundred positions, and is only willing to
pay five dollars an hour? Five hundred people from Potterville apply
and all are accepted, and one hundred positions go asking. Potter's
Mill Inc. can raise its offered wage, or do without that labor, but
it's up to the mill. The mill offers 100 positions at six dollars an
hour. One hundred people from Potterville take the jobs. Potter's Mill
has filled its employment needs, and saved five hundred dollars an
hour over what it would have had to pay at a market clearing price for
all six hundred positions, using its pricing power. If the mill needs
more workers, it can go back in the market and pick up another hundred
at seven dollars an hour, another hundred at eight dollars an hour,
and so on. And that's assuming some of the people over in Millerville
don't get wind of this and start applying at lower wages than the
remaining Potterville residents will accept.

Competition and Pricing Power

Let's say another business opens in town - Bailey's Pool Cleaning
Service. It's a small outfit that needs only five workers. If they
offer six dollars an hour, they may get over five hundred applicants
who currently work at the mill for less. They pick five people, and
put them to work. Them mill must fill those positions, and finds that
they must offer a higher wage to do so, but they're still the holders
of substantial pricing power, and they still save a lot of money on

If forced to compete for the Potterville pool of workers against
enough other employers, Potter's Mill would find it didn't have that
kind of pricing power, and would have to pay the higher market
clearing wage when hiring all its workers. Some workers in that market
would benefit by being paid more than they would have been willing to
work for if they had to. A few employers that would have been willing
to pay more if they needed to, find that they can save their money and
fill their labor needs for less at the market clearing price.

The Minimum Wage Comes to Town

In an effort to curb vagrancy, vandalism, and voyeurism, the town
council in Potterville decides to enact a minimum wage. Some of the
townspeople aren't being paid enough at work to keep up with the rent,
so they wander the streets at night, tagging street signs and looking
in other people's windows. To abate the scourge, they declare a
minimum wage of seven dollars an hour. Currently some six hundred five
people are employed at the town's two businesses, at wages of five or
six dollars an hour. The board of directors at Potter's Mill Inc. goes
over the numbers with management, and determines that they can't
afford to run the business with the extra sixteen hundred dollars an
hour it will cost them given their current workforce level. They
decide to relocate the mill to Millerville. Meanwhile, Bailey's Pool
Cleaning Service could have afforded to give their workers a dollar
raise, except suddenly they don't have any business as all the people
with pools in their back yard are out of work. They reluctantly close
their doors.

Leaving the extreme of Potterville behind, in a larger town with a
more competitive labor market, the effect of a higher minimum wage is
unlikely to create a ghost town. There will be some employers at the
margins whose primary cost of business is commodity labor that will be
in trouble. There will be some few people who are pushed out of the
commodity labor market, unable to command the higher wage when the
number of labor hours purchased falls off. A fair number of people
will be slightly better off, given a raise at the expense of a few
employers whose costs have gone up and whose profit margins have
fallen, or at the expense of the consumers who pay higher prices if
the costs have instead been passed along by those employers.


On net, when the commodity labor market is restricted, just like when
restrictions are placed in any commodity market, the total value of
the exchange possible in that market is cut. We are all worse off in
the aggregate, although for many of us there may have been no effect,
costs may have risen for very few of us, and for another few of us
there was a benefit. Sometimes in some non-economic sense, obtaining
the benefit for a few may outweigh the net negative effect on total
value. It's not easy to say that this is clearly the case for a
minimum wage.

Saturday, September 20, 2008

The Intelligent Person's Guide to Derivatives and The Recent Financial Meltdown

You probably have a reasonable idea of what stocks are. Stock represents a fractional share of ownership of a company. If a company has issued a million shares of stock, and you own one share, then you own one millionth of the company, referred to as your equity. If the company makes a profit, and they distribute it to the owners as a dividend, then you will get one millionth of the amount of profits they distribute. When you own stock, your upside is unlimited, and your downside is, the company can go bankrupt and your shares will be worthless. However, you can't lose more than you invest, which isn't true of some other kinds of investments.

Bonds are pretty simple, too. A bond is a kind of loan note created by a company, saying that if you buy their bond, they will pay you back the face value of the bond on a specified date. This is called the maturity date, or when the bond comes due. Some bonds are sold at face value, but include periodic interest payments, called coupons, in a specified amount. (Once upon a time, bond certificates actually had some paper coupons printed on them that you had to clip off and physically redeem for your interest payment. Nowadays, for the great majority of bonds, you just register your bond and they send you the money.) Other bonds, called zero coupon bonds, or zeroes for short, don't make any periodic interest payment, and instead are sold at a discount to the face value. The interest is paid as the difference between what you bought the bond for and what the company repays you when the bond comes due. US Savings Bonds work like this.

Investing in bonds, like investing in stocks, has a downside limited to what you invest. The upside, however, is limited because when the bond matures, it's worth the face value and nothing more. On the other hand, when a company goes bankrupt, the stockholders have nothing, but the bondholders get first claim on the company's assets. Admittedly, that may not be much consolation.

Stocks and bonds can be bought and sold, and depending on how much people want to pay for them and how much they're willing to sell them for, the price may change with each transaction. When this happens to a share of stock, it represents a change in the market value of the company. When the share price goes up, it's because people think the company is more valuable, and when the share price goes down, people think the company is less valuable. The relationship between what people are willing to pay for a company, and what the assets and profitability of the company are, can be tenuous. Famous investors like Warren Buffett have made their fortunes by buying companies that have good profitability prospects when most people think their stock is a dog and it trades for some relatively small amount compared to its value. Everyone is familiar with the way stock prices go up and down, and it's reported every day on the news.

People are less familiar with the way bond prices fluctuate every day. A bond has a fixed interest rate, but we know that interest rates change all the time, though not quite like stock prices do, A bond that pays 5% when the prevailing interest rate is 10% is not a very good deal, and so its price goes down. In fact, its price goes down about 5% for every year to maturity, until the effective difference between the 10% interest you can get on a new bond and the 5% you get on the old bond is gone. Say you have a $1000 face value bond that matures next year, and it pays 5%. If the current interest rate is 10%, then your bond's price in the marketplace will have fallen to about $955, which is what that $1050 you're due to collect next year in principal and interest is worth as an investment that pays 10%. On the other hand, if the current interest rate is a measly 1%, then your 5% bond is a pretty good deal, and someone would probably pay close to $1040 to take it off your hands. So you see how bond prices change to reflect the current interest rate situation.

The other thing that affects the bond price is a change in the creditworthiness of the company issuing the bond. When you buy a bond from the government, you're going to get paid back barring something like a nuclear war or planet-killing asteroid, in which event you probably don't care much. Companies, on the other hand, have a nasty propensity to go out of business, or lose lots of money, and might not be able to pay you back. How likely a company is to pay back its bondholders is measured by its credit rating. Companies with excellent credit ratings can sell their bonds at relatively low discounts or alternatively, with relatively low interest rates, at or just above the rates on government bonds. Companies that have not-so-good credit have to offer a bigger discount, or higher interest rate, to interest people in their bonds. Crummy credit ratings lead to really high interest rates on bonds, which are usually called junk bonds and represent a real gamble.

So when a company goes from a good credit risk to a mediocre one, suddenly nobody wants to be a bondholder, and the price of its bonds goes down, raising the effective interest rate paid if you buy one at the new, lower price. On the other hand, if you bought a cheap junk bond and the company's prospects suddenly improve, you may be able to sell your bond for much more than you paid, and the effective interest rate on the bond will have gone down proportionately. You could wind up owing capital gains taxes on your bonds, as well as taxes on the interest! I suppose there are worse problems to have.

This is all preamble to the concept of a derivative. In general, a derivative is a kind of security with a value that represents some aspect of some underlying security. For example, a stock option is a kind of derivative. If a stock is currently trading at $100, and you buy an option for a dollar to purchase a share of that stock at $100 in a month, then as the price rises, the value of your option rises right along with it. If the price falls to $100 or below, your option is worthless. At the end of the month, if the price is above $100, you can buy the share for $100 and you pocket the difference in the price, less the dollar you paid for the option, as a profit. If the price is less than $100, your option just expires, worthless. The option is sold by someone who would rather have the dollar you paid for the option than the potential upside on the stock over the next month. If they think the price will be flat or fall a little, this is a way to make some extra money, but they risk losing out on the stock's gains if the price goes up. The option is derived from the price change of the stock, so we can call it a derivative.

Another kind of derivative applies to bonds. One way to trade a coupon bond is to sell the right to collect on the coupon and the right to collect the principal separately. What you've done is split the bond into two separate securities, one that's called a strip that collects the interest, and another that's essentially a zero-coupon bond. Since these two securities are derived from an underlying one, they get called derivatives. They will have values that fluctuate along with interest rates and the fortunes of the underlying company, just like the regular bond, but with different properties which might be more valuable to various purchasers than the original bond. The company that creates the derivatives holds on to the original bond, but forwards the interest payments to the strip holder, and sends the principal due at maturity to the zero holder.

When you split off the interest payment on a bond like that, you can split it in more than one way, creating even more complicated derivatives. For example, you could take a regular coupon bond and sell a lower-interest strip and a higher-discount zero, or vice-versa. These will react in different ways to changes in interest rates compared to the original bond, so if buyers are looking for more volatility, or less, in their bond values, they can get what they are looking for.

Yet another way to create derivatives is to pool some securities together, then sell off new securities that represent some aspect of the underlying securities. For example, you could combine some treasury bills with some junk bonds and effectively create new bonds that are intermediate between the two in interest rate and creditworthiness. You can sell the high volatility and the low volatility aspects separately to parties that are looking for more risk and more upside, and parties that want less risk and will accept a smaller payout.

Now let's say someone has a big pile of mortgages. These all will have various interest rates and the payers will have various credit ratings and payment histories, but we can combine the mortgages into groups, and create new derivative securities that look like bonds out of them. Depending on how we group them, we can get low-interest, high credit rating ones together, or high-interest, lower rated ones, and create new bond-like securities with similar properties. The risk that a few of the mortgages might go into default gets built into the new mortgage-backed security's discount, effectively raising the interest rate. If the group has a lot of mortgages that might default, then the new security is more like a junk bond, and its price should drop and interest rate rise accordingly. The problem with these new securities is that it's hard for someone to tell whether a given instance really ought to be considered AAA or junk without going through all of the underlying mortgages and checking each one. One of them might have started out in good shape, but be composed of mortgages from somewhere that just had a big plant close, and suddenly lots of those houses are on the market for cheap, and how would you know? You rely on the credit rating agencies to stay on top of it, but this level of detail may be beyond them.

So, let's say you have some bond, and you're willing to part with some of the interest on the bond in return for a guarantee that you'll get your principal back, because you're worried about that more than you want a high return. Say someone comes along and says, I will agree to buy your bond from you at par (that is, the present value of the face value of the bond at maturity at the prevailing interest rate) if something happens to it to significantly change its value, such as going into default, and in return, all I ask is that you pay me all the interest your bond pays over and above what a treasury note with the same maturity pays, plus a little extra for my trouble. What you're doing is taking your bond and turning it into something more like a treasury note, because someone else has agreed to take on the default risk in return for a risk premium. This kind of derivative is called a credit default swap, and it's what got AIG into such awful straits.

What happened was, AIG and others were busy minting money by taking on the default risk for mortgage-backed securities, because they figured there was no way to lose - house prices just go up, right? And more and more financial institutions were willing to buy the mortgage-backed securities because companies like AIG were willing to sign up for the default risks, which were hidden inside and not really reflected in the price of the securities. And the mortgage companies that created the mortgage-backed securities and sold them to banks and insurers and brokerages, were busily plowing the money they got from selling them into making ever more mortgages to ever less credit-worthy borrowers, who were busy driving up the price of housing with their borrowed money.

And then the bubble popped.

Gradually, sub-prime borrowers, and a few prime ones, got in trouble as their teaser-rate variable mortgages started getting adjusted upwards, the economy slowed and house prices fell, and they couldn't refinance into something they could afford. More and more mortgages went into default, showing up as these mortgage-backed securities not making their interest payments and going into default even when they'd gotten high ratings from the credit rating firms. Financial institutions started looking into their portfolios and finding these hot potatoes and all started trying to unload them at the same time, and the market evaporated. They had to come up with more cash to cover the lost interest payments they weren't getting anymore on these things, to try and avoid going into default themselves, and cash started getting hard to come by. Firms like AIG that had guaranteed the securities without much of a cash reserve started getting viciously squeezed. Firms that had purchased the securities with borrowed money found that they had no way to get money to pay their lenders, since they couldn't sell them at any price. That's when the excrement really struck the rotational airflow facilitators.

When you buy something, and its price drops, the most you can lose is what you paid for it. When you buy something with borrowed money, and its price drops, you can lose more than you started with and find yourself in a deep debt hole. And if you can't service your debt, then whoever lent you the money feels the pain, too. If you're a major financial player and it's also going on with a bunch of other major players, it can snowball into a general financial meltdown. And so even though the underlying market value for houses has dropped by maybe 20%, and foreclosure rates are still just a small fraction of total mortgages, the number of firms that have had their capital wiped out as a result is impressive. Or perhaps depressive.