“Prices are set on the margin,” goes a general statement in economics and finance. It sounds a bit glib as an explanation for the current abject state of the global economy. How for the “want of a nail” could the battle be lost?
Think of an airplane consisting of 100 seats which only breaks even on the cost for a single journey once there are 65 paying customers on board. The blue seats in the image below are the 64 patiently waiting to start their travels. The red chair waits for the 65th customer.
How much pricing power does the 65th passenger have?
The 65th fare is the difference between failure and success for the airline; whether the journey can take place or not for the travellers.
In most countries, airlines certainly don’t wait for break-even before taking off. They accumulate losses on some flights and offset them with surpluses on others. However, for any African travellers out there who have spent a day or two waiting for a mini-bus to fill up with passengers before departing, this example is rather real.
Even so, for airlines, that 65th passenger is not theoretical. On average there must be breakeven otherwise the airline will fail.
That final passenger is the difference between survival and ruin. If that passenger is never going to turn up then all the other passengers must accept not travelling or that they must make up the fare that will never be paid. One fare divided up amongst 64 is only a 1.6% increase. Maybe they can cover that. But what happens if one person cannot?
Suddenly it’s 2 amongst 63…
As for the airline, what can it do? Frequent flying programs, gold cards, seat upgrades, special benefits for those who are loyal. In short, they favour the customers who pay the most.
The other passengers don’t own the plane. They may grumble about such blatant favouritism but these perks don’t necessarily come out of their pockets (not that they can see, anyway).
This is the impact of marginal pricing. Small changes can reduce even prosperous economies to a similar state of dependency.
Welcome the 7 billion
In A tale of three islands, The Economist takes a look at the world population which reaches a tally of 7 billion on 31 October 2011.
“By 1968 John Brunner, a British novelist, observed that the earth’s people—by then 3.5 billion—would have required the Isle of Man, 572 square kilometres in the Irish Sea, for its standing room. Brunner forecast that by 2010 the world’s population would have reached 7 billion, and would need a bigger island. Hence the title of his 1968 novel about over-population, “Stand on Zanzibar” (1,554 square kilometres off east Africa).”
Which goes to show just how deterministic population growth is that Brunner could predict, with considerable accuracy, when the world population would hit 7 billion.
More interestingly is what The Economist says about population growth (which is stabilising) and its impact on economies.
“In 1970 the total fertility rate was 4.45 and the typical family in the world had four or five children. It is now 2.45 worldwide, and lower in some surprising places. Bangladesh’s rate is 2.16, having halved in 20 years. Iran’s fertility fell from 7 in 1984 to just 1.9 in 2006. Countries with below-replacement fertility include supposedly teeming Brazil, Tunisia and Thailand. Much of Europe and East Asia have fertility rates far below replacement levels.”
“A fall in fertility sends a sort of generational bulge surging through a society.”
That demographic bulge has three stages represented in the following three charts. The blue line represents population and the red line represents the demand on economic support not earned directly. Children, obviously, depend on their parents (or the state for education / healthcare) while retirees may draw down their savings or depend on the state or relatives.
First, a linear fall-off with many children, a few of working age, and even fewer retirees.
This is the situation for most of Africa and the Middle East and is where most of the next billion will be born.
The second stage is one which can result in tremendous economic growth. A large working-age population has few children or retirees to support and so can invest dramatically in infrastructure and social wellbeing. This is the era of the Baby Boomers in the US and much of Europe and also of a similar period during the 1980s to recently in East Asia.
The fewer dependents there are on those who are working, the lower the taxes they need to pay and the more of their income which can be saved.
Watch that wave, though. The bubble will retire. That’s where we hit the problem. As the first part of that wave starts to retire, draw down their savings and require more healthcare they start to place pressure on social insurance.
The dependency ratio starts to change; fewer people of working age support more people who do not. Worse, though (from a financial perspective) is that this massed period of retirement is coinciding with a burst in longevity.
A retiree at 65 used to rely on their (or the state’s) savings for maybe five years at the maximum. Now they could be retired for 20. A Baby Boomer who retires at 65 could be drawing funds from Medicare and Medicaid for far longer than any generation before. And there will be a lot of them.
This generational shift goes some way to explaining why Europe and the US are finding it so difficult to escape from recession. The burden on those working is increasing.
By way of comparison, Japan’s population over 65 is already 23.1% of the total and life-expectancy is about 80. China, worryingly, is the fastest aging country in the world. Its dependency ratio is projected to reach 64 by 2050, from 38 now.
Age is one factor. The other is progressive taxation.
Don’t cry for the wealthy
This implies that 45% of the population covers the state benefits of the other 55%. However, not all Americans earn sufficient to pay tax. According to the US Inland Revenue Service 104 million file income tax returns. There are 83 million people who earn between $20,000 and $200,000 a year and they earn 66% of total income and pay 54% of total income tax.
726,000 people earn over $500,000 annually, 0.7% of income tax-payers. They earn 17.8% of total income and pay 27% of the total tax take.
I’m not sure where the 1%/99% line is supposed to sit. However, income tax only pays for about 33% of the taxes raised in the US. So the wealthiest 0.7% pay 9% of the total while making up 0.2% of the population.
Megan McArdle, writing in The Atlantic, says “I doubt Occupy Wall Street will be assuaged by learning that the top 0.1% now only receive 8% of the income earned in the US, even if that number is the lowest it’s been since 2003.”
But, as she says, it is important.
Professor Steven Kaplan of the University of Chicago has explained in lurid detail how the incomes of the top 1% have fallen in the past few years. Nothing to worry about if you are wealthy; nobody is asking you to sob for the rich.
However, if 9% of the tax spent on entitlements like Medicare and Medicaid comes from a mere 0.2% of the population and their income drops 10% then billions of dollars just got added to the deficit.
Progressive taxation, and a massive dependency on the wealthy, puts them in charge of the economy. The alternative is for everyone else to pay more.
“Why do you hate me, what have I ever done for you?”
We’re all on the runway waiting for that final passenger to take his seat. That passenger is demanding special treatment or he won’t fly. He wants tax breaks, subsidies, special security for his home and better education for his kids.
None of us, already in our seats, want to pay more for our flight.
The perks that the 1% demand don’t appear to come out of our pockets but they are opportunity costs that our economies can’t really afford.
If my example about marginal pricing has meant anything to you then you realise what this means. The 1% don’t have to earn 100% or 80% or even 40% of all income to make greater demands on government. What they earn is irrelevant; they just need to pay a disproportionate amount of the total tax take. They need to make up the margin.
This they do.
The way we have structured our economies in the US, Japan and Europe (the “West”) means that we need the super-rich to keep being super-rich and pay for a disproportionate amount of our social services so that the rest of us can pay less.
In exchange, whether we meant to or not, we have given them negotiating power. They get to travel first class, get tax loopholes and special meetings with senior political leaders. As long as the rich earn sufficient to pay for our needs, we grudgingly accept this.
Now they are earning less and so the benefits they receive appear even more unfair. Robert Frank in his The High-Beta Rich: How the Manic Wealthy Will Take Us to the Next Boom, Bubble and Bust, points out that the wealthy tend to gain more during the booms but they fall further during the busts. From 2007-08 the top 1% lost 8% of their income as compared to 2% for the rest. Pegging a significant portion of tax collection to people whose incomes are this volatile dooms stability in your tax system.
That hasn’t stopped us hating them or Wall Street. After all, there is a Chinese saying, “Why do you hate me, what have I ever done for you?” What do they have to do for us to hate them less? The Economist has some ideas.
We are all the one percent.
Yet the “West” is not Cameroon. There the top 1% own almost half of the economy through their control of that West African nation’s oil wealth. Everyone else is a peasant farmer.
Those peasants lack the skills, opportunities and protection of law to get ahead.
Not so in the West where the 1% make up far less of our economies. We could actually depend on them less if we so choose.
It isn’t necessary for the 1% to earn less for them to have less power. The economy is not a fixed-size pie. Since 2000, the US economy has grown 42% in size. The rich got richer because the economy got much, much bigger. Unfortunately, so did the benefits paid by the state and the reliance on the wealthy to finance those benefits.
We don’t need the rich to be poorer in a flexible economy. It is simply necessary for us to rely on them less to pay for our social benefits.
Indeed, right now – because of the global recession – everyone is earning less. Even when the 65th person gets on the plane we still can’t afford to take off. If the 99% refuse to pay more and demand more of the wealthy then we also give them more power than they have already. Now is the perfect time to demand less and take that power back.
If you decide not to, and for as long as you depend on the wealthy, you are the one percent. We all are.