Seems fairly straight forward doesn’t it.

The purpose of life is the pursuit of pleasure, and the quest for those objects and experiences that will make our life more enjoyable.

As I recently discovered while reading “The Consolations of Philosophy” by Alain de Botton, this was exactly the philosophy held by Epicurus, an ancient Greek philosopher born on the island of Samos in 341 BC.

To summarise his philosophy in a single sentence, Epicurus believed that:

Pleasure is the beginning and the goal of a happy life.

What are the first images that spring to mind when you think of pleasure? You might think of a fast car, an opulent villa overlooking the ocean, or limitless money.

Imagine you had all three. Would you be happy? Maybe you would. However, it is possible to imagine that a fast car without a friend to show-it-off to would not make you happy, an opulent villa without the time to enjoy it would not make you happy, and limitless money accompanied by high levels of anxiety and no time to relax or contemplate the good life would also not make you happy.

Not every type of pleasure will lead to happiness (or be sufficient for happiness) in the same way that not every type of medicine will lead to good health.

If we assume that Epicurus is right, and that pleasure is indeed the goal of the happy life, then it would seem important to develop a clear understanding of the types of pleasure that will actually lead to happiness.

In his book, Alain de Botton outlines the three simple pleasures that we need to pursue and acquire if we are to enjoy a life of Epicurean happiness:

1. Friendship;
2. Freedom; and
3. Thought.

Although sometimes difficult to acquire, it turns out that the three essential pleasures of life are goals that we can all afford to pursue.

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There is talk about town and in the media of an economic upturn in the final quarter of 2009 – “banks are lending, consumers are buying, and companies are hiring.”  While it is not possible to predict the movement of the economy with any level of certainty, and recent history has reminded us of this fact, it is important for business people and government policy makers to have some idea of what lies ahead.

The practice of reading omens in order to foretell the future has been employed since ancient times. In ancient Rome, priests known as “Augurs” would determine the will of the gods by studying the flight of birds, while other persons known as “Haruspices” practiced a form of divination which involved inspecting the entrails of sacrificed animals.

Things have progressed a little since then. Today economists devine the future by examining “economic indicators”.

Economic Indicators

In order to assess the likely strength of the economy in the future, economists look at “economic indicators”.

An economic indicator is any economic statistic (e.g. the unemployment rate, GDP, or the inflation rate), which indicates the current strength of the economy and/or the future strength of the economy.

Economic indicators are generally classified by reference to  two attributes:

1. Correlation with the strength economy; and
2. Contemporaneousness with the strength of the economy (let me know if you can think of a simpler word)

1. Correlation

If an economic indicator is “correlated” with the economy, then we would expect a change in the value of the economic indicator to correspond with a movement in the economy.  The correlation of an economic indicator may be described as procyclical, countercyclical, or acyclical:

1. Procyclical: A procyclical economic indicator is one that moves in the same direction as the economy. For example, Gross Domestic Product (GDP) is a procyclic economic indicator because it gets larger as the economy gets stronger.
2. Countercyclical: A countercyclical economic indicator is one that moves in the opposite direction as the economy. For example, the unemployment rate is a countercyclical economic indicator because it gets larger as the economy gets weaker.
3. Acyclical: An acyclical economic indicator is one that has no relationship to the economy and is generally of little use in predicting the future strength of the economy.

2. Contemporaneousness

Contemporaneousness refers to the timing of the change in the economic indicator relative to the movement in the economy.  The contemporaneousness of an economic indicator may be described as leading, lagged, or coincident:

1. Leading: A leading economic indicator changes before the economy changes. For example, construction activity is a leading indicator as the level of construction activity usually begins to decline before the economy declines and improve before the economy improves. Leading economic indicators are the most important type of indicator for investors, business people and policy makers because they help to predict the future performance of the economy.
2. Lagged: A lagged economic indicator is one that does not change direction until a few quarters after the economy does. For example, the unemployment rate is a lagged economic indicator because it typically takes at least two quarters to decrease after the economy begins to recover.
3. Coincident: A coincident economic indicator is one that moves at the same time as the economy does. For example, Gross Domestic Product is a coincident indicator.

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Following on from the theme of my last post, which highlighted Alain de Botton’s kinder and gentler philosophy of success, I think it would be valuable to consider why we do what we do. In an attempt to become “successful” many of us work long hours and sacrifice time that could be spent with friends and family. Why?

Tony Robbins is an American self-help writer and professional speaker who believes that there are six basic human needs, and that people are motivated by their desire to fulfill these needs:

1. Certainty/Comfort

We all require a basic level of certainty that we will be able to avoid pain and obtain pleasure. For example, at a very basic level we want the comfort that comes from having a roof over our head, clean water and three meals a day for ourselves and our family.

2. Variety

If life is completely certain and predictable it is likely to become boring. So, we also require some level of variety.

3. Significance

We all require a feeling that we are unique and important, and that our life has meaning. This need can be fulfilled in various ways, one way might be work in a highly paid, highly respected profession.

4. Connection/Love

We all want to feel part of a community, to be cared for and cared about.

5. Growth

Growth is an important part of life in general. We all want to grow, develop and improve our abilities and position in life.

6. Contribution

On some level, we all want to contribute something of value, to help others, or to make the world a better place.

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1. Importance of economies of scale

In the early 20th century, by using assembly lines to mass produce the Model T Ford, Henry Ford became one of the richest and best-known men in the entire world.

Economies of scale provide a company with two main benefits:

1. Increased market share: Lower per unit costs allow a company to reduce prices and increase market share. Economies of scale allow larger companies to be more competitive and to undercut smaller firms.
2. Higher profit margins: If a company is able to maintain current prices, then lowering the average cost per unit will result in higher profit margins. For example, a drinks manufacturer which can produce 100,000 cans of soft drink at $0.50 each might expand production to 500,000 cans of soft drinks at a cost of $0.20 each. Assuming it can sell cans for $1 each in either situation its profit margin per can has increased from $0.50 to $0.80, which represents a 60% increase.

2. Relevance of economies of scale

There are many times when, for a firm to make a good strategy decision or for a government to engage in sound policy making, an understanding of ‘economies of scale’ is useful.

2.1 Barriers to entry

The existence of economies of scale in an industry creates barriers to entry. This is relevant if you are trying to determine the competitive intensity and attractiveness of an industry (see Porter’s 5 Forces analysis).

Where economies of scale exist, they represent a barrier which inhibit new firms from enter the industry. A large incumbent firm is in a better position to exploit economies of scale than a new entrant and, as such, may be able to force a new entrant out of the market by undercutting on price.

2.2 Natural monopoly

An industry is a natural monopoly if one firm can produce a desired output at a lower social cost than two or more firms. That is, a natural monopoly exhibits economies of scale in social costs.

In a natural monopoly, since it is always more efficient for one firm to expand than for a new firm to be established, the dominant firm often has significant market power. Therefore, it makes sense that a natural monopoly is usually highly regulated or publicly-owned. Examples of natural monopolies include railways, water, electricity, telecommunications, and postal services.

2.3 Free trade

Economies of scale provide a justification for free trade policies since some economies of scale may require a larger market than is possible within a particular country. For example, it is unlikely that Airbus, based in Toulouse, would be able to operate profitably if it could only sell aeroplanes within France.

3. Economies of scale explained

‘Economies of scale’ refers to the situation where the average cost of producing one unit of a good or service decreases as the quantity of output increases. One reason economies of scale are possible is that large overheads and other fixed costs can be spread over more units of output. Reduced average costs may result from increased output by an individual firm (internal economies of scale) or due to the growth in the size of the industry as a whole (external economies of scale). The situation where the average cost of production increases as output increases is known as diseconomies of scale.

3.1 Internal economies of scale

Internal economies of scale are the cost savings that accrue to a firm as output increases. Seven (7) reasons that internal economies of scale may occur are:

1. Lower input costs: A larger company will have more bargaining power with suppliers and will be able to negotiate lower prices for raw materials by bulk buying and through entering long term agreements.
2. Efficient technology: A company that uses more efficient production technology will be able to produce higher output at a lower average cost.
3. Research and development: Research and development is a large fixed cost for many firms. As a company increases output, R&D can be spread over a larger number of products.
4. Access to finance: A large company will typically find it easier to borrow money, to access a larger range of financial instruments, and may also be able to borrow at lower interest rates.
5. Marketing: Many marketing costs are fixed costs, such as the cost of advertising. A larger company is able to spread the cost of marketing over a larger number of products, thus reducing the average marketing cost per unit produced.
6. Specialisation of labour: In a large company, managers and workers are able to specialise in particular tasks. Management specialisations include operations, marketing, human resources, and finance. Specialist managers are likely to be more effective and efficient in carrying out their roles because they will have a higher level of expertise and experience, and can obtain role specific training and qualifications.
7. Learning by doing: Workers can improve their productivity by regularly repeating the same type of action. The increased productivity may be achieved through practice, self-perfection and the introduction of minor innovations.

3.2 External economies of scale

External economies of scale occur outside of a firm, within an industry, and arise when firms benefit from the way in which their industry is organised. Three (3) reasons that external economies of scale may occur are:

1. Improved transport and communication links: As an industry becomes established and grows in a particular location, the government is likely to provide better transport and communication links to the region. This benefits firms as they will need to spend less money on transport and communication. Improved transport also allows firms to attract more customers, and recruit from a broader pool of employees.
2. More focused training and education: As an industry becomes more dominant, universities will offer more courses suitable for a career in that industry. For example, the rise of the IT industry led to a proliferation of IT courses. Firms benefit from being able to recruit from a larger pool of appropriately skilled employees.
3. Growth of support industries: If a network of suppliers or support industries becomes established and grows alongside the main industry then a firm will be able to purchase higher quality inputs at lower cost.

3.3 Diseconomies of scale

‘Diseconomies of scale’ refers to the situation where the average cost of production increases as output increases. As a firm benefits from economies of scale and grows in size it also becomes more complex to manage and run. Diseconomies may result as the increasing bureaucracy of a larger firm leads to inefficiency, as well as from problems of motivating a larger work force, greater barriers to innovation and entrepreneurial activity, and an increased principle-agent problem.

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This article is intended to be pretty light-hearted. It provides an insight into the strengths of the current Australian economy after talking with two aspiring amateur economist taxi drivers.

Taxi driver 1

I was chatting with the taxi driver on the way home from work last week, and he was complaining to me that, despite talk of a “resources boom” and a resilient Australian economy, he felt that the economy is weak because he has been experiencing a significant reduction in business over the last little while.

My taxi driver turned out to be quite an economist and inspired this article and my last one, Economic recession 2008: measuring the strength of the economy.

Australia has been negatively affected by the sub-prime mortgage crisis in a similar way to most other countries. At the same time, however, Australia is benefiting from a resources boom. High commodity prices and strong demand for raw materials from countries like China has seen large amounts of money flow into Australia.

As my taxi driver made me realise, however, it’s all very well to be told about a “resources boom” and a record Federal Government surpluses, if the tell tale signs are painting a different picture. A company might appreciate that the economy is weakening when its inventory levels start to rise above expected levels. The government might appreciate that the economy is weakening when tax revenues start to decline or grow more slowly. But how does the common man, how do you and I, appreciate that the economy is weakening?

Obviously, if your wage isn’t rising and the price of things like food and oil rise, then you will have less money to spend on other things. However, this tells you nothing about the strength of the economy over all.

Here is a list of four tell tale signs, from day to day life, that might indicate the economy is weakening (some of these ideas are borrowed from a discussion on James Valentine‘s program on 702 ABC radio last week):

1. The length of the cab rank: The theory goes like this. When the economy weakens and people are put under financial strain, they cut spending. Expenditure on necessary things like food and accommodation are the last things that people cut out of their budget. The first thing that people do away with is entertainment. If people are not attending concerts and not staying out late, then they are not using taxis, and consequently there will be an oversupply of taxis. So, when the cab ranks become inexplicably longer than normal, or taxis become easier to catch on a Friday night, it might be a sign that the economy is weakening.
2. The length of the queues in Aldi: For those of you who are unaware, Aldi is a discount supermarket chain that is slowly but surely taking the world by storm. In Sydney at least, Aldi stores are not always so conveniently located. Increased queues in Aldi might indicate that people are tightening their budgets due to weaker economic conditions.
3. The length of Tuesday petrol queue: In Sydney, the cheapest day for petrol is, for some unexplained reason, Tuesday.
4. The number of new Aston Martins on the road: Flashy sports cars are a luxury good, when the economy weakens there is less disposable income available and you would expect to see less new luxury cars on the streets.

Taxi driver 2

I had another encounter last night with an aspiring amateur economist taxi driver on my way home from work (my taxi drivers are such a source of inspiration). Having discussed the economy with the other taxi driver last week, I was intrigued to find out whether this driver also thought that business was slow at the moment, and why he thought that might be.

He informed me that business had been a little slower than normal, but nothing out of the ordinary. Unlike my first taxi driver, he didn’t attribute this to a slowing economy. “The weather has been cloudy and wet lately, and people don’t like to go out in this weather. Winter is coming. This means that it gets dark earlier, it’s colder at night and less people are out in the city. There are also less tourists in the winter. I make more money when it is sunny.”

The conclusion

So, all things considered, perhaps these aspiring economist taxi drivers haven’t really been able to give me any insights on the current strength of the Australian economy. But at least they got me thinking.

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It’s the economy, stupid

“It’s the economy, stupid” is a well known phrase that was widely used during Bill Clinton‘s 1992 presidential campaign against George Bush senior. The phrase was coined by Clinton campaign strategist James Carville and refers to the notion that Clinton was a better choice because Bush had not adequately addressed the economy, which had recently headed into a recession. Clinton went on to win a decisive victory.

Having entered the second quarter of 2008, the American economy may be heading towards a recession once again.

What is a recession?

Broadly speaking, a recession is a period of slow or negative economic growth, usually accompanied by rising unemployment. Economists have other more precise definitions of a recession, the easiest of which to understand is “two consecutive quarters of falling GDP”.

This definition was borrowed from the Economist A-Z, which is a really useful resource for understanding economic terms. I have added it to my list of useful links.

Strength of the US economy

A key contributor to the current weakness of the US economy is the sub-prime mortgage crisis. To indicate the magnitude of the losses suffered from the crisis, it is useful to note that the largest US bank, Citigroup Inc., has alone incurred more than US$45 billion of write-downs and credit losses since 30 June 2007.

In order to stimulate the American economy, the Federal Reserve has slashed the Federal Funds Rate by 2.75% between 18 September 2007 and 30 April 2008.

Gordon Brown, George Soros and Warren Buffett are all of the opinion that America, and the world at large, is currently facing its worst financial crisis since the 1930s. In particular, Warren Buffet was quoted by the LA Times on May 5 saying, “I would say that we’re in a recession, clearly”.

In the first three months of 2008, the US economy managed to achieve a modest annual growth rate of 0.6%. So, at least according to the precise Economists’ definition provided above, the US is not yet in a recession.

However, things are far from in the clear. Reuters reports that Scotia Capital senior currency strategist Camilla Sutton outlined that there are some very negative indicators for the strength of the US economy in the short term,

[T]he housing market has yet to bottom, consumer confidence is at multi-decade lows, employment growth has evaporated and high commodity prices are … exacerbating an already weak economic backdrop.

Bearing all of this in mind, concern about the short term strength of the US economy was sparked yesterday, May 6, when US crude oil prices hit a record high of US$120.36 a barrel. The rising price of oil (and food) is contributing to a higher US inflation rate. The US inflation rate, for the 12 months ending March 2008, was 4.0%. This compares with an inflation rate for the same period last year of 2.8%. Inflation is a procyclical coincident economic indicator because price levels tend to rise when the economy is booming. However, the rising price of oil is being driven by booming developing economies, in particular India and China, and not from growth in the US economy. Higher oil prices are also being driven by the uncertainty of oil supply resulting from political unrest in certain oil producing countries and interruptions in supply due to extreme weather conditions, leading to higher prices and slower growth in the US economy.

There is some cause for optimism however. According to the Times Online, recent economic data on the American economy (measuring things like jobs, GDP, business confidence, industrial orders and consumer spending) indicates that, although the US economy weakened abruptly in the final quarter of 2007 (October to December), the US economy is not nearly as weak as it has been at the start of previous recessions.

Strength of the world economy

According to the IMF, the growth prospects for the world economy in 2008 appear to be strong.

In the IMF’s World Economic Outlook, published in October 2007, the IMF indicates that global economic growth is predicted to be 4.75% in 2008. Interestingly, this prediction is made in light of the fact that financial market strains might trigger a more pronounced slowdown in the world economy.

Growth in developing countries appears to be the main driver for the expected strong global economic growth in 2008. In 2007, economic growth in China, Russia and India accounted for half of global economic growth. The IMF indicates that in 2008, the Chinese economy is expected to grow by 10% and the Indian economy by 8.4%. This is an extremely fast rate of economic growth, which would see the size of the Chinese economy double in less than 8 years.

If you enjoyed this article, you may want to read about The benefits of an economic recession and how to prepare for one, on the James Cox finance blog.

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