The Fed's New Year's Resolution

So, we have all heard about the looming fiscal cliff at the beginning of January.  It has been hotly discussed and debated on many fronts and the rhetoric of the politicians have controlled the direction of the financial markets.  The Fed has assured that there will be more stimulus through buying of long-term treasuries and selling of short-term treasury bonds. 

This just means that the Fed will, in effect, attempt to drive the interest rates for mortgages down and drive short-term interest rates up.  Thus, in theory, stimulating the economy because one can earn more in the short-term with higher interest rates, right?  Right.  Now here in lies the problem...banks are not so willing to lend as the Fed would like and thus stunting the growth - or stimulus - for the economy.  Banks are still incurring the consequences of the downturn of the mortgage industry in 2007.  What to do?  Refinance your mortgage.  Those who refinance their mortgage will drive the interest rates back up for mortgage loans.  This is also a hard line to walk, though.  If mortgage rates go up consumers will be less willing to buy...but...banks will be more willing to lend so long as underwriting stays solid - which it has seemed to do for the most part as of late.  There is still a long way to go in the recovery but there are signs of life...not enough but some. 

The Fed also announced that it will tie the stimulus programs (previously mentioned) to actual targets in the unemployment rate and inflation rate.  6.5% and 2.5% respectively.  In essence, the Fed is trying to instill more confidence in the market by giving exact targets.  Will this work?  Perhaps, but any new approach seems to initially instill confidence in the market.  I wouldn't suggest that the Fed is going to stick to this curriculum because the employment rate dropped just this month two tenths to 7.7%.  However, over 300,000 dropped out of the labor force.  I'm sure it's just a coincidence, though...

The bottom line...the Fed is trying to stick to its almost impossible dual mandate of low unemployment and steady inflation.  While this is commendable, it's not realistic to think a single entity can truly gauge what the economy needs.  The economy is too complex.  The Fed does have an effect on the system, but it is only part of that system and in many cases its probably better that the Fed listen rather than speak. 

Unemployment at 7.9%

Recently, we have seen a rise in the unemployment rate to 7.9%.  This coincides with an increase in the labor force participation rate to 63.8% according to BLS.gov.  Perhaps due to the recent drop below 8% people have become encouraged that there are more opportunities to get a job.  However, for once this shows a more accurate picture of the unemployment rate by including a few more participants in the labor force.  Some say that the true unemployment rate is upwards of 11 or even 12 percent.  These numbers include those discouraged workers who have quit looking for a job and simply dropped out of the labor force.  I find it interesting that the unemployment rate is given much more weight in the political spectrum when it seems to me the labor force participation rate is equally relevant when describing the state of the economy. 

The labor force participation rate has seen a steady decline over the past 3 years.  The unemployment rate has seen some modest improvement over the past year and a half but that may be due to that decline in the labor force participation rate.  These two rates have a relationship that helps paint a somewhat clearer picture of the economy.  While the labor force participation rate has declined we have also seen prices increase--the price of gas the most notable indicator of rising prices.  Wages have decreased and inflation has increased.  It's a pretty bleak picture, I know.  However, I feel this picture only reenforces the core principles of economics and finance.  These principles suggest that there are consequences when spending is increased.  An increase in the money supply leads to higher prices. Bailouts of bankrupt companies may keep the status quo and save jobs in the short term but overall purchasing power has now decreased because we have an industry that was bailed out.  No one can say exactly what would have happened but one thing is for sure:  jobs were prevented from being created elsewhere. 

Unemployment, Uncertainty, QE3, November 6th

It's been quite some time since my last post.  All I can say is that it has been a very busy semester.  However, I feel an economics post is always warranted.  Obviously, the presidential election is on most people's minds as November 6th draws much closer.  We've seen debates between the candidates and shifts in momentum on either side with the most concerning topic being the economy.  As employment is still abnormally high and the national debt at over $16 trillion, the economy has shown only mild signs of improvement.  Investment is still low(even with record low interest rates) mostly due to uncertainty in the future economy.  Are there any signs of life?  Some, but not much.  The housing market has consistently shown gains in 2012 since the bubble burst back in 2007.  However, it has yet to make a full recovery.  This seems to coincide with the general theme of the recovery for the past two-three years that has been slower than expected.  

In the beginning of October we saw the unemployment rate unexpectedly drop below 8% to 7.8%.  This was the sharpest job-gain in over 30 years and for lack of a better word, it was well...weird.  The unemployment rate is derived by two surveys that are sent out to both employers (business owners) and households.  And while the employer survey sent back gains of a meek 140,000 jobs, the household survey showed gains of over 800,000 jobs in September.  This is a staggering contrast and makes one understandably skeptical of the methods used while conducting this survey.  

Perhaps part of the reason for the slow economic recovery is the fact that most of the job gains have been low-wage earning jobs which have effectively increased the ever-so-delicate wage gap.  This has effectively shrank the middle class and forced many to pursue two jobs in order to make up for earnings from previous employment.  Not only that, but another round of Quantitative Easing has hit the fore front with no deadline in sight.  In effect, QE3 will inject currency into the economy in order to generate liquidity and create an incentive to invest or spend.  While the FED pushes money into the economy, it walks a tough line with the declining dollar on the world market.  The injection of currency also contributes to inflation and may lead to a decrease in REAL income, i.e. purchasing power.  

The big question is:  What will happen after the election?  Does the country need another sales pitch to increase confidence in the economy, or a CEO that will substantively implement changes from what we've previously seen?  Perhaps this uncertainty will lead us to make a substantive decision to make change, rather than JUST rely on hope. 

100 Million now on Welfare

Recently, the number of Americans receiving welfare benefits exceeded 100 million.  Now most, I'm sure, are not surprised by this fact given the state of the economy.  With the unemployment rate steadily above 8% over the past 4 years it is easy to see why the number of welfare recipients has increased.  However, this is a staggering 1/3 of the U.S. population.  I'm sure after the 1996 welfare reform bill was signed into law in order to create work incentives for those on welfare would have never expected such a sharp increase only 16 years after the law was passed.  Perhaps, there is more to the story.  

One of the things the passage of the 1996 welfare reform act did was introduce the benefit-reduction rate.  This rate worked by creating an optimal amount of hours per week the beneficiary should work in order to make the most money possible through welfare benefits and earned income.  For example, someone on welfare has a benefit reduction rate of 50% then for every dollar earned there is a 50 cent reduction in welfare benefits.  This creates an incentive to work because one could earn more through working and receiving welfare benefits at the same time.  Now, each state can set the BR rate however they like.  Something to note is the lower the BR rate, the higher the incentive to work because one could simply earn more by working more.  It works the other way as well.  If the BR rate is 100%, as it was before the 1996 bill, then the incentive is to not work at all and simply receive benefits because each dollar earned is a dollar lost in welfare benefits.  

Texas has done well in this economy and perhaps the BR rate has something to do with it.  
Take a look at the map below.



 This map shows which states increased and which states decreased the BR rate from 2007 to 2009.  As the map shows, most states increased their rate (incentivizing more leisure and less work) but Texas and a few others actually reduced their rate.  This is not surprising because in Texas the policies and regulations are very business-friendly and this map may be just one of the many contributing factors for Texas' success during this "great recession". 
 

Social Insurance Continued

In a previous post where I talked about social insurance I contended that there should be an opt-out age at 25 and because of this there would likely be an increase in federal funding for welfare programs.  I say this because if most opt-out of social security payments, it might lead to an increase in taxes else-where since the government is no longer receiving the funds to support welfare programs.  Yes, through social security taxes, government supports other programs.  Now, the reason for this is because the social security trust fund isn't actually there.  It is an IOU from the government to the government through bonds.  This IOU is expected to be depleted in the next twenty years.  And after the IOU is depleted then social security goes back to a pay as you go system.  Did I just call a trust fund an IOU?  I can't be making any sense.  Well, nothing is really new here, as the government seems to mostly function on IOUs social security is no different.  Except that instead of issuing an IOU to another country like China, it's actually an IOU to itself.  We have truly come a long way. 

The way I see it, government has crowded out the market for retirement insurance from those who could afford a small premium for retirement.  Now I would assume, again, that those who go off of their social security plan will probably take that extra money and use it for themselves in day-to-day expenses as opposed to instantly investing in a retirement account.  OR, they might now have an incentive to open a brand new retirement account since they will no longer have social security.  I don't know for sure but my belief is the latter.  If one opts our for social security they may be doing so in order to open their own retirement account because social security is so marginal in almost every way.  7.5% of your paycheck goes into the social security fund.  If you make $50000 a year that is $3250.  Now here's the catch; social security is not means-tested which means even if you have a 401k with your employer or you make over a million dollars a year, or both, you will still qualify for social security benefits, this is also what puts it in a separate category from welfare.  Just think.  If you were able to take that extra $3250 what would you do with it?  If you only made $15000 a year that's $1125!  I point this out because there is a market for these accounts!  Why not allow the private sector to provide retirement insurance?  If this were to happen, there would be an influx of jobs.  Social security crowds out this market for low premium retirement insurance companies.  This amount of money going towards social security could easily be transferred to low premium, private sector, retirement insurance for individuals.  Now I'm well aware of the transition problem that always exists which is why I mentioned an opt-out age of 25 to help alleviate this issue.  Those still relying on social security will still receive their benefits.  And I'm aware that many individuals would likely keep the extra money for day-to-day expenses, but I also believe the extra jobs created by this seemingly massive market may help to alleviate the poverty as well.  Retirement insurance is a large market, and in today's economy, we would do well by saving. 

Gun Control

Recently, I read an article from The Economist on the subject of gun control.  If you're interested in reading the article, here is the link http://www.economist.com/blogs/democracyinamerica/2012/07/gun-rights?spc=scode&spv=xm&ah=9d7f7ab945510a56fa6d37c30b6f1709

In this article the author refers to Justice Scalia's comments on the second amendment.  As a Justice, Scalia interprets the amendment in a very literal sense calling "bear" the idea of being able to wield a gun with your "bear" hands, so to speak.  This idea rules out the possession of say a tank or a fighter jet.  The original intent of the second amendment is to allow the citizens to prevent a tyrannical governmental takeover.  In today's world, the government military has possession of much better artillery than a handgun or even an AK-47.  Scalia suggests that if the second amendment is to live up to its' original intent, citizens should be aloud to own a tank or a rocket launcher.  I completely agree.  Of course, the way to go about doing this would be to amend the second amendment (which of course is very unlikely to happen).  Or, simply legalize the purchase of these military weapons!  Yeah, I'm sure this will go over well in the media...the simple fact of the matter is that the more of those who own guns, the less likely it is we will kill each other.  

The author goes on in this article and makes this point if we are to legalize all sorts of weaponry for purchase in the United States:  "And should those citizens decide to fully exercise such rights, then their second-amendment freedom will become the freedom to be attacked and crushed by the police and the US military, on behalf of those of us who support the integrity of the American government we have elected and the enforcement of its laws."  To which I say, very unlikely.  It is the citizenry which enacts such laws and protections.  It's an easy argument to make when you say everybody has a gun so we're all dead.  It's much tougher to make the argument that if we all have guns then we're all protected.  However, it is much easier for someone to attack an unarmed enemy than it is an armed one.  This notion has been proven on numerous occasions.  Namely, the cold war. 

Social Insurance

Social insurance, the idea of government provided insurance, has its roots in the era of FDR and the New Deal of the 1930s where Social Security was developed.  It has been a controversial topic in today's political field and probably always will be.  One of the biggest debates is about the trust fund for the baby boomer generation.  This fund is about $3 trillion and will disperse from 2011 to 2030.  The idea behind it is to cover social security benefits for the generation born between 1946 and 1964 in which there was a substantial increase in births during that period.  After that, it will go back to a pay-as-you-go system.  The idea that social security is bankrupt is misleading.  However, given the fact that people are working longer and are less likely to retire at age 65 presents a problem for future beneficiaries.  This has led to the increase in "retirement age" to 67 for the generation of people in their early 20s.  If social security isn't to change to adjust to the health of individuals then it will certainly go bankrupt as later generations are likely to outlive the funds paid into social security.  

I think that social security should be gradually depleted OR an opt-out option should be available at some age.  What age that should be could be up for debate, but, my initial thought is at age 25.  At that age, I feel that an individual should be allowed to opt out of paying for social security.  That age could help alleviate the transition problem as well.  However, the counter-argument is that most would probably opt-out so they could keep the extra money and this won't create a strong enough incentive to open their own retirement account, especially those in poverty.  So this could lead to an increase in funding for welfare expenditures.  

Immigration 1

Immigration is a delicate topic is today's political spectrum.  There is the Arizona law that was recently upheld in the U. S. Supreme Court which allows for officers who make a routine traffic stop to inquire about legal status in the United States.  That, with many other steps taken by border states to contain illegal immigration, has fueled the immigration debate in the country.  In order to become a citizen in the United States residents with a green card are eligible after 5 years of resident status to apply for U.S. citizenship; or, one can Mary and wait only three years or just go strait into the military during wartime.  The only issue is the process can be very long after applying for citizenship and even though you are paying taxes because you are a resident, you can not vote or participate in the political process.  However, you are welcome to go to our schools and even receive lower tuition rates because of your immigrant status.  

Since Mexico's wage gap is so vast and inflation so large, the currency in Mexico is extremely weak in comparison to the United States.  This creates a strong incentive to migrate and I can hardly blame those who have come to the United States for a better life.  After all, we are the shining light on a hill for the rest of the world, at least for now.  I want to know what the incentives are to actually migrate legally.  The process of receiving your green card and then waiting to gain legal status can, in many cases, take years and sometimes decades.  The incentive to migrate illegally is high, especially given the state of the economy of our southern border neighbor.  Now, I don't think the Dream Act is the right solution.  However, I do think that something must be done in order to fix this problem.  There is nothing wrong with immigration, and it is done legally everyday.  The incentives for immigration to the southern border states outweigh the incentives for legal immigration.  There is what is known as the bottleneck in the southern border states.  The system can't handle that many immigrants at one time, and so the incentive for illegal immigration is high. 

Wage Gap

The wage gap is something often talked about in today's economy.  I would like to inquire about a theory I have of why the wage gap is so vast.  I theorize the the idea of a minimum wage does not promote an equal share of the money supply.  While that may seem counter-intuitive, I would argue that a minimum wage actually brings other wages in the market down as well.  The reason being is that an employer will hire someone worth a few more dollars than the minimum wage for that minimum wage amount.  This is possible because the wedge the government has created between the desired lower wage for some employees offsets the higher wage desired by others and in essence creates a lower wage for overall even though it is granting a higher wage for a few employees.  The lower wage overall only increases the wage gap between the middle and lower classes and the upper class. 

A Quote From Hayek

Given recent events, It has been difficult to find time to create a new post.  However, I do have some now.  Since classes have ended I have been reading a book titled "The Road to Serfdom" by F.A. Hayek.  In it there is a quote which says, "But to call private property as such, which all can acquire under the same rules, a privilege, because only some succeed in acquiring it, is depriving the word 'privilege' of its meaning."  This quote struck me and I began to wonder whether or not healthcare was really a privilege or indeed a right.  I began thinking about the quote in the Declaration of Independence that says, "that they[men] are endowed by their creator with certain unalienable Rights, that among these are Life, Liberty, and the pursuit of happiness..."  Indeed Life is a right.  You have a right to your life and not to be deprived thereof by another individual.  You also have a right to Property which would be included in the idea of liberty and the pursuit of happiness which is later specified in the U.S. constitution.  Now, what about healthcare?  Is healthcare a right?  By the definition of privilege above, I certainly wouldn't call it a privilege.  Nor would I call healthcare a right.  Healthcare is similar to property in the sense that all may acquire it but not all will, except that all will be treated if need be in the healthcare industry even if they don't have insurance.  The word privilege applies to congressmen who receive health benefits through their elected position.  It is a privilege to be elected by the people to receive those benefits through that office which elected.  It is not a privilege for any individual to receive healthcare benefits for free and nor is it a right.  It is, rather, a result.  

It is a result of the three things every American is guaranteed which were previously cited from the Declaration of Independence.  Without Liberty, property cannot exist, and without property, a pursuit of happiness cannot ensue for any individual.  Health Insurance would fall under the category of a property and is therefore accessible to all American citizens.  To say that healthcare or health insurance is a right IS depriving the word property of ITS' meaning and therefore once taken away by the government, it can just as easily be taken away all together.  

I'm Just a Bill

Obamacare has been surprisingly up held.  The Supreme Court's ruling is based on the idea that congress in allowed to tax under the constitution and thus the individual mandate is constitutional.  This means that if you chose not to purchase healthcare you will be stuck with a small fine, at first.  For the first two years of Obamacare there will be a fine much less than that of the actual cost to have a health insurance plan and then the fine goes up substantially.  What does this do?

This cheaper fine is not only for individuals, it is for businesses as well who will be required to provide health coverage.  The fact that a business can pay a small fine rather than provide health coverage to its employees creates an incentive to not provide health coverage at all.  Whether employers choose not to provide it to their employees is yet to be seen, of course, as an effect of Obamacare, but rather from the current recession.  Given the fact that we are in a recession it would make sense that employers will look for any incentive to keep their business afloat and choose not to provide health insurance but rather leave it up to the individual employee to acquire on their own.  I suspect many will choose to pay the fine as well because their healthcare was originally free but now must be paid for and it would only make sense that most would simply pay the fine because it is cheaper.  As soon as this begins to happen, the  Affordable Care Act is in full swing and the economic effects will begin to take place.  Health insurance providers will probably lower their prices for a short period as well to match the subsidized pricing.  However, this is not meant to last.  Competition will weed out the the firms that can't compete with the subsidized healthcare or the fine and as soon as that happens prices will start to climb again because less firms means more market power for each individual firm.  By this time, the fine will have been increased for those who chose not to purchase healthcare and if you notice, prices are now higher across the board.  This is obviously a generic outlook on the economic repercussions of Obamacare.  


Now, what we have is an oligopolistic market where a few large firms share most of the market.  I feel this will only amplify the wage gap that already exists in our economy which is ever so often brought up by the media and the occupy movement.  Now a few large firms can charge substantially higher prices to those top wage earning individuals and the government will just provide healthcare to the low wage earners.  Everyone is happy because they receive healthcare!  Woo Hoo!  The End right?  Not so fast.  Why are the top wage earners paying more?  Not only can they afford it but they will be paying for a better service.  This means they get care first and this is possible because it is a private firm that they have health insurance from.  Remember, fewer can afford it, so much fewer customers, and thus much shorter line meaning better and faster healthcare.  This concept of the rich getting richer and the poor getting poorer is unethical and capitalism at work according to today's rhetoric in the media but this is what you get with the Affordable Care Act.  Now those on subsidized care must wait.  This is the effect of one firm crowding out the rest of the market.  While everyone has access to the service, there is only one place to get it.  However, I'm sure we can be reassured by a hopeful message like, "great things come to those who wait."  Yeah, good luck with that. 
 

A Truly Affordable Act

The healthcare law is set to be ruled on in the next coming days.  The repercussions of this ruling could be massive if the law is struck down partially.  If the ruling on the mandate is that it is unconstitutional, it would not make sense to have any other part of the law upheld.  The Affordable Care Act is set to work on this premise which is why the healthcare industry has been preparing for its implementation in the last two years.  The economic repercussions of allowing MORE subsidized medicine will be substantial and, just like any service, must be paid for.  If the mandate, and the mandate only, is ruled unconstitutional then the ACA will have to be paid for by other means.  This may mean higher taxes across the board.  And even if the individual mandate is struck down by the Supreme Court that still leaves the business mandates which requires businesses with over 50 employees to provide health coverage. 

Clearly the ACA has many strings attached and if the main one is cut then we have nothing but a dysfunctional puppet trying to put on a show.  Insurance companies will be required to take on customers even if they have pre-existing conditions without charging extra, costing even more money which will in turn raise prices on those who can afford it to a point where they no longer can.  This will then force those individuals to take the subsidized healthcare which will in turn raise taxes even further.  Just the fact that insurance companies will have to cover anybody and everybody will send some out of business and cause prices to skyrocket forcing more people on subsidized care or to simply not have healthcare, since the mandate was struck down.  Thus, we are still in the same predicament we started in, if not worse.  

This law if put into effect will simply crowd out the private sector of healthcare.  It will put your health in the hands of politicians and not doctors.  

The best alternative I can see is to strike the entire law down and take a look at the policies already in place.  Some argue that regulating healthcare is regulating interstate commerce.  Even if healthcare is interstate commerce, health insurance is not.  Therefore the market for health insurance should be less regulated and allowed to cross state lines in order for competition to take place.  That is a truly AFFORDABLE and CARING ACT.

The Laffer Curve

In my last post I mentioned the underlying problem in the economy.  I feel like I should be clear on what I'm talking about here.  To start there is something called the Laffer Curve in economics.  This curve suggests an ideal rate of taxation by government and follows common economic laws for the business cycle.  It is shown below:
 

This curve shows the revenue for the government as it increases taxes.  The point of diminishing  returns to scale suggest incentives to work have decreased because taxes are so high.  Now, what does this have to do with the underlying economic problem?  Well, given the recent state of the economy one could suggest a shift in this curve.  I would certainly suggest that the optimal tax rate for maximum revenue would decrease in a recessing economy.  This notion however is countered by increased government spending during a recession through stimulus packages.  These stimulus packages are meant to keep spending at current levels by simply giving people and industries more money to sustain the "optimal" level of spending.  I put optimal in quotations because I don't feel there is an ideal universal level of spending for the private sector or public sector for that matter.  In order to maintain this level of spending that has generated economic growth in recent years stimulus packages are expected to trickle down and solve the economic crisis. 

We all live in this economy and have noticed very bleak improvements.  One of the reasons for some improvements is perhaps the system of government we have which separates state and federal responsibilities.  However, that is another blog post for another day.  The fact that the economy is in a state of decline is due to the idea that an increased amount of spending will always solve the problem.  It doesn't.  And simple economics shows us that there is a point of diminishing returns to all spending...as marginal cost increases it eventually hits a point where it increases exponentially and thus diminishing marginal returns come about.  These stimulus packages only allow to pay for the increasing marginal costs but do not increase marginal returns and in fact keep the economy in the area of diminishing marginal returns with no ability to correct and begin a new cycle.  

The attitude that spending will solve the problem can be traced back to the mortgage loans given to unqualified recipients.  It can also be seen in the increased government funding to education.  While education has not been the best in America, we have seen increased government spending with very little, if any, improvement.  And while state governments make cuts to education, that attitude shows it's ugly face again and demands MORE spending to fix the problem. 

What do we know about public education? I dont know.

This past weekend was the Texas GOP Convention.  Full of campaign rhetoric, and events from politicians from all over the state and nation from people like Ted Cruz, David Dewhurst and even Paul Ryan, the convention was not without drama.  While Ted Cruz seemed to own the crowd with overwhelming tea-party support, David Dewhurst, known as the establishment candidate, was actually booed when he attempted to paint his opponent as a Chinese supporting traitor.  Ted Cruz and Dewhurst are in a runoff for the senate seat formerly held by Kay Bailey Hutchinson.  This event happened on the heels of one of the biggest statement elections of the year, the Wisconsin Recall elections of Scott Walker(Governor of Wisconsin) and his supporting cast.  Walker and every one of the state legislators won their recall election in a huge landslide victory.  The victory marking a strong message to unions AND the education system across America.

These all were huge events of the past week, but, what I want to talk about is the education system in question in Wisconsin and Texas.  As most know, the Wisconsin recall event was in response to Walker's large budget cuts to state-funded teacher unions in the state of Wisconsin.  These teacher unions were asked to contribute more to their own pension funds by these cuts.  They were asked to contribute to their own insurance.  Now, the argument is that Scott Walker could have made cuts elsewhere besides public school funding, but is that true?  Let's take a look how school districts actually budget.  Well, that is actually tough to find.  When looking at local budgets it is tough to find any transparency on what schools actually spend their money on.  However, state and federal government funding is available.  State and government funding for public education has increased nationwide over the past decade with much of it coming through federal stimulus packages.  the stimulus packages were to be used to encourage reform in education but instead were used to prevent layoffs.  Given the current state of the economy, this is understandable.  Or does it speak to the underlying problem of the economy?  

Texas education funding, like Wisconsin, was also cut in the last legislative session.  According to politifact.com per-student spending was decreased by an average of  $500 per student in Texas.  This number was down from almost $8000 to just above $7000 a year per student.  This decrease in state funding must be due to the trend in the last decade for increased spending by individual school districts in Texas!  The graph below shows this trend.






  

In this graph we can see that education expenditures have greatly exceeded enrollment in the last decade by almost 5 to 1 according to this website http://fastexas.org/study/exec/spending.php

This trend begs the question:  Is another student in the classroom really five times more expensive than the previous amount?  Are the increasing marginal costs really that steep?

I only ask this question in response:  Every year, students in elementary school are required to bring new supplies to be shared by everybody in the class.  My question, what happens to all the scissors every year?

Oklahoma City Thunder’s Advantage

The NBA’s Oklahoma City Thunder has enjoyed an immense amount of success the last couple of years.  Making the NBA Western Conference Finals two years in a row, they have cemented themselves as the youngest and most promising team of the future for the Western Conference.  While the Thunder is a remarkable team, it is unusual that a pro sports team in such a small market (Oklahoma City, Oklahoma) would have so much success.  The common notion is that only large market teams have continued success while small market teams struggle to acquire the stars needed for consistent winning seasons.  I will attempt to show that the Oklahoma City Thunder is not actually in conflict with this notion. 

This notion has been consistent in the NBA since its’ founding in 1946 when the large market team Boston Celtics dominated the league in the 50s and 60s.  In fact, the two most successful teams in the history of the NBA have been the Boston Celtics and the LA Lakers.  Both of these teams are considered to be two of the biggest markets for professional basketball in the NBA.  It begins to make one wonder what has led to these dominant franchises in the last 60 years of NBA history.  One explanation is the invariance principle from the economics of sports research.  It states that certain types of players will always end up in the same places or on the same teams.  Generally speaking, star players will go to where their marginal revenue product (MRP) is greatest.  That is, players will end up where they can gain the most by playing a professional sport.  Thus, these large market teams of Boston and LA have been able to provide the largest benefit for a player’s MRP.  This leads to a payroll imbalance between large market and small market teams.  Essentially, because the large market teams earn more revenue they can afford players with a larger MRP than smaller markets.  A player’s marginal revenue product is what determines the cost for that player in terms of player salary.  The idea is that a better player will produce more on the field, or court in this case, and generate higher revenue for the franchise owner.  Given that most, if not all, owners’ bottom line to maximize profits there will be a definite revenue imbalance throughout the league because of the differential in market sizes.  Therefore, a payroll imbalance throughout the league ensues and thus there is competitive imbalance.   The payroll imbalance ensues from the inability for smaller markets to pay for better talent and vice-versa with the larger market teams.  An illustration of this concept is shown in the graph below. 

This graph shows us the interaction between franchises in a two team league, one small market team and one large.  The red-shaded area shows the payroll for the smaller market team and the green for the larger.  Given the marginal revenue curves we can see that the small market team generates much less revenue for players than the large market team.  The intersection of the two lines is the point where the marginal revenues are equal and hence the higher winning percentage goes to the large market team.  P* denotes marginal revenue price for each team. 

The Oklahoma City Thunder has a much higher winning percentage than the small market team depicted in the graph.  This raises an interesting question.  What is Oklahoma City doing that other small markets aren’t in order to gain the MRP of its players?  Well, let us take a look at a comparison of NBA payrolls for the Thunder as compared to other teams.  According to sportscity.com the Thunder payroll is in the middle of the pack at about $58 million.  A larger market team like LA, for example, has a payroll of almost $94 million and Boston’s payroll is almost $81 million.  With these payroll imbalances, one would expect a large competitive imbalance associated; with Boston and LA outperforming Oklahoma City by a very large margin.  However, this is not the case.  While Boston and LA are still dominant teams in the NBA, the Thunder have outperformed them by a slight edge the last two years. 

Star players in the NBA are often paid close to $20 million a year.  Dallas Mavericks’ Dirk Nowitzki made a little over $19 million in the 2011-12 season.  LeBron James, Dwayne Wade and Chris Bosh of the Miami Heat will make about $16 million this season.  The salaries for LeBron and D-wade are large pay cuts.  Kobe Bryant of the LA Lakers will make $25 million this season.  The Oklahoma City Thunder’s Kevin Durant will make just over $16 million this season.  Given that Durant was second in the NBA MVP race, behind LeBron James, it could be argued that Durant is underpaid.  Russell Westbrook is also a key player for the Thunder in their recent success.  Westbrook is considered one of the elite point guards in the league along with Derrick Rose, Chris Paul, and Deron Williams.  Deron Williams and Chris Paul will both make $16 million this season with Derrick Rose reaching the end of his contract making only $5 million.  With Derrick Rose’s resume he will undoubtedly receive a raise when he signs a new contract.  Westbrook will make just over $5 million this NBA season.  With the MRP for Westbrook and Durant it would be reasonable to assume that they are underpaid.  Other players are probably underpaid as well, but for our purposes we will focus on the two best players on the team.  The assumption that these players aren’t receiving their marginal revenue product may be true if they were in a larger market.  However, given the small market they play in, their MRP will be much smaller.  By this understanding, the MRP that is generated by Durant and Westbrook is just what the market demands.  In essence, the Thunder’s success is not contradictory to the idea of a winning percent equilibrium depicted in the previous graph.  To help illustrate this point the same graph is drawn for the OKC market below. 

This graph shows the same concept as noted earlier with a two team league.  However, MR(small market) curve has been pivoted to show a slight increase in marginal revenues for wins.  This in turn raises the price for the marginal revenue equilibrium and winning percentage with the edge now going to the smaller market team.  This small market team has a payroll well above average for a normal small market team and in this two team league it is above the larger market payroll. 

In the case of the Oklahoma City Thunder, their payroll is still below larger market teams, but it is above the average payroll for a small market team.  This can also be explained by the idea of diminishing marginal returns since the Thunder are still new to the city and the marginal utility is still much higher than other cities.  Thus, demand is higher in Oklahoma City.  To understand this further, Durant is certainly underpaid as compared to other players of his caliber around the league.  However, his MRP for the market of OKC is met.  Russell Westbrook is also underpaid but his MRP for the market in OKC is also met.  This is explained in the graph by the lower starting point for MR(small market) along the right vertical axis than the higher starting point on the left axis for MR(large market).  The change in slope for MRP denotes the change in demand for the smaller market and we see a large increase in payroll for the Oklahoma City Thunder.  Thus, the Thunder are not in conflict with the idea of a winning percent equilibrium.  The lower starting point for MR(small market) denotes the fan’s willingness to pay for better talent.  However, with the shift in the small market curve, the owner is willing to pay more for better players, but still under their MRP as considered league-wide.  All of these things denote an advantage for the smaller market Oklahoma City Thunder.  Now, the question is, how long will this last?