The improvements in communication and information technology have merged the world into one whole unit. Trade among different countries has been facilitated. Moreover, financial transactions can take place between two countries oceans apart. Therefore, the whole world got entangled up into the financial crisis along with United States of America.
Characteristics of Recession A recession is usually represented by business cycles. The business cycle incorporates three periods throughout the cycle. It includes recession followed by recovery and then trough (peak). This cycle repeats and the trough slow down eventually resulting in a recession.
The recession period is characterized with very slow economic activity. An economic recession neglects the economic concept of the Philip’s Curve and the indirect relationship between inflation and unemployment. Instead, the prevalence of high inflation rate and a high unemployment rate makes the situation worse.
During this period there is low consumer demand which is mainly due to two reasons:
Lower Purchasing Power due to high inflation and low income
Uncertainty about the economic conditions
The consumers tend to save (if they have enough income) for future purposes as high uncertainty prevails in the economy.
The extent of recession may vary from country to country and so does the period from where it would start recovering.
The Great Depression (1930) The concept of recession of financial crisis is not novel for the world. America in 1930 experienced the greatest recession which was termed as “The Great Depression.” This is referred to as the darkest period in the history of America.
The American economy was experiencing a boom in 1920s. Industrial output was increasing in spite of the not very high demand from the consumers. Ford Motors launched its car that was affordable by ordinary people as well. The manufacturers were encouraged to avail credits for their production which in the other hand did not have demand to that extent. Moreover, there was a persistent crisis in the agricultural sector. This might have contributed towards the low demand. The economy was also inflated due to the credit boom which was due to the help provided to UK whose economy was facing persistent deflation accompanied with high unemployment.
On October 29, the famous Black Tuesday, the stock market crashed eroding the confidence of people. An atmosphere of uncertainty rose and consumer demand fell down considerably.
In 1930, several banks went bankrupt. Some called in for the loans they had rendered also when the people did not have the financial strength to pay. This pressure accumulated with uncertainty of declaring bankruptcy, people started collecting their savings from the banks. The persistent fall in savings resulted in low investments.
The combination of low output high unemployment was severe. Moreover, reduced saving and thus, low investment posed a negative multiplier impact on the economy. Thus, recession got severe and transformed into a Depression.
Some measure were taken by President Roosevelt to rectify the deep crisis but the release of the U.S economy is credited to the World War II when there was a huge demand for ammunitions and weapons from the European World.
Financial Crisis of 2008 The recent financial crisis is most commonly attributed towards the house loans/mortgage market and the credit crunch. However, this is not the only cause of the recession that is prevailing today. There are several other background causes that led to this devastating financial position of the world.
Causes of Financial Crisis According to Marxian School of thought the fall in the rate of profit from about 22% to 12% caused the twin evil of high unemployment and inflation (Moseley, 2009). This resulted in low real wages which meant lower savings and a decline in the investment of the country. The solution that was adopted were the expansionary fiscal and monetary policies which did result in higher employment and output but at the same time exacerbated the inflation.
In order to raise the profits capitalists focused on cost cutting techniques. These mainly related to cutting the wages of workers by introducing speedup techniques, lowering down health premiums /health benefits and retirement benefits (Moseley, 2009).
This overtime did result in the expected profits for the American capitalists who had excess money in their hands. However, investment did not increase that greatly as the earned profits were not invested in any sort of ventures. The profits were distributed and conspicuous and luxury oriented consumption was done.
The main problem that arose was that the capitalists had money to lend but there were no borrowers. Therefore, they decided to focus upon the general public and introduced the concept of mortgage loans. This led to a revolution in the credit market and bank lending to households increased from 30 percent in 1970 to 50 percent in 2006. The total value of home mortgages tripled between 1998 and 2006. And the ratio of household debt to disposable income increased from 60 percent in 1970 to 100 percent in 2000 to 140 percent in 2007 (Moseley, 2009).
With time and lots of money at hand the credit worthiness of borrowers was given a back seat and NINJA (no income, no job, and no asset) loans were granted. It was believed that the price of houses would increase persistently and so initially loans were granted at a teaser rate (low rate). It was believed that when the price of houses would rise, the mortgage could be renewed by paying the previous one.
Mechanism of the Crisis The housing market crash was the focal cause of the financial crisis. By 2006 the house prices started to decline. The real estate market crashed. The problem arose due to the securization of the house mortgages.
Commercial Banks in the United States started selling these mortgaged loans as securities to investment banks not only in USA but all over the world. The securities were rated as low risk AAA securities and passed on. The commercial banks and the mortgage companies greedily passed on loans without proper checking the credit worthiness. Investment banks also gained from this. However, the final receiver of the mortgage security was contented on the AAA rating, unknowing that the rating companies were private and welcomed income. Therefore, the rating companies had a boom period during this time.
By 2007 the prices of the houses fell severely. The NINJA borrowers failed to pay back their loans. This triggered the beginning of the recession as the banks had no money left. The defaulters on loan grew day by day. Due to a lack of liquidity the banks stopped lending and hence, people who needed loans from the bank for their business operations had nothing to do. The credit crunch required maintenance capital to loan ratio by reducing lending.
Consequences The global impact has been severe. Consumer confidence has been thrashed. There is low aggregate demand in the economy. The interest rate in U.S has fallen down to about 1% and thus, consumers are not willing to save. Bank borrowing is minimal. The low liquidity in the economy is producing a negative multiplier due to low investments in the economy.
Downsizing has been at its peak with unemployment rate being 9.4% in December 2010(Bureau of Labor Statistics).The Consumer Price Index has been 0.4 which has been greater than the previous years (Bureau of Labor Statistics). Workers are being laid off from jobs and some are working overtime without extra salary. Moreover, the filing of bankruptcy under Section 11 by several market leaders such as Lehman Brothers and General Motors resulted in loss of jobs to many. This has further added to the inability towards non-payment of loans.
The crises have had spillover effects over the whole globe such as the Greece Crisis.
Role of Government The role of the government has been useful but not to a great extent. According to Richard C. Cook,
“Everything the Federal Reserve and the U.S. Treasury Department are trying to do to stem the tide of the self-destructing U.S. financial system is a stopgap. They are locking the barn door after the horse-many horses-have already escaped, and they know it.”
The government tried to adopt expansionary policies. Not only this but the Fed realized its role and for the first time in history, leant to investment banks. It also bailed out Lehman Brothers and the Insurance Company AIG.
The Democrats coming into power realized the vast disaster financially. They have introduced health reforms which would be increasing government spending and might serve as a stimulus to increase demand and reduce the effects of the negative multiplier.
Corporate Finance Corporate Finance deals with the strategic financial issue in order to add value to firm/country. Presently, the U.S banks are reluctant to provide loans to the public. Although the government did somewhat show a willingness towards the loans to be given out. But the banks are in no position to do so.
The corporate investment in the field of Real Estate had been immense. The real estate bubble has said to be artificial by many analysts. According to Michael Burry (2010), “”It’s an artificial market. The private mortgage market is practically nonexistent; 96-97% of mortgages are flowing through Fannie and Freddie now. I think Fannie and Freddie are exercising a tremendous amount of power over the market by withholding properties from sale and not forcing foreclosure, the foreclosure process (Burry,2010).
The investment at this stage is stagnant. Previously there has been great investment. Today savings are not existent due to downsizing. Moreover, people are reluctant due to the uncertainty in the market. Therefore, in order for the corporate finance to flourish and investments to take place some significant steps are essential.
Conclusion It is a fact that consumers are risk averse. The prevailing conditions would not emerge as very demand yielding. The government needs to take some crucial steps.
Demand side stimulus is the requirement of the economy at this time. The government needs to increase its spending, just like President Roosevelt did during the 1930 by provision of jobs for the people. The Real Estate Market should be regulated.
Houses in my opinion are a necessary good. Like health and education, the government should pick up responsibility of providing it. The mortgages if administered through government loans could have been more viable and prosperous.
Social Conventions and social responsibility fall upon humans. Therefore, the citizens should realize their civic responsibilities towards re-payment of loans.
Nature Of Competition Collusion And Pricing Airline Industry Economics Essay
The enactment of the Airline Deregulation Act of 1978 eliminated price and entry regulation of the domestic airline industry. Since then the U.S. airline industry has grown tremendously. The US domestic market competes in an oligopoly landscapes. Hence there is certain level of barriers to competition. For example, control over the computerised reservation systems used by travel agents provided the majors with a powerful weapon for disadvantaging smaller competitors. American Airlines’ “Sabre” system and United’s “Apollo” system together accounted for three-quarters of all national computer reservation systems by the late 1980s. Control of this important avenue for travel agents to make reservations enabled the majors to discriminate against smaller firms in a variety of ways-from instituting “screen bias” favouring the on-screen presentation of the controlling firm’s flights, to charging exorbitant fees to other carriers for displaying their flights on these computer systems (transferring upwards of a half-billion dollars annually from the smallest to the largest carriers).
More recently, the Big Five carriers have joined together to collectively market their tickets online through their Orbitz Web site-an alliance that may enable them to better coordinate their non-competitive oligopoly pricing and to circumvent rules put into place to prevent them from anticompetitive using their computer reservation systems while, at the same time, disadvantaging competing distributors of air tickets.
Predatory Pricing Furthermore, dominant carriers were suppressing competition through predatory pricing. For example, when Spirit Airlines attempted to penetrate Northwest’s Detroit hub with a one-way Detroit-Philadelphia fare of $49, Northwest Airline responded by slashing its average fare on the route by 71% (from $170 to $49) and scheduling 30% more seats. Once Spirit abandoned the route, Northwest raised its fare to $230 and cut its seat capacity. Similarly, when Frontier Airlines initiated service from Denver (United-dominated hub) to Billings, Montana, it offered an average $100 fare, half the prevailing fare charged by United. United slashed its fare to match Frontier; when Frontier exited the route, United raised its fare above its original level.
Collusion Collusion is a difficult game to play when the number of conspiring rivals is large. It is hard to keep a hundred firms in line when their cost structures differ, when their production facilities vary, and when some have an incentive to cheat on a price agreement or to violate output restrictions. Numbers make a difference. When numbers are large, conspiracies are difficult to organize, difficult to conceal, and difficult to enforce.
However, public policy faces a serious challenge in oligopolistic industries like the case of the Airline industry where major carriers eschew outright collusion and rely instead on a course of conduct characterised as “tacit collusion,” or “recognition of mutual interdependence” to resemble the effects of outright conspiracy. The mechanics of tacit collusion is apparent particularly in an oligopoly market dominated by a few major players. Each carrier naturally recognises the mutual interdependence between it and its rivals.
Carrier X knows that it if were to cut price in order to increase its market share, its aggression would immediately be detected by carriers Y and Z, which would respond with retaliatory price cuts of their own. Market shares would be unaffected, but all carriers would now operate at lower prices and profits. Henceforth, Carrier X cannot expect to increase its market share or revenue at the expense of its rivals. It cannot afford to calculate in terms of maximising its own profits in isolation but instead must constantly ask whether a particular decision on price or output will be not only in its own self-interest, but also in the best interests of its rivals.
By recognising mutual oligopolistic interdependence, it must be concerned with group profits and group welfare. In other word, under oligopoly landscape, independent, aggressive, genuinely competitive behaviour is perceived as counterproductive-an “irrational” strategy for the individual carrier. In an oligopoly, groupthink will influence a carrier’s strategy when it is contemplating price increases as it cannot act alone. In other word, groupthink replaces the calculus of individual advantage, and each carrier must behave as a “responsible” member of the oligopoly group rather than as a reckless, self-seeking competitor. In oligopolies, this recognition of mutual interdependence may extend to non-price competition.
For example, if carrier A refrains from aggressive price competition but seeks to increase its market share through aggressive innovation program, it cannot expect its rivals to sit idly by. It must expect them to increase their research efforts as a simple matter of self-defence, thereby nullifying its expected gains. Anticipating such retaliation which could erode oligopoly profits- carrier A might refrain from innovation for the same reasons it would avoid price-cutting. Rationality again commands “responsible” nonaggressive behaviours; the most effective profit-maximisation rule under oligopoly is to “get ahead by getting along.”
Nevertheless, the level of oligopolistic interdependence and collusion varies from situation to situation. It depends on such factors as whether the oligopoly is tightly knit (small number of firms) or loosely knit (a larger number);whether it is homogeneous or heterogeneous; whether it is symmetrical (having firms of roughly equal size) or asymmetrical (with one firm disproportionately larger); whether or not the industry is mature (having had time to develop its internal arrangements and institutions to promote cooperation); whether the industry is populated by “reasonable” managers or by a few mavericks.
In the US domestic market, the advent of the Internet has increased the efficient of signaling or collusion. Carriers can see what the competition is doing immediately by going to the Internet that allow them to react quickly by adjusting their own prices. This is a far cry from the days when price books were set in type and could not be changed for months. Now most prices can be adjusted several times a day, if needed. Apparently, this is a game that the airlines are particularly adept at. As consumers have more transparent access to real-time flight pricing through online services like Orbitz, so the airlines are almost obligated to adjust to each other. This is particularly apparent on routes where there is no rogue player, like Southwest Airlines or JetBlue as they are (within limits) free to adjust prices upward. As long as the members of the oligopoly with real selling power tacitly agree that a major price war is not in their interest, chances are that prices can quickly readjust themselves, keeping in mind the balance of costs and optimal prices for maintaining profitable sales levels.
Nevertheless, the combined market share of the “Big Five” network airlines (Delta, United, American, US Airways, and Northwest ) that peaked in 1992 has been declining since deregulation [ *]. Furthermore, with the influx of several low-cost carriers, tacit collusion is becoming difficult to organize, conceal and enforce even though oligopolistic rationality and its collusive consequences are inevitable concomitants of oligopoly industry structure.
Pricing Pricing is important for the carriers. If prices are too low or too high, it can drag down profits. Thus, it is important for the carriers to derive profitable airfares and discourages unprofitable one.
To maximise profits, the carriers should set prices so that marginal revenue just equals marginal cost. In other words, it should use profit-maximising prices as the starting point.
The economic model of pricing ****show diagram****,
which is called marginal cost pricing, clearly identifies a pricing strategy that will maximise profits. This pricing strategy also identifies the information needed to set prices, thus simplifying the process. In other words, the profit-maximising price is where the incremental margin percentage equals the reciprocal of the absolute value of the price elasticity demand  [ **] Based on pricing rule, the carriers should adjust its price where there are changes in the price elasticity of demand or marginal cost since the carriers compete under oligopoly landscapes with homogeneous services.
Airfares have dropped significantly over the years [***] since deregulation which helped to simulate competition resulting in the entrance of several low-cost carriers. This could partially due to regulator and oligopolies increase efficiencies, putting direct or indirect price pressure on their suppliers as well as putting pressure on the wages and benefits of their employees Hence there is growing belief is that oligopolies can be price-neutral as opposed to manipulating prices.
The strategic variable for airline carrier is price in the short run. Generally without product and service differentiation, the basic service offered by the carriers would be homogeneous. Under the Bertrand model, the carriers which produce at constant marginal cost and compete aggressively on price in order to gain a bigger share of the market. Under such condition, the market equilibrium is perfectly competitive pricing.
However, in a loosely knit oligopoly structure, the individual carrier has incentive to offer heterogeneous services. Through heterogeneous services, it can charge personalised pricing or group pricing based on passenger willing-to-pay to achieve higher profits. For example, if carrier X sells its airfares at a single, it loses in two ways. Firstly, some passenger would be willing to pay more than $100 for a ticket during the last hour of the flight. Secondly the carrier does not sell to passengers who are willing to pay more than $50 but less than $60. This is illustrated in the graphic below, where P=price and Q=quantity.
By charging such passengers at different price, the carrier could profitably sell to a much larger passenger base.
Furthermore, with differentiated services, should one carrier cut its price below other carriers’ price; it would take away only part of the other carriers’ entire demand. Thus, carriers should have strong incentive to differentiate its offering in order to raise their equilibrium prices. However, there is a risk of loosing the market if the services are not on par with its pricing and demand. The carriers must balance their desire for market share at the same time avoid head-to-head price competition since the less differentiation in their services, the more direct will be in price competition among them and the lower would be incremental margins.