From the Economist

OPEC

The Organisation of Petroleum Exporting Countries, a CARTEL set up in 1960 that wrought havoc in industrialised countries during the 1970s and early 1980s by forcing up oil prices (which quadrupled in a few weeks during 1973–74 alone), resulting in high INFLATION and slow GROWTH. A lot of productive CAPITAL equipment that had been viable at lower oil prices proved to be unprofitable to run at the higher prices and was shut down. Some economists reckon that MARKET FORCES would have driven up oil prices anyway and that OPEC merely capitalised on the opportunity. Since the early 1980s, OPEC's influence has waned. Many firms have switched to production methods that need less oil, or less energy altogether. Non-OPEC producers such as the UK have brought new oil fields on stream. And some individual members of the cartel have broken ranks by failing to restrict their oil production, resulting in lower oil prices.

Real options theory

A newish theory of how to take INVESTMENT decisions when the future is uncertain, which draws parallels between the real economy and the use and valuation of financial options. It is becoming increasingly fashionable at business schools and even in the boardroom.

Traditional investment theory says that when a firm evaluates a proposed project, it should calculate the project’s NET PRESENT VALUE (NPV) and if it is positive, go ahead.

Real options theory assumes that FIRMS also have some choice in when to invest. In other words, the project is like an option: there is an opportunity, but not an obligation, to go ahead with it. As with financial options, the interesting question is when to exercise the option: certainly not when it is out of the money (the cost of investing exceeds the benefit). Financial options should not necessarily be exercised as soon as they are in the money (the benefit from exercising exceeds the cost). It may be better to wait until it is deep in the money (the benefit is far above the cost). Likewise, companies should not necessarily invest as soon as a project has a positive NPV. It may pay to wait.

Most firms’ investment opportunities have embedded in them many managerial options. For instance, consider an oil company whose bosses think they have discovered an oil field, but they are uncertain about how much oil it contains and what the PRICE of oil will be once they start to pump. Option one: to buy or lease the land and explore? Option two: if they find oil, to start to pump? Whether to exercise these options will depend on the oil price and what it is likely to do in future. Because oil prices are highly volatile, it might not make sense to go ahead with production until the oil price is far above the price at which traditional investment theory would say that the NPV is positive and give the investment the green light.

Options on real ASSETS behave rather like financial options (a SHARE option, say). The similarities are such that they can, at least in theory, be valued according to the same methodology. In the case of the oil company, for instance, the cost of LAND corresponds to the down-payment on a call (right to buy) option, and the extra investment needed to start production to its strike price (the money that must be paid if the option is exercised). As with financial options, the longer the option lasts before it expires and the more volatile is the price of the underlying asset (in this case, oil) the more the option is worth. This is the theory. In practice, pricing financial options is often tricky, and valuing real options is harder still.

Sticky prices

Petrol-pump PRICES do not change every time the oil price changes, and holiday prices and standard hotel rates are fixed for months. Sticky prices are slow to change in response to changes in SUPPLY or DEMAND. As a result there is, at least temporarily, DISEQUILIBRIUM in the market. The causes of stickiness include MENU COSTS, inadequate information, consumers’ dislike of frequent price changes and long-term contracts with fixed prices. Prices change only when the cost of leaving them unchanged exceeds the expense of adjusting them. In FINANCIAL MARKETS, prices move all the time because the cost of quoting the wrong price can be huge. In other industries, the penalty may be much less severe. Small disequilibria in, say, the pricing of hotel rooms will not make much difference. So hotel prices are often sticky.

Commodity

A comparatively homogeneous product that can typically be bought in bulk. It usually refers to a raw material – oil, cotton, cocoa, silver – but can also describe a manufactured product used to make other things, for example, microchips used in personal computers. Commodities are often traded on commodity exchanges. On AVERAGE, the PRICE of natural commodities has fallen steadily in REAL TERMS in defiance of some predictions that growing CONSUMPTION of non-renewables such as copper would force prices up. At times the oil price has risen sharply in real terms, most notably during the 1970s, but this was due not to the exhaustion of limited supplies but to rationing by the OPEC CARTEL, or war, or fear of it, particularly in the oil-rich Middle East.

Asymmetric shock

When something unexpected happens that affects one economy (or part of an economy) more than the rest. This can create big problems for policymakers if they are trying to set a macroeconomic policy that works for both the area affected by the shock and the unaffected area. For instance, some economic areas may be oil exporters and thus highly dependent on the price of oil, but other areas are not. If the oil price plunges, the oil-dependent area would benefit from policies designed to boost demand that might be unsuited to the needs of the rest of the economy. This may be a constant problem for those responsible for setting the interest rate for the euro given the big differences--and different potential exposures to shocks--among the economies within the euro zone.

Inflation

Rising PRICES, across the board. Inflation means less bang for your buck, as it erodes the purchasing power of a unit of currency. Inflation usually refers to CONSUMER PRICES, but it can also be applied to other prices (wholesale goods, WAGES, ASSETS, and so on). It is usually expressed as an annual percentage rate of change on an INDEX NUMBER. For much of human history inflation has not been an important part of economic life. Before 1930, prices were as likely to fall as rise during any given year, and in the long run these ups and downs usually cancelled each other out. By contrast, by the end of the 20th century, 60-year-old Americans had seen prices rise by over 1,000% during their lifetime. The most spectacular period of inflation in industrialised countries took place during the 1970s, partly as a result of sharp increases in oil prices implemented by the OPEC CARTEL. Although these countries have mostly regained control over inflation since the 1980s, it continued to be a source of serious problems in many DEVELOPING COUNTRIES.

Inflation would not do much damage if it were predictable, as everybody could build into their decision making the prospect of higher prices in future. In practice, it is unpredictable, which means that people are often surprised by price increases. This reduces economic efficiency, not least because people take fewer risks to minimise the chances of suffering too severely from a PRICE SHOCK. The faster the rate of inflation, the harder it is to predict future inflation. Indeed, this uncertainty can cause people to lose confidence in a currency as a store of value. This is why HYPER-INFLATION is so damaging.

Most economists agree that an economy is most likely to function efficiently if inflation is low. Ideally, MACROECONOMIC POLICY should aim for stable prices. Some economists argue that a low level of inflation can be a good thing, however, if it is a result of INNOVATION. New products are launched at high prices, which quickly come down through COMPETITION. Most economists reckon that DEFLATION (falling AVERAGE prices) is best avoided.
To keep inflation low you need to know what causes it. Economists have plenty of theories but no absolutely cast-iron conclusions. Inflation, Milton FRIEDMAN once said, “is always and everywhere a monetary phenomenon”. Monetarists reckon that to stabilise prices the rate of GROWTH of the MONEY SUPPLY needs to be carefully controlled. However, implementing this has proven difficult, as the relationship between measures of the money supply identified by monetarists and the rate of inflation has typically broken down as soon as policymakers have tried to target it. ­KEYNESIAN economists believe that inflation can occur independently of monetary conditions. Other economists focus on the importance of institutional factors, such as whether the INTEREST RATE is set by politicians or (preferably) by an independent CENTRAL BANK, and whether that central bank is set an inflation target.

Is there a relationship between inflation and the level of UNEMPLOYMENT? In the 1950s, the PHILLIPS CURVE seemed to indicate that policymakers could trade off higher inflation for lower unemployment. Later experience suggested that although inflating the economy could lower unemployment in the short run, in the long run you ended up with unemployment at least as high as before and rising inflation as well. Economists then came up with the idea of the NAIRU (non-accelerating inflation rate of unemployment), the rate of unemployment below which inflation would start to accelerate. However, in the late 1990s, in both the United States and the UK, the unemployment rate fell well below what most economists thought was the NAIRU yet inflation did not pick up. This caused some economists to argue that technological and other changes wrought by the NEW ECONOMY meant that inflation was dead. Traditionalists said it was merely resting.