Maritime Economics

Economics contains three (3) elements:

  1. Scarcity
  2. Demand
  3. Choice

Basically, there is a scarcity of resources (factors of production) to meet the limitless demand of human being. Due to scarcity of resources (factors of production), considerable care must be taken in choosing the way resources (factors of production) are to be allocated. Since resources (factors of production) can be used in many ways, the question that needs to be asked is: What is the best use of these resources (factors of production) to meet limitless demand of human being?. Some economy gurus refer to economics as the science of choice, others economists refer to it as a dismal science because its essential problem is scarcity. Economics is a study of the allocation of scarce resources (factors of production) that have alternative uses to satisfy the limitless demand of human being.

Maritime Economics is the application of economic analysis to all the functions involved in moving goods and people by sea. McConville, in his book Economics of Maritime Transport 1999 edition, defined Maritime Economics as a field of study concerned with the manner in which scarce productive resources are used to bridge the spatial separation of international trading countries most effectively. Maritime Economics is a broad the subject with imprecise boundaries.

Resources (Factors of Production):

Economists call resources ‘factors of production’. Due to the shortage of resources (factors of production), scarcity arises. Resources (factors of production) are defined as anything else needed to produce goods such as raw materials, services, infrastructure, capital, work force. All resources (factors of production) are combined together in an economy to produce a range of goods and services to satisfy demand. Generally, resources (factors of production) are divided into:

  1. Land
  2. Labor
  3. Capital
  4. Enterprise

1. Land: comprises space required for production of goods and services. Land also comprises raw materials and natural resources (gifts of nature). Natural resources include mineral deposits such as oil, coal, iron ore, agricultural land, forests and building sites. Natural resources are in limited quantities.

2. Labor: is fundamental factor of production. Labor comprises both human physical effort, skill and intellectual power. Labor is defined as human being’s physical and mental contribution to production of goods and services. Quantity and Quality of labor will vary in every country. At any given time, labor is limited in both quality and quantity wise. Quantity and Quality of labor depend on:

  • Age profile of a country
  • Educational opportunities in country
  • Political, social and cultural structure of a country

3. Capital: is created by the use of resources to increase the value or productivity of land and labor. Capital comprises financial capital and stock of all material goods used in production. Capital goods are not usually wanted for their own sake, rather for the contribution they make to production, such as stock of machines, equipment, buildings, roads, coal mines, oil wells, ships.

4. Enterprise: combines Land, Labor and Capital into one working production process. Without Enterprise, production might not be possible. Enterprise provides a better organization, as production processes have become more and more complex. Entrepreneurs provide the structure for production and brings together Land, Labor and Capital.

Total stock of resources (factors of production) determines what an economy can produce. Every country has varying resources (factors of production). Generally, in every country, proportion of resources (factors of production) used in production process usually depends upon which resources (factors of production) are most abundant, hence cheap. For example, in United States, most abundant and cheap resource (factors of production) is the Capital for building of transport infrastructure. On the other hand, in China, it will more likely be built using large amounts of Labor which the most abundant and least expensive resource (factors of production). Another example, in shipping business, Labor accounts for 40%-50% of the cost of building a new ship. In the last decade, one reason why shipbuilding has shifted from Japan and Korea to China, is due to the average shipyard wage in China being one-tenth (1/10) that of Korea which is a significant competitive advantage.

Resource (Factors of Production) Example in Shipping Business:

Shipowner ordering a new ship at a shipyard will need to have money to pay for this new-building order. Hence, shipowner will be using one factor of production: capital. Shipyard need the facilities to build the ship in other words more capital. All the buildings and slipways in the shipyard physically exist, which means they use the other factor of production: land. Apart of the physical buildings, shipyard will also need manpower: labor. Modern ships are very complicated pieces of machinery and their construction requires a high level of expertise, careful planning, management and co-ordination: enterprise.

Resources (Factors of Production) are used in production to create what economists call utility. This is attributed to any commodity capable of creating human satisfaction. Power of goods or services to give pleasure, satisfaction or what is termed real need fulfillment. Purely subjective idea incapable of direct measurement. Objective of the process of production is to increase the amount of goods and services available to satisfy human desire, that is, to create utility. For example, when you buy a product or service and say it is value for money, what you are really saying is that the utility you have obtained from the good or service purchased was worth at least the price you paid. If instead, you feel that something is a bargain, what you are saying is that you value this product more than the price that you paid for it; you would have been prepared to pay more, but you did not need to. A bargain therefore illustrates the difference between price and utility (what you subjectively feel that the product is worth to you).

Shipping business is an important element in the process of creating utility. Shipping is involved in creating utility in a number of ways:

  • Place Utility: accessibility of goods at a certain place such as potatoes shipped from Mexico to a grocery shop in New York.
  • Time Utility: accessibility of goods at a certain time such as heating oil from Saudi Arabia to the storage tank of a small house in Tokyo in midwinter.

Shipping is a major factor in creating utility and other forms of utility are also contributed to by shipping such as the act of providing service and act of exchange.

Real Prices Vs Nominal Prices

In economics, if a comparison is made in monetary terms over different periods, face value (nominal value) will lead to wrong conclusions. Nominal values do not take changes in price (inflation) into consideration. Due to inflation the most recent values will often be the highest, but will not necessarily be the largest if we compensate for inflation. Values obtained after corrections for inflation are known as real values. In order to calculate the nominal value (N) of a commodity, we multiply the price (P) for a unit of that commodity and the quantity (Q).

Nominal Value = Ni= Pi x Qi

In order to calculate of the real value, we need a price index for every year we are comparing. We divide the nominal value in a specific year (t) by the price index of the same year (Pt).

Real Value = Rit = Nit / Pt = (Pit x Qit) / Pt

Opportunity Cost

Scarcity of resources (factors of production) and insatiable demand forces the making of choices. Every time a choice is made something must be foregone or sacrificed. For example, in an economy which can only produce two goods, cars or gain, car factories will use a certain amount of the available resources (factors of production). In other words, they cannot be used in the production of grain. So, an amount of grain that could have been produced has been foregone. Assume that grain is the best alternative to cars using the same amount of resources (factors of production) available. Opportunity foregone or sacrificed by the use of resources in one way rather than another is the central idea of cost in economics. Opportunity or Alternative Cost doctrine defines the utility of what has been produced, in our example, cars, by measuring the utility of the best alternative production given up, which is grains. Opportunity Cost, the cost of producing a unit of A is the utility of the unit of B that as a result must be given up.

Price Mechanism

Price mechanism is a central feature of price theory (how prices are set). Two basic components of the price mechanism are demand and supply. Demand and supply are governed by what are known as economic laws:

1 – Law of Demand: Demand for goods or services falls when the price increases. Demand for goods or services rises when price decreases, all other things being equal. Demand and price are inversely related.

2 – Law of Supply: Higher the price the greater the quantity supplied by the producer. Lower the price the smaller the quantity the producer will supply, all other things being equal. Supply of goods increases or decreases in relation to the increase or decrease of the price. Price and quantity supplied are directly related.

Other things being equal: is used to isolate or concentrate on particular effects, as it is impossible to study all economic changes at the same time. In the present case, it is only possible to concentrate on the relationship between supply and demand of a commodity and its price or price changes by assuming all other influences remain unchanged. It isolates the effect of any changes that are being examined by holding all other relevant factors constant.

Demand

Demand in economics is not just want, need or desire. Demand is need, want, desire that is backed up by willingness and ability to pay the price. Hence, it is called as effective demand, but it is generally referred to simply as demand. Demand expresses the quantity of a commodity which consumers are prepared to buy over a range of prices. Two factors of primary interest are the price and quantity demanded. Here below is an example of international cruise market. Demand schedule records how much consumers are prepared to pay at different price levels.

Price ($) Quantity Demanded (D)  (D1) (D2)
15,000 9,000 10,000 7,000
14,000 10,000 12,000 8,000
13,000 12,000 15,000 10,000
12,000 15,000 18,000 12,000
10,000 20,000 22,000 15,000
  9,000 25,000 27,000 16,000
  1. Market demand schedule for cruises shipping
  2. New higher level of demand (D1)
  3. New lower level of demand (D2)

Here above demand schedule serves to illustrate the law of demand. As price ($) falls in column one, the quantity demanded increases in column two (D) and vice versa. For example, at Price ($) level $13,000, quantity demanded is 12,000. Here above demand schedule for cruise ship example gives the different quantities demanded at six selected price levels.

Negative slope for the demand curve (down to the right), reflects the demand and price/quantity relationships. Negative slope illustrates that a reduction in price leads to an increase in the quantity demanded. An increase in the price results in a fall in the quantity demanded. Higher the price the lower the quantity demanded and vice versa. Other factors have to be assumed to remain constant. Other factors that affect the levels of demand are:

  • Income

Generally, it is expected that any change in income will create a change in demand. If people have more income (money), people buy more. If income falls, people buy less. An increase in income has been a factor raising the demand.

  • Taste

Taste represents all other factors which influence demand. There might be many influences on taste and taste can change quite suddenly. Like, a serious disaster involving a cruise ship would change demand levels.

Prices of other commodities are often interrelated. Change in the price of one commodity might well influence the level of demand for another commodity. For example, in respect of complementary goods and substitutes goods.

  • Price of complementary goods: goods are a complement if consumers purchase them jointly with another product like sugar and tea, milk and coffee. In our cruise ship example above, change in air fares might have a positive or negative effect on the demand for cruise trips if there is air link.
  • Price of substitute goods: goods is a substitute if consumers purchase it instead of another product. If price increases for one product, triggers the demand increases for the substitute product, it is a substitute If one good has many substitutes, then it is very sensitive to price change. In our cruise example, if prices of other holiday packages change, this would have an impact on the cruise ship.

When there is a rise in income, this would create an increase in demand, all other things being equal. On our cruise ship example above, this is shown in column three of the table (New higher level of demand D1). Income rise effect would be to shift the demand curve to the right as shown in figure below, from D to D1. A reduction in income would cause the demand to fall, all other things being equal. On our cruise ship example above, this is shown in column four of the table (New lower level of demand D4). Income reduction effect would be to shift the demand curve to the left as shown in figure below, from D to D2.

Two distinct movements in demand curve.

  • Movement along the curve in any direction known as changes in the quantity
  • Shift of the whole curve bodily to left or right is known as a shift in conditions of demand.

Supply

Supply refers to the quantity of a product that will be offered on the market at a given price during a particular time period. Law of supply states that more of a commodity will be supplied at a higher price than at a lower one, assumption that the market is a perfectly competitive one. Cruise ship industry does not fit this model perfectly, but cruise ship is still a useful model to develop because it impinges directly upon the final consumer. Here below supply schedule shows the different quantities the sellers are willing to offer on the market at various prices at a given time.

 

Price ($) Quantity Supplied (S) (S1) (S2)
15,000 25,000 27,000 21,000
14,000 20,000 22,000 17,000
13,000 18,000 20,000 15,000
12,000 15,000 18,000 12,000
10,000 12,000 15,000 10,000
9,000 10,000 12,000 8,000
  1. Market supply schedule
  2. Increase in quantity supplied passenger trips (S1)
  3. Decrease in quantity supplied passenger trips (S2)

Supply schedule serves to illustrate the law of supply. As price ($) increases in column one the suppliers (cruise companies in our example) increase the numbers of trips offered, as shown in column two. On our cruise ship example above, for example, at a price of $14,000, cruise companies supply 20,000 trips are supplied.

Positive slope of the supply curve (upward to the right), reflects the law of supply and the direct relationship of price to quantity. Positive slope illustrates that an increase in the price of leads to an increase in the quantity supplied, all other things being equal. Fall in the price means a fall in the quantity offered. On the supply curve here below, at price $10,000 per trip the quantity supplied is 12,000 trips. When price has increased to $14,000, quantity offered increased to 20,000 trips. Supply schedule is based on the assumption that during the period under consideration the assumptions underlying the schedule remains constant. Factors affecting supply:

  • Costs of resources (factors of production): changes in costs resources (factors of production) would influence the quantity supplied at any particular price. For example, in our cruise ship example above, major change in crew costs would change cruise trips offered.
  • Changes in the method of production: new technologies or inventions can reduce costs of production so suppliers reduce price. For example, in our cruise ship example above, new invention in engine or hull design would trigger to lower cruise price.
  • Inventory or stock levels: when suppliers have substantial inventory (stock) of product, suppliers lower the prices. For example, in our cruise ship example above, if there is a substantial amount of cruise ship is laid up or under-utilized, cruise shipowners might accept lower prices or offer discounts.
  • Expectations of future price: when there is an expectation of a rise in price of a good, supplier become reluctant to sell. For example, in our cruise ship example above, suppliers (cruise shipowners) may be reluctant to sell tickets for their next cruise, if they expect market price rise due to holiday season or if cruise shipowner expect a fall in bunker prices, all things being equal.

On market supply schedule above, increase in quantity supplied passenger trips (S1) is shown in column three and Decrease in quantity supplied passenger trips (S2) is shown in column four. Here below figure shows supply curve shifts to the right (S1) or left (S2).

When supply curve (S) shifted to the right S1, 15,000 trips are supplied at the price of $10,000, and 18,000 trips are offered if the price is $12,000. When supply curve (S) shifted to the left S2, decrease in quantity supplied passenger trips (S2). On new curve S2, supply will be less at any possible price, compared to the original curve S. Two different and distinct movements in supply:

  • Movement along supply curve in any direction is known as changes in the quantity supplied.
  • Shift of the whole curve to the left or the right is known as change in conditions of supply.

Neither demand nor supply can by themselves decide the market price of any product. Individually, demand and supply only indicate consumers’ and suppliers’ intentions. Next stage is to bring the intentions into reality, so demand and supply must be combined in a single schedule here below.

 

Price Per Passenger ($) Quantity Demand (D) Quantity Supplied (S) Passenger

Shortage

Trips

Surplus

Market Pressure
15,000 9,000 25,000 14,000 Downward
14,000 10,000 20,000 10,000 Downward
13,000 12,000 18,000 6,000 Downward
12,000 15,000 15,000 0 0 Equilibrium
10,000 20,000 12,000 8,000 Upward
9,000 23,000 11,000 14,000 Upward
8,000 25,000 10,000 15,000 Upward

* Cruise market demand and supply equilibrium

We should bring together demand and supply schedules, in order to observe market price.

  • Column one is a list of prices ($) a cruise passenger could be asked to pay.
  • Column two is the quantity passengers would demand (D) at those different price levels.
  • Column three is the quantity cruise operators would offer (S) at different price levels.
  • Columns four and five highlight the differences between demand and supply.

When we observe the table of our cruise ship example above, we can easily see that, at the higher prices there is a positive difference or an excess of quantity supplied. At the lower prices there is a negative difference or an excess of demand. At the price of $12,000, intention of passengers and cruise operators are exactly matched. A price where there is neither an excess of supply nor demand is known as the equilibrium price or market clearing price. Equilibrium price is the point where the opposing forces of demand and supply are in perfect balance and there is no net tendency for market prices to change.

Equilibrium price is a point where the quantity demanded of a commodity equals the quantity supplied, causing market clearance. Once equilibrium price is obtained, there will be a tendency for the equilibrium point to persist. Changes in equilibrium price will only occur if the basic conditions of either demand or supply (or both) are disturbed.

On price market model above, individual demand curve and supply curve are brought together. In our cruise ship example above, demand curve shows the passengers’ intentions or plans to purchase at each level of price, following the law of demand. As prices fall, the quantity demanded increases. The curve slopes downwards from left to right. Supply curve shows the quantity cruise operators plan to sell at each level of price. Law of supply, suppliers offer more at a higher price. Supply curve moves upwards from left to right. Only at an equilibrium price of $12,000 are the intentions of the passengers and cruise operators (suppliers) exactly matched.

  • At a price above $12,000 there is a surplus and market pressures force prices to fall. Suppliers will withdraw from the market.
  • At prices below the equilibrium value, there is a shortage and market pressure force prices to rise. Quantity demanded will fall while the quantity supplied will increase, reducing the excess of demand over supply. Excess demand disappears at $12,000.

Here above market price model, equilibrium price is P with quantity Q.

  • At the higher price P1, quantity demanded stands at Q1 and quantity supplied is Q2. There is an excess of quantity supplied over the quantity demanded at price P1 which creates downward pressure on the price, forcing it towards equilibrium price P. Comparing P to P1, less is supplied but more is consumed. These two processes both help to eliminate the excess supply that exists.
  • At the lower price P2, the quantity supplied would be Q3, while buyers wish to purchase Q4. This means that at price P2, there is an excess of quantity demanded over the quantity supplied. A shortage exists at price P2, and pressure will be built up to force the price up, to return to market equilibrium P.

Market price model described above is the simplest possible model of competitive market price determination. This is a static model, in other words, effects of shifts in supply and demand on the model are not really considered. Indeed, there is an assumption that all transactions that take place in the market do so only at the equilibrium price (P). No transactions are permitted to take place at disequilibrium prices. This static model is a useful model in many ways, but it also has some drawbacks. Biggest drawback of this static model is failure to allow for the fact that there may be a considerable period of time for the required adjustments in supply to take place. For example, the shipping markets went through a crisis of severe overcapacity of tonnage in the early 1980s and 2010s. Over capacity problem did not resolve itself for several years.

Example of Price Mechanism for demand and supply in shipping business:

When there are several ships available to carry one cargo (excess supply), the freight rate will be low as shipowners compete by lowering freight rate. On the other hand, when there are several cargoes for one ship (excess demand) the freight rate will be higher as charterers try to insure transport for their cargoes by offering higher rates. In the long term, when shipowners observe the first case (excess supply) in a systematic way, shipowners will order fewer ships in an effort to limit the supply of shipping capacity and over time push rates higher: at low prices, shipping capacity gets limited. On the other hand, when shipowners find themselves systematically in the second case (excess demand), high freight rates will encourage shipowners to order more ships and increase shipping capacity. Over time, this will stabilize and possibly reduce rates.