The ability of people to undertake economic transactions with people in other countries free from any restraints imposed by governments or other regulators. Measured by the volume of imports and exports, world trade has become increasingly free in the years since the second world war. A fall in barriers to trade, as a result of the general agreement on tariffs and trade and its successor, the world trade organization, has helped stimulate this growth. The volume of world merchandise trade at the start of the 21st century was about 17 times what it was in 1950, and the world's total output was not even six times as big. The ratio of world exports to GDP had more than doubled since 1950. Of this, trade in manufactured goods was worth three times the value of trade in services, although the share of services trade was growing fast.
For economists, the benefits of free trade are explained by the theory of comparative advantage, with each country doing those things in which it is comparatively more efficient. As long as each country specializes in products in which it has a comparative advantage, trade will be mutually beneficial. Some critics of free trade argue that trade with developing countries, where wages are usually lower and working hours longer than in developed countries, is unfair and will wipe out jobs in high-wage countries. They want autarky or fair trade.
Real-world trade patterns sometimes seem to challenge the theory of comparative advantage (see new trade theory). Most trade occurs between countries that do not have huge cost differences. The biggest trading partner of the United States, for instance, is Canada. Well over half the exports from France, Germany and Italy go to other European Union countries. Moreover, these countries sell similar things to each other: cars made in France are exported to Germany, and German cars go to France. The main reason seems to be cross-border differences in consumer tastes. But the agricultural exports of Australia, say, or Saudi Arabia’s reliance on oil, do clearly stem from their particular stock of natural resources. Also poorer countries often have more unskilled labor, so they export simple manufactures such as clothing.
Friday, January 15, 2010
GDP
Gross domestic product, a measure of economic activity in a country. It is calculated by adding the total value of a country's annual output of goods and services. GDP = private consumption + investment + public spending + the change in inventories + (exports - imports). It is usually valued at market prices; by subtracting indirect tax and adding any government subsidy, however, GDP can be calculated at factor cost. This measure more accurately reveals the income paid to factors of production. Adding income earned by domestic residents from their investments abroad, and subtracting income paid from the country to investors abroad, gives the country's gross national product (GNP).
The effect of inflation can be eliminated by measuring GDP growth in constant real prices. However, some economists argue that hitting a nominal GDP target should be the main goal of macroeconomic policy. This is because it would remind policymakers to take into account the effect of their decisions on inflation, as well as on growth. GDP can be calculated in three ways. The income method adds the income of residents (individuals and firms) derived from the production of goods and services. The output method adds the value of output from the different sectors of the economy. The expenditure method totals spending on goods and services produced by residents, before allowing for depreciation and capital consumption. As one person's output is another person's income, which in turn becomes expenditure, these three measures ought to be identical. They rarely are because of statistical imperfections. Furthermore, the output and income measures exclude unreported economic activity that takes place in the black economy but that may be captured by the expenditure measure.
GDP is disliked as an objective of economic policy by some because it is not a perfect measure of welfare. It does not include aspects of the good life such as some leisure activities. Nor does it include economically valuable activities that are not paid for, such as parents teaching their children to read. But it does include some things that lower the quality of life, such as activities that damage the environment.
The effect of inflation can be eliminated by measuring GDP growth in constant real prices. However, some economists argue that hitting a nominal GDP target should be the main goal of macroeconomic policy. This is because it would remind policymakers to take into account the effect of their decisions on inflation, as well as on growth. GDP can be calculated in three ways. The income method adds the income of residents (individuals and firms) derived from the production of goods and services. The output method adds the value of output from the different sectors of the economy. The expenditure method totals spending on goods and services produced by residents, before allowing for depreciation and capital consumption. As one person's output is another person's income, which in turn becomes expenditure, these three measures ought to be identical. They rarely are because of statistical imperfections. Furthermore, the output and income measures exclude unreported economic activity that takes place in the black economy but that may be captured by the expenditure measure.
GDP is disliked as an objective of economic policy by some because it is not a perfect measure of welfare. It does not include aspects of the good life such as some leisure activities. Nor does it include economically valuable activities that are not paid for, such as parents teaching their children to read. But it does include some things that lower the quality of life, such as activities that damage the environment.
Government
There are few more hotly debated topics in economics than what role the state should play in the economy. Plenty of economists provided intellectual support for state intervention during the era of big government, particularly from the 1930s to the 1980s. Keynesians argued that the state should manage the amount of demand in the economy to maintain full employment. Others advocated a command economy, in which the government would decide price levels, oversee the allocation of scarce resources and run the most important parts of the economy (the "commanding heights") or, in communist countries, the entire economy. The role of the state increased at the expense of market forces. Economists provided plenty of examples of market failure that seemed to justify this.
Since the 1950s, there has been growing evidence that government intervention can also be flawed, and can often impose even greater costs on an economy than market failure. One reason is that when a government acts, it usually does so as a monopoly, with all the attendant economic inefficiencies this implies.
In practice, policies of Keynesian demand management often resulted in inflation, and thus lost much of their credibility. There was growing concern that public investment was crowding out superior private investment, and that other public spending on things such as health care, education and pensions was similarly discouraging private provision. Government management of commercial enterprises was often seen to be inefficient and, starting in the 1980s, nationalization gave way to privatization. Even when the state was not directly responsible for economic activity, but instead set the rules governing private behavior, there was evidence of regulatory failure. High rates of taxation started to discourage people and companies from undertaking economic activities that would, without the tax, have been profitable; wealth creation suffered.
Most economists agree that there is a need for some government role in the economy. A market economy can function only if there is an adequate legal system, and, in particular, clearly defined, enforceable property rights. The legal system is probably an example of what economists call a public good (although the existence in many countries and industries of some self-regulation shows it is not always so).
Although politicians in many countries spent most of the period since 1980 talking about the need to reduce the role of the state in the economy, and in many cases introduced policies of privatization, deregulation and liberalization to help this happen, public spending has continued to increase as a share of GDP. Within the OECD, public spending accounted for a larger slice of GDP in 2002 than in 1990, which was in turn higher than in 1980. Indeed, it has risen during every decade since the start of the 20th century. One reason was that governments had to honor spending commitments on pensions and health care made by previous generations of politicians.
Since the 1950s, there has been growing evidence that government intervention can also be flawed, and can often impose even greater costs on an economy than market failure. One reason is that when a government acts, it usually does so as a monopoly, with all the attendant economic inefficiencies this implies.
In practice, policies of Keynesian demand management often resulted in inflation, and thus lost much of their credibility. There was growing concern that public investment was crowding out superior private investment, and that other public spending on things such as health care, education and pensions was similarly discouraging private provision. Government management of commercial enterprises was often seen to be inefficient and, starting in the 1980s, nationalization gave way to privatization. Even when the state was not directly responsible for economic activity, but instead set the rules governing private behavior, there was evidence of regulatory failure. High rates of taxation started to discourage people and companies from undertaking economic activities that would, without the tax, have been profitable; wealth creation suffered.
Most economists agree that there is a need for some government role in the economy. A market economy can function only if there is an adequate legal system, and, in particular, clearly defined, enforceable property rights. The legal system is probably an example of what economists call a public good (although the existence in many countries and industries of some self-regulation shows it is not always so).
Although politicians in many countries spent most of the period since 1980 talking about the need to reduce the role of the state in the economy, and in many cases introduced policies of privatization, deregulation and liberalization to help this happen, public spending has continued to increase as a share of GDP. Within the OECD, public spending accounted for a larger slice of GDP in 2002 than in 1990, which was in turn higher than in 1980. Indeed, it has risen during every decade since the start of the 20th century. One reason was that governments had to honor spending commitments on pensions and health care made by previous generations of politicians.
Growth
What economic activity is all about, but how can it be made to happen? Economists have plenty of theories, but none of them has all the answers.
Adam Smith attributed growth to the invisible hand, a view shared by most followers of classical economics. Neo-classical economics had a different theory of growth, devised by Robert Solow during the 1950s. This argued that a sustained increase in investment increases an economy's growth rate only temporarily: the ratio of capital to labor goes up, the marginal product of capital declines and the economy moves back to a long-term growth path. Output will then increase at the same rate as the growth in the workforce (quality-adjusted, in later versions) plus a factor to reflect improvements in productivity.
This theory predicts specific relationships among some basic economic statistics. Yet some of these predictions fail to fit the facts. For example, income disparities between countries are greater than the differences in their savings rates would suggest. Moreover, although the model says that economic growth ultimately depends on the rate of technological change, it fails to explain exactly what determines this rate. Technological change is treated as exogenous.
Some economists argued that doing this ignored the main engine of growth. They developed a new growth theory, in which improvements in productivity were endogenous, meaning that they were the result of things taking place within the economic model being used and not merely assumed to happen, as in the neo-classical models. Endogenous growth was due, in particular, to technological innovation and investments in human capital. In looking for explanations for differences in rates of growth, including between rich and developing countries, the new growth theory concentrates on what the incentives are in an economy to create additional human capital and to invent new products.
Factors determining these incentives include government policies. Countries with broadly free-market policies, in particular free trade and the maintenance of secure property rights, typically have higher growth rates. Open economies have grown much faster on average than closed economies. Higher public spending relative to GDP is generally associated with slower growth. Also bad for growth are high inflation and political instability.
As countries grew richer during the 20th century annual growth rates declined, as a result of diminishing returns to capital. By 1990, most developed countries reckoned to have long-term trend growth rates of 2-2.5% a year. However, during the 1990s, growth rates started to rise, especially in the United States. Some economists said this was the result of the birth of a new economy based on a revolution in productivity, largely because of rapid technological innovation but also (perhaps directly stemming from the spread of new technology) to increases in the value of human capital
Adam Smith attributed growth to the invisible hand, a view shared by most followers of classical economics. Neo-classical economics had a different theory of growth, devised by Robert Solow during the 1950s. This argued that a sustained increase in investment increases an economy's growth rate only temporarily: the ratio of capital to labor goes up, the marginal product of capital declines and the economy moves back to a long-term growth path. Output will then increase at the same rate as the growth in the workforce (quality-adjusted, in later versions) plus a factor to reflect improvements in productivity.
This theory predicts specific relationships among some basic economic statistics. Yet some of these predictions fail to fit the facts. For example, income disparities between countries are greater than the differences in their savings rates would suggest. Moreover, although the model says that economic growth ultimately depends on the rate of technological change, it fails to explain exactly what determines this rate. Technological change is treated as exogenous.
Some economists argued that doing this ignored the main engine of growth. They developed a new growth theory, in which improvements in productivity were endogenous, meaning that they were the result of things taking place within the economic model being used and not merely assumed to happen, as in the neo-classical models. Endogenous growth was due, in particular, to technological innovation and investments in human capital. In looking for explanations for differences in rates of growth, including between rich and developing countries, the new growth theory concentrates on what the incentives are in an economy to create additional human capital and to invent new products.
Factors determining these incentives include government policies. Countries with broadly free-market policies, in particular free trade and the maintenance of secure property rights, typically have higher growth rates. Open economies have grown much faster on average than closed economies. Higher public spending relative to GDP is generally associated with slower growth. Also bad for growth are high inflation and political instability.
As countries grew richer during the 20th century annual growth rates declined, as a result of diminishing returns to capital. By 1990, most developed countries reckoned to have long-term trend growth rates of 2-2.5% a year. However, during the 1990s, growth rates started to rise, especially in the United States. Some economists said this was the result of the birth of a new economy based on a revolution in productivity, largely because of rapid technological innovation but also (perhaps directly stemming from the spread of new technology) to increases in the value of human capital
Hedge
Reducing your risks. Hedging involves deliberately taking on a new risk that offsets an existing one, such as your exposure to an adverse change in an exchange rate, interest rate or commodity price. Imagine, for example, that you are British and you are to be paid $1m in three months’ time. You are worried that the dollar may have fallen in value by then, thus reducing the number of pounds you will be able to convert the $1m into. You can hedge away that currency risk by buying $1m of pounds at the current exchange rate (in effect) in the futures market. Hedging is most often done by commodity producers and traders, financial institutions and, increasingly, by ¬non-financial firms.
It used to be fashionable for firms to hedge by following a policy of diversification. More recently, firms have hedged using financial instruments and derivatives. Another popular strategy is to use “natural” hedges wherever possible. For example, if a company is setting up a factory in a particular country, it might finance it by borrowing in the currency of that country. An extension of this idea is operational hedging, for example, relocating production facilities to get a better match of costs in a given currency to revenue.
Hedging sounds prudent, but some economists reckon that firms should not do it because it reduces their value to shareholders. In the 1950s, two economists, Merton miller (1923–2000) and Franco Modigliani argued that firms make money only if they make good investments, the kind that increase their operating cash flow. Whether these investments are financed through debt, equity or retained earnings is irrelevant. Different methods of financing simply determine how a firm’s value is divided between its various sorts of investors (for example, shareholders or bondholders), not the value itself. This surprising insight helped win each of them a Nobel Prize. If they are right, there are big implications for hedging. If methods of financing and the character of financial risks do not matter, managing them is pointless. It cannot add to the firm’s value; on the contrary, as hedging does not come free, doing it might actually lower that value. Moreover, argued Messrs Miller and Modigliani, if investors want to avoid the financial risks attached to holding shares in a firm, they can diversify their portfolio of shareholdings. Firms need not manage their financial risks; investors can do it for themselves. Few managers agree.
It used to be fashionable for firms to hedge by following a policy of diversification. More recently, firms have hedged using financial instruments and derivatives. Another popular strategy is to use “natural” hedges wherever possible. For example, if a company is setting up a factory in a particular country, it might finance it by borrowing in the currency of that country. An extension of this idea is operational hedging, for example, relocating production facilities to get a better match of costs in a given currency to revenue.
Hedging sounds prudent, but some economists reckon that firms should not do it because it reduces their value to shareholders. In the 1950s, two economists, Merton miller (1923–2000) and Franco Modigliani argued that firms make money only if they make good investments, the kind that increase their operating cash flow. Whether these investments are financed through debt, equity or retained earnings is irrelevant. Different methods of financing simply determine how a firm’s value is divided between its various sorts of investors (for example, shareholders or bondholders), not the value itself. This surprising insight helped win each of them a Nobel Prize. If they are right, there are big implications for hedging. If methods of financing and the character of financial risks do not matter, managing them is pointless. It cannot add to the firm’s value; on the contrary, as hedging does not come free, doing it might actually lower that value. Moreover, argued Messrs Miller and Modigliani, if investors want to avoid the financial risks attached to holding shares in a firm, they can diversify their portfolio of shareholdings. Firms need not manage their financial risks; investors can do it for themselves. Few managers agree.
House prices
When they go through the roof it is usually a warning sign that an economy is overheating. House prices often rise after interest rate reductions, which lower mortgage payments and thus give buyers the ability to fund a larger amount of borrowing and so offer a higher price for their new home. Strangely, people often regard house-price inflation as good news, even though it creates as many losers as gainers. They argue that rising house prices help to boost consumer confidence, and are part of the wealth effect: as house prices rise, people feel wealthier and so spend more. However, against this must be set a negative wealth effect. An increase in house price makes many people worse off, such as first-time buyers and anyone planning to trade up to a better property.
As long as people think that their house is a vehicle for speculation, rather than merely accommodation, it seems inevitable that prices will be volatile, prone to a boom-bust cycle. As house prices rise, profits are made, tempting more speculative buyers into the market; eventually, they start to pay too much, interest rates rise, demand falls and prices plunge. People have also invested in housing as a hedge against inflation: house prices generally rise when other prices rise, whereas the real value of mortgage debt is eroded by inflation. However, when mortgage interest rates are variable (as they generally are in the UK) rather than fixed (as in the united states), they may rise painfully during times of high inflation as a result of macroeconomic policy efforts to slow the pace of economic growth.
One of the reasons why the united states has long-term fixed mortgage rates is the financing provided by government-sponsored agencies such as the federal national mortgage association and the federal home loan mortgage corporation, nicknamed, respectively, Fannie Mae and Freddie Mac. Economists increasingly debate their role, especially as they have grown into some of the world's largest lenders. Supporters claim that, as well as reducing macroeconomic volatility, they make housing more affordable, particularly for poorer people, and that other governments should play a similar role in the mortgage market. Critics say they have become a huge potential risk in the global financial system by creating a moral hazard through the controversial but widespread belief that if they were to get into difficulties the government would bail them out and, thus, their financial counterparties.
As long as people think that their house is a vehicle for speculation, rather than merely accommodation, it seems inevitable that prices will be volatile, prone to a boom-bust cycle. As house prices rise, profits are made, tempting more speculative buyers into the market; eventually, they start to pay too much, interest rates rise, demand falls and prices plunge. People have also invested in housing as a hedge against inflation: house prices generally rise when other prices rise, whereas the real value of mortgage debt is eroded by inflation. However, when mortgage interest rates are variable (as they generally are in the UK) rather than fixed (as in the united states), they may rise painfully during times of high inflation as a result of macroeconomic policy efforts to slow the pace of economic growth.
One of the reasons why the united states has long-term fixed mortgage rates is the financing provided by government-sponsored agencies such as the federal national mortgage association and the federal home loan mortgage corporation, nicknamed, respectively, Fannie Mae and Freddie Mac. Economists increasingly debate their role, especially as they have grown into some of the world's largest lenders. Supporters claim that, as well as reducing macroeconomic volatility, they make housing more affordable, particularly for poorer people, and that other governments should play a similar role in the mortgage market. Critics say they have become a huge potential risk in the global financial system by creating a moral hazard through the controversial but widespread belief that if they were to get into difficulties the government would bail them out and, thus, their financial counterparties.
Inflation
Rising prices, across the board. Inflation means fewer bangs 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 industrialized 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 minimize 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 stabilize 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.
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 minimize 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 stabilize 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.
Inflation target
The goal of monetary policy in many countries is to ensure that inflation is neither too high nor too low. It became fashionable during the 1990s to set a country's central bank an explicit rate of inflation to target. By 1998, some 54 central banks had an inflation target, compared with just eight at the end of 1990, the year in which New Zealand’s reserve bank became the first to be set a target. In most industrialized countries, the target, or, typically, the mid-point of a target range, for consumer-price inflation is between 1% and 2.5%. The reason it is not zero is that official price indices overstate inflation, and that the countries would prefer a little inflation to any deflation.
Monetary policy takes time to have an impact. So central banks usually base their policy changes on a forecast of inflation, not its current rate. If forecast inflation in two years' time, say, is above the target, interest rates are raised. If it is below target, rates are cut.
Why has an inflation target? Setting an inflation target usually goes hand-in-hand with allowing a central bank considerable discretion in setting policy, so transparency in its decision-making is vital and is therefore usually increased as part of the process of adopting a target. More fundamentally, by making it easier to judge whether policy is on track, an inflation target makes it easier to hold a central bank to account for its performance. The pay of central bankers can be designed to reward them for achieving the target. But some central bankers argue that an inflation target restricts their policy flexibility too much, which is one reason why the world's most powerful central bank, America’s federal reserve, has argued (so far successfully) against having one.
Monetary policy takes time to have an impact. So central banks usually base their policy changes on a forecast of inflation, not its current rate. If forecast inflation in two years' time, say, is above the target, interest rates are raised. If it is below target, rates are cut.
Why has an inflation target? Setting an inflation target usually goes hand-in-hand with allowing a central bank considerable discretion in setting policy, so transparency in its decision-making is vital and is therefore usually increased as part of the process of adopting a target. More fundamentally, by making it easier to judge whether policy is on track, an inflation target makes it easier to hold a central bank to account for its performance. The pay of central bankers can be designed to reward them for achieving the target. But some central bankers argue that an inflation target restricts their policy flexibility too much, which is one reason why the world's most powerful central bank, America’s federal reserve, has argued (so far successfully) against having one.
Innovation
A vital contributor to economic growth. The big challenge for firms and governments is to make it happen more often. Although nobody is entirely sure why innovation takes place, new theories of endogenous growth try to model the innovation process, rather than just assume it happens for unexplained, exogenous reasons. The role of incentives seems to be particularly important. Although some innovations are the result of scientists and others engaged in the noble pursuit of know¬ledge, most, especially their commercial applications are the result of entrepreneurs seeking profit. Joseph Schumpeter, a leading practitioner of Austrian economics, described this as a process of “creative destruction”. A firm innovates successfully and is rewarded with unusually high profits, which in turn encourages rivals to come up with a superior innovation.
To encourage innovation, innovators must be allowed to make a decent profit, otherwise they will not incur the risk and expense of trying to come up with useful innovations. Most countries have patents and other laws protecting intellectual property, which allow innovators to enjoy a (usually temporary) monopoly over their innovation. Economists disagree over how long that protection should last, given the inefficiencies that result from any monopoly.
For most of the second half of the 20th century, governments played a crucial role in funding and directing pure research and early-stage development. In the 1980s, however, legal changes in the United States started to reduce this role. One change aimed to move technological development out of the country’s state-financed national laboratories. Another allowed universities, not-for-profit research institutes and small businesses doing research under government contract to keep the technologies they had developed and to apply for patents in their own names. This appears to have contributed to a surge in innovation in the United States, as government researchers and university professors teamed up with outside firms, or started their own. Hoping for similar results, many other countries have followed suit.
Is innovation all it is cracked up to be, or is it just change for change’s sake? A few years ago, Robert Solow, a Nobel Prize-winning economist, observed that “you can see the computer age everywhere these days except in the productivity statistics”. Although new computer technology clearly had affected people and firms in visible and obvious ways, the slowdown in productivity growth that had afflicted the American economy since the 1970s did not appear to have been reversed. Believers in the new economy argued that the “Solow Paradox” no longer holds true; in the late 1990s, the computer revolution started to deliver the productivity growth long promised. Even so, this shows that innovation can take a long time to deliver the goods.
To encourage innovation, innovators must be allowed to make a decent profit, otherwise they will not incur the risk and expense of trying to come up with useful innovations. Most countries have patents and other laws protecting intellectual property, which allow innovators to enjoy a (usually temporary) monopoly over their innovation. Economists disagree over how long that protection should last, given the inefficiencies that result from any monopoly.
For most of the second half of the 20th century, governments played a crucial role in funding and directing pure research and early-stage development. In the 1980s, however, legal changes in the United States started to reduce this role. One change aimed to move technological development out of the country’s state-financed national laboratories. Another allowed universities, not-for-profit research institutes and small businesses doing research under government contract to keep the technologies they had developed and to apply for patents in their own names. This appears to have contributed to a surge in innovation in the United States, as government researchers and university professors teamed up with outside firms, or started their own. Hoping for similar results, many other countries have followed suit.
Is innovation all it is cracked up to be, or is it just change for change’s sake? A few years ago, Robert Solow, a Nobel Prize-winning economist, observed that “you can see the computer age everywhere these days except in the productivity statistics”. Although new computer technology clearly had affected people and firms in visible and obvious ways, the slowdown in productivity growth that had afflicted the American economy since the 1970s did not appear to have been reversed. Believers in the new economy argued that the “Solow Paradox” no longer holds true; in the late 1990s, the computer revolution started to deliver the productivity growth long promised. Even so, this shows that innovation can take a long time to deliver the goods.
Invisible hand
Adam Smith’s shorthand for the ability of the free market to allocate factors of production, goods and services to their most valuable use. If everybody acts from self-interest, spurred on by the profit motive, then the economy will work more efficiently, and more productively, than it would do were economic activity directed instead by some sort of central planner. It is, wrote smith, as if an “invisible hand” guides the actions of individuals to combine for the common good. Smith recognized that the invisible hand was not infallible, however, and that some government action might be needed, such as to impose antitrust laws, enforce property rights, and to provide policing and national defense.
Invisible trade
Exports and imports of things you cannot touch or see: services, such as banking or advertising and other intangibles, such as copyrights. Invisible trade accounts for a growing slice of the value of world trade.
J-curve
The shape of the trend of a country’s trade balance following a devaluation. A lower exchange rate initially means cheaper exports and more expensive imports, making the current account worse (a bigger deficit or smaller surplus). After a while, though, the volume of exports will start to rise because of their lower price to foreign buyers, and domestic consumers will buy fewer of the costlier imports. Eventually, the trade balance will improve on what it was before the devaluation. If there is a currency appreciation there may be an inverted j-curve.
Liberalization
A policy of promoting liberal economics by limiting the role of government to the things it can do to help the market economy work efficiently. This can include privatization and deregulation.
LIBOR
Short for London Interbank Offered Rate, the rate of interest that top-quality banks charge each other for loans. As a result, it is often used by banks as a base for calculating the interest rate they charge on other loans. Libor is a floating rate, changing all the time.
Life
Human life is priceless. But this has not stopped economists trying to put a financial value on it. One reason is to help firms and policymakers to make better decisions on how much to spend on costly safety measures designed to reduce the loss of life. Another is to help insurers and courts judge how much compensation to pay in the event of, say, a fatal accident.
One way to value a life is to calculate a person’s human capital by working out how much he or she would earn were they to survive to a ripe old age. This could result in very different sums being paid to victims of the same accident. After an air crash, probably more money would go to the family of a first-class passenger than to that of someone flying economy. This may not seem fair. Nor would using this method to decide what to spend on safety measures, as it would mean much higher expenditure on avoiding the death of, say, an investment banker than on saving the life of a teacher or coal miner. It would also imply spending more on safety measures for young people and being positively reckless with the lives of retired people.
Another approach is to analyze the risks that people are voluntarily willing to take, and how much they require to be paid for taking them. Taking into account differences in wages for high death-risk and low death-risk jobs, and allowing for differences in education, experience, and so on, it is possible to calculate roughly what value people put on their own lives. In industrialized countries, most studies using this method come up with a value of $5m–10m.
One way to value a life is to calculate a person’s human capital by working out how much he or she would earn were they to survive to a ripe old age. This could result in very different sums being paid to victims of the same accident. After an air crash, probably more money would go to the family of a first-class passenger than to that of someone flying economy. This may not seem fair. Nor would using this method to decide what to spend on safety measures, as it would mean much higher expenditure on avoiding the death of, say, an investment banker than on saving the life of a teacher or coal miner. It would also imply spending more on safety measures for young people and being positively reckless with the lives of retired people.
Another approach is to analyze the risks that people are voluntarily willing to take, and how much they require to be paid for taking them. Taking into account differences in wages for high death-risk and low death-risk jobs, and allowing for differences in education, experience, and so on, it is possible to calculate roughly what value people put on their own lives. In industrialized countries, most studies using this method come up with a value of $5m–10m.
Life-cycle hypothesis
An attempt to explain the way that people split their income between spending and saving, and the way that they borrow. Over their lifetime, a typical person’s income varies by far more than how much they spend. On average, young people have low incomes but big spending commitments: on investing in their human capital through education and training, building a family, buying a home, and so on. So they do not save much and often borrow heavily. As they get older their income generally rises, they pay off their mortgage, the children leave home and they prepare for retirement, so they sharply increase their saving and investment. In retirement, their income is largely or entirely from state benefits and the saving and investment they did when working; they spend most or all of their income, and, by selling off assets, often spend more than their income.
Broadly speaking, this theory is supported by the data, though some economists argue that young people do not spend as much as they should on, say, being educated, because lenders are reluctant to extend credit to them. One puzzle is that people often have substantial assets left when they die. Some economists say this is because they want to leave a generous inheritance for their relatives; others say that people are simply far too optimistic about how long they will live.
Broadly speaking, this theory is supported by the data, though some economists argue that young people do not spend as much as they should on, say, being educated, because lenders are reluctant to extend credit to them. One puzzle is that people often have substantial assets left when they die. Some economists say this is because they want to leave a generous inheritance for their relatives; others say that people are simply far too optimistic about how long they will live.
Liquidity
How easily an asset can be spent, if so desired. Cash is wholly liquid. The liquidity of other assets is usually less; how much less may be measured by the ease with which they can be exchanged for cash (that is, liquidated). Public financial markets try to maximize the liquidity of assets such as bonds and equities by providing a central meeting place (the exchange) in which would-be buyers and sellers can easily find each other. Financial market makers (middlemen such as investment banks) can also increase liquidity by using some of their capital to buy securities from those who want to sell, when there is no other buyer offering a decent price. They do this in the expectation that if they hold the asset for a while they will be able to find somebody to buy it. Typically, the higher the volume of trades happens in a marketplace, the greater is its liquidity. Moreover, highly liquid markets attract more liquidity-seeking traders, further increasing liquidity. In a similar way, there can be vicious cycles in which liquidity dries up. The amount of liquidity in financial markets can vary enormously from one moment to the next, and can sometimes evaporate entirely, especially if market makers become too risk averse to put their capital at risk in this way.
Liquidity preference
The proportion of their assets that firms and in¬dividuals choose to hold in varying degrees of ¬liquidity. The more cash they have, the greater is their desire for liquidity.
Liquidity trap
When monetary policy becomes impotent. Cutting the rate of interest is supposed to be the escape route from economic recession: boosting the money supply, increasing demand and thus reducing unemployment. But Keynes argued that sometimes cutting the rate of interest, even to zero, would not help. People, banks and firms could become so risk averse that they preferred the liquidity of cash to offering credit or using the credit that is on offer. In such circumstances, the economy would be trapped in recession, despite the best efforts of monetary policymakers.
Keynesians reckon that in the 1930s the economies of both the United States and the UK were caught in a liquidity trap. In the late 1990s, the Japanese economy suffered a similar fate. But monetarism has no place for liquidity traps. Monetarists pin the blame for the great depression and Japan’s more recent troubles on other factors and reckon that ways could have been found to make monetary policy work.
Keynesians reckon that in the 1930s the economies of both the United States and the UK were caught in a liquidity trap. In the late 1990s, the Japanese economy suffered a similar fate. But monetarism has no place for liquidity traps. Monetarists pin the blame for the great depression and Japan’s more recent troubles on other factors and reckon that ways could have been found to make monetary policy work.
Long run
When we are all dead, according to Keynes. Un¬impressed by the thrust of classical economics, which said that economies have a long-run tendency to settle in equilibrium at full employment, he wanted economists to try to explain why in the short run economies are so often in disequilibrium, or in equilibrium at high levels of unemployment.
Lump of labour fallacy
One of the best-known fallacies in economics is the notion that there is a fixed amount of work to be done – a lump of labor – which can be shared out in different ways to create fewer or more jobs. For instance, suppose that everybody worked 10% fewer hours. Firms would need to hire more workers. Hey presto, unemployment would shrink.
In 1891, an economist, D.F. Schloss, described such thinking as the lump of labor fallacy because, in reality, the amount of work to be done is not fixed. Government-imposed restrictions on the amount of work people may do be able to actually reduce the efficiency of the labor market, thereby increasing unemployment. Shorter hours will create more jobs only if weekly pay is also cut (which workers are likely to resist) otherwise costs per unit of output will rise. Not all labor costs vary with the number of hours worked. Fixed costs, such as recruitment and training, can be substantial, so it will cost a firm more to hire two part-time workers than one full-timer. Thus a cut in the working week may raise average costs per unit of output and cause firms to buy fewer total hours of labor. A better way to reduce unemployment may be to stimulate demand and so increase output; another is to make the labor market more flexible, not less.
In 1891, an economist, D.F. Schloss, described such thinking as the lump of labor fallacy because, in reality, the amount of work to be done is not fixed. Government-imposed restrictions on the amount of work people may do be able to actually reduce the efficiency of the labor market, thereby increasing unemployment. Shorter hours will create more jobs only if weekly pay is also cut (which workers are likely to resist) otherwise costs per unit of output will rise. Not all labor costs vary with the number of hours worked. Fixed costs, such as recruitment and training, can be substantial, so it will cost a firm more to hire two part-time workers than one full-timer. Thus a cut in the working week may raise average costs per unit of output and cause firms to buy fewer total hours of labor. A better way to reduce unemployment may be to stimulate demand and so increase output; another is to make the labor market more flexible, not less.
Lump-sum tax
A tax that is the same amount for everybody, regardless of income or wealth. Some economists argue that this is the most efficient form of taxation, as it does not distort incentives and thus it has no deadweight cost. This is because each person knows that whatever they do they will have to pay the same amount. It is also cheap to administer, as there is no complex process of measuring each person’s income and assets in order to calculate their tax bill. However, because rich and poor people pay the same, the tax may be perceived as unfair – as Margaret Thatcher found out when she introduced a lump-sum “poll tax”, a decision that was later to play a large part in her ousting as British prime minister.
Luxuries
Goods and services that have a high elasticity of demand. When the price of, say, a Caribbean holiday rises, the number of vacations demanded falls sharply. Likewise, demand for Caribbean holidays rises significantly as average income increases, certainly by more than demand for many normal goods. Contrast this with necessities, such as milk or bread, which people usually demand in quite similar quantities whatever their income and whatever the price.
Macroeconomic policy
Top-down policy by government and central banks, usually intended to maximise growth while keeping down inflation and unemployment. The main instruments of macroeconomic policy are changes in the rate of interest and money supply, known as monetary policy, and changes in taxation and public spending, known as fiscal policy. The fact that unemployment and inflation often rise sharply, and that growth often slows or GDP falls, may be evidence of poorly executed macro¬economic policy. However, business cycles may simply be an unavoidable fact of economic life that macroeconomic policy, however well conducted, can never be sure of conquering.
Macroeconomics
The big picture: analyzing economy-wide phenomena such as growth, inflation and unemployment. Contrast with microeconomics, the study of the behavior of individual markets, workers, households and firms. Although economists generally separate themselves into distinct macro and micro camps, macroeconomic phenomena are the product of all the microeconomic activity in an economy. The precise relationship between macro and micro is not particularly well understood, which has often made it difficult for a government to deliver well-run macroeconomic policy.
Manufacturing
Making things like cars or frozen food has shrunk in importance in most developed countries during the past half century as services have grown. In the United States and the UK, the proportion of workers in manufacturing has shrunk since 1900 from around 40% to barely 20%. More than two-thirds of output in OECD countries, and up to four-fifths of employment, is now in the services sector. At the same time, manufacturing has grown in importance in developing countries.
Many people think that manufacturing somehow matters more than any other economic activity and is in some way superior to surfing the internet or cutting somebody’s hair. This is prob¬ably nothing more than nostalgia for times past when making things in factories was what real men did, just as 150 years ago growing things in fields was what real men did. Mostly, the shift from manufacturing to services (as with the earlier shift from agriculture to manufacturing) reflects progress into jobs that create more utility, this time for real women as well as real men, which may explain why it is happening first in richer countries.
Many people think that manufacturing somehow matters more than any other economic activity and is in some way superior to surfing the internet or cutting somebody’s hair. This is prob¬ably nothing more than nostalgia for times past when making things in factories was what real men did, just as 150 years ago growing things in fields was what real men did. Mostly, the shift from manufacturing to services (as with the earlier shift from agriculture to manufacturing) reflects progress into jobs that create more utility, this time for real women as well as real men, which may explain why it is happening first in richer countries.
Marginal
The difference made by one extra unit of something. Marginal revenue is the extra revenue earned by selling one more unit of something. The marginal price is how much extra a consumer must pay to buy one extra unit. Marginal utility is how much extra utility a person gets from consuming (or doing) an extra unit of something. The marginal product of labour is how much extra output a firm would get by employing an extra worker, or by getting an existing worker to put in an extra hour on the job. The marginal propensity to consume (or to save) measures by how much a household’s consumption (savings) would increase if its income rose by, say, $1. The marginal tax rate measures how much extra tax you would have to pay if you earned an extra dollar.
The marginal cost (or whatever) can be very different from the average cost (or whatever), which simply divides total costs (or whatever) by the total number of units produced (or whatever). A common finding in microeconomics is that small incremental changes can matter enormously. In general, thinking “at the margin” often leads to better economic decision making than thinking about the averages.
Alfred Marshall, the father of neo-classical economics, based many of his theories of economic behavior on marginal rather than average behavior. For instance, given certain plausible assumptions, a profit-maximizing firm will increase production up to the point where marginal revenue equals marginal cost. This is because if marginal revenue exceeded marginal cost, the firm could increase its profit by producing an extra unit of output. Alternatively, if marginal cost exceeded marginal revenue, the firm could increase its profit by producing fewer units of output.
In all walks of life, a basic rule of rational economic decision making is: do something only if the marginal utility you get from it exceeds the marginal cost of doing it.
The marginal cost (or whatever) can be very different from the average cost (or whatever), which simply divides total costs (or whatever) by the total number of units produced (or whatever). A common finding in microeconomics is that small incremental changes can matter enormously. In general, thinking “at the margin” often leads to better economic decision making than thinking about the averages.
Alfred Marshall, the father of neo-classical economics, based many of his theories of economic behavior on marginal rather than average behavior. For instance, given certain plausible assumptions, a profit-maximizing firm will increase production up to the point where marginal revenue equals marginal cost. This is because if marginal revenue exceeded marginal cost, the firm could increase its profit by producing an extra unit of output. Alternatively, if marginal cost exceeded marginal revenue, the firm could increase its profit by producing fewer units of output.
In all walks of life, a basic rule of rational economic decision making is: do something only if the marginal utility you get from it exceeds the marginal cost of doing it.
Market capitalization
The market value of a company’s shares: the quoted share price multiplied by the total number of shares that the company has issued.
Market failure
When a market left to itself does not allocate resources efficiently. Interventionist politicians usually allege market failure to justify their interventions. Economists have identified four main sorts or causes of market failure.
• The abuse of market power, which can occur whenever a single buyer or seller can exert significant influence over prices or output.
• Externalities – when the market does not take into account the impact of an economic activity on outsiders. For example, the market may ignore the costs imposed on outsiders by a firm polluting the environment.
• Public goods, such as national defense. How much defense would be provided if it were left to the market?
• Where there is incomplete or asymmetric information or uncertainty.
Abuse of market power is best tackled through antitrust policy. Externalities can be reduced through regulation, a tax or subsidy, or by using property rights to force the market to take into account the welfare of all who are affected by an economic activity. The supply of public goods can be ensured by compelling everybody to pay for them through the tax system.
• The abuse of market power, which can occur whenever a single buyer or seller can exert significant influence over prices or output.
• Externalities – when the market does not take into account the impact of an economic activity on outsiders. For example, the market may ignore the costs imposed on outsiders by a firm polluting the environment.
• Public goods, such as national defense. How much defense would be provided if it were left to the market?
• Where there is incomplete or asymmetric information or uncertainty.
Abuse of market power is best tackled through antitrust policy. Externalities can be reduced through regulation, a tax or subsidy, or by using property rights to force the market to take into account the welfare of all who are affected by an economic activity. The supply of public goods can be ensured by compelling everybody to pay for them through the tax system.
Market forces
Shorthand for the pressures from buyers and sellers in a market, rather than those coming from a government planner or from regulation.
Market power
When one buyer or seller in a market has the ability to exert significant influence over the quantity of goods and services traded or the price at which they are sold. Market power does not exist when there is perfect competition, but it does when there is a monopoly, monopsony or oligopoly.
Marshall Plan
Probably the most successful programme of international aid and nation building in history. It was named after General George Marshall, an American secretary of state, who at the end of the Second World War proposed giving aid to Western Europe to rebuild its war-torn economies. North America gave around 1% of its GDP in total between 1948 and 1952; most of it came from the United States and the rest from Canada. The Americans left it to the Europeans to work out the details on allocating aid, which may be why, according to most economic analyses; it achieved more success than latter day aid programmes in which most of the decisions on how the money is spent are made by the donors. The main institution through which aid was administered was the organization for European economic co-operation (OEEC), which in 1961 became the OECD. Nowadays, whenever there is a proposal for the international community to rebuild an economy damaged by war, such as Iraq’s in 2003, you are sure to hear the phrase “new Marshall Plan”.
Mean reversion
The tendency for subsequent observations of a random variable to be closer to its mean than the current observation. For example, if the current number is 7, the average is 5, and there is mean reversion, then the next observation is likelier to be 6 than 8.
Medium term
Somewhere between short-termism, which is bad, and the long run, lies the hallowed ground of the medium term – far enough away to discourage myopic behaviour by decision makers but close enough to be meaningful. But not many governments say exactly how long they think the medium term is.
Menu costs
How much it costs to change prices. Just as a restaurant has to print a new menu when it changes the price of its food, so many other firms face a substantial outlay each time they cut or raise what they charge. Such menu costs mean that firms may be reluctant to change their prices every time there is a shift in the balance of supply and demand, so there will be sticky prices and the market for their output will be in disequilibrium. The internet may sharply reduce menu costs as it allows prices to be changed at the click of a mouse, which may improve efficiency by keeping markets more often in equilibrium.
Mercantilism
The conventional economic wisdom of the 17th century that made a partial come-back in recent years. Mercantilists feared that money would become too scarce to sustain high levels of output and employment; their favored solution was cheap money (low interest rates). In a forerunner to the 20th-century debate between Keynesians and monetarists, they were opposed by advocates of classical economics, who argued that cheap and plentiful money could result in inflation. The original mercantilists, such as john law, a Scots financier (and convicted murderer), believed that a country’s economic prosperity and political power came from its stocks of precious metals. To maximize these stocks they argued against free trade, favoring protectionist policies designed to minimize imports and maximize exports, creating a trade surplus that could be used to acquire more precious metal. This was contested for the classicists by Adam Smith and David Hume, who argued that a country’s wealth came not from its stock of precious metals but rather from its stocks of productive resources (land, labor, capital, and so on) and how efficiently they are used. Free trade increased efficiency by allowing countries to specialize in things in which they have a comparative advantage.
Mergers and acquisitions
When two businesses join together, either by merging or by one company taking over the other. There are three sorts of mergers between firms: horizontal integration, in which two similar firms tie the knot; vertical integration, in which two firms at different stages in the supply chain get together; and diversification, when two companies with nothing in common jump into bed. These can be a voluntary marriage of equals; a voluntary takeover of one firm by another; or a hostile takeover, in which the management of the target firm resists the advances of the buyer but is eventually forced to accept a deal by its current owners. For reasons that are not at all clear, merger activity generally happens in waves. One possible explanation is that when share prices are low, many firms have a market capitalization that is low relative to the value of their assets. This makes them attractive to buyers. In theory, the different sorts of mergers have different sorts of potential benefits. However, the damning lesson of merger waves stretching back over the past 50 years is that, with one big ex caption – the spate of leveraged buy-outs in the United States during the 1980s – they have often failed to deliver benefits that justify the costs.
Microeconomics
The study of the individual pieces that together make an economy. Contrast with macroeconomics, the study of economy-wide phenomena such as growth, inflation and unemployment. Microeconomics considers issues such as how households reach decisions about consumption and saving, how firms set a price for their output, whether privatisation improves efficiency, whether a particular market has enough competition in it and how the market for labour works.
Minimum wage
A minimum rate of pay that firms are legally obliged to pay their workers. Most industrial countries have a minimum wage, although certain sorts of workers are often exempted, such as young people or part-timers. Most economists reckon that a minimum wage, if it is doing what it is meant to do, will lead to higher unemployment than there would be without it. The main justification offered by politicians for having a minimum wage is that the wage that would be decided by buyers and sellers in a free market would be so low that it would be immoral for people to work for it. So the minimum wage should be above the market-clearing wage, in which case fewer workers would be demanded at that wage than would be hired at the market wage. How many fewer will depend on how far the minimum wage is above the market wage?
Some economists have challenged this simple supply and demand model. Several empirical studies have suggested that a minimum wage moderately above the free-market wage would not harm employment much and could (in rare circumstances) potentially raise it. These studies are not widely accepted among economists. Whatever it does for those in work, a minimum wage cannot help the majority of the very poorest people in most countries, who typically have no job in which to earn a minimum wage.
Some economists have challenged this simple supply and demand model. Several empirical studies have suggested that a minimum wage moderately above the free-market wage would not harm employment much and could (in rare circumstances) potentially raise it. These studies are not widely accepted among economists. Whatever it does for those in work, a minimum wage cannot help the majority of the very poorest people in most countries, who typically have no job in which to earn a minimum wage.
Misery index
The sum of a country’s inflation and unemployment rates. The higher the score, the greater is the economic misery.
Mixed economy
A market economy in which both private-sector firms and firms owned by government take part in economic activity. The proportions of public and private enterprise in the mix vary a great deal among countries. Since the 1980s, the public role in most mixed economies declined as nationalization gave way to privatization.
Mobility
The easier it is for the factors of production to move to where they are most valuable, the more efficient the allocation of the world’s scarce resources is likely to be and the faster gdp will grow. Apart from continental drift, land is immobile. Capital has long been extremely mobile within countries, and, with the rise of globalization, it is now able to move easily around the world. Enterprise is mobile, although to what extent depends on the particular entrepreneur. Some members of the labor market zoom around the world to work; others will not move to the next town.
Capital controls are the main obstacle to capital mobility, and these have been mostly removed or reduced since 1980. The sources of labor immobility are more numerous and complex, including immigration controls, transport costs, language barriers and a reluctance to move away from family or friends. Workers are far more mobile within the United States than they are within the European union or within individual EU countries. Some economists reckon that the willingness of workers to move to where the work is helps to explain the stronger economic performance and lower unemployment of the United States.
Can you sometimes have too much mobility? Certainly, some developing countries have suffered from hot money rushing into and then out of their markets.
In general, the possibility that a factor of production may suddenly move elsewhere can create serious economic problems. For instance, an employer may think twice about investing in training an employee if it fears that the employee may suddenly take a job with another firm. Similarly, entrepreneurs are unlikely to take the risk of pursuing a new idea if they fear that their capital may disappear at any moment, hence the importance of having access to long-term capital, such as by issuing bonds and equities.
Capital controls are the main obstacle to capital mobility, and these have been mostly removed or reduced since 1980. The sources of labor immobility are more numerous and complex, including immigration controls, transport costs, language barriers and a reluctance to move away from family or friends. Workers are far more mobile within the United States than they are within the European union or within individual EU countries. Some economists reckon that the willingness of workers to move to where the work is helps to explain the stronger economic performance and lower unemployment of the United States.
Can you sometimes have too much mobility? Certainly, some developing countries have suffered from hot money rushing into and then out of their markets.
In general, the possibility that a factor of production may suddenly move elsewhere can create serious economic problems. For instance, an employer may think twice about investing in training an employee if it fears that the employee may suddenly take a job with another firm. Similarly, entrepreneurs are unlikely to take the risk of pursuing a new idea if they fear that their capital may disappear at any moment, hence the importance of having access to long-term capital, such as by issuing bonds and equities.
Modelling
When economists make a number of simplified assumptions about how the economy, or some part of it, behaves, and then see what this implies in various different scenarios. Milton Friedman argued that economic models should not be judged on the basis of the validity of their assumptions, but on the accuracy of their predictions. An expert billiards player, he said, may not know the laws of physics, but acts as if he knows such laws. So his behavior could be predicted accurately with a model that assumes he knows the laws of physics. Likewise, the behavior of people making economic decisions may be accurately predicted by a model that assumes their goal is, say, profit maximization, even if they are not actually conscious of this being their goal. The more complex the thing being modeled, the harder it is to get right. Economic forecasting has a poor overall track record. The more micro¬economic the thing being modeled, the more likely it is that a model can be designed that will deliver accurate predictions.
Modern portfolio theory
One of the most important and influential economic theories about finance and investment. Modern portfolio theory is based upon the simple idea that diversification can produce the same total returns for less risk. Combining many financial assets in a portfolio is less risky than putting all your investment eggs in one basket. The theory has four basic premises.
• Investors are risk averse.
• Securities are traded in efficient markets.
• Risk should be analyzed in terms of an investor’s overall portfolio, rather than by looking at individual assets.
• For every level of risk, there is an optimal portfolio of assets that will have the highest expected returns.
All of this seems comparatively straightforward now, except perhaps the bit about efficient markets. But it was shocking when it was put forward in the early 1950s by harry Markowitz, who later won the Nobel Prize for it. According to Mr. Markowitz, when he explained his theory to the high priests of the Chicago school, “Milton argued that portfolio theory was not economics”. It is now.
• Investors are risk averse.
• Securities are traded in efficient markets.
• Risk should be analyzed in terms of an investor’s overall portfolio, rather than by looking at individual assets.
• For every level of risk, there is an optimal portfolio of assets that will have the highest expected returns.
All of this seems comparatively straightforward now, except perhaps the bit about efficient markets. But it was shocking when it was put forward in the early 1950s by harry Markowitz, who later won the Nobel Prize for it. According to Mr. Markowitz, when he explained his theory to the high priests of the Chicago school, “Milton argued that portfolio theory was not economics”. It is now.
Monetarism
Control the money supply, and the rest of the economy will take care of itself. A school of economic thought that developed in opposition to post-1945 Keynesian policies of demand management, echoing earlier debates between mercantilism and classical economics. Monetarism is based on the belief that inflation has its roots in the government printing too much money. It is closely associated with Milton Milton Friedman, who argued, based on the quantity theory of money, that government should keep the money supply fairly steady, expanding it slightly each year mainly to allow for the natural growth of the economy. If it did this, market forces would efficiently solve the problems of inflation, unemployment and recession. Monetarism had its heyday in the early 1980s, when economists, governments and investors pounced eagerly on every new money-supply statistic, particularly in the United States and the UK.
Many central banks had set formal targets for money-supply growth, so every wiggle in the data was scrutinized for clues to the next move in the rate of interest. Since then, the notion that faster money-supply growth automatically causes higher inflation has fallen out of favor. The money supply is useful as a policy target only if the relationship between money and nominal GDP, and hence inflation, is stable and predictable. The way the money supply affects prices and output depends on how fast it circulates through the economy. The trouble is that its velocity of circulation can suddenly change. During the 1980s, the link between different measures of the money supply and inflation proved to be less clear than monetarist theories had suggested, and most central banks stopped setting binding monetary targets. Instead, many have adopted explicit inflation targets.
Many central banks had set formal targets for money-supply growth, so every wiggle in the data was scrutinized for clues to the next move in the rate of interest. Since then, the notion that faster money-supply growth automatically causes higher inflation has fallen out of favor. The money supply is useful as a policy target only if the relationship between money and nominal GDP, and hence inflation, is stable and predictable. The way the money supply affects prices and output depends on how fast it circulates through the economy. The trouble is that its velocity of circulation can suddenly change. During the 1980s, the link between different measures of the money supply and inflation proved to be less clear than monetarist theories had suggested, and most central banks stopped setting binding monetary targets. Instead, many have adopted explicit inflation targets.
Monetary neutrality
Changes in the money supply have no effect on real economic variables such as output, real interest rates and unemployment. If the central bank doubles the money supply, the price level will double too. Twice as many dollars means half as much bang for the buck. This theory, a core belief of classical economics, was first put forward in the 18th century by David home. He set out the classical dichotomy that economic variables come in two varieties, nominal and real, and that the things that influence nominal variables do not necessarily affect the real economy. Today few economists think that pure monetary neutrality exists in the real world, at least in the short run. Inflation does affect the real economy because, for instance, there may be sticky prices or money illusion.
Monetary policy
What a central bank does to control the money supply, and thereby manage demand. Monetary policy involves open-market operations, reserve requirements and changing the short-term rate of interest (the discount rate). It is one of the two main tools of macroeconomic policy, the side-kick of fiscal policy, and is easier said than done well.
Monday, January 11, 2010
Money
Makes the world go round and comes in many forms, from shells and beads to gold coins to plastic or paper. It is better than barter in enabling an economy’s scarce resources to be allocated efficiently. Money has three main qualities:
• as a medium of exchange, buyers can give it to sellers to pay for goods and services;
• as a unit of account, it can be used to add up apples and oranges in some common value;
• as a store of value, it can be used to transfer purchasing power into the future.
A farmer who exchanges fruit for money can spend that money in the future; if he holds on to his fruit it might rot and no longer be useful for paying for something. Inflation undermines the usefulness of money as a store of value, in particular, and also as a unit of account for comparing values at different points in time. Hyper-inflation may destroy confidence in a particular form of money even as a medium of exchange. Measures of liquidity describe how easily an asset can be exchanged for money (the easier this is, the more liquid is the asset).
• as a medium of exchange, buyers can give it to sellers to pay for goods and services;
• as a unit of account, it can be used to add up apples and oranges in some common value;
• as a store of value, it can be used to transfer purchasing power into the future.
A farmer who exchanges fruit for money can spend that money in the future; if he holds on to his fruit it might rot and no longer be useful for paying for something. Inflation undermines the usefulness of money as a store of value, in particular, and also as a unit of account for comparing values at different points in time. Hyper-inflation may destroy confidence in a particular form of money even as a medium of exchange. Measures of liquidity describe how easily an asset can be exchanged for money (the easier this is, the more liquid is the asset).
Money illusion
When people are misled by inflation into thinking that they are getting richer, when in fact the value of money is declining. Whether, and how much, people are fooled by inflation is much debated by economists. Money illusion, a phrase coined by Keynes, is used by some economists to argue that a small amount of inflation may not be a bad thing and could even be beneficial, helping to “grease the wheels” of the economy. Because of money illusion, workers like to see their nominal wages rise, giving them the illusion that their circumstances are improving, even though in real (inflation-adjusted) terms they may be no better off. During periods of high inflation double-digit pay rises (as well as, say, big increases in the value of their homes) can make people feel richer even if they are not really better off. When inflation is low, growth in real incomes may hardly register.
Money markets
Any market where money and other liquid assets (such as treasury bills) can be lent and borrowed for between a few hours and a few months. Contrast with capital markets, where longer-term capital changes hands.
Money supply
The amount of money available in an economy. In the heyday of monetarism in the early 1980s, economists pounced upon the monthly (in some countries, even weekly) money-supply numbers for clues about future inflation. Central banks aim to manage demand by controlling the supply of money through open-market operations, reserve requirements and changing the rate of interest (to be exact, the discount rate).
One difficulty for policymakers lies in how to measure the relevant money supply. There are several different methods, reflecting the different liquidity of various sorts of money. Notes and coins are completely liquid; some bank deposits cannot be withdrawn until after a waiting period. M3 (M4 in the UK) is known as broad money, and consists of cash, current account deposits in banks and other financial institutions, savings deposits and time-restricted deposits. M1 is known as narrow money, and consists mainly of cash in circulation and current account deposits. M0 (in the UK) is the most liquid measure, including only cash in circulation, cash in banks’ tills and banks’ operational deposits held at the bank of England.
Although it is a poor predictor of inflation, monetary growth can be a handy leading indicator of economic activity. In many countries, there is a clear link between the growth of the real broad-money supply and that of real GDP.
One difficulty for policymakers lies in how to measure the relevant money supply. There are several different methods, reflecting the different liquidity of various sorts of money. Notes and coins are completely liquid; some bank deposits cannot be withdrawn until after a waiting period. M3 (M4 in the UK) is known as broad money, and consists of cash, current account deposits in banks and other financial institutions, savings deposits and time-restricted deposits. M1 is known as narrow money, and consists mainly of cash in circulation and current account deposits. M0 (in the UK) is the most liquid measure, including only cash in circulation, cash in banks’ tills and banks’ operational deposits held at the bank of England.
Although it is a poor predictor of inflation, monetary growth can be a handy leading indicator of economic activity. In many countries, there is a clear link between the growth of the real broad-money supply and that of real GDP.
Monopolistic competition
Somewhere between perfect competition and monopoly, also known as imperfect competition. It describes many real-world markets. Perfectly competitive markets are extremely rare, and few firms enjoy a pure monopoly; oligopoly is more common. In monopolistic competition, there are fewer firms than in a perfectly competitive market and each can differentiate its products from the rest somewhat, perhaps by advertising or through small differences in design. These small differences form barriers to entry. As a result, firms can earn some excess profits, although not as much as a pure monopoly, without a new entrant being able to reduce prices through competition. Prices are higher and output lower than under perfect competition.
Monopoly
When the production of a good or service with no close substitutes is carried out by a single firm with the market power to decide the price of its output. Contrast with perfect competition, in which no single firm can affect the price of what it produces. Typically, a monopoly will produce less, at a higher price, than would be the case for the entire market under perfect competition. It decides its price by calculating the quantity of output at which its marginal revenue would equal its marginal cost, and then sets whatever price would enable it to sell exactly that quantity.
In practice, few monopolies are absolute, and their power to set prices or limit supply is constrained by some actual or potential near-competitors (see monopolistic competition). An extreme case of this occurs when a single firm dominates a market but has no pricing power because it is in a contestable market; that is if it does not operate efficiently, a more efficient rival firm will take its entire market away. Antitrust policy can curb monopoly power by encouraging competition or, when there is a natural monopoly and thus competition would be inefficient, through regulation of prices. Furthermore, the mere possibility of ¬antitrust action may encourage a monopoly to self-regulate its behavior, simply to avoid the trouble an investigation would bring.
In practice, few monopolies are absolute, and their power to set prices or limit supply is constrained by some actual or potential near-competitors (see monopolistic competition). An extreme case of this occurs when a single firm dominates a market but has no pricing power because it is in a contestable market; that is if it does not operate efficiently, a more efficient rival firm will take its entire market away. Antitrust policy can curb monopoly power by encouraging competition or, when there is a natural monopoly and thus competition would be inefficient, through regulation of prices. Furthermore, the mere possibility of ¬antitrust action may encourage a monopoly to self-regulate its behavior, simply to avoid the trouble an investigation would bring.
Monopsony
A market dominated by a single buyer. A monopolist has the market power to set the price of whatever it is buying (from raw materials to labor). Under perfect competition, by contrast, no individual buyer is big enough to affect the market price of anything.
Moral hazard
One of two main sorts of market failure often associated with the provision of insurance. The other is adverse selection. Moral hazard means that people with insurance may take greater risks than they would do without it because they know they are protected, so the insurer may get more claims than it bargained for.
Most-favoured nation
Equal treatment, at least, in international trade. If country a grants country b the status of most-favored nation, it means that B’s exports will face tariff that are no higher (and also no lower) than those applied to any other country that a calls a most-favored nation. This will be the most favorable tariff treatment available to imports.
Most-favored nation treatment is one of the most important building blocks of the international trading system. The world trade organization requires member countries to accord the most favorable tariff and regulatory treatment given to the product of any one member to the “like products” of all other members. Before the general agreement on tariffs and trade, there was often a most-favored nation clause in bilateral trade agreements, which helped the world move towards free trade. In the 1930s, however, there was a backlash against this, and most-favored nations were treated less favorably. This shift pushed the world economy towards division into regional trade areas. In the United States, most-favored nation status has to be re-ratified periodically by congress.
Most-favored nation treatment is one of the most important building blocks of the international trading system. The world trade organization requires member countries to accord the most favorable tariff and regulatory treatment given to the product of any one member to the “like products” of all other members. Before the general agreement on tariffs and trade, there was often a most-favored nation clause in bilateral trade agreements, which helped the world move towards free trade. In the 1930s, however, there was a backlash against this, and most-favored nations were treated less favorably. This shift pushed the world economy towards division into regional trade areas. In the United States, most-favored nation status has to be re-ratified periodically by congress.
Multiplier
Shorthand for the way in which a change in spending produces an even larger change in income. For instance, suppose a government loosens fiscal policy, increasing net public spending by pumping an extra $10 billion into education. This has an immediate effect by increasing the income of teachers and of people who sell educational supplies or build or maintain schools. These people will in turn spend some of their extra money, putting more cash into the pockets of others, who spend some of it, and so on.
In theory, this process could continue indefinitely, in which case the multiplier would have an infinite value. In practice, most people save some of their extra income rather than spend it. How much they spend will depend on their marginal propensity to consume. The value of the multiplier can be calculated by this formula:
Multiplier = 1 / (1 – marginal propensity to consume)
If the marginal propensity to consume is 0.5 (50 cents of an extra dollar), the multiplier is 2. In practice, it is often hard to measure the multiplier effect, or to predict how it will respond to, say changes in monetary policy or fiscal policy.
In theory, this process could continue indefinitely, in which case the multiplier would have an infinite value. In practice, most people save some of their extra income rather than spend it. How much they spend will depend on their marginal propensity to consume. The value of the multiplier can be calculated by this formula:
Multiplier = 1 / (1 – marginal propensity to consume)
If the marginal propensity to consume is 0.5 (50 cents of an extra dollar), the multiplier is 2. In practice, it is often hard to measure the multiplier effect, or to predict how it will respond to, say changes in monetary policy or fiscal policy.
Nash equilibrium
An important concept in game theory, a Nash equilibrium occurs when each player is pursuing their best possible strategy in the full knowledge of the strategies of all other players. Once Nash equilibrium is reached, nobody has any incentive to change their strategy. It is named after john Nash, a mathematician and Nobel prize-winning economist.
Nation building
Creating a country that works out of one that does not - because the old order has collapsed (as in the former Soviet Union), or been destroyed by war (Iraq), or never really functioned in the first place (Afghanistan). To transform a failed country can involve establishing order through the rule of law and creating legitimate government and other effective social institutions, as well as a credible currency and a functioning market economy. Nation building is rarely easy, and often fiendishly difficult, especially where there are deep ethnic, religious or political divisions in the population or the country has no history of ever functioning effectively. Outside expertise, such as from the World Bank, and money (as in, most famously, the Marshall plan) can help, but they are no guarantee of success.
National debt
The total outstanding borrowing of a country’s government (usually including national and local government). It is often described as a burden, although public debt may have economic benefits (see balanced budget, fiscal policy and golden rule). Certainly, debt incurred by one generation may become a heavy burden for later generations, especially if the money borrowed is not invested wisely. The national debt is a total of all the money ever raised by a government that has yet to be paid off; this is very different from an annual public-sector budget deficit. In 1999, the American government celebrated a huge budget surplus, yet the country still had a national debt equal to nearly half its GDP.
Nationalisation
When a government takes ownership of a private-sector business. Nationalisation was a fashionable part of the mix in countries with a mixed economy between 1945 and 1980, after which the privatisation of state-owned firms became increasingly popular. The amount of public ownership in different countries has always varied considerably. Nationalisation has taken place for various reasons, ranging from socialist ideology to attempts to remedy examples of market failure.
The performance of nationalized firms has often, but not always, been poor compared with their private-sector counterparts. State-owned businesses often enjoy a legally protected monopoly, and the lack of competition means the firms face little pressure to be efficient. Politicians often interfere in important management decisions, making it harder to take unpopular actions on pay, factory closures and job cuts, particularly when there are strong public-sector trade unions and a union-friendly government. Politically imposed financial constraints may also force public-sector firms to underinvest. Although privatization has not been universally beneficial, on balance it has increased economic efficiency.
The performance of nationalized firms has often, but not always, been poor compared with their private-sector counterparts. State-owned businesses often enjoy a legally protected monopoly, and the lack of competition means the firms face little pressure to be efficient. Politicians often interfere in important management decisions, making it harder to take unpopular actions on pay, factory closures and job cuts, particularly when there are strong public-sector trade unions and a union-friendly government. Politically imposed financial constraints may also force public-sector firms to underinvest. Although privatization has not been universally beneficial, on balance it has increased economic efficiency.
Natural monopoly
When a monopoly occurs because it is more efficient for one firm to serve an entire market than for two or more firms to do so, because of the sort of economies of scale available in that market. A common example is water distribution, in which the main cost is laying a network of pipes to deliver water. One firm can do the job at a lower average cost per customer than two firms with competing networks of pipes. Monopolies can arise unnaturally by a firm acquiring sole ownership of a resource that is essential to the production of a good or service, or by a government granting a firm the legal right to be the sole producer. Other unnatural monopolies occur when a firm is much more efficient than its rivals for reasons other than economies of scale. Unlike some other sorts of monopoly, natural monopolies have little chance of being driven out of a market by more efficient new entrants. Thus regulation of natural monopolies may be needed to protect their captive consumers.
Natural rate of unemployment
A controversial phrase, which actually means little more than the lowest rate of unemployment at which the jobs market can be in stable equilibrium. Keynesians, encouraged by the phillips curve, assumed that a government could lower the rate of unemployment if it was willing to accept a little more inflation. However, economists such as milton friedman argued that this supposed inflation-for-jobs trade-off was in fact a trap. Governments that tolerated higher inflation in the hope of lowering unemployment would find that joblessness dipped only briefly before returning to its previous level, while inflation would rise and stay high. Instead, they argued, unemployment has an equilibrium or natural rate, determined not by the amount of demand in an economy but by the structure of the labor market. This is the lowest level of unemployment at which inflation will remain stable. When unemployment is above the natural rate demand can potentially be increased to bring it to the natural rate, but attempting to lower it even further will only cause inflation to accelerate. Hence the natural rate is also known as the non-accelerating-inflation rate of unemployment, or nairu.
At first, the nairu became synonymous with the view that macroeconomic policy could not conquer unemployment. It was often used to justify policy inaction even when unemployment rose to more than 10% of workers in industrialized countries during the 1980s and 1990s, even though economists’ estimates of the nairu differed hugely. More recently, economists looking for ways to reduce unemployment have started to ask whether, and under what circumstances, the natural rate might change. Most solutions have stressed the need to make more people employable at the prevailing level of wages, in particular by increasing labour market flexibility. Econ¬omists still disagree over what jobless rate at any particular point in time is the nairu, but nobody any longer thinks that the natural rate is fixed. Indeed, some think the concept has no meaning at all.
At first, the nairu became synonymous with the view that macroeconomic policy could not conquer unemployment. It was often used to justify policy inaction even when unemployment rose to more than 10% of workers in industrialized countries during the 1980s and 1990s, even though economists’ estimates of the nairu differed hugely. More recently, economists looking for ways to reduce unemployment have started to ask whether, and under what circumstances, the natural rate might change. Most solutions have stressed the need to make more people employable at the prevailing level of wages, in particular by increasing labour market flexibility. Econ¬omists still disagree over what jobless rate at any particular point in time is the nairu, but nobody any longer thinks that the natural rate is fixed. Indeed, some think the concept has no meaning at all.
Negative income tax
A way of building redistribution into the taxation system by taking money from people with high incomes and paying it to people with low incomes. Because it takes place automatically through the tax system, it may attach fewer stigmas to the receipt of financial help than some other forms of welfare assistance. However, it may also discourage recipients from working to increase their income (see poverty trap), which is why some countries have introduced a form of negative income tax that is available only to the working poor. In the United States, this is known as the earned income tax credit.
Neo-classical economics
The school of economics that developed the free-market ideas of classical economics into a full-scale model of how an economy works. The best-known neo-classical economist was Alfred Marshall, the father of marginal analysis. Neo-classical thinking, which mostly assumes that markets tend towards equilibrium, was attacked by Keynes and became unfashionable during the Keynesian-dominated decades after the Second World War. But, thanks to economists such as Milton Friedman, many neo-classical ideas have since become widely accepted and uncontroversial.
Net Present Value
A measure used to help decide whether or not to proceed with an investment. Net means that both the costs and benefits of the investment are in cluded. To calculate net present value (NPV), first add together all the expected benefits from the investment, now and in the future. Then add together all the expected costs. Then work out what these future benefits and costs are worth now by adjusting future cash flow using an appropriate discount rate. Then subtract the costs from the benefits. If the NPV is negative, then the investment cannot be justified by the expected returns. If the NPV is positive, it can, although it pays to make comparisons with the NPVs of alternative investment opportunities before going ahead.
Network effect
When the value of a good to a consumer changes because the number of people using it changes. For instance, owning a phone becomes more valuable as more people are plugged into the telephone network. Network effects are sometimes called network externality, although this implies, often wrongly, that the benefits from being part of a network are a sort of market failure. They give a huge competitive advantage to the firm that owns the network. This incumbent advantage arises because a new entrant must persuade people to join a network that starts with fewer members, and thus may be less valuable to them than the network they are currently in. This is why markets for products with network effects are often dominated by only a few firms or a single monopoly. Some economists argue that many recent technological innovations, notably the internet, have large positive network effects, which make possible much higher productivity and growth than in the past.
New economy
In the last years of the 20th century, some economists argued that developments in information technology and globalization had given birth to a new economy (first, in the united states), which had a higher rate of productivity and growth than the old economy it replaced. Some went further, adding that in the new economy inflation was dead, the business cycle abolished and the traditional rules of economics were redundant. These claims were highly controversial. Other economists pointed out that similar prediction had been made during earlier periods of rapid technological change, yet the nature of economics was not fundamentally altered.
With the bursting of the dotcom stock market bubble in 2000, the phrase fell into disuse, although productivity continued to soar, thanks not least to new technology, especially in the United States.
With the bursting of the dotcom stock market bubble in 2000, the phrase fell into disuse, although productivity continued to soar, thanks not least to new technology, especially in the United States.
New trade theory
Although most economists support free trade, in the 1970s a growing number of them became increasingly puzzled by the large differences between the predictions of free trade theory and real-world trade flows. Their solution to this puzzle is known as new trade theory.
One mystery was that trade was growing fastest between industrial countries with similar economies and endowments of the factors of production. In many new industries, there was no clear comparative advantage for any country. Patterns of production and trade often seemed matters of chance. Trade between two countries would often consist mostly of similar goods, for example, one country would sell cars to another country from which it would import different models of cars.
One explanation, associated in particular with Paul Krugman of the Massachusetts institute of technology, drew on Adam Smith’s idea that the division of labor lowers unit costs. Economies of scale within firms are incompatible with the perfect competition assumed by traditional trade theory. A more realistic assumption is that many markets have monopolistic competition. When a monopolistically competitive market expands, it does so through a mixture of more firms (greater product variety) and bigger firms, with bigger-scale economies. Free trade expands market size beyond national borders and so allows firms to reap bigger economies of scale, to the benefit of consumers, workers and shareholders.
The upside may be greater the more similar are the trading economies. This may explain why trade liberalization is easier to achieve between similar countries. Thus, for example, the free-trade agreement between the United States and Canada produced only minor local complaints, whereas its subsequent expansion to include the very different economy of Mexico was much more controversial.
One mystery was that trade was growing fastest between industrial countries with similar economies and endowments of the factors of production. In many new industries, there was no clear comparative advantage for any country. Patterns of production and trade often seemed matters of chance. Trade between two countries would often consist mostly of similar goods, for example, one country would sell cars to another country from which it would import different models of cars.
One explanation, associated in particular with Paul Krugman of the Massachusetts institute of technology, drew on Adam Smith’s idea that the division of labor lowers unit costs. Economies of scale within firms are incompatible with the perfect competition assumed by traditional trade theory. A more realistic assumption is that many markets have monopolistic competition. When a monopolistically competitive market expands, it does so through a mixture of more firms (greater product variety) and bigger firms, with bigger-scale economies. Free trade expands market size beyond national borders and so allows firms to reap bigger economies of scale, to the benefit of consumers, workers and shareholders.
The upside may be greater the more similar are the trading economies. This may explain why trade liberalization is easier to achieve between similar countries. Thus, for example, the free-trade agreement between the United States and Canada produced only minor local complaints, whereas its subsequent expansion to include the very different economy of Mexico was much more controversial.
Nominal value
The value of anything expressed simply in the money of the day. Since inflation means that money can lose its value over time, nominal figures can be misleading when used to compare values in different periods. It is better to compare their real value, by adjusting the nominal figures to remove the inflationary distortions.
Non-price competition
Trying to win business from rivals other than by charging a lower price. Methods include advertising, slightly differentiating your product, improving its quality or offering free gifts or discounts on subsequent purchases. Non-price competition is particularly common when there is an oligopoly, perhaps because it can give an impression of fierce rivalry while the firms are actually colluding to keep prices high.
Normal goods
When average income increases, the demand for normal goods increases, too. It is opposite of inferior goods.
Offshore
Where the usual rules of a person or firm’s home country do not apply. It can be literally offshore, as in the case of investors moving their money to a Caribbean island tax haven. Or it can be merely legally offshore, as in the case of certain financial transactions that take place within, say, the city of London, which are deemed for regulatory purposes to have taken place offshore.
Oligopoly
When a few firms dominate a market. Often they can together behave as if they were a single monopoly, perhaps by forming a cartel. Or they may collude informally, by preferring gentle non-price competition to a bloody price war. Because what one firm can do depends on what the other firms do, the behavior of oligopolists is hard to predict. When they do compete on price, they may produce as much and charge as little as if they were in a market with perfect competition.
OPEC
The organization of petroleum exporting countries, a cartel set up in 1960 that wrought havoc in industrialized 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 Capitalized 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.
Open economy
An economy that allows the unrestricted flow of people, capital, goods and services across its borders; the opposite of a closed economy.
Open-market operations
Central banks buying and selling securities in the open market, as a way of controlling interest rates or the growth of the money supply. By selling more securities, they can mop up surplus money; buying securities adds to the money supply. The securities traded by central banks are mostly government bonds and treasury bills, although they sometimes buy or sell commercial securities.
Opportunity cost
The true cost of something is what you give up to get it. This includes not only the money spent in buying (or doing) the something, but also the economic benefits (utility) that you did without because you bought (or did) that particular something and thus can no longer buy (or do) something else. For example, the opportunity cost of choosing to train as a lawyer is not merely the tuition fees, price of books, and so on, but also the fact that you are no longer able to spend your time holding down a salaried job or developing your skills as a footballer. These lost opportunities may represent a significant loss of utility. Going for a walk may appear to cost nothing, until you consider the opportunity forgone to use that time earning money. Everything you do has an opportunity cost (see shadow price). Economics is primarily about the efficient use of scarce resources, and the notion of opportunity cost plays a crucial part in ensuring that resources are indeed being used efficiently.
Optimum
As good as it gets, given the constraints you are operating within. For the concept of optimum to mean anything, there must be both a goal, say, to maximise economic welfare, and a set of constraints, such as an available stock of scarce economic resources. Optimising is the process of doing the best you can in the circumstances.
Output gap
How far an economy’s current output is below what it would be at full capacity. On average, inflation rises when output is above potential and falls when output is below potential. However, in the short run, the relationship between inflation and the output gap can deviate from the longer-term pattern and can thus be misleading. Alas for policymakers – because nobody really knows what an economy’s potential output is, the size and even the direction of the output gap can easily be misdiagnosed, which can contribute to serious errors in macroeconomic policy.
Outsourcing
Shifting activities that used to be done inside a firm to an outside company, which can do them more cost-effectively. Big firms have outsourced a growing amount of their business since the early 1990s, including increasingly off shoring work to cheaper employees at firms in countries such as India. This has become politically controversial in countries that lose jobs as a result of off shoring. However, a firm that outsources can improve its efficiency by focusing on those activities in which it can create the most value; the firm to which it outsources can also increase efficiency by specializing in that activity. That, at least, is the theory. In practice, managing the outsourcing process can be tricky, particularly for more complex activities.
Over the counter
In the case of drugs, those that can be purchased without a prescription from a doctor. In the case of financial securities, those that are bought or sold through a private dealer or bank rather than on a financial exchange.
Overheating
When an economy is growing too fast and its productive capacity cannot keep up with demand. It often boils over into inflation.
Overshooting
The common tendency of prices in financial markets initially to move further than would seem strictly necessary in response to changes in the fundamentals that should, in theory, determine value. One reason may be that in the absence of perfect information, investors move in herds, rushing in and out of markets on rumour. Eventually, as investors become better informed, the price usually returns to a more appropriate level. Overshooting is especially common during significant realignments of exchange rates, but there are plenty of other examples. For instance, following the abolition of capital controls by some developing countries, the prices of equities in those countries initially soared to what proved to be unjustified levels as foreign capital rushed in, before settling in the longer-term at more sustainable valuations.
Pareto efficiency
A situation in which nobody can be made better off without making somebody else worse off. Named after Vilfredo Pareto (1843–1923), an Italian economist. If an economy’s resources are being used inefficiently, it ought to be possible to make somebody better off without anybody else becoming worse off. In reality, change often produces losers as well as winners. Pareto efficiency does not help judge whether this sort of change is economically good or bad.
Paris club
The name given to the arrangements through which countries reschedule their official debt; that is, money borrowed from other governments rather than banks or private firms. The club is based on avenue Kléber in Paris. Its members are the 19 founders of the ORCD as well as Russia. Other institutions such as the World Bank attend in an ¬informal role. Rescheduling requires the consensus agreement of members and must not favor one creditor nation over another. Private debt re¬scheduling takes place through the London club.
Patents
In 1899 the commissioner of the American office of patents recommended that his office be abolished because “everything that can be invented has been invented”. The fact that there has been so much innovation during the subsequent 100 years may owe something to the existence of patents. Economists reckon that if people are going to spend the time and money needed to think up and develop new products, they need to be fairly confident that if the idea works they will earn a decent profit. Patents help achieve this by granting the inventor a temporary monopoly over the idea, to stop it being stolen by imitators who have not borne any of the development risk and costs. Like any monopoly, patents create inefficiency because of the lack of competition to produce and sell the product. So economists debate how long patent protection should last. There is also debate about which sorts of innovation require the encouragement of a potential monopoly to make them happen. Furthermore, the pace of innovation in some industries has sharply reduced the number of years during which a patent is valuable. Some economists say that this shows that patents do not play a large part in the process of innovation.
Path dependence
History matters. Where you have been in the past determines where you are now and where you can go in future. Indeed, even small, apparently trivial, differences in the path you have taken can have huge consequences for where you are and can go. In economics, path dependence refers to the way in which apparently insignificant events and choices can have huge consequences for the development of a market or an economy.
Economists disagree over how widespread path dependence is, and whether it is a form of market failure. One focus of this debate is the QWERTY keyboard. Some argue that the QWERTY design was deliberately made slow to use so as to overcome a jamming-at-speed problem in early typewriters. Much faster alternative layouts of keys have failed to prosper, even though the anti-jamming rationale for QWERTY has been defunct for years. Others say that the QWERTY system is as efficient a layout of keys as any other and that its success is a triumph of market forces. Having invested in learning to make and use the QWERTY keyboard, it makes no economic sense to switch to an alternative that is no better than QWERTY.
Economists disagree over how widespread path dependence is, and whether it is a form of market failure. One focus of this debate is the QWERTY keyboard. Some argue that the QWERTY design was deliberately made slow to use so as to overcome a jamming-at-speed problem in early typewriters. Much faster alternative layouts of keys have failed to prosper, even though the anti-jamming rationale for QWERTY has been defunct for years. Others say that the QWERTY system is as efficient a layout of keys as any other and that its success is a triumph of market forces. Having invested in learning to make and use the QWERTY keyboard, it makes no economic sense to switch to an alternative that is no better than QWERTY.
Peak pricing
When capacity is fixed and demand varies during a time period, it may make sense to charge above-average prices when demand peaks. Because this will divert some peak demand to cheaper off-peak periods, it will reduce the total amount of capacity needed at the peak and reduce the amount of capacity lying idle at off-peak times, thus resulting in a more efficient use of resources. Peak pricing is common in services with substantial fixed capacity, such as electricity supply and rail transport, as anybody who pays higher fares to travel during rush hours knows only too well.
Percentage point
A unit of size, a one-hundredth of the total. Not to be confused with percentage change. When something increases by 1 percentage point this may be quite different from a 1% increase. For instance, if GDP grew last year by 1% and this year by 2%, the growth rate this year increased by 1 percentage point compared with last year (the difference between 1% and 2%) and also by 100% (2% is double 1%). A 1% increase would mean that the growth rate this year was only 1.01%.
Percentile
Part of the “ILE” family that signposts positions on a scale of numbers (see also quartile). The top percentile on, say, the distribution of income, is the richest 1% of the population.
Perfect competition
The most competitive market imaginable. Perfect competition is rare and may not even exist. It is so competitive that any individual buyer or seller has a negligible impact on the market price. Products are homogeneous. Information is perfect. Everybody is a price taker. Firms earn only normal profit, the bare minimum profit necessary to keep them in business. If firms earn more than that (excess profits) the absence of barriers to entry means that other firms will enter the market and drive the price level down until there are only normal profits to be made. Output will be maximised and price minimised. Contrast with monopolistic competition, oligopoly and, above all, monopoly.
Permanent income hypothesis
Over their lives, people try to spread their spending more evenly than their income. The permanent income hypothesis, developed by Milton Friedman, says that a person’s spending decisions are guided by what they think over their lifetime will be their average (also known as permanent) income. A sharp increase in short-term income will not result in an equally sharp increase in short-term consumption. What if somebody unexpectedly comes into money, say by winning the lottery? The permanent income hypothesis suggests that people will save most of any such windfall gains. Reality may be somewhat different.
Phillips curve
In 1958, an economist from New Zealand, A.W.H. Phillips (1914–75), proposed that there was a trade-off between inflation and unemployment: the lower the unemployment rate, the higher was the rate of inflation. Governments simply had to choose the right balance between the two evils. He drew this conclusion by studying nominal wage rates and jobless rates in the UK between 1861 and 1957, which seemed to show the relationship of unemployment and inflation as a smooth curve.
Economies did seem to work like this in the 1950s and 1960s, but then the relationship broke down. Now economists prefer to talk about the Nairu, the lowest rate of unemployment at which inflation does not accelerate.
Economies did seem to work like this in the 1950s and 1960s, but then the relationship broke down. Now economists prefer to talk about the Nairu, the lowest rate of unemployment at which inflation does not accelerate.
Pigou effect
Named after Arthur Pigou (1877–1959), a sort of wealth effect resulting from deflation. A fall in the price level increases the real value of people’s savings, making them feel wealthier and thus causing them to spend more. This increase in demand can lead to higher employment.
Population
At the beginning of the 20th century the population of the world was 1.7 billion. At the end of that century, it had soared to 6 billion. Recent estimates suggest that it will be nearly 8 billion by 2025 and 9.3 billion by 2050. Almost all of this increase is forecast to occur in the developing regions of Africa, Asia and Latin America. For what economists have had to say about this, see demographics.
Positional goods
Things that the Joneses buy. Some things are bought for their intrinsic usefulness, for instance, a hammer or a washing machine. Positional goods are bought because of what they say about the person who buys them. They are a way for a person to establish or signal their status relative to people who do not own them: fast cars, holidays in the most fashionable resorts, clothes from trendy designers. By necessity, the quantity of these goods is somewhat fixed, because to increase supply too much would mean that they were no longer positional. What would own a Rolls-Royce say about you if everybody owned one? Fears that the rise of positional goods would limit growth, since by definition they had to be in scarce supply, have so far proved misplaced. Entrepreneurs have come up with ever more ingenious ways for people to buy status, thus helping developed economies to keep growing.
Positive economics
Economics that describes the world as it is, rather than trying to change it. The opposite of normative economics, which suggests policies for increasing economic welfare.
Sunday, January 10, 2010
Poverty
The state of being poor, which depends on how you define it. One approach is to use some absolute measure. For instance, the poverty rate refers to the number of households whose income is less than three times what is needed to provide an adequate diet. (though what constitutes adequate may change over time.) Another is to measure relative poverty. For instance, the number of people in poverty can be defined as all households with an income of less than, say, half the average household income. Or the (relative) poverty line may be defined as the level of income below which are, say, the poorest 10% of households. In each case, the dividing line between poverty and not-quite poverty is somewhat arbitrary.
As countries get richer, the number of people in absolute poverty usually gets smaller. This is not necessarily true of the numbers in relative poverty. The way that relative poverty is defined means that it is always likely to identify a large number of impoverished households. However rich a country becomes, there will always be 10% of households poorer than the rest, even though they may live in mansions and eat caviar (albeit smaller mansions and less caviar than the other 90% of households).
As countries get richer, the number of people in absolute poverty usually gets smaller. This is not necessarily true of the numbers in relative poverty. The way that relative poverty is defined means that it is always likely to identify a large number of impoverished households. However rich a country becomes, there will always be 10% of households poorer than the rest, even though they may live in mansions and eat caviar (albeit smaller mansions and less caviar than the other 90% of households).
Precautionary motive
Keeping some money handy, just in case. One of three motives for holding money identified by Keynes, along with the transactional motive (having the cash to pay for planned purchases) and the speculative motive (you think asset prices are going to fall, so you sell your assets for cash).
Predatory pricing
Charging low prices now so you can charge much higher prices later. The predator charges so little that it may sustain losses over a period of time, in the hope that its rivals will be driven out of business. Clearly, this strategy makes sense only if the predatory firm is able eventually to establish a monopoly. Some advocates of anti-dumping policies say that cheap imports are examples of predatory pricing. In practice, the evidence gives little support for this view. Indeed, in general, predatory pricing is quite rare. It is certainly much less common in practice than it might appear from the propaganda of firms that are under pricing pressure from more efficient competitors.
Price
In equilibrium, what balances supply and demand. The price charged for something depends on the tastes, income and elasticity of demand of customers. It depends on the amount of competition in the market. Under perfect competition, all firms are price takers. Where there is a monopoly, or firms have some market power, the seller has some control over the price, which will probably be higher than in a perfectly competitive market. By how much more will depend on how much market power there is, and on whether the firm(s) with the market power are committed to profit maximisation. In some cases, firms may charge less than the profit-maximising price for strategic or other reasons.
Price discrimination
When a firm charges different customers different prices for the same product. For producers, the perfect world would be one in which they could charge each customer a different price: the price that each customer would be willing to pay. This would maximise producer surplus. This cannot happen, not least because sellers do not know how much any individual would pay.
Yet some price discrimination is possible if an overall market can be segmented into somewhat separate markets and the equilibrium price in each of these markets is different, perhaps because of differences in consumer tastes, perhaps because in some segments the firm enjoys some market power. But this will work only if the market segments can be kept apart. If it is possible and profitable to buy the product in a low-price segment and resell it in a high-price segment, then price discrimination will not last for long.
Yet some price discrimination is possible if an overall market can be segmented into somewhat separate markets and the equilibrium price in each of these markets is different, perhaps because of differences in consumer tastes, perhaps because in some segments the firm enjoys some market power. But this will work only if the market segments can be kept apart. If it is possible and profitable to buy the product in a low-price segment and resell it in a high-price segment, then price discrimination will not last for long.
Price elasticity
A measure of the responsiveness of demand to a change in price. If demand changes by more than the price has changed, the good is price-elastic. If demand changes by less than the price, it is price-inelastic. Economists also measure the elasticity of demand to changes in the income of consumers.
Price regulation
When prices of, say, a public utility are regulated, giving producers an incentive to maximise their profits by reducing their costs as much as possible. Contrast with rate of return regulation.
Price/earnings ratio
A crude method of judging whether shares are cheap or expensive; the ratio of the market price of a share to the company’s earnings (profit) per share. The higher the price/earnings (P/E) ratio, the more investors are buying a company’s shares in the expectation that it will make larger profits in future than now. In other words, the higher the p/e ratio, the more optimistic investors are being.
Prisoners' dilemma
A favourite example in game theory, which shows why co-operation is difficult to achieve even when it is mutually beneficial. Two prisoners have been arrested for the same offence and are held in different cells. Each has two options: confess, or say nothing. There are three possible outcomes. One could confess and agree to testify against the other as state witness, receiving a light sentence while his fellow prisoner receives a heavy sentence. They can both say nothing and may be lucky and get light sentences or even be let off, owing to lack of firm evidence. Or they may both confess and probably get lighter individual sentences than one would have received had he said nothing and the other had testified against him. The second outcome would be the best for both prisoners. However, the risk that the other might confess and turn state witness is likely to encourage both to confess, landing both with sentences that they might have avoided had they been able to co-operate in remaining silent. In an oligopoly, firms often behave like these prisoners, not setting prices as high as they could do if they only trusted the other firms not to undercut them. As a result, they are worse off.
Private equity
When a firm’s shares are held privately and not traded in the public markets. Private equity includes shares in both mature private companies and, as venture capital, in newly started businesses. As it is less liquid than publicly traded equity, investors in private equity expect on average to earn a higher equity risk premium from it.
Privatisation
Selling state-owned businesses to private investors. This policy was associated initially with Margaret Thatcher’s government in the 1980s, which privatized numerous companies, including public utility businesses such as British telecom, British gas, and electricity and water companies. During the 1990s, privatization became a favorite policy of governments all over the world.
There were several reasons for the popularity of privatization. In some instances, the aim was to improve the performance of publicly owned companies. Often nationalization had failed to achieve its goals and had become increasingly associated with poor service to customers. Sometimes privatization was part of transforming a state-owned monopoly into a competitive market, by combining ownership transfer with deregulation and liberalization. Sometimes privatization offered a way to raise new capital for the firm to invest in improving its service, money that was not available in the public sector because of constraints on public spending. Indeed, perhaps the main attraction of privatization to many politicians was that the proceeds from it could ease the pressure on the public purse. As a result, they could avoid (in the short-term) doing the more painful things necessary to improve the fiscal position, such as raising taxes or cutting public spending.
There were several reasons for the popularity of privatization. In some instances, the aim was to improve the performance of publicly owned companies. Often nationalization had failed to achieve its goals and had become increasingly associated with poor service to customers. Sometimes privatization was part of transforming a state-owned monopoly into a competitive market, by combining ownership transfer with deregulation and liberalization. Sometimes privatization offered a way to raise new capital for the firm to invest in improving its service, money that was not available in the public sector because of constraints on public spending. Indeed, perhaps the main attraction of privatization to many politicians was that the proceeds from it could ease the pressure on the public purse. As a result, they could avoid (in the short-term) doing the more painful things necessary to improve the fiscal position, such as raising taxes or cutting public spending.
Probability
How likely something is to happen, usually expressed as the ratio of the number of ways the outcome may occur to the number of total possible outcomes for the event. For instance, each time you throw a dice there is six possible outcomes, but in only one of these can a six come up. Thus the probability of throwing a six on any given throw is one in six. The fact that you threw a six last time does not alter the one-in-six probability of throwing a six next time
Producer surplus
The difference between what a supplier is paid for a good or service and what it cost to supply. Added to consumer surplus, it provides a measure of the total economic benefit of a sale.
Production function
A mathematical way to describe the relationship between the quantity of inputs used by a firm and the quantity of output it produces with them. If the amount of inputs needed to produce one more unit of output is less than was needed to produce the last unit of output, then the firm is enjoying increasing returns to scale (or increasing marginal product). If each extra unit of output requires a growing amount of inputs to produce it, the firm faces diminishing returns to scale (diminishing marginal product).
Productivity
The relationship between inputs and output, which can be applied to individual factors of production or collectively. Labour productivity is the most widely used measure and is usually calculated by dividing total output by the number of workers or the number of hours worked. Total factor productivity attempts to measure the overall productivity of the inputs used by a firm or a country.
Alas, the usefulness of productivity statistics is questionable. The quality of different inputs can change significantly over time. There can also be significant differences in the mix of inputs. Furthermore, firms and countries may use different definitions of their inputs, especially capital.
That said, much of the difference in countries’ living standards reflects differences in their productivity. Usually, the higher productivity is the better, but this is not always so. In the UK during the 1980s, labor productivity rose sharply, leading some economists to talk of a “productivity miracle”. Others disagreed, saying that productivity had risen because unemployment had risen – in other words, the least productive workers had been removed from the figures on which the average was calculated.
There was a similar debate in the United States starting in the late 1990s. Initially, economists doubted that a productivity miracle was taking place. But by 2003, they conceded that during the previous five years the United States enjoyed the fastest productivity growth in any such period since the Second World War. Over the whole period from 1995, labor productivity growth averaged almost 3% a year, twice the average rate over the previous two decades. That did not stop economists debating why the miracle had occurred.
Alas, the usefulness of productivity statistics is questionable. The quality of different inputs can change significantly over time. There can also be significant differences in the mix of inputs. Furthermore, firms and countries may use different definitions of their inputs, especially capital.
That said, much of the difference in countries’ living standards reflects differences in their productivity. Usually, the higher productivity is the better, but this is not always so. In the UK during the 1980s, labor productivity rose sharply, leading some economists to talk of a “productivity miracle”. Others disagreed, saying that productivity had risen because unemployment had risen – in other words, the least productive workers had been removed from the figures on which the average was calculated.
There was a similar debate in the United States starting in the late 1990s. Initially, economists doubted that a productivity miracle was taking place. But by 2003, they conceded that during the previous five years the United States enjoyed the fastest productivity growth in any such period since the Second World War. Over the whole period from 1995, labor productivity growth averaged almost 3% a year, twice the average rate over the previous two decades. That did not stop economists debating why the miracle had occurred.
Profit
The main reason firms exist. In economic theory, profit is the reward for risk taken by enterprise, the fourth of the factors of production – what is left after all other costs, including rent, wages and interest. Put simply, profit is a firm’s total revenue minus total cost.
Economists distinguish between normal profit and excess profit. Normal profit is the opportunity cost of the entrepreneur, the amount of profit just sufficient to keep the firm in business. If profit is any lower than that, then enterprise would be better off engaged in some alternative economic activity. Excess profit, also known as super-normal profit, is profit above normal profit and is usually evidence that the firm enjoys some market power that allows it to be more profitable than it would be in a market with perfect competition.
Economists distinguish between normal profit and excess profit. Normal profit is the opportunity cost of the entrepreneur, the amount of profit just sufficient to keep the firm in business. If profit is any lower than that, then enterprise would be better off engaged in some alternative economic activity. Excess profit, also known as super-normal profit, is profit above normal profit and is usually evidence that the firm enjoys some market power that allows it to be more profitable than it would be in a market with perfect competition.
