Essential Economics

The aim of this book is to explain economics and its most important ideas, and to demystify the most important pieces of economic jargon.

Matthew Bishop

289 Pages

33385 Reads



PDF Format

2.37 MB

Economics Books

Download PDF format

  • Matthew Bishop   
  • 289 Pages   
  • 18 Feb 2015
  • Page - 1

    read more..

  • Page - 2

    Essential Economics001-085 5-12-2003 17:06 Pagina i read more..

  • Page - 3

    OTHER ECONOMIST BOOKSGuide to Analysing CompaniesGuide to Business ModellingGuide to Economic IndicatorsGuide to the European UnionGuide to Financial MarketsGuide to Management IdeasNumbers GuideStyle GuideBrands and BrandingBusiness EthicsChina’s StockmarketE-CommerceE-TrendsGlobalisationSuccessful InnovationSuccessful MergersWall StreetDictionary of BusinessDictionary of EconomicsInternational Dictionary of FinanceEssential DirectorEssential FinanceEssential InternetEssential read more..

  • Page - 4

    Essential EconomicsMatthew Bishop001-085 5-12-2003 17:06 Pagina iii read more..

  • Page - 5

    THE ECONOMIST IN ASSOCIATION WITH PROFILE BOOKS LTDPublished by Profile Books Ltd58A Hatton Garden, London ec1n 8lxCopyright © The Economist Newspaper Ltd 2004Text copyright © Matthew Bishop 2004Developed from a title previously published as Pocket EconomistAll rights reserved. Without limiting the rights under copyright reserved above,no part of this publication may be reproduced, stored in or introduced into aretrieval system, or transmitted, in any form or by any means read more..

  • Page - 6

    ContentsIntroductionviThe joy of economics1A to Z11001-085 5-12-2003 17:06 Pagina v read more..

  • Page - 7

    IntroductionThe aim of this book is to explain economics and its most im-portant ideas, and to demystify the most important pieces ofeconomic jargon. It is intended to be practical, rather thanprovide a comprehensive tour of economic theory. It focuses onthe economics that affects jobs and prices and trade, that raisesvoices in boardrooms and bars and among politicians andpundits, in short, the economics that touches and shapes every-day life. The book starts with an essay that examines the read more..

  • Page - 8

    The joy of economicsEconomics has come in for a lot of abuse over the years. TheVictorian writer Thomas Carlyle christened it the “dismalscience” because of its gloomy predictions. In the event, thoseforecasts, like much economic crystal ball gazing since, werewrong. As Will Rogers, an American wag, later put it, “Aneconomist’s guess is liable to be as good as anybody else’s.”Economists have been criticised equally for failing to make pre-dictions. George Bernard Shaw quipped: “If read more..

  • Page - 9

    scarce things are used, the less they are wasted and the greateris the likelihood that people achieve their goals. True, choosingto do one thing means choosing not to do another. Perhaps themost important rule in economics is that every opportunity hasa cost. Pointing this out can make economists seem to be pro-fessional party-poopers. Nobody tucking into a slap-up mealenjoys being reminded that there is no such thing as a freelunch. Yet an economic concept known as opportunity cost –which read more..

  • Page - 10

    tively low wages in the caring industries might reflect a goodsociety rather than a selfish one.Economics is sometimes accused of being dismal because itignores the needs of the poor. In fact, how (not whether) toreduce poverty has long been one of the most importantdebates in economics. Some poor countries that have followedsound economic policies have quickly reduced poverty. Manyof the poorest countries in the world follow economic policiesthat would appal most economists. But it is true that read more..

  • Page - 11

    If things go wrong, or even if they go well, it will rarely be clearif a policy was right (or wrong) or merely lucky (or unlucky).True scientists, such as chemists, would find out by rerun-ning the experiment many times. The events on which macro-economic theory is based cannot be replicated, at least with theprecision and frequency that would generate enough data toreach rock solid conclusions. With historical events, such as thehigh unemployment of the 1930s or the hyper-inflation of the1970s, read more..

  • Page - 12

    a giant machine that could be driven by clever people in govern-ment, smoothly as a Rolls-Royce, to the promised land of low in-flation and full employment. The failure during the 1970s ofKeynesian demand management – so-called economic “fine-tuning” – and, later, of the rival policy of monetarism, was pow-erful proof of what economists should have known all along.Yet macroeconomic failures such as these have helped to makethe public cynical about economics.It took the troubles of read more..

  • Page - 13

    macroeconomic demand management policies has declined.The new favourite policy is a “micro-macro” approach based onpromoting markets and the conditions that enable markets towork well. Many government-owned firms have been priva-tised and government-controlled markets deregulated. Competi-tion has been promoted, increasing choice in the marketplace.Tax rates have been cut to give people a greater financial incen-tive to sell their skills in the market. Trade barriers have beenlowered, making read more..

  • Page - 14

    least built on economic ideas tested, literally, in the marketplace.Certainly, understanding better the relationship between macroand micro factors is likely to be the focus of much future eco-nomic thinking.Will the influence of market economics continue to grow? Itis not inevitable. Demonstrations against globalisation, theWorld Trade Organisation and the International MonetaryFund have highlighted the potential for an anti-markets back-lash. It happened before, starting in the 1920s and read more..

  • Page - 15

    bubbles? What are the circumstances in which governmentactions to deal with market failure go wrong?How best to reduce poverty will remain an important ques-tion for economists. The goal of helping the poor has often beenused to justify government action, particularly the Robin Hood-style taxation of the rich. In recent years, the persistence ofpoverty in rich countries despite massive redistribution and therise of market economics has resulted in this approach beingquestioned. One worry is that read more..

  • Page - 16

    economic success or failure, that take environmental and othernon-monetary factors into account, are needed.Nevertheless, in recent decades, countries with the highestlevels of gdphave made the greatest progress in reducing envi-ronmental damage. And although many environmentalistsargue that governments should tackle the problem by banning“undesirable” economic activity, some plausible economictheory suggests that a market-based alternative might be moreefficient. For instance, pollution read more..

  • Page - 17

    traits identified by experimental psychologists, which amountto a frontal assault on the whole idea that people, individuallyor as a group, mostly act rationally. As yet, it is unclear if eco-nomic models can be developed using these traits that work atleast as well as traditional models. But it does seem possible thatin the not too distant future economics will be built on an in-creasingly accurate and realistic understanding of people. Whoknows? People might not regard economics with a human read more..

  • Page - 18

    A–Z001-085 5-12-2003 17:06 Pagina 11 read more..

  • Page - 19

    001-085 5-12-2003 17:06 Pagina 12This page intentionally left blank read more..

  • Page - 20

    AAbsolute advantageThis is the simplest yardstick of economic performance. If oneperson, firm or country can produce more of something withthe same amount of effort and resources, they have an absoluteadvantage over other producers. Being the best at somethingdoes not mean that doing that thing is the best way to use yourscarce economic resources. The question of what to specialise in– and how to maximise the benefits from international trade – isbest decided according to comparative read more..

  • Page - 21

    be sufficient to cover the claims that eventually arise, becauseamong the people who have bought the policy more will haveabove-average risk than below-average risk. Putting up thepremium will not solve this problem, for as the premium risesthe insurance policy will become unattractive to more of thepeople who know they have a lower risk of claiming. One wayto reduce adverse selection is to make the purchase of insurancecompulsory, so that those for whom insurance priced foraverage risk is read more..

  • Page - 22

    the shareholders who own a public company and the managerswho run it. The owners would like managers to run the firm inways that maximise the value of their shares, whereas themanagers’ priority may be, say, to build a business empirethrough rapid expansion and mergers and acquisitions,which may not increase their firm’s share price. One way to reduce agency costs is for the principal tomonitor what the agent does to make sure it is what he has beenhired to do. But this can be costly, too. read more..

  • Page - 23

    workforce employed in such activities has dropped below 6% inthese and most other industrialised countries.The total value of international trade in agriculture has risensteadily. But the global agriculture market remains severely dis-torted by trade barriers and government subsidy, such as theeuropean union’s Common agricultural policy.Agricultural policyCountries often provide support for their farmers using tradebarriers and subsidybecause, for example:domestic agriculture, even if it is read more..

  • Page - 24

    policy has combined incometop-ups and some guaranteedprices.As most governments have become more committed to in-ternational trade, such agricultural policies have come under in-creasing attack, although the free traderhetoric has often runfar ahead of genuine reform. In 2003, rich countries togetherspent over $300 billion supporting their farmers, more than sixtimes what they spent on international aid. Finding a wayto end agricultural support had become by far the biggest re-maining challenge read more..

  • Page - 25

    AmortisationThe running down or payment of a loan by instalments. Anexample is a repayment mortgage on a house, which is amor-tised by making monthly payments that over a pre-agreedperiod of time cover the value of the loan plus interest. Withloans that are not amortised, the borrower pays only interestduring the period of the loan and then repays the sum bor-rowed in full.Animal spiritsThe colourful name that keynesgave to one of the essential in-gredients of economic prosperity: confidence. read more..

  • Page - 26

    opolise commerce. In the early 20th century this law was usedto reduce the economic power wielded by so-called “robberbarons”, such as JP Morgan and John D. Rockefeller, who domi-nated much of American industry through huge trusts that con-trolled companies’ voting shares. Du Pont chemicals, therailroad companies and Rockefeller’s Standard Oil, amongothers, were broken up. In the 1970s the Sherman Act wasturned (ultimately without success) against ibm, and in 1982 itsecured the break-up read more..

  • Page - 27

    policies of building up national champions, allowing chosenfirms to enjoy some monopoly power at home which could beused to make them more effective competitors abroad.However, during the 1990s the European Commission becameincreasingly active in antitrust policy, mostly seeking topromote competition within the eu. In 2000, the eucontroversially blocked a merger betweentwo American firms, geand Honeywell; the deal had alreadybeen approved by America’s antitrust regulators. The contro-versy read more..

  • Page - 28

    nities for pure arbitrage have become rare in recent years, partlybecause of the globalisationof financial markets.Today, much of what is called arbitrage, much of it done byhedge funds, involves assets that have some similarities butare not identical. This is not pure arbitrage and can be far fromrisk free.Arbitrage pricing theoryThis is one of two influential economic theories of how assetsare priced in the financial markets. The other is thecapital asset pricing model. The read more..

  • Page - 29

    disciplined banking and lack of transparency.In the yearsfollowing the crisis, most of the countries involved have intro-duced reforms designed to increase transparency and improvethe health of the banking system, although some (such as SouthKorea) went much further than others (such as Indonesia).AssetsThings that have earning power or some other value to theirowner. Asymmetric informationWhen somebody knows more than somebody else. Such asym-metric information can make it difficult for the two read more..

  • Page - 30

    needs of the rest of the economy. This may be a constantproblem for those responsible for setting the interest rateforthe eurogiven the big differences – and different potential ex-posures to shocks – among the economies within the eurozone.AuctionsGoing, going, gone. Holding an auction can be an extremely ef-ficient way for a seller to set the priceof its products, especiallyif it does not have much informationabout how muchpeople may be willing to pay for them. Auctions read more..

  • Page - 31

    depends on how many bidders take part and how well in-formed they are. Unfortunately for the seller, this information isnot always available before the auction takes place.Austrian economicsA brand of neo-classical economicsestablished in Viennaduring the late 19th century and the first half of the 20thcentury. It was strongly opposed to Marxism and, morebroadly, to the use of economic theories to justify govern-mentintervention in the economy. Prominent members in-cluded Friedrich hayek, Joseph read more..

  • Page - 32

    do so have condemned themselves to inefficiency and compar-ative poverty, compared with countries that engage in inter-national trade.AverageA number that is calculated to summarise a group of numbers.The most commonly used average is the mean, the sum of thenumbers divided by however many numbers there are in thegroup. The median is the middle value in a group of numbersranked in order of size. The mode is the number that occursmost often in a group of numbers. Take the following group read more..

  • Page - 33

    BBackwardationWhen a commodityis valued more highly in a spot market(that is, when it is for delivery today) than in a futures market(for delivery at some point in the future). Normally, interestcosts mean that futures pricesare higher than spot prices,unless the markets expect the price of the commodity to fallover time, perhaps because there is a temporary bottleneck insupply. When spot prices are lower than futures prices it isknown as contango.Balance of paymentsThe total of all the read more..

  • Page - 34

    lead to sharp movements in exchange rates, whichbear little relation to what currencies should be worthjudging by fundamental measures of value such aspurchasing power parity.As bills must be paid, ultimately a country’s accounts mustbalance (although because real life is never that neat a balanc-ing item is usually inserted to cover up the inconsistencies). “Balance of payments crisis” is a politically charged phrase.But a country can often sustain a current account deficit formany years read more..

  • Page - 35

    borrowing need necessarily be bad. For instance, if the debtisused to invest in things that will increase the growthrate ofthe economy – infrastructure, say, or education – it may bejustified. It may also make more economic sense to try tobalance the budget on averageover an entire economic cycle,with public-sector deficits boosting the economy during reces-sionand surpluses stopping it overheating during booms, thanto balance it every year.BankStarting out as places that would guard your read more..

  • Page - 36

    bonds. Universal banks do most or all of the above including,through bancassurance, selling insurance. These banks havelong been a feature of continental European economies.However, in the United States financial laws such as the Glass-Steagall Act have separated different forms of banking fromeach other and kept banks out of the insurance business. Theselaws were abolished in 1999, although during the precedingcouple of decades regulators effectively dismantled them bychanging the way they were read more..

  • Page - 37

    A firm may own a crucial resource, such as an oil well, orit may have an exclusive operating licence, for instance,to broadcast on a particular radio wavelength.A big firm with economies of scalemay have asignificant competitive advantage because it can producea large outputat lower costs than can a smallerpotential rival.An incumbent firm may make it hard for a would-beentrant by incurring huge sunk costs, spending lots ofmoneyon things such as advertising, which anyrival must match to compete read more..

  • Page - 38

    relative riskiness of different loans was crude. For instance, itpenalised banks no more for making loans to a fly-by-night soft-ware company in Thailand than to Microsoft; no more for loansto South Korea, bailed out by the imfin 1998, than to Switzer-land. In 1998, “Basel 2” was proposed, using much more sophis-ticated risk classifications. However, controversy over thesenew classifications, and the cost to banks of administering thenew approach, led to the introduction of Basel 2 being read more..

  • Page - 39

    psychologists have found that they generally compartmentalise,often on superficial grounds. They then make choices aboutthings in one particular mental compartment without takingaccount of the implications for things in other compartments.There is lots of evidence that people are persistently and irra-tionally overconfident. They are also vulnerable to hindsightbias: once something happens they overestimate the extent towhich they could have predicted it. Many of these traits are cap-tured in read more..

  • Page - 40

    cepts in international economics, purchasing powerparity(ppp), the notion that a dollar, say, should buy the sameamount in all countries. In the long run, argue pppfans, cur-rencies should move towards the exchange rate, whichequalises the pricesof an identical basket of goods and ser-vicesin each country. In this case, the basket is a McDonalds’Big Mac, which is produced in more than 100 countries. The BigMac pppis the exchange rate that would leave hamburgerscosting the same in the United read more..

  • Page - 41

    Bonds“Gentlemen prefer bonds,” punned Andrew Mellon, an Ameri-can tycoon. A bond is an interest-bearing securityissued bygovernments, companies and some other organisations.Bonds are an alternative way for the issuer to raise capital toselling sharesor taking out a bankloan. Like shares in listedcompanies, once they have been issued bonds may be tradedon the open market. A bond’s yieldis the interest rate(orcoupon) paid on the bond divided by the bond’s market price.Bonds are regarded as read more..

  • Page - 42

    since most of the world’s best-known brands, from Coca-Colato Nike, are American. That is the case against.Many economists regard brands as a good thing, however. Abrand provides a guarantee of reliability and quality. Consumertrust is the basis of all brand values. So companies that own thebrands have an immense incentive to work to retain that trust.Brands have value only where consumers have choice. Thearrival of foreign brands, and the emergence of domesticbrands, in former communist and read more..

  • Page - 43

    “men who bought property at prices they knew perfectly wellwere fictitious, but who were prepared to pay such pricessimply because they knew that some still greater fool could bedepended on to take the property off their hands and leavethem with a profit”. Such behaviour is a feature of all bubbles.Famous bubbles include tulip mania in Holland during the17th century, when the prices of tulip bulbs reached unheard oflevels, and the South Sea Bubble in Britain a century later, al-though there read more..

  • Page - 44

    BullAn investor who expects the priceof a particular security torise; the opposite of a bear. Business confidenceHow the people who run companies feel about their organisa-tions’ prospects. In many countries, surveys measure averagebusiness confidence. These can provide useful signs about thecurrent condition of the economy, because companies oftenhave informationabout consumer demand sooner thangovernmentstatisticians do. Business cycleBoom and bust. The long-run pattern of economic growthand read more..

  • Page - 45

    Johnson, proclaimed that the business cycle was “obsolete”. Ayear later, the American economy was in recession. Again, in thelate 1990s, some economists claimed that technological innova-tionand globalisationmeant that the business cycle was athing of the past. Alas, they were soon proved wrong.Buyer’s marketA market in which supplyseems plentiful and pricesseemlow; the opposite of a seller’s market.B38BUYER’S MARKET001-085 5-12-2003 17:06 Pagina 38 read more..

  • Page - 46

    CCannibaliseEating people is wrong. Eating your own business may not be.firmsused to be reluctant to launch new products and ser-vicesthat competed with what they were already doing, as thenew thing would eat into (cannibalise) their existing business. Intoday’s innovative, technology-intensive economy, however, awillingness to cannibalise is more often seen as a good thing.This is because innovationoften takes the form of whateconomists call creative destruction (see schumpeter), inwhich a read more..

  • Page - 47

    production, along with land, labourand enterprise.Production processes that use a lot of capital relative to labourare capital intensive; those that use comparatively littlecapital are labour intensive. Capital takes different forms. Afirm’s assets are known as its capital, which may include fixedcapital (machinery, buildings, and so on) and working capital(stocks of raw materials and part-finished products, as well asmoney, that are used up quickly in the production process). Fi-nancial read more..

  • Page - 48

    still be risky. People must be rewarded for investing in such arisky basket by earning returns on average above those thatthey can get on safer assets, such as treasury bills. Assuminginvestors diversify away alpha risks, how an investor valuesany particular asset should depend crucially on how much theasset’s priceis affected by the risk of the market as a whole.The market’s risk contribution is captured by a measure of rela-tive volatility, beta, which indicates how much an asset’sprice read more..

  • Page - 49

    capital controls in the 1980s and did so more rapidly during the1990s.In developed countries, there were two main reasons whycapital controls were lifted: free markets became more fashion-able and financiers became adept at finding ways around thecontrols. Developing countries later discovered that foreigncapital could play a part in financing domestic investment, fromroads in Thailand to telecoms systems in Mexico, and, further-more, that financial capital often brought with it valuablehuman read more..

  • Page - 50

    Capital gainsThe profitfrom the sale of a capital asset, such as a shareor a property. Capital gains are subject to taxationin mostcountries. Some economists argue that capital gains should betaxed lightly (if at all) compared with other sources of income.They argue that the less tax is levied on capital gains, the greateris the incentive to put capital to productive use. Put anotherway, capital gains tax is effectively a tax on capitalism.However, if capital gains are given too friendly a read more..

  • Page - 51

    Opinion (and practice) differs considerably among capitalistcountries about what role the state should play in the economy.But everyone agrees that, at the very least, for capitalism towork the state must be strong enough to guarantee propertyrights. According to Karl marx, capitalism contains the seeds ofits own destruction, but so far this has proved a more accuratedescription of Marx’s progeny, communism.Capital structureThe composition of a company’s mixture of debtand equityfinancing. A read more..

  • Page - 52

    tion. Identifying and breaking up cartels is an important partof the competition policy overseen by antitrustwatchdogsin most countries, although proving the existence of a cartel israrely easy, as firms are usually not so careless as to put agree-ments to collude on paper. The desire to form cartels is strong.As Adam smithput it, “People of the same trade seldom meettogether, even for merriment and diversion, but the conversa-tion ends in a conspiracy against the public or in some read more..

  • Page - 53

    financial system, including by acting as lender of lastresortto commercial banks that get into financial difficulties.The Federal Reserve, the central bank of the United States, wasfounded in 1913. The Bank of England, known affectionately asthe “Old Lady of Threadneedle Street”, was established in 1694,26 years after the creation of the world’s first central bank inSweden. With the birth of the euroin 1999, the monetarypolicypowers of the central banks of 11 European countrieswere read more..

  • Page - 54

    Charity“Bah! Humbug”, was Scrooge’s opinion of charitable giving.Some economists reckon charity goes against economic ratio-nality. Some have argued that the popularity of charitablegiving is proof that people are not economically rational. Othersargue that it shows that altruismis something that people getpleasure (utility) from, and so are willing to spend some oftheir incomeon it. An interesting question is the extent towhich the state is competing with private charity when it read more..

  • Page - 55

    economics. Classical economists, who included Adamsmith, David ricardoand John Stuart Mill, believed that thepursuit of individual self-interest produced the greatest possibleeconomic benefits for society as a whole through the power ofthe invisible hand. They also believed that an economy isalways in equilibriumor moving towards it.Equilibrium was ensured in the labourmarket by move-ments in wagesand in the capitalmarket by changes in therate of interest. The interest rateensured that read more..

  • Page - 56

    CollateralAn assetpledged by a borrower that may be seized by a lenderto recover the value of a loan if the borrower fails to meet therequired interestcharges or repayments. CollusionSee cartel.Command economyWhen a governmentcontrols all aspects of economic activity(see, for example, communism).CommodityA comparatively homogeneous product that can typically bebought in bulk. It usually refers to a raw material – oil, cotton,cocoa, silver – but can also describe a manufactured productused to read more..

  • Page - 57

    costing a lot and earning their makers a high profiton eachchip. Now chips are largely homogeneous: the same chip can beused for many things, and any manufacturer willing to invest insome fairly standardised equipment can make them. As a result,competitionis fierce and pricesand profit margins are low.Some economists argue that in today’s economy the faster paceof innovation will make the process of commoditisation in-creasingly common.Common goodsSee tragedy of the commons.CommunismThe enemy read more..

  • Page - 58

    vantage– in every sort of economic activity. Comparative ad-vantage is about identifying which activities a country (or firmor individual) is most efficient at doing.To see how this theory works imagine two countries, Alphaand Omega. Each country has 1,000 workers and can make twogoods, computers and cars. Alpha’s economy is far more pro-ductive than Omega’s. To make a car, Alpha needs two workers,compared with Omega’s four. To make a computer, Alpha uses10 workers, compared with read more..

  • Page - 59

    have a comparative advantage in the industry in which it is rel-atively least bad.There is no reason to assume that a country’s comparativeadvantage will be static. If a country does what it has a com-parative advantage in and sees its incomegrow as a result, itcan afford better education and infrastructure. These, inturn, may give it a comparative advantage in other economic ac-tivities in future.CompetitionThe more competition there is, the more likely are firmsto beefficient and pricesto be read more..

  • Page - 60

    Competitive advantageSomething that gives a firm (or a person or a country) an edgeover its rivals. Competitiveness“Real economists don’t talk about competitiveness,” said PaulKrugman, a much-respected contemporary economist. Realbusinessmen and real politicians talk about it all the time,however. Many firmshave undergone savage downsizing toremain competitive, and governments have set up numerouscommittees to examine how to sharpen their countries’ eco-nomic performance.Krugman’s read more..

  • Page - 61

    demandfor one leads to an increase (fall) in demand for theother. Complements are the opposite of substitute goods.For instance, Microsoft Windows-based personal computersand Apple Macs are substitutes.Compound interestIf a deposit account of $100 earns an interest rateof 10% ayear, then at the end of the year the account will contain $110. Ifall of that money is left in the account, then the 10% interest willbe paid on the $110, so at the end of the second year $11 of in-terest will be added, read more..

  • Page - 62

    ConditionalityWhen there are strings attached – for example, to interna-tional aidor loans from the imfor world bank. Deliveryof the moneymay be made subject to the governmentofthe country implementing economic or political reforms desiredby the donor or lender. Consumer confidenceHow good consumers feel about their economic prospects. Mea-sures of averageconsumer confidence can be a useful, thoughnot infallible, indicator of how much consumers are likely tospend. Combined with measures such read more..

  • Page - 63

    spending). The more resources a society consumes, the less ithas to save or invest, although, paradoxically, higher consump-tion may encourage higher investment. The life-cycle hy-pothesissuggests that at certain stages of life individuals aremore likely to be saving than consuming, and at other stagesthey are more likely to be heavy consumers. Some economistsargue that consumption taxes are a more efficient form of tax-ationthan taxes on wealth, capital, property or income.ContagionThe domino read more..

  • Page - 64

    human capital. They also attract less foreign direct in-vestment.There is no such thing as good corruption, but some sortsof corruption are less bad than others. Some economists pointto similarities between bribery and paying taxes or buying alicence to operate. Where it is predictable – where the briberknows what to pay and can be sure of getting what it paysfor – corruption harms the economy far less than where it iscapricious.The absence of corruption has huge economic benefits,however, read more..

  • Page - 65

    Cost of capitalThe amount a firm must pay the owners of capitalfor theprivilege of using it. This includes interestpayments oncorporate debt, as well as the dividends generated for share-holders. In deciding whether to proceed with a project, firmsshould calculate whether the project is likely to generate suffi-cient revenue to cover all the costs incurred, including the costof capital. Calculating the cost of equitycapital can be tricky(see capital asset pricing modeland beta).Creative read more..

  • Page - 66

    Credit crunchWhen bankssuddenly stop lending, or bondmarket liquid-ityevaporates, usually because creditors have become ex-tremely risk averse.CreditorA lender, whether by making a loan, buying a bondor allow-ing moneyowed now to be paid in the future.Crony capitalismAn approach to business based on looking after yourself bylooking out for your own. At least until the crisis of the late1990s, some Asian companies, and even governments, werenotable for awarding contracts only to family and read more..

  • Page - 67

    Currency boardA means by which some countries try to defend their currencyfrom speculative attack. A country that introduces a currencyboard commits itself to converting its domestic currency ondemand at a fixed exchange rate. To make this commitmentcredible, the currency board holds reservesof foreign cur-rency (or goldor some other liquid asset) equal at the fixedrate of exchange to at least 100% of the value of the domesticcurrency that is issued.Unlike a conventional central bank, which can read more..

  • Page - 68

    more, a classic currency board, unlike a central bank, cannot actas a lender of last resort. A conventional central bank canstem a potential banking panic by lending money freely tobanks that are feeling the pinch. A classic currency boardcannot, although in practice some currency boards have morefreedom than the classic description implies. The danger is thatif they use this freedom, governments may cause currency spec-ulators and others to doubt the government’s commitment toliving within read more..

  • Page - 69

    DDeadweight cost/lossThe extent to which the value and impact of a tax, tax relief orsubsidyis reduced because of its side-effects. For instance, in-creasing the amount of tax levied on workers’ pay will leadsome workers to stop working or work less, so reducing theamount of extra tax to be collected. However, creating a taxrelief or subsidy to encourage people to buy life insurancewould have a deadweight cost because people who wouldhave bought insurance anyway would benefit.Debt“Neither a read more..

  • Page - 70

    countries. Some of these countries have to pay so much ininteresteach year to foreign lenders that they have littlemoneyleft to spend on the long-term solutions to theirpoverty, such as educating their workers and building amodern infrastructure. In 1998 the world bankcalcu-lated that around 40 of the world’s poorest countries had an“unsustainably high” debt burden: the present value of theirtotal debts was more than 220% of their exports.Debt forgiveness has potential drawbacks. For read more..

  • Page - 71

    DeficitIn the red – when more money goes out than comes in. Abudgetdeficit occurs when public spendingexceeds gov-ernmentrevenue. A current account deficit occurs whenexportsand inflows from private and official transfersareworth less than importsand transfer outflows (see balanceof payments).DeflationSince 1930 it has been the norm in most developed countries foraverage pricesto rise year after year. However, before 1930deflation (falling prices) was as likely as inflation. On the eveof the read more..

  • Page - 72

    prices also inflate the real burden of debt(that is, increase realinterest rates) causing bankruptcyand bankfailure. Thismakes deflation particularly dangerous for economies that havelarge amounts of corporate debt. Most serious of all, deflationcan make monetary policyineffective: nominal interestrates cannot be negative, so real rates can get stuck too high.DemandOne of the two words economists use most; the other issupply. These are the twin driving forces of the marketeconomy. Demand is not read more..

  • Page - 73

    Demand curveA graph showing the relationship between the price of a goodand the amount of demand for it at different prices. (See alsosupply curve.)DemographicsPeople, and the statistical study of them. In the 200 years sinceThomas Malthus forecast that population growthwouldresult in mass starvation, dire predictions based on demo-graphic trends have come to be taken with a pinch of salt. Evenso, demography does matter. In developed countries,economists have studied the impact of the post-war read more..

  • Page - 74

    increasingly looked after retired people, and infant mortalityrates were lower so fewer births were required to ensure thatthere were some children around in the parental dotage. Also,with a lower probabilityof a child dying, it paid the parentsto have fewer children and to channel their energy and re-sources into maximising the humancapitalof the few.Alternatively, it may have had something to do with an im-portant innovation: the cheap and easy availability of reli-able contraception.Deposit read more..

  • Page - 75

    only in secure assets; and uninsured institutions, “broad banks”,which could range more widely under a much lighter regulatorysystem. Savers who invested in a broad bank would probablyearn much higher returnsbecause it could invest in riskierassets; but they would also lose their shirts if it went bust.Yet another possible answer is to require every bank tofinance a small proportion of its assets by selling subordinateddebtto other institutions, with the stipulation that the yieldonthis debt read more..

  • Page - 76

    The most famous example is the Great Depression of the1930s. After growing strongly during the “roaring 20s”, theAmerican economy (among others) went into prolonged reces-sion. Output fell by 30%. unemploymentsoared and stayedhigh: in 1939 the jobless rate was still 17% of the workforce.Roughly half of the 25,000 banksin the United States failed.An attempt to stimulate growth, the New Deal, was the mostfar-reaching example of active fiscal policythen seen andgreatly extended the role of the read more..

  • Page - 77

    Bad monetary policywas abetted by bad fiscal policy.Taxes were raised in 1932 to help balance the budget and restoreconfidence. The New Deal brought deposit insuranceandboosted governmentspending, but it also piled taxes onbusiness and sought to prevent excessive competition. Pricecontrols were brought in, along with other anti-business regula-tions. None of this stopped – and indeed may well have con-tributed to – the economy falling into recession again in 1937–38,after a brief recovery read more..

  • Page - 78

    allowing more precise pricing of financial riskand better riskmanagement. However, they concede that when derivativesare misused the leveragethat is often an integral part of themcan have devastating consequences. So they come with aneconomists’ health warning: if you don’t understand it, don’t use it.The world of derivatives is riddled with jargon. Here aretranslations of the most important bits.A forward contract commits the user to buying or sellingan asset at a specific price on a read more..

  • Page - 79

    that most of the people feel that the law is on their side. Oneof the best ways to achieve this is to give full legal protection tothe de facto property rights that are observed informally bythe poor, such as when a community recognises that a certainfamily is entitled to occupy a particular piece of land.According to his research, carried out in several countrieswith his think tank, the Institute for Liberty and Democracy,such informal property rights cover assets(notably land andhousing) worth read more..

  • Page - 80

    veloping countries are to become developed. neo-classicaleconomicspredicts that poor countries will grow faster thanricher ones. The reason is diminishing returnson capital.Since poor countries start with less capital, they should reaphigher returnsthan a richer country with more capital fromeach slice of new investment. But this catch-up effect(orconvergence) is not supported by the data. For one thing, thereis, in fact, no such thing as a typical developing country. The of-ficial developing read more..

  • Page - 81

    that some developing countries do not help themselves becausethey squander the resources they have. Institutions thatproduce effective governance of an economy are crucial. Thosecountries that use their resources well can grow quickly. Indeed,the world’s fastest-growing economies are a small subgroup ofexceptional performers among the poor countries.Development economicsSpawned by the end of the colonial era in the 1950s and 1960s,a whole branch of economic theory grew up around the ques-tion read more..

  • Page - 82

    Diminishing returnsThe more you have, the smaller is the extra benefit you get fromhaving even more; also known as diseconomies of scale (seeeconomies of scale). For instance, when workers have a lotof capitalgiving them a little more may not increase theirproductivityanywhere near as much as would giving thesame amount to workers who currently have little or no capital.This underpins the catch-up effect, whereby there is (sup-posedly) convergence between the rates of growthof de-veloping read more..

  • Page - 83

    in future is worth less than money now, because money nowcould be invested and earn interest, whereas future moneycannot. firmsuse discounted cash flow to judge whether aninvestmentproject is worthwhile. The interest rate is a meansof reflecting the opportunity costof tying up money in theinvestment project. To test whether an investment makes eco-nomic sense, the incomemust be discounted so that it can bemeasured against the costs. If the present value of the benefitsexceeds the costs, the read more..

  • Page - 84

    technological changes have done away with the need for estab-lished intermediaries. bankshave seen much of their businessslip away, such as lending to companies that now tap capitalmarketsdirect. new economytheorists argued that manyretailers would be disintermediated as the internet enabled cus-tomers to transact directly with producers without needing tovisit a shop. But this has happened more slowly than theypredicted.DiversificationNot putting all your eggs in one basket. Investors are read more..

  • Page - 85

    trades and ending up masters of none. The logic of dividing theworkforce into different crafts and professions is the same asthat underpinning the case for free trade: everybody benefitsfrom doing those things in which they have a comparativeadvantageand using incomefrom doing so to meet theirother needs.DollarisationWhen a country’s own moneyis replaced as its citizens’ pre-ferred currency by the US dollar. This can be a deliberate gov-ernmentpolicy or the result of many private choices read more..

  • Page - 86

    DumpingSelling something for less than the cost of producing it. Thismay be used by a dominant firmto attack rivals, a strategyknown to antitrustauthorities as predatory pricing. Par-ticipants in international trade are often accused of dumping bydomestic firmscharging more than rival imports. Countriescan slap duties on cheap imports that they judge are beingdumped in their markets. Often this amounts to thinly disguisedprotectionismagainst more efficient foreign firms.In practice, genuine read more..

  • Page - 87

    EECBSee european central bank.EconometricsMathematics and sophisticated computing applied to eco-nomics. Econometricians crunch data in search of economicrelationships that have statistical significance. Some-times this is done to test a theory; at other times the computerschurn the numbers until they come up with an interestingresult. Some economists are fierce critics of theory-free econo-metrics. Economic and monetary unionIn January 1999, 11 of the 15 countries in the european unionmerged read more..

  • Page - 88

    How well the euro zone functions will depend on how closelyit resembles what economists call an optimal currencyarea. When the euro economies are not growing in unison, acommon monetary policyrisks being too loose for someand too tight for others. If so, there may need to be large trans-fersof funds from regions doing well to those doing badly. Butif the effects of shocks persist, fiscal transfers would merelydelay the day of reckoning; ultimately, wagesor people (orboth) would have to shift. In read more..

  • Page - 89

    altruismand charity. behavioural economicshasdrawn on psychological insights into human behaviour toexplain economic phenomena.Economic rentSee rent.EconomicsThe “dismal science”, according to Thomas Carlyle, a 19th-century Scottish writer. It has been described in many ways,few of them flattering. The most concise, non-abusive, defini-tion is the study of how society uses its scarce resources.Economic sanctionsA way of punishing errant countries, which is currently moreacceptable than read more..

  • Page - 90

    Widely considered a notable success was the use of eco-nomic sanctions against the apartheid regime in South Africa, al-though some economists question how big a part the sanctionsactually played. Clearly important was the fact that the sanc-tions were imposed multilaterally by the international commu-nity, so there were comparatively few breaches of therestrictions. But, arguably, the most crucial factor in persuadingthe government in Pretoria to cave in was that foreign compa-nies, fearing read more..

  • Page - 91

    Efficient market hypothesisYou can’t beat the market. The efficient market hypothesis saysthat the priceof a financial assetreflects all the informa-tionavailable and responds only to unexpected news. Thusprices can be regarded as optimal estimates of true investmentvalue at all times. It is impossible for investors to predictwhether the price will move up or down (future price move-ments are likely to follow a random walk), so on averagean investor is unlikely to beat the market. This belief read more..

  • Page - 92

    supplyof a good, or demandfor it, changes if its pricechanges. If the percentage change in quantity is morethan the percentage change in price, the good is priceelastic; if it is less, the good is price inelastic.incomeelasticity of demand measures how thequantity demanded changes when income increases.Cross-elasticity shows how the demand for one good(say, coffee) changes when the price of another good(say, tea) changes. If they are substitute goods(tea and coffee) the cross-elasticity will be read more..

  • Page - 93

    budgets of poor people. Hence the share of food in total spend-ing falls as incomes grow.EnronIn a word, all that was wrong with American capitalismatthe start of the 21st century. Until late 2001, Enron, an energycompany turned financial powerhouse based in Houston,Texas, had been one of the most admired firms in the UnitedStates and the world. It was praised for everything from pio-neering energy trading via the internet to its innovative corpor-ate culture and its system of employment read more..

  • Page - 94

    Environmental economicsSome people think capitalismis wholly bad for the environ-ment as it is based on consuming scarce resources. They wantless consumptionand greater reliance on renewable re-sources. They oppose free tradebecause they favour self-suf-ficiency (autarky), or at least so-called fair trade, andbecause they believe it encourages poorer countries to destroytheir natural resources in order to get rich quick. Although fewprofessional economists would share these views, in recentyears read more..

  • Page - 95

    outside the poor countries, or that rich people disapprove of,such as chopping down the rain forests. Choices on environ-mental policy, notably on measures to reduce the threat ofglobal warming, involve costs today with benefits delayed untilthe distant future. How are these choices to be made? Traditional cost-benefit analysisdoes not help much. In measuring costs andbenefits in the far distant future, two main things seem to inter-vene and spoil the conventional calculations. One is read more..

  • Page - 96

    EquitiesSee shares.EquityThere are two definitions in economics.1 The capital of a firm, after deducting any liabilities to outsidersother than shareholders, who are typically the legal owners ofthe firm’s equity. This ownership right is the reason sharesarealso known as equities.2 Fairness. Dividing up the economic pie. Economists have beenparticularly interested in this with regard to how systems oftaxationwork. They have examined whether taxes treatfairly people with the same ability to pay read more..

  • Page - 97

    appears to be justified by the average riskiness of shares. Tosolve this so-called equity premium puzzle, some economistshave suggested that investors may have greater risk aversiontowards shares than traditional theory assumes. Some claimthat the past equity premium was mismeasured, or reflected anunrepresentative sample of share prices. Others suggest thatthe high premium is evidence that the efficient market hy-pothesisdoes not apply to the stockmarket. Some economiststhink that the premium read more..

  • Page - 98

    European UnionA club of European countries. Initially a six-country tradeareaestablished by the 1957 Treaty of Rome and known as theEuropean Economic Community, it has become an increasinglypolitical union. In 1999 a single currency, the euro, waslaunched in 11 of the then 15 member countries. Viewed as asingle entity, the euhas a bigger economy than the UnitedStates. In 2002, a further 10 countries were invited to join the euin 2004, increasing its membership to 25 countries, with morecountries read more..

  • Page - 99

    especially monopoly, because otherwise the existence ofexcess returns would quickly attract competition, whichwould drive down returns until they were normal.Exchange controlsLimits on the amount of foreign currency that can be taken intoa country, or of domestic currency that can be taken abroad. Exchange rateThe priceat which one currency can be converted intoanother. Over the years, economists and politicians have oftenchanged their minds about whether it is a good idea to try tohold a read more..

  • Page - 100

    amounts of capital flow in or out of a country. This instabilityhas real economic costs.To get the best of both worlds, many emerging economieshave tried a hybrid approach, loosely tying their exchange rateeither to a single foreign currency, such as the dollar, or to abasket of currencies. But the currency crises of the late 1990s, andthe failure of Argentina’s currency board, led many economiststo conclude that, if not a currency union such as the euro, thebest policy may be to have a freely read more..

  • Page - 101

    Expenditure taxA tax on what people spend, rather than what they earn or theirwealth. Economists often regard it as more efficient than othertaxes because it may discourage productive economic activityless; it is not the creating of incomeand wealth that is taxed,but the spending of it. It can be a form of indirect taxation,added to the priceof a good or service when it is sold, ordirect taxation, levied on people’s income minus theirsavingsover a year.Export creditLoans to boost exports. In read more..

  • Page - 102

    arising from an economic activity that affect somebody otherthan the people engaged in the economic activity and are not re-flected fully in prices. For instance, smoke pumped out by afactory may impose clean-up costs on nearby residents; beeskept to produce honey may pollinate plants belonging to anearby farmer, thus boosting his crop. Because these costs andbenefits do not form part of the calculations of the people de-ciding whether to go ahead with the economic activity they area form of read more..

  • Page - 103

    FFactor costA measure of outputreflecting the costs of the factors ofproductionused, rather than market prices, which maydiffer because of indirect taxand subsidy(see gdp).Factors of productionThe ingredients of economic activity: land, labour, capitaland enterprise.Factory pricesThe pricescharged by producers to wholesalers and retailers.Because these prices are eventually passed on to the end cus-tomer, changes in factory prices, also known as producerprices, can be a leading indicatorof read more..

  • Page - 104

    traders’ other complaint, that free trade harms poor countries.(See comparative advantage.)FDISee foreign direct investment.Federal Reserve SystemAmerica’s central bank. Set up in 1913, and popularly knownas the Fed, the system divides the United States into 12 FederalReserve districts, each with its own regional Federal Reservebank. These are overseen by the Federal Reserve Board, consist-ing of seven governors based in Washington, dc. monetarypolicyis decided by its Federal Open Market read more..

  • Page - 105

    Financial intermediaryA middleman. An individual or institution that brings togetherinvestors (the source of funds) and users of funds (such as bor-rowers). May be increasingly at risk of disintermediation.Financial marketsSee capital marketsand money markets.Financial systemThe firmsand institutions that together make it possible formoneyto make the world go round. This includes financialmarkets, securities exchanges, banks, pension funds, mutualfunds, insurers, national regulators, such as the read more..

  • Page - 106

    FirmsFor many years, economists had little interest in what happenedinside firms, preferring instead to examine the workings of thedifferent sorts of industries in which firms operate, rangingfrom perfect competitionto monopoly. Since the 1960s,however, sophisticated economic theories of how firms workhave been developed. These have examined why firms grow atdifferent rates and tried to model the normal life cycle of acompany, from fast-growing start-up to lumbering mature busi-ness. The aim is read more..

  • Page - 107

    constant or are changed only gradually. By contrast, when theeconomy grows, income, spending and corporate profitrise.So the tax-take increases too, without any need for govern-mentaction. This helps slow the rate of increase in demand,reducing the pace of growth, making it less likely to result inhigher inflation. Thus fiscal drag is an automatic stabiliser, asit acts naturally to keep demand stable.Fiscal neutralityWhen the net effect of taxationand public spendingisneutral, neither read more..

  • Page - 108

    Some economists and policymakers argue for a balancedbudget. Others say that a persistent deficit(public spendingexceeding revenue) is acceptable provided, in accordance withthe golden rule, the deficit is used for investment(in in-frastructure, say) rather than consumption. However,there may be a danger that public-sector investment will resultin the crowding outof more productive private invest-ment. Whatever the overall stance on averageover an eco-nomic cycle, most economists agree that read more..

  • Page - 109

    FlotationGoing public. When sharesin a company are sold to the publicfor the first time through an initial public offering. The numberof shares sold by the original private investors is called the“float”. Also, when a bondissue is sold in the financialmarkets. ForecastingBest guesses about the future. Despite complex economic theo-ries and cutting-edge econometrics, the forecasts economistsmake are often badly wrong. Indeed, following economic fore-casts has been likened to driving a car read more..

  • Page - 110

    regard fdiand trade as complementary. For example, a firmcan use a factory in one country to supply neighbouringmarkets. Some investments, especially in servicesindustries,are essential prerequisites for selling to foreigners. Who wouldbuy a Big Mac in London if it had to be sent from New York?Governments used to be highly suspicious of fdi, often re-garding it as corporate imperialism. Nowadays they are morelikely to court it. They hope that investors will create jobs, andbring expertise and read more..

  • Page - 111

    However, there can sometimes be a free-rider problem, if thenumber of people willing to pay for the good or service is notenough to cover the cost of providing it. In this case, the good orservice might not be produced, even though it would be benefi-cial for the economy as a whole to have it. public goodsareoften at risk of free riding; in their case, the problem can beovercome by financing the good by imposing a tax on the entirepopulation.Free tradeThe ability of people to undertake economic read more..

  • Page - 112

    Most trade occurs between countries that do not have huge costdifferences. The biggest trading partner of the United States, forinstance, is Canada. Well over half the exports from France,Germany and Italy go to other european unioncountries.Moreover, these countries sell similar things to each other: carsmade in France are exported to Germany, and German cars goto France. The main reason seems to be cross-border differencesin consumer tastes. But the agricultural exports of Australia, say,or read more..

  • Page - 113

    Like Adam smithand Friedrich hayek, who inspired him,Friedman praises the free market not just for its economic effi-ciencybut also for its moral strength. For him, freedom – eco-nomic, political and civil – is an end in itself, not a means to anend. It is what makes life worthwhile. He has said he wouldprefer to live in a free country, even if it did not provide ahigher standard of living, than a country run by an alternativeregime. However, the likelihood of a free country being poorerthan read more..

  • Page - 114

    who is owed $1 does not care which particular dollar he gets.Anything that people want to use as moneymust be fungible,whether it be goldbars, beads or shells.FuturesSee derivatives.FUTURES107080-160 5-12-2003 17:07 Pagina 107 read more..

  • Page - 115

    GG7, G8, G10, G21, G22, G26“I don’t want to belong to any club that will accept me as amember,” quipped Groucho Marx. But the world’s politiciansare desperate to join the economic clubs that are the Group ofSeven (g7), g8, g10 and so on. Being a member shows that, eco-nomically speaking, your country matters. Alas, beyond makingpoliticians feel good, there has not been much evidence inrecent years that they do anything useful, apart from lettinggovernmentofficials and journalists talk to read more..

  • Page - 116

    take into account what others are likely to do and how othersmight respond to what they do. For instance, competitionbetween two firms can be analysed as a game in which firmsplay to achieve a long-term competitiveadvantage(perhaps even a monopoly). The theory helps each firm todevelop its optimal strategy for, say, pricing its products anddeciding how much to produce; it can help the firm to antici-pate in advance what its competitor will do and shows howbest to respond if the competitor does read more..

  • Page - 117

    government subsidy, however, gdpcan be calculated atfactor cost. This measure more accurately reveals theincomepaid to factors of production. Adding incomeearned by domestic residents from their investments abroad,and subtracting income paid from the country to investorsabroad, gives the country’s gross national product (gnp).The effect of inflationcan be eliminated by measuringgdpgrowthin constant real prices. However, someeconomists argue that hitting a nominal gdptarget should bethe main read more..

  • Page - 118

    General Agreement on Tariffs and TradeOr gatt, the vehicle for promoting international free trade,through a series of rounds of negotiations between the govern-ments of trading countries. The first gattround began in 1945.The last led to the establishment of the world trade or-ganisationin 1995.General equilibriumEconomic perfection. This is when demandand supplyare inbalance (the market is in equilibrium) for each and everygood and service in the economy. Nobody thinks that real-world economies read more..

  • Page - 119

    Giffen goodsNamed after Robert Giffen (1837–1910), a good for whichdemand increases as its pricerises. But such goods may notexist in the real world.GiltsShorthand for gilt-edged securities, meaning a safe bet, atleast as far as receiving interestand avoiding default goes.The priceof gilts can vary considerably over time, however,creating a degree of riskfor investors. Usually the term isapplied only to government bonds.Gini coefficientAn inequalityindicator. The Gini coefficient measures the read more..

  • Page - 120

    notably the growthin international trade and in flows ofcapitalaround the world. Globalisation has also been used todescribe growing incomeinequality between the world’s richand poor; the growing power of multinational companies rela-tive to national government; and the spread of capitalisminto former communist countries. Usually, the term is synony-mous with international integration, the spread of free marketsand policies of liberalisationand free trade. The processis not the result simply read more..

  • Page - 121

    alone but only by the joint efforts of many (strictly, all) coun-tries. Some economists, along with global institutions such asthe un, reckon that such goods include international law andlaw enforcement, a stable global financial system, an opentrading system, health, peace and environmental sustainability.GNIShort for gross national income, a term now used instead ofgnp in national accounts.GNPShort for gross national product, another measure of a country’seconomic performance. It is read more..

  • Page - 122

    failed to keep pace with inflation. The liquidityof gold is alsoless than that of a foreign currency so it cannot as easily be usedfor foreign exchange intervention in defence of a currency underattack. In short, gold is no longer a monetary asset. It hasbecome just another commodity, although so-called gold-bugsstill believe that should inflation ever soar again, gold will oncemore become the thing to have.Gold standardA monetary system in which a country backs its currency witha reserve of read more..

  • Page - 123

    GovernmentThere are few more hotly debated topics in economicsthanwhat role the state should play in the economy. Plenty ofeconomists provided intellectual support for state interventionduring the era of big government, particularly from the 1930s tothe 1980s. keynesians argued that the state should manage theamount of demandin the economy to maintain full em-ployment. Others advocated a command economy,inwhich the government would decide pricelevels, oversee theallocation of scarce resources read more..

  • Page - 124

    defined, enforceable property rights. The legal system isprobably an example of what economists call a public good(although the existence in many countries and industries ofsome self-regulation shows it is not always so).Although politicians in many countries spent most of theperiod since 1980 talking about the need to reduce the role ofthe state in the economy, and in many cases introduced policiesof privatisation, deregulationand liberalisationto helpthis happen, public spending has continued read more..

  • Page - 125

    Greenspan, AlanThe most famous of all central bankbosses, so far. A formerjazz musician turned economist, he became chairman of theboard of governors of America’s federal reserve in 1987,shortly before Wall Street crashed. In 2003, he was reappointeduntil 2005. He won admirers for delivering monetary policythat helped to bring down inflationand create the conditionsfor strong economic growth. Some people considered him thenearest thing capitalismhad to God. In 1996, he famouslywondered aloud read more..

  • Page - 126

    GrowthWhat economic activity is all about, but how can it be madeto happen? Economists have plenty of theories, but none ofthem has all the answers.Adam smithattributed growth to the invisible hand, aview shared by most followers of classical economics.neo-classical economicshad a different theory ofgrowth, devised by Robert Solow during the 1950s. This arguedthat a sustained increase in investmentincreases aneconomy’s growth rate only temporarily: the ratio of capitalto labourgoes up, the read more..

  • Page - 127

    rights, typically have higher growth rates. Open economieshave grown much faster on average than closed economies.Higher public spendingrelative to gdpis generally associ-ated with slower growth. Also bad for growth are high infla-tionand political instability.As countries grew richer during the 20th century annualgrowth rates declined, as a result of diminishing returnsoncapital. By 1990, most developed countries reckoned to havelong-term trend growth rates of 2–2.5% a year. However, read more..

  • Page - 128

    HHard currencymoneyyou can trust. A hard currency is expected to retainits value, or even benefit from appreciation, against softercurrencies. This makes it a popular choice for people involvedin international transactions. The dollar, d-mark, sterling andthe Swiss franc each became a hard currency, if only some ofthe time, during the 20th century.HawalaAn ancient system of moving moneybased on trust. It pre-dates western bankpractices. Although it is now more associ-ated with the Middle East, a read more..

  • Page - 129

    business cyclemany years after this body of work seemed tohave been disproved by keynes. Born in 1899, Hayek attendedhis home-town University of Vienna after the first world war.He was attracted to socialismuntil he read a pioneering Aus-trian economist, Ludwig von Mises, on the subject, after which,he said, “the world was never the same again”.Hayek argued that the business cycle originated from ex-panded credit creationby banks, which was followed byfirmsand people making mistaken read more..

  • Page - 130

    ducers and traders, financial institutions and, increasingly, bynon-financial firms.It used to be fashionable for firms to hedge by following apolicy of diversification. More recently, firms have hedgedusing financial instruments and derivatives. Another popularstrategy is to use “natural” hedges wherever possible. Forexample, if a company is setting up a factory in a particularcountry, it might finance it by borrowing in the currency of thatcountry. An extension of this idea is operational read more..

  • Page - 131

    rather than relative ones; that is, they concentrate on making asmuch moneyas possible, not (like many mutual funds) simplyon outperforming an index. Although they are often accused ofdisrupting financial markets by their speculation, their will-ingness to bet against the herd of other investors may push se-curity prices closer to their true fundamental values, not away.Herfindahl-Hirschman indexA warning signal of possible monopoly. antitrusteconomists often gauge the competitivenessof an read more..

  • Page - 132

    people with a similar ability to pay taxes should pay the sameamount. (See equityand vertical equity.)Horizontal integrationMerging with another firm just like yours, for example, twobiscuit makers becoming one. Contrast with vertical inte-gration, which is merging with a firm at a different stage inthe supplychain. Horizontal integration often raises anti-trustconcerns, as the combined firm will have a larger marketshare than either firm did before merging. Hot moneymoney that is held in one read more..

  • Page - 133

    speculation, rather than merely accommodation, it seems in-evitable that prices will be volatile, prone to a boom-bust cycle.As house prices rise, profits are made, tempting more specula-tive buyers into the market; eventually, they start to pay toomuch, interest rates rise, demandfalls and prices plunge.People have also invested in housing as a hedgeagainst in-flation: house prices generally rise when other prices rise,whereas the real valueof mortgage debtis eroded by infla-tion. However, when read more..

  • Page - 134

    and faith, rather than the result of detailed empirical analysis.Economists have made little progress in solving the trickyproblem of how to measure human capital, even within thesame country over time, let alone for comparisons betweencountries. Levels of spending on, say, education are not neces-sarily a good indicator of how much human capital an educationsystem is creating; indeed, some economists argue that higher ed-ucation spending may be a consequence of a country becomingwealthy rather read more..

  • Page - 135

    wreaks huge economic damage. After the first world war,German prices at one point were rising at a rate of 23,000% a yearbefore the country’s economic system collapsed, creating a polit-ical opportunity grasped by the Nazis. In former Yugoslavia in1993, prices rose by around 20% a day. Typically, hyper-inflationquickly leads to a complete loss of confidence in a country’s cur-rency, and causes people to search for other forms of moneythatare a better store of value. These may include read more..

  • Page - 136

    that high unemploymentwas a cyclical phenomenon. Even-tually, unemployment would cause people to lower their wagedemands, and so new job opportunities would arise and unem-ployment would fall. More recently, however, economists havesuggested that some unemployed people, especially the long-term jobless, can display hysteresis. They find it hard, perhapsimpossible, to return to work, even when jobs become avail-able. For instance, unemployed workers may gradually lose themotivation, read more..

  • Page - 137

    IILOShort for International Labour Organisation, founded in 1919 aspart of the Treaty of Versailles, which created the League ofNations. In 1946, it became the first specialised agency of theun. Based in Geneva, it formulates international labourstan-dards, setting out desired minimum rights for workers: freedomof association; the right to organise and engage in collective bar-gaining; equality of opportunity and treatment; and the aboli-tion of forced labour. It also compiles international read more..

  • Page - 138

    fortunately, the imfhas often approved “one size fits all” poli-cies that, not much later, turned out to be inappropriate. It hasalso been accused of creating moral hazard, in effect en-couraging governments (and firms, banksand other in-vestors) to behave recklessly by giving them reason to expectthat if things go badly the imfwill organise a bail-out. Indeed,some financiers have described an investmentin a finan-cially shaky country as a “moral-hazard play” because theywere so read more..

  • Page - 139

    Income effectA change in the demandfor a good or service caused by achange in the incomeof consumers rather than, say, a changein consumer tastes. Contrast with substitution effect.Income taxA much-loathed method of taxation based on earnings. Itwas first collected in 1797 by the Dutch Batavian Republic. In theUK it was introduced in 1799 as a “temporary” measure tofinance a war against Napoleon, abolished in 1816 and reintro-duced, forever, in 1842. In most countries, people do not pay read more..

  • Page - 140

    pensions, unemploymentbenefits and some other sorts ofincomeare automatically raised according to recent move-ments in the consumer priceindex. This allows these differentsorts of income to retain their value in real terms.Index numbersEconomists love to compile indices aggregating lots of individ-ual data, so they can analyse broad trends in the behaviour ofan economy. inflationis measured by an index of consumer(retail) prices. There are indices of all sorts of things that arebought and sold read more..

  • Page - 141

    because it may be less noticeable to people paying it thanincome tax and is harder to avoid paying. InelasticWhen the supplyor demandfor something is insensitive tochanges in another variable, such as price.(See elasticity.)InequalityDoes economic growthcreate more or less equality? Dounequal societies grow more or less slowly than equal ones?Economists have debated these questions for as long as anyonecan remember. One problem is to agree which sort of inequalitymatters: equality of outcome read more..

  • Page - 142

    Inferior goodsProducts that are less in demand as consumers get richer. Fornormal goods, demandincreases as consumers have moreto spend.InflationRising prices, across the board. Inflation means less bang foryour buck, as it erodes the purchasing power of a unit of cur-rency. Inflation usually refers to consumer prices, but it canalso be applied to other prices (wholesale goods, wages,assets, and so on). It is usually expressed as an annual per-centage rate of change on an index number. For much read more..

  • Page - 143

    policyshould aim for stable prices. Some economists arguethat a low level of inflation can be a good thing, however, if it isa result of innovation. New products are launched at highprices, which quickly come down through competition. Mosteconomists reckon that deflation(falling averageprices) isbest avoided.To keep inflation low you need to know what causes it.Economists have plenty of theories but no absolutely cast-ironconclusions. Inflation, Milton friedmanonce said, “is alwaysand read more..

  • Page - 144

    Inflation targetThe goal of monetary policyin many countries is to ensurethat inflationis neither to high nor too low. It became fash-ionable during the 1990s to set a country’s central bankanexplicit rate of inflation to target. By 1998, some 54 central bankshad an inflation target, compared with just eight at the end of1990, the year in which New Zealand’s Reserve Bank becamethe first to be set a target. In most industrialised countries, thetarget, or, typically, the mid-point of a target read more..

  • Page - 145

    without all the information they need. One reason for thefailure of the command economyis that governmentplanners were not good at gathering and processing informa-tion. Adam smith’s metaphor of the invisible handis allabout how, in many cases, free markets are much more efficientat processing information on the needs of all the participants inan economy than is the visible, and often dead, hand of stateplanners. asymmetric information, when one party to adeal knows more than the other party, read more..

  • Page - 146

    InnovationA vital contributor to economic growth. The big challenge forfirmsand governments is to make it happen more often.Although nobody is entirely sure why innovation takes place,new theories of endogenousgrowth try to model theinnovation process, rather than just assume it happens forunexplained, exogenousreasons. The role of incentivesseems to be particularly important. Although some innovationsare the result of scientists and others engaging in the noblepursuit of knowledge, most, read more..

  • Page - 147

    Is innovation all it is cracked up to be, or is it just change forchange’s sake? A few years ago, Robert Solow, a Nobel prize-winning economist, observed that “you can see the computerage everywhere these days except in the productivitystatis-tics”. Although new computer technology clearly had affectedpeople and firms in visible and obvious ways, the slowdown inproductivity growth that had afflicted the American economysince the 1970s did not appear to have been reversed. Believersin the read more..

  • Page - 148

    Institutional economicsSee evolutionary economics.Institutional investorsThe big hitters of the financial markets: pension funds,fund-management companies, insurancecompanies, invest-ment banks, hedge funds, charitable endowment trusts. Inthe United States, around half of publicly traded sharesareowned by institutions and half by individual investors. In theUK, institutions own over two-thirds of listed shares. This givesthem considerable clout, including the ability to move thepricesin read more..

  • Page - 149

    Private firms are unwilling to provide insurance if theyare uncertain about the likely cost of providing sufficientcover, especially if it is potentially unlimited.moral hazardmeans that people with insurance maytake greater risks because they know they are protected,so the insurer may get a bigger bill than it bargained for. Insurers are at risk of adverse selection. The peoplewho are most likely to claim buy insurance, and thosewho are least likely to claim do not buy it. In thissituation, read more..

  • Page - 150

    InterestThe cost of borrowing, which compensates lenders for the riskthey take in making their money available to borrowers.Without interest there would be little lending and thus a lot lesseconomic activity. The charging of interest is contrary to Sharia(Islamic) law, being considered usury. Some American statesalso have usury laws, imposing tough conditions on the termsset by lenders, although not actually prohibiting interest. Yet, asthe recent rise of a substantial banking industry in read more..

  • Page - 151

    average, than those that receive very little. By contrast, perhapsthe most successful aid programme ever – the marshall planfor rebuilding Europe after the second world war – involvedrich countries giving to other hitherto rich countries.During the second half of the 20th century rich countriesgave over $1 trillion in aid to poor ones. During the 1990s,however, flows of official aid stagnated. In 2001, official aidwas a little over $50 billion, roughly one-quarter of the gdpofdonor read more..

  • Page - 152

    International Monetary FundSee imf.International tradeSee free trade.InterventionWhen central bankstry to influence an exchange rateby buying the currency they want to appreciate and selling theone they want to weaken. The evidence seems to suggest that itis at best a short-term measure. In the longer term, governmentsprobably do not have the resources to beat market forces.InvestmentPutting moneyto work, in the hope of making even moremoney. Investment takes two main forms: direct spending read more..

  • Page - 153

    low rates of taxation. Curiously, economic studies have notfound evidence that higher levels of investment lead to higherrates of gdp growth. One explanation for this is that the cir-cumstances and manner in which money is invested count atleast as much as the total sums invested. It ain’t how much youdo, it’s the way that you do it.Invisible handAdam smith’s shorthand for the ability of the free market to al-locate factors of production, goods and servicestotheir most valuable use. If read more..

  • Page - 154

    JJ-curveThe shape of the trend of a country’s trade balance following adevaluation. A lower exchange rateinitially meanscheaper exportsand more expensive imports, making thecurrent account worse (a bigger deficitor smaller surplus).After a while, though, the volume of exports will start to risebecause of their lower priceto foreign buyers, and domesticconsumers will buy fewer of the costlier imports. Eventually,the trade balance will improve on what it was before the de-valuation. If there is read more..

  • Page - 155

    KKeynes, John MaynardA much quoted, great British economist, not famous for holdingthe same opinion for long. Born in 1883, he studied at Cambridgebut came to reject much of the classical economicsandneo-classical economicsassociated with that university.Keynes helped set up the bretton woodsframework, but heis best known for hisGeneral Theory of Employment, Interest andMoney, published in 1936 in the depths of the Great depression.This invented modern macroeconomics. It argued thateconomies read more..

  • Page - 156

    1960s, when fiscal policybecame bigger-spending andlooser in most developed countries as policymakers tried to killoff the business cycle. During the 1970s, widely blamed forthe rise in inflation, Keynesian policies gradually gave wayto monetarism and microeconomic policies that owed muchto the neo-classical economicsthat Keynes had at timesopposed. Even so, the idea that public spendingand taxa-tionhave a crucial role to play in managing demand, in orderto move towards full employment, remained read more..

  • Page - 157

    LLabourOne of the factors of production, with land, capitaland enterprise. Among the things that determine the supplyof labour are the number of able people in the population,their willingness to work, labour laws and regulations, and thehealth of the economy and firms. demandfor labour is alsoaffected by the health of the economy and firms, labour lawsand regulations, as well as the priceand supply of other factorsof production.In a perfect market, wages(the price of labour) would bedetermined read more..

  • Page - 158

    if they were let go. Supporters claim that it improves economicefficiencyby leaving it to market forcesto decide theterms of employment. Broadly speaking, the evidence is thatgreater flexibility is associated with lower rates of unemploy-mentand higher gdpper head.Labour theory of valueThe notion that the value of any good or service depends onhow much labourit uses up. First suggested by Adam smith,it took a central place in the philosophy of Karl marx. Someneo-classical economists disagreed read more..

  • Page - 159

    Lagging indicatorsOld news. Some economic statistics move weeks or monthsafter changes in the business cycleor inflation. They maynot be a reliable guide to the current state of an economy or itsfuture path. Contrast with leading indicators.Laissez-faireLet-it-be economics: the belief that an economy functionsbest when there is no interference by government. It can betraced to the 18th-century French physiocrats, who believed ingovernment according to the natural order and opposed mer-cantilism. read more..

  • Page - 160

    amount of usable land. Owners earn moneyfrom land bycharging rent.Land taxHenry George, a 19th-century American economist, believedthat taxes should be levied only on the value of land, not onlabouror capital. This “single tax”, he asserted in his book,Progress and Poverty, would end unemployment, poverty,inflationand inequality. Many countries levy some taxon land or property values, although George’s single tax hasnever been fully implemented. This is mainly because of fearsthat it would read more..

  • Page - 161

    protecting small firmsor opposing big ones just because theyare big. It has also ventured into broader sociological issues,such as analysing the economic causes of criminality and howto structure legal incentives to reduce crime. (See also evolu-tionary economics.)LBOSee leveraged buy-out.Leading indicatorsEconomic crystal balls. Also known as cyclical indicators, theseare groups of statistics that point to the future direction of theeconomy and the business cycle. Certain economic vari-ables, read more..

  • Page - 162

    LeverageSee gearing.Leveraged buy-outBuying a company using borrowed moneyto pay most of thepurchase price. The debtis secured against the assetsof thecompany being acquired. The interestwill be paid out of thecompany’s future cash flow. Leveraged buy-outs (lbos) becamepopular in the United States during the 1980s, as public debtmarkets grew rapidly and opened up to borrowers that wouldnot previously have been able to raise loans worth millions ofdollars to pursue what was often an unwilling read more..

  • Page - 163

    it is often used by banks as a base for calculating the interestratethey charge on other loans. liboris a floating rate, chang-ing all the time.LifeHuman life is priceless. But this has not stopped economiststrying to put a financial value on it. One reason is to help firmsand policymakers to make better decisions on how much tospend on costly safety measures designed to reduce the loss oflife. Another is to help insurers and courts judge how muchcompensation to pay in the event of, say, a fatal read more..

  • Page - 164

    Over their lifetime, a typical person’s income varies by far morethan how much they spend. On average, young people havelow incomes but big spending commitments: on investing intheir human capitalthrough education and training, buildinga family, buying a home, and so on. So they do not save muchand often borrow heavily. As they get older their income gener-ally rises, they pay off their mortgage, the children leave homeand they prepare for retirement, so they sharply increase theirsaving and read more..

  • Page - 165

    volume of trades happening in a marketplace, the greater is itsliquidity. 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. Theamount of liquidity in financial markets can vary enormouslyfrom one moment to the next, and can sometimes evaporate en-tirely, especially if market makers become too risk aversetoput their capital at risk in this way.Liquidity preferenceThe read more..

  • Page - 166

    Lock-inSee path dependence.Long runWhen we are all dead, according to keynes. Unimpressed bythe thrust of classical economics, which said thateconomies have a long-run tendency to settle in equilibriumat full employment, he wanted economists to try to explainwhy in the short run economies are so often in disequilib-rium, or in equilibrium at high levels of unemployment.Lump of labour fallacyOne of the best-known fallacies in economicsis the notionthat there is a fixed amount of work to be done read more..

  • Page - 167

    Lump-sum taxA tax that is the same amount for everybody, regardless ofincome or wealth. Some economists argue that this is the mostefficient form of taxation, as it does not distort incentivesand thus it has no deadweight cost. This is because eachperson knows that whatever they do they will have to pay thesame amount. It is also cheap to administer, as there is nocomplex process of measuring each person’s incomeandassetsin order to calculate their tax bill. However, because richand poor read more..

  • Page - 168

    MMacroeconomicsThe big picture: analysing economy-wide phenomena such asgrowth, inflationand unemployment. Contrast withmicroeconomics, the study of the behaviour of individualmarkets, workers, households and firms. Although economistsgenerally separate themselves into distinct macro and microcamps, macroeconomic phenomena are the product of all themicroeconomic activity in an economy. The precise relationshipbetween macro and micro is not particularly well understood,which has often made it read more..

  • Page - 169

    in importance in developing countries.Many people think that manufacturing somehow mattersmore than any other economic activity and is in some way su-perior to surfing the internet or cutting somebody’s hair. This isprobably nothing more than nostalgia for times past whenmaking things in factories was what real men did, just as 150years ago growing things in fields was what real men did.Mostly, the shift from manufacturing to services (as with theearlier shift from agriculture to read more..

  • Page - 170

    certain plausible assumptions, a profit-maximising firm will in-crease production up to the point where marginal revenueequals marginal cost. This is because if marginal revenue ex-ceeded marginal cost, the firm could increase its profitby pro-ducing an extra unit of output. Alternatively, if marginal costexceeded marginal revenue, the firm could increase its profit byproducing fewer units of output.In all walks of life, a basic rule of rational economic decision-making is: do something only if read more..

  • Page - 171

    Abuse of market power is best tackled through antitrustpolicy. Externalities can be reduced through regulation, a taxor subsidy, or by using property rightsto force the marketto take into account the welfareof all who are affected by aneconomic activity. The supplyof public goods can be ensuredby compelling everybody to pay for them through the taxsystem.Market forcesShorthand for the pressures from buyers and sellers in a market,rather than those coming from a governmentplanner orfrom read more..

  • Page - 172

    Marshall PlanProbably the most successful programme of internationalaidand nation building in history. It was named afterGeneral George Marshall, an American secretary of state, whoat the end of the second world war proposed giving aid toWestern Europe to rebuild its war-torn economies. NorthAmerica gave around 1% of its gdpin total between 1948 and1952; most of it came from the United States and the rest fromCanada. The Americans left it to the Europeans to work out thedetails on allocating read more..

  • Page - 173

    away” of the state. Marx thought that this version of historywas inevitable. So far, history has proved him wrong, largelybecause capitalism has delivered a much better deal to themasses than he believed it would.MeanSee average.Mean reversionThe tendency for subsequent observations of a random vari-able to be closer to its mean than the current observation. Forexample, if the current number is 7, the average is 5, and there ismean reversion, the next observation is likelier to be 6 than read more..

  • Page - 174

    luctant to change their prices every time there is a shift in thebalance of supplyand demand,so there will be stickypricesand the market for their outputwill be in disequi-librium. The internet may sharply reduce menu costs as itallows prices to be changed at the click of a mouse, which mayimprove efficiencyby keeping markets more often in equi-librium.MercantilismThe conventional economic wisdom of the 17th century thatmade a partial come-back in recent years. Mercantilists fearedthat read more..

  • Page - 175

    between firms: horizontal integration, in which twosimilar firms tie the knot; vertical integration, in whichtwo firms at different stages in the supplychain get together;and diversification, when two companies with nothing incommon jump into bed. These can be a voluntary marriage ofequals; a voluntary takeover of one firm by another; or a hostiletakeover, in which the management of the target firm resists theadvances of the buyer but is eventually forced to accept a dealby its current owners. read more..

  • Page - 176

    young people or part-timers. Most economists reckon that aminimum wage, if it is doing what it is meant to do, will lead tohigher unemploymentthan there would be without it. Themain justification offered by politicians for having a minimumwage is that the wage that would be decided by buyers and sellersin a free market would be so low that it would be immoral forpeople to work for it. So the minimum wage should be above themarket-clearing wage, in which case fewer workers would be de-manded at read more..

  • Page - 177

    MobilityThe easier it is for the factors of productionto move towhere they are most valuable, the more efficient the allocationof the world’s scarce resources is likely to be and the faster gdpwill grow. Apart from continental drift, landis immobile.capitalhas long been extremely mobile within countries, and,with the rise of globalisation, it is now able to move easilyaround the world. enterpriseis mobile, although to whatextent depends on the particular entrepreneur. Somemembers of the read more..

  • Page - 178

    ModeSee average.ModellingWhen economists make a number of simplified assumptionsabout how the economy, or some part of it, behaves, and thensee what this implies in various different scenarios. Miltonfriedmanargued that economic models should not be judgedon the basis of the validity of their assumptions, but on the ac-curacy of their predictions. An expert billiards player, he said,may not know the laws of physics, but acts as if he knows suchlaws. So his behaviour could be predicted accurately read more..

  • Page - 179

    Risk should be analysed in terms of an investor’s overallportfolio, rather than by looking at individual assets.For every level of risk, there is an optimal portfolio ofassets that will have the highest expected returns.All of this seems straightforward now, except perhaps the bitabout efficient markets. But it was shocking when it was putforward in the early 1950s by Harry Markowitz, who later wonthe Nobel prize for it. According to Markowitz, when he ex-plained his theory to the high priests read more..

  • Page - 180

    between money and nominal gdp, and hence inflation, isstable and predictable. The way the money supply affectspricesand outputdepends on how fast it circulates throughthe economy. The trouble is that its velocity of circula-tion can suddenly change. During the 1980s, the link betweendifferent measures of the money supply and inflation proved tobe less clear than monetarist theories had suggested, and mostcentral banks stopped setting binding monetary targets. Instead,many have adopted explicit read more..

  • Page - 181

    MoneyMakes the world go round and comes in many forms, fromshells and beads to goldcoins to plastic or paper. It is betterthan barterin enabling an economy’s scarce resources to beallocated efficiently. Money has three main qualities:as a medium of exchange, buyers can give it to sellers topay for goods and services;as a unit of account, it can be used to add up apples andoranges in some common value;as a store of value, it can be used to transfer purchasingpower into the future.A farmer who read more..

  • Page - 182

    double-digit pay rises (as well as, say, big increases in the valueof their homes) can make people feel richer even if they are notreally better off. When inflation is low, growthin realincomes may hardly register.Money marketsAny market where moneyand other liquid assets(such astreasury bills) can be lent and borrowed for between a fewhours and a few months. Contrast with capital markets,where longer-term capitalchanges hands.Money supplyThe amount of moneyavailable in an economy. In the read more..

  • Page - 183

    many countries, there is a clear link between the growth of thereal broad-money supply and that of real gdp.Monopolistic competitionSomewhere between perfectcompetitionandmonopoly, also known as imperfect competition. It describesmany real-world markets. Perfectly competitive markets are ex-tremely rare, and few firmsenjoy a pure monopoly;oligopolyis more common. In monopolistic competition,there are fewer firms than in a perfectly competitive marketand each can differentiate its products from read more..

  • Page - 184

    more efficient rival firm will take its entire market away.antitrustpolicy can curb monopoly power by encouragingcompetitionor, when there is a natural monopolyandthus competition would be inefficient, through regulationofprices. Furthermore, the mere possibility of antitrust action mayencourage a monopoly to self-regulate its behaviour, simply toavoid the trouble an investigation would bring.MonopsonyA market dominated by a single buyer. A monopsonist has themarket power to set the priceof read more..

  • Page - 185

    trade organisationrequires member countries to accordthe most favourable tariff and regulatory treatment given to theproduct of any one member to the “like products” of all othermembers. Before the general agreement on tariffs andtrade, there was often a most-favoured nation clause in bilat-eral trade agreements, which helped the world move towardsfree trade. In the 1930s, however, there was a backlashagainst this, and most-favoured nations were treated lessfavourably. This shift pushed the read more..

  • Page - 186

    NNAFTAShort for North American Free-Trade Agreement. In 1993, theUnited States, Mexico and Canada agreed to lower the barriersto trade among the three economies. The formation of this re-gional trade areawas opposed by many politicians in allthree countries. In the United States and Canada, in particular,there were fears that naftawould result in domestic job lossesto cheaper locations in Mexico. In the early years of the agree-ment, however, most studies found that the economic gains read more..

  • Page - 187

    to be paid off; this is very different from an annual public-sectorbudget deficit. In 1999, the American government celebrated ahuge budget surplus, yet the country still had a national debtequal to nearly half its gdp.National incomeShorthand for everything that is produced, earned or spent in acountry (see gdp and gnp).NationalisationWhen a governmenttakes ownership of a private-sectorbusiness. Nationalisation was a fashionable part of the mix incountries with a mixed economybetween 1945 and read more..

  • Page - 188

    because the old order has collapsed (as in the former Sovietbloc), or been destroyed by war (Iraq), or never really func-tioned in the first place (Afghanistan). To transform a failedcountry can involve establishing order through the rule of lawand creating legitimate governmentand other effectivesocial institutions, as well as a credible currency and a function-ing market economy. Nation building is rarely easy, and oftenfiendishly difficult, especially where there are deep ethnic, reli-gious read more..

  • Page - 189

    the lowest rate of unemploymentat which the jobs marketcan be in stable equilibrium. keynesians, encouraged by thephillips curve, assumed that a governmentcould lowerthe rate of unemployment if it was willing to accept a little moreinflation. However, economists such as Milton friedmanargued that this supposed inflation-for-jobs trade-off was in facta trap. Governments that tolerated higher inflation in the hopeof lowering unemployment would find that joblessness dippedonly briefly before read more..

  • Page - 190

    taking moneyfrom people with high incomes and paying it topeople with low incomes. Because it takes place automaticallythrough the tax system, it may attach less stigma to the receiptof financial help than some other forms of welfareassistance.However, it may also discourage recipients from working to in-crease their income(see poverty trap), which is why somecountries have introduced a form of negative income tax that isavailable only to the working poor. In the United States, this isknown as read more..

  • Page - 191

    Network effectWhen the value of a good to a consumer changes because thenumber of people using it changes. For instance, owning aphone becomes more valuable as more people are plugged intothe telephone network. Network effects are sometimes callednetwork externalities, although this implies, often wrongly,that the benefits from being part of a network are a sort ofmarket failure. They give a huge competitive advan-tageto the firm that owns the network. This incumbent ad-vantagearises because a read more..

  • Page - 192

    With the bursting of the dotcom stockmarket bubblein 2000,the phrase fell into disuse, although productivitycontinuedto soar, thanks not least to new technology, especially in theUnited States.New growth theorySee growth.New trade theoryAlthough most economists support free trade, in the 1970s agrowing number of them became increasingly puzzled by thelarge differences between the predictions of free trade theoryand real-world trade flows. Their solution to this puzzle isknown as new trade read more..

  • Page - 193

    The upside may be greater the more similar are the tradingeconomies. This may explain why trade liberalisationiseasier to achieve between similar countries. Thus, for example,the free-trade agreement between the United States and Canadaproduced only minor local complaints, whereas its subsequentexpansion to include the very different economy of Mexicowas much more controversial (see nafta).NGOShort for non-government organisation. Although such groupshave existed for generations (in the early read more..

  • Page - 194

    Nobel prize for economicsThe sixth annual prize established in memory of Alfred Nobel.Strictly speaking, this is not a fully fledged Nobel prize, as it wasnot mentioned in Nobel’s will, unlike the five prizes establishedearlier for peace, literature, medicine, chemistry and physics.Still, the title of Nobel laureate and the $1m award stumped upeach year by Sweden’s central bankmake it worth winning.Since 1969, when its first (joint) winners hailed from Norwayand the Netherlands, it has been read more..

  • Page - 195

    Normative economicseconomicsthat tries to change the world, by suggesting poli-cies for increasing economic welfare. The opposite of posi-tive economics, which is content to try to describe the worldas it is, rather than prescribe ways to make it better.NPVSee net present value.Null hypothesisA statement that is being put to the test. In econometrics,economists often start with a null hypothesis that a particularvariable equals a particular number, then crunch their data tosee if they can prove read more..

  • Page - 196

    OOECDThe Organisation for Economic Co-operation and Development,a Paris-based club for industrialised countries and the best ofthe rest. It was formed in 1961, building on the Organisation forEuropean Economic Co-operation (oeec), which had been es-tablished under the marshall plan. By 2003, its membershiphad risen to 30 countries, from an original 20. Together, oecdcountries produce two-thirds of the world’s goods and ser-vices. The oecdprovides a policy talking shop for govern-ments. It read more..

  • Page - 197

    grows faster, the unemployment rate will fall by half of whatthe growth rate exceeds 3% by; that is, if gdpgrows by 5%, un-employment will fall by 1 percentage point.Likewise, alesser, say 2%, increase in gdpwould be associated with a halfa percentage point increase in the jobless rate.This relationship is not carved in stone, as it merely reflectsthe American economy during the period studied by Okun.Even so, in most economies Okun’s Law is a reasonable rule ofthumb for estimating the likely read more..

  • Page - 198

    stream. And some individual members of the cartel havebroken ranks by failing to restrict their oil production, resultingin lower oil prices.Open economyAn economy that allows the unrestricted flow of people,capital, goods and servicesacross its borders; the oppositeof a closed economy.Open-market operationscentral banksbuying and selling securitiesin the openmarket, as a way of controlling interestrates or thegrowthof the money supply. By selling more securities,they can mop up surplus money; read more..

  • Page - 199

    economicsis primarily about the efficient use of scarce re-sources, and the notion of opportunity cost plays a crucial partin ensuring that resources are indeed being used efficiently. Optimal currency areaA geographical area within which it would pay to have a singlecurrency. An optimal currency area can come in many sizes.Some may span several countries and others may be smallerthan an individual country.The benefits of having one currency are lower foreign ex-change and currency hedgingcosts read more..

  • Page - 200

    areas, probably including the euro zone, although having asingle currency often makes them become gradually more alikeand thus more optimal.OptimumAs good as it gets, given the constraints you are operatingwithin. For the concept of optimum to mean anything, theremust be both a goal, say, to maximise economic welfare, anda set of constraints, such as an available stock of scarce eco-nomic resources. Optimising is the process of doing the best youcan in the circumstances.OptionSee derivatives and read more..

  • Page - 201

    OutsourcingShifting activities that used to be done inside a firmto anoutside company, which can do them more cost-effectively. Bigfirms have outsourced a growing amount of their business sincethe early 1990s, including increasingly offshoring work tocheaper employees at firms in countries such as India. This hasbecome politically controversial in countries that lose jobs as aresult of offshoring. However, a firm that outsources canimprove its efficiency by focusing on those activities in which read more..

  • Page - 202

    examples. For instance, following the abolition of capitalcontrolsby some developing countries, the prices ofequitiesin those countries initially soared to what proved tobe unjustified levels as foreign capitalrushed in, before set-tling in the longer term at more sustainable valuations.Over the counterIn the case of drugs, those that can be purchased without a pre-scription from a doctor. In the case of financial securities,those that are bought or sold through a private dealer or bankrather read more..

  • Page - 203

    PPareto efficiencyA situation in which nobody can be made better off withoutmaking somebody else worse off. Named after Vilfredo Pareto(1843–1923), an Italian economist. If an economy’s resources arebeing used inefficiently, it ought to be possible to make some-body better off without anybody else becoming worse off. Inreality, change often produces losers as well as winners. Paretoefficiency does not help judge whether this sort of change iseconomically good or bad.Paris ClubThe name given read more..

  • Page - 204

    the lack of competitionto produce and sell the product. Soeconomists debate how long patent protection should last.There is also debate about which sorts of innovation require theencouragement of a potential monopoly to make them happen.Furthermore, the pace of innovation in some industries hassharply reduced the number of years during which a patent isvaluable. Some economists say that this shows that patents donot play a large part in the process of innovation.Path dependenceHistory matters. read more..

  • Page - 205

    demand to cheaper off-peak periods, it will reduce the totalamount of capacity needed at the peak and reduce the amountof capacity lying idle at off-peak times, thus resulting in a moreefficient use of resources. Peak pricing is common in serviceswith substantial fixed capacity, such as electricity supply andrail transport, as anybody who pays higher fares to travelduring rush hours knows only too well.Percentage pointA unit of size, a one-hundredth of the total. Not to be confusedwith read more..

  • Page - 206

    profits to be made. outputwill be maximised and price min-imised.Contrastwithmonopolisticcompetition,oligopolyand, above all, monopoly.Permanent income hypothesisOver their lives, people try to spread their spending moreevenly than their income. The permanent income hypothesis,developed by Milton friedman, says that a person’s spendingdecisions are guided by what they think over their lifetime willbe their average(also known as permanent) income. A sharpincrease in short-term income will not read more..

  • Page - 207

    effectresulting from deflation. A fall in the pricelevel in-creases the real valueof people’s savings, making themfeel wealthier and thus causing them to spend more. This in-crease in demandcan lead to higher employment.Plaza AccordOn September 22nd 1985, finance ministers from the world’s fivebiggest economies – the United States, Japan, West Germany,France and the UK – announced the Plaza Accord at the epony-mous New York hotel. Each country made specific promises oneconomic policy: read more..

  • Page - 208

    Positional goodsThings that the Joneses buy. Some things are bought for theirintrinsic usefulness, for instance, a hammer or a washingmachine. Positional goods are bought because of what theysay about the person who buys them. They are a way for aperson to establish or signal their status relative to people whodo not own them: fast cars, holidays in the most fashionableresorts, clothes from trendy designers. By necessity, the quan-tity of these goods is somewhat fixed, because to read more..

  • Page - 209

    10% of households. In each case, the dividing line betweenpoverty and not-quite poverty is somewhat arbitrary.As countries get richer, the number of people in absolutepoverty usually gets smaller. This is not necessarily true of thenumbers in relative poverty. The way that relative poverty isdefined means that it is always likely to identify a largenumber of impoverished households. However rich a countrybecomes, there will always be 10% of households poorer thanthe rest, even though they may read more..

  • Page - 210

    cates of anti-dumping policies say that cheap importsare ex-amples of predatory pricing. In practice, the evidence gives littlesupport for this view. Indeed, in general, predatory pricing isquite rare. It is certainly much less common in practice than itmight appear from the propaganda of firmsthat are underpricing pressure from more efficient competitors.PreferenceWhat consumers want (see revealed preference).Present valueSee net present value.PriceIn equilibrium, what balances supplyand read more..

  • Page - 211

    one in which they could charge each customer a different price:the price that each customer would be willing to pay. Thiswould maximise producer surplus. This cannot happen,not least because sellers do not know how much any individualwould pay.Yet some price discrimination is possible if an overall marketcan be segmented into somewhat separate markets and theequilibriumprice in each of these markets is different,perhaps because of differences in consumer tastes, perhapsbecause in some segments read more..

  • Page - 212

    Price regulationWhen pricesof, say, a public utility are regulated, givingproducers an incentive to maximise their profits by reducingtheir costs as much as possible. Contrast with rate of returnregulation.Principal–agent theorySee agency costs.Prisoner’s dilemmaA favourite example in game theory, which shows why co-operation is difficult to achieve even when it is mutually bene-ficial. Two prisoners have been arrested for the same offenceand are held in different cells. Each has two read more..

  • Page - 213

    Private equityWhen a firm’s shares are held privately and not traded in thepublic markets. Private equity includes shares in both matureprivate companies and, as venture capital, in newly startedbusinesses. As it is less liquid than publicly traded equity, in-vestors in private equity expect on average to earn a higherequity risk premium from it.PrivatisationSelling state-owned businesses to private investors. This policywas associated initially with Margaret Thatcher’s governmentin the read more..

  • Page - 214

    ProbabilityHow likely something is to happen, usually expressed as theratio of the number of ways the outcome may occur to thenumber of total possible outcomes for the event. For instance,each time you throw a dice there are six possible outcomes, butin only one of these can a six come up. Thus the probability ofthrowing a six on any given throw is one in six. The fact thatyou threw a six last time does not alter the one-in-six probabil-ity of throwing a six next time (see risk).Producer read more..

  • Page - 215

    ProductivityThe relationship between inputs and output, which can beapplied to individual factors of productionor collectively.labourproductivity is the most widely used measure and isusually calculated by dividing total output by the number ofworkers or the number of hours worked. Total factor productivityattempts to measure the overall productivity of the inputs used bya firm or a country.Alas, the usefulness of productivity statistics is questionable.The quality of different inputs can change read more..

  • Page - 216

    including rent, wagesand interest. Put simply, profit is afirm’s total revenue minus total cost.Economists distinguish between normal profit and excessprofit. Normal profit is the opportunitycostof theentrepreneur, the amount of profit just sufficient to keepthe firm in business. If profit is any lower than that, thenenterprise would be better off engaged in some other eco-nomic activity. Excess profit, also known as super-normalprofit, is profit above normal profit and is usually evidencethat read more..

  • Page - 217

    Propensityeconomicsabounds with propensities to do various things:consume, save, invest, import, and so on. In each case, it is im-portant to distinguish between the averagepropensity andthe marginalone. The average propensity to consume issimply total consumptiondivided by total income. Themarginal propensity to consume measures how much of eachextra dollar of income is consumed: the percentage change inconsumption divided by the percentage change in income. Thevalue of the marginal propensity read more..

  • Page - 218

    taxationis a clear example of the state infringing taxpayers’ownership of their money. The economic cost of infringingproperty rights underlines how important it is that govern-ments think carefully about the consequences for economicgrowthof their tax policies.Prospect theoryA theory of “irrational” economic behaviour. Prospect theoryholds that there are recurring biases driven by psychologicalfactors that influence people’s choices under uncertainty. In par-ticular, it assumes that read more..

  • Page - 219

    non-rejectable – people cannot choose not to consumethem even if they want to.Examples include clean air, a national defence system andthe judiciary. The combination of non-rivalry and non-exclud-ability means that it can be hard to get people to pay toconsume them, so they might not be provided at all if left tomarket forces. Thus public goods are regarded as anexample of market failure, and in most countries they areprovided at least in part by governmentand paid for throughcompulsory read more..

  • Page - 220

    electricity and postal services, usually involving elements ofnatural monopoly. Food is essential, but because it is pro-vided in a competitive market, food supplyis not usually re-garded as a public utility. Because public utilities have somemonopolypower, they are typically subject to some regula-tionby government, such as pricecontrols and perhaps anobligation to provide their services to everybody, even thosewho cannot afford to pay a market price (the universal serviceobligation). Public read more..

  • Page - 221

    QQ theorySee tobin.Quantity theory of moneyThe foundation stone of monetarism. The theory says thatthe quantity of moneyavailable in an economy determines thevalue of money. Increases in the money supplyare the maincause of inflation. This is why Milton friedmanclaimed“inflation is always and everywhere a monetary phenomenon”.The theory is built on the Fisher equation, MV = PT, namedafter Irving Fisher (1867–1947). M is the stock of money, V is thevelocity of circulation, P is the average read more..

  • Page - 222

    QueueingMarket failure? Not necessarily. Usually a queue reflects apricethat is set too low, so that demandexceeds supply, sosome customers have to wait to buy the product. But a queuemay also be the result of deliberate rationing by a producer,perhaps to attract attention – by a restaurant that wants toappear popular, say. Customers may regard a queue, such as awaiting list for health treatment, as a fairer way to distribute theproduct than using the price mechanism.QuotaA form of read more..

  • Page - 223

    RRandom walkImpossible to predict the next step. efficient markettheorysays that the pricesof many financial assets, such asshares, follow a random walk. In other words, there is no wayof knowing whether the next change in the price will be up ordown, or by how much it will rise or fall. The reason is that inan efficient market, all the informationthat would allow aninvestor to predict the next price move is already reflected in thecurrent price. This belief has led some economists to argue read more..

  • Page - 224

    RatingsA guide to the riskiness of a financial instrumentprovidedby a ratings agency, such as Moody’s, Standard and Poor’s andFitch ibca. These measures of creditquality are mostlyoffered on marketable governmentand corporate debt.Atriple-A or A++ rating represents a low risk of default, and a Cor D rating an extreme risk of, or actual, default. Debt pricesandyields often (but not always) reflect these ratings. A triple-Abondhas a low yield. High-yielding bonds, also known as junkbonds, read more..

  • Page - 225

    The theory of rational expectations, for which Robert Lucaswon the nobel prize for economics, initially becamepopular with monetarists because it seemed to prove that key-nesianpolicies of demandmanagement would fail. With ra-tional expectations, people learn to anticipate governmentpolicy changes and act accordingly; since macroeconomic finetuningrequires that governments be able to fool people, thisimplies that it is usually futile. Subsequently, this conclusion hasbeen challenged. However, read more..

  • Page - 226

    Real interest rateThe interest rateless the rate of inflation.Real options theoryA newish theory of how to take investmentdecisions whenthe future is uncertain, which draws parallels between the realeconomy and the use and valuation of financial options. It is be-coming increasingly fashionable at business schools and evenin the boardroom.Traditional investment theory says that when a firm evalu-ates a proposed project, it should calculate the project’s netpresent value (npv) and if it is read more..

  • Page - 227

    Options on real assetsbehave rather like financial options(a shareoption, say). The similarities are such that they can, atleast in theory, be valued according to the same methodology.In the case of the oil company, for instance, the cost of landcorresponds to the down-payment on a call (right to buy)option, and the extra investment needed to start production toits strike price (the money that must be paid if the option is ex-ercised). As with financial options, the longer the option lastsbefore read more..

  • Page - 228

    RedliningNot lending to people in certain poor or troubled neighbour-hoods – drawn with a red line on a map – simply because theylive there, regardless of their credit-worthiness judged byother criteria.ReflationPolicies to pump up demandand thus boost the level of eco-nomic activity. Monetarists fear that such policies may simplyresult in higher inflation.Regional policyA policy intended to boost economic activity in a specific geo-graphical area that is not an entire country and, read more..

  • Page - 229

    should always be taken with a pinch of salt. How big a pinchcan vary considerably and is indicated by the degree of statis-tical significanceand r squared. The relationshipbetween a dependent variable (gdp, say) and a set of explana-tory variables (demand, interest rates, capital, unem-ployment, and so on) is expressed as a regression equation.Regressive taxA tax that takes a smaller proportion of incomeas the tax-payer’s income rises, for example, a fixed-rate vehicle tax thateats up a much read more..

  • Page - 230

    individuals may face substantial compliance costs. Firms maydevote substantial resources to regulatory arbitrage,which would leave consumers no better off. Regulation maylead to moral hazardif people believe that the governmentis keeping an eye on the behaviour of the regulated businessand so do less monitoring of their own. Regulation may bebadly designed and thus lock an industry into an inefficientequilibrium. Rigid regulation may hold back innovation.There is also the danger of regulatory read more..

  • Page - 231

    Regulatory riskA riskfaced by private-sector firmsthat regulatory changeswill hurt their business. In competitive markets, regulatory riskis usually small. But in natural monopolyindustries, suchas electricity distribution, it may be huge. To ensure that regula-tory risk does not deter private firms from offering their ser-vices, a governmentwishing to change its regulations mayhave good reason to compensate private firms that suffer lossesas a result of the change.Relative income read more..

  • Page - 232

    without any adverse impact on the real economy, assumingthat it really is rent.Rent-seekingCutting yourself a bigger slice of the cake rather than makingthe cake bigger. Trying to make more money without producingmore for customers. Classic examples of rent-seeking, a phrasecoined by an economist, Gordon Tullock, include:a protection racket, in which the gang takes a cut fromthe shopkeeper’s profit;a cartelof firmsagreeing to raise prices;a uniondemanding higher wageswithout offeringany read more..

  • Page - 233

    this trend continues, those countries may face long-term prob-lems such as a relatively growing proportion of retired olderpeople having to be supported by a relatively shrinking propor-tion of younger people. RepoAn agreement in which one party sells a security to anotherparty and agrees to buy it back on a specified date for a speci-fied price. central banksdeal in short-term repos to provideliquidityto the financial system, buying securitiesfrom bankswith cash on the condition that the banks read more..

  • Page - 234

    Reservation wageThe lowest wagefor which a person will work.Reserve currencyA foreign currency held by a governmentor central bankas part of a country’s reserves. Outside the United States thedollar is the most widely used reserve currency. Everywhere theeurois increasingly widely used.Reserve ratioThe fraction of its deposits that a bankholds as reserves.Reservesmoneyin the hand, available to be used to meet plannedfuture payments or if some other need arises. firmsmay puttheir reserves in a read more..

  • Page - 235

    economy or industry. Residual risk, also known as alpha, is whatis left after you take out all the other shared risk exposures. Ex-posure to this risk can be reduced by diversification. Con-trast with systematic risk.Restrictive practiceA general term for anything done by a firm, or firms, to inhibitcompetition. Generally against the law. (See antitrustandcartel.)ReturnsThe rewards for doing business. Returns usually refer to profitand can be measured in various ways (see rate of returnand total read more..

  • Page - 236

    The ordinal approach does not require consumers to sayhow much utility they get in absolute terms fromconsuming a particular good. Instead, it asks them toindicate the relative utility they get from consuming oneitem compared with another, that is, to say if they preferone basket of goods to another, or are indifferentbetween them.The third approach is revealed preference. To modeldemand it is only necessary to be able to compare anindividual’s consumptiondecisions in situations withdifferent read more..

  • Page - 237

    the case for freetrade. In his 1817 book,The Principlesof Political Economy and Taxation, he outlined a theory ofdistribution of outputin an economy. In this he arguedthat the allocation of factorsofproductionto anyarea of economic activity is determined by the level ofeconomic rentthat can be earned from it. As this graduallyfalls because of diminishingreturns, capitalandother resources shift to more profitable projects. He exam-ined the split between wagesand profit, arguing that“there can read more..

  • Page - 238

    Risk averseSomeone who thinks riskis a four-letter word. Risk-averse in-vestors are those who, when faced with two investments withthe same expected returnbut two different risks, prefer theone with the lower risk.Risk-free rateThe rate of returnearned on a risk-free asset. This is acrucial component of modern portfolio theory, whichassumes the existence of both risky and risk-free assets. Therisk-free asset is usually assumed to be a government bond,and the risk-free rate is the yieldon that read more..

  • Page - 239

    Risk premiumThe extra returnthat investors require to hold a risky assetinstead of a risk-free one; the difference between the expectedreturnsfrom a risky investmentand the risk-free rate.(See equity risk premium.)Risk seekingSomeone who cannot get enough risk. Risk-seeking investorsprefer an investmentwith an uncertain outcome to one withthe same expected returnsand certainty that it will deliverthem.R squaredAn indicator of the reliability of a relationship identified by re-gression analysis. read more..

  • Page - 240

    SSafe harbourProtection from the rough seas of regulation. Laws and regu-lations often include a safe harbour clause that sets out the cir-cumstances in which otherwise regulated firmsor individualscan do something without regulatory oversight or interference.SatisficingSettling for what is good enough, rather than the best that is pos-sible. This may occur in any situation in which decision-makersare trying to pursue more than one goal at a time. classicaleconomicsand neo-classical read more..

  • Page - 241

    different age groups (see life-cycle hypothesis) and nation-alities. Everywhere, people of all ages save more as their incomerises. The supply of savings rises when interest rates rise; arise in interest rates causes demandfor funds to invest to fall;a rise in demand for investment funds may cause interest rates,and thus the cost of capital, to rise. The level of savings isalso influenced by changes in wealth (see wealth effect)and by taxationpolicies.Say’s lawsupplycreates its own demand. So read more..

  • Page - 242

    most efficient way to allocate scarce resources, with govern-mentplanning playing at most a minor role. Scarcity does notimply poverty. In economic terms, it means simply that needsand wants exceed the resources available to meet them, whichis as common in rich countries as in poor ones.Scenario analysisTesting your plans against various possible scenarios to see whatmight happen should things not go as you hope. Scenario analy-sis is an important technique in risk management, helpingfirmsand read more..

  • Page - 243

    from the incumbent, thus blowing “gales of creative destruc-tion” through the economy. Eventually, the new entrants growfat on their monopoly profits, until the next gale of creative de-struction blows them away.Ever controversial, and often wrong, in his 1942 book, Capi-talism, Socialism and Democracy, he predicted the downfall ofcapitalism at the hands of an intellectual elite. He is associatedwith both austrian economicsand, arguably as foundingfather, evolutionary economics.SDRShort for read more..

  • Page - 244

    Secondary marketA market in second-hand financial instruments. bondsand sharesare first sold in the primary market, for instance,through an initial public offering. After that, their new ownersoften sell them in the secondary market. The existence of liquidsecondary markets can encourage people to buy in the primarymarket, as they know they are likely to be able to sell easilyshould they wish.Second-best theoryAs we do not live in a perfect world, how useful are economictheories based on the read more..

  • Page - 245

    SecuritiesFinancial contracts, such as bonds, sharesor derivatives,that grant the owner a stake in an asset. Such securitiesaccount for most of what is traded in the financial markets.SecuritisationTurning a future cash flow into tradable, bond-like securities.Creating such asset-backed securities became a lucrative busi-ness for financial firmsduring the 1990s, as they invented newsecurities based on cash flow ranging from future mortgage andcredit-card payments to bankloans, movie revenue and read more..

  • Page - 246

    SeniorityThe order in which creditorsare entitled to be repaid. In theevent of a bankruptcy, senior debtmust be paid off beforejunior debt. Because junior debt has a lower chance of beingrepaid than senior debt, it carries more risk, and thus typicallypays a higher yield.SequencingShorthand for implementing economic reforms in the rightorder. In recent years, this has become a hot topic in develop-ment economics. Some economists argue that introducingthe right policies alone is not enough to read more..

  • Page - 247

    cost-benefit analysis, where the whole purpose of theanalysis is to capture all the variables involved in a decision, notmerely those for which market prices exist.Shareholder valuePutting shareholders first; the notion that all business activityshould aim to maximise the total value of a company’s shares.Some critics argue that concentrating on shareholder value willbe harmful to a company’s other stakeholders, such as em-ployees, suppliers and customers. SharesFinancial securities, each read more..

  • Page - 248

    an investment has done in the past, the Sharpe ratio does notguarantee similar performance in future.ShockAn unexpected event that affects an economy (see asymmet-ric shock).ShortingSelling a security, such as a share, that you do not currentlyown, in the expectation that its pricewill fall by the time thesecurity has to be delivered to its new owner. If the price doesfall, you can buy the security at the lower price, deliver it towhoever you sold it to and make a profit. The riskis that read more..

  • Page - 249

    where the stockmarket was less important, such as Germanyand Japan.SignallingA solution to one of the biggest sources of market failure:asymmetricinformation. Often the biggest problemfacing sellers is how to convince buyers that what they areselling is as good as they say it is. This problem arises in situa-tions where the qualities of the thing being sold cannot be ob-served easily by buyers, who thus fear that sellers may beconning them. In such situations, an answer may be for sellersto do read more..

  • Page - 250

    emphasised the role of specialisation (the division of labour),technical progressand capital investmentas the mainengines of economic growth. Above all, he stressed the impor-tance of the invisible hand, the way in which self-interestpursued in free markets leads to the most efficient use of eco-nomic resources and makes everybody better off in the process.Social benefits/costsThe overall impact of an economic activity on the welfareofsociety. Social benefits/costs are the sum of read more..

  • Page - 251

    Social marketThe name given to the economic arrangements devised inGermany after the second world war. This blended marketcapitalism, strong labourprotection and unioninfluence,and a generous welfarestate. The phrase has also been usedto describe attempts to make capitalism more caring, and to theuse of market mechanisms to increase the efficiencyof thesocial functions of the state, such as the education system orprisons. More broadly, it refers to the study of the differentsocial institutions read more..

  • Page - 252

    SpeculationAn attitude to investmentthat is often criticised. According tocritics, speculation involves buying or selling a financial assetwith the aim of making a quick profit. This is contrasted withlong-term investment, in which an asset is retained despiteshort-term fluctuations in its value. Speculators actually play avaluable role in financial marketsas their appetite for fre-quent buying and selling provides liquidityto the markets.This benefits longer-term investors, too, as it enables read more..

  • Page - 253

    from a company and the price the underwriter chargesthe public;the yieldon two different bonds.Stabilisationgovernmentpolicies intended to smooth the economic cycle,expanding demandwhen unemploymentis high and re-ducing it when inflationthreatens to increase. Doing this byfine tuninghas mostly proved harder than keynesianpol-icymakers expected, and it has become unfashionable.However, the use of automatic stabilisers remains widespread.For instance, social handouts from the state usually read more..

  • Page - 254

    blights had not appeared simultaneously. Indeed, policymakersbelieved the message of the PHILLIPS CURVE: that UNEMPLOYMENTand inflation were alternatives. StagnationA prolonged recession, but not as severe as a depression.StakeholdersAll the parties that have an interest, financial or otherwise, ina company, including shareholders, creditors, bondholders,employees, customers, management, the community andgovernment. How these different interests should becatered for, and what to do when they read more..

  • Page - 255

    a British prime minister. Certainly, even if the result of numbercrunching is statistically significant, it does not actually mean itis true. But it does mean it is much more likely to be true thanfalse. Statistical significance means that the probabilityofgetting that result by chance is low. The most commonly usedmeasure of statistical significance is that there must be a 95%chance that the result is right and only a 1 in 20 chance of theresult occurring randomly.Sterilised interventionWhen a read more..

  • Page - 256

    disequilibria in, say, the pricing of hotel rooms will not makemuch difference. So hotel prices are often sticky.Stochastic processA process that exhibits random behaviour. For instance, Brown-ian motion, which is often used to describe changes in sharepricesin an efficient market(the random walk), is astochastic process.StocksAnother term for shares. What are called ordinary shares inthe UK are known as common stock in the United States. It isalso another word for inventories of goods held by a read more..

  • Page - 257

    Structural unemploymentThe hardest sort of unemploymentto cure because it iscaused by the structure of an economy rather than by changesin the economic cycle. Contrast with cyclical unemployment,which can, in theory if not always in practice, be cut withoutsparking inflationby stimulating faster economic growth.Structural unemployment can be reduced only by changing theeconomic structures causing it, for instance by removing rulesthat limit labour market flexibility.Subsidymoneypaid, usually by read more..

  • Page - 258

    relative to everything else, so people switch some of theirconsumptionout of goods that are now relativelymore expensive and buy more petrol instead.Sunk costsWhen what is done cannot be undone. Sunk costs are costs thathave been incurred and cannot be reversed, for example,spending on advertisingor researching a product idea. Theycan be a barrier to entry. If potential entrants would haveto incur similar costs, which would not be recoverable if theentry failed, they may be scared off.SupplyOne read more..

  • Page - 259

    Supply curveA graph of the relationship between the priceof a good andthe amount supplied at different prices. (See also demandcurve.)Supply-side policiesIncreasing economic growthby making markets work moreefficiently. In the 1980s, Ronald Reagan and Margaret Thatcherchampioned supply-side policies as they attacked keynesiandemandmanagement. Pumping up demand without makingmarkets work better would simply lead to higher inflation;economic growth would increase only when markets were ableto read more..

  • Page - 260

    SwapSee derivatives.Systematic riskThe riskthat remains after diversification, also known asmarket risk or undiversifiable risk. It is systematic risk that de-termines the returnearned on a well-diversified portfolio ofassets.Systemic riskThe riskof damage being done to the health of the financialsystemas a whole. A constant concern of bankregulators isthat the collapse of a single bank could bring down the entire fi-nancial system. This is why regulators often organise a rescuewhen a bank gets read more..

  • Page - 261

    TTangible assetsassetsyou can touch: buildings, machinery, gold, works ofart, and so on. Contrast with intangible assets.TariffOften used to describe a tax on goods produced abroadimposed by the governmentof the country to which they areexported. Many countries have reduced such tariffs as part ofthe process of freeing up world trade.TaxationProstitution may be the oldest profession, but tax collection wassurely not far behind. In its early days, taxation did not alwaysinvolve handing over read more..

  • Page - 262

    around the world took a growing share of their country’s na-tional incomein tax, mainly to pay for increasingly moreexpensive defence efforts and for a modern welfarestate. in-direct taxationon consumption, such as value-addedtax, has become increasingly important as direct taxationon income and wealth has become increasingly unpopular.But big differences among countries remain. One is theoverall level of tax. For example, in United States tax revenueamounts to around one-third of its gdp, read more..

  • Page - 263

    tax evasion. However, who ultimately pays (the tax inci-dence) may be different from who is initially charged, if thatperson can pass it on, say by adding the tax to the price hecharges for his output. Taxes on companies, for example, arealways paid in the end by humans, be they workers, customersor shareholders.Tax arbitrageCreating financial instrumentsor transactions that allowthe parties involved to exploit loopholes in or differencesbetween their tax exposures, so that all involved pay less read more..

  • Page - 264

    Tax burdenTotal tax paid in a period as a proportion of total incomeinthat period. It can refer to personal, corporate or nationalincome.Tax competitionLow-tax policies pursued by some countries in the hope of at-tracting international businesses and capital. Economistsusually favour competitionin any form. But some say thattax competition is often a beggar-thy-neighbour policy, whichcan reduce another country’s tax base, or force it to change itsmix of taxes, or stop it taxing in the way it read more..

  • Page - 265

    Tax evasionPaying less tax than you are legally obliged to. Contrast withtax avoidance. There may be a thin line between the two,but as Denis Healey, a former British chancellor, once put it,“The difference between tax avoidance and tax evasion is thethickness of a prison wall.”Tax havenA country or designated zone that has low or no taxes, or highlysecretive banks, and often a warm climate and sandy beaches,which make it attractive to foreigners bent on tax avoidanceor even tax evasion. Tax read more..

  • Page - 266

    Third wayAn economic philosophy espoused by some leftish politicalleaders in the late 20th century, including Bill Clinton and TonyBlair. According to the rhetoric, it is not capitalismand notsocialism, but a third (pragmatic) way. Many have thereforefound it rather hard to pin down. It was earlier used to describeSweden’s economic model.TickThe minimum pricechange possible in a financial market-place.Tiger economiesThe fast-growing developing economies of Asia, at least beforethe asian crisis read more..

  • Page - 267

    Tobin, JamesA Nobel prize-winning economist, James Tobin (1918–2002)theorised that firmswould continue to invest as long as thevalue of their sharesexceeded the replacement cost of theirassets. The ratio of the market value of a firm to the netreplacement cost of the firm’s assets is known as “Tobin’sq”. If qis greater than 1, then it should pay the firm to expand,as the profitit should expect to make from its assets (reflectedin the share price) exceeds the cost of the assets. If qis read more..

  • Page - 268

    also produces gains from economies of scale. But anotherreason for the fast growth in trade among nearby countries maybe less benign. The proliferation of regional trade agreementsmay be causing neighbours to trade with each other when itwould be more efficient for them to export to and import fromafar.In the past 50 years more than 150 regional trade agreementshave been notified to the general agreement on tariffsand trade (gatt) or the world trade organisation(wto), most of which are still in read more..

  • Page - 269

    Trade deficit/surplusAn excess of importsover exportsis a trade deficit. Anexcess of exports over imports is a trade surplus. (See balanceof payments.)Trade unionsSee unions.Trade-weighted exchange rateA country’s exchange ratewith the currencies of its tradingpartners weighted by the amount of trade done by the countryin each currency.Tragedy of the commonsA 19th-century amateur mathematician, William Forster Lloyd,modelled the fate of a common pasture shared among rational,utility-maximising read more..

  • Page - 270

    Transaction costsThe costs incurred during the process of buying or selling, ontop of the priceof what is changing hands. If these costs can bereduced, the price mechanismwill operate more efficiently. TransfersPayments that are made without any good or service beingreceived in return. Much public spendinggoes on trans-fers, such as pensions and welfarebenefits. Private-sectortransfers include charitable donations and prizes to lotterywinners.Transfer pricingThe pricesassumed, for the purposes read more..

  • Page - 271

    Transition economiesFormer communist economies that, with varying degrees of en-thusiasm, have embraced capitalism.Transmission mechanismThe process by which changes in the money supplyaffect thelevel of total demandin an economy.TransparencyA buzz word for the idea that the more informationis dis-closed about an economic activity the better. Many regulators,private lenders, politicians and economists reckoned that theasian crisis of the late 1990s would not have been so severe,or even have read more..

  • Page - 272

    TroughTransition point between economic recessionand recovery.TrustOne of the most valuable economic assets, hard to create buteasy to destroy – a crucial ingredient of a country’s socialcapital. People are more likely to do business together whenthey trust each other. Trust can reduce market failurethatotherwise results from asymmetric information. Whenthere is a lack of trust, people may have to spend heavily onmonitoring others’ behaviour to ensure they do what they saythey will do. read more..

  • Page - 273

    UUncertaintySee information.Underground economySee black economy.UnemploymentThe number of people of working age without a job is usuallyexpressed as an unemployment rate, a percentage of the work-force. This rate generally rises and falls in step with the busi-ness cycle – cyclical unemployment. But some joblessness isnot caused by the cycle, being structural unemployment.There are also voluntary unemploymentand involuntaryunemployment. Some people who are not in work have no in-terest in read more..

  • Page - 274

    they do will make them worse off. Also known as the povertytrap, it can be addressed, to an extent, by continuing to paybenefit for a while to unemployed people returning to work.(See welfare to work.)UnionsIn developed countries, at least, trade union membership andinfluence has declined over the past three decades. Fewerwagesare now set by collective bargaining, and far fewerworking days are lost to strikes. Unions, which are in effect acartelof workers, probably make unemploymenthigherthan it read more..

  • Page - 275

    in 1745, interest should be regarded as a sin because “the creditordesires more than he has given”. In most modern economies, in-terest is recognised as a crucial part of the economic system, areward to the lender for the risktaken in making a loan. Even so,many countries have some form of usury law imposing limits onhow high interest charges can be to protect borrowers frombeing exploited by unscrupulous loan sharks.UtilityEconomist-speak for a good thing; a measure of satisfaction.(See read more..

  • Page - 276

    VValue addedThis usually refers to firms, where it is defined as the value ofthe firm’s outputminus the value of all its inputs purchasedfrom other firms. It is therefore a measure of the profitearnedby a particular firm plus the wages it has paid. As a rule, themore value a firm can add to a product, the more successful itwill be. In many countries, the main form of indirect taxa-tionis value-added tax, which is levied on the value created ateach stage of production. However, it is paid, read more..

  • Page - 277

    Velocity of circulationThe speed with which moneywhizzes around the economy,or, put another way, the number of times it changes hands.Technically, it is measured as gnpdivided by the moneysupply(pick your own definition). It is an important ingredientof the quantity theory of money.Venture capitalprivate equityto help new companies grow. A valuable al-ternative source of finance for entrepreneurs,who mightotherwise have to rely on a loan from a probably riskaversebank manager. The United States read more..

  • Page - 278

    already enjoys some monopolypower, which the deal mightallow it to extend into a new market.Visible tradePhysical exportsand imports, such as coal, computer chipsand cars. Also known as merchandise trade. Contrast with in-visible trade. (See balance of payments.)VolatilityThe most widely accepted measure of riskin financialmarketsis the amount by which the price of a securityswings up and down. The more volatile the price, the riskier isthe security. Not least because there is no obvious read more..

  • Page - 279

    WWage driftThe difference between basic pay and total earnings. Wage driftconsists of things such as overtime payments, bonuses, profitshare and performance-related pay. It usually increases duringperiods of strong growthand declines during an economicdownturn.WagesThe priceof labour. In theory, wages ought to change so thatthe supplyand demandin the labour market are always inequilibrium. In practice, wages are often sticky, especially ina downward direction: when demand for labour falls, wages read more..

  • Page - 280

    Wealth effectAs people get wealthier, they consume more. This wealth effecthas important consequences for monetary policy. Whenthere is an interestrateincrease, future incomefromassetssuch as equitiesmust be discounted at a higher ratethan before. As a result their owners feel poorer and spend less.A cut in interest rates has the opposite effect. Economists dis-agree on the wealth elasticityof consumption: how muchconsumer spending would rise if wealth increased by, say, 1%.Different consumers read more..

  • Page - 281

    the revenue collected may prove disappointing. The wealthiestpeople are often the most skilled at tax avoidance, not leastbecause they can afford good tax accountants. Despite the enor-mous concentration of wealth in a small part of the population,on average across the oecdwealth taxes account for lessthan 2% of total tax revenue.A wealth tax can achieve horizontal equityand verti-cal equity(so that people of similar means pay the same andthose with more pay more) in ways that income read more..

  • Page - 282

    an individual or society, as in “Are tax cuts welfare-enhanc-ing?”. This is economist-speak for “Will tax cuts improve theoverall well being of the country?”. (See utility.)Welfare economicsEconomics with a heart. The study of how different forms ofeconomic activity and different methods of allocating scarce re-sources affect the well being of different individuals or coun-tries. welfare economics focuses on questions about equityas well as efficiency.Welfare to workActive labourmarket read more..

  • Page - 283

    a result of the efforts of the firm, taxing them should not harmthe firm’s incentives to maximise future profits. The problemcomes when greedy politicians start claiming that profits arewindfalls when in fact they are deserved and expected. Thentaxing them sends a signal to firms that they should not try toohard to make profits, as if they do too well they will not get tokeep the profits anyway. If this became widely believed, effortwould probably decline and economic growthwould read more..

  • Page - 284

    that because of more liberalised markets there will be growinginequalityin most professions and the emergence of awinner-takes-all society.Withholding taxA tax that is collected at source, before the taxpayer has seen theincomeor capitalto which the tax applies. In other words,that part of the income or capital due in tax is withheld from thetaxpayer, who therefore cannot easily avoid paying the tax.Withholding taxes are frequently imposed on interestanddividends.World BankAn institution created read more..

  • Page - 285

    bad job, the World Bank will come to the rescue. The increase inprivate-sector lending to and investmentin emerging marketshas led to growing discussion of whether the World Bank is anylonger needed.World Trade OrganisationBête noire of anti-globalisation protesters. The World TradeOrganisation (wto) is the governing body of internationaltrade, setting and enforcing the rules of trade and punishing of-fenders. Established during the Uruguay Round of talks underthe general agreement on tariffs read more..

  • Page - 286

    XX-efficiencyProducing outputat the minimum possible cost. This is notenough to ensure the best sort of economic efficiency, whichmaximises society’s total consumer plus producersurplus, because the quantity of output produced may not beideal. For instance, a monopolycan be an x-efficient pro-ducer, but in order to maximise its profitit may produce a dif-ferent quantity of output than there would be in asurplus-maximising market with perfect competition.X-EFFICIENCY279233-282 5-12-2003 17:08 read more..

  • Page - 287

    YYieldThe annual income from a security, expressed as a percent-age of the current market priceof the security. The yield on ashareis its dividenddivided by its price. A bondyield isalso known as its interest rate: the annual coupon dividedby the market price.Yield curveShorthand for comparisons of the interest rateon govern-ment bondsof different maturity. If investors think it is riskierto buy a bond with 15 years until it matures than a bond withfive years of life, they will demand a higher read more..

  • Page - 288

    Yield gapA way of comparing the performance of bondsand shares.The gap is defined as the average yieldon equitiesminusthe average yield on bonds. Because shares are usually riskierinvestments than bonds, you might expect them to have ahigher yield. In practice, the yield gap is often negative, withbonds yielding more than equities. This is not because investorsregard equities as safer than bonds (see equityriskpremium). Rather, it is that they expect most of the benefitfrom buying shares to come read more..

  • Page - 289

    ZZero-sum gameWhen the gains made by winners in an economic transactionequal the losses suffered by the losers. It is identified as aspecial case in game theory. Most economic transactions arein some sense positive-sum games. But in popular discussion ofeconomic issues, there are often examples of a mistaken zero-sum mentality, such as “profit comes at the expense ofwages”, “higher productivitymeans fewer jobs”, and“imports mean fewer jobs here”.282ZERO-SUM GAME233-282 5-12-2003 read more..

Write Your Review