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ECONOMICS
Guiding you through the A to Z of contemporary economics in all
its forms, Economics: The Key Concepts is an essential, affordable and
accessible reference for students, lecturers and economists at every
level.
Key concepts covered include:
Competition and monopoly
Development economics
Equality
Ethics and economics
Game theory
Happiness
Property rights
Entries include extensive guides to further reading and are fully cross-
referenced throughout to give readers a comprehensive pocket refer-
ence to the ideas, issues and practice of economics in the twenty-first
century.
Donald Rutherford is Lecturer in Economics at the University of
Edinburgh and the author of The Routledge Dictionary of Economics (2002).
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YOU MAY ALSO BE INTERESTED IN THE
FOLLOWING ROUTLEDGE STUDENT
REFERENCE TITLES
Fifty Major Economists (Second Edition)
Steven Pressman
Economics: The Basics
Tony Cleaver
Business: The Key Concepts
Mark Vernon
Fifty Key Figures in Management
Morgen Witzel
The Routledge Companion to Global Economics
Edited by Robert Benyon
Management: The Basics
Morgen Witzel
Internet: The Basics
Jason Whittaker
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ECONOMICS
The Key Concepts
Donald Rutherford
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First published 2007
by Routledge
2 Park Square, Milton Park, Abingdon, Oxon OX14 4RN
Simultaneously published in the USA and Canada
by Routledge
270 Madison Ave, New York, NY 10016
Routledge is an imprint of the Taylor & Francis Group, an informa business
This edition published in the Taylor & Francis e-Library, 2007.
“To purchase your own copy of this or any of Taylor & Francis or Routledge’s
collection of thousands of eBooks please go to www.eBookstore.tandf.co.uk.”
# 2007 Donald Rutherford
All rights reserved. No part of this book may be reprinted or reproduced or utilised in any
form or by any electronic, mechanical, or other means, now known or hereafter invented,
including photocopying and recording, or in any information storage or retrieval system,
without permission in writing from the publishers.
British Library Cataloguing in Publication Data
A catalogue record for this book is available from the British Library
Library of Congress Cataloging in Publication Data
A catalog record for this book has been requested
ISBN 0-203-94661-8 Master e-book ISBN
ISBN 978–0–415–40056–5 (hbk)
ISBN 978–0–415–40057–2 (pbk)
ISBN 978–0–415–94661–9 (ebk)
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CONTENTS
List of Key Concepts
vi
Introduction
ix
KEY CONCEPTS
1
Bibliography
224
Names Index
241
Subjects Index
245
v
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LIST OF KEY CONCEPTS
Accelerator
Aid
Altruism
Arbitrage
Auction
Austrian economics
Balance of payments
Banking
Bubble
Capitalism
Capital theory
Classical economics
Clubs, theory of
Coase theorem
Cobweb
Collective bargaining
Comparative economic systems
Competition and monopoly
Consumer’s surplus
Consumption
Contract theory
Cooperation
Core
Corruption
Cost
Cost-benefit analysis
Credit
Cultural economics
Currency
Customs union
Cycles
Debt
Demand curve
Development economics
Discrimination
Disequilibrium economics
Division of labour
Dual economy
Economic anthropology
Economic concentration
Economic demography
Economic growth
Economic integration
Economic methodology
Economic modelling
Economics as rhetoric
Economic system
Economic welfare
Economies of scale and scope
Efficiency
Elasticity
Energy economics
Entrepreneur
Environmental economics
Equality
Equilibrium
Ethics and economics
Evolutionary economics
Ex-ante, ex-post
Exchange rate
Exhaustible resources
Expectations
Experimental economics
Externality
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Family, economics of
Firm
Fiscal federalism
Fiscal policy
Fix price, flex price
Freedom
Game theory
Globalisation
Happiness
Health economics
Holism
Homo economicus
Household behaviour
Human capital
Impossibility theorem
Incentives
Income distribution
Incomes policy
Industrial organisation
Industrial relations
Inflation
Informal economy
Information
Innovation
Input-output analysis
Institutional economics
Interest rate
Investment
Invisible hand
IS-LM model
Keynesianism
Labour
Laissez-faire
Libertarian economics
Macroeconomic forecasting
Marginalism
Market
Marxian economics
Mercantilism
Merit good
Migration and mobility
Monetarism
LIST OF KEY CONCEPTS
Monetary policy
Money
Multinational corporation
Multiplier
National economy
National income
Neoclassical economics
Neo-Ricardian economics
Neuroeconomics
New classical economics
New political economy
Non-profit enterprise
Physiocracy
Planning
Political business cycle
Political economy
Poverty
Price
Price index
Price-specie flow mechanism
Privatisation
Production function
Productivity
Profit
Property rights
Protection
Public choice
Public finance
Public good
Public sector
Quantity theory of money
Rationality
Rawlsian justice
Real business cycle
Regional policy
Regulation
Rent
Returns
Risk and uncertainty
Robinson Crusoe economy
Satiability of wants
Saving
vii
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LIST OF KEY CONCEPTS
Say’s law
Scarcity
Search theory
Segmented labour market
Self-managed enterprise
Social capital
Social choice theory
Socialism
Spatial economics
Stabilisation policy
Stockholm School
Structural adjustment
Structure of an economy
Supply-side economics
Surplus value
Taxation
Technical progress
Terms of trade
Time in economics
Trade theory
Trade (labor) union
Tragedy of the commons
Transfer income
Transfer pricing
Unemployment
Utility
Value
Wealth
Welfare economics
viii
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I N T RO D U C T I O N
Economics has been studied for centuries as there has always been
great curiosity about the nature and determinants of wealth and well-
being, and how scarce resources should be employed. Economics
operates at different levels: the theoretical, the technical and the
advisory. Sometimes all are combined in one concept, for example,
an examination of prices requires a consideration of theory, methods
of pricing and prices policies. Some economic ideas are basic to
much of economics discourse, such as cost; others are related to the
analysis of particular problems, as is the case with environmental
economics. Economics has long been sectarian so attention has to be
paid to the many schools of thought. Political and social problems
often have an economic dimension so different types of economic
policy abound.
Central to the study and understanding of any academic discipline
is an awareness of the nature and limits of the concepts used. The
central themes of this work were chosen by consulting a range of
economics books and economists. In this book over 170 concepts
justify separate articles but subordinate concepts are mentioned
within each discussion. Each entry takes a central concept and relates
it to the variants which form a cluster of related ideas. A short
definition introduces the concept and, where relevant and known,
the origins of it are mentioned. At the end there are cross-references
and further reading. The reading amplifies what has been written in
the text.
There is a list of concepts, and an index of the names of economics
writers cited in the text. Birth and death dates are stated to locate
these writers intellectually in the successive ages of economics, whe-
ther mercantilist, classical or neoclassical either propounding the
dominant theme of what economics was then or dissenting from it.
Further information can be obtained on these writers by using
reference books such as M Blaug (ed.) (1983) Who’s Who in Economics
(1983); D Rutherford (ed.) (2004) Biographical Dictionary of British
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INTRODUCTION
Economists; and RB Emmett and J Madison (eds) (2006) Biographical
Dictionary of American Economists.
A guide to concepts takes its place in the working library of an
economist alongside textbooks on the basics and specialisms of eco-
nomics as well as manuals on mathematical methods and econo-
metrics. Knowing concepts allows the economics researcher to build
the foundations of an investigation theoretical or applied. Conceptual
awareness ensures greater rigour.
New economics terms are coined every year but they are not
important concepts until they inspire a body of economics literature.
Economic concepts are surprisingly durable. Even an abandoned type
of economic policy is a permanently useful idea as it exists as an
option for the future.
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ECONOMICS
The Key Concepts
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AID
ACCELERATOR
The relationship between an increase in net investment and changes
in real income or output. This early twentieth-century theory is
especially associated with Aftalion and JM Clark.
Although regarded chiefly as a theory based on a macroeconomic
relationship between a change in aggregate income and aggregate net
investment, it has microeconomic roots. When incomes increase, there
is an increased demand for goods which will increase in price when the
capital to make those goods is fully utilised. Manufacturers will increase
the capital stock to meet the expected increase in demand. The
accelerator can apply to a particular industry or to the economy as a
whole. In the simplest expression for the accelerator it is the amount by
which an increase in income is multiplied to predict the amount of
net investment. It is also regarded as the desired capital-output ratio and
will be more than one as the value of output from capital is much less
than the value of the capital itself. The basic accelerator equation has
been modified to deal with the problems of the time it takes to
respond to an increase in income and the existence of excess capacity.
Making net investment a function of previous income deals with slow
responses; subtracting the value of the capital stock multiplied by the
degree of excess capacity produces a better estimate of net investment.
An important application of the accelerator principle is in trade
cycle theory. Hicks combined the accelerator with the multiplier, ceil-
ings and floors to generate cycles. Increased income leads to increased
investment through the accelerator, that extra investment creates
more income through the multiplier, then the accelerator operates
again. Only the full employment ceiling prevents infinite expansion
of the economy; net investment independent of income will enable
an economy to recover from the floor. In the first phase there is dis-
investment as the extra demand is met from stocks, in the next there
is induced investment and in the third oscillations as depreciated
reserves are increased or run down as replacement takes place.
See also: cycles; investment
Further reading: Clark 1917; Hicks 1950
AID
Grants of money or of goods and services by national governments or
private organisations and individuals to poor countries or regions.
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AID
There are different degrees of aid. Emergency help at a time of
crisis such as an earthquake, medium-term assistance until a country
establishes its own services, such as the loan of teachers and doctors,
and long-term investment in infrastructure and business enterprises
are the major categories. Multilateral aid consists of the distribution
of donations from many sources through an international agency such
as the World Bank to the recipient country. Bilateral aid flows directly
between donor and recipient. Aid to foreign countries still amounts
to a tiny fraction of the national income of developed countries.
There are many motives for aid. For strategic military reasons,
superpowers help countries in return for military bases and to main-
tain internal political stability within them. From the nineteenth
century large countries have tried to extend their power by creating
spheres of influence: to be successful, such a policy needs continuous
flows of help. This aid will be largely bilateral. For balance of pay-
ments reasons it is cheaper to offer goods and services in one’s own
currency, but the value of that aid can be devalued by inferior and
more expensive goods than available in world markets. But aid
offered by supposedly impartial international agencies has its own
problems. Lobbies in such organisations will achieve more for some
countries than others. Also the potential amount of aid can be deva-
lued by the large administrative costs of allocating it. Idealists genu-
inely hope that through aid there can be a movement to a greater
equality of per capita incomes throughout the world, but the small
volume of aid makes that unlikely.
Generous individuals through charities and religious organisations
send monetary and other help to poorer countries. A sense of moral
duty motivates such aid. Often it is untainted by the political moti-
vation of official aid. But it can be only enough to launch new
initiatives or supplement inter-governmental assistance.
Aid is an example of a transfer income. Boulding conceptualised
aid through distinguishing a grants economy from an exchange
economy. Grants are non-coercive, an expression of benevolence and
a method of creating an international community: aid has these
characteristics at its best.
Aid can be part of a plan, or the encouragement of the sponta-
neous mechanisms of an indigenous economy. Aid is either a means
to making a country more dependent or a stimulus to sustainable
development. Experience of managing aid programmes has modified
them. Increasingly there are safeguards to avoid destroying local cul-
tures and environment. The choice of technology is important as the
recognition that large reserves of labour have to be considered, as has
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ALTRUISM
the expense of choosing capital intensive methods. The contribution
of aid to encouraging trade is essential, otherwise one tranche of aid
has to be succeeded by another. The method of distribution of aid is
vital if those most in need are to be helped, and it is important that
corruption is minimised by careful monitoring which keeps gifts
out of the hands of the ruling elite and military. The greatest danger
of aid is the creation of aid dependency, which means that a country
loses its economic independence and is unable to plot its destiny. But
it can be argued that few countries have any autonomy because of the
growth of international corporations and the process of globalisation.
See also: development economics; equality; globalisation; poverty;
trade theory
Further reading: Boulding 1973; Singer 1984
ALTRUISM
A philosophy of preferring the welfare of others to one’s own;
unselfishness; the opposite of egoism.
Altruism can be practised within a family; perhaps the commonest
examples are gifts, extended credit and the sharing of risk, within
the wider population through private charity or government trans-
fers, or even in the world as a whole through economic aid. This
ideal has formed the basis of utopian communities.
It is agreed that it is the opposite of selfishness, which has often
been confused with self-interest. This term was invented by the
positivist Auguste Comte in 1851 and derived from the Italian word
altro, other. The altruist forsakes personal gain and advancement in
order to help the weak. Generally this attitude is derived from a
moral stance, rather than the practicalities of economic life. The
pursuit of profit under capitalism and the insistence on workers
receiving the product of their labour under socialism are both hard
to reconcile with altruism. It is possible to have short-term altruism in
order to establish good industrial and international relations, and then to
revert to usual market principles. Others would argue that the awareness
of social cost in an environmentally conscious age necessitates the curb-
ing of private interests for the others who constitute the wider com-
munity. Economic analysis of charities and religion has to consider
altruism as a central motive for institutional behaviour. However,
globalisation has had both the consequence of new opportunities
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ALTRUISM
for exploitation and also an awareness of greater and more distant
needs, which inevitably will move the altruistic to action.
Altruism can take many forms. It can be intergenerational, where
economic and social activities are restricted now for the sake of future
generations’ enjoyment of the environment. It can be private or
public. A wise government might select the amount of help requisite
to others more capably than less informed individuals and charities,
or not. Taxation can be used both to discourage bad action against
others and to make individuals pay the social costs of their actions.
Embedding altruism as a principle in economic institutions and
economic policy is always controversial. It is difficult to sum individual
preferences to form any scheme of improvement. Also qualities of self-
reliance, ambition and risk taking can be discouraged by recreating an
economy according to a social model. The problem of altruism
having destructive effects is recognised in the Samaritan’s Dilemma,
in which helping others can lead to one’s own destruction. Buchanan
recognised that there are predators within one’s own species in his
account of the dilemma. It has many applications to welfare states.
Altruism is not always as genuine as it appears, as Collard pointed
out. It can be enlightened self-interest, when what is ostensibly for
others also benefits oneself. Gifts are prompted by many motives.
They may be implicit exchange because we expect something back.
They might be a form of personal security to appease potential ene-
mies. The benevolent person in society has enhanced reputation and
status so can benefit commercially.
There is a loose relationship between the stage of economic devel-
opment and the incidence of altruism. In richer societies there might
be few on low incomes and the government can afford through its
fiscal policy to eliminate the needy.
Altruism requires imagination, empathy and a benevolent disposi-
tion. This can be practised directly, or by proxy, when voters require
other people who are richer to help the poor. Altruism can be
practised for the benefit of the present or future generations. What is
crucial is the proportion of income consumed. By restraining con-
sumption there can be more saving and investment for the future.
Also the environment is improved by restraining the consumption of
non-renewable resources.
See also: homo economicus; social choice theory
Further reading: Andreoni 1989; Buchanan 1975, 1977; Collard 1975; Fontaine
2000; Simon 1993
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ARBITRAGE
AUCTION
Parallel simultaneous purchases and sales in different markets in order
to gain from price differentials. Arbitrage is extensively practised in
stock, bond, commodity and currency markets.
By this process efficient and consistent prices emerge despite places
and times of sales and purchase being different. In pure arbitrage a
riskless profit emerges as it costs nothing to hold contracts for dif-
ferent dates. The amount gained through arbitrage can be small but it
has to be large to cover transaction costs, otherwise it is pointless.
This form of arbitrage does not require the commitment of capital.
Under arbitrage pricing theory in a stock market selling a homo-
geneous stock, or share, the expensive will be sold and the cheap
purchased in order to reach an equilibrium. A few risk factors will
affect the price of an asset, including the rate of interest and the price
of the asset relative to the price of a portfolio of assets. As financial
markets have become more innovative, introducing a host of financial
derivatives, so have the techniques for conducting arbitrage, includ-
ing the use of stochastic differential equations.
Arbitrage can also be part of a merger and takeover strategy when
an equity holding is acquired with a view to a company being taken
over at a higher price. There can also be arbitrage over the current
price of a company and its liquidation value.
See also: risk and uncertainty
Further reading: Ross 1976
AUCTION
A method of selling through a process of bidding which ultimately
reaches an accepted price.
The simplest of these is the English auction, in which the auc-
tioneer proposes a starting bid then conducts subsequent bidding
until no one is willing to bid any higher. The successful bid
must reach the seller’s reserve price. As ‘auction’ is derived from the
Latin word augere meaning to augment or increase, there is the possi-
bility that the English form of bidding has its origins in the Roman
empire.
Other types of auction abound. The Dutch auction is conducted
in reverse order to the English. The auctioneer deliberately starts
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AUCTION
with a price far higher than buyers are likely to accept then reduces
the price until a buyer accepts by shouting ‘mine’. An automated
version of this auction uses a ‘clock face’ with a hand moving from
the highest to lower prices. Auctions are open, in the English or
Dutch cases. The first-price auction uses the method of sealed bids
being submitted and, when opened, the highest being accepted. This
is used by the US Treasury for selling short-term securities. Similarly
in second-price auctions there are sealed bids but the second highest
is chosen. In hybrid auctions the bidders bid for quantities and the
prices are negotiated subsequently. All these auctions have different
outcomes. Auctions are assessed according to the revenue raised and
passing the efficiency test of whether the person with the highest
valuation succeeds.
The auction is important in understanding the working of mar-
kets, as it is the device for reaching equilibrium through the process
of tatonnement, or groping, in general equilibrium theory. Under
that Walrasian system the auctioneer announces a price and the
buyers and sellers write down on pieces of paper whether the price is
acceptable or not. The auctioneer can then collect the papers and
determine whether at the suggested price there is excess demand or
excess supply. The process will continue until demand and supply are
balanced.
An auction is only one mode of selling. That they occur at all is to
be questioned. They are public so can attract into a market more
potential buyers. They can have lower information costs. Where
there is uncertainty about the worth of an article an auction is
superior to pricing by using customary formulae. The revenue
equivalence theorem shows how risk-neutral traders will achieve the
outcome of the sellers and buyers, achieving an equivalent exchange
in terms of expected revenue to the seller and expected profits to the
bidder. Bidders are ignorant of the private valuations of their rivals
but sometimes can guess because a common source of information is
used by all the auction participants.
Vickrey analysed auctions as games of incomplete informa-
tion. He examined markets in a state of imperfect competition
by considering counter-speculation as a means of achieving effi-
cient resource allocation, and devised second highest price as a
solution.
See also: price
Further reading: Krishna 2002; Vickrey 1961
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AUSTRIAN ECONOMICS
AUSTRIAN ECONOMICS
A school of economics which began with Carl Menger in 1871.
This branch of economics was a reaction to the German historical
school which had despised timeless universal economic laws, pre-
ferring the view that economies develop through stages. Both macro-
and microeconomic theories are propounded by the Austrians. The
former has been concerned with the theory of economic cycles and
the latter with prices, interest rates and investment.
The distinctive features of the school are its emphases on indivi-
dualism, subjectivism, opportunity costs and the time preference in
consumption and investment. Also they have made contributions to
the study of entrepreneurship, money and inflation.
Carl Menger in his Principles of Economics (1871) demonstrated the
usefulness of marginal concepts, but avoiding mathematics in the
form of the differential calculus used by his contemporary WS
Jevons. Implicitly using an idea of marginal utility, Menger showed
how there would be a consumer equilibrium by equating marginal
satisfactions from different goods consumed. He carefully considered
a range of markets from an isolated exchange between two indivi-
duals to oligopoly and monopoly. Consumption and capital goods
were shown to be in a continuum of lower to higher goods with the
higher, capital goods producing the lower to satisfy consumer
demand.
The next major figure in the school was Eugen von Boehm-
Bawerk, who derived a theory of capital with only land and labour as
original factors of production, asserting that capital initiated round-
about methods of production, increasing the average period of pro-
duction as first capital goods then consumer goods would be
produced. His three-volume Capital and Interest of 1884, 1889 and
1921 surveyed theories of interest, rejecting ideas of exploitation and
the labour theory of value. In his theory, interest is justified because
of a time preference for present over future goods. He both explained
how an individual producer allocates resources and also how alloca-
tion occurs in the economy as a whole to achieve full employment.
Also in the first generation of the Austrians was his colleague Frie-
drich von Wieser. His significant contributions to the subject were
the theory of imputation, deriving factor prices from product prices,
and his theory of alternative, or opportunity, cost. Previously value
theories had been sharply divided between value based on cost of
production and value based on utility: Wieser saw there was a unity
between the two approaches, for costs could be translated into utilities
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AUSTRIAN ECONOMICS
because the cost of production determines the yield from the pro-
ductive process.
The leading figures of the second generation were Ludwig von
Mises, Ludwig Lachmann and Joseph Schumpeter. Mises, in the
‘socialist calculation debate’, attacked socialism by arguing that as
the government owned the means of production there could be no
pricing for capital goods and hence no full system of pricing for the
economy as a whole. Lachmann did much to detach Austrian from
neoclassical economics and anticipated some of the capital con-
troversies between the two Cambridges of Massachusetts and England
in the 1960s by tackling the problem of measuring the aggregate
capital stock through preferring to examine capital structures. He was a
subjectivist with a great interest in economic methodology. His views
on expectations were similar to Shackle’s. Schumpeter expounded a
theory of entrepreneurship and innovation to explain economic
development, and was an early theorist of evolutionary economics.
The third generation included a galaxy of stars: Friedrich August
von Hayek, Oscar Morgenstern, Gottfried von Haberler, Fritz
Machlup, and Paul Rosenstein-Rodan. Hayek, with his wide intel-
lectual range of economics, psychology, and political theory, opposed
Keynesianism by attributing the economic ills of the 1930s to over-
investment, and went on to write about the spontaneous order and
information generation inherent in markets. Morgenstern’s early
interest in economic cycles led to a study of speculation and fore-
casting: with Neumann he was a founder of game theory. Haberler,
an authority on trade theory and cycles, shared with Hayek a dislike
of the Keynesian underinvestment approach to macroeconomics.
Machlup combined a training under Mises and Hayek with experi-
ence of manufacturing to write on the economics of information,
industrial organisation and international monetary economics; and
Rosenstein-Rodan, after early forays into the study of marginal utility
and the issue of time in economics, advanced the thesis that eco-
nomic development depended on industrialisation as this brought
about increasing returns.
Through its opposition to central economic planning and govern-
ment intervention, this school of economics is popular with libertar-
ian economists. Austrian economics became popular in the USA,
particularly because of its robust pro-capitalist libertarianism. The
tradition lives on in neo-Austrian economics, led by James Buchanan,
with his public choice theory; Israel Kirzner and his theory of
entrepreneurship; and Murray Rothbard, a disciple of Mises and an
advocate of libertarian economics.
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BALANCE OF PAYMENTS
Austrian economics is not to be confused with neoclassical eco-
nomics, as it is scarcely mathematical in its methodology and less
interested in equilibrium economics, preferring disequilibrium notions
of flux and evolution. To distinguish original Austrian from neo-
classical economics, the ‘marginal revolution’ can be called ‘the sub-
jectivist revolution’. With its fervent belief in the efficacy of markets
to provide information, it has favoured decentralised, unplanned
national economies. Much of Austrian economics has always been
microeconomic, but in the 1930s Hayek opposed the emerging
Keynesian economics, arguing that increased savings would restore
harmony to the economy.
See also: freedom; libertarian economics; neoclassical economics
Further reading: Caldwell 1990; Gloria-Palermo 1999; Hicks and Weber 1973
BALANCE OF PAYMENTS
The accounting record of monetary transactions between the resi-
dents of one country and another. This balance technically always has
to balance under the rules of double entry accounting, but there can
be structural imbalances when a balance is only achieved by con-
tinuous resort to external financing: this can occur through a chronic
failure to export more than is imported.
Within the balance of payments there are several constituent bal-
ances. The visible balance consists of exports less imports of goods;
the invisible shows the difference between exports and imports of
services: these are as varied as payments for services such as shipping,
travel and professional services, as well as personal and intergovern-
mental transfers, and incomes arising from financial investments. The
current balance adds together the visible and invisible balances. Fur-
ther there are balances for short- and long-term capital flows.
The accounting balance provides a record of all transactions
between the residents of one country and those of another within the
time period of a quarter or a year. For there to be a fundamental
equilibrium in the balance of payments, the current and capital
accounts have to be in balance and the economy internally balanced
at full employment.
The balance of payments can be regarded in stock terms as the
relation between stocks of commodities and stocks of cash, or in the
flow sense of incomes being transferred across national boundaries.
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BANKING
See also: trade theory
Further reading: Stern 1973
BANKING
The activity of exchanging or lending money.
In many languages a similar word for a bank, derived from the
bench on which the money exchangers sat, is used. In the Middle
Ages the growth of banking into moneylending was impeded in
Europe by the church’s teaching on usury, the making of a charge for
the use of money. Gradually a justification for the payment of interest
was found. Today in strict Islamic countries there is also a con-
demnation of usury, so it is only possible to lend money by partici-
pating in a joint venture, rather than potentially exploiting the borrower
by charging a fixed rate for the use of money.
London goldsmiths in the seventeenth century discovered it was
possible to lend more than is deposited – hence goldsmith banking. A
study of depositors’ demand for cash can ensure that banks can both
profit from lending and ensure they have enough on deposit to meet
demands for the redemption of banknotes. A cautious risk-free
banking system has 100 per cent reserves. Experience showed that it
was possible to have a base of 10 per cent cash or a monetary base of
about 30 per cent cash and liquid assets which could be changed into
cash with little risk of capital loss. The money multiplier is the ratio
of the increase in bank deposits to a change in reserve assets. In the
twentieth century banks diversified into the provision of other
financial products, often riskier because they were not repayable in
such short time periods as bank loans or represented investments in
other financial institutions.
Several tiers of banking exist – central, wholesale and retail. Cen-
tral banking has the tasks of financing government borrowing, issuing
currency, conducting monetary policy, maintaining the liquidity of
the banking system, liaising with central banks of other countries and
supervising component banks of the system. As the government’s
bank, a central bank will be engaged in debt management, ensuring
that a shortfall in government revenue after expenditures have been
incurred will be financed by the short-term issue of bills, often
repayable in ninety days, and bonds with five years if short, five to
fifteen if medium, over fifteen if long, to redemption, or even unda-
ted. As the ultimate source of credit, banks maintain liquidity by
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BANKING
buying short-term bills held by banks or other recognised financial
institutions to inject cash into the banking system to meet customers’
demands, especially when mass panic causes a run on a bank. Liaising
with other central banks will vary according to the currency regime
but can involve inter-bank lending to support a faltering currency. To
maintain the quality and solvency of commercial banks, central banks
will be involved in audit and inspection, as well as setting capital
standards. In a country with a federal constitution such as the USA,
state chartered banks will be regulated by state commissions. Some
central banks have a long history, such as the Riksbank of Sweden,
founded in 1668, and the Bank of England, established in 1694, but
others were created in the twentieth century, including the most
important, the Federal Reserve System of the USA, which was estab-
lished in 1913 as a group of twelve banks covering the geographical
divisions of the country, with an open market committee, all under
the control of a board of governors. Central banks have varying
degrees of independence but have their duties defined by statute. The
most important mark of independence of a central bank is the right
to set interest rates: both the USA and the UK have central bank
independence in this sense. There can be hybrid banks which combine
the functions of central and private banks, servicing many clients: these
were possible in the nineteenth century, when national economies
were smaller and the role of government less ambitious in scope.
Wholesale banking has other financial institutions, not the general
public, as its customers and is engaged in services which include bor-
rowing and lending. They exist because some banks are secondary
banks in that they lend to, but do not collect deposits directly from,
the public. These banks can also provide liquidity for other banks, which
can then avoid seeking the help of the central bank. Retail banking,
meeting the financial needs of firms and private individuals, is usually
conducted by a financial firm with many branches. In the past in the
USA there was unit banking, which restricted each bank to operation
within a narrow geographical area, even a single site. Branch banking
has the advantages of reducing the risk associated with business
recession in a particular area and of collecting savings more widely.
At the international level, the World Bank (the ‘International Bank
for Reconstruction and Development’) and the International Monetary
Fund provide banking services for member nations. The World Bank
is heavily involved in making grants to less developed countries; the
IMF lends money to member countries finding it difficult to pay
external debt. In a sense the IMF is a bank and the World Bank a
fund. Not only has the IMF collected currencies to lend to indebted
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BUBBLE
nations, but it has also invented a reserve currency of its own, Special
Drawing Rights.
The business of a bank has been described as the business of its bal-
ance sheet. Its liabilities are the deposits it has received or created for its
customers: they are liabilities as they can be transferred elsewhere, elec-
tronically or by a check/cheque. The assets matching the liabilities
will range from cash, deposits with the central bank, loans to money
markets, bills, bonds, loans to customers and trade investments in other
financial institutions. There is a spectrum of liquidity and a spectrum
of profitability running through the assets. Cash is a zero interest asset
and the most liquid; then there are short-term assets which are near
liquid. Loans and trade investments are the most profitable and least
liquid. Skilled bankers finely balance the composition of their assets.
The free banking movement in Scotland (1810–45) and the free
banking state legislation in the USA, as early as 1837 in Michigan and
more widely under the National Banking Act of 1863, took away
control by a central bank or legislature, providing, in the American
case, that banks were backed by bonds. Since the 1980s deregulation
in the financial sector has blurred the distinctions between one
financial institution and another so that retail banks will also offer
advice on mergers and investments and sell insurance and real prop-
erty. But this has made banking more risky through moving out of
areas of traditional expertise and lending for longer periods.
The demand for banking services varies according to the state of
economic development. A largely subsistence agricultural economy is
not very monetised so needs little banking; then savings banks, chiefly
interested in storing deposits, emerge. An extensive financial sector is
a defining characteristic of a developed economy. But there can be
‘disintermediation’ when the banking system is used less as a financial
intermediary because firms borrow and lend from each other, espe-
cially under monetary policies which reduce bank lending.
See also: monetary policy; money
Further reading: El-Garnal 2006; Heffernan 1996; Selgin 1988; White 1995,
1999
BUBBLE
An unsustainable increase in the price of an asset or commodity
encouraged by speculation.
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BUBBLE
A bubble occurs when prices are different from their fundamental
values because speculators expect prices to rise further. Bubbles occur
in bullish markets and can be fuelled by fraudulent schemes, such as
the Ponzi scheme in which prices rise because of high profits
financed by the new investors themselves. For there to be a bubble,
what is priced is in a sense unique as there cannot be bubbles if there
is an elastic supply of substitutes. A bubble is measured by a volatility
test, for example, the volatility of the returns from an asset. Bubbles
occur in dynamically inefficient markets, especially markets full of
information deficiencies where the determinants of fundamental
prices, for example, of precious metals, foreign currencies and works
of art, are obscure. As a bubble has to be financed it will grow at a
rate equal to the rate of interest.
The most famous examples are the Dutch tulip mania of 1625–37,
and the speculation in the shares of the English South Sea Company
in 1720. Recent examples include stock markets in a bullish state, as
with the dotcom boom around the year 2000, and the housing
market where prices took off, especially in countries with rising
housing demand and a low rate of new construction, as in the UK.
There can be a ‘bubble economy’, as Japan was alleged to be in the
1980s, in which security prices as measured by a stock market price
index have reached heights unjustified by underlying values or
expected earnings. In general, when prices are too high, there is
‘irrational exuberance’, to quote the previous chairman of the board
of governors of the US Federal Reserve system, Alan Greenspan.
Determinants of bubbles include a deliberate cultivating of the
mass psychology of investors by the media; financial fraud, often
aided by a lax regulatory regime for financial markets; and repeated
economic crises which lead to shortages in supply, as in wartime or
siege conditions. Bank lending to support the purchase of financing
by encouraging stock market inflation is known as ‘bubble financing’.
An examination of the psychology of investors can explain the herd-
like behaviour which encourages the formation of bubbles. Poor
investment techniques can cause many miscalculations and the
encouragement of bubbles. In an economy accustomed to severe and
regular cycles in output and profits there will be the repeated expec-
tation of upswings in the rise in stock market prices which will
encourage the formation of bubbles.
A bubble bursts through the announcement of bad news – for
example, the cancellation of dividends, or the revelation of the low
potential of a mine or other asset. Although in the early days of the
formation of a bubble real investment can be encouraged, when the
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CAPITALISM
bubble bursts thousands of investors suffer wealth losses and even
destitution, plunging the national economy into recession, or worse.
Further reading: Cohen 1997
CAPITALISM
Both a method of production and a type of economic system.
As a method of production it uses roundabout methods of pro-
duction so that capital goods are produced first, then final consumer
goods. A non-capitalist method of production would be a primitive
activity such as picking berries or catching fish by hand. With a
capitalist method some resources are devoted to immediate con-
sumption and others for making capital goods in the form of tools
and machines. By creating an extra factor of production, the pro-
ductive process becomes longer and achieves a higher output. The
early Austrian economists, especially Boehm-Bawerk, explained this
at length. Another, broader and less technical notion of capitalism,
was Marx’s approach. He was keen to distinguish different modes of
production, including merchant capitalism and industrial capitalism.
The merchant capitalist obtains goods in one place and sells them in
another. This requires the investment of capital in stocks of goods to
be sold at a later date. Marx describes that circulation as money being
exchanged for commodities which are sold for a greater amount of
money. The industrial capitalist invests in machines and buildings to
complement labour in the production process, and through such
investment can extract surplus value through not paying workers the
full value of their product.
In a capitalist economic system there is private property, and the
economic independence of firms that can set prices, invest, recruit
and dismiss labour, and decide what to produce in the absence of
government interference. The values of the system are the pursuit of
private gain, of profit, rather than the maximisation of any social
production function. There is a clear distinction between capital
owned often by absentees and the alienated labour it employs. Many
types of capitalism have been identified, often according to the nature
of ownership. Popular capitalism, for example, encourages widespread
share ownership so millions of people each have a holding of capital.
At the other extreme is state capitalism of the old Soviet-type econ-
omy, in which all land and industry were owned by the state.
Smith, influenced by the Physiocrats’ laissez-faire ideas, made use
of the idea of natural liberty, the freedom to use one’s abilities without
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CAPITALISM
interference, in his discussion of economic systems in The Wealth of
Nations. Self-interested individuals following their natures will pro-
duce the best outcome for society. Capitalism was, therefore, a nat-
ural development, not something created as happens with socialist
schemes. Although Smith has been called the father of capitalism he
had little need for the term ‘capital’, preferring to speak of ‘stock’.
Except under state capitalism, which uses the apparatus of planning
to allocate resources, capitalism is reliant on the price system to
match production and desired consumption. Smith with his ‘invi-
sible hand’ concept, and Hayek’s successor concept of the sponta-
neous order, expected economic activity to need no central direction.
The working of markets was sufficient to supply the information
economic agents need to operate the economy. Capitalism does not
require a state of perfect competition. Private monopolies can flour-
ish under capitalism in the absence of a strong competition policy.
Marx, as the title of his most famous work Das Kapital proclaims,
chose capitalism as his principal research programme. The capitalist
has command over the means of subsistence for workers so can con-
trol them and exploit them. Capitalism is a mode of production in
which capital seizes the means of production. Whereas before indus-
trial capitalism workers as small craftsmen owned their tools, when
the factory age is born the capitalist owns all machinery so can decide
who works and on what terms. With the advent of private ownership
of the means of production, social relations have changed. The driv-
ing motive of the capitalist is accumulation of capital to acquire more
surplus value in a competitive world. The population is dehumanised
so that it can exist to serve the capitalist’s ends.
Proponents of capitalism point to the strengths which have deliv-
ered economic growth and a widespread increase in per capita incomes.
The mistakes of not too wise governments have been avoided by
allowing markets to follow their natural course. Critics have been
keen to point out that many forms of exploitation are inherent in
capitalism. Large inequalities of wealth and income indicate that the
rich are doing well at the expense of the poor. Workers endure long
hours in factories and offices to provide a pampered life of leisure for
the rich. In Marxist thought it is stated that the working day is longer
than is needed to provide workers’ subsistence so that surplus value
can be created for the owners of capital. Workers are alienated
because the system of production separates workers from the capital
they use and the products they produce.
There is an intimate relationship between capitalism and political
pluralism. Capitalist activity which is not heavily taxed or regulated is
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CAPITAL THEORY
said to create economic freedom, the foundation of a free society. As
capitalism makes possible the financing of political parties in opposi-
tion to a government, and the establishment of a free press, there is
political freedom.
Capitalism has successfully fought off ideological competitors.
Gradually ‘Anglo-Saxon capitalism’, the system which emerged in
the 1980s in the USA and the UK, has become the dominant form
of economic system in most countries. Its characteristics are private
property, flexible labour practices, few trade unions, free trade,
income inequalities, especially in the massive remuneration of senior
executives, and a swift reaction to changing economic circumstances
provoked by financial markets determining the industrial structure.
See also: comparative economic systems; laissez-faire; socialism
Further reading: Amable 2003; Broome 1983; Cowling 1982; Schumpeter
1954; Tawney 1926
CAPITAL THEORY
The debate about the nature of capital and its measurement.
A starting point is to regard capital as a fund, an accumulated stock
of goods or financial assets. Financial capital consists of the funds to
acquire real, mainly physical, capital. Also, as technical capital, it is a
collection of productive resources, especially machines, used to
achieve an output in conjunction with land and labour. It can be
owned privately or by a community or the state itself. In classical
economic theory a major element of capital was the wages fund,
which made production possible through having a stock to maintain
workers during the production period.
From the 1870s, Austrian economists, including Carl Menger and
Boehm-Bawerk, made leading contributions to the theory of capital,
particularly through emphasising the role of time through capital
being a roundabout method of production. Menger thought there
was a hierarchy of goods, with the higher-order capital goods pro-
ducing the lower-order consumer goods. Boehm-Bawerk con-
troversially would not accord capital the status of an original factor of
production like labour and land.
The Cambridge capital controversies debates of the 1960s, between
Cambridge, England and Cambridge, Massachusetts, centred on the
measurement of capital in the aggregate production function. Paul
Samuelson, Robert Solow, Frank Hahn and Christopher Bliss, in the
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CLASSICAL ECONOMICS
American group, used the largely neoclassical approach of an aggre-
gate production function to attack Joan Robinson, Piero Sraffa, Luigi
Pasinetti and Pierangelo Garegnani in the ‘English’ camp.
Measurement of capital is difficult when its heterogeneous char-
acter is recognised, abandoning a neoclassical assumption. Either its
cost of production is computed or the present value of the stream of
services it produces is calculated, but changes in the value of capital
and its quality raise severe measurement problems. There are the
problems of re-switching, where the same technique is chosen at
more than one rate of interest, and capital reversing when a lower
capital-labour ratio is chosen despite the interest rate being low.
Static approaches were criticised for ignoring the relationship
between capital and the passage of time. The neoclassical attempt to
explain the rate of return using the concept of marginal productiv-
ity was shown to be limited to a world of homogeneous capital, and
not the basis of allocating capital according to relative scarcities. A
criticism of Joan Robinson and her Cambridge, England disciples is
that they revealed difficulties but failed to construct an alternative.
Capital and growth theories overlap. Capital deepening occurs
when the capital-labour ratio increases so that production becomes
more capital intensive; capital widening means an increase in the
amount of the capital stock in an economy with unchanged capital-
labour ratios.
When the notion of capital was extended from physical to human
capital, earlier in Petty and Smith, and more recently in the works of
Schultz and his contemporaries, the distinction between separate
factors of production became blurred.
See also: investment; Neo-Ricardian economics
Further reading: Cohen and Harcourt 2003; Dewey 1965; Felipe and Fisher
2003; Kregel 1976
CLASSICAL ECONOMICS
The theories of the group of economists headed by Adam Smith
which were dominant in British economics from c.1750 to c.1870. Its
leading figures included David Ricardo, Robert Malthus, Nassau
Senior, John Stuart Mill and Karl Marx.
As the title of Smith’s influential work An Inquiry into the Nature
and Causes of the Wealth of Nations (1776) indicates, economic growth
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CLASSICAL ECONOMICS
was central to their concerns. Smith, sharing in the Scottish
Enlightenment’s attempt to explain human nature, argued that the
basic human desire for betterment will lead to saving, which is
invested so that division of labour is possible, bringing about growth
in productivity. Most classical economists feared an end to economic
growth, with the exception of JS Mill, who welcomed the slower pace
of a stationary economy, providing incomes were properly distributed.
Ricardo in his Principles of Political Economy and Taxation (1817)
constructs an abstract model of the economy relating value to wages
distribution. Malthus in his Essay on the Principle of Population (1798) and
Principles of Political Economy (1820) forcefully asserts that an unchecked
population would grow faster than its means of subsistence. He was
also an important precursor of John Maynard Keynes in his study of
an underemployed economy and his policy recommendation of
public works. In his Principles he sets out some of the clearest demand
and supply analysis of the period. NW Senior’s achievements inclu-
ded a movement of value theory from labour to utility foundations,
and a justification for profits as the reward for waiting.
Prominent in classical economics was the study of value. Three
questions were asked. What is the nature of value? What is the measure
of value? What are the determinants of value? Following Aristotle,
value in use and value in exchange were distinguished. Smith also sepa-
rated natural prices based on cost of production from market prices
determined by demand and supply. Natural prices were the long-run
‘central’ equilibrium prices around which market prices fluctuated.
Later Ricardo refined Smith’s diffuse discussion of the relationship
between labour and value into a theory of relative prices determined
by relative labour quantities. Marx expanded Ricardo’s value theory
through introducing the notion of ‘socially necessary labour time’.
The distribution of national income into rent, wages and profits
was another central theme. The differential rent theory, which ori-
ginated with the Scottish agricultural writer James Anderson, was a
pillar of Ricardo’s model of the economy. At the margin of cultiva-
tion no rent was paid, leaving the product to be divided between
wages and profits, the latter declining as real wages rose. Wages were
discussed at the macro and micro levels of the economy. Smith used
the notion of the wages fund as the total amount which had to be
accumulated to pay workers throughout the period of production.
The justification for wage differentials, including the amount of
human capital embodied in each worker, was also set out. Profits
were subject to a minimum level reflecting risk. Factor mobility
would tend to equalise wage rates, as well as profit rates.
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CLASSICAL ECONOMICS
Like the Physiocrats, the classical economists by recommending
free trade reacted to the dominant mercantilist view that an economy
to be strong had to be protectionist. To maximise the effects of
division of labour a large, and international, market was needed.
Smith argued that trade took place because of a country having an
absolute advantage in production over another, Ricardo and Robert
Torrens used a comparative advantage trade theory. Mill refined
Ricardo by using the concept of reciprocal demand to determine the
terms of trade.
These economists were writing at a time when Britain endured
long wars with France, with severe consequences for the economy. A
boom occurred during the war and a severe recession after 1815.
Insufficient taxation was levied to finance the war with the con-
sequence that there was a great increase in the national debt and
discussion of using a sinking fund to reduce it. A shortage of bullion
reserves compelled the Bank of England to go off the gold standard in
1797. A debate with many contributors on the nature of paper cur-
rency and the role of the Bank of England in central banking con-
tinued until the Bank Charter Act of 1844. Throughout this
discussion reference was made to Smith’s views on the nature of
paper currency and Ricardo’s doctrine that a currency had to fluc-
tuate with the amount of precious metals in the economy.
The roles for national government proposed by Smith were few –
defence, law and order, some public works partly financed by the
users, and support for the sovereign. To achieve the public good
intentional effort was not required. By the pursuit of self-interest
economic agents would be guided by an invisible hand to help
society at large. Smith saw economic welfare in material terms and
fervently preached that it was in everyone’s interest to be a specialist,
following division of labour principles, so that the income of the
society as a whole would grow. However, classical economists granted
exceptions to extreme laissez-faire economics. Specific problems
were solved through directed legislation. The Navigation Acts, which
required Britain’s trade to be carried in British shipping, were
approved as a means of creating a reserve navy to boost Britain’s
defences. Banking regulations improved the liquidity of the banking
system. JS Mill had some sympathy for socialism and public ownership;
but some contemporary legislation was strongly opposed. Malthus
wanted the Poor Laws to be phased out as they irresponsibly pro-
moted population growth. Many, including Senior, criticised the
Factory Acts, those regulations which were progressively reducing
hours and the employment of women and children.
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CLUBS, THEORY OF
The commanding position of classical economic theories had been
lost by 1870. The advent of neoclassical economics, with the more
precise analytical tools provided by WS Jevons and especially Alfred
Marshall, took over. But the individual themes of classical economics
continue to be discussed.
See also: Austrian economics; neoclassical economics; value
Further reading: Eltis 1984; Hollander 1987; O’Brien 2004
CLUBS, THEORY OF
An explanation of the provision of goods which are part private and
part public by a voluntary association of similar persons who share
production costs.
Unlike pure public goods they are not consumed by all; unlike
pure private goods, one person’s consumption does not diminish
another’s. Cases of sharing are so common that theorising about them
is sensible. There are costs and benefits of joining a club and differ-
ences in clubs with respect to their size and activities to be con-
sidered. Clubs exist because the costs to many individuals would be
prohibitive, for example, owning an Olympic-size swimming pool,
or because the activity can only be done by a group of people, as is
the case with games and sports.
Without a club being formally constituted the provision of a good
or service can follow the principles of a club, as with the supply of ser-
vices to households by a local government or a commercial concern.
Considerations of relative costs and benefits will determine the optimal
size of sub- and quasi-governmental organisations. A complex club
provides a mixture of benefits. Large clubs can afford to charge lower
membership fees but will run the risk of reducing the advantages of
membership through creating congestion and losing their exclusivity.
Under the usual rules of optimisation, membership will expand until
the marginal benefit of membership equals its marginal cost. Clubs can
be homogeneous with members having the same relevant character-
istic, or they can be mixed clubs with a diversity of members. Inevi-
tably the measurement of costs and benefits is difficult. For members
the opportunity cost of membership has to be considered: to finance
the membership fee other consumption or saving has to be reduced.
The cost of preserving the existence of a club introduces the dif-
ficult interdependence of costs and benefits: present benefits might
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COASE THEOREM
have to be reduced to guarantee a continued flow of them. Benefits
are variable depending on how much other members consume of the
output of the club, and might be disproportionately consumed by
some members to the detriment of others, especially if the member-
ship is heterogeneous. If there are spill-over benefits of a club, for
example when the health of a community is improved by the provi-
sion of gardens, there is a case for non-members to subsidise the
members. A club which has shared consumption and homogeneous
membership is called ‘discriminatory’, as persons lacking the crucial
characteristics such as race or gender are excluded. The costs of
excluding non-members reduce the amount of resources which could
be offered to members. Game theory recognises the usefulness of the
theory of clubs in that it discusses the circumstances in which coali-
tions occasion a welfare benefit.
The analogy of the club has been used for the pricing of public
utilities, road charging to reduce transport congestion, the provision
of public services locally, migration, political alliances and interna-
tional organisations.
See also: public good
Further reading: Buchanan 1965; Sandler and Tschirhart 1980
COASE THEOREM
An alternative approach to responding to externalities such as pol-
lution, avoiding the charging of the polluter or imposing special taxes.
Coase argued that instead of analysing the problem of social cost in
terms of A inflicting harm on B and restraining A, the reciprocal
relationship between A and B has to be recognised. He uses the
example of a factory which makes noise upsetting a medical practi-
tioner. If the factory had to be silenced then it would harm the
manufacturer so the parties have to negotiate. Another example is of
a cattle farmer with straying animals damaging the crops of a neigh-
bouring arable farmer. Rather than propose legislation to establish
who is allowed to do what he proposes a private solution. Providing
property rights have been defined, an agreement to allow cattle to
stray can be attempted to compensate the arable farmer and allow the
other farmer some freedom in animal management. How much is
paid depends on the loss of net income. It is assumed that there are
no transaction costs in reaching this agreement. Instead of examining
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COBWEB
the divergence between private and social cost he proposed that
there be an opportunity cost approach, looking at the effects on the
market value of production of different social arrangements. The
starting point should be that the world as it is is not an ideal state of
affairs. Further factors of production should be regarded as rights to
do various things. He asserts that the cost to exercise a right can be
measured by the loss elsewhere. Thus the total effects of one social
arrangement rather than another are considered.
Originally the Coase approach assumed zero transaction costs, which
is often regarded as virtually impossible. When there are positive
transaction costs there is an even greater role for the law as it is con-
cerned with duties and privileges. The whole nature of the negotia-
tions between the parties will be not an exchange of things but of
rights to act in particular ways, hence an exchange of property rights.
Challenges to the theorem include an attack on the assumptions
that there is perfect competition, property rights are defined and
the transaction costs of negotiating an agreement are low. The possi-
bility of applying the theorem to real life situations is questioned,
especially when several parties with different opinions are involved so
the negotiations will be protracted. Environmental scientists have
questioned the Coasian approach, especially the idea that there can be
efficient levels of pollution.
Coase’s original intention was to attack the Pigou approach of
using taxes or other government action to deal with firms that are
polluters. By using a new analysis of the problem of pollution he
made a major contribution to environmental economics.
See also: environmental economics; property rights
Further reading: Coase 1960, 1988
COBWEB
The path of a change in a market as it moves towards, or away from,
an equilibrium between demand and supply.
At the beginning of a cobweb demand will be less or more than
supply. For the market to clear there has to be a movement in price.
If there is excess demand, the price will rise to reduce demand and
encourage suppliers to send more to the market. Under conditions of
excess supply a lowering of price will encourage purchasers and dis-
courage suppliers. The whole underlying principle is that there can
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COLLECTIVE BARGAINING
be different responses to an imbalance between demand and supply.
Assumptions have to be made about the price expectations of the
producers, especially whether there is price rigidity. Crucial is the elas-
ticity of demand and supply curves. If the demand elasticity is greater
than the supply, there will be a movement to a stable equilibrium; if
supply elasticity is greater, the cobweb will be unstable in that the path
will be further and further away from equilibrium. This is a challenge to
the optimistic classical view that markets tending towards equilibrium
cobwebs can be divergent. If the cobweb mechanism results in a dis-
equilibrium this will be manifest in unemployment or excess capacity.
Cobweb theory has been applied especially to pig (hog) markets
where there is a long production period, but in principle any mar-
kets, including labour markets, can be analysed in this way.
See also: disequilibrium economics; equilibrium
Further reading: Kaldor 1934; Nerlove 1958
COLLECTIVE BARGAINING
Negotiations between a trade (labor) union and an employer or
employers’ federation to determine pay and other employment
conditions.
As unionisation increased so did the replacement of individual
bargaining between a worker and an employer by collective bargain-
ing. This increased bargaining strength in turn made union mem-
bership more attractive through creating a union effect on wages.
Rarely does collective bargaining cover the whole of a national
labour force, unless union membership is compulsory. With the
decline of traditional heavy industries such as coal mining and ship-
building, and extensive de-industrialisation, private sector collective
bargaining has fallen in some Western countries.
Most of collective bargaining is bilateral, but it can be multilateral
when interest groups, for example parents’ associations at teacher
wage bargaining, are present. Its scope varies according to the aims of
the negotiators. Pay and hours of work are the most basic of terms in
agreements; more ambitiously a range of fringe benefits, including
health insurance, can be included.
Collective bargaining can take place annually, when requested by
one of the parties or under the terms of a previous agreement. Such
systems have differing attitudes towards the law. In the USA the
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COMPARATIVE ECONOMIC SYSTEMS
purpose of the bargaining has been to produce an enforceable con-
tract, unlike in the UK. In a totalitarian state collective bargaining has
no role. Also there has been a limit to the power of employers and
unions in concert to determine the economic terms of their rela-
tionship in freer societies where incomes policies have been used.
See also: industrial relations; labour; trade (labor) union
Further reading: Beal 1976; Hutt 1975
COMPARATIVE ECONOMIC SYSTEMS
The study of the nature of national economies with a view to classi-
fying them according to the type of ownership, the method of allo-
cating output and the determination of incomes. Prior to the
extensive repudiation of the Soviet-type economy in the late 1980s, it
was common to contrast capitalist, socialist and mixed economies.
The differences in economic organisation used to be sufficiently
stark to differentiate one economy from another. Whether businesses
and houses could be privately owned was crucial: where they were
not there was the possibility of total state economic and social con-
trol. The use of the price mechanism through free markets or central
economic planning underlay the method of allocation in each type
of economy and whether income distribution would follow on
from market freedom or administrative diktat. Mixed economies
attempted to soften the effects of capitalism, without adopting the
strong central controls of many types of socialism. Where there is a
fringe of experimental mini-economies such as producer cooperatives
or privately owned small firms, the economy is also ‘mixed’.
In the 1960s the ‘convergence hypothesis’ argued that different
economic systems were converging to a kind of managerial capitalism
with a measure of planning at the national level, but that there were
still sharp contrasts in terms of ownership of businesses and the free-
dom of the price system. In the 1990s this branch of economics
changed to the economics of transition, analysing the difficulties and
costs of changing the basis of economic organisation in countries free
to make more use of market mechanisms.
See also: capitalism; economic system; socialism
Further reading: Wiles 1977
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COMPETITION AND MONOPOLY
COMPETITION AND MONOPOLY
Contrasting states of markets classified according to the number of
firms participating in them.
Market structures are often arrayed on a spectrum of conditions
between the extremes of perfect competition and its complete
opposite, monopoly. Previously in the nineteenth century competi-
tion was contrasted with cooperation. Competition was regarded as
an evil which pushed down wages and added to workers’ misery;
cooperation was supposed to guarantee a fair reward. In the more
modern view of competition and other market states, the spectrum
starts with the largest number of firms in perfect competition, then
the number of firms declines through monopolistic competition,
oligopoly, duopoly and finally to monopoly: these markets operate
according to different principles in determining output and prices.
Seen from a buyer’s point of view, a market with a sole buyer would
be a monopsony, or with a few dominant sellers, an oligopsony.
Perfect competition, a limiting case, is a popular market type for
economic analysis. It is usually defined by the conditions necessary to
establish it. There should be a large number of buyers and sellers,
freedom of entry and exit to the market, a homogeneous product, an
absence of government intervention and transport costs, and perfect
information. The last condition, that potential buyers and sellers have
full relevant information, is so demanding that sometimes it is called a
state of pure competition. The large numbers assumption means
that no market participant can influence the price: they are price
takers. The homogeneous product assumption requires that all
buyers regard the product as identical, even if there are some dif-
ferences in, for example, its chemical composition. The elasticity
of the demand curve for each firm will be horizontal, perfectly
elastic as every firm’s output is regarded as identical to the others’;
the demand curve for the industry will be downward sloping with
some inelasticity because by definition every industry has a distinct
product. If there were product heterogeneity, individual sellers would
have some monopoly power. Freedom of entry and exit, in the
negative sense of an absence of barriers, ensures that firms in equili-
brium earn only normal profit, the minimum return to an entrepre-
neur. Because governments stand back from the market, buyers and
sellers are free, without interference, to arrive jointly at a market
price; because there are no transport costs, local monopolies cannot
develop. Some information assumption is necessary, otherwise eco-
nomic agents could not behave in the market. As a result of these
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COMPETITION AND MONOPOLY
conditions holding, in equilibrium the price equals both average total
and marginal costs.
Similar to perfect competition is monopolistic competition, a
market state first recognised by Ed Chamberlin, and similar to the
notion of imperfect competition devised by his contemporary Joan
Robinson in the 1930s. Monopolistic competition is principally dis-
tinguished from its similar state, perfect competition, by allowing
product differentiation. For this to occur, selling costs, especially
through advertising, will be incurred with the consequence that there
will be an upward shift in the average total cost, posing a barrier to
entry of marginal firms and hence reducing the number of firms in
the industry. Product differentiation will mean that the firm’s demand
curve will be elastic but not perfectly so. In equilibrium the firm will
not be operating at a large enough output to minimise average costs,
an effect called the excess capacity theorem.
Where a market consists of a small group of firms it is called an
oligopoly. The temptation to collude is strong, and if it occurred then
the firms would be jointly acting as a single monopoly setting a single
price for its product. Competition law and its antitrust equivalent
have outlawed collusion in many developed countries. Sometimes an
industry consists of the output predominantly produced by a group of
oligopolists with a competitive fringe of smaller firms: retailing in
Britain exemplifies this well. If oligopolists have to fix prices sepa-
rately they have nevertheless to anticipate their rivals’ reactions. A
famous model of a non-collusive oligopolist’s behaviour is described
by the kinked oligopoly demand curve. This shows that such a firm’s
demand curve consists of two demand curves joined together so that
up to the price set the demand curve is elastic, for if the firm raised
its prices no one would follow. The demand curve beyond the ruling
price is inelastic, in fact the industry’s demand curve, for if a firm cuts
its prices its rivals follow. This description of oligopoly was used to
attempt to explain price rigidity under oligopoly, although rigidity
can occur for a variety of reasons, including the menu cost of chan-
ging product prices frequently. Empirical tests do not confirm that
oligopolists behave in a herd-like manner only when they lower their
prices.
Duopoly has been powerfully analysed by Cournot and Bertrand.
The former posited the case of a market with two proprietors con-
trolling a spring of water each. They are profit maximisers who will
adjust their prices in reaction to the other until a market price
emerges. In the Bertrand refinement the two producers pursue price
strategies until an equilibrium is established.
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CONSUMER’S SURPLUS
Monopoly is the other limit to the spectrum of market structures.
A monopoly is a sole producer so the firm and the industry are
coterminous and the firm’s demand curve, downward sloping, will be
the industry curve. Monopolies are established in various ways. A
government can by law exclude rival firms, perhaps on grounds of
national security or public safety, and even own the monopoly. An
early technological lead with patent protection for the invention used
will keep out other firms. If the industry has largely fixed cost pro-
duction and attendant economies of scale then it could be described
as a ‘natural monopoly’. Sometimes it is difficult for an industry to
attract firms because the product is unsafe or unsavoury. Monopoly
has its rewards – the quiet life of not having to meet competitive
challenges and the supernormal profits through its average revenue
being in excess of its average cost. It can be difficult for a domestic
monopoly to retain its market dominance in its own country, unless
there is protection to keep at bay international competitors. Infant
industries, sometimes with monopoly status, have been encouraged as
an exception to free trade.
Public objections to the exploitative behaviour of dominant firms
have brought about laws to promote competition. In the USA at
the federal level the Sherman Act of 1890 started the control of
monopoly, mergers and anti-competitive practices. In the UK a
competition policy started in 1948 with the mild Monopolies and
Restrictive Practices (Inquiry and Control) Act and was succeeded by
tougher legislation, especially on the control of agreements between
firms.
See also: game theory; industrial organisation; price
Further reading: Fellner 1960; Stigler 1966
CONSUMER’S SURPLUS
The difference between the amount a consumer is prepared to pay
and the amount actually paid.
This was devised by Dupuit and extended by the Cambridge
economist Marshall, who illustrated the concept in a standard demand
and supply diagram. In the case of a downward sloping demand
curve at less than equilibrium output, consumers have a reservation
price as they would be willing to pay more than the equilibrium
price. Thus there is a notional surplus for each part of the demand
curve between it and the equilibrium price. Marshall said that there
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CONSUMPTION
could be ‘thin parallelograms’ under the demand curve: when these
are summed into the area under the curve they are called the con-
sumer’s surplus. In welfare economics the consumer surplus idea
has been repeatedly used in devising compensation tests to ensure
that when there is an economic change there is a net welfare gain. In
cost-benefit analysis the concept is crucial to estimating the bene-
fits from investment. As the notion shows that richer consumers
have a higher surplus, it is taken into account in devising price
structures and schemes of indirect taxation.
Marshall also suggested there could be a producer’s surplus because
of it being possible to obtain supply of a good or service at less than
equilibrium price.
See also: welfare economics
CONSUMPTION
The spending alternative to investment for a household, a firm or a
government; the using of a service or the destruction of a good.
The whole point of production is to satisfy the wishes of the con-
sumer. As Adam Smith put it, ‘consumption is the end of all pro-
duction’. Consumption is analysed at both the micro and macro
levels in economics. At the micro level theories have been advanced
to explain how a consumer makes choices between various goods and
services in the face of an income constraint. From Jevons onwards a
consumer has been seen as a utility maximising individual wanting to
choose a combination of goods and services which will extract the
most utility from a given income. Through equating the ratios of
marginal utilities to prices a consumer equilibrium will be reached
as the same amount of utility per unit of currency spent is obtained.
In another micro-theory Lancaster attempted to break away from
utility-based consumer theory with his characteristics theory of con-
sumer demand, suggesting that consumers demand the attributes of
goods rather than the goods themselves, for example, the location of
a house rather than the building.
At the macro level, since Keynes the relationship between aggre-
gate consumption and national income has been an essential part of
macroeconomic modelling. Keynes stated that as income rises con-
sumption also increases, but at a slower rate: this produces an absolute
non-linear consumption function. Diverse theories of the consump-
tion function arise from the use of different measures of income –
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CONTRACT THEORY
absolute, relative and permanent. Absolute income is current income
without any qualification. Relative income is current income relative
to a previous peak income, or the income of one group relative to
another. Permanent and transitory consumption are contrasted with
permanent and transitory income so that there are two consumption
functions. It is possible to split aggregate income into these short-
and long-run components by regarding permanent income as trend
income and transitory as fluctuations around the trend, or by regard-
ing some types of income as permanent, particularly contractual
employment incomes, and others, such as windfall stock market
gains, as transitory.
An Euler equation is used to estimate aggregate consumption
growth over time. In this inter-temporal approach consumption can
be deferred, encouraged by the prospect of high real interest rates.
Veblen in his analysis of the leisure class noted the phenomenon of
‘conspicuous consumption’, which is undertaken for the purpose of
flaunting one’s status in society. Hirsch devised the term ‘positional
good’ to describe something rare and exclusive which cannot be
reproduced in large amounts. Its appeal is its non-availability to more
than a few. Various forms of education, artistic performances and
properties have this character.
See also: Keynesianism
Further reading: Hirsch 1976; Lancaster 1971
CONTRACT THEORY
An extension of the analysis of exchange and production.
Aristotle in the Nichomachean Ethics, book V, stated that it is dis-
similar things which are exchanged so that some rules are necessary
to bring about fairness. Francis Hutcheson, who taught Adam Smith,
in his System of Moral Philosophy (1755), book II, chapter 9, examined
the obligations which arise from contracting. He argued that com-
merce would be obstructed if the contracting parties could repudiate
imprudent contracts. The contract should be naturally possible and
the parties should make every attempt to discover the factors which
affect the value of the goods and restore any excess which has been
given. In the 1880s Edgeworth used contract curves to describe
bilateral exchanges in the absence of uncertainty and asymmetric
information.
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CONTRACT THEORY
Contracting can be bilateral or multilateral. Employment contracts
are often bilateral, even under collective bargaining as two bargaining
bodies negotiate. Multilateral contracts are common in insurance,
where risks are widely shared, and in industries such as construction,
where many different contractors aim to produce a complex building;
also multilateral contracts occur in sharecropping, partnerships and
franchise operations. The presence of several contractors raises ques-
tions of collusion and competition, both of which can affect the
optimality of the contract. In the formation of contracts the parties
are faced with problems of hidden or misleading information and
uncertainty. There can be repeated bilateral contracting when cir-
cumstances surrounding the contract are short-term, for example,
demand is volatile or output is variable, so that a chain of contracts
reduces uncertainty. Contracts can refer to a present sale or to a
future transaction. Also the contract might be an option to buy rather
than an actual purchase. An efficient contract will produce stable
prices and output.
Through the voluntary creation of a contract the parties to an
exchange attempt to produce a mutually acceptable exchange. Many
complications arise. The contract might be obscure or even implicit.
The parties could fail to foresee many events so that later renegotia-
tion of the contract is necessary. Where there are high set-up costs,
such as training costs for new employees, there is a strong motive for
making a long-term contract but to do so raises problems of antici-
pating random events and also the fact that the less well-endowed
party will be more risk averse. These difficulties have encouraged the
use of game theory to devise a strategy for the design of the contract.
Much of the problem of contracting is that of informational defi-
ciency. A way of diminishing this danger is by signalling, which pro-
vides a hint of a future state. The future performance and productivity
of an employee cannot be guaranteed but the past education and
employment record are pointers to performance. Also the behaviour
of a contracting party at the time of forming the contract can be a
clue, hence the use of interviewing to detect honesty and attitudes.
Established habits and customs in a social group can indicate likely
conduct under the contract.
The existence of long-term contracts has stimulated the development
of incomplete contract theory. To encourage agricultural improvement,
long leases are granted. Banks in financial markets and employers of
highly skilled staff have to devise contracts for periods of time when
much is unforeseen. The inability of the contracting parties to describe
the subject of the contract can lead to disputes about the fulfilment of
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CONTRACT THEORY
the contract which have to be resolved, perhaps by negotiation, per-
haps by arbitration. The incompleteness of the contract’s provisions
can render the original ex-ante investment futile or disappointing.
The variety of contracts has given rise to the analysis of a range of
commercial transactions, for example, ‘mixed bundling’ when there is
a simultaneous separate and joint sale of two associated products.
Throughout there is a search for an optimal contract which will
maximise the benefits to the contracting parties.
Many of the difficulties of contracting can be reduced to the
‘principal-agent problem’. The principal can be the owner of a
business who delegates to managers and employees various tasks, or a
principal can be a firm granting to other firms the power to act on its
behalf. As with all contracts there is the difficulty of monitoring to
ensure that an agreement has been effectively executed. An incentive
scheme has to be devised to ensure compliance with the contract and
thereby maximise the principal’s expected utility. The contract has to
determine how the risk is shared between principal and agent. The
principal-agent problem can also be analysed by considering the costs
and benefits to the principal of having one form of relationship rather
than another.
Implicit contract theory raises different issues, especially in the
labour market, which differs from many types of product market
because the contracting parties do not spell out the terms of their
relationship. The nature of the employment and expectations of
promotion and job tenure are based on long-held practices. Sub-
jective evaluations motivate the agreement rather than a stated com-
ponent of a contract. Also, in commercial transactions where the
parties have an established relationship, there is often sufficient trust
to make explicit contractual terms unnecessary.
Contract theory is an important element of labour economics,
industrial organisation and corporate finance. The modern analysis
of the role of information in markets inevitably includes contract
analysis. Insurers have long been aware of the dangers of deficient
knowledge of the insured. A problem of ‘adverse selection’ can occur
if through ignorance a bad risk is accepted. Also there is always the
possibility of ‘moral hazard’ when the insured cares less when a risk is
covered by insurance and can behave recklessly.
See also: game theory
Further reading: Azariadis 1975; Bolton and Dewatripont 2005; Hart 2001;
Hart and Moore 1988
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COOPERATION
COOPERATION
Joint production or consumption by a group of people for their
mutual benefit; the opposite of competition; a mild form of
socialism.
In the literature of utopias there are many examples of producer
cooperatives. Charles Fourier and Robert Owen both designed such
communities. There was a fear of the deadening effect of division of
labour, so producer cooperatives were devised which were both
agricultural and manufacturing in their activities. Fourier attacked
labour specialisation because of his belief that humans have a basic
‘papillon’, or butterfly, tendency so want to flit from one activity to
another. Also, members of the cooperative would benefit by not having
to distribute profits to outside owners. In low-technology industries
such as shoemaking, producer cooperatives persisted in England well
into the twentieth century. The self-managed enterprise is an exten-
sion of the cooperative idea.
Consumer cooperatives have enjoyed more success. The coopera-
tive society founded in Rochdale, England in 1844 spread through-
out the UK and has survived to this day. The advantage of such
societies is the offering of goods at lower prices through reducing
profit margins.
Cooperation is also a major theme of game theory. Instead of the
aim of a game being to defeat and disadvantage an opponent, the joys
of participation, fun and the exhilaration of the activity can be
sought. Instead of individuals pitting themselves against each other
there are coalitions of players.
See also: competition and monopoly; game theory; socialism
Further reading: Webb 1921
CORE
A set of equilibrium prices.
The Oxford economist Edgeworth in Mathematical Psychics (1881)
examined a market with two commodities and two consumers and
drew a contract curve linking all the possible equilibria. It is supposed
that there is perfect competition and a barter economy. Instead of
assuming that economic agents take prices as given, he introduces
the idea of recontracting. In an exchange economy when there is a
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CORRUPTION
large number of players, it is more difficult to have collusive beha-
viour so the core, the number of equilibrium relative prices, is smal-
ler. Later this idea was powerfully generalised in game theory, where
the core is that set of allocations in which a sub-group cannot benefit by
deserting the coalition (players bound together by the same strategy).
Also there is a Walras core. This is an allocation for a nation in
which every trader has a budget balanced at the price schedule. It is
an equilibrium position in that there is not a price schedule which
would allow a coalition of traders to trade better.
A core economy is dominant in world economic relations, a core
firm leads an industry and a core region determines the economic
fate of the rest of a country.
CORRUPTION
The diversion of the revenues and assets owned by governments or
corporate bodies for the benefit of officials and their associates; often
narrowly defined as the misuse of public office for private gain.
In a sense much corruption is the consequence of an inefficient
principal-agent relationship. Much of this is indistinguishable from
ordinary theft, but some is more subtle and difficult to detect, taking
the form of the splitting of benefits between legitimate and illegal
recipients. The array of corruption techniques is great. There can be
off balance sheet accounting to disguise the extent of a government’s
debt, and the continuance of a governmental body without accep-
table auditing, such as the European Commission: such deception
gives corruption a chance to flourish.
Corruption is a function of size. It is larger contracts, especially for
construction projects, which give much scope for hiving off funds
illegally. Smaller organisations have little scope for the corrupt to
benefit, hence the attractions of employment in major banks. A
large organisation can be hierarchical, with opportunities for rent
seeking at all levels. Under a democracy there is less opportunity
for corruption as a government is exposed to scrutiny. An indepen-
dent civil service with a tradition of honesty helps to keep corruption
at bay.
Levels of taxation, if high, can provoke the growth of a shadow
economy where much activity is hidden, so potentially corrupt. Also,
the structure of industry is important as monopolists lack the chal-
lenge of competitors and oligopolists can collude, despite severe
competition and antitrust legislation.
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The effects of corruption are severe. It can lead to the refusal of
charities to help poor countries, a reduction in trade and investment,
and the creation of societies with very unequal income distributions.
To eliminate corruption different strategies can be employed. The
supervision by international agencies of governments reduces crook-
edness at that level. The creation of a framework of company/cor-
porate law is a curb on the misappropriation of funds within firms.
As corruption is the product of a political and social culture, it takes a
long time to include transparency and honesty. Within a public body
it is important to have enough remuneration and incentives so that
corruption is less attractive, hence the importance of paying judges
highly so that it is less necessary to accept bribes from litigants.
Corruption from country to country is often compared using
measures such as the Corruption Perception Index (CPI) based for
each country on surveys of businesses and residents who estimate
corruption on a scale from 0 to 10. Since the corrupt always try to
hide their activities the index produces questionable results.
Further reading: Jain 2001; Shleifer and Vishny 1993; Svensson 2005
COST
The sacrifice of time, effort or resources which makes production
possible.
For every factor of production a cost is incurred through partici-
pation in the productive process. Labour needs sufficient means for
its maintenance and subsistence according to the demands of that society.
Capital incurs costs in its hire and depreciation. Rent must be paid
for land for exclusive use on one occupation rather than another.
The accounting cost will be the sum of the expenses incurred to
produce a given output and recorded in the books of a firm. It is a
narrower concept than economic cost, which includes opportunity
cost. Opportunity cost is a central idea in economics. Given that
there is scarcity, the use of labour or another factor of production in
one way means sacrificing other uses. The opportunity cost will
therefore be what can be gained in the next best employment.
Because of the choice between one use and another, in a diagram the
production possibility lines showing the amounts of a product
obtainable from combinations of two factors will be downward
sloping. As both an individual and society at large are affected by a
particular choice, there are both private and social opportunity costs:
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COST
there can be a loss of personal income as well as a fall in national
income. Wieser expounded the idea of opportunity costs in his theory
of alternative cost.
Buchanan, in the Austrian tradition, relates cost to choice in that it
is what is sacrificed when one alternative is rejected. In this decision
making process cost is subjective so cannot be measured by anyone
else, but it can be dated, as a decision is made in time. It is an ex-ante
concept because it is based on expectations.
Costs can be classified according to time, as in the distinction
between fixed and variable cost. A long-term commitment such as a
building will incur fixed costs, but the hire of casual labour, which is
hardly a commitment at all, will be very variable. The nature of the
contract buying the services of a factor of production will have a time
element. The longer the time specified, the more fixed the cost is.
With the growth of employment contracts labour has changed from
mainly a variable to a fixed, or quasi-fixed, cost for many occupa-
tions. Marshall in his Principles of Economics, wanting to use terms
known to contemporary businessmen, distinguished prime (‘variable’)
from supplementary (‘fixed’) costs. Prime costs, also known as special
or direct costs, will include the costs of raw materials and of labour
employed by the hour or the piece. For it to be worthwhile to con-
tinue in business, at least prime costs have to be covered. Supple-
mentary costs will include standing charges for capital and the wages
of senior staff who are paid salaries rather than wages. Sunk costs are
fixed costs incurred before production begins. They are so specific
that they cannot be recovered on the closure of a business, so will
constitute a barrier to exit: heavy industries such as shipbuilding
provide good examples.
In the theory of the firm, marginal, average and total costs are
separately calculated. Marginal cost is the cost of producing the last
unit of output, or the average for the last range of output if it is
impossible to vary output a unit at a time. Average cost is simply the
total cost divided by output. Average cost can be calculated as average
variable cost, average fixed cost and average total cost. These different
notions give rise to cost curves. These are used to illustrate econo-
mies of scale which will produce falling average cost curves; dis-
economies produce rising average cost curves. The optimum firm has
been defined as the minimum point of an average cost curve if that
curve is U-shaped.
Many types of cost are paid by an individual person or organisation
and hence are called private. When the costs affect others in society
they are called social costs. Much of environmental economics
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relies on this distinction. Despite the distinction, a single individual
can incur both private and social costs, for example, by burning a fire
which requires obtaining fuel and applying heat, and producing
smoke which has a spillover effect on surrounding people. The bearer
of costs will define the cost, whether private or social.
Specialist uses of the word cost include the ‘cost of living’, the total
expenses of maintaining a person in a particular society at a particular
time. The cost of living is usually measured with a view to showing
different purchasing powers over time. Through employing a price
index it can be seen whether the same group of goods and services
costs more or less over time. Such calculations produce essential data
for wage negotiations as the starting point is usually the preservation
of real incomes.
Costs are also regarded as factor prices as they represent the
amount which has to be paid for obtaining factors of production.
This means that they emerge from the working of the market forces
of various factor markets for labour, capital and land. Excess demand
in both factor and product markets will usually lead to higher prices.
Cost is a foundation of product prices and central to any theory of
value. In fixing prices, costs, marginal or average, can be used as a
basis. Often firms find that a formula linking average cost and a profit
margin can produce the final price. To allocate resources efficiently,
prices are equated with marginal costs.
Theories of value have been divided into those based on cost,
especially labour, as with Ricardo and Marx, and those founded on
utility, as with Jevons. Cost of production theories of value explain
basic prices and long-run equilibrium prices. Smith regarded natural
prices based on the cost of production as the central prices around
which market prices fluctuated. These basic prices related to cost are
dominated by supply considerations. Wieser imaginatively showed
that both costs and prices are related to utility.
Recent studies in industrial organisation have examined at length
transaction costs, arguing that their existence justifies firms growing
in size so that many transactions are within a firm and not between
firms in the market. Transaction costs are the costs of running an
economic system, or of effecting an exchange, so will amount to all
the costs of negotiating and contracting.
So central a notion as cost has produced various forms of specialist
analysis, including cost accounting, cost effectiveness analysis and
cost-benefit analysis.
See also: consumer’s surplus; cost-benefit analysis; efficiency; firm
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COST-BENEFIT ANALYSIS
CREDIT
A method of investment appraisal for major projects such as trans-
portation systems, energy installations such as dams, and public health
and education projects.
Although first used for assessing projects under the US Flood
Control Act of 1936, it has its intellectual roots in the writings of
Dupuit in 1844 and Marshall in 1890 with his concepts of consumer’s
and producer’s surplus.
The point of such exercises is to estimate if there will be a net
benefit from undertaking investment. In order to make the compar-
ison, both benefits and costs have to be measured in the same units,
usually a particular currency at a particular date. As the flows of ben-
efits and costs can be uneven and of a different duration, it is usual to
discount them to their present value. To produce the fullest assess-
ment, many costs and benefits without market prices have to be
measured by shadow or proxy prices. By using a survey, the sub-
jective valuations of a beautiful view, for example, can be deter-
mined. If an improved transport link saves time and reduces fatal
injuries then the opportunity cost of the saving will be calculated and
the value of a human life ascertained, beginning with the loss of earnings
through dying before normal retirement age. A major project does
enable increased consumption, which can be valued in terms of the
extra units, for example of electricity, consumed times the marginal
benefit to the consumer. To make the calculations manageable it is
usual to consider the net benefit of a project to a region or city, rather
than for a whole country. However, critics of this type of analysis
always question the placing of a money value on so many intangibles
and the accuracy of the expected income flows.
Further reading: Dupuit 1844; Marshall 1920; Mishan 1972
CREDIT
Finance available to firms and households which exists because of trust.
An early writer on this subject, Henry Thornton, in his Paper
Credit (1802) analysed both the determinants of commercial con-
fidence and the range of credit instruments within the context of a
balance sheet for the economy as a whole. He regarded commercial
credit as the confidence among the commercial classes which dis-
posed them to lend money to each other and undertake other
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CULTURAL ECONOMICS
monetary engagements. There would be little confidence where
there is a weak sense of moral duty and insecure property. Where
there is confidence, paper credit, whether banknotes or commercial
bills, can exist. If faith in the ability of a bank to honour its obliga-
tions collapses, then the credit it has issued is worthless.
There are many types of credit – loans from family and friends,
loans from pawnbrokers on the security of deposited goods, bank
loans, and bills of exchange. A traditional form of credit is trade
credit, which consists of loans and permission to delay payment
offered by manufacturers and wholesalers to retailers. One type can
be a substitute for another but is often differentiated by the length of
period the money is borrowed for.
The quality of debtors varies greatly. For individuals there is credit
scoring, which consists of awarding points for each personal char-
acteristic then seeing if the total meets an acceptance level. For cor-
porations and governments there is credit rating to indicate the
creditworthiness of the organisation. Crucial to these assessments is
the probability of default in the servicing of the debt.
Increasingly in poor countries and neighbourhoods, informal credit
networks have been established because of the reluctance of banks to
lend to persons with little collateral. Credit unions of persons con-
tributing small deposits and having the right to borrow from the
association have been set up. This ‘micro-credit’ has permitted the
borrowing of small sums to start up businesses. Increasingly micro-
credit has been recommended as a route to economic development.
The very poor, women and other groups suffering discrimination are
given access to finance for the first time.
Credit rationing is used by monetary authorities to achieve an
optimal distribution of credit. It can be used as an alternative to
interest rate changes. Some borrowers have limited access to
finance so for social reasons there can be special credit deals, for
example to buy housing. A credit crunch occurs when a limitation
on lending curtails the activities of businesses and other potential
borrowers.
See also: banking; money
CULTURAL ECONOMICS
A study of the arts as an industry, investigating the nature of its
output, productivity, employment, consumers and financing. The
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CULTURAL ECONOMICS
wide range of activities considered includes theatre, opera, radio,
television, painting, sculpture and museums.
As with other industries the degree of monopoly is important,
especially whether a state monopoly or a competitive structure is
appropriate. The types of output range from the perishable live per-
formances of the performing arts to robust sculptures which have
survived millennia. Like other industries, quality issues and the effi-
ciency of production of every type of ‘artist’ is examined to see if the
same outcome could be realised with a smaller input. As so much of
art is durable the relative claims of the present and future generations
are considered, and used as an argument for current artistic activities
being loss-making. As with other productive activities, it is necessary
to decide the amount of production. Crucial will be the probable
rates of return, not only in monetary but in aesthetic and educational
terms, as culture is a very sophisticated type of output.
The resources required to achieve a great work of art can be
immense, so questions of private and public financing arise. There is
a long history of monarchs, state and regional governments sponsor-
ing musical events and artists. Culture is regarded as a merit good,
improving human character and creativity, so attracts subsidisation. As
a consequence of democracy and the financing of the arts through
taxation, questions are raised about the use of public finances in this
way. Inevitably with the more refined productions appealing to a
small proportion of society the fairness of subsidising, for example,
opera is much debated. As some cultural products are entertainment
(for example, the theatre) it is asked why the beneficiaries expect to
consume them at less than full cost.
Culture has attracted many analytical approaches. Consumer
theory can be used to analyse art lovers’ preferences and the demand
for a particular medium so that a more rational allocation of resources
can be attempted. Ruskin’s lectures of 1857 on the political economy
of art are an early example of using economic concepts of the nature
of labour, accumulation and distribution to analyse artistic activities.
The labour market for the arts is complex. The nature of training, or
lack of it, is unusual. The market is often characterised by excess
supply of unpublished authors, resting actors and musicians and
penurious painters. There is much self-employment and a variety of
ways of selling artistic production, including present sales and second
sales through auctions. The nature of incomes in this sector is com-
plicated by the existence of copyright to generate long-term income
streams. Baumol and Bowen argued that there is little scope for
productivity increases in the labour intensive live arts, so that with
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CURRENCY
increasing costs there would be a case for state subsidy – a view
which was challenged by Peacock.
It is difficult to estimate all of the effects of the arts on a national
economy: employment, the relaxing benefits of entertainment, the
enrichment of education, the expansion of tourism and the long-term
creation of a national heritage. Many estimation difficulties spring
from problems of valuation. Performances are perishable, unless a
recording is acceptable as a substitute, and it can be difficult to achieve
a consensus about an object’s value.
See also: value
Further reading: Baumol and Bowen 1966; Peacock 1969, 2000; Ruskin
1867; Scitovsky 1972, 1976; Throsby 1994
CURRENCY
The official money of a country or of an economic union.
A currency can be issued by a central bank, a national government
or its agency. Under free banking individual banks have the power
to issue notes without many restraints. It can also be produced by a
federation of nations, as with the euro. It is the medium of exchange
which is currently used for transactions within a currency area. It can
take the form of coin, banknotes or other forms of liquidity such as the
special drawing rights of the International Monetary Fund. A coun-
try can have its official currency but extensively use another because
of its greater monetary stability or its popularity for trading purposes,
hence the popularity of holding dollars in many small countries.
Currencies are classified according to their function. A reserve
currency is held by central banks because of its stability of value and
usefulness in trade. A dominant currency is widely held because of its
stability and because it is issued by a major national economy. In
the twentieth century the US dollar initially had this role, but later
the rise of the Asian countries challenged the supremacy of the US
economy and hence of its currency.
Currencies are regarded as hard or soft. A hard currency will
maintain its value for many years because it is issued by country with
strict monetary and fiscal policies which keep inflation at bay. The
attractiveness of a currency as a store of value makes it popular as a
reserve currency. So many foreigners might want to hold a hard currency
that its issue is strictly controlled. The Swiss franc has a long-held
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CURRENCY
reputation for its hardness. Soft currencies, associated with countries
which have weak economies, poor control of government finances
and trade deficits, are used primarily for internal trading purposes.
A currency can be flexible, with its value fluctuating continuously
in foreign exchange markets, or it can be fixed to gold or reference
currencies and allowed fluctuation only within a band, or it can be
pegged to the value of another currency with no less of national
independence in monetary policy. In the past fixed currencies exis-
ted under the gold standard and under Bretton Woods 1944–71. The
growth of currency unions has revived fixed exchange rates. Under a
currency union it is necessary for the area covered to be economically
homogeneous, with a great mobility of labour and capital. A currency
union is supposed to be an optimal currency area, one with factor
mobility and exposure to similar shocks to the constituent economies,
as set down by Mundell. Where there is a common currency transac-
tion costs are lower and there is price transparency. The USA meets
the conditions for being an optimal currency area better than the
European Union, helped by the widespread use of the English lan-
guage. The members of a currency union sacrifice much freedom in
economic policy making. As a single currency can be too strong for
the weaker parts of an economy, it is necessary to have fiscal transfers
to deal with unemployment and low levels of economic activity.
The euro was the last major currency to be created. By the end of
2006 it was the currency of twelve European countries, member
states of the European Union which has also become a currency
union. The currency has circulated as banknotes and coins since the
beginning of 2002. For three years the participating countries had
irrevocably bound their currencies together with fixed conversion
rates. The currency reduces transaction costs and facilitates the
working of the single market but, as it is governed by a single interest
rate, it has varying degrees of effectiveness in managing inflation and
economic growth in the different member states. Just as it would be
difficult to have a single currency for the whole world, it is difficult to
have one for a wide area with varying degrees of economic attainment.
Governments want their currencies to be attractive so that it is easy
to pay for imports and meet other international obligations. Main-
taining its value is the most attractive attribute of a currency. In the
nineteenth century the competing systems for anchoring the value of
a currency were the gold standard and bimetallism. Under the gold
bullion standard, which flourished from 1880 to 1914, national cur-
rencies were related to weights of gold. The central bank was required
to inflate or deflate the national economy so that the currency could
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CUSTOMS UNION
remain on the standard. The gold exchange standard linked the value
of one currency to another on the gold standard, as happened in the
1920s in the UK and the USA. Bimetallism required the use of two
metals, usually silver and gold, in a fixed ratio (Adam Smith approved
of this basis for value). In the nineteenth century it was used in the
USA and in the Latin Union (France, Belgium, Switzerland, Italy,
Greece and Romania) until increased silver production made a dual
standard unstable.
As a consequence of issuing a currency a monetary authority
obtains seignorage, originally the charge for minting coin from pre-
cious metals, but now the income net of the cost of production for
expanding the money supply. A government can induce inflation by
the over-issue of currency then repay its debt more easily because its
value has been reduced.
Some countries undertake currency reform by replacing their
existing currency with a new one: this can happen because a period
of inflation has made the number of currency units required to buy
simple goods unwieldy. Schemes to improve the value and stability of
a currency have often been ordered by the International Monetary
Fund. These usually include reducing excessive government spend-
ing, and market reforms such as making labour markets more flexible.
See also: exchange rate
Further reading: Madrid Conference on Optimum Currency Areas 1973
CUSTOMS UNION
An economic association of independent countries that abandon
customs duties between each other in favour of a common external
tariff, or a system of import quotas.
It is a stronger union than a free trade association, which lacks the
same customs duties and a common trade policy. It can be a stage
towards a complete economic union with common monetary, fiscal,
trade and other economic policies. Many examples abound, including
the European Union and regional groupings in North and South
America, Asia and Africa. Increasingly, the setting up of many regional
trading blocs has led to economic losses among the excluded countries.
The consequences of a customs union can be divided into trade
creation between the members of the union who have privileged access
to each other’s market and trade diversion through the abandonment
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CYCLES
of trade patterns which existed pre-union. Also there are expected to
be efficiency gains, greater economic stability and a promotion of
political and cultural ties. Static effects are largely associated with
economies of scale; dynamic effects include behavioural changes and
technological investment.
See also: protection; trade theory
Further reading: Janssen 1961
CYCLES
Regular movements in national economic activity, measured by
output, prices or unemployment.
Each cycle moves between a trough and a peak then back to the
trough again: its length is measured from peak to peak or trough to
trough. There is an upswing to a ceiling, or upper turning point,
then a downswing to a floor, or lower turning point. The types of
cycle are classified according to their usual length and the type of
investment which has generated the cycle. Cycles are transitory
movements around a trend which shows potential output based on
productivity growth. When studying cycles it is important to distin-
guish the impulse or shock which sets off the cycle from the propa-
gation mechanism which sustains it.
Wesley Mitchell defined cycles as follows:
Business cycles are a type of fluctuation found in the aggregate
economic activity of nations that organise their work mainly in
business enterprises: a cycle consists of expansion occurring at
about the same time in many economic activities, followed by
similarly general recessions, contractions, and revivals which
merge into the expansion phase of the next cycle. This sequence
of changes is recurrent but not periodic; in duration business
cycles vary from more than one year to ten or twelve years; they
are not divisible into shorter cycles of similar character with
amplitudes approximating their own.
(Burns and Mitchell 1946: 3)
Mitchell’s views have been qualified in many ways. Different types of
cycle have been suggested, distinguished by their length and asso-
ciated type of investment. Kitchin suggested there were minor cycles,
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CYCLES
on average lasting 3.5 years or 40 months, evident in the data on
bank clearings, prices and interest rates of the USA and Great Britain,
1890–1922. He particularly attributed these to mass psychology. The
Juglar cycle was identified in 1862 as a cycle of seven to ten years,
associated with changes in fixed investment in factories and machines.
(The Juglar cycle is often called the ‘business cycle’ or ‘major cycle’.)
Kuznets identified cycles of twenty-two years on average in produc-
tion and twenty-three years in prices for the American and British
economies. A cycle in unemployment led to a cycle in the labour
force and in net investment. He found that troughs and peaks in
immigration coincided with highs and lows in output. In response to
labour market shortages, immigration rose, leading to changes in
residential building. Most controversial of all was the Kondratieff
cycle, or long wave, of about 45 to 60 years. A long cycle of this kind
would be launched by a cluster of innovations starting a new industry.
The first of these started in the 1780s with cotton and the canal age,
and the second in the 1840s with the railway age; the coming of the
motor car in the 1890s and aircraft in the 1930s also stimulated long
upswings. Thus as the cycle becomes longer the type of investment
associated with it changes from inventories in the case of Kitchins,
fixed investment for the Juglars, housing for the Kuznets cycles and
major industries and infrastructure for the Kondratieffs.
Classical and later economists advanced theories of the trade cycle.
Malthus wrote about oscillations in production. JS Mill had a psy-
chological theory of alternating moods of optimism and pessimism.
Marx argued that there were ten-year cycles reflecting the average
age of fixed capital. JM Keynes argued that fluctuations in the mar-
ginal efficiency of capital were primarily responsible for cycles,
although there are fluctuations also in the propensity to consume and
in the state of liquidity preference. Doubts about future yields can
cause a downturn. Hicks used an accelerator and multiplier mechan-
ism, with an increase in income generating extra investment via the
accelerator and the multiplier translating higher net investment into
higher income. Expansion and decline will only be halted by ceilings
of full employment, which will cause a downturn and a floor because
there will have to be replacement investment which can generate an
upturn.
The consequences of an economy being cyclical are severe. A
downturn will lead to unemployment of labour and other factors of
production; an upturn can produce the threat of inflation. Thus the
search for stabilisation measures has long been sought. Wicksell, in his
analysis of cumulative processes of expansion and contraction, hoped
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DEBT
through setting out the conditions for monetary equilibrium to
establish price stability and thence stability for a whole national
economy. Price stability was regarded as a key to taming the cycle
until the changes in macroeconomic theory from the 1930s put more
emphasis on managing demand. In the 1950s and 1960s monetary,
and even more, fiscal measures were used to ‘fine-tune’ the economy
so that fluctuations would be slight. The public sector was seen, as
the Stockholm School had earlier suggested, as crucial. Government
financed investment projects could be advanced or halted to change
the level of demand. More recently, with the popularity of central
bank independence and the associated inflation targeting, price sta-
bilisation has become a leading theme in managing economies prone
to boom and slump.
Further reading: Abramovitz 1968; Burns and Mitchell 1946; Haberler 1968;
Kitchin 1923; Kondratieff 1935
DEBT
A financial claim created by a borrower in order to obtain money;
anything that is owed or due.
Governments and incorporated businesses issue debt in the long
and medium term as bonds but in the short term as bills. Debt is
fixed interest in nature, unlike equity, which entitles the holder to a
share of net earnings. Banks can create deposits and issue them to
customers.
Debt can be owed by individual persons, firms or governments. A
sovereign debt is owed, or guaranteed, by a government (for example,
the borrowing by a state-owned industry) and usually takes the form
of bonds. The accumulated debt of a government is the national or
public debt. It is either floating or funded with no immediate obli-
gation to pay the sums borrowed. A more sophisticated financial
sector will devise new forms of debt to meet the varied needs of
borrowers. Some debts are for a long period, such as a mortgage to
finance house purchase or a bank loan to buy consumer durable
goods. Much of personal debt takes the form of unpaid balances on
credit cards. Debt in the form of loans can be converted into mar-
ketable forms, especially bonds, through the process of securitisation.
There is a chronic tendency to over-borrow so that debts can be
unsustainable, the worst case being a ‘debt trap’ when the cost of
servicing a debt rises faster than the income of the borrower.
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DEMAND CURVE
See also: credit; fiscal policy
Further reading: Jochnick and Preston 2006
DEMAND CURVE
The graphical representation of the relationship between price, or
sometimes income, and quantity. The normal demand curve is
negatively sloped downwards to the right as lower prices usually
attract more demand. But some demand curves are horizontal or
even upward sloping, depending on the elasticity of demand.
JS Mill in his Some Unsettled Questions of Political Economy hinted at
demand curves without drawing them. The Edinburgh professor of
engineering Fleeming Jenkin constructed some in an article of 1870.
Demand curves were prominent in Marshall’s Principles of Economics as
part of his partial equilibrium analysis. His treatment of them raised
two important questions. Do empirical demand curves exist? Is it
possible to isolate the relationship between demand and supply under
ceteris paribus conditions?
Marshall questioned whether more than a single point could exist
on a demand curve. Friedman pointed out that movement along the
demand curve for a good constituting a major part of a consumer’s
budget would change real income, a variable which has to be held
constant if other things are to be equal. Later empirical work on
demand curves used either time series or cross-section approaches. In
the case of time series the quantity demanded at prices associated
with particular dates is recorded; cross-section data can be obtained
by setting prices in different markets, for example different regions, at
the same date.
Further reading: Friedman 1953
DEVELOPMENT ECONOMICS
Theories and policies recommended for increasing economic wel-
fare in low income countries.
These arise from theories of economic growth which investigate
the relationship between saving and investment and the role of tech-
nical progress in the long run. As this branch of economics is a
mixture of theoretical and applied economics, inevitably it has been
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split between a laissez-faire approach of allowing the natural pro-
cesses of markets to produce growth, and the advocacy of planning
and initiatives by national governments and international organisa-
tions such as the International Monetary Fund, the World Bank, and
regional banks including the Inter-American Development Bank.
Strategies such as balanced growth, growth poles and a big push were
commonplace in the literature. Neoclassical economists argued that
the capital needed for economic growth in poor countries would
flow of its own accord, attracted by lower factor costs. A leading
proponent of a non-interventionist approach was Peter Bauer, who
looked at the traditional mechanisms of the West African and Asian
economies to advocate a hands-off organic development strategy: he
believed that many of the problems of poor countries were the con-
sequence of bad bureaucratic government.
Mercantilists such as William Petty and classical economists led by
Adam Smith, by making economic growth a central theme of their
work, were precursors of later development economists. A major
classical framework employed for studying growth was ‘stages theory’,
describing the emergence of modern economies from early primitive
states of hunting then nomadic shepherding to agriculture and finally
commerce and manufacturing.
The target of development economics is developing countries.
They are regarded as a special case in the world economy, often
treated as having similar problems rather than being different. An
initial measure of economic underdevelopment is low GDP per
capita. However, in countries with subsistence agriculture much
produce is for own consumption so measures of GDP will under-
estimate national income, requiring supplementary estimates of pro-
duction. Many extreme cases of underdevelopment exist in Africa
and Asia, especially in desert areas. Underdevelopment has other
dimensions, including little infrastructure in the form of roads,
schools and hospitals. There are also deficiencies in political and
economic institutions, often with little democracy and a shortage of
banking and corporate structures. Human capital stocks are small,
with low proportions of the population even literate and capable of
practising medicine and using modern management skills.
Later, development economics came to mean prescribing eco-
nomic policies for the poorer countries of the world. The pioneers of
this specialism include Arthur Lewis, Gunnar Myrdal, Raul Prebisch,
Paul Rosenstein-Rodan, Hla Myint and later Hans Singer and
Amartya Sen. Particular theories are associated with these economists.
Lewis highlighted the dual economy nature of poor countries.
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Myrdal combined economic and sociological approaches to analyse
Asian development problems, being acutely aware of the problems of
corruption. Prebisch considered protection and import substitution
to industrialise underdeveloped countries and improve their terms
of trade; also he recommended long-term loans to prevent secular
decline. Rosenstein-Rodan wanted poorer countries to benefit from
the increasing returns associated with industrialisation. Myint linked
economic development to international trade theory. Singer was an
advocate of balanced growth. Sen has applied social choice theory to
inequality and poverty issues.
Partly inspired by Marx’s theory of imperialism, ‘dependency
theory’ was articulated. To explain relative development within the
context of a world economy system the processes of capitalism were
regarded as practising exploitation of Third World countries through
controlling access to technology and markets. Development eco-
nomics has long been an ideological battleground, especially between
neoclassical and Marxian economists. As Resnick demonstrated, the
neoclassical economists, many of them in international agencies, used
a microeconomic approach of seeing barriers to development in the
failings of particular markets. Inevitably, changes in tariffs, exchange
rates and the monetary systems of less developed countries were
recommended to improve these economies. The Marxian approach is
more internationalist, taking into account the relations between
centre and peripheral economies, and recognising the importance of
different social classes historically when analysing exploitation.
Examples of wrong development strategies are plentiful, hence the
reaction of ‘sustainable development’, which takes into account the
need for long-term plans which prefer to use renewable rather than
exhaustible resources, and invest in education and the infrastructure.
The Brundtland Report, Our Common Future, of the United Nations
World Commission on Environment and Development in 1987,
linked meeting present needs to being able to respond to future needs
when considering sustainability. Economic development is linked to
social development and conservation of the environment. However,
the urgency of present requirements can lead to forgetting the long
term. The report recommended redistribution from rich to poorer
countries as part of a growth strategy.
The problems of underdevelopment occur within the world
economy, so international economic solutions are proposed. The
New International Economic Order was proposed at the General
Assembly of the United Nations in 1974, suggesting trading boards
and the redistribution of monopoly profits to the poorer countries.
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More recently campaigns to make poverty a thing of the past have
started with schemes to write off the external debt of many poor
countries. Many countries fell into the ‘debt trap’ of holding debt
with servicing costs rising faster than national income. Poverty
cannot be relieved permanently in this way until there are political
changes in dictatorial regimes so that income can be redistributed
more fairly within countries, and the governments of these countries
adopt fiscal policies which can facilitate investment without incur-
ring further foreign debt.
See also: corruption; economic growth; globalisation
Further reading: Gemmell 1987; Jomo 2005; Lal 1983; Meier 2005; Resnick 1975
DISCRIMINATION
Treating identifiable groups less favourably than others, because of
their age, sex/gender or race; charging different prices for the same
thing.
Discrimination can occur at different stages of life: when young
through limited access to education; when older through restricted
access to employment and housing. Discrimination is exercised in
product markets by setting unfair prices, in the labour market
through paying wages which are lower for the less favoured group, in
the housing market by charging rents to exclude tenants. The less
valued group will be offered something inferior, whether it be
training, conditions and stability of employment or prospects of pro-
motion. Discrimination can be vertical, between different layers of a
hierarchical organisation, or horizontal, when persons in similar
employment are rewarded and treated differently. Much of the legis-
lation from the 1960s was concerned with horizontal treatment.
Various types of economic analysis have been applied to dis-
crimination. The oldest is probably JS Mill’s, in his discussion of
women’s wages in his Principles of Political Economy (1848); book II,
chapter 14 analysed the segmented nature of the labour market such
that women are only allowed into a group of occupations, hence
increasing supply and reducing wages relatively. This approach can be
applied to other forms of wage discrimination. Becker, with a dif-
ferent approach, asserted that employers could have a taste for dis-
crimination. This is costly to the discriminator as she can deliberately
reject a more productive worker because of sex or race.
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Discrimination can be created and sustained by governments,
reflecting their opinions of different sections in the population,
especially different racial groups. This is usually carried out to
maintain the relative position of successful elites. New migrants are
often the target of indigenous populations afraid of competition.
On the other hand, governments can practise positive discrimina-
tion, favouring the disadvantaged in housing, employment and
education. Often this leads to a backlash from those not privileged in
this way.
Discrimination is usually measured as a residual after data for two
groups have been standardised for personal characteristics. Thus to
discover if there is discrimination between men and women in
wages the data will be standardised for levels of education, occupa-
tional title, length of service, working hours, etc. The problem with
the residual approach is that it can always be argued that the data
can be further refined to reduce the differential. The alternative
approach is the legal approach of calculating the damage done by
discriminatory acts, such as only allowing one sex to apply for a
particular job.
Price discrimination consists of dividing up a market and charging
different prices for the same good or service. Because the cost of
production is the same for the different sub-markets, higher profits
arise where greater prices can be imposed. Discrimination is accord-
ing to personal characteristics such as age or location. It is essential to
be able to keep the sub-groups separate. In formal terms, it is because
the elasticity of demand is different for different sub-groups that this
pricing practice is possible.
See also: segmented labour market
Further reading: Becker 1971; Benton 1994
DISEQUILIBRIUM ECONOMICS
The study of a market or a national economy, or part of it, which
is in a state of persistent excess demand or excess supply.
Disequilibrium economics is a direct challenge to standard accep-
ted neoclassical economics, as it outlines the forces in markets
which impede movement to equilibrium. A lack of information can
prevent economic agents responding to price signals. Monetary and
psychic costs can make factors of production immobile. Forces of
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DISEQUILIBRIUM ECONOMICS
custom and statutory and contractual norms can create price stickiness,
which prevents prices from having their equilibrating role. In the
cobweb theorem, differences in the elasticities of demand and
supply can make convergence to an equilibrium an impossibility.
According to Say’s law a national economy would move to equi-
librium as every producer is also a consumer so there could not be a
‘general glut’. This was challenged by Malthus, who also presented
another famous case of disequilibrium: population unless checked
would tend to grow faster than its subsistence, thus hurtling along on
a disequilibrium path. Wicksell outlined the conditions for a national
economy being on a cumulative path of expansion or decline because
of a divergence between natural and market rates of interest. JM
Keynes in his General Theory of Employment, Interest and Money (1936)
considered national economies with persistent unemployment. It is
possible for disequilibria to persist for a long time because of gov-
ernment interference in markets, as happened in many consumer
markets in the former Soviet-type economies because of deliberate
restriction of supply. For shorter periods markets can be in dis-
equilibrium because of the lagged responses to price changes.
Economists have made use of Open Systems Theory to examine
processes which never reach equilibrium. This approach looks at the
interdependence of the components of a system and how their rela-
tionships become more and more complex. Mechanical relationships
become more fluid and biological, as Marshall recognised. Later,
Boulding was interested in the importance of feedback loops in
complex systems. This has been applied to development econom-
ics to show how spillover effects can keep an economy from equili-
brium. Previously, equilibrium economics heavily used thermodynamics
to explain states of rest.
Disequilibrium can deliberately be created by a government dis-
satisfied with the prices produced by a market; for example, rents can
be regulated to obtain affordable accommodation. The inefficiency of
markets themselves can sustain disequilibria for a long time, especially
if the supply of information to buyers and sellers is sparse and market
players are slow to react to prices.
A structural disequilibrium can exist in the balance of payments
of a country for years. The continued sharp differences in income
between countries suggest that the world economy itself is in a state
of disequilibrium.
Disequilibrium has its costs in terms of unemployed resources and
inflation, so many economic policies have been designed to encou-
rage a movement towards equilibrium. In a labour market, once the
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type of unemployment is recognised remedies are suggested, for
example, training to reduce structural unemployment, and labour
exchanges to lower frictional unemployment. Disequilibria in popu-
lation, national income and the balance of payments need more
widespread measures both macro and micro.
See also: equilibrium; Say’s law
Further reading: Vroe 1999
DIVISION OF LABOUR
The principle of economic specialisation between or within occupations.
There is both occupational division of labour, for example, the
difference between a farmer and a physician, and sub-division of
labour, when the performance of a job such as building a house is
divided into its component tasks. If there is a fine division of occu-
pations then the specialists arising from the sub-division of labour will
have new job titles, thus making the sub-division of labour a type of
occupational division.
Xenophon in his Cyropedia contrasts a small town, where all the
manufacturing operations to make a pair of shoes are done by one
person, with a larger settlement where different operations can be
performed by different specialised workers. Adam Smith, using the
example of pin-making from the French Encyclopedie, noted too that
the division of labour is limited by the extent of the market. As
division of labour was regarded by him as the principal cause of
economic growth, he explained how productivity is increased by
employing the principle. Through dividing up labour, time is saved
in passing from one operation to another, workers would become
more dextrous, and this subdivision of tasks would facilitate the
introduction of machines. Later he noted that the performance of
repetitive tasks could reduce mental capacity, but he never abandoned
the principle. To have the greatest amount of division of labour
requires free trade in a global economy.
Classical economists loosely regarded agriculture as subject to
diminishing returns because of soil exhaustion and looked on man-
ufacturing as being in a state of increasing returns through extensive
practice of the division of labour.
See also: returns
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DUAL ECONOMY
ECONOMIC ANTHROPOLOGY
A national economy with two sectors, one traditional and the other
modern.
Developing economies have been described as having a modern
sector, with the capital city, industries, services and international
trade, as well as a traditional sector with a low level of technology
engaged in a low-productivity agricultural and primary sector. The
different sectors represent different stages of economic development,
with much of the older sector non-monetised and lacking labour and
financial markets. In the modern sector capitalist production with
profit-maximising firms employing workers is the norm; in the tra-
ditional sector employers tolerate low productivity. Saving can only
occur in the modern sector, so the economic growth of the country
as a whole is dependent on that sector’s expansion.
Barriers to mobility sustain the dualism of such economies, but
civil wars and climate change have forced populations out of rural
areas into cities, where the attempt to enter modern economic life is
often frustrated by a lack of capital and education. Economic policy
can aim to bring about a convergence between the two sectors by
transferring resources into backward areas, but caution is needed to
prevent the creation of new imbalances and devastation resulting
from the use of inappropriate technologies.
See also: development economics
Further reading: Lewis 1954, 1979
ECONOMIC ANTHROPOLOGY
An analysis of economic institutions based upon the observations and
models of social behaviour devised by anthropologists.
Anthropologists have studied the relationships within many primi-
tive and more advanced societies. Key issues discussed, with the
insights of different schools of economics, are the nature of work,
exchange and money.
In the Ancient Greek economics of Aristotle and Xenophon the
study of the household linked social and economic analysis together.
Later the stages theory of Adam Smith and his eighteenth-century
contemporaries noted that countries develop from hunting to shep-
herding to agriculture, then commerce and manufacturing. In all of
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these stages, methods of production, resource allocation and dis-
tribution of national income are different. In other ways anthro-
pology has the character of classical economics with a description
of how simple physical barter evolves into modern money. Marxian
analysis has been fruitful in applying concepts such as the labour
process and commodity fetishism to explain the working of primitive
labour markets. Also the Enlightenment interest in human nature
linked economics to the other social sciences. In the substantivist
meaning of economics suggested by Polanyi in the Great Transforma-
tion, economics is concerned with how individuals make a living in
their circumstances.
Institutionalists, especially Veblen, linked economics and anthro-
pology by importing the term tropism, the response of an organism to
an external stimulus. Neoclassical economics has been used by
anthropologists to provide conceptual frameworks, especially utilising
terms such as competition, rationality and uncertainty.
See also: altruism; homo economicus; public choice; social choice theory
Further reading: Gudeman 2001; Polanyi 1944; Veblen 1900
ECONOMIC CONCENTRATION
The dominance of one industry, firm or activity within the industrial
or regional structure of a country.
Concentration is inevitable in the industries of small countries
where, if economies of scale exist, there have to be few firms if the
market is small to keep costs low. In wartime industrial concentra-
tion is encouraged as governments intervene extensively in industry
and use a measure of central planning. New science-based industries
are concentrated as it is not possible for other firms to gain access to
the technology.
Absolute, or aggregate, concentration is the dominance of a few
large firms in the output, sales or employment of a particular indus-
try, or in a national economy as a whole. This is distinguished from
relative concentration, which is based on the size distribution of firms
within an industry. Aggregate concentration is also known as the
dominant firms ratios. Relative concentration is measured using the
device of Lorenz curves and Gini coefficients. These curves plot the
percentage of firms against the percentage of output, employment or
income: if there is equal distribution the curve will lie along a 45
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degree line; the further the Lorenz curve is away from that diagonal
the less equality there is between firms. A Gini coefficient is the ratio
of the area between the curve and the diagonal to the area between
the 45 degree line and the horizontal access.
Calculations of concentration are used to identify monopolies and
potential market abuse. Therefore concentration is a major concern
of antitrust and competition laws in many developed countries.
See also: competition and monopoly
Further reading: Blair 1972
ECONOMIC DEMOGRAPHY
The study of the nature of human populations and their effect on
economic conditions.
Population problems can be simply divided into the problems of
under-population and of overpopulation. In the earliest stage of
economic development a shortage of people can be a barrier to
economic growth; later a declining population raises many concerns
as it is invariably ageing. Over-population can lead to a shortage of
resources to sustain a large number of people.
Early writers on population, especially the mercantilists, were
concerned to have enough people to maintain the strength of a
nation absolutely and relatively. With vast tracts of fertile land unpo-
pulated, encouraging the creation and settlement of large families was
imperative, even to the extent of using fiscal penalties and rewards to
boost the birth rate. Whereas population growth could be encour-
aged in parts of the world, in the older countries such as England
population growth was seen as a problem. In the eighteenth century
an awareness of the dangers of rapid population growth led Thomas
Robert Malthus to formulate his principle of population.
Many economics writers have highlighted the relationship between
population and subsistence, including Steuart, Cantillon and Smith,
but Wallace came closest to being Malthus’ precursor in that he
mentioned the checks to population growth. Malthus argued that
food is necessary for a human population and that passion between
the sexes is constant. His stark population principle was that the
human population unchecked would grow in a geometric progres-
sion but subsistence only in an arithmetic progression. In the first
edition of his Essay on Population of 1798, the checks mentioned were
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ECONOMIC DEMOGRAPHY
different forms of misery, including plague and war, and vice. In the
second edition of 1803 he included the check of moral restraint
through late marriages to reduce the birth rate. His critics were many.
Christians argued that a benevolent God would not allow babies to
be born with the certain prospect of fatal starvation. Others argued
that technical progress would provide more subsistence, or a desire
for improvement would entice potential parents to prefer luxury to
more children. Although Malthus was not an advocate of birth con-
trol, some of his disciples, especially the ‘Malthusians’, were.
Students of population trends have noted that there is a ‘demo-
graphic transition’ between early societies with high fertility and
mortality to advanced societies where the birth and death rates are
lower. Mortality falls when there are public health measures to
improve the quality of water and to eliminate major diseases. There is
a further fall in the death rate when more people receive personal
health care. The birth rate fell dramatically in many advanced coun-
tries through the widespread use of the contraceptive pill. Also the
increased education and labour force participation of women is asso-
ciated with a fall in the birth rate.
Populations grow through natural increase and net migration.
Natural increase is the excess of births over deaths in a given popu-
lation. Net migration is the number of immigrants less the number of
emigrants of a given country. Fluctuations in the relative prosperity of
countries will induce migratory population flows.
The composition of population is important, especially the ratio of
births to deaths and of the young to the old. Through the ageing of a
population, the ‘dependency ratio’, those outside the labour force as
a percentage of the whole population, grows. The determination of
Malthus to solve the problem of a disequilibrium between population
growth and subsistence growth by having a balanced economy is still
a modern concern.
Given the dialogue between advocates of population growth and
opponents of rising numbers, it is inevitable that the notion of an
‘optimum population’ should arise. JS Mill and Edwin Cannan sup-
ported this idea. The population is optimal in the sense that a parti-
cular size maximises output per head. Such a measure can be attacked
from different angles, especially that a nation might be a satisfier and
not a maximiser keener to improve the quality of life than the
quantity of output.
When a ‘population problem’ is perceived, population policy
responses are often devised. Various ways of increasing a population
have often been attempted. To stimulate natural increase, financial
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ECONOMIC GROWTH
inducements can be offered to couples to have more children. Assis-
tance with travel and housing can be used to attract international
migrants. Reducing population size takes time, but family planning
and immigration controls can be used.
See also: migration and mobility
Further reading: Caldwell 1972; Rosenzweig 1997
ECONOMIC GROWTH
An increase in national income caused by an increase in the quan-
tity of the factors of production or of their productivity.
This concern, which has been prominent in economics from at
least the seventeenth century, has continued vigorously, although
dissenters have questioned the advocacy of materialism and the social
costs resulting from higher production.
In the eighteenth century stages theory was popular, especially in
writers such as Smith and Malthus. Economic development was
traced from a primitive stage of hunting and gathering to the age of
shepherds and thence to agriculture, finishing with manufacturing
and commerce. Rostow revived stages theory in his account of eco-
nomic growth. In his first stage of ‘the traditional society’ growth is
curbed by the lack of technical progress; in the second stage of
‘transition’ there is an increase in the rate of investment to at least that
of population growth. Then there is ‘take-off ’ when growth is at a
geometrical progression: this period lasts about twenty years. In the
fourth stage, about a sixty-year period, is ‘the drive to maturity’ in
which modern technology is applied throughout the economy. The
growth process comes to the final stage of mass consumption of
durable goods when a choice has to be made between such con-
sumption and the pursuit of either national power or social welfare.
Although initially applied to the development of the American and
Russian economies, it has other national applications. The neatness of
the division of history into separate stages is questionable, as the
activity dominant in each stage can overlap with the process in the
next.
Economic growth is usually studied by considering a series of
theories and models. In the outburst of economic research into
growth in the 1960s, a number of prominent approaches emerged.
The Harrod-Domar model from 1948 onwards had a central place. It
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ECONOMIC GROWTH
argued that there is both a natural and a warranted rate of growth.
The natural rate is the maximum long-run growth rate equal to the
sum of the growth of the population and technical progress. The
warranted rate is equal to the ratio of the proportion of income saved
to the capital-income ratio.
Lewis in 1954 outlined his influential model of economic growth
based on the idea of a dual economy of modern and traditional
sectors, the agricultural and the industrial. By transfers of labour from
the underemployed agricultural labour force to industry, there would
be an increase in overall productivity and food surpluses in rural areas
after the agricultural population fell. Increased incomes would make
possible higher amounts of investment. Food exports would be pos-
sible. Questions have been raised about the productivity assumptions
and the trading regime of the world economy.
In the 1960s there was a quest for viable steady state growth
models. The variants of these were produced by making different
assumptions about savings and technical progress. The Solow growth
model is based on a Cobb-Douglas production model with constant
returns to scale. Then labour productivity is considered and a savings
function and equilibrium condition of savings equal to the depre-
ciated capital stock are introduced. Capital accumulation brings about
economic growth.
Growth need not be deliberate. It can be an unintended con-
sequence, for example, of learning by doing as in Arrow’s model. In
the process of production experience is gained which will increase
productivity through economies of scale. Productivity will be subject
to diminishing returns.
The economic growth theory industry continues to expand.
Endogenous growth theory attributes economic growth to advances
in innovation and extra human capital. Encouraging a knowledge-
based economy will produce many spill-overs and a second stage of
growth through increasing returns. Kaldor and Mirrlees in 1962
presented a Keynesian model of economic growth, using a technical
progress function which related the rate of change of gross fixed
investment per employee to the rate of increase of labour productiv-
ity on newly installed capital equipment. Technical progress was
shown to be crucial to economic growth, giving rise to many endo-
genous growth studies.
The Ramsey-Cass-Koopmans model assumes that a constant
number of households has income streams from its labour and from
the income flowing from its capital assets. These households will
attempt to maximise the present value of an infinite utility stream.
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Growth accounting involves decomposing the growth in national
income according to the amounts of inputs and adding a residual
determined by total factor productivity. This production function,
using as inputs physical capital and the size of the labour force, can be
extended by including human capital as an input.
Policies to encourage regional and national economic growth abound.
At the regional level, grants and fiscal incentives are used to increase
the rate of net investment. At the national level, growth policies include
the employment of existing monetary and fiscal policies to stimulate
investment, and the introduction of policy innovations such as indi-
cative economic planning.
Further reading: Arrow 1962; Deane 1967; Domar 1957; Hahn and Matthews
1964; Hamberg 1971; Harrod 1948; Kaldor and Mirrlees 1962; Kuznets
1966; Rostow 1960
ECONOMIC INTEGRATION
The harmonisation and combination of the economic activities of
separate economies.
Integration, the bringing together of separate parts into a whole,
can occur at the levels of the firm, industry or national economy. A
firm integrates its activities by reducing the amount of diversification
of its activities, often by selling off assets which are not relevant to the
principal of the enterprise. An industry experiencing mergers will
consolidate the number of firms into fewer and larger units: this can
be under the encouragement of government when there is a severe
shortage of resources. At the national level economic integration
occurs when industries or regions have more linked activities. This
can occur by providing incentives to specialise. Old industries are
allowed to die gracefully and new industries are encouraged. Regions
concentrate on their core activities.
There can also be integration between nations. This occurs as the
consequence of the creation of a federation, as has happened under
the European Union, or when by agreement joint activities are
instituted. Firms can have cross-country activities: governments can
implement joint monetary, fiscal, labour, industrial and regional
policies.
Integration has many motivations. Reducing costs is a dominant
aim. Also there are equity issues: for example, in order to have fair
competition tax rates are harmonised. Economic integration can be
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ECONOMIC METHODOLOGY
used as a first step to political integration in the interests of avoiding
international conflict. Integration naturally occurs when in response
to differentials in wage or profit rates there is movement in factors of
production, equalising rates in a unified market.
See also: customs union; holism
Further reading: Machlup 1977; Streeten 1961
ECONOMIC METHODOLOGY
The way in which economic analysis is conducted; the application of
scientific method to economics.
Economics was slow to emerge as a distinct subject. Not until the
second half of the eighteenth century were comprehensive surveys of
economics, by Cantillon, Steuart and Smith, produced. In the early
nineteenth century classical economists began to include a discussion
of economic methodology and to ask what economics attempts to be.
Nassau Senior, the first professor of political economy at Oxford
University, thought that the focus of political economy was the study
of wealth’s production but that the subject was divided into two
branches. The theoretical consists of deductions from obvious pro-
positions. The practical depends on induction from phenomena.
JS Mill, attempting a definition of political economy in his fifth
essay on Some Unsettled Questions of Political Economy, narrowed the
subject to the ‘moral or psychological laws of the production and
distribution of wealth’ and concluded that it was an abstract science
with an a priori method. In his Principles of Political Economy he made
a sharp distinction between the laws of production and those of dis-
tribution, which he asserted are only a matter of human institution.
Cairnes in his discussion of economics argued that it is concerned
with the means to reach our ends. It explains phenomena without
approving or disapproving them. Political economy is to be seen as a
hypothetical science showing what tends to take place. Using as an
illustration Malthus’ population theory, he argues that the method to
be adopted is to consider the nature and power of a principle of
human nature, then consider how restrained it is by external condi-
tions, see what happens if it were unrestrained and look at the
strength of opposing economic agents.
Marshall in his Principles of Economics explains his partial equilibrium
method of ‘a bit at a time’, isolating pairs of economic variables to
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ECONOMIC METHODOLOGY
see the relationship between them with the assumption of ceteris par-
ibus, of other things being equal. He thought that economics is con-
cerned with ‘normal action’ – what can be expected under certain
conditions. He did not regard the laws of economics as precise as
those of gravitation but more akin to the science of the tides which is
based on probability. In the first stage of economic reasoning he
advocated the use of mechanical analogies, including equilibrium, but
in the later biological, dynamic ideas to show oscillations around a
centre which is progressing.
JN Keynes distinguished positive science which determines eco-
nomic laws from an ethical approach to economics. Physical laws are
presupposed so that economics can study cases of voluntary human
action. Also psychology is presupposed to examine social relations.
Abstract economics can provide fundamental principles, such as on
utility, which pervade all economic reasoning in the preliminary
stages.
Friedman thoroughly approved of Keynes’ positivist approach and
explained how positive economics is conducted. Economic hypoth-
eses are creative acts using assumptions which cannot be completely
realistic but need enough reality to have predictive power.
Robbins’ celebrated essay on the nature of economics used an a
priori approach to attack Marshallian economics so that economics
becomes a study of ‘human behaviour as a relationship between ends
and scarce means which have alternative uses’.
JM Keynes used a comparative statics approach, unlike his Cam-
bridge contemporary Dennis Robertson, who made his economics
dynamic by introducing time lags, and Swedish competitors such as
Bertil Ohlin who employed a period analysis.
Later the methodological studies of Kuhn and Lakatos attracted
much debate among economists. Kuhn in his explanation of scien-
tific revolutions begins with a scientific community which practises
normal science which is based on past scientific achievements. These
paradigms are a mixture of theory and methodology to explain col-
lected facts. They are solutions to what are regarded as the acute
problems of a scientific discipline in a particular time period and
will guide what a scientist does. Although the scientist works
according to rules, there can be unexpected results from experi-
ments. There is a scientific revolution, a paradigm change, through
discovering a new fact or inventing a new theory. There can be
repeated failures to solve problems with existing science as theories
do not fit the facts and the social climate has changed. A crisis leads
to a new scientific theory. The old paradigm is abandoned when a
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successful alternative has emerged constructed from new funda-
mentals. There is a discontinuity rather than a steady cumulative
process. It can take some time for a new paradigm to be widely
accepted; Kuhn did not regard paradigm changes as a march or
evolution to ‘the truth’.
Lakatos considered research programmes in science, beginning
with Newton’s gravitational theory and shifts in the definition of
problems as a consequence of empirical discoveries. Initial condi-
tions are gradually developed in a scientific programme. There is an
increase in content through research programmes absorbing coun-
ter-evidence. He wanted competing research programmes rather
than a particular model becoming a monopoly. Lakatos, studying
the philosophy of mathematics, argued that science progresses by
making conjectures and attempting to prove them; criticism pro-
duces counter-conjectures. Thus theorems are not ultimately true
but awaiting possible refutation. He sought to reconcile Popper and
Kuhn through introducing the idea of scientific programmes, or
groups of similar theories. Programmes can be progressive or in
decline.
See also: economics as rhetoric; Keynesianism; neoclassical economics;
new classical economics
Further reading: Backhouse 1994; Cairnes 1875; Caldwell 1982; Friedman
1953; Keynes 1891; Kuhn 1996; Lakatos 1972; Latsis 1972; Machlup 1963;
Mill 1844; Popper 1959; Robbins 1932; Robinson 1962; Senior 1827
ECONOMIC MODELLING
Constructing an abstract description of economic relationships, often
the relationship between two or more variables.
Non-mathematical models were used by Cantillon and Ricardo,
but as the nineteenth century progressed important borrowings were
made from mathematics, especially calculus, to sharpen economic
analysis, as in the works of Dupuit and Jevons. Richard Cantillon in
his Essay on the Nature of Commerce in General (1755) used a macro-
economic model of the flows of rents between villages where the
farmers lived, market towns with the larger farmers and artisans, and
cities where the landowners resided. David Ricardo in his Principles
of Political Economy and Taxation (1817) constructed a ‘corn model’
of the economy in which as the population expanded the cost of
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subsistence would rise, as would real wages, and the rate of profit
would decline.
Models are everywhere in economics. In macroeconomics there
are national income, growth and planning models; in micro-
economics models of the behaviour of households and firms. By
modelling, economics tries to be its scientific best, attempting to
show that the discipline can approach the rigour of the natural sci-
ences. Hypotheses are carefully chosen, the structure of the model
designed and the data collected. As a popular test of the worth of a
model is its predictive force, it is not surprising that modelling is
crucial to economic forecasting. Modellers show their seriousness by
engaging in computational modelling.
Models can be static or dynamic. Many equilibrium models are of
the former category; period analysis with variables lagged to intro-
duce time constitutes the latter. Inevitably the growing sophistication
of statistics and econometrics has introduced further intricacies into
models. Stochastic models test hypotheses concerning the values of
economic variables at different times. Accounting models reflect the
balance between debits and credits. Optimality and constrained opti-
misation models are used extensively in microeconomics in the ana-
lysis of profit and utility maximisation. Many models are criticised for
the unrealistic nature of their assumptions and their limited ambition,
for example, examining only the case of perfect competition. From
their earliest steps in economics, students are familiar with Keynesian
macroeconomic models, the IS-LM model, and consumer equili-
brium models.
Models can be quantitative or, less commonly, qualitative, as with
decision trees. Stochastic models usually employ time series and the
techniques of econometrics. Non-stochastic models are less precise in
their predictions.
See also: game theory; macroeconomic forecasting
Further reading: Kreps 1990
ECONOMICS AS RHETORIC
A postmodernist literary approach to economics texts proposed by
Donald, now Deirdre, McCloskey.
This is the method of finding good reasons for assertions rather than
using abstract methods, common to most scientific methodology, to
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prove something to be true. It is a reaction against the techniques and
accumulated results of positive economics which are obtained
through collecting observations to test hypotheses for their predictive
force, using the falsification theory of scientific research associated
with Karl Popper. Introspection is denied a role in justifying a theory,
but shaky statistical procedures are credited with creating evidence.
By argument and entering into conversation, meaning in economics
is realised. Thus the rhetorical approach examines the metaphors
which abound in economics, even when using mathematical analysis
to show that there are not closed fixed interpretations.
By changing the practice of economics to recognise rhetoric, a
broader and more rational approach to the subject occurs. Although
mainstream positive economic methods can be free from a political
bias, rhetoric is no less dangerous as it is humanistic and permits
free inquiry in the broadest sense. The rhetorical method can build
upon, rather than cut down, neoclassical economics, but has an
openness which could make economics more like poetry than scien-
tific prose.
See also: economic methodology
Further reading: McCloskey 1985
ECONOMIC SYSTEM
The institutions and methods of arranging production, exchange,
distribution and consumption.
Economic systems have been classified according to the relative
amount of private and public ownership, the mixture of markets and
planning to effect allocation, and their openness to foreign trade.
In the simplest of systems, households engage in production and
consumption, then exchange their surpluses through barter with no
government intervening in economic activity. With the growth of
markets and firms, economic life becomes more impersonal and
complicated. Economic development brings a greater sophistication
in consumer tastes and new goods made possible through technical
change. With industrialisation and migration from the country to
towns there was a call for governments to extend their functions and
respond to social problems. The implementation of socialist doc-
trines, especially in the planned economies of Eastern Europe, and in
the mixed economies with some partly private and partly state
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industries, reshaped economic systems. From the 1750s, when the
Physiocrats succeeded mercantilist thinkers, there has been the basic
distinction between economic systems which have organically grown
to their present state and those deliberately designed to serve the ends
of government. Government legislation and orders cut across the
spontaneous economic order, to use the expression of Hayek, for
economies adjusting through response to price changes.
The contrast between a production and an exchange economy
distinguishes an economy viewed as a giant machine for producing
goods and services from one where quantities of products are given
but their allocation is affected by the nature of exchange. The latter is
a monetised economy. Edgeworth in his Mathematical Psychics mod-
elled an exchange economy with two commodities, and two con-
sumers having identical preferences and initial resources.
See also: capitalism; comparative economic systems; socialism
ECONOMIC WELFARE
The benefits accruing to persons as a result of economic activity.
In classical economics the production of goods but not of ser-
vices constitutes economic activity, so that welfare is measured in
material terms. But increasingly economic activity was regarded as
productive of utilities and economic welfare as the sum of human
satisfactions or utilities. The welfare of an individual is contrasted
with the social welfare of society as whole. Economics makes the
distinction between ‘goods’ and ‘bads’ so that there has to be a pre-
ponderance of life-enhancing outputs over bads such as pollution and
harder work for there to be a net gain in economic welfare.
Pareto devised a notion of optimality, that there is an increase in
economic welfare if everyone is better off without anyone being
worse off. The shorthand way of measuring economic welfare is of
Gross Domestic Product per head, a concept pioneered by Smith in
the introduction to his Wealth of Nations. From this starting point,
basic national income data has to be refined to take account of the
composition of output and the circumstances under which it is pro-
duced, for example the average number of hours of workers.
See also: welfare economics
Further reading: McKenzie 1983
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ECONOMIES OF SCALE AND SCOPE
ECONOMIES OF SCALE AND SCOPE
An economy of scale exists if an expansion in output causes the average
cost of production to fall; an economy of scope arises from increasing
the range of a firm’s activities, including operating in more markets.
Marshall, in his explanation of scale economies, distinguished
internal economies arising from the expansion of a firm from exter-
nal economies caused by an industry having a higher output.
The causes of scale economies are shown by examining the exer-
cise of the functions of a firm, especially its management, production,
financing and marketing. A typical case of a scale economy is where
production has fixed costs, for example, the preparation of a template,
so that the unit cost will fall as the output increases. There can also
be diseconomies, usually attributed to the inability of managements
to control larger organisations. Economies are depicted graphically in
a falling average cost curve; diseconomies in a rise. As a scale econ-
omy is the consequence of the relationship between two variables,
output and cost, the ceteris paribus conditions that the same technol-
ogy is used when output grows, that factor proportions are constant
and the scope of the firm remains the same, are assumed.
To reduce its costs a firm can increase the scope of its activities in
many ways. It can extend its product range and it can market its
products in a larger number of markets. A major reason for scope
economies is the existence of common costs which can be spread
over a greater range of activities. Thus it is worthwhile to merge two
firms requiring distribution of their products over the same places.
Many cases of coordination illustrate the idea of an economy of
scope. A sharing of inputs can be achieved within firms as they
absorb other enterprises, and by contractual relationships between
different firms.
See also: cost; firm
Further reading: Gold 1981; Panzar and Willig 1981; Robinson 1953
EFFICIENCY
Producing at minimum cost; achieving a goal with minimal effort.
Productive activities have to be analysed and excess activity elimi-
nated to achieve maximum efficiency. In neoclassical economics,
efficiency is a constant goal. Idealistic economies, especially those
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EFFICIENCY
with a tendency towards utopianism, are more tolerant of waste and
low productivity.
Different types of efficiency include technical efficiency and allo-
cative efficiency. Technical efficiency can refer to a single factor of
production, whereas economic efficiency is concerned with the output
per cost unit whatever the factor is. It is dependent on the technol-
ogy used; thus manufacturing efficiency will be related to the type of
machine and the working methods of a factory. There are specific
types of technical efficiency. In energy economics, for example, thermal
efficiency is important: this is the ratio of the net output of a heat
engine to the amount of heat supplied at high temperatures. Network
efficiency is full utilisation of the network’s resources. Productive
efficiency necessitates cost minimisation.
Economic efficiency is regarded by users of a system as that level of
performance meeting their requirements. Market efficiency is the
extent to which prices reflect current information: this is an impor-
tant notion in capital markets. Allocative efficiency occurs where the
combination of goods produced maximises consumers’ satisfaction
and profits: the concept is often applied to monopoly and to inter-
national trade. From a welfare point of view, the benchmark for
efficiency is Pareto optimality, of reaching a state of improvement
which is not at the expense of anyone. Under it the marginal rates of
transformation of production for different goods will be equal and the
marginal rates of substitution between goods will be the same for
consumers, and the marginal rates of technical substitution between
pairs of factors of production will be the same.
Efficiency in economics is often regarded as achieving the max-
imum output for a unit of input, and is the consequence of the
optimal use of resources. It can be the average efficiency for a whole
range of output, or the marginal efficiency for the last unit produced.
Also it is identified with the minimum point of a U-shaped average
cost curve; if the average cost curve is L-shaped, then the notion of
efficiency is the minimum efficient size, the output associated with
the turning point of the curve.
Efficiency has many determinants, including choice of the appro-
priate technology and quality of factor inputs, especially labour. The
relationship between a type of organisation and efficiency is often
considered. In industries, monopolies are suspected of inefficiency
because they do not have to be as cost-conscious as competitive
firms. Large firms are potentially more efficient than smaller enter-
prises if economies of scale exist. Private firms could be superior in
efficiency to public enterprises, as they have the extra financial
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ELASTICITY
support of government and lack the market discipline of possible
takeover.
A leading concept in Keynesian economics is the marginal effi-
ciency of capital, which Keynes stated was ‘the relation between the
prospective yield of one more unit of that type of capital and the cost
of producing that unit’.
Leibenstein’s concept of X-efficiency is broader than allocative
efficiency, taking into account psychological factors. X-efficiency is
the result of intra-plant motivation, external motivational efficiency
and non-market input efficiency. He also argued that the return to
inputs could be small because labour contracts are incomplete so do
not maximise performance. Some factors of production are not
marketed, production functions are unknown and the influence other
firms can have is difficult to measure. He concluded through his
research that neither was production maximised nor costs minimised,
as many workers prefer to work more slowly and spend time in
interpersonal relationships.
Many economic entities can be said to be efficient. An efficient
contract concerns an exchange between a buyer and seller which
encourages efficient effort and investment by not producing a loss
for the contracting parties. A socially efficient contract will achieve
a social optimum. An efficient market achieves an allocation which
cannot be improved. It will produce, in the case of a financial
market, the true value of an investment. Any deviations from the
true value will be random. The price will be a reflection of all the
information on which past prices are based and, possibly in the
strongest form of efficiency, all public information also. In efficient
markets no investment strategy can consistently beat the market. In
the labour market efficiency wages are equal to the marginal pro-
ducts of workers. This will be achieved by trial and error. If firms
pay less, workers are encouraged to reduce effort or move to
other employers; if they pay more, they will attract better quality
workers so marginal products will rise to the high level of wages.
Further reading: Leibenstein 1966
ELASTICITY
The response of one variable to another, especially the response of
demand or supply to price or income. This is one of the most powerful
tools in economics.
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ENERGY ECONOMICS
Mun, Mill and Marshall made important contributions to the
development of the concept. Thomas Mun in England’s Treasure by
Forraign Trade (1664), writing of the vent (sale) of cloth in Turkey,
made use of a primitive idea of elasticity: ‘We find that twenty five in
the hundred less in the price of these . . . to the loss of private men’s
revenues may raise above fifty upon the hundred in the quantity
vented to the benefit to the publique’, thus introducing the idea of
price elasticity of demand as the ratio of the percentage change in
quantity demanded to a percentage change in price. JS Mill in his
Principles of Political Economy, book 3, chapter 18, refers to the
‘extensibility of demand’. Marshall in book 3, chapter 4 of his Prin-
ciples of Economics presented the modern description of elasticity as
responsiveness, taking the case of price elasticity of demand.
Elasticity has many applications. Price elasticities of demand are
used to classify the usefulness of goods, with an inelastic demand
indicating a necessity. Supply elasticities are connected with time: the
shorter the period of production the less elastic (more inelastic) is the
supply. Income elasticities separate normal goods from luxuries (elas-
tic income elasticity). The cross-price elasticity of demand shows the
responsiveness of quantity demanded of good X to a change in price
of good Y: this measure indicates whether goods are complements
(negative elasticity) or substitutes (positive elasticity) and is used in
the analysis of markets to indicate monopoly power. The elasticity
of substitution shows how substitutable one factor of production is
for another: this version of the concept is used in the study of pro-
duction functions and economic growth.
ENERGY ECONOMICS
The study of the production and distribution of coal, gas, oil and
electricity, as well as wind and solar power.
A careful examination is made of the stocks of exhaustible
resources and the means of production. Much of this branch of
economics is interested in projecting supply and demand. There is a
dynamic relationship between the price of energy and the supply of
it. In the case of oil, a rise in price will make possible production
from oilfields previously too costly to exploit. With the exhaustion of
coal and oil reserves new sources of energy from the sun, the wind
and the sea have been investigated.
With the rapid economic development of China and India, the
demand for electricity has added to the continuing problem of energy
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ENTREPRENEUR
deficiency. Given the scarcity of many forms of energy, there is a high
level of interest in applying efficiency measures on the part of
economics.
As countries have become less self-sufficient in energy, interna-
tional trading has become necessary. This has created spot and future
markets for energy. Some types of fuel, such as gas and coal, can be
stored; others cannot. Each type of energy will have different supply
conditions and often various demand circumstances as particular sorts
of equipment will often have a peculiar demand for fuel, for example,
vehicles usually use oil. However a variety of fuels can be employed
for some purposes, for example heating a house. Demand for fuel will
be uneven, with peaks in some seasons and at some times of day. This
raises problems of peak-load pricing designed to finance extra capa-
city for peak times and to encourage a smoothing of demand over time.
Taxation has many roles in energy economics. The large profits
made from oil have become a tempting source of extra tax revenue.
The inelasticity of demand for basic heating and lighting also leads to
a steady source of tax revenue. Taxes affect human behaviour, as most
recipients of income want to maximise post-tax income, thus an
indirect tax on dirty kinds of fuel will be likely to reduce their
consumption.
Because energy is a basic necessity for production and consump-
tion it is a sensitive political issue. Lower-income households will be
deprived of minimal levels of energy unless there is price dis-
crimination in their favour. Security of supply is essential if economic
and social life is not to be disrupted. To meet their responsibilities,
governments often interfere in energy matters. Regulation is
common to ensure fair prices and wide distribution. Some countries
have nationalised their major energy industries, as the UK did in the
late 1940s, to attempt a direct furthering of the government’s policy
aims.
Energy use raises many environmental concerns. The growth in car
and air travel creates pollution by producing carbon emissions. Indus-
trialisation invariably leads to an increase in the amount of effluents.
Further reading: Griffin 1986
ENTREPRENEUR
The fourth factor of production after land, labour and capital; the
bearer of risk; a creative person.
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ENVIRONMENTAL ECONOMICS
The functions of the entrepreneur are variously regarded as either
the organisation of production or the bearing of risk. The reward to
the entrepreneur is profit. According to Cantillon in his Essai sur la
Nature du Commerce en Ge´ne´ral (1755) the entrepreneur buys at a fixed
price and sells at an uncertain price, thus bearing risk; the entrepre-
neurial function can be executed by any occupational group. Entre-
preneurship in the pure sense of risk bearing can be undertaken by
individuals, companies or corporations with distributed equity capital
with a variable income. Governmental organisations can use their
resources, including tax revenues, to undertake risky projects.
To be entrepreneurial is to be enterprising and innovative. There is
the question of whether entrepreneurship can be innate or the pro-
duct of training. Management schools have courses in entrepreneur-
ship which include the mechanics of setting up a business. Certainly,
many successful entrepreneurs in the past had little formal education,
but the increasing use of science by modern industry rules out the
inspired and ignorant. Entrepreneurship can be the product of
necessity, as in a war economy engaged in military competition, or in
a failing business with outdated products.
Kirzner regarded entrepreneurship as the quality of alertness, of
knowing where to look for knowledge rather than having substantial
information. What the entrepreneur achieves is to create a mutual
adjustment of discordant elements arising from mistaken decisions
and missed opportunities.
Further reading: Cantillon 2001; Casson 1982; Kirzner 1973
ENVIRONMENTAL ECONOMICS
The study of the costs and benefits of using land; an examination of
the impact on the non-built environment of economic activity.
From the Ancient Greeks to the Physiocrats of the eighteenth
century the environment was not ‘a problem’ but the prime source of
wealth and income. Agriculture, the leading sector of early econo-
mies, was regarded as superior and to be encouraged. With indus-
trialisation from the beginning of the nineteenth century, the
problem of pollution of the air and water arose. Thomas Carlyle was
an early observer of the environmental disasters brought about
through industrialisation and associated urbanisation. In the twentieth
century the measurement of these destructive consequences was
attempted in the calculation of social cost. Most of the measures of
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ENVIRONMENTAL ECONOMICS
pollution, however, are physical, not monetary, such as the quantity
of particles of pollutants in a volume of air or water.
Apart from studying the effects of damaging the environment, this
branch of economics also looks at the consequences of the scarcity
of natural resources. Classical economists such as Ricardo emphasised
that land was fixed in quantity: the same can be said of the earth’s
mineral deposits and many of its products. The curse of diminishing
returns is that successive units of a variable composite factor of pro-
duction, usually labour-capital, when applied to a fixed factor, land,
will have a declining yield. Quite simply, the land will be exhausted
with nothing more to offer to the user. Because the environment
within which economic activity is conducted boldly displays its scarce
nature, economists have devoted much attention to resource man-
agement. Agricultural economics has long employed advanced
econometric techniques to estimate production functions. Forestry
and fishery economics have analysed the effects of depleting a
resource at different rates.
National governments have employed a variety of regulatory devi-
ces to improve the quality of the environment. Command and control
regulation lays down acceptable standards and can lead to criminal
sanctions against those in breach of them. Regulatory bodies have to
pay attention to the optimal rate of pollution, which is that rate
which equates the marginal social benefit of pollution control to the
marginal cost of pollution control. Various taxes attempt to tackle
pollution. A carbon tax can charge for the carbon content of coal,
natural gas or oil related either to the quantity charged or the value of
the fuel. The external cost of a discharge can be imposed on a private
polluter in the form of an environmental tax. There can be effluent
and emissions charges. A pollution tax is related to the marginal value
of emissions. The range of environmental or ‘green taxes’ grows.
Taxes on fuel can discourage the production of emissions. There can
also be taxes on specific activities, such as shopping with plastic bags
or filling land with rubbish.
No longer can environmental problems be regarded as a domestic
problem of a particular country. Climate change, and air and sea qual-
ity, are not problems confined within national boundaries. By interna-
tional treaty some activities can be proscribed, for example, hunting
rare species to extinction. In other cases it is recognised that some
pollution is inevitable if an industry is to continue in existence. The
tradable discharge, or emission, permit allows a particular rate of pol-
lutant discharge. If the permits are tradable then larger users can buy
the permits of the smaller, and can cope with peaks in production.
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EQUALITY
Much of environmental economics is neoclassical, founded on
the recognition that scarcity is the great economic problem, and with
a heavy use of marginal concepts. Inevitably, several branches of
economics have similar tools in their kitbags. The idea of market
failure, cost-benefit analysis and welfare economics are imported
into environmental economics. But there is also Marxian environ-
mental economics. Some Marxists object to the agenda of environ-
mental economics, as it blames environmental problems on the poor
and ignores the role of social factors such as the class system by
attempting to unite all classes to attack pollution and similar negative
aspects of production. However, by promoting an increase in material
production as a goal, Marxists have clashed with ecologists. Further-
more, the economies of Eastern Europe have had appalling records of
pollution, which are no advertisement for Marxist ideas.
Pollution can be easily measured, but other aspects of the envir-
onment are more obscure as they rest on subjective opinion, as in the
case of a pleasant view: techniques such as contingent valuation based
on opinion surveys are tried to assess the worth of this. There is a
strong normative element in much of environmental economics. It is
assumed that in the midst of competing demands for land, conserva-
tion is vital. Also the promotion of biodiversity is asserted without
question. As part of the environment is undeveloped wilderness
beloved by environmentalists, it is assumed that perpetual preserva-
tion is intrinsically worthwhile. Growth of extractive and manu-
facturing industries will always be criticised for environmental
reasons. However, a relative of environmental economics, ecological
economics, which looks at the relationship between ecological sys-
tems and human activity, has a heavy scientific content, especially
physics and biology.
Environmental economists have long been on a collision course
with economic growth enthusiasts. Low sustainable growth is the
hope of the former; increasing the supply of inputs and their pro-
ductivities the desire of the latter.
See also: exhaustible resources
Further reading: Hay 2002; Ma¨ler 1974; Tietenberg 1994
EQUALITY
Having the same size of income or wealth.
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EQUALITY
What is equalised varies from one advocate of egalitarianism to
another. It can be equality of income, of wealth, of primary goods, of
basic capabilities, of resources, or of access to the means of produc-
tion. Inequality can take various forms. In the case of income
inequality there is inequality between different groups in the labour
market, between the recipients of income from labour and from
other factors of production, and between those at work and those in
receipt of various welfare benefits. To indicate the amount of
inequality, Lorenz curves plotting the distribution of income against
the standard of a 45 degree line of absolute equality and the asso-
ciated Gini coefficient measure, the ratio of the area between the
curve and the 45 degree line and of the area of the triangle under the
45 degree line, are used. Also it is usual to examine the median,
quartile, deciles and percentiles of an income distribution to see how
wide income differences are. One measure of inequality is the ratio of
the levels of income at the upper and lower quartiles.
A popular distinction is between equality of opportunity (having
the same access to education and employment) and equality of out-
come (the same achievement of income). The distinction is spurious
as opportunity is often the consequence of the endowments of par-
ents. Those who believe that there is a separate concept of equality of
opportunity will promote positive discrimination to help the worse
off. The cost of such policies can be greater government interference
and a lack of incentives. Formal equality means equal treatment,
judging persons without taking into account characteristics such as
gender and race. Substantive equality requires persons receiving
similar amounts of income and wealth. To ‘correct’ an income dis-
tribution requires the arbitrary assignment of weights to members of
a population so that their shares of total income increases.
The advocacy of equality has always been linked to that of justice.
That human beings born with the same basic needs should be treated
differently has long been challenged. Also at every stage of life the
allocation of more resources and more income to one person or class
rather than another has been questioned. The existence of blatant
inequalities has stirred up political revolutions, including the French
Revolution of 1789, to address perceived economic injustice. Issues
of equity in distribution are raised because of persistent attitudes and
prejudices. However, equality and equity have to be distinguished.
Aristotle’s distinction in the Nicomachean Ethics between commutative
and distributive justice is a contrast between treating persons equally and
recognising inequalities by rewarding in proportion, which is a more
subjective exercise. Income from work is seen to be more justifiable
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EQUALITY
than income from capital and property. It is feared that large dis-
parities in income will occasion unrest and can lead to crime. If a
society has some with very large incomes then pointless luxurious
consumption is possible: there could even be crowding out of the
production of necessities for the poor. A maldistribution in income
can also be caused by discrimination against particular despised
groups. Also there can be disproportionate incomes because of
criminal or sharp practices.
Without sufficient income to support families a society will disin-
tegrate. The labour market is not performing the useful function of
providing a reasonable livelihood for all employed workers. The
persistence of poor pay can affect productivity and slow down eco-
nomic growth. Economics writers have argued that greater equality is
a benefit to society and that inequality is a loss. Bentham and others
argued that because of the diminishing utility of wealth, total hap-
piness would be increased by redistributing a unit of income or
wealth from the rich to the poor, conveniently ignoring the difficul-
ties of making interpersonal comparisons of utility.
To advocate inequality of incomes is to say that a differentiation of
incomes creates economic incentives. Rarely has a labour market
functioned without wage differentials. Even in the USSR occupa-
tional wage differentials were necessary in order to encourage persons
to train for the more difficult occupations and to accept greater
responsibility. Inequality is a spur which encourages demand for
training and hard work to get to the top. This prospect of social
mobility becomes the key to economic growth, as Smith recognised
in describing the desire for betterment. If one believes in life as a
Darwinian struggle to eliminate the unfit, income differences are
accepted. Also there are some high incomes, such as those of singers
and footballers, which are widely accepted without criticism.
Through inequality there can be some high incomes providing the
opportunity to finance the arts and be philanthropic, rather than
delegate such concerns to the state.
To reconcile equality and efficiency, which leads to a few becoming
very rich, Okun proposed removing some social goods, such as income
distribution, from the market. He uses the parable of a ‘leaky bucket’
to allow 1 per cent of redistributed income to leak away as waste.
Improved communications and the faster pictorial transmission of
news have increased awareness of the huge differences in incomes and
living standards between different parts of the world. Where there is
rampant disease and high infant mortality rates, a call for greater
equality between countries has been demanded; ending world poverty
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EQUILIBRIUM
has become a marching cry. Inequality can be addressed by granting
poor countries more access to developing countries’ markets or by
economic aid. The pursuit of equality is always easier when there is
economic growth, because greater equality can be effected by letting
lower income groups grow at a faster rate. In a static economy, to
seek equality is painful as it means making some people worse off.
See also: aid; discrimination; Rawlsian justice
Further reading: Bronfenbrenner 1973; Charvet 1981; Green 1981; Okun
1974; Pen 1971; Tawney 1964
EQUILIBRIUM
A state of rest with no further movement in a market to change
prices or the quantities demanded and supplied. In a traditional
society using custom and the same technology for long periods, an
equilibrium can persist for a long time. In modern societies an equi-
librium will be more temporary.
The notion of equilibrium is longstanding in economics. In the
mercantilist period, Steuart in his Principles of Political Economy dis-
cussed many balances in the economy, some of which would be ‘in
equilibrio’. Smith discussed the ‘tendency towards equality’ brought
about in, for example, local labour markets, when workers responded
to differences in wages and moved from low- to high-wage employ-
ment, driving wages down and making them more equal. In classical
economics, heavily reliant on Newtonian mechanics and Le Chate-
lier’s principle, a movement towards equilibrium was assumed but not
always regarded as achievable.
In the last quarter of the nineteenth century an important distinc-
tion arose between general equilibrium and partial equilibrium.
Walras presented the conditions for there being a general equili-
brium, a state of a national economy wherein all markets have
demand equal to supply. If there are n goods exchanged then there
will be one price for an exchange of two goods, so nÀ1 for goods in
general based on nÀ1 separate equations. At one level a general
equilibrium appears an ideal of harmony. To explain the establish-
ment of an equilibrium of this kind requires the study of a vast
number of price and output changes in a large national economy.
Marshall was the pioneer of much of partial equilibrium analysis.
Using the established idea of ceteris paribus (other things being equal),
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EQUILIBRIUM
he was able to examine the relationship between two variables,
especially a price and a quantity demanded or supplied, assuming that
anything which could influence that relationship would be unchan-
ged and hence not influential. He regarded ‘a bit at a time’ method as
a way of making economic analysis manageable. Neoclassical eco-
nomics, which is dominated by the idea of an equilibrium, is con-
cerned with whether there are unique or multiple equilibria, as well
as whether an equilibrium exists. There can be a temporary equili-
brium over, say, a week, or an equilibrium over time. An equilibrium
can be stationary, persisting for a long period if the forces governing
demand and supply are stable, as happens in traditional societies with
no technical progress. No change is expected and none occurs. An
equilibrium can be static or dynamic. If static, the notion of time is
excluded; if dynamic, movement on an equilibrium path is con-
sidered.
With the rise of modern macroeconomics in the 1930s under
Keynes and others, the equilibrium between aggregate demand and
aggregate supply was investigated. As with microeconomic analysis,
in macroeconomics ‘scissors diagrams’ showing an equilibrium at the
intersection of the demand and supply curves expounded this idea.
If seeking an equilibrium is regarded as important then the route to
that goal has to be explained. There is an initial choice between price
adjustments and quantity adjustments. Prices can be moved up and
down until the equilibrium price which will clear the market is
achieved. Quantities can be altered by changes in the rate of pro-
duction and in the use of accumulated stocks until there is neither
excess demand nor excess supply. Reaching an equilibrium is not
always achievable, as the cobweb theorem shows. Some markets
remain in disequilibrium for a long time because of price rigidities.
Much of the notion of equilibrium is associated with markets but
there can be an equilibrium idea employed in central economic
planning where the planners deliberately attempt a series of material
balances. The stages of reaching or passing an equilibrium are akin to
the phases of an economic cycle. A shock can set a market or econ-
omy on a disequilibrium path until forces, including income changes,
bring it back to equilibrium.
An equilibrium is a desired state of affairs, so that without eco-
nomic agents revealing their preferences and desires a judgement
cannot be made. What might appear to be disequilibrium because of
the presence of unsold stocks can reflect the desire of the supplier to
have temporary or permanent excess capacity so that there is a higher
chance of being able to satisfy customers at any time.
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ETHICS AND ECONOMICS
In game theory, a strategic equilibrium can take a multitude of
forms. In the case of the Nash equilibrium, central to game theory,
two or more players in a game cannot benefit by changing their strate-
gies. A Bayesian equilibrium, recognising there is incomplete infor-
mation, is the consequence of a game in which the players consider
expected utilities based on private information concerning the char-
acteristics of the players. A sunspot equilibrium is an allocation of
resources dependent on an extrinsic random economic variable.
As an equilibrium is a balance between different forces or entities,
the term can be applied broadly to cases of a general or market
equilibrium. Writers as early as the mercantilists were concerned with
the balance between nations, their relative strength, especially as
measured by their balances of trade or payments. An internal balance
of a country is distinguishable from its external balance with the rest
of the world. The internal, according to Meade, has to take into
account employment, inflation and wages; the external considers the
balance of payments and related international variables such as
foreign exchange rates.
See also: cobweb, disequilibrium economics; neoclassical economics;
new classical economics
Further reading: Meade 1951; Weintraub 1974
ETHICS AND ECONOMICS
The relationship between standards of conduct and economic principles.
Hausman and McPherson (1993: 673) argue a fourfold case for
economists attending to moral questions:
1 The morality of economic agents influences their behavior
and hence influences economic outcomes. Moreover, econo-
mists’ own moral views may influence the morality and the
behavior of others in both intended and unintended ways.
Because economists are interested in the outcome, they must
be interested in morality.
2 Standard welfare economics rests on strong and contestable
moral presuppositions. To assess and to develop welfare eco-
nomics thus requires attention to morality.
3 The conclusions of economics must be linked to the moral com-
mitments that drive public policy. To understand how economics
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ETHICS AND ECONOMICS
bears on policy thus requires that one understand these moral
commitments, which in turn requires attention to morality.
4 Positive and normative economics are frequently intermingled.
To understand the moral relevance of positive economics
requires an understanding of the moral principles that deter-
mine this relevance.
Much of economics grew out of moral philosophy so it cannot be
easily dismissed as an immoral or amoral science. Aristotle, Smith and
JS Mill were both interested in well-being and in economic issues. In
British universities the teaching of economics often sprang out of
moral philosophy, for example, at Edinburgh and Cambridge. Lead-
ing economists such as WS Jevons and Alfred Marshall were partially
motivated to study economics because the poverty question of their
day raised issues of conscience for economists. Marshall, in his inau-
gural lecture in 1885 at Cambridge, declared that his aim as professor
was to send out graduates with cool heads but warm hearts.
Much of the strident criticism of economics as a dismal, or possibly
wicked science, springs from economic theories which assume that
economic agents are self-interested. In the eighteenth century eco-
nomic theory, especially in Smith’s The Wealth of Nations, made self-
interest central and provoked ill-informed criticism because of self-
interest being confused with selfishness. David Hume separated
questions of fact from those of value in his is/ought distinction,
giving rise to the familiar separation of positive from normative
economics. Unfortunate consequences were that much of formal
economics was perceived as valueless and that policy recommenda-
tions were founded on an unexamined moral philosophy.
In economics there is a distinction between the behaviour of the
individual person and of collective entities, especially firms and gov-
ernments. If morality is about altruism then it can formulate rules for
all of these acting as economic agents. An individual as consumer,
saver or worker is faced with choices which can lead to goodness or
badness. Firms are crucial economic agents in the allocation of
resources. Through their production and investment decisions, present
and future possibilities for living are determined. Also they have a
major effect on income distribution through their wage and salary
policies. A government in its fiscal, trade and investment policies is
responsible for the ultimate incidence of the measures it enacts.
There are many theories of ethics and hence many interfaces
between ethics and economics. Ethical theories include utilitarianism
and intuitionism. Contractarians also enter the debate between ethics
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EVOLUTIONARY ECONOMICS
and economics. A moral position is argued from an alleged founda-
tional contract which establishes rights: a familiar case of this approach
is Rawlsian justice. Earlier exponents of a contractarian view included
Hobbes and Rousseau. By adopting such a position, a way of dealing
with income inequality and deprivation is established. Also, commu-
nitarianism aims to emphasise the social and collective rather than the
individual. Social capital is regarded more highly than the free working
of markets to achieve welfare goals.
In many branches of economics ethical issues are raised. Questions
of fairness are raised in discussions of income distribution, interna-
tional trade, competition and allocation of scarce resources. Also
there is the established concept of exploitation. Marx associated it with
the extraction of surplus value. Furthermore, in the study of monopoly
exploitation springs from prices being in excess of marginal cost and
thereby producing supernormal profits. Firms, governments and
individual persons are all capable of exploiting each other.
As economics has become more technical it seems less obvious that
it is engaged in ethical matters. Like engineering, it shows the effects
of changes in a system, not stating whether the consequences are
good or bad. To say, for example, that market prices tend to rise
when there is a shortage of supply is merely a statement of fact.
Whately stated that the object of political economy is a study of the
nature, production and distribution of wealth, unconnected to hap-
piness and virtue. He used the example of a treatise on shipbuilding
which would be about construction and management, not the utility
of a ship. This approach in effect is an assertion that economics is
ultimately positive economics. In neoclassical economics the dis-
cipline becomes the use of a method and little more. Samuelson
(1948: 75) precisely stated: ‘The primary end of economic analysis is
to explain a position of minimum (or maximum) where it does not
pay to make a finite movement in any direction.’
See also: happiness; homo economicus; utility; welfare economics
Further reading: Hausman and McPherson 1993; Little 2002; Samuelson 1948;
Sen 1989; Whately 1847
EVOLUTIONARY ECONOMICS
An application of the ideas of biological evolution to economic pro-
blems; a type of game theory; a dynamic approach to economics.
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EVOLUTIONARY ECONOMICS
The theme of long-term economic change was central to classical
economics. Both Smith and Marx were keen to apply the stages
theory of human populations becoming more technologically
sophisticated as they progressed from hunting to shepherding to
agriculture to commerce and manufacturing. A central question was
whether such change would lead to the no-growth situation of the
stationary state. Ideas of evolution propounded by Herbert Spencer
and Charles Darwin inspired economists in their analyses of the pro-
cesses of economic change. The ideas of the survival of the fittest and
the natural selection of species had their economic applications.
Marshall used biological analogies to discuss the long-term aspects of
economic problems after the short-term problems had been analysed
in mechanical equilibrium terms. He introduced the idea of ‘the
representative firm’ as an average firm which survived using the
analogy of trees in the forest.
Schumpeter, in his analysis of capitalism, outlined how capitalism
was evolving into corporate capitalism. In his consideration of eco-
nomic growth he viewed the entrepreneur as the agent of change
and innovation engaged in a process of creative destruction. Through
the process of discovering new ideas and innovating, the economy
would move from one macroeconomic equilibrium to another.
These processes are largely endogenous.
Boulding described the process of social evolution as a human
understanding of patterns which is transmitted as the knowledge to
produce something. Production is thus based on a biological process
which is systems of threats, exchange and integration.
Evolutionary theory can be applied to the more micro levels of
the industry and the firm. Nelson and Winter use micro-level evo-
lution to create a theory of the firm which attacks the equilibrium
approach of the neoclassical economists. In the first stage firms
behave according to routines in their pricing, production and
investment; then in the next stage there is a search for methods of
production; and finally in the third stage there is a process of selec-
tion in which the less profitable firms disappear. In a competitive
struggle using imitation and innovation, the industrial structure
emerges. Alchian uses a biological evolutionary approach to his
theory of the firm, showing that firms survive through superior
ability or fortuitous circumstance. Imitation and trial-and-error are
crucial.
Evolutionary game theory shows how, in a process of learning, the
fittest who win in one game go on to further games. This is a move
away from the study of super-rational individuals. It is dynamic,
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EX-ANTE, EX-POST
including in the modelling the learning which comes from observing
one’s opponents. Non-cooperation is assumed to explain the devel-
opment of markets, money, the price mechanism and other economic
institutions.
Further reading: Alchian 1950; Boulding 1978; Hodgson 1993; Loasby 1991;
Nelson and Winter 1982; Schumpeter 1954; Weibull 1995
EX-ANTE, EX-POST
A distinction between the planned and actual values of economic
variables.
In the macroeconomic debates of the 1930s in Sweden careful
attention was paid to this contrast. Gunnar Myrdal in his Monetary
Equilibrium described the contrast in detail. Ex-ante calculus is a
question of anticipations, calculations and plans driving the dynamic
process forward; ex-post is an overall bookkeeping balance. With this
conceptual tool he then asserted that in monetary theory it is neces-
sary to explain how a disparity between savings and investment ex-
ante becomes a balance ex-post. The Stockholm School used a
period analysis to show how savings would grow to equal invest-
ment expenditures which were larger at the planning stage. The
initial investment generates increased incomes. Out of each round of
increased income, savings will occur which accumulate to equal the
investment. Expectations, interest rates and prices will change
through the movement to an ex-post equilibrium.
EXCHANGE RATE
The price of one currency in terms of another.
These rates can be ‘nominal’, i.e. the trading prices in ‘forex’,
(foreign exchange) markets, or ‘real’ because the nominal rate has
been adjusted for inflation. They can be entirely market determined
or can be managed by banks, which make appropriate sales and pur-
chases in currency markets to maintain the currency at the desired
rate. Rates can be fixed, a ‘pegged rate’, as under the Bretton Woods
system 1944–71, or float with changes in the market, or a ‘dirty float’
in which a central bank interferes from time to time. Countries can
use the currency of another, for example, the US dollar, thus having
no control over their exchange rates.
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EXHAUSTIBLE RESOURCES
The exchange rate is the most important price of a national
economy, as it reflects the relationship between that country and the
rest of the world. A country with an exchange rate which is too high
will find it difficult to sell its exports, thus risking a balance of trade
deficit and provoking speculative attacks on the currency.
Purchasing power parity is an equilibrium exchange rate which
will purchase the same amount of goods and services in each country.
This approach, associated with Gustav Cassel, is widely employed to
compare living standards across the world. It suffers from the fact that
not all of the production of a country enters into international trade
and there are non-market determinants of exchange rates.
See also: currency
Further reading: Taylor 1995
EXHAUSTIBLE RESOURCES
The fixed amount of some non-renewable resources such as minerals;
features of the landscape giving rise to the formulation of rules for
their exploitation.
This is a major aspect of environmental economics, sharing the
principal concern that resources are fixed in amount so need to be
protected and conserved. There can be a complete ban on their use
or an orderly depletion of them to satisfy the demand for oil or some
other mineral, either as a consequence of taxation discouraging
excessive use or regulation overseeing the rate of depletion. Another
response to natural resources scarcity is to advocate recycling, but
that in turn is a poor attempt at a solution, as recycling needs much
energy for transportation and processing.
Hotelling discussed in a foundational article the optimum rate of
present production of such resources, given that we would not want
to conserve all of the fixed stock of such assets for posterity, con-
trasting extraction under free competition and monopoly. He viewed
the problem as one of profit maximisation, and formulated the rule
that prices of such resources should rise exponentially at a rate equal
to the interest rate. He treated such resources as similar to financial
assets.
The fixed nature of such resources has led some ecologists to cri-
ticise severely the promotion of economic growth. Understandable
as this is, it does ignore the fact that an element in economic growth
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EXPECTATIONS
is usually technical progress, which can include methods which
economise on material inputs.
Information deficiencies abound. The extent of a mineral reserve
may be unknown until further geological research, which in turn may
wait until price rises make exploration financially viable. Prohibition can
excite unscrupulous people to seek out the protected species or nat-
ural feature because of its scarcity and hence high black market price.
As non-renewable resources are depleted there is a diminution in
national wealth. Just as income is a net addition to wealth and
depletion a subtraction, so both should be recognised in interpreta-
tions of national income accounts.
Exhaustible resources are often owned by monopolies, public or
private. They benefit from a fixed supply, in this case natural, not the
consequence of contrived artificial barriers to entry. Monopoly status
runs the danger of leading to inefficiencies. As it is costly to sink
mines, or engage in other infrastructure projects to extract these
finite resources, in less developed countries foreign multinationals are
often engaged in extraction, thus leading to disputes about the aims
of national governments and private corporations.
See also: environmental economics
Further reading: Hotelling 1931; Krautkraemer 1998
EXPECTATIONS
Estimates or views about the future which drive investment and
other economic activities forward.
Economic actions are undertaken for their future effects. This is
especially so in the case of investment. Some view of the likely
income from creating physical capital is needed. Possible consumer
preferences and incomes, government policies and the state of the
world all have to be taken into account. In financial markets, views
on the future course of prices are crucial to portfolio adjustment.
Some kind of qualification or weighting is needed for the data accu-
mulated to date.
The simplest assumption is that the future will be the same as the
past, not an unreasonable opinion in the case of a static society with
no technical progress and at peace with its neighbours. Today’s world
is more turbulent, with information technology showing how rapid is
change. Industrial structures are repeatedly altered by mergers and
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EXPECTATIONS
other acquisitions. War is a commonplace in many parts of the world.
Hence simple extrapolation is useless.
An expectation can be single-valued or multi-valued, as one can
expect a precise outcome of definite proportions or a range of pos-
sibilities which might conform to a probability distribution. If
expectations concern many aspects of a future state, then weights are
added to establish the more likely predictions.
Irving Fisher, a leading American economist, had a practical atti-
tude towards expectations, introducing the idea of ‘adaptive expecta-
tions’ which are based on past data extrapolated into the future,
taking into account the margin of error, hence its alternative name of
the ‘error learning hypothesis’. Previously na¨ıve or static expectations
excluded random shocks. The cobweb was an early example of this.
This approach to forecasting does depend for its efficacy on con-
siderable economic stability. Cagan and Friedman used this approach
to expectations in their study of inflation.
Keynes wrote much on expectations. In his General Theory he
noted that entrepreneurs and investors have to take a view on what
consumers are willing to pay. Short-term expectations, he asserted,
were concerned with the cost of output and sales proceeds from
using existing capital equipment; long-term expectations concern
future incomes if investment is undertaken. Expectations will thus
determine output and eventually employment. Past expectations now
embodied in capital equipment are also taken into account. In the
long term, expectations of prospective yields will partly be based on
present facts about the capital stock and consumer demand, and
partly on the future course of capital investment, tastes and effective
demand.
Shackle, in his analysis of Keynes’ views on expectations, pointed
out that when we make decisions based on our views of the future
we can be surprised by news so that we can discern little about the
future. Some of our expectations will be fairly certain, others classi-
fiable as potential surprises. Our expectations are subjective and
cannot be fully rational, as we can only make guesses about the future
decisions which will determine future events.
Myrdal, in his exposition of ex-ante and ex-post values of eco-
nomic variables, regarded the ex-ante as containing expectations
which drove forward economic activity.
Recently rational expectations has become the most discussed
type of expectations. Muth started this precise and limited view of
expectations. He argued that expectations depend on the whole state
of a national economy and no information being wasted. It is
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EXPERIMENTAL ECONOMICS
assumed that individuals do not make mistakes in forecasting the
future. All relevant information has been acquired and all profitable
opportunities exploited. The outcome in terms of the future value of
an economic variable is not systematically different from a market
equilibrium. Expectations are not always accurate but errors will have
specific properties. This attitude to expectations is used to explain
why market speculators only benefit if there is new information.
Rational expectations theory was used to attack the discretionary
demand management policies of the 1950s in the USA and the UK,
through its conclusion that people would anticipate policy changes
and adjust their economic behaviour appropriately. Pesaran raised
many doubts about the rational expectations hypothesis and testing it.
He argued that the more is known by economic agents about the
future values of economic variables, the lower the probability of the
econometrician knowing the underlying mechanism of agents’ deci-
sion making. Ignorance of the time lags in economic relations would
make it more difficult to model rational expectations. Thus, he
argues, there is a case for regarding the formation of expectations as
lying between pure adaptive and full rational expectations models.
Davidson argued that agents, if sensible, would reject information
when forming expectations on the basis of probability.
Behavioural economics provides a different view of expectations,
by taking insights from psychology on cognitive dissonance and
regret to show that the status quo is preferred. It is a less precise
and technical notion of expectations than adaptive or rational
expectations.
Further reading: Cagan 1956; Evans and Honkapohja 2001; Muth 1961;
Shackle 1949, 1973; Pesaran 1987; Davidson 1982/83
EXPERIMENTAL ECONOMICS
Attempts to test economic theory by simulating real life economic
decision making.
This tries to overcome the central problem of the social sciences,
namely that, unlike the physical sciences, it is impossible to repeat
experiments in every detail. Economic events occur at points in time
so are all unique. Economic agents change, availability of resources
alters, knowledge and technology advance. This means that any
simulated experiments ideally concern static equilibrium problems
which ignore time. The essence of partial equilibrium analysis is to
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EXTERNALITY
examine the relationship between two variables with the rest of the
world controlled by the ceteris paribus (other things being equal)
assumption. Other assumptions have to be made about the rationality
of economic choice.
Wage negotiations, purchasing goods and services and investing are
all suitable subjects for economic experiments. In some experiments
volunteers are presented with a sum of money, then told prices of
various goods to see how they will distribute their purchases. In a
wage negotiation problem the financial realities of an employer and
other relevant information will be presented to the two sides.
Experimental game theory is the most sophisticated of experi-
mental approaches to economics. Experiments are used to provide an
empirical basis for principles of strategic behaviour. Bargaining games
with two or three persons have looked at the nature of discounting.
Rewards in these games will depend on the payoffs. Deviations from
a sub-game perfect equilibrium can be detected.
See also: evolutionary economics
Further reading: Castro and Weingarten 1970; Fontaine and Leonard 2005;
O’Neill 1987; Smith 1989
EXTERNALITY
The third party consequence of economic actions, which can be
costly or beneficial.
All transactions between buyers and sellers, between producers and
consumers, and between employers and workers can affect wider
society. An externality can also be described as a spill-over or neigh-
bourhood effect. The early modern analysts of externalities were the
Cambridge economist Pigou, with his contrast between private and
social dimensions to economic variables, and the Chicago economist
Coase, who continued with the analysis of pollution.
The ‘external’ has various contrasts dependent on which economic
entity is compared with the outside. The individual is compared with
society at large. What occurs internally within a firm, especially
production, is compared with its impact on other firms in that or
other industries. The bulk of economic activity occurs within coun-
tries, but has an impact on other countries and internationally
through organisations such as the World Bank and the International
Monetary Fund. However, the most popular use of ‘externality’ is in
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EXTERNALITY
the microeconomic sense of what effect a household or a firm has
upon others for good or ill. An externality is the context of a parti-
cular economic activity formed by it. An externality can be some-
thing specific such as an injury to a particular person, or more
generally, a phenomenon or state of affairs such as pollution or a low
level of crime.
The most popular use of ‘externality’ in environmental matters is
the wider physical consequences of the behaviour of persons and
firms. The separation of private from social costs and benefits allows
an externality to be viewed as a social matter. An external cost in
microeconomics is often regarded as waste or inefficiency.
Given the objection to externalities that the sufferers are not
compensated for damage and loss caused by others, ways of making
the polluter or other perpetrator pay are proposed. By changing a
social cost to a private cost, the process of ‘internalising the extern-
ality’ occurs. A firm pouring waste into a river can be ordered to
clean up the waterway: this internalises the social cost to the firm.
Pigou pioneered the idea of taxation to discourage firms, especially
polluters, producing negative externalities.
Meade, in looking at the external economies or diseconomies,
distinguished the external as an unpaid factor of production, and as
the creation of an atmosphere. The first is illustrated by the case of an
apple grower who by increasing apple production also increases the
output of honey. There is an unpaid factor because the apple farmer
cannot charge the beekeeper. The atmosphere is a fixed condition of
production, such as the rainfall of an area.
Because externalities work through different mechanisms they are
tackled in different ways. They can affect prices, the quality of pro-
duction, the exercise of property rights, and the scope for other
economic activity. If an externality leads to a complaint, either
through causing damage or conferring benefits others do not pay for,
there is the principal choice between finding a remedy through a
private action in the law courts or resorting to a regulatory body, if it
exists. Where the social costs of private activities are severe, for
example having coal fires in houses, the tackling of the externality
can be achieved by regulation even to the extent of an outright
prohibition.
Externalities can be beneficial. This was recognised by Marshall in
his distinction between internal and external economies. Suppose a firm
finds others of the same industry taking up location nearby, their growth
will benefit the original firm, for example, through joint research,
training of the labour force and enhanced lobbying ability to persuade
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EXTERNALITY
government to improve the infrastructure. Actions which have ben-
eficial side effects give rise to the free rider problem. A popular
example is in wage bargaining, where through the actions of a trade
union a pay increase is obtained which is applied to all the members of
that bargaining unit whether or not they are members of the union.
Examples of negative externalities invariably use the case of two
parties to an exchange mutually gaining something of worth but the
rest of the community not. However, a government can cause nega-
tive externalities, especially in its taxation and expenditure policies.
A particular industry can be subsidised, perhaps for the worthy reason
of avoiding localised unemployment, but the subsidy has to be
financed, thus imposing a reduction in post-tax income of taxpayers
who are not in the favoured industry.
It can be difficult to make the concept of externality operational, as
the effects can be long-term or so dispersed as to be not easily dis-
cernible. If land is not properly valued then the cost of pollution is
unknown. Where simple general principles of measurement do not
apply, a piecemeal approach has to be adopted, often by law courts
experienced through the use of precedent to ascertain how severe a
tort is.
The existence of externalities gives rise to policy responses. Gov-
ernments can tax external costs and subsidise those with the potential
to create external benefits. The goal of such fiscal policies is ‘to
internalise an externality’, which amounts to changing the status and
incidence of something from social to private. There are limits to this
process, including the difficulties in identifying the creator of an
externality, and also the capacity of the perpetrator to pay for what
can be colossal and widespread damage. In the absence of a govern-
ment policy to cope with a particular type of externality, the bene-
ficiaries of and sufferers from externalities have to resort to a
settlement under the law of tort.
Externalities arise because of interdependences. Households, firms,
governments and the physical environment are constantly interacting
to their mutual advantage or loss. This is more general than a causal
process. The utility I gain is related to other persons’ utilities.
Therefore for a full analysis of externalities a general equilibrium
approach must be attempted.
See also: Coase theorem; environmental economics
Further reading: Cornes and Sandler 1986; Meade 1952; Papandreou 1994
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FAMILY, ECONOMICS OF
FAMILY, ECONOMICS OF
The study of the consequences of the existence and behaviour of the
family.
As a major social institution the family requires the attention of the
economist. So much of economics has been about the individual that
this branch of the subject can examine the behaviour within and
between such collective entities. It shares with the firm its potential
for production and also, like the national economy, is a network
of consumption and production activities organised according to
principles which vary from a central dictatorship to considerable
democracy.
There are reasons both social and economic for the formation,
expansion and dissolution of families. The traditional family of par-
ents and children has been superseded by a variety of groups, not
always with children, who have the principal characteristic of residing
together, or otherwise being bound together by obligations towards
each other. There are economic advantages which create families.
Individuals find it difficult to be self-sufficient, sometimes almost
impossible in the case of a person with several dependants. Compa-
nionship also makes a family attractive. A brotherhood or sisterhood
based on following a religion or another philosophy of life will also
constitute a family. One of the advantages of family life is gaining
economies of scale by joint production of the means of life. Also
families become an important joint protection against attack. Expan-
sion of a family can be by childbirth or by an invitation to outsiders
to join. The diminution or dissolution of families occurs when family
members choose to set up new families or find the economic and
psychic costs of living with a particular set of persons intolerable. A
major reason for family shrinkage is divorce, which can occur
through incompatibility or bad behaviour.
The principal economic activity of a family is sustaining its exis-
tence. It can attempt to be self-sufficient or can place some of its
members in the labour market. Any labour force participation by
one member of a family has consequences for the rest. It can be a
substitute for others’ participation or the consequence of one
member stimulating the others to work. As there is the possibility of
home production, there is always the choice of staying at home or
going into the labour market. The family is also engaged in produ-
cing a surplus, which means producing within and without the
family to achieve a total output greater than the family’s consump-
tion. Saving will be motivated by having a reserve to meet emer-
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FIRM
gencies, the wish to help descendants and to accumulate sufficient
capital to obtain non-employment income.
Becker dominates the economics of the family through applying
many tools of neoclassical economics to the subject. In A Treatise
on the Family he analyses different types of family and single-person
households. With the building block of maximising within a family
individual utility, family income and gains from non-market activ-
ities, he describes the allocation of roles among family members
according to their comparative advantage. He also recognises that
altruism has a role. His account is a broad enough essay in demo-
graphics to include the efficiency of the marriage market, with per-
sons of similar quality mating, and the determinants of fertility,
including the reasons for investing in children and the costs of doing
so. The theory is ambitious in applying to any stage of economic
development and in translating the theory used for larger markets to
so small a microcosm as the family.
See also: altruism; household behaviour
Further reading: Becker 1981
FIRM
A unit within an industry which produces goods and services.
Economics has paid much attention to the consequences of the
organisation of firms and the motivation of their owners and man-
agers. The simplest case is that of the sole trader who owns and
manages a productive enterprise able to select as her goals from profit
maximisation to maintaining a satisfactory level of profit and market
share as their goals. A partnership with joint ownership of capital has
to reach a consensus among the owners. A company or corporation is
more complicated, as hired managers are often employed who can
have different aims and practices from the ultimate owners.
A firm operates within an industry and a market which can be
structured in different ways, the extreme case being monopoly with
the firm being coterminous with the market or industry. The
market structure determines the extent of freedom of the firm.
Competition will severely limit a firm’s pricing decisions and mar-
keting strategy. The relative size of firms, and their absolute size, will
have an effect on their power over customers and even national
governments.
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FIRM
Firms grow at different rates, partly as a consequence of the growth
of demand for their products and partly through their ability to raise
finance to become larger organisations. There is a choice between
internal expansion or external expansion through mergers and
acquisitions. The latter will often be chosen because a faster rate of
growth can be achieved and because there is no other way of gaining
access to scarce managerial and other skills. Also it is easier to join
together firms with established markets than expand an existing firm
into an uncertain new market. Any limit to their growth is likely to
depend on the ability to avoid managerial diseconomies of scale and
the strictures of competition policy.
Firms can be organised internally according to different patterns.
Patterns of activity such as production, marketing, research and
finance are often used, but there can also be a greater integration of
functions and a division of activity largely according to location of
the parts of the firm. Whether a firm is one shape or another
depends on management responses to likely productivity and costs.
Four types of firm have been identified. The M-firm is multi-
divisional, with operating divisions separated from decision making.
The H-firm is the holding company with the parent company
engaged in evaluating the performance of subsidiaries. The X-firm is
a hybrid mixture of H- and M-firms. The U-firm divides a firm
according to the main functions and is more suited to smaller than
larger firms, as in the latter the cost of communications between
divisions could be great.
Coase asked the fundamental question: what is a firm? He noted that
within the firm it is management by order, not the price mechanism,
which allocates resources. Within the firm there is vertical integration
of the different stages of production. When many of the activities of
an external market are absorbed within a firm by managerial direc-
tion, costs are saved, especially those of contracting. Taxation in a
market, such as a sales tax, will be avoided if exchanges occur within
firms. There will be a limit to the size of the firm set by the marginal
costs of operating within a firm as opposed to in the external market.
Coase also considers the nature of the employment relationship rather
than the less intimate principal-agent connection. A firm can also be
seen as a production function transforming inputs into outputs, as a
legal entity, or a capability based on accumulated knowledge.
See also: competition and monopoly
Further reading: Coase 1937; Cohen 1975
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FISCAL FEDERALISM
FISCAL POLICY
The financing of a government which functions at different levels, for
example, national, state and city.
At each level there is a different capacity for making expenditure
decisions, varying abilities to raise taxes and different claims, and to
receive grants from other levels of government. The neatest form of
fiscal federalism is where each level of government has specific func-
tions and finances them itself from its own tax base. A scheme could
be that the national government is responsible for defence, social
security, foreign affairs and health, and receives the revenue from an
income tax to pay for them. At the state level there could be
responsibility for transport and industrial policy, with a corporation
tax to finance this. At the city level, police and education are pro-
vided and financed by a sales tax.
Fiscal federalism becomes complicated when a level of government
has too small an exclusive revenue to execute its functions: it then has
to be in receipt of grants as well as its particular tax revenue. The
problems of fiscal federalism remain as long as lower levels of gov-
ernment have some measure of autonomy. It is argued that some
activities, such as road maintenance and education, are best run by
local government but if a central government demands adherence to
national standards and gives grants to ensure compliance, the multi-
layered structure of the state will inevitably be questioned.
Further reading: Hughes 1987; Oates 1991
FISCAL POLICY
The stance of government in its spending and taxing policy. Asso-
ciated with this policy is debt policy, the consequence of not raising
enough revenue over time so that a government has to borrow.
As virtually all governments need tax revenues to finance what
they choose as their functions, they have to make many fiscal deci-
sions. There is the issue of the total tax burden – what proportion of
national income a government wants to tax – either a low amount to
encourage enterprise or a high amount to achieve a large welfare
programme including income redistribution. Also it has to be deci-
ded what type of tax to use to raise revenue. The choice between
raising revenue through direct, mainly income, taxes and indirect
taxes on sales, goods and value-added will have crucial consequences
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for how much people work and spend their incomes. A fiscal policy
will be neutral if it does not affect the consumption of one group
more than another.
Fiscal policy will be different in times of war and peace. The task
of financing armed forces and their equipment is so large during a
war that there is a temptation to accumulate debt rather than pay for
the increased expenditure through an equal amount of tax revenue.
In times of peace the scope for pursuing social goals through fiscal
policy will be limited if much has to be spent on servicing govern-
ment debt. Fiscal policy in peacetime can be used to stabilise a
national economy, taxing less and spending more during a down-
turn and doing the reverse in times of prosperity to balance the public
finances over a cycle. An automatic stabiliser is a built-in feature of a
tax system in order that changes in income are dampened down; for
example, with a progressive income tax, post-tax income available for
spending will rise slower than pre-tax income. If changes in taxes do
not compensate for inflation then there will be ‘fiscal drag’.
See also: taxation
Further reading: Peacock and Shaw 1971
FIX PRICE, FLEX PRICE
The contrast in speed of adjustment of various prices.
Fixed rigid prices can affect, or even prevent, the movement of a
market to equilibrium. In Keynes’ General Theory of Employment,
Interest and Money it was assumed that money wage rates were
inflexible downwards and that there was a minimum to the rate of
interest because of the operation of the speculative demand for
money. Myrdal in Monetary Equilibrium considers the relationship
between the price stability condition for equilibrium and the degree
of flexibility of prices. In Marshall’s Principles of Economics the working
of flexi-price markets is described.
The extent of flexibility has a mixture of determinants. In the
labour market statutory provisions such as minimum wage laws and
employment contracts prevent the rapid change of wages to market
conditions. In capital markets the rate of interest has often been
regulated under usury laws. In product markets prices can be fixed
for a long time, either because of a firm’s reluctance to alienate cus-
tomers by altering prices, the cost of making catalogue changes, or
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the insistence of a government under a prices policy to change prices
only in accordance with a set formula.
Further reading: Backhouse 1980; Hicks 1965
FREEDOM
The absence of restraint; the ability to do something. These two
concepts of liberty were expounded by the philosopher Isaiah Berlin
in a book with that title.
Economic freedom, the freedom to own property, run businesses
and fix prices, is a basis of political freedom. Free enterprise is
business in the private sector operating without state ownership and
control. Without such economic independence it is impossible to
have a free press and to finance political parties. Freedom to perform
a range of actions does require resources, but if the resourceless are
provided with means by the state they are limited by state policies
and at any time could be destitute again.
Free trade means the absence of physical and financial barriers to
the movement of goods and services; a freeport operates without
such penalties too. To say that something is free is to recognise that its
price is zero. Given scarcity, nothing is ‘free’, as every use has its
opportunity cost: there is no such thing as a free lunch. A person
who does not pay for a benefit is known as a free rider, for example,
a worker who is not a member of a trade union but accepts the pay
increases negotiated by the union. Non-union labour, often used to
break strikes, is called free labour.
To a large extent, the Physiocrats in their reaction against mer-
cantilism and in their doctrine of laissez-faire, and Adam Smith in
his system of natural liberty, regarded the free economy as one which
operated with little government activity to blunt the activity of an
exchange economy.
See also: Austrian economics; libertarian economics
Further reading: Berlin 2002; Friedman and Friedman 1980; Peacock 1997
GAME THEORY
A study of decision making, including strategic behaviour, primarily
to explain microeconomic behaviour. Although used in many social
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GAME THEORY
sciences, including psephology and defence studies, it has increasingly
been employed in industrial organisation, labour and other branches
of economics.
Neumann and Morgenstern attempted to apply a mathematical
theory of games to fundamental economic problems, including
rational behaviour, social exchange, competition and utility max-
imisation. They contrasted the maximisation of an isolated person
such as Robinson Crusoe with an economy with many participants.
They set out to devise a set of rules for rational economic behaviour
suitable for all situations.
Although game theory is now conducted according to strict rules
of mathematics and logic, there are earlier discussions of making
strategic decisions presented in a literary way, as in Plato’s Symposium
and Hobbes’ Leviathan. In them is the fundamental concern of the
game theorist, the analysis of interdependent rational behaviour.
In the application of game theory to economics, the paramount
concern is the examination of rational economic agents desiring to
maximise their utility according to their preferences. Specific terms
abound to analyse games. The agents are called players. The choice
faced is between at least two strategies.
A game theorist begins with a statement of the identities of the play-
ers, their interests and the information available to them and a state-
ment of the rules. A ‘game’ can involve several persons and consist of
coalitions with rules for compensation. The gains might sum to zero
for the players so any personal gain is at the expense of another par-
ticipant, or result in an overall loss or gain. Games can be for enter-
tainment or, more seriously, for the allocation of scarce resources.
Games are broadly divided into those which are cooperative and
the more commonly non-cooperative games. Games can have perfect
information, meaning that everything that has happened in the game
to date is known to the player: if there is ignorance of the other
player, the game has imperfect information. In economics most of the
information is private to the player and unknown to the other
players, excepting in perfect competition. There can be simultaneous
move or sequential move games. The outcome of a choice to a player is
measured in units of utility and called a payoff. The payoffs to the
players can be presented in a matrix, with one player represented by
the rows and other down the columns in a two-player game. These
are normal form or strategic form games. Instead of a matrix there can be
a game tree to produce an extensive form game which shows different
choices branching out as lines from nodes. These nodes, the points
joining the lines, can be initial to represent the first action, or terminal
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GAME THEORY
for the outcome. The nodes and branches coming from a single node
are known as a sub-game. If a player takes an action but fails to exe-
cute it so the game proceeds down another path, there is a trembling
hand. If there is a single optimal course of action then there is a pure
strategy, but if several a mixed strategy. In making strategic moves the
player can influence the other by commitment, which reduces the
number of choices, threats or promises.
Economists use game theory to discover equilibria, stable states
endogenous to a system. The most common equilibrium is the
Nash equilibrium, which is a solution for zero-sum games where one
player can only gain at the expense of the other. Where there is a
non-zero game, there can be more than one Nash equilibrium. If one
of the equilibria is removed in the solution, then there is a refinement
to the Nash equilibrium. A sub-game perfect equilibrium occurs where
there is a Nash equilibrium for the whole game and all sub-games.
Nash took game theory into an important new phase in his study of
non-cooperative games. Under Nash bargaining in a two-person
game, a solution is produced in which a unique pair of utility levels is
assigned to each bargaining solution. When equilibrium is reached no
player has an incentive to depart from a chosen strategy. Nash gen-
eralised his results to include cooperative games.
Popular games have long had the same names. The most famous is
the ‘prisoners’ dilemma’, concerning whether it is better for each
prisoner to confess or not confess. By cooperating, the two prisoners
in a joint confession can maximise the outcome. Many special games
have entered the literature. In the ‘tit-for-tat’ game there is coopera-
tion in the first round but afterwards each player copies the action of
the opponent in the previous round.
An obvious application in the economics of games is the study of
pricing under the different market conditions of duopoly and oligo-
poly, where there are few players and strategy is crucial. Game theory
is also important in public policy analysis and the study of environment
systems.
Inevitably there are critics of game theory. It is noted that it is not
essentially economic in content and makes uncomfortable assump-
tions of measurable utility and crude maximising behaviour. Rubin-
stein, considering the rhetoric of game theory, questions the
applicability of the theory to devising actual strategies. The game is
affected by the nature of the payoff, a utility number being different
from an amount of money. The notion of strategy, central to game
theory, is more than a plan of action as it requires assumptions about
rivals’ plans. Nash bargaining by using numbers wrongly suggests that
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GLOBALISATION
it can generate quantitative results. Also the assumptions underlying
the idea of a solution to a game are not clear.
See also: competition and monopoly; neoclassical economics
Further reading: Binmore 1992; Kreps 1990; Neumann and Morgenstern
1947; Osborne 2004; Rubinstein 2000
GLOBALISATION
The process of integrating the world economy through the trading of
goods and services and flows of labour and capital.
As early as the time of the Roman empire 2,000 years ago, there
was an extensive network of trade. The pace of globalisation
increased in the nineteenth century through improvements in trans-
port. With the expansion of multinational corporations, succes-
sors to the earlier mercantilist companies such as the English East
India Company, a late stage of globalisation in which there was an
international division of labour within companies effected by the
creation of subsidiaries with different tasks. The internet has been a
further force transcending national economic boundaries. Trade leads
to investment flows, a greater number of economic connections
between countries, then finally economic integration.
Globalisation requires a world infrastructure and peace in a sub-
stantial part of the world. It was because there was a Pax Romana
that early exercises in globalisation occurred; the Pax Americana in
recent decades has similarly facilitated the movement towards an
integrated world economy and polity. Advances in transport tech-
nology and reductions in the cost of travel have allowed product and
factor flows to quicken.
Globalisation transcends national boundaries and has the potential
to frustrate national economic policy goals. This is especially acute in
matters of taxation and employment. Some countries have high tax
regimes so will be avoided by overseas investors. Also employment
laws grant more rights to workers and their trade unions in one
country than another. The tendency of globalisation is to locate
economic activity where it is most beneficial, so national govern-
ments can face the prospect of becoming more and more closed
economies if they do not produce a congenial business environment.
Opponents of globalisation fear that it spells the end to diversity. In
particular, Americanisation through American management methods
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HAPPINESS
and the consumption of American products, especially food and
drink, is seen as a threat to local production and culture. There is a
convergence in economic systems with trade liberalisation and pro-
market running of economies promoted. There is a fundamental
collision between nationalism and globalisation. Whereas a nation
state can devise laws and regulate its citizens, there is a potential for
lawlessness in the global economy as the United Nations falls short of
being a world government. Those suspicious of the business cor-
poration fear there is no democratic control over powerful global
forces. A new disorder has been created, a runaway world. Propo-
nents of globalisation argue that the creation of an integrated world
economy both helps poor countries as world specialisation raises
productivity, and growth of incomes and trade. More prosperity also
increases the possibility of transfers from the rich to the poor.
Globalisation is often related to empire building, as in the theory of
imperialism advanced by Marxists, which attempts to explain why a
country expands its economic activities across the globe. Because, it is
asserted, there is a tendency for the rate of profit to fall, firms can
only maintain their profits by overseas expansion. This is especially so
with a firm that has originally maintained its profits by its monopoly
position. Once the monopoly is weakened it is only by conquering
new markets that the domestic competitive threat can be escaped.
Globalisation seems to be irreversible, for to try to turn back the
clock would be, as in past cases of the adoption of protectionism, to
lead to more costly production and less consumer choice. It is hard to
forecast how far globalisation can go, as factor immobilities and
stubborn consumer and political preferences can thwart a shift to an
homogenised world.
See also: development economics
Further reading: Bhagwati 2004; Jones 1995
HAPPINESS
An examination of the sources of well-being and its relationship with
economic activity.
There are three important approaches to studying happiness – the
utilitarian, the socialist and the econometric. Early exponents of
the utilitarian were Francis Hutcheson, who used the term ‘the
greatest happiness for the greatest number’, and Jeremy Bentham,
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HAPPINESS
who repeated the expression as part of a calculus of pain and plea-
sure. Out of this WS Jevons formulated his theory of exchange. The
second strand, the socialist, is evident in the titles of several early
nineteenth-century socialist books, such as John Gray’s A Lecture on
Human Happiness (1825). Happiness would come through workers
getting the product of their labour, needing to work fewer hours to
obtain a reasonable livelihood. More recently, happiness has been
studied by the correlation of economic and psychological variables in
the third, econometric form of analysis.
Modern quantitative studies implicitly assert that greater income
and wealth produce greater well-being. The rich have more access to
education, health care, housing, travel and entertainment, which are
either ends in themselves or routes to personal satisfaction. Antago-
nists of this view can point to the well publicised cases of the bore-
dom and misery of the rich, especially their increasing withdrawal
from society into high-walled compounds, demonstrating that their
wealth has bought them loneliness. Surveys of levels of satisfaction in
different countries are linked to data on aggregate economic variables
such as GDP. Measures of unhappiness include the number of sui-
cides. Happiness functions are not necessarily continuous, especially
where increasing income is accompanied by more happiness only up
to a particular income level.
Economic studies of happiness have relevance in many parts of
economics. In labour economics the human condition cannot be
ignored, so satisfaction and happiness are related to types of wage
remuneration and industrial conflict. Throughout economic policy
making the goal is often the increased happiness of individuals, as in
democratic societies policy choice does influence the prospect of
being re-elected. Any analysis of decision making ignores happiness,
satisfaction and utility at its peril. Studying happiness is important in
explaining economic behaviour. The quality of work, the nature of
consumption and the choice of investments will all be conditioned by
happiness received or expected.
Happiness is considered as the aggregation of individuals’ satisfac-
tions, but there is the earlier idea of a state as a whole making a gain
or a loss. The early mercantilists viewed the goal of a state as being
better off than its rivals through trading so successfully as to build up
a large store of bullion. Other mercantilists wanted a nation to have
high levels of employment and personal welfare, anticipating modern
attitudes to this question.
Just as the concept of the GDP as a measure of economic welfare
has long been questioned, so has the idea of thinking of happiness as
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HAPPINESS
having material determinants been severely scrutinised. Perhaps mate-
rial welfare can be at most regarded as a necessary condition. Alfred
Marshall, writing in his Principles of Economics in 1890, observed that the
poor could derive the highest happiness from religion, family relation-
ships and friends, but that grinding poverty would dull those pleasures.
Much of the debate about happiness is centred on what it is.
Avoiding the extreme view of Jonathan Swift in A Tale of a Tub – that
happiness is the state of being well deceived – many questions can be
asked. Is happiness a commodity or a piece of property which can be
bought and sold? Is it an outcome of resource allocation? Is it a state
of satisfaction which is induced by drugs, wealth or leisure? Is hap-
piness a subjective feeling, or a state of blessedness? Is it the product
of altruism through happiness arising from absorption in an outside
goal, or the pursuit of the welfare of others, or in promoting fairness?
Is happiness associated with one type of personality rather than
another? If the amount of happiness is a product of family, finances,
work, friends, health, or personal freedom, can it be accurately pre-
dicted? Is it age-related so that happiness is related to the life cycle? Is
happiness, like misery, an aberration from a long-term trend?
The controversies over the nature of happiness can perhaps be
resolved by settling on the idea of ‘well-being’. This is a dynamic
concept which recognises the flourishing of individuals within a
society. It avoids excessive individualism and has the dynamic of
considering more than the moment by building the possibility of
growth and improvement, which takes one back to Aristotle. Well-
being is often distinguished from growth of GDP in that it embraces
non-material rewards.
There is a loose identity between utility or subjective satisfaction
and happiness in economics, but happiness is a broader concept.
There can be such a thing as a happy society characterised by har-
mony, low crime, the existence of much social capital, fair income
distribution and a good standard of income and health. Given the
complexity of ‘happiness’, to seek it is more than to follow the
principle of utility maximisation.
Robert Barro in the 1970s also created a ‘misery index’, which is
the sum of the rates of unemployment and of inflation in percentage
terms: when both are high stagflation occurs.
See also: economic welfare; ethics and economics; utility; wealth
Further reading: Bruni 2004; Easterlin 2001; Frey and Stutzer 2002; Ng 1978;
Oswald 1997
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HEALTH ECONOMICS
HEALTH ECONOMICS
The study of the health care industry.
The industry has a large range of products both in the form of
public health and personal health care. Public health measures include
health education, which will reduce later the demand for health care,
and protection of the public against epidemics and contamination
from poor quality food and unsafe working conditions. Governments
also have an important role in licensing health professionals and
drugs. Personal health care consists of all those interventions, whether
surgical, medical or therapeutic, chosen to deal with a particular dis-
ease, injury or other debilitating condition. Health systems differ from
country to country according to the structure of production. There
can be state-provided hospitals and clinics, facilities offered by com-
mercial firms or charities. It is usual for there to be a mixture of
ownership. All these types of provider will operate according to dif-
ferent principles, whether meeting need as decided by government
with state medicine, making a profit through private production, or
furthering a welfare goal set by a charity either concerned generally
with helping the sick or dealing with a particular type of medical
problem.
Supplying health care has parallels with production in other
industries. It can be offered according to the principle of a state
monopoly which reflects the tastes and priorities of government, or
in response to the demand of potential patients in an open market.
An unusual feature of this industry is the interaction of supply and
demand, as the suppliers literally create their own demand by telling
ignorant consumers what they need in treatment. The financing and
delivery of health care have also given rise to much discussion. The
provision of health care in countries such as the UK through a pub-
licly run and financial service based on rationing has been criticised.
Given this dissatisfaction with the efficiency of state-run health ser-
vices, attempts have been made to simulate the market by having
‘internal markets’ in which parts of the massive organisation act as
providers competing to satisfy other parts of the system. This requires
careful costing and contracting.
Health care is labour intensive, and the labour force is highly skil-
led with many specialisms. Where doctors have little control over the
allocation of their time, conflict with administrators can be great. As
health care increasingly uses new types of equipment and more and
more new pharmaceutical products, there is a constant struggle in the
allocation of funds between spending on one input rather than the
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HOLISM
other. Because the pharmaceutical industry is research intensive, new
drugs are frequently introduced to the market: these are initially
expensive through their patent protection and the need to have high
prices to recoup research costs.
Demand for personal health care grows rapidly. As per capita
incomes rise, the demand for basic health care rises. At higher levels
of income, demand moves from health necessities to stop acute pain
and ensure survival to dealing with less urgent conditions, including
allergies and psychiatric conditions, and lifestyle enhancement such as
cosmetic surgery. Furthermore, much demand is unpredictable because
of the occurrence of accidents and impact of viruses. This massive
increase in demand, if delivered in treatment, needs financing. The
ways of doing so include general taxation, hypothecated taxation,
direct charging to the patient, or charging through a health insurance
company. As with the provision of health care itself, the financing of
it comes usually through a mixture of these channels of finance.
The provision of preventive and curative care is surrounded by
emotive issues which make many argue that health care is a special
case, a matter of life and death, so should be supplied differently from
other goods and services, even freely. There is the assumption that
health care is a ‘good’, but it can lead to a deterioration in health.
Also there is the popular notion that a country has more health care
if it devotes a greater percentage of its GDP to health care than other
countries, but it might merely have a different wage structure, with
health care workers relatively better off.
Further reading: Jones 2006; Sorkin 1975
HOLISM
The tendency of organisms to produce wholes greater than the sum
of their parts, according to JC Smuts; a cooperative approach to
economic organisation which rejects atomistic competition.
An early advocate of the holistic approach was Veblen, a founder of
the US school of institutional economics. Unlike the partial equi-
librium approach of neoclassical economics, holism sees each part
of an economic system conditioned by the economic system as a
whole. Individual entities are influenced by interrelationships of the
whole system, thus collectivism is preferred to individualism. Econ-
omists such as Keynes have claimed that their theories are ‘general’,
based on the relationships between economic aggregates, with varying
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HOMO ECONOMICUS
degrees of success. Later, macroeconomics, which sought out its
microeconomic foundations, had the flavour of holism. Also eco-
nomic behaviour has to be viewed as an aspect of human behaviour
as a whole, an echo of the concerns of eighteenth-century econom-
ics. Holism enables economics to be linked with the other social
sciences, especially sociology.
Causal holism abandons the economic methodology of producing
elegant models with predictive power in favour of description with
many explanations. Instead of simple specific inputs leading to specific
outputs, an output is the product of the system as a whole.
Further reading: Fleetwood 2002; Polanyi 1944
HOMO ECONOMICUS
An economic agent determined to maximise material gain.
As part of the Enlightenment project, economics was regarded as
part of the study of human nature and ‘economic man’ became pro-
minent. Adam Smith in his Wealth of Nations argued that the funda-
mental human propensity is to truck and barter. This makes possible
an exchange economy, but this market activity is to advance one’s
own interest. This self-interested behaviour of a rationalising eco-
nomic person is heavily criticised as it is wrongly thought that to be
self-interested is the same as being selfish. The Biblical command-
ment ‘to love your neighbour as yourself ’ suggests the importance of
pursuing one’s own advantage as the basis for being other-directed.
Also it is in a person’s interest to be productive and create wealth –
distribution is another issue. Smith asserted that the desire for bet-
terment is possessed from the cradle to the grave and is the driving
force behind economic growth. In the invisible hand principle, the
beneficial consequences of self-interest are stated. The asocial indivi-
dualism of the economic man brings benefits.
In neoclassical economics the homo economicus with utility
functions and goals seeks to maximise satisfaction, often only in the
short term. Seeking the most cost-effective way of achieving one’s
ends is regarded as a form of instrumental rationality. The idea of
economic agents as rational and engaged in maximising their utility
has been attacked because of doubts about rationality and an aware-
ness of the subtlety of economic motivation.
Further reading: Grampp 1948; Oakley 1994
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HOUSEHOLD BEHAVIOUR
The actions of members of a household as suppliers of labour and
savings and consumers of goods and services produced outside the
household. This branch of economics makes use of neoclassical
economic theory, feminist economics, the economics of the family,
labour economics and consumption theory.
A starting point for the analysis of households is to consider them
as bundles of assets or bundles of activities. The assets of a household
are its holding of financial claims, physical wealth in the form of
housing and other objects, and human capital. The stock of assets will
be determinants of the health, education and business and labour
force participation of the members of that household. The activities
conducted by households collectively or individually by their mem-
bers can be broadly divided into work or leisure. The work can be
employment or self-employment. Neoclassical analysis considers the
goals and production functions of households. In economic terms a
household attempts to maximise its income from its resources, many
of which are in the form of human capital. The activities can either
be for the sake of the household itself or given to or traded with the
outside world. What is own production for the sake of the household
often escapes national income accounts.
It is important to ask if a household is just a special type of firm
which combines residence with workplace, workers and dependants.
If this line of conceptualisation is taken then questions of the initial
financing of the household, its size and optimisation or other aims,
are important. There are limits to the analogy, as few households can
be regarded merely or predominantly as productive units.
A household has many choices to make, including whether to
engage in market or non-market production, work or leisure, and
criminal or legitimate pursuits. It must have an income which can
come from work, gifts, welfare payments or theft. Market activity
will be encouraged by the amount of remuneration proposed. For
some occupations the labour supply will be inelastic with respect to
the wage rate, as no other source of income is possible, but this is an
extreme case. The attraction of market work will be different for the
principal earner of the family than for the others. Non-market pro-
duction in the form of housework is often undertaken because of the
high cost of hiring cleaners, childminders, gardeners, decorators and
drivers. Living off gifts is a way of life open to only a small proportion
of the population, given the distribution of wealth. Welfare payment
distribution is decided by social policy and in some depressed areas
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can be the major source of household income for many families.
Criminal activity in the form of property offences has been much
studied. There is a cost to individuals of such behaviour – getting
caught so losing the chance of earning and acquiring a bad
reputation – but a gain from acquiring valuable goods, often devalued
by the low prices criminal fences will pay.
The study of labour force participation raises the question of why
men, women and children look for work and become employed.
These studies begin with an examination of the trade-off between
work and leisure. Many important determinants have been identified,
including the length of a person’s education. Women have increased
their participation, especially since 1960, and male participation has
declined.
Paradoxically, the growth of macroeconomics from the 1930s trig-
gered research into household behaviour which is substantially
microeconomic. To understand effective demand its components had
to be analysed, which began research into consumption. Aggregate
economic growth is related to savings ratios, so savings requires
special attention too. The consumption of households is offset against
that of firms and governments. In the case of households there is
more scope for the examination of psychological motives. All three
institutions will be affected by their incomes, by interest rates and by
expectations.
The economics of household behaviour is not to be confused with
the practical subject of home economics, domestic science, which is
concerned with the techniques of household production, cooking,
cleaning and rearing children. There is some overlap between
household economics and feminist economics, as the latter is con-
cerned with the management of time and labour force participation.
Economics began as oeconomica in the writings of Greeks such as
Aristotle and Xenophon. The view that oeconomica was concerned
with household management was contrasted with chrematistike, the art
of wealth-getting. Much economic activity occurred in those ancient
households, both agricultural and manufacturing. Xenophon in his
Oeconomica observed that men were engaged in wealth gaining but
women in household management, perhaps the first gender analysis
of occupations.
See also: family, economics of
Further reading: Kooreman and Wunderink 1997
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HUMAN CAPITAL
The value of human beings as assets producing a stream of income.
Through investment in education there is a private return to the
educated person, as well as a social return as society benefits through
the population being rational and cultured.
The earliest application of this capital notion was to slaves. It was
common in Ancient Greece to list slaves in an inventory of posses-
sions, and even friends could be included because they can be used.
Later the appreciation of human beings as labour crucial to the pro-
ductive process led to attempts to value human capital. One of the
earliest measurers of human capital was Petty, who applied the tech-
nique of valuing land as so many years’ purchase to valuing the
population. A later economist to attempt human capital calculations
was JS Nicholson. More recently Schultz produced estimates. Human
capital is both an embodiment of natural ability and education: it is
mainly the latter which is calculated, so either the cost of education
or the present value of extra lifetime income through schooling is
used. Usually human capital is now measured using cross-section data
on occupational pay or financial data from educational institutions.
The latter approach selects formal education as the principal element
in creating human capital so the number of years of schooling times
the average cost per year is calculated.
Both Cantillon and Smith recognised that the cost of education
could be a reason for wage differentials. A rational person or parent
would only pay for education if it would enhance a person’s prospects
in life. Human capital studies are used to justify investment in edu-
cation. The private return to education stimulates enrolment in
educational institutions; the social return persuades governments to
subsidise it. However, such a policy can be self-defeating. There can
only be a private return to human capital investment if educated
people have differentially higher incomes. Educating more people
increases the supply of persons available for better paid jobs, thus
reducing the income differential and destroying the private return.
Decisions to invest in human capital can be taken by various per-
sons. Parents are major investors where school and university educa-
tion is privately financed. In advanced countries where the state
provides free education, the amount and type of policy will be
determined by the goals of education policy. But state provision of
education can lead to the state’s assertion of the right to keep the
human capital it has created within the country, as was proposed to
stop the brain drain by limiting the emigration of graduates, as happened
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IMPOSSIBILITY THEOREM
in Soviet-type economies. Firms pay for training. This can be gen-
eral or specific. General training will be of use in many firms (for
example, word processing), so a single firm will be reluctant to
finance the teaching of a transferable skill which can be used else-
where, and will leave education to local colleges. Specific training,
for example in the internal accounting procedures of a large firm,
will be of exclusive use to that firm and hence more likely to be
financed by it.
To concentrate on education as a creator of human capital is con-
troversial, as there are other determinants of personal income,
including inherited ability, the social environment and general health.
To regard persons as capital might be considered a degraded view
of human nature. On the other hand, to assert that humans are
valuable will discourage activities which depreciate the human capital
stock, for example, expecting workers to be employed in an unheal-
thy environment for an excessive number of hours.
See also: capital theory; labour
Further reading: Becker 1964; Blaug 1975; Kiker 1974; Schultz 1971, 1972
IMPOSSIBILITY THEOREM
The problem under democracy of more than two individuals faced
with several options making consistent choices when their pre-
ferences are different; also known as the general possibility theorem.
Arrow stated this problem of collective choice as that occurring
when more than two choosers confronted by at least three possibi-
lities seek a collective order which corresponds to all the individual
orders of preference. It is impossible to achieve this as several condi-
tions have to be met: a transitive ranking of preferences, the inde-
pendence of irrelevant alternatives, the non-imposition of x above y
in the collective order, and the non-dictatorship of any chooser in
that no individual has the same preferences as the collective order. As
there could be no satisfaction of these conditions, Arrow asserted that
it was impossible to have a social welfare function. This impossibility
of making a consistent choice is also called the paradox of voting.
This problem of aggregation of individual preferences into a social
choice function is widely discussed throughout the social sciences,
including international relations. The cases where the majority view
solves the problem is distinguished from those where it does not. This
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INCENTIVES
formalisation of social choice is criticised for its assumptions, includ-
ing that there is a transitive ranking of options independent of
excluded possible options. The theorem refers to a particular social
welfare function so has a limited role in welfare economics. To
apply this type of decision making to democratic choice is difficult as
voters lack the information to see what the different options actually
are, and the world is more dynamic than Arrow assumes. Tullock
examined the interdependence of the preference structures of indivi-
duals, and concluded that under majority voting a determinate and
satisfactory outcome is usually achieved.
Further reading: Arrow 1950, 1962; Tullock 1967b
INCENTIVES
Inducements to make an economic agent perform, especially to work
or to save and invest.
All factors of production have their minimum supply price;
otherwise a factor would not enter, or remain, in a particular occu-
pation. Workers need at least subsistence wages otherwise they would
lack the strength to work and ultimately to survive. If capital does not
receive a return comparable with alternative investments and enough
to cover risk, it will not be supplied. Rent has to cover the incidents
of ownership, especially maintaining secure possession. These are the
basic incentives which ensure only the low-level functioning of an
economy.
Incentive mechanisms also aim to improve performance, as when
they are employed to encourage increased productivity. In wage sys-
tems premium pay, bonuses and share or stock options are designed
to encourage greater effort. At the heart of the principal-agent pro-
blem is the devising by contract, or otherwise, of a mechanism to
ensure the principal reaches desired objectives. Also either the principal
or agent can have private information, which raises questions of
moral hazard.
The extremes of poverty and the prospect of bettering one’s con-
dition induce greater performance. A barren or devastated area will
provide a strong push to a population to emigrate. The chance of a
better life is a major motivating factor. Smith, in his growth model,
asserted that a desire for betterment which we have from the cradle
to the grave will encourage saving and investment, setting a national
economy on a growth trajectory. Hume argued that manufactures
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INCOME DISTRIBUTION
could be an incentive encouraging higher productivity in agri-
culture as farmers would have to work harder to buy them.
As taxation, especially income taxes, reduces post-tax income it
threatens work incentives. A disincentive can be produced by high
marginal rates of income tax as the net reward to supplying more
hours of work can be unattractive to workers. But such tax rates
could also be an incentive to workers with a post-tax income goal
who will have to work harder if tax rates rise.
Apart from monetary gain, other benefits can incite greater activ-
ity. The charity worker with altruistic motives, the loving parent,
the loyal friend will not expect a measurable reward. Even for
employees in the traditional firm some incentives are non-mone-
tary, especially through collectively provided agreeable working
conditions in pleasant workplaces with flexibility of hours and man-
agement.
Incentives are usually regarded as positive in the form of a reward,
but they can also be negative, as when there is punishment such as
withholding resources until compliance is met, or criminal sanctions
to desist in one activity to promote another – for example, to pre-
serve an area as rural by penalising the builders. The most question-
able form of incentive is an inducement to influence a member of a
government to change an economic policy. This can be corruption
or financial help for an associated activity.
See also: labour; migration and mobility; taxation
Further reading: Merrett 1968
INCOME DISTRIBUTION
The array of incomes within a national economy.
Different types of distribution include the factor distribution of
incomes between land, labour and capital, and the personal distribution
between groups in different bands of income. Changes in demand
and supply, the durability of custom and the welfare policies of gov-
ernments will be principally responsible for the differences in the
incomes of individuals and households.
Factor distribution of income between land, labour and capital,
especially ‘labour’s share’, is quite stable over time, with over 60 per
cent of national income going to labour in wages and salaries and
the rest to profit, interest and rent. The distribution of incomes
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INCOMES POLICY
between and within occupations reflects the bargaining power of
each group and the hierarchical and other reasons for differences in
pay. Personal incomes are the consequence of labour market activity,
ownership of income producing assets and transfer incomes.
Measures of inequality applied to income distributions include
Lorenz curves, Gini coefficients and an examination of deciles and
quartiles. These measures are the triggers for redistributive policies,
especially fiscal changes. The shape of the income distribution reflects
certain basic ideas – that labour should be rewarded for its work, that
more difficult and skilled work should command higher remunera-
tion, that owners of capital should be paid for its use and that the
poor should get some help but not enough to be a disincentive to
work. Income redistribution can be attempted at the pre- or post-tax
income levels. If the former, there have to be rules for wage differ-
entials and for capital ownership; if the latter, taxes, especially direct
taxes, have to be high enough and progressive to effect a switch of
income from the rich to the poor.
See also: equality
Further reading: Atkinson 1975
INCOMES POLICY
A set of government measures to restrain the growth of incomes,
especially wages, in times of inflation; a macroeconomic policy to
supplement monetary and fiscal policies.
In several economies, including the Netherlands, Sweden, the UK
and the USA, this type of policy was employed, often as a short-term
crisis measure. The policy could be addressed to annual pay increases,
the wage bill as a whole, or all types of income, including dividends.
A target for income growth was usually set: a popular percentage was
the trend growth in productivity so that income increases would be
financed by comparable output growth. To accommodate particular
strains in the labour market threatening to defeat the policy, it usually
allowed exceptional cases justifying higher than the norm increases,
especially labour shortages, pay out of line with comparable groups
and unusually low pay. To administer the policy and to vet claims for
exceptional increases special institutions, especially pay boards, were
set up. Sometimes an incomes policy was used in conjunction with a
prices policy which monitored increases in product prices.
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INDUSTRIAL ORGANISATION
It was difficult to have an incomes policy as a permanent measure
because of its conflict with the market determination of incomes.
Employers short of labour in particular occupations and areas had
every incentive to bypass the policy guidelines. Jobs would be
upgraded or non-wage remuneration increased. Unions resented
being presented with permitted maxima for pay increases and tried to
exceed the target to impress their members. The benefit in the long
term bequeathed by such policies was an education in the implica-
tions of pay rising too high. Also in some industries bad labour
practices were bought out through permitting exceptional pay
increases: this improved productivity for many years.
See also: labour
Further reading: Corina 1966; Fels 1972
INDUSTRIAL ORGANISATION
The study of the structure of industries, including the number and
size of firms within them; a study of firms’ behaviour in markets.
This analysis of industries is crucial to formulating and imple-
menting competition policy, especially the US federal antitrust policy
since 1890 under the Sherman, Clayton and subsequent acts. Indus-
trial organisation (IO) does much to explain the nature of markets
and the behaviour within them. As in other branches of economics,
static, dynamic and evolutionary approaches can be employed.
A basic approach is to consider the extent of concentration of
output, sales or employment in the hands of the leading firms of an
industry, taking into account changing consumer tastes and technol-
ogy. An industrial structure often emerges by changes in demand over
time but it can also be devised as part of a planning process, an ideal
structure would also have to recognise market changes. Depending
on the extent to which an industry is monopolistic or competitive,
different pricing methods and investment decision making will ensue.
The ‘structure-conduct-performance’ model roots the behaviour
and success of firms in the structural nature of an industry. Under
structure, attention is paid to barriers to entry, how much product
branding is used and the absolute or relative concentration of firms.
Production and pricing decisions of firms are examined under con-
duct. Profits, efficiency, innovation and the creation of jobs are
the performance.
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INDUSTRIAL RELATIONS
Inevitably such studies have sociological implications. How firms
are organised and managed will determine attitudes of workers and of
politicians governing a society. The impact on productivity of differ-
ent forms of organisation is considerable.
Game theory has formalised this branch of economics, showing
the strategic interactions between firms, especially in the cases of
duopoly and oligopoly. Instead of having simple models based on
firms motivated only by profit maximisation, a formal analysis of the
broader behaviour of firms is possible. The empirical study of indus-
trial organisation includes demand estimation, mergers, advertising
and auctions. Institutional economists also look at the corporate
system, the relationship between public and private sectors, the
degree of centralisation in an economy and the consequences of
industrial concentration. Industrial organisation is at the interface
between economics and management science, entering into detailed
studies of price discrimination, product branding, the markets for
different types of good and the conditions determining the entry and
exit of firms from particular activities and markets.
See also: competition and monopoly; economic concentration
Further reading: Aoki 1984; George et al. 1992; Needham 1978; Shubik with
Levitan 1980
INDUSTRIAL RELATIONS
An examination of employers’ organisations, trade unions and their
mutual interchange in the course of work and in the negotiation of pay.
Industrial relations constitute a ‘system’ in that a set of rules is
devised to regularise relationships between employers and workers. The
rules are complex, as they arise through legislation, labour contracts
and various customs and understandings. Some of these are expressed
formally in documents; others are part of an oral tradition.
This branch of labour economics is necessary because of the
imperfections in the principal institutions of the labour market and
the many signs of friction. Unions, in particular, are criticised if they
are too numerous or have overlapping jurisdictions leading to a
competition for members. Employers’ associations are rebuked for
having few sanctions to keep their members in line.
Friction in an industrial relations system is manifest in strikes and
other forms of industrial unrest which occasion either complete
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INFLATION
cessation of work or a reduction in workers’ effort. Although most
strikes are in connection with pay disputes, some strikes are the
inevitable consequence of a lack of clarity in the rules in the system.
The most powerful route to reforming a system is a new compre-
hensive statute, but it will only improve matters if it commands
general assent from both sides of industry.
Included in industrial relations are systems of arbitration to recon-
cile conflicts between capital and labour. One type of arbitration is
pendulum arbitration, under which the arbitrator either has to accept
the employer offer or the union demand: as each side wants to win
there is an incentive to be moderate.
See also: game theory; labour; trade (labor) union
Further reading: Clegg 1976; Hyman 1975
INFLATION
The persistent rise in the price level of an economy.
A monetary phenomenon which is usually measured by a change
in the level of a consumer or retail price index. The rate of inflation
is central to determining wages and interest rates. When the price
increase reaches very high rates, even hundreds or thousands, as in
Germany in the 1920s and recently in South America and Africa, this
rise is called ‘hyperinflation’. Such out-of-control inflation will make
money lose its store of value function and serve as a medium of
exchange only briefly. ‘Inflationists’, such as Hume or Thornton, how-
ever, recommended a short-term expansion in the money supply to
increase output and encourage the employment of unused capacity.
Inflation has been classified according to its cause. Demand infla-
tion is the consequence of excess demand in the economy as a whole,
usually starting in the labour market and being transmitted to product
markets. Cost inflation occurs when there is an increase in the price
index in the absence of excess demand, often through trade union
militancy or an increase in the cost of imports.
The Phillips curve originally plotted wage rate data against
unemployment percentages (a proxy measure of macroeconomic
demand). Further studies of this relationship separated short- from
long-term curves, with the latter being vertical at the natural rate of
unemployment. NAIRU is the non-accelerating inflation rate of
unemployment.
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INFORMAL ECONOMY
Stagflation is the unpleasant combination of rising prices and stag-
nation in a national economy. Often inflation is the consequence of
rising demand, but it can also occur when a stagnant economy suffers
cost-push inflation through high import prices, as when oil prices
rose in the 1970s, or trade union militancy.
See also: price index
Further reading: Jackman et al. 1981
INFORMAL ECONOMY
The set of economic activities not recorded in official statistics; the
black or unofficial economy.
Criminal activities such as property thefts, drug dealing and pros-
titution would be outside the published figures, but a host of other
activities also disappear statistically. To avoid taxation much ordinary
economic activity, especially in construction and personal services, is
kept from tax collectors’ eyes. Another important reason for the non-
recording of economic activity is the failure of some forms of pro-
duction to be marketed, for example, subsistence agriculture and
suburban gardening. Often statistics on the output of the smallest
enterprises are not collected to reduce the cost of data collection.
Because the national income is measured by income, output and
expenditure methods it is possible to see discrepancies between expen-
diture and income: if the latter is smaller than expenditure then income
could be hidden. Direct inspections of assets by tax authorities can
lead to investigations into the sources of persons’ incomes. Also a
change in the composition of the money supply, with more of it con-
sisting of cash to meet changing demand, can indicate the growth of
the informal economy.
An informal economy can be an economy at its earliest and most
primitive stage before there has been extensive monetisation. Early
economies with much self-sufficient agriculture have a small proportion
of production passing through markets so most output is not directly
measured. In these countries population and average consumption
have to be multiplied together to estimate their own production.
The extent of an informal economy is a function of the degree of
regulation of an economy. Where there is tight bureaucratic control
there is an incentive to evade the eyes of inspectors but not always
the means, thus reducing the chance of an informal economy.
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INFORMATION
See also: corruption; national income
Further reading: Schneider 2002
INFORMATION
The influence on the behaviour of economic agents of the data they
possess; the study of the market for information.
Every component of economics is concerned with information
because the markets, and their substitutes, have varying degrees of
knowledge of what is actually the state of affairs. This is especially
true of labour and financial markets.
Under perfect competition there is the assumption of perfect
knowledge. This does not mean full information on the past and the
future but sufficient information for firms to make decisions about
entering and leaving a market. Classical economists were aware of
information deficiencies. De Quincey, for example, questioned whe-
ther the ‘competition of capitals’, the increasing number of capitalists
entering a profitable industry, would lead to a fall in the rate of profit:
in his Logic of Political Economy, chapter V, he admits that individual
tradesmen can be ignorant even of their own profits.
Problems arise because information is rarely complete and costless.
Much information is kept private by economic agents to their own
benefit. Some information is obtained at high, some at low, cost. The
cost of searching for information is expected to have a return which
will recoup the cost – for example, the search for a job will result in a
higher income. There is the cost of collection and processing before
information can be useful. Information can be deliberately generated
or the incidental by-product of the working of markets. It is acquired
differently according to the nature of the economic system. Under
central planning, reports and surveys will attempt to establish the
expected output and demands of the various sectors of the economy,
then material balances will be drawn up to see if adjustments in
demand and supply are necessary. In the capitalist economy, the
market itself is spontaneously providing information, as Hayek
repeatedly proclaimed. Movements in prices will show whether
demand or supply are in excess, and these movements will be suffi-
cient information to signal to producers the need to adjust their
schedules. Hayek pointed out that there is a movement to equili-
brium because economic agents acquire information from the situa-
tion they are in. The fragments of knowledge that individuals possess
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INNOVATION
are spontaneously combined in a way that is beyond the capacity of a
single directing mind. A perfectly coordinated economy is a full
information economy.
Ignorance leads to a loss of welfare. Goods may be purchased at an
unnecessarily high price because the full range of prices for the same
good in a particular market is disguised from buyers. Wrong invest-
ments occur if the full array of data on different possible investments
is unknown.
Akerlof began the modern discussion of the effects of information
deficiencies. In his famous article on the market for lemons, he
recognised the imbalance, or ‘asymmetric information’, in knowledge
of heterogeneous goods with the seller knowing more than the buyer.
With such uncertainty the buyer will assume that there are defects, so
will be prepared to pay only an average price. This destroys the
incentive to sell high-quality goods so they have to be traded else-
where. Where there is an absence of trust, businesses will suffer.
Information is regarded as ‘news’ when fundamental information
about key economic variables, such as unanticipated movements in
interest rates or the national income, is reported, causing unanti-
cipated changes in other economic variables.
A form of restrictive anti-competitive practice is the ‘information
agreement’. Instead of firms meeting and deciding market arrange-
ments, there can be joint action on the basis of the circulation of
information on costs and prices. Because of knowing such informa-
tion on other businesses, the same prices can emerge as under a
collusive oligopoly.
An ‘information economy’ takes into account the growth and
operation of the internet and other forms of communication.
See also: competition and monopoly; game theory
Further reading: Akerlof 1970; De Quincey 1897; Hayek 1937; Hillier 1997;
Macho-Stadler and Pe´rez-Castrillo 1997
INNOVATION
The application of an invention to production.
An innovation, essentially meaning a change, doing something
different, can occur in products, processes and behaviour. Such new
things can be self-generated by a person or organisation, or purchased
from a previous innovator.
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INPUT-OUTPUT ANALYSIS
The extent of innovation is a product of the competitive pressures
on a firm from rival firms, either domestically or internationally.
Innovation will also be provoked by the state of the economic cycle.
The taking up of a bunch of inventions can revive a stagnant econ-
omy, as partly happened in the 1930s when the motor car industry
expanded.
Whereas the quantity of inventions is crudely measured by the
number of patents, the amount of innovation is counted by the pro-
portion of a type of capital stock embodying a technical change. Also
the amount of product differentiation, reduction in costs and man-
agement structures are indirect indicators of innovation.
Further reading: Antonelli 2003; Freeman 1997
INPUT-OUTPUT ANALYSIS
The use of a matrix of columns and rows showing the flow of
output between different industries, the rest of the world and final
consumption.
This type of analysis, inspired by the idea of the circulation of the
blood, was translated into economics by using the concept of the
circular flow of income. Quesnay, a leader of the French Physiocrats,
in his tableau e´conomique of 1758, drew a diagram describing the flows
of income between landlords, farmers and manufacturers. Modern
input-output analysis is based on the work of Leontief, who started
with a table for the USA economy of 1925.
The usefulness of such tables is seen in regional and national eco-
nomic planning. They are extensively published by national
accounting offices. They are static if they merely show the dis-
tribution of output to other industries and to final demand; a
dynamic version will incorporate time lags in production, hold-
ings of stocks and fixed capitals and the adjustment of output to
excess demand. These tables have more application in the short
run when the input-output coefficients can be assumed to be
reasonably stable, but it is possible to revise input coefficients in line
with technical change. Input coefficients can be direct, indirect or
induced.
Further reading: Cameron 1968; Department of Economic and Social Affairs
1999
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INSTITUTIONAL ECONOMICS
INTEREST RATE
An approach to economics which is built on the examination of key
institutions of the modern economy, especially the corporation.
A full study of institutions requires an examination, sometimes using
anthropology, of traditions and customs in a spontaneous order, then
an examination of more sophisticated institutions with bureaucratic
rules and property rights, considering their governance, including
through private contract, and their methods of working, including
the types of incentive used and the form of allocation adopted.
At the end of the nineteenth century in the USA, prominent
institutional economists included Ely (founder of the American Eco-
nomics Association in 1885), Commons and Veblen. Commons
turned from the study of trade unions to an examination of capit-
alism, trying to understand the changing industrial structure of his
day. Veblen attempted to connect anthropology and economics, as
well as looking extensively at the US corporation owned by absen-
tees. By examining the emerging economic institutions of the
modern American economy and collective economic action, these
writers were able to challenge the emerging neoclassical econom-
ics of the day. Rather than use simple maximisation assumptions,
they acquired a deep knowledge of the rules of those institutions.
New source materials were used, including Supreme Court judge-
ments, to show how economic decisions were made.
This approach to economics has been transformed by the new
institutional economics, which embraces rather than despises neo-
classical economics. Coase, Williamson and Demsetz have made
leading contributions. The tradition of viewing economics in con-
versation with law, politics, anthropology and sociology as truly a
social science continues. It makes uses of ideas such as transaction
costs and property rights to provide a new approach to old problems.
See also: contract theory; economic anthropology; property rights
Further reading: Gruchy 1973; Tsuru 1993; Williamson 1985, 2000
INTEREST RATE
The price imposed by lenders for using borrowed money; the reward
to lenders of capital. It is usually expressed as a percentage and paid in
money. An ‘own interest rate’, according to Sraffa, is an interest rate
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INVESTMENT
expressed in terms of itself, avoiding the use of money, so there can,
for example, be a steel interest rate.
Interest rates can be fixed by governments and monetary autho-
rities or by the market. A neutral interest rate will have no effect
on the real economy. Older theories of interest included the clas-
sical loanable funds theory, which stated that real factors of thrift
and investment demand will bring about a unique rate of interest.
Keynes looked at interest rates as a phenomenon of money markets.
The demand for liquidity has to be taken into account. Levels of
interest rates will take into account time, as a longer period means
a greater sacrifice of liquidity, the risk of default by the borrower,
the possibility of exchange rate fluctuations and the chance of
inflation.
The term structure of interest rates shows the relationship between
short- and long-term rates. A central bank by the open market
operations of buying and selling treasury bills and bonds, can change
the relationship between rates, partly to change the nature of bor-
rowing, as long rates will determine investments in buildings and
machinery but short rates will be crucial to financial market opera-
tions. Interest rates can be fixed for a stated period or floating in line
with money market indicators.
The three ancient religions of Judaism, Islam and Christianity
prohibited the imposing of interest, which was called ‘usury’ or ‘use’,
as it was regarded as exploitative, especially to relatives who were
borrowing because of their distress. Without interest, borrowers
wishing to exploit an investment opportunity could be without
finance and economic growth would be impeded.
See also: banking; monetary policy; money
Further reading: Robinson 1952
INVESTMENT
Additions to, or replacements of, the capital stock, either in real or
financial terms.
Smith assumed that what was saved would be immediately inves-
ted, but the possibility of savings going into idle hoards was recog-
nised by both Malthus and Keynes. Investment is undertaken in the
expectation of a future return either as a flow of income or of other
identifiable benefits, such as purity of air. The decision to invest will
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INVISIBLE HAND
be made when the expected yield is greater than the cost of finance.
The motive for investment is the obtaining of a rate of return suf-
ficient to cover the risk of committing funds, higher than the cost of
finance and as high as alternative uses of funds.
The purchase of financial securities is called investment as it is the
alternative to consumption and is undertaken for the sake of future
gain. In terms of the economy as a whole this kind of investment
does not add to real national income if it is the purchase of existing
securities, but by leading to the inflation of the money value of
financial capital enlarges the national wealth.
Much investment is in physical things such as buildings and
machinery, unlike human capital. Reputation is an important form of
investment, increasing demand for a firm’s output and allowing the
charging of higher prices.
Sometimes current expenditure, which is consumption, is loosely
called ‘investment’, causing endless confusion. This is done especially
for education expenditures, as the aim is to add to the human capital
stock, but part of this expenditure will always be consumption.
See also: accelerator; capital theory; human capital
INVISIBLE HAND
The mechanism by which individuals although pursuing self-interest
unintentionally promote the public good.
It is an expression used by Adam Smith in his Theory of Moral Sen-
timents and The Wealth of Nations. In the former work Smith says that
the rich are
led by an invisible hand to make nearly the same distribution of
the necessaries of life, which would have been made had the
earth been divided into equal portions among all its inhabitants,
and thus without intending it, without knowing it, advance the
interest of society, and afford means to the multiplication of the
species.
(Smith 1976a: book IV, 1.10)
The expected achievement of the invisible hand in that passage is
modest: it is only necessaries, not entire incomes, which are equal-
ised, sufficient to maintain the population in subsistence. In the
Wealth of Nations, in a discussion of investment, Smith argues
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INVISIBLE HAND
by directing that industry in such a manner as its produce may be of
the greatest value, he intends only his own gain, and he is in this, as
in many other cases, led by an invisible hand to promote an end
which was no part of his intention. Nor is it always the worse for
the society that it has no part of it. By pursuing his own interest
he frequently promotes that of the society more effectually than
when he really intends to promote it. I have never known much
good done by those who affected to trade for the public good.
(Smith 1976b: book IV, ch. II)
This attack on swaggering persons who claim to be promoting the
public good severely questions their motives. There is no need con-
sciously to seek the public good if economic agents following the
principles of natural liberty go about their business.
Great debate has surrounded the concept. Rothschild notes some
early uses of it, such as the bloody and invisible hand mentioned in
Shakespeare’s play Macbeth. The ‘hand of Jupiter’ is a parallel, as is the
‘hand of God’ in Christian theology. Baumol makes use of ‘the
hidden hand’ of God. Theological parallels are sensible because the
kind of specialisation linked by the invisible hand is very like St Paul’s
description of the different offices of the church having a favourable
joint outcome. Ahmad identified four functions of this concept in
Smith’s work: to limit the size of the landlord’s stomach, to curb the
residual selfishness of the landlord, to optimise production and to
preserve the natural order. Its chief significance, however, is to show
that an economy following its natural course can have desirable out-
comes without the interference of a government.
The invisible hand concept is used to justify a laissez-faire atti-
tude towards the running of a national economy: instead of a
government promoting public welfare, private individuals achieve the
same. The concept is popular with Austrian economists such as
Hayek, who linked the invisible hand to the idea of a spontaneous
economic order. Critics point out that the existence of market failure
means we should be cautious about unregulated markets. It is less
certain that in oligopolistic markets and national economies with
much economic concentration there would be separate producers
independently pursuing their interests. The world is much more
integrated now and more regulated by government.
See also: Austrian economics; laissez-faire
Further reading: Ahmad 1990; Rothschild 2001; Smith 1976a, 1976b
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IS-LM MODEL
KEYNESIANISM
A formalisation of the principal elements of John Maynard Keynes’
model of the economy constructed by John Hicks in his article ‘Mr
Keynes and the Classics’ (he used SI-LL for the model).
The IS, or investment-savings, curve shows the locus of combinations
of income and the rate of interest where investment equals savings. The
LM curve, using the same axes, shows equilibria between L, liquidity or
the demand for money, and M, the supply of money. This graphical
description of an economy shows at the intersection of the IS and LM
curves there is both an equilibrium in the goods market, represented
by the IS curve, and in the money market, shown in the LM curve.
This apparatus has been used to show the relative efficacy of fiscal
and monetary policies. Its flexibility and adaptability has given it
prominence in most macroeconomics textbooks. Changes in fiscal
policy can stimulate the economy: this is shown by a shift in the IS
curve. Changes in the amount of money supplied by monetary
authorities will shift the LM curve, with an increase in the money
supply reducing interest rates and increasing income. The elasticity
of the respective curves shows the relative potency of each policy.
Where there is a steep, i.e. inelastic, IS curve fiscal policy will be
most effective, but least where the LM curve is inelastic as there will
be ‘crowding out’. Crowding out occurs when there is a fiscal sti-
mulus to an economy which raises interest rates, thereby cutting
private sector investment and cancelling out public sector expansion.
The apparatus was used in the debates between Keynesians and
monetarists to argue the relative merits of different policies. The
diagram became so over-used that even Hicks regarded it as an alba-
tross. The post-Keynesians especially disliked a reformulation of
Keynesian macroeconomics which resembled too much the equili-
brium approach of neoclassical economics.
Further reading: Hicks 1937; History of Political Economy 2004
KEYNESIANISM
The branch of economics devised by the followers of John Maynard
Keynes; a development, rather than a literal repetition, of his thinking.
Keynes in his General Theory of Employment, Interest and Money
contrasted his theory with the classical version of macroeconomics,
especially Say’s law, and undertook the creation of a macroeconomic
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KEYNESIANISM
model based on effective demand. There are elements taken from
Marshall’s economics in that a demand and supply analysis is trans-
ferred from the micro to the macro branch of economics. Certain
concepts are bound together in Keynes’ analysis, particularly the
multiplier, the consumption function, liquidity preference and the
marginal efficiency of capital. In policy terms, the use of fiscal
policy to have deficit-financed public works schemes gave Key-
nesianism an identity; monetary policy is of less significance. For
ever fixed in the public mind is that Keynesians are keen on discre-
tionary fiscal policy, hence the popular contrast with monetarists who
emphasised the pre-eminence of a monetary policy following simple
rules as the best way to manage a national economy.
Klein, an early expositor of Keynes, argued that the General Theory
was revolutionary in presenting a theory of effective demand, a
theory of the determination of the level of output as a whole. In
other words he made economics move on from a study of households
and firms to aggregate relations in the national economy overall. Also
full employment is not inevitable, as there can be a permanent
unemployment disequilibrium. Many anticipations of every theme
of the General Theory exist, as Laidler details. Robertson, for example,
as early as 1915 in his A Study of Industrial Fluctuation, referred to
output as a whole in his analysis. Despite Keynes being more in a
continuous tradition than a revolutionary, he did introduce a formal
model which revolutionised the teaching of economics.
Coddington identified three types of Keynesian – the fundamen-
talist, the hydraulic and the reconstructed reductivist. Different approa-
ches choose between fiercely guarding the holy shrine and allowing
linkages to other schools of economics, especially the neoclassical.
Leijonhuvud was keen to show how the revolutionary approach of
Keynes had been tamed. He objects to the attempt to give the Gen-
eral Theory a neoclassical rewrite. Keynes was attempting to escape
from a Walrasian general equilibrium world in which markets failed
to clear to formulate his own analysis of the relationship between
markets. Crucial to the analysis of Keynes, and not the Keynesians,
was his consumption function.
It was the achievement of Patinkin to integrate value theory with
monetary and employment theories. He introduced a real balance effect,
the change in aggregate expenditure causing a movement in the price
level which affects the purchasing power of money. The demand for real
balances, the private demand for all consumer goods, the demand for
all investment goods and for securities, in real terms, will be determined
by real income, the interest rate and the price level (if the money
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KEYNESIANISM
supply is constant). It is a short period and general theory because pri-
cing is applied to real balances, individual goods and goods in aggregate.
Keynesianism has been the parent of several new schools of thought,
including neo/new Keynesianism and post-Keynesianism. The inheri-
tors of the Keynesian creed have split into different camps, including
the neo-Keynesians and post-Keynesians. Neo-Keynesians take from
Keynes the ideas of sticky prices and wages and a possible failure to
reach full employment, but use the methodology of neoclassical
economics with the assumption that economic agents are rational.
They use general equilibrium theory and emphasise the micro-foun-
dations of macroeconomics. The view that markets are competitive is
replaced by the recognition of varying degrees of monopoly power.
The Cambridge economist Joan Robinson referred to illegitimate
interpretations of Keynes as ‘bastard Keynesianism’, insisting that both
a static equilibrium and the process to reach it had to be dis-
tinguished. Hicks and Meade were associated with this illegitimacy
through arguing that a given stock of capital could achieve full
employment if real wages fell to an equilibrium position. In Britain
the post-Keynesians were influenced by Kalecki’s formulation of
Keynes, especially his examination of the role of finance in invest-
ment with its implications for liquidity and effective demand. Also
they emphasised the foundation of Keynes’ General Theory in the
Marshallian short period in which the level of money prices is related
to the level of activity, and stressed the importance of demand rather
than supply. They are opposed to neoclassical general equilibrium
modelling, and argue that under capitalism there is no natural
movement of an economy to full employment.
New Keynesians, starting with Keynes himself and Joan Robinson,
and including Mankiw, in their work on fiscal policy emphasise the
slowness of prices and wages to react thus impeding progress to full
employment. They attack the New Classical School, especially its use
of rational expectations. Building on Keynes’ attack on neoclassical
economics, especially on unemployment, and Joan Robinson’s work
on imperfect competition, the New Keynesians have linked micro-
to macroeconomics in their interests, which include efficiency wage
theories, capital market imperfections, credit rationing and monetary
policy.
See also: capital theory
Further reading: Coddington 1976; Klein 1952; Laidler 1999; Leijonhufvud
1968; Patinkin 1956
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LABOUR
LABOUR
The factor of production which cooperates with land and capital to
produce goods and services. It is remunerated by wages and salaries
in the case of employed labour, but by a hybrid income mixing
wages and profits in the case of self-employment. Labour itself is
conceptually similar to capital inasmuch as much of it embodies
human capital, and like land in that much of it is scarce, earning
economic rent.
The demand for labour is determined by the demand for its pro-
duct. The supply of labour can be the supply of persons willing to
work, the supply of hours or the supply of effort. The total supply of
labour constitutes those employed, unemployed and self-employed,
thus membership of the labour force depends on receiving wages or a
salary or being engaged in job search activity. This supply depends on
the growth in the population and the participation of that group in
the labour market, hence reference is made to labour force partici-
pation (economic activity) rates.
The market for labour consists of employers and workers. It exists
at the national level but also in local areas and occupations because of
the heterogeneity of the labour supply. Labour markets can be dif-
ficult to clear and often are in a state of disequilibrium, as evi-
denced by the coexistence of unemployment and unfilled job
vacancies. Poor clearing leads to frictional unemployment and is
sometimes the result of high search costs. Governments subsidise the
clearing of labour markets to reduce unemployment and increase
output. The traditional way of doing this is to reduce labour market
information deficiencies by setting up labour exchanges or job
centres, with free advice on obtaining employment and a free notifi-
cation of vacancies service for employers to use. Many labour mar-
kets are notorious for poor clearing. Workers can be very reluctant
to move to another place, to retrain and to accept different working
conditions. Employers can be slow or partial in advertising for the
labour they need and have selection procedures which fail to obtain
an optimal labour force. There can be interference in the setting of
wages, as under incomes policies, so the wage level is kept below
the market clearing price.
The interaction of employers demanding labour and workers sup-
plying it determine wages and salaries. Labour costs are usually
greater than the amounts paid in direct remuneration. The extra
elements of cost include fringe benefits, such as pensions, and the
expense of running collective facilities such as sports centres.
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LABOUR
Wages come in different forms. At the macroeconomic level there
is the wage rate, which is an average for the whole economy and is
not specifically determined in non-planned economies but emerges as
a statistical phenomenon. Given the segmented nature of the labour
market, wage differentials abound. Cantillon and Smith suggested the
principal reasons for occupations being paid differently. Wage differ-
entials occur because of varying amounts of training, the pleasantness
of the job, the degree of trust placed in the worker and the prob-
ability of success. Regional and industrial differentials also exist
because of their relative prosperity. In internal labour markets, those
within large firms, wages will be determined by hierarchical and
other managerial rules; in the external labour market by competition
between firms. As firms are not completely self-sufficient in labour,
they will have to connect with the external market for first-time work-
ers from schools and universities and where they have labour shortages.
Existing workers recruited from the external labour market will be
paid the ‘key rates’ determined competitively: these rates are joined
together to form a wage contour for that group of firms. Wages
under collective bargaining can be determined nationally or locally.
What often happens is that the national level determines basic pay,
often called the wage rate, and the local or even plant level, additional
bonuses and other allowances which when added to the wage rate
constitute earnings. The rate of growth of wage rates and of earnings
can diverge so that there is ‘wage drift’, the number of percentage
points difference between the rates growth and the earnings growth.
Outcomes in a labour market are often disliked. The wages and
employment levels which emerge are regarded as sub-optimal. Because
wages are below an acceptable welfare level, minimum wage legisla-
tion is introduced, partly to exercise a mild form of egalitarianism.
Whereas Keynes and the Stockholm School were concerned with
the non-flexibility of wages, modern policy makers are obsessed by
labour market rigidities. These rigidities are impediments to the
flexible use of labour. Protective labour legislation and the welfare state
and the nature of labour contracts, whether negotiated by trade unions
or not, can make it difficult to change the use of labour. Without
rigidities there would be less job security, more adjustments to pay,
including pay reductions, and higher levels of labour productivity.
Labour has always had a special status in economics because the
way it is treated determines the quality of life for most of the popu-
lation. The length of the working day and the level of pay relative to
subsistence are central welfare issues. Both classical economists such as
Smith and marginalists such as Jevons regarded labour as disutility.
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LAISSEZ-FAIRE
The labour market will always be difficult to analyse because of the
heterogeneity of labour and the many cases of asymmetric information.
In Marxian economics concrete labour is what labour actually
does, for example, weave cloth, and created use values, but abstract
labour is devoid of the actual circumstances of work – a general
property measured in the quantity of hours worked essential to capital
accumulation and the creation of exchange values. Labour power is a
worker’s capacity to work, which is sold to capital.
The special roles of labour, as the recipient of most of the national
income – a major element in costs and the basis of some theories of
value – have prompted the idea of the standard of value being a
labour standard rather than a gold standard. Writers as diverse as the
early nineteenth-century socialist Robert Owen and the later John
Hicks have suggested this.
Further reading: Addison and Siebert 1979; Cahni 2004; Ehrenberg 1997
LAISSEZ-FAIRE
Opposition to governments with extensive power to interfere in
economic life.
The origin of the expression is attributed to Boisguilbert and
Legendre, who objected to the mercantilist policies in the seventeenth-
century France of Colbert. The Physiocrats were eager followers of
this doctrine of little interference in the economy. It was argued that
free internal and external trade would be of immense benefit. Also
production would follow its natural course if capitalists could invest
in response to prospective rates of profit. The eighteenth century, an
age of enlightenment, attacked old superstitions and unjustifiable meth-
ods of living and working. The classical economists were only partial
converts, despite often being associated with this anti-intervention
stance. In matters of trade, banking and responding to poverty, they
recommended a mixture of government action and private initiative.
Laissez-faire attitudes have long been regarded as brutal and
uncaring. They seem to be based on the unrealistic assumption that
people are naturally good and do not need the oversight of govern-
ment to restrain bad conduct and order actions with good social
outcomes. The critics of laissez-faire point to market failures; the
advocates to the expense and shortcomings of government.
Further reading: Bastiat 1964
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LIBERTARIAN ECONOMICS
LIBERTARIAN ECONOMICS
A branch of economics especially associated with the Chicago School
of economics which emphasises the role of markets and minimises
the role of the state.
It is a descendant of Physiocratic laissez-faire and natural law
economics. The Physiocrats resisted an imposed political order, as
under a social contract, preferring nature to take its course. Natural
law writers emphasised that through conscience rather than outside
controls public conduct would be proper. Libertarian economics
continues themes from classical economics and often uses neoclassical
methods.
Early writers in this stream of economics include Ludwig von
Mises, who wrote extensively about the dangers and mistakes of
socialism. Later Austrian economists, including Hayek, showed the
importance of understanding the spontaneous nature of a national
economy freely using market mechanisms. Because of these
mechanisms the economy can be self-managed.
The ‘Chicago School’, founded within the University of Chicago
in the 1920s by Frank Knight and Jacob Viner, departed from Chi-
cago’s earlier institutionalism. They were concerned to apply neo-
classical price theory to a variety of economic problems. The school
was soon to attack Keynesianism. Later from the 1950s Milton
Friedman and George Stigler, helped by Hayek in an adjacent
department, initiated its distinctive libertarianism. Friedman exten-
sively attacked government intervention through policies which
constantly meddled, as did demand management, rather than follow a
central rule as did monetarism.
The policy proposals of this school of thought are few and echo
the recommendations of political liberals. It is important for there to
be little regulation in the running of a national economy and for
choice mechanisms to be reinforced, for example, by granting edu-
cational vouchers to parents so they can choose between publicly
financed schools. Consumer sovereignty and individual choice are
always paramount. These economists have a preference for monetary
over fiscal policy, which is consistent with their view that the state
should have minimal functions. Every activity of the state is examined
to see whether there can be a market alternative, even for welfare
programmes.
Inevitably the libertarians have been criticised for ignoring the
modern desire to recognise that there are welfare needs which require
state provision, for caring little for the environment, for disregarding
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MACROECONOMIC FORECASTING
the ill effects of property rights and for being willing to sit back as
the mechanisms of markets turn over, not caring how many
inequalities will be created. Much of libertarian economics is micro-
economic because of its persistent use of price theory, with less
interest in the macroeconomic issues raised by critics.
Libertarian economics has to be distinguished from anarchy, as
libertarians always stress the importance of the role of law as one of
the pillars of a minimal state: even libertarians who advocate privati-
sation of policing still want it to exist in every country. It is also dif-
ferent from the ideas of ‘liberals’, in the American sense, which
overlaps with European democratic socialism
See also: Austrian economics; capitalism
Further reading: Tilman 2001
MACROECONOMIC FORECASTING
The use of aggregate data on the different aspects of a national
economy to predict the future values of key economic variables,
especially GDP, prices, wages, productivity, money supply, con-
sumption and investment.
Stages in the creation of a forecasting model began with a process
of abstraction, of reducing the vast diverse complexity of economic
life to a few relationships between selected economic entities.
Early attempts to model the economy were made by Cantillon and
Quesnay, the latter with his tableau e´conomique. Of the classical economists,
Ricardo was the most abstract through creating a model of value and
distribution. The foundation of modern macroeconomics in the
1930s, and the associated development of national income
accounting, made possible the formulation of basic equations to
describe a national economy and the data to estimate their value.
Leading banks, research institutes and finance or treasury departments
of governments attempt to create their own forecasting models. The
simplest of sets of equations is the starting point before a cluster of more
intricate equations is used. Issues which need to be constantly addressed
include the linearity of functions and the justification for engaging in the
extrapolation of time series. Crucial to the success of forecasting exer-
cises is the correct specification of economic relationships and the iden-
tification of causal mechanisms. ‘Granger causality’ is constantly assumed,
i.e. using one time series of data to forecast another by introducing
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MARGINALISM
time lags of varying duration. Endogenous variables must be dis-
tinguished from those which are exogenous. An important tool of
the forecaster is the econometrics of time series. Types of forecasting
error have to be discovered so that predictions can be more refined.
A distinction is made between structural forecasting, based on
economic theory, and non-structural forecasting, which is based on
reduced form correlations. Stochastic models which use time series,
the values of an economic variable at different dates, and the auto-
regressive method of relating past to current values, are distinguished
from qualitative or quantitative non-stochastic models.
The success of monetary and fiscal policies is heavily dependent on
the accuracy of forecasting. But also the underlying macroeconomic
theory used can imperil the choice of model. More ambitiously, a
macroeconomic model can attempt to identify the sources of eco-
nomic growth in an economy and test long-range economic policy.
There is also modelling of the regions of national economies.
Further reading: Klein 1970; Whitley 1994
MARGINALISM
A school of economics which succeeded classical economics and
laid the foundations for neoclassical economics.
It is argued that there was a ‘marginal revolution’ in 1870, with
three leaders: Stanley Jevons in Manchester, Leon Walras in Lausanne,
and Carl Menger in Vienna. Several attitudes were shared by these
writers. An interest in consumer equilibrium, in optimisation at the
margin using the concepts of marginal cost, marginal revenue and
marginal utility, characterised their work. There are sufficient pre-
cursors to these writers to question whether there was indeed a
revolution. In particular Lloyd, Senior, Dupuit, Gossen and Jennings
were aware of the concept of marginal utility, without considering
the full range of marginal entities.
Jevons in his Theory of Political Economy (1871) consciously sought
to challenge the doctrines, especially the labour theory of value, of
Smith and Ricardo, by placing marginal utility in the central position
of the theory of exchange. Combining the utilitarian analysis of
pleasure and pain devised by Bentham and the mathematical method
of differential calculus, he formalised the nature of exchange and set out
the conditions for consumer equilibrium through equating marginal
utilities of different goods. Also he applied marginal analysis to the
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MARKET
supply of labour and theories of capital and interest. His con-
temporary Carl Menger, in his Principles of Economics (1871), also
made use of obtaining satisfaction at the margin. He also rejected
labour theories of value and showed how a consumer maximises
satisfaction from a given income, without using mathematics more
advanced than arithmetic. Walras, the third of the leaders, also pro-
duced an economics making marginal utility central and differential
calculus the crucial tool, in his Elements of Pure Economics (1874).
Value in exchange emerges spontaneously as a consequence of free
competition. The analysis of exchange is elaborated to many com-
modities, laying the foundations for general equilibrium theory.
To look at the margin is crucial to decision making because it is in
decisions to expand or reduce a commitment of resources that con-
sumption and investment are affected. Marginal cost and marginal rev-
enue are the most important of marginal concepts: the equalising of
these two measures is the rule followed by a profit-maximising firm.
Marginal cost pricing is at the heart of the efficient allocation of
resources. Prices then have the function of ensuring that there is
social efficiency. What is good in theory cannot always be imple-
mented, especially because it is difficult to identify the marginal unit
of a complex system. Also if average cost is declining then marginal
cost will be declining at a faster rate. This means that the revenue
obtained when setting prices equal to marginal cost will be insuffi-
cient to cover fixed costs.
The marginal approach has the major advantage of looking at
infinitesimal changes, so can be expressed using calculus. That was
perhaps the main legacy of this school of thought. Mathematics was
employed more in economics, enhancing the subject’s status.
The opponents of marginalism are many. To some extent they are the
descendants of the critics of utilitarianism. Others make the simple point
that it has encouraged too stylised a form of economics to be useful as
a guide to policy. Marxists dislike marginalism for providing a theory
of value which is subjective and ignores labour as the source of value.
See also: Austrian economics; neoclassical economics
MARKET
The bringing together of buyers and sellers to effect exchanges at a
mutually acceptable price. Markets can be based on any communications
network, including a physical meeting, telephonic and internet contact.
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MARXIAN ECONOMICS
Factor markets for labour, land and capital are distinguished from
the product markets for goods and services resulting from the
employment of those factors. A market is a buyer’s market or a seller’s
depending on which side has an advantage: the buyer when there is a
surplus of supply and the seller when there is scarcity.
There will be market clearing if the amount demanded exactly
matches the amount supplied. Market failure occurs if the free
working out of the forces of demand and supply does not achieve a
welfare goal. In the public sector often there is a lack of a market
because of the free provision of services, so that a market has to be
simulated by, for example, surveying consumers.
The extent to which markets are used distinguishes one type of
national economy from another. Planning is contrasted with the
market as a method of allocation. The existence of markets is often
heavily criticised. ‘Market forces’ are alleged to be harsh in their
operation, caring little for the violent effects of adjusting to new
equilibria, such as when unemployment results. On the other hand,
the tolerance of inefficiency can lead to welfare losses. Experience has
shown the triumph of the market over other forms of allocation,
partly because it is less arbitrary than rationing, partly because of it
being central to the capitalism which has become dominant in the
economic systems of the world.
An ‘efficient market’, especially a stock market, has prices which
reflect all information, in the weak sense of using all past prices, or in
the strong sense of using all publicly available prices.
In some economies markets are few, especially where there is self-
sufficient subsistence agriculture, or a plentiful public provision of
services and control of consumption by government. Markets will
emerge to make allocations more efficient and to challenge the arbi-
trariness of government.
See also: efficiency; price
Further reading: Aldridge 2005; Salanie´ 2000
MARXIAN ECONOMICS
Economic analysis suggested by Marx and developed by his disciples.
The economics of Marx grew out of earlier theories, especially the
dialectical materialism he had absorbed as a philosopher from Hegel
and the eighteenth-century stages theory, and the leaders of the classical
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MARXIAN ECONOMICS
school, Smith and Ricardo. The principal themes of Marx’s eco-
nomics occur in volume one of his Capital (volumes two and three
were published posthumously through his literary collaborator Engels
creating a manuscript from notes). Building on Aristotle’s distinction
between use value and exchange value, and using Ricardo’s labour
theory of relative value, he developed his theory of value based on
socially necessary labour time then outlined the circulations of com-
modities and money as a prelude to explaining absolute and relative
surplus value. With such tools he was able to analyse the nature of
capital accumulation and its implications for wages and the working
classes. Capital is composed of constant capital, ‘dead’ labour embo-
died in commodities in the past, and variable capital which is current
labour. As capital accumulates the ratio of constant to variable capital
increases, leading to a falling rate of profit and to more intense
exploitation of labour. Workers are alienated through not owning the
means of production and its product, and lacking control over the pro-
ductive process. There is exploitation of industrial workers through the
extraction of surplus value from them by means of lengthening the
working day beyond the time needed to produce subsistence.
Although there are parallels with Marx in much of classical eco-
nomics, he did have some original approaches. His theory of crises
was an important contribution to trade cycle theory, despite being
carelessly scattered through Capital. A crisis, or upper turning point,
occurs every ten years. Only in monetised economies will there be
cycles, because the nature of capitalist production is to separate
buying from selling so that the proceeds from sales may be hoarded
rather than passed on in new purchases. Using contemporary eco-
nomic experience, he examined many causal contributions to cycles,
including different growth rates between industries.
Much of his economic writing is critical in tone, reflecting the aim
to analyse and attack capitalism rather than provide an elaborate
blueprint for a new economy and society – apart from in his German
Ideology, where production in communities avoiding too much divi-
sion of labour was advocated.
Historical experience of capitalism in the nineteenth century led to
the questioning of Marxism, especially its claim that there would be a
sequence of events leading to the collapse of capitalism. In the twentieth
century the concerns of this school of economists went in new direc-
tions, including studying the transformation problem, analysing mono-
poly capitalism, especially with the expansion of the multinational
corporation, and considering whether at the level of the state or
smaller community, including the firm, ideals could be realised.
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MERCANTILISM
In the second half of the twentieth century many economists,
including Baran, Sweezy, Dobb, Joan Robinson and Meek, developed
the ideas of Marx. Themes prominent in neo-Marxist works have been
value theory, distribution, crises of capitalism and the international
spread of capitalism through the multinational corporation. Devel-
opment economics has used Marxian analysis, for example, in the
dependency theory of Andre Gunder Frank, which divided countries
into the centre and the periphery with the more important countries
extracting a surplus from the poorer countries. As in Marx’s own
precursor Ricardo, there is a broad sweep in Marxian economics, an
attempt to analyse long period changes; hence Marxian economics
cannot be divorced from Marxian historiography and Marxian sociology.
See also: surplus value
Further reading: Frank 1978; Howard 1992; Junankar 1982; Marx 1976
MERCANTILISM
The economic theories and policies pursued by merchant pamphle-
teers in several European countries from the sixteenth to the eight-
eenth centuries.
They believed states should be strong through balance of trade
surpluses and the accumulation of bullion. Just as merchants had as a
central goal the obtaining of value-added by selling dear and buying
cheap, so also should a nation endeavour to obtain a surplus from
other countries. As pillars of the state the merchants expected privi-
leges, especially monopoly rights to trade to particular countries with
their exclusive trading companies.
Central theoretical concerns were the maintenance of a sound
currency, trade restrictions, full employment, population growth and
state establishment of industries. The mercantilists were interested in
promoting the power of national states, which they thought could
only be at the expense of others in a zero sum game. This static view
of economic life was later superseded by a conscious attempt to pro-
mote economic growth. New industries were to be encouraged,
and output expanded through full employment and measures to
increase productivity. The rapid circulation of money was advocated,
and a primitive quantity theory of money outlined.
Mercantilist writers in their vast scope stumbled across many eco-
nomic concepts and theories. Perhaps the most inventive of all was
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MERIT GOOD
Petty. He pioneered demographic methods and manpower planning,
advocated public works schemes to reduce unemployment, had a
broad view of the functions of the state which included education
and providing medical services, recommended a general expenditure
tax, outlined a land and labour theory of value, used the idea of
opportunity cost, asserted that the labour supply curve is backward
bending, and made human capital calculations.
With the growth of the English East India Company after 1620
there was a loosening of mercantilist doctrine with the advocacy of a
general balance of payments surplus, rather than a surplus in every
balance, and a movement towards free trade. Leading mercantilist
writers included Mun and Petty in England, and Steuart in Scotland.
In French economics the mercantilism of Colbert was replaced by
Physiocracy, in Britain by classical economics.
The fame of Smith’s analysis of the mercantile system in The
Wealth of Nations allowed his criticisms of the system to be a kind of
definition of mercantilism: that it defined wealth to be gold and
silver, opposed free trade and preferred the producer’s interest to the
consumer’s. The nature of mercantilism was more complex and
contradictory, especially the increased approval of free trade in the
eighteenth century by mercantilists such as Josiah Child. Also,
Hume was one of the economists who challenged the very heart of
mercantilism by showing that the price specie flow mechanism made
a permanent balance of payments surplus a futile goal.
In the 1980s in Western economies, the appeal of protection
caused some economists to be labelled neo-mercantilists. With the
decline of manufacturing industry in developed countries and the
attendant unemployment costs from restructuring their economies,
there was an attraction to promoting the welfare of individual states
and being more isolationist. With transport and other forms of
communication becoming faster and globalisation more of a reality,
the desire to turn the clock back was attractive. In a sense neo-mer-
cantilism occurred gradually with the expansion of public sectors
extending and emphasising the power of the state.
Further reading: Grampp 1952; Heckscher 1935; Magnusson 1995; Viner 1937
MERIT GOOD
A good which has beneficial effects when consumed, with the con-
sequence that governments are willing to subsidise its consumption.
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MIGRATION AND MOBILITY
Education, health care and the arts are prime examples. Such goods
receive special attention because there are social as well as private gains
from encouraging consumption. There are also merit ‘bads’, includ-
ing addictive substances in the form of tobacco, alcohol and hard drugs.
To label goods and activities as worthy or unworthy of consump-
tion does appear as paternalist. In democratic societies the list of what
is approved can change, as in the case of prohibition in the USA
where alcohol consumption was legal, then banned, then again lega-
lised. As governments respond to medical research, for example by
banning smoking in public places, the list of merit bads lengthens.
It is through the pattern of government spending and taxing that
the promotion of merit goods is possible. However, because the
demand for merit bads is often inelastic, fiscal authorities imposing
indirect taxes on them can obtain considerable tax revenues, thus
giving governments an incentive to encourage bad behaviour.
MIGRATION AND MOBILITY
The movement of persons between one place and another. Migra-
tion, a population shift between countries, can take the forms of emi-
gration elsewhere or immigration, which is the inflow of people.
Mobility, whether geographical, industrial or occupational, is a move-
ment between one part of a national labour market and another.
Flows between countries have been exceptionally high during periods
of rapid economic development, such as to North America during
the nineteenth century, and in times of great turbulence when a refugee
problem is created by the vicious action of national governments or
civil war. Modern international migration has been largely of two types.
The brain drain consists of highly trained scientists, teachers, doctors and
nurses filling personnel shortages in rich countries. There is also the
movement of unskilled persons, often to provide a replacement
population taking over the less pleasant jobs abandoned by an indi-
genous population which has moved on to good, well paid employ-
ment. Gross flows always have to be distinguished from net, the
phenomenon of emigrants returning home is very well established.
A distinction is made between primary migration and secondary.
In the first flow of primary migration persons in a spirit of adventure,
often with little information, go to another country: that movement
is often quite slow. Subsequently there is a secondary flow of family
and friends. There is a ‘wave theory of migration’ linking the primary
to the secondary flows.
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MONETARISM
The determinants of migration have been neatly divided into pull
factors making the destination attractive and push factors inducing
people to leave. Poverty and persecution are the principal reasons
compelling populations to move. The attractions pulling people to a
new place include job opportunities, higher wages, plentiful high-
quality land and a pleasant climate. These factors can be combined
into models of migratory flows as a function of net differences. Real
incomes, employment, and climate are measurable for inclusion in
these models. To predict the magnitude of migration, gravity models
have been used which estimate that the flow will be greater according
to the size of the population in the original and final places and the
closer they are together. Movements of people have also been ana-
lysed using Markov analysis. This calculates the probability of a
person moving from one cell of a transition matrix to the next.
Migration can be seen as a Darwinian process of the survival of the
fittest, which was literally true in the arduous early voyages to
America. There is the related concept of motility, which is the
potential for mobility, estimated by extrapolating past trends or con-
ducting surveys of intentions.
Moving to another place, another occupation or a new employer is a
costly process. There are the monetary costs of travel, acquiring housing
and learning the new skills required. Also there are the psychic costs
of losing proximity to friends and relatives and even having to aban-
don communication in one’s native language. These costs can be met
privately or subsidised by new employers or governments. National
governments are often interested in promoting flows within and from
without their boundaries. Skill shortages and ageing populations can
prompt schemes to encourage immigrants: such a population policy is
more expedient than taking years to train the present population and
increase the birth rate to remedy the perceived problem. A concern
for economic growth will lead to regional policies, including
subsidising moves to new areas where there are labour shortages.
See also: economic demography
Further reading: Giersch 1994
MONETARISM
A doctrine for the conduct of monetary policy based on rules rather
than discretion.
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MONETARY POLICY
This policy was partly an attempt to revive the quantity theory of
money and partly an alternative to the discretionary demand man-
agement policies which failed to conquer inflation. Associated with
the monetary policy were proposals to curb public expenditure and
deregulate the economy. It had intellectual underpinnings in the
works of the US economist Milton Friedman and his colleague Anna
Schwartz, who analysed long time series to see the relationship between
changes in the money supply and in economic activity. The policy
conclusion was that inflation and economic cycles could be tackled
by following the rule that the rate of growth for the money supply
should be that of the trend growth of productivity for a national
economy In order to make such a monetary policy a success, it was
essential to have strict controls on public expenditure with few temp-
tations for governments to borrow and expand the money supply.
Implementing the doctrine, as took place in the USA, the UK and
many European countries, quickly ran into difficulties. Defining the
money supply was difficult, and often the measure used as a target
was evaded so a new definition was required. Also the demand for
money functions was unstable as velocities of circulation were not as
constant as thought. There was the difficult underlying question of
the causal role of money, including whether the money supply
changed passively to changes in economic activity, and what was the
transmission mechanism for money affecting economic activity.
Further reading: Friedman and Schwartz 1963; Laidler et al. 1981
MONETARY POLICY
Those actions of a central bank on behalf of, or independent of, a
government as part of its macroeconomic policy.
Originally monetary policy had few instruments, concentrating on
interest rate changes and open market operations. Experience of
money markets and their greater sophistication of products extended
the range of monetary tools over time. The Federal Reserve Board of
Governors in the USA from 1913 has extended its powers to set
reserve requirements and set targets for the growth of monetary
aggregates. The Bank of England since 1951 has experimented with
many approaches, including setting rules for consumer credit, looking
at liquidity as a whole and controlling the monetary base.
The goals set for monetary policy include the achievement of a
target rate of inflation or target rate of interest, as well as the principal
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MONEY
macroeconomic goals of low unemployment, growth in the Gross
Domestic Product, the stability of the economy over time and the
stability of the financial sector, output or price stability. An activist
monetary policy can be destabilising because due to the time lags
associated with monetary policy the ultimate outcome of using such a
policy can be surprising.
A crucial issue is the extent of independence for monetary policy
makers. Partly because of the possibility of there being a political
business cycle, the idea of a central bank conducting monetary
policy without government ministers interfering has become popular.
It is difficult to have complete independence, as there is political
interference through careful choosing of the members of monetary
policy committees, in the setting of policy objectives and in the
management of other macroeconomic policies which can defeat the
exercise of monetary policy. Before the implementation of Keynesian
demand management, most of macroeconomic policy was monetary
rather than fiscal, with the interest rate a key tool. Changing fashions
in economics reduce or diminish the importance of monetary policy.
In the 1980s when monetarism was popular in Western countries,
monetary policy was prominent.
See also: banking; fiscal policy
Further reading: Bofinger 2001
MONEY
The most liquid of assets; what is generally used for the discharge of a
debt; a social institution facilitating exchange.
Money replaced barter because it was more convenient and por-
table and there were fewer search costs to establish ‘the double coin-
cidence of wants’, that a person with a surplus could find another
person with surplus which they mutually wanted to exchange.
A distinction is made between inside and outside money, a contrast
between privately and publicly issued money. The latter can be pos-
sessed of intrinsic value, or be ‘fiat money’ whose value is accepted
on trust because of the integrity of the issuing authority. Privately
issued money can be less generally acceptable as there are fewer
constraints on its general issue. Publicly issued money by a monetary
authority can be excessive, especially when controlled by a high
spending government with little concern about depreciating its own
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MONEY
currency. Hayek argued for the privatisation of money; Smith in his
real bills doctrine asserted that an excessive issue would be redun-
dant, as bills of exchange corresponded to real transactions in an
economy.
As long ago as Aristotle in book V of his Nicomachean Ethics, the
threefold functions of money as a unit of account, medium of
exchange and store of value were noticed. There is little dispute that
money is useful for aggregating the values of different things, for
example, apples and steel, using the same standard or yardstick. A
variety of types of record-keeping rely on being able to use monetary
units. Also there is much evidence of its success as an instrument of
exchange, but it has had less success as a store of value.
Money is a medium of exchange but held between exchanges,
assuming a store of value role. Clower asserted that money buys
goods but goods do not buy goods, ‘cash in advance’. This means
that bonds cannot be used to buy goods. Demand for money is
related to consumption of goods and to the nominal rate of interest.
Clower asserted that the distinction between money and non-money
commodities is crucial to creating monetary theory and is possible
because of some commodities being means of payment. A commod-
ity which is money can be traded for all other commodities.
Money can be neutral in the sense that a change in its quantity has
no effect on the real economy. Money can be an illusion; for exam-
ple, it can lead to false evaluations which promote unintentional
switches from consumption to investment. Money is said to be a
‘veil’ obscuring the real processes of an economy: an increase in the
supply of money, therefore, could affect prices without changing
output. Money can be regarded as passive, expanding or contracting
according to the needs of trade. However, the view that one can
separate the real from the money economy has been challenged.
David Hume argued in his essay ‘Of Interest’ that in the short term
the increase in the money supply could stimulate output and
employment in an underemployed economy. Also the amount of
money will affect the rate of interest, which in turn will influence the
level of investment.
Discussions about money often become debates about the demand
for and supply of money. Keynes set out the three types of demand
for money – transactions, precautionary and speculative. These arise
from money having different functions. Because money is a medium
of exchange it is used to effect transactions; because it is a store of
value it can be kept as a precaution to meet unusual demands for
cash. The demand for money is the demand to hold it as cash rather
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MONEY
than to convert it into less liquid assets. The speculative demand for
money is the holding of cash because investors do not expect to be
able to make a capital gain as bond prices are believed to have
reached a peak. Money can be held because our plans and contracts
are incomplete, providing it is adequately performing its store of
value function
The money supply is variously measured depending on how
sophisticated the monetary system is in providing a range of assets
with the characteristics of money. The most primitive supply is coinage,
or even commodities such as shells; then follow paper money in the
form of banknotes and bills of exchange, then bank deposits trans-
ferable by cheque and a range of modern financial instruments such
as certificates of deposit. It is difficult for a central bank or other
monetary authority to control the money supply, as not always is the
whole range of types of money regulated and more financial instru-
ments are invented. If control of the money supply is very tight then
disintermediation might occur, i.e. instead of borrowing and lending
being effected through the use of a bank or other finance house there
are direct relations between borrowers and lenders, for example, by
corporations lending through the issue of commercial bills.
Why do we need money, rather than have a substitute economic
institution? The functions of money partly give an answer, because as
a unit of account it makes possible contracts and the measurement of
the national income. As a medium of exchange it enables more
complicated commerce involving more people than physical barter
ever did: hence the possibility of a single coincidence of wants when
money is introduced. Saving is possible if money preserves its value
long enough over time to be a store of value so that it can be a
medium of exchange at a later date.
Recent theorists of money include Kiyotaki and Moore, who
acknowledge the problem of the double coincidence of wants which
money can solve. They argue that the trade which money facilitates
can be between goods available at different dates, rather than physi-
cally different at the same date. Because of a lack of trust there is a
limit to the commitment an economic agent can make to accept
another’s inside money at a later date. Wallace divided models of
money into a category governed by physical characteristics and the
ability to achieve some allocations, and another which produced
utility directly or indirectly by freeing resources.
Further reading: Clower 1967; Hayek 1976; Kiyotaki and Moore 2002;
Wallace 2001
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MULTINATIONAL CORPORATION
MULTINATIONAL CORPORATION
An international firm which produces in several different countries;
also known as a transnational.
Firms of this character have evolved from companies which
exported much of their output. The time came when it became
sensible to produce abroad rather than incur transport and related
costs. Distant locations can have the attractions of lower labour costs,
easier taxes and fewer regulations inhibiting the right to manage. Also
there can be a profitable transfer of technology from an advanced
economy. Corporations which have sprung from the USA, UK,
Switzerland, France, Sweden and Japan principally, have reached an
individual size in terms of total income larger than that of some
national economies. The different subsidiaries spread across the
world are linked by the internal market within the corporation, with
exchanges of components and services taking place at ‘transfer prices’
which do not always reflect full costs.
Multinationals give less developed countries access to technology,
networks of customers, modern management and finance difficult to
obtain locally. The companies themselves through the geographical
diversity of their locations have been able to cope easily with the shift
in manufacturing from North America and Europe.
Criticisms of these corporations are many, both by critics in the
country of origin of the corporation and in the countries where its
subsidiaries operate. The very size of multinationals and their parti-
cipation in financial markets challenges the power of national gov-
ernments who have a declining ability to set their own economic
policies. Through shifting employment from one location to another,
sometimes to avoid industrial strife and incessant demands for higher
pay, from developed to less developed countries, these corporations
can create unemployment in particular places. They can compro-
mise the finance of national governments, for example by avoiding
taxation. Tax revenues from corporations will fall through use of
accounting devices which make profits appear mainly in countries
with low tax regimes, so that governments which have a high tax policy
will find their corporate tax revenues diminishing. Multinationals
which have expanded through mergers and acquisition can change
the character of the national economies in which they invest by fol-
lowing a global specialisation policy. This can lead to important
functions such as finance and research being abandoned in the
country where the subsidiaries are located. For example, Scotland,
like Canada and France, resents being turned into a branch economy.
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MULTIPLIER
Given the controversial behaviour of these corporations, many
institutions have attempted to regulate them. Trade unions have
attempted in the course of collective bargaining to increase job
security. National governments have sought to use competition
policy to prevent predatory practices and have tightened their fiscal
management to obtain a fair tax revenue. Some governments are
too small to control huge commercial concerns, so have used
Organisation for Economic Cooperation and Development codes of
conduct.
However, many attacks on these firms reek of economic national-
ism and hypocrisy. Direct investment overseas can be a response to
regional policies which have offered many inducements to persuade
multinationals to locate in those countries. Also critics ignore the fact
that they have brought investment to countries which otherwise
would have found it difficult to raise finance domestically.
See also: firm; transfer pricing
Further reading: Caves 1996; Humer 1993
MULTIPLIER
A measure of the expansion of employment or income; the ratio of
an increase in income to a change in aggregate demand.
Kahn’s 1931 article describing the employment multiplier – the
ratio of the secondary employment in industries which have expan-
ded to the primary employment in the industry which has initiated
the change – started the formalisation of the multiplier. The inge-
nious Colin Clark made many estimates of national income and of
the multiplier, which were cited in John Maynard Keynes’ General
Theory of Employment, Interest and Money (1936).
Other useful versions of the multiplier emerged. The investment
multiplier relates the income increase to net investment. The foreign
trade multiplier is the ratio of the increase in income to the increase
in investment and exports which have stimulated it. The balanced
budget multiplier shows that a government with its expenditure and
revenue equal can stimulate the economy because it has raised taxa-
tion from households with low marginal propensities to consume
and transferred it to a government with a high marginal propensity to
consume. The credit, or money, multiplier is the ratio of the
increase in the money supply to a change in the monetary base of
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NATIONAL INCOME
liquid assets. Multipliers can be calculated for a region or the whole
of a national economy.
Further reading: Kahn 1931
NATIONAL ECONOMY
The totality of economic activity of the households, firms and gov-
ernment of an independent country.
Economies are variously classified as young or mature, developed,
less developed and underdeveloped. A taxonomy of national econo-
mies, based on ideologies, whether socialist or market, is also possi-
ble. Until the end of the 1980s there was a vivid contrast between the
Soviet-type economy based on central national planning and the
market or mixed economies outside the communist bloc.
Traditionally a national economy had autonomy over the conduct
of its economic policy, but countries which have joined regional
blocs such as the European Union have steadily transferred their
independence to a central supranational body.
The total value of a national economy can be valued as a stock of
assets, the national wealth, or as a production flow over a period of time
as in the national income. National income accountants calculate the
latter and also create input-output tables showing the flows between
different incomes, final consumers and the rest of the world. The
‘size’ of a national economy is often measured by its gross domestic
product (GDP); the size of a country by its land area or population.
The formal economy known to the government statistician and tax
collector is contrasted with the informal/underground/black/shadow
economy. Such a parallel economy exists sometimes to conduct
criminal acts such as theft and tax evasion. Official statisticians delib-
erately exclude some activities because of measurement difficulties, as
with household production, and non-monetised activities.
See also: economic system; informal economy
NATIONAL INCOME
The total of incomes accruing to the residents of a country in a given
time period, especially a quarter or a year, as a result of economic
activity.
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NEOCLASSICAL ECONOMICS
In the 1940s, in the USA Kuznets and in the UK Stone were
major writers on the methodology of national income accounts. The
attempt to manage the economy more precisely, which the changes
in macroeconomic in the 1930s argued were possible, would never
have occurred without the systematic and consistent collection and
presentation of this aggregate data. Earlier in economics many wri-
ters, using the analogy of the circulation of the blood, such as Petty,
Richard Cantillon and Quesnay, wrote of the circular flow of
income.
National income can be measured variously as the sum of incomes,
expenditures or outputs, because an economic activity produces an
output which when sold constitutes expenditure, which provides
incomes for factors of production. Estimates of national income can
be at factor cost (what the factors of production – land, labour,
capital and the entrepreneur – receive), or at market price (what the
consumers pay) which is in excess of national income at factor cost
by the amount of indirect taxes net of subsidies.
There is always debate about what to include in national income as
some activities are not openly declared, especially criminal activity,
work in the black/informal economy and income attributed to
owner-occupiers of property. Where there is extensive household
production, as with self-sufficient agriculture, proxy measures of
income based on population size and average consumption have to be
estimated.
Further reading: Beckerman 1980
NEOCLASSICAL ECONOMICS
An individualistic approach to economics emphasising the rationality
of economic agents and using equilibrium methods.
The school’s debt to classical economics is slight. The working
of competitive markets, the self-interested economic agent, the
notion of a decentralised economy and the invisible hand are
favourite borrowed concepts. Differential rent theory expounded by
Ricardo used a marginal idea with many echoes in the neoclassical
school. An examination of the prose of writings of the two schools
shows the classical to be more literary and discursive with much
appeal to history; neoclassical economics often has few preliminaries
before a model is set out: issues of ethics or philosophy are avoided in
this positivist economics.
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NEOCLASSICAL ECONOMICS
Beginning with the ‘marginal revolution’ of the 1870s, in which a
new approach to economics emerged in parallel with Jevons in
Manchester, Leon Walras in Lausanne and Carl Menger in Vienna,
neoclassical economics soon acquired its distinctive features. But
some marginal concepts, especially marginal utility, were present in
earlier writings, including those of Senior and Dupuit. An interest in
consumers maximising their utility and firms maximising their
profit, and economic decision making subject to rationality rules,
became central. Jevons insisted that economics was essentially math-
ematical because it deals with quantities, and was one of the pioneers
of the use of differential calculus. Marshall in his Principles of Economics
(1890) built up a supply and demand analysis which provided a
method for much of neoclassical economics.
Economic agents, especially firms and consumers, have the task of
maximising their utilities. The concept of equilibrium is dominant.
In neoclassical models the establishing of an equilibrium is a primary
task: without it the fundamental analysis would fall apart. Utility of a
subjective, individualistic kind is a repeatedly used idea. Without
mathematics there would be little of this modern form of economics.
Neoclassical theories of production and distribution were expoun-
ded supremely in Samuelson’s Foundations of Economic Analysis. He
considered equilibrium systems and comparative statics before
expounding dynamical theory. He also presented the theory of max-
imising behaviour, a pure theory of consumer’s behaviour, and a
welfare economics including a social welfare function. The book
demonstrated how powerful a few mathematical tools borrowed from
calculus and algebra can be.
Neoclassical economics extensively applies demand and supply theory
to a range of economic problems, such as scarce resources, dis-
crimination, patents and foreign exchange markets. A standard check-
list of the themes of neoclassical economics – the theory of the firm,
consumer behaviour, human capital theory, the economics of the
family, general equilibrium theory, marginal productivity theory,
switching and reswitching in capital theory, the Heckscher-Ohlin-Vanek
trade theory, the use of models based on rationality and approval
of monetarism – shows how much the school has come to dominate
the economics faculties of universities in developed countries.
This school of economics in today’s economic literature has its
critics. Opposition is focused on several issues. The extreme for-
malisation captures little of the nature of the modern world, and the
constant search for an equilibrium appears a vain quest. Although
attempting to provide a value-free positive economics, neoclassical
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NEO-RICARDIAN ECONOMICS
economics is not as neutral as it seems. It does not accommodate any
socialist-type views. There is little attempt to take into account the
distinctiveness of modern institutions, including the corporation.
Unlike Marxian analysis, neoclassical economics firmly separates
economics from social considerations. Because neoclassical econo-
mists are heavily critical of government action, believing in self-reg-
ulating mechanisms for national economies, and blaming trade unions
for being monopolists, they are accused of being ideological and
capitalist in their sympathies. As resources, technology and pre-
ferences are assumed, critics argue that essential bits of economics are
ignored, including the concept of entrepreneurship as it is a dis-
equilibrium phenomenon. It is assumed that economic agents act
independently on the basis of full information. An ‘as if ’ metho-
dology is employed, using the assumption that economic agents are
solely engaged in maximising an objective subject to constraints. The
maximisation hypothesis central to neoclassical economics is ques-
tioned for a lack of testability, and for it not being contrasted with
competing aims.
When neoclassical economists take to macroeconomics, they are
fond of two approaches, which overlap with supply side advocates –
recommending cuts in real wages to increase employment and pre-
dicting that the price level will increase in proportion to a rise in the
money supply. An aggregate production function is used to explain
supply. The models chosen are usually short-run and general equili-
brium in character. At times neoclassical economics appears to be
only a technique for applying a maximising model.
The neoclassical dichotomy is the separation of the value of capital
from the value of money. The neoclassical synthesis disliked by the post-
Keynesians was a formalisation of the Keynesian macroeconomic system
started by Hicks and Modigliani. The central ideas of Keynes could be
expressed in a set of simultaneous equations which tended to produce
a full employment equilibrium and assumed the neutrality of money.
See also: evolutionary economics
Further reading: Henry 1990; Hicks 1937; Modigliani 1944
NEO-RICARDIAN ECONOMICS
A reformulation of the economics of David Ricardo by Piero Sraffa
in his Production of Commodities by Means of Commodities (1960).
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NEUROECONOMICS
Although this school of economics has its roots in the works of
economists such as Joan Robinson and Kalecki, the school more
recently has been associated with Sraffa, Pasinetti, Garegnani and
Harcourt. It challenges the assumptions and methods of neoclassical
economics, especially attacking equilibrium analysis. It is concerned
with the creation, distribution and accumulation of the ‘economic
surplus’ in the economy after subsistence needs have been met and
depreciated capital replaced.
Wages, quantities of capital and profits, the basis of real prices, are
unchanging, until there is a change in technology. Sraffa produced a
model with a resemblance to an input-output model, without speci-
fying input coefficients, classical in tone with outputs moving in
a circular flow to provide the inputs of other industries. This com-
modity-production model expressed in physical terms determined
prices and profits under the conditions of a capitalist economy. Sraffa
used a ‘standard commodity’, a weighted composite of commodities
in the system, to solve the problem of obtaining an invariant standard
of value. The quantities of goods produced are given without refer-
ence to the scale, composition and elasticity of demand. This makes
it difficult to determine what should be produced. His foundational
work was written in the 1920s but not published until 1960, so it
ignored developments such as activity analysis.
See also: Keynesianism
Further reading: Na¨slund and Sellstedt 1978
NEUROECONOMICS
A study of the relationship between neural processes and economic
decision making: an account of the processes of thinking in economics.
Economics has made psychological assumptions. For example,
there is Smith’s assumption that we all have a desire for betterment;
and the neoclassical assumption that we prefer pleasure to pain. But
neuroeconomics, by linking an examination of the nervous system to
economics, can provide a more deterministic account of decision
making. A modest form of neuroeconomics is to add to other
explanatory variables an observation based on the nervous system.
Instead of decision making being viewed as a deliberative act, the
study of the brain enables it to be considered as a seemingly uncon-
scious process. The mapping of the brain produces an understanding
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of reward systems, intertemporal choice and the practice of ration-
ality. Glimcher’s examination of the activity of neurons provides a
basis for the predictions of a Nash equilibrium. Economic concepts
can also be useful in neuroscience, for example, by showing the
power of ideas like the division of labour and a constraint.
Further reading: Camerer et al. 2005; Glimcher 2003
NEW CLASSICAL ECONOMICS
A macroeconomic theory assuming that economic agents make
rational market decisions based on optimisation and that markets
clear. Its leaders are Barro, Lucas, Sargent and Wallace.
To the classical assumption that markets clear is added the
assumption that buyers and sellers have rational expectations using
all the information available. Because of this view, the school is
sometimes called simply the Rational Expectations School. This gives
new classical models consistency and allows the optimisation of future
events. Within a general equilibrium framework private individuals
maximise their utilities, as occurs in Lucas’ 1972 article which has a
model structural in nature and not affected by policy changes.
New classical economists prefer rules rather than discretion, and
recommend tax cuts and the control of the supply of money. They
object to Keynesianism and reactive economic policy which adjusts
to economic events. The popularity of this school of economics has
been linked to the laissez-faire attitudes of the 1980s and later.
Rather than debate a trade-off between inflation and unemploy-
ment, the proponents of this type of economics pointed out that
governments are unable to change unemployment from its equili-
brium. The price level is swiftly affected by anticipated monetary
policy because there is no systematic relationship between such
policy and output or the velocity of circulation in the quantity theory
of money. Lucas’ 1973 article on the Phillips curve found a positive
correlation between output and inflation in the ‘Lucas supply func-
tion’. He assumes that the money market and labour market have
cleared, reflecting labour and product market rigidities. Aggregate
demand policies tended to move both inflation and output in the
same direction.
Barro and others of the school believed in Ricardian equivalence,
that is, that if government spending is kept constant and a fall in
present taxation is matched by the present value of a future tax
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NEW POLITICAL ECONOMY
increase, or vice-versa, there will be no impact by government on the
equilibrium real interest rate and consumption. This means that they
can disregard the method of government financing.
Another concern has been the real business cycle which shows
that fluctuations in an economy are caused by technology shocks, not
the exercise of monetary policy. Lucas has used the natural rate
hypothesis (unemployment will in the long run be stable at the
equilibrium rate where labour demand equals labour supply) to
affirm that monetary policy cannot affect the levels of unemployment
and output.
Further reading: Barro 1989; Lucas 1972, 1973; McCallum 1989; Stein
1982
NEW POLITICAL ECONOMY
An examination of the economic effects of political mechanisms.
Its concerns include regulation, rent-seeking, the political busi-
ness cycle, redistribution and the international interdependence of
monetary policies. Much of this subject has an overlap with public
choice theory. Because of its political roots, NPE has generated
literature stimulated by economic events such as the development
of the European Monetary System, Bank of England indepen-
dence, globalisation, sovereign debt crises and the collapse of
communism.
This attempt to explain economic policies does not chain itself to a
social welfare function approach. It seeks out the sources of power in
a society, as does any political scientist, and shows how policies
emanate from such sources. Insights from politics literature, especially
on voting and lobbying, are connected to economic discussions of
reputation, credibility and commitment.
Despite the wide range of the new political economy school, it
will always be criticised for lacking a central and unifying theoretical
core as it focuses so much on specific problems at specific times. Its
methodology does not fully place policy analysis within a general
equilibrium framework. Also there are complaints that quantitative
testing is difficult because of the existence of too many explanatory
variables. The recognition of the political limits to economic policy
helps to avoid too purist an economic analysis.
Further reading: Drazen 2000
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NON-PROFIT ENTERPRISE
NON-PROFIT ENTERPRISE
A firm with goals other than the attainment of maximum or satis-
factory profits.
These can exist in the private sector as charities, clubs, mutual
insurance societies and households. In the public sector they can be
government departments, but are especially public corporations. It is
generally not expected that the aim of governmental and quasi-gov-
ernmental organisations will be the pursuit of profit. As the aim of
production in the public sector is the supply of merit goods, the
provision of enough at a desired level of quality will be the goal.
Britain’s nationalised industries, for example, when set up in the late
1940s were expected to break even, rather than maximise profits,
over a five-year period: in practice some made persistent deficits and
others increased their profitability.
There is a suspicion that the making of profits is a form of
exploitation. Also there is a distrust of markets, partly because they
trade at prices too high for poorer consumers. The conventional
firm, if blamed for these reasons, can link up with non-profit enter-
prises, partly to enhance its reputation, by offering professional
expertise and services including transport and marketing.
Without the goal of making a profit, such an organisation is
tempted to let costs mount up and efficiency diminish. Investment
decisions are more difficult as profits are not available as a guide to
the allocation of funds. However, given the altruistic nature of these
enterprises it is possible to employ high-quality workers at less than
market salary levels, because the mission goals of the NPE are trans-
parently worthwhile. If efficiency is important, it is safer to let such
enterprises flourish at the small and local level.
PHYSIOCRACY
The doctrine of a group of eighteenth-century French thinkers,
known as the e´conomistes, who rejected mercantilism in favour of
laissez-faire economics.
They held as a central doctrine that agriculture alone produces a
net product so that manufacturing is sterile. The early leaders were
Dupont de Nemours, Franc¸ois Quesnay and the Marquis de Mir-
abeau. The last great member of this school was Turgot. Their early
writings appeared in the French Encyclope´die. Quesnay produced a
tableau e´conomique, a representation of the circular flow of incomes as a
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PLANNING
consequence of annual advances, which was an important acknowl-
edged precursor of the input-output table.
In opposition to the idea of a social order based on a social con-
tract, they asserted that there is a natural order, giving rise to making
agriculture the basic activity of an economy and advocating a mini-
mum of government activity to contradict natural processes. They
developed price theory to explain allocation, advocated taxation
only on land, as it alone produced a net product, and were opposed
to tariffs which were impediments to domestic trade.
They inspired classical economics; Adam Smith visited Quesnay on
his grand tour in 1764. Smith believed strongly in natural liberty but
criticised the view that only agriculture is productive.
Further reading: Meek 1962
PLANNING
The organisation of economic activity by a central bureaucracy rather
than by a diversified market.
National governments have undertaken planning in either the
command or indicative forms. Their motivation has usually been the
desire to accelerate the rate of growth. Huge economies, such as the
USSR, emerging from being economies with large agricultural sec-
tors, used planning to force the pace of industrialisation. Developing
countries in Africa and elsewhere after 1945 were often urged to put
planning at the centre of their growth strategies. Countries which
were developed but lagging behind their neighbours also played with
planning, as did Britain in the 1950s.
In the USSR, five-year plans with the force of law set targets for
separate industries and their subordinate organisations from the
1920s. As well as those plans there were additional annual operational
plans. Many difficulties were encountered, including the problems of
using prices which did not reflect relative scarcity, the impossibility
of meeting simultaneously a large number of targets and the lack of
worker incentives.
Indicative planning started in France in 1946. Instead of planning
by government order, the government had the role of indicating
through influential economic forecasts the course of the economy,
thereby inducing the investment to fulfil these created expectations.
Commissions were set up for major industries and for cross-industrial
interests such as research. Parliament participated in choosing overall
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POLITICAL BUSINESS CYCLE
planning targets. The employment of fiscal incentives encouraged
firms to undertake the planned investment. In 1960s Britain, both
Conservative and Labour governments made short-lived attempts to
improve the British economy by this approach. A National Economic
Development Council, with subordinate bodies for major industries,
was set up. It was tripartite in nature with business, trade union and
governmental representatives. The ill-fated Department for Economic
Affairs drew up the National Plan in 1965. The failure of the plan
after nine months reflected traditional planning problems: it is diffi-
cult to have national economic planning for an open economy, to
attempt planning for growth whilst being on a fixed exchange rate
(because deflation is often needed to maintain the currency at its par
value), and to produce a plausible plan by aggregating the forecasts of
individual industries.
See also: comparative economic systems; market
Further reading: Bergson 1980; Heal 1973; Meade 1970
POLITICAL BUSINESS CYCLE
The fluctuations in national economic activity induced by politicians
who attempt artificial stimulation of the economy to encourage
voters to perpetuate them in office.
Nordhaus produced a model to formalise political choices between
economic objectives, looking closely at the trade-off between unem-
ployment and inflation. He argued that a political party when in
office would start with austerity, then employ generosity towards the
date for re-election. These short-term attitudes of democratically
elected governments would threaten social investment. Solutions to
this induced instability could be planning, extending the period
between elections, making more information available to voters so
that they can understand the behaviour of politicians, incomes
policies which abolish the unemployment-inflation trade-off, and
the removal of policy-making to an independent body – as happens
when central banks have control over the setting of interest rates.
In this opportunist approach it is asserted that an incumbent gov-
ernment will use monetary policy to stimulate the economy and
create a feel-good atmosphere to induce voters to re-elect them. The
partisan approach contrasts a left-wing political party with a right-
wing party. They differ in their attitudes to the trade-off between
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POLITICAL ECONOMY
inflation and unemployment. Left-wingers prefer a higher level of
economic activity and are more tolerant of inflation. Also, rational
expectations models of the political business cycle can be based on
expected inflation.
Challenges to this view of the political process include evidence on
how long-sighted governments actually are in their policies, how
ineffective government policies are in creating cycles, and how
sophisticated the electorate is as a consequence of living under the
political business cycle.
See also: new political economy
Further reading: Alesina et al. 1997; Hibbs 1977; Minford and Peel 1982;
Nordhaus 1975
POLITICAL ECONOMY
An early synonym for economics, later an attempt to integrate economic
and political science.
The mercantilist writer Monchre´tien de Wattville in his tract on
political economy of 1615 qualified ‘economy’ with the word ‘poli-
tical’ to expand the notion of economics from the Greek idea of
household management to include the state. Many economics writers
have described their surveys of economics as principles of political
economy, including Steuart, JS Mill and more recently Meade. They
expounded a large number of economic theories, including some on
value, trade, money, population, wages, economic systems and the
scope for economic policy.
To Adam Smith, political economy was intended ‘to provide a
plentiful revenue or subsistence for the people’ and ‘to provide the
state with a revenue sufficient for the public purposes’ (The Wealth of
Nations, book IV). This was to narrow political economy to public
finance. More recently the subject has become a forum for discuss-
ing radical economic policy proposals, a neo-Marxism which puts
income distribution centre-stage and uses a historical method to see
economic issues within the context of an entire socio-economic
system. There is a deliberate attempt to integrate politics and eco-
nomics, with government assuming a role much greater than in
Smith’s time. The nature of capitalism and the aims and practice of
political parties are explored. There is considerable interest in public
goods, externalities and monopolies. The different ways various
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POVERTY
types of government allocate scarce resources is studied. Modern
political economy is in sharp contrast to mathematical economics,
which strives to produce a value-free economics.
See also: new political economy
Further reading: Lindbeck 1971; Meltzer 1991; Sherman 1972
POVERTY
Being devoid of resources; worse off than a reference group because of
illness, physical and social location, or a lack of economic opportunity.
Absolute poverty means a state of destitution in which people have
no food, shelter or possessions. This extreme state occurs often in
civil wars and after natural disasters before relief is brought. In more
normal times absolute poverty occurs when income is insufficient to
obtain sufficient food and water for survival.
Supporters of egalitarianism use a relative poverty concept, arbi-
trarily choosing a point in the income distribution, for example, the
lowest decile, or even the median, below which all are poor. It is
argued that being poor is not merely being short of food but finding
it difficult to participate in society, including having the standard
range of consumer durables and being able to afford entertainment. A
deprivation index such the Townsend Material Index combines data
on unemployment, overcrowding, non-car ownership and low
social class – the indicators of relative poverty.
Poverty has many causes, including mismanagement of a national
economy so that there are recurrent recessions and the attendant
unemployment. Also the patterns of wage differentials and the rela-
tionship between wages and profits can produce a large number of
persons with low incomes. Lack of education has often been seen to
create an impoverished stratum of society, as Marshall recognised, in
his examination of the poorest section of society, ‘the residuum’.
There can be a passive acceptance of poverty because it has long been
experienced by a whole community and no one has urged the suf-
ferers to complain. For spiritual reasons poverty can be sought as a
way of life, as in religious and other communities in revolt against
materialism and consumerism.
A poverty trap exists for persons returning to the labour market
after living off welfare payments, as there is a high marginal tax rate
on those who change from one type of income to another.
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See also: equality; income distribution
Further reading: Banerjee et al. 2006; Lister 2004; Townsend 1979
PRICE
PRICE
The amount of money or something of worth which has to be
sacrificed to obtain one unit of a good or service.
In value theory, value in use is separated from value in exchange, the
latter being the prices which emerged from markets. Prices were
temporary aberrations from the long-run fundamental value of goods.
As demand fluctuates, prices move around a fundamental value based
upon the cost of production. In the development of economic
theory, market value, or price, received more detailed attention. It
was appreciated that markets are subject to varying degrees of com-
petition and monopoly. Nineteenth-century writers such as Samuel
Bailey and JS Mill related price determination to different types of
markets, thus making a price a market phenomenon.
Prices have many functions. They provide a method of allocation
which will result impersonally from a competitive market process,
measure of total income and a signal to producers who will gain
information merely by watching price movements. Prices also point
to the changes occurring in a national economy.
Types of price abound in economics – natural prices, market
prices, product prices, shadow prices and factor prices. Originally
prices were necessary to facilitate barter or monetised exchange, and
resulted from buyers and sellers coming into contact with each other
and agreeing their exchange rate. They were relative prices; later they
were expressed in money when physical barter was abandoned. Adam
Smith used the concept of natural price, a central price to which all
prices gravitated, which was the sum of the natural rent, natural wage
rate and natural profit. There is a crucial distinction between product
prices, the prices charged for goods and services to final consumers,
and factor prices, the cost of employing the factors of production.
Given that many prices are based on the cost of production, espe-
cially if the labour theory of value is believed, product prices and
factor prices have an intimate relation: with a time lag, they change
in the same direction.
A profit maximising firm will fix the price for each product such
that at that price and output the marginal revenue will equal the
marginal cost. A price is synonymous with average revenue, as total
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PRICE
revenue equals output multiplied by price and average revenue equals
total revenue divided by output. A whole structure of prices can be
devised to reflect a different state of demand in each sub-market. This
price discrimination is possible if the sub-markets can be effectively
separated from each other, such as by time of day with different
prices for peak time travel, or by age as when concessionary rates are
available to young and old consumers, or by geographical location. If
the firm is a profit maximiser then it will set the prices in the sub-
markets such that the marginal revenue in each sub-market will be
equal.
A variety of approaches to pricing can be followed. Marginal cost
pricing, advocated to maximise efficiency, requires setting prices so
that they are equal to the corresponding marginal cost. Often this
cannot be practised as collecting data on marginal costs is difficult.
Prices can also be fixed by administrative action. ‘Full cost pricing’
entails adding to average total cost a margin for net profit, or adding
to average variable cost a gross profit margin which will both finance
fixed costs and leave a return for the firm. This type of pricing
involves guessing at the nature of the demand curve so that the sales
at that price level can be predicted and average cost calculated. Also
changes in demand will require marginal adjustments to prices,
questioning whether the formula should be abandoned.
Prices can remain the same for decades under central planning
because to change them frequently would make the fundamental
calculations of the plan very difficult. But some pricing has to be
attempted as a nume´raire is required to aggregate inputs, outputs and
other economic quantities to show the relationship between produc-
tive units, sectors and the national economy. Even in the market-
orientated economies of the West at times of war (especially the
Second World War) and of inflation (notably the 1960s and 1970s),
governments attempted to fix prices within the framework of a prices
policy. This required the collection of cost data and the invention of a
formula to transform costs into prices. Inevitably the prices which
were set would be difficult to maintain for very long under changing
market conditions. Governments can attempt to stabilise prices by
more modest methods than a national prices policy; for example by
investing in buffer stocks, accumulating when prices are low to sti-
mulate their price and selling them when prices are high to bring
prices back to customary levels.
The effects of a change in price can be split into an income effect,
as a rise in price reduces real income, and a substitution effect, as a
price rise can reduce consumption in favour of the consumption of
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PRICE INDEX
another good, and the opposite for a price fall. For a normal good, a
fall in price raises the quantity demanded as these effects are both
positive. For a Giffen good a price rise leads to an increase in the
quantity demanded because the income effect is greater than the
negative substitution effect.
Because prices change, speculation is possible. The motive of the
speculator is the hope of gaining from future trends in prices. Spec-
ulation can be studied as an exchange of information, or as an
exchange of risks.
See also: competition and monopoly
Further reading: Dorfman 1967; Hirshleifer 1980; Wiles 1961
PRICE INDEX
A measure of inflation.
This is calculated by measuring the total cost of buying a bundle of
goods and services representative of the consumption of an average
consumer of a particular national economy at different dates.
Price indexes are created to serve different client groups and
therefore can be of different types. There is a sharp distinction
between consumer and producer price indexes, with the latter
anticipating changes in the former. Also there are indexes for forms
of consumption especially prone to rapid increases, such as house
prices. Originally the main purpose of constructing an index was to
see if real wages were stationary, declining or increasing. Wage bar-
gainers use such an index as the starting point in pay negotiations.
The relative amounts of each item consumed appear in the index
as ‘weights’. An index will show the movement of prices between a
base year, the starting year for an index, and the current year. The
Laspeyres index uses the weights of a base year; the Paasche employs
current weights. As price increases can reduce expenditure and
price decreases encourage more spending, the pattern of con-
sumption will change with the consequence that current weights
are different from base weights. This means that both of these indices
present a false picture of price movements. The Fisher ideal index
took the square root of the product of the results from the two
indices as a compromise.
Early endeavours to produce a price index were made by William
Fleetwood, George Poulett Scrope and, more importantly, Stanley
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PRICE-SPECIE FLOW MECHANISM
Jevons. Price indices are produced for the retail and wholesale trades
and for different types of consumer.
Further reading: Fisher 1972
PRICE-SPECIE FLOW MECHANISM
A description of the relationship between the balance of payments
and prices; an adjustment mechanism under the gold standard.
This idea has been attributed to David Hume, Isaac Gervaise and
Richard Cantillon. Hume in his essay Of the Balance of Trade wrote
Suppose four-fifths of all the money in GREAT BRITAIN to be
annihilated in one night, and the nation reduced to the same
condition, with regard to specie, as in the reigns of the
HARRYS and EDWARDS, what would be the consequence?
Must not the price of all labour and commodities sink in pro-
portion, and every thing be sold as cheap as they were in those
ages? What nation could then dispute with us in any foreign
market, or pretend to navigate or to sell manufactures at the same
price, which to us would afford sufficient profit? In how little
time, therefore, must this bring back the money which we had
lost, and raise us to the level of all the neighbouring nations?
Where, after we have arrived, we immediately lose the advantage
of the cheapness of labour and commodities; and the farther
flowing in of money is stopped by our fulness and repletion.
In opposition to the original mercantilist view that a country should
and could have a permanent balance of payments surplus, these wri-
ters stated that the price consequences of a trade balance would cause
it to swing between surplus and deficit. As a consequence of a bal-
ance of payments surplus there would be an influx of silver and gold
which would push up the price level. Then the higher prices would
make it more difficult to export, so the balance of payments would
swing to deficit, specie would flow out and prices would fall.
PRIVATISATION
The movement of assets, usually by sale, from the public to the private
sectors.
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PRIVATISATION
This can take the form of the sale of state-owned industries, social
housing stock and parts of the infrastructure such as bridges, roads
and cemeteries. As early as Adam Smith, the sale of state-owned
forests, then one of the few government-owned assets, was recom-
mended. In the USA over a billion acres of public land was privatised
in the 1790–1820 period. In the UK in the 1980s nationalised
industries created forty years before, including telecommunications,
gas, electricity and an airline, were sold to the public. In the transi-
tional economies of Eastern Europe in the 1990s, many state-owned
assets passed into private hands. The scope for privatisation has
increased because of the accumulation of industrial assets by states in
the twentieth century.
Various motives have prompted this change in the ownership of
assets. As part of a budgetary strategy, the acquisition of further short-
term revenues through asset sales was attractive. Also, given the poor
commercial record of some publicly owned concerns, government
expenditure in the form of subsidies to the loss makers could be
reduced. The greater commercial discipline which was possible in the
private sector increased profitability. Managers were able to direct
their enterprises without constant interference from government
ministers. The policy aims of a firm are narrower than those of a
government as they are not subject to so many lobbies and are not
expected to have social objectives central to their activities. There is
the added discipline of having to be exposed to stock market criti-
cism, including the possibility of take-over by another firm.
Critics of privatisation often exposed the faults of the mechanism
of privatisation. For privatisation to succeed a share price had to be
chosen which would both realise substantial revenue from the sale
and avoid shares being left with the underwriters. In Britain it was
claimed that nationalised industries were sold too cheaply, thus
depriving the public of annual revenue and squandering the future
wealth of the state. On the other hand it was argued that those who
bought the new shares were better-off people who had suffered higher
taxes in the past through the inefficiencies of nationalised industries
so they were, in a crude sense, receiving some compensation.
Also the structure of the privatised industry had to be decided.
Prior to nationalisation they would often be competitive industries;
subsequently they were organised as state monopolies. To make the
industries more marketable there was a case for allowing them to
retain their monopoly rights, but this raised new concerns, thus a
demand for regulation, especially to avoid reduction in the quality
of service, including safety, and the unnecessary raising of product
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PRODUCTION FUNCTION
prices. However, an industry which was organised as a single cor-
poration because of the belief that it was a natural monopoly should
continue with monopoly status.
Inevitably an industry which has drastically changed its ownership
will be subjected to official and informal audits. The criteria used to
judge whether a privatisation has succeeded include the growth of
output, market shares of domestic and foreign markets, returns to
assets employed, levels of employment and remuneration, commit-
ment to research and development, and levels of consumer satisfac-
tion with the goods and services produced. Where the privatised
concern remains a monopoly, anxiety about exploitation of con-
sumers through high prices suggests the need for price controls, for
example, only allowing product prices to rise by the general rate of
inflation less an arbitrary number of percentage points.
Privatisation of publicly owned housing stock was criticised for
creaming off the better houses for sale to tenants so that persons
unable to purchase any house could only rent inferior property. Also
local authorities with a responsibility for the homeless found they had
to work with a smaller number of houses. The sale of transport sys-
tems and other major parts of the infrastructure raised fears of price
increases and misuse of subsidies granted to private firms to maintain
high-cost services on social grounds.
Further reading: Gayle and Goodrich 1991; Littlechild 2000; Thompson et al.
1986
PRODUCTION FUNCTION
The relationship between inputs and an output.
Such functions have been central to economic growth theory
and important in the theory of the firm. They are central to under-
standing returns and costs. They show the extent to which a form of
economic activity is labour- or capital-intensive. The structure of
costs follows from the nature of the function.
The best known is the Cobb-Douglas function which shows phy-
sical output as the product of labour and capital inputs, assuming
constant returns to scale and the elasticity of substitution between
labour and capital is 1. Different types of production function occur
when the assumptions are relaxed. There can be the constant elasti-
city of substitution function with that elasticity being greater than
one, as suggested by Arrow et al. 1961.
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PRODUCTIVITY
The production function will indicate whether increased
amounts of inputs result in constant, diminishing or increasing
returns/products. Classical economists, especially Smith, Malthus
and Ricardo, were aware of production functions in their discus-
sion of diminishing and increasing returns. Usually agriculture was
thought to have diminishing, and manufacturing increasing,
returns.
See also: cost; economies of scale and scope; efficiency; returns
Further reading: Arrow et al. 1961; Douglas 1948; Heathfield 1971
PRODUCTIVITY
The amount of output resulting from employing one unit of a factor
input, especially labour or capital; the output from the joint
employment of several factors, hence total productivity.
There is always the problem of separating the productivity of one
factor from another, as changes in the use of one factor often coin-
cide with more or less of another factor being employed. Thus
measuring labour productivity is difficult because it is hard to
conceive of a constant amount of capital. It is easier to measure
productivity for occupations with a physical product; productivity of
government employees is crudely measured with averages.
Schemes to increase productivity include improving the motivation
and work methods of workers and economy in the use of labour,
often through changing capital-labour ratios. Incomes policies have
used the idea of productivity to set out rules for approving non-
inflationary pay increases: if productivity is expected to increase then
a pay increase can be self-financing. Fixing overall pay increases to
the trend rate of productivity growth in the economy, say 2.5 per
cent, will avoid inflation.
The classical economists, especially Smith, attributed productivity
increases to the use of the division of labour principle as it econo-
mised in the use of labour. A later writer, Denison, in Why Do
Growth Rates Differ? emphasised the importance of education as a
force for productivity growth.
See also: division of labour
Further reading: Denison 1967; Jorgensen 1995
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PROFIT
PROFIT
The portion of the national income awarded to the owner of
capital; the residual income after rent, wages and interest are paid if
other factors of production have priority; the return for bearing risk.
The reasons for justifying the payment of profit as a consequence
of owning capital have long been debated. Adam Smith related profit
to risk; Nassau Senior to the abstinence of the person who refrains
from consumption in order to save and invest.
In classical economics there was the strong belief that the rate of
profit had a tendency to fall. Smith in the Wealth of Nations argued
that the ‘competition of capitals’, i.e. more capitalists entering a
market, would push down the rate of profit. Ricardo in his Principles
of Political Economy and Taxation set out a model for a national econ-
omy in which with the population expanding and having to rely on
increasingly inferior ground, the real cost of food and of wages would
rise, thus squeezing the rate of profit. Thomas de Quincey in his
Logic of Political Economy built on hints of Smith to expound three
reasons for disputing this tendency. He challenged the view that
capitalists knew enough about profit rates to respond to high profits
by entering an industry. He questioned the notion of diminishing
returns in agriculture assumed by Ricardo. Also, by using the rate of
interest as a proxy for the rate of profit, he noted that it fluctuated
rather than following a secular downward trend.
Some regard the existence of profit as proof of exploitation, fol-
lowing on from Marx’s idea of surplus value. Others think of profit
as a signal helping the investor to choose a project. The profit margin
is the difference between the cost and selling price. Taxes on profits,
or excess profits, have attacked high profits, partly because of their
association with private monopoly power. To make profit more
acceptable, some firms have instituted profit sharing schemes to top
up wages and salaries and increase the identification of an employee
with the employer, and some organisations have been set up on a
non-profit basis.
Further reading: Parker 1991
PROPERTY RIGHTS
The rights accruing to persons, corporate bodies and governments
over material objects, claims and funds.
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Locke linked the idea of possession of land to the labour of culti-
vating it in his Two Treatises of Government (second treatise, chapter V).
He distinguishes what is common to the human race, the earth and
inferior animals, from the property of one’s person as a result of
labour and the work of one’s hands. By removing the fruits of nature
out of the common ownership my labour makes it my property. Land
cultivation justifies private property. There are private possessions
because it is the condition of human life to labour and have materials
to labour upon.
Smith, like Hobbes before him in Leviathan, argued that humans
join together in society to obtain common security. In The Wealth of
Nations as population grows land is appropriated and the landlord
class emerges spontaneously. In book V when discussing justice,
Smith asserts that in the earliest society of hunters there will be
equality and poverty but in the second stage, that of shepherds,
there will be inequalities of wealth, with the richer having authority
to command the subordination of the other shepherds. Thus private
property as an institution and its attendant rights result naturally from
economic development. Private property replaces common property
when animals are owned by individual shepherds. David Hume in An
Inquiry Concerning the Principles of Morals, section III, part II, fervently
expresses his support for private property rights, that men’s posses-
sions should be separated for the sake of the interest and peace of
society: they are crucial to the development of commerce.
Honore´ (1961: 113–20) listed these as rights to possess, use,
manage, receive an income, to alienate to another owner and con-
tinue as owner without expropriation. Private property rights can
always be overridden by a government. As the scope of government
has expanded in the interests of reducing income inequalities, clean-
ing the environment, planning economic development and providing
accommodation for its own activities, private property rights have
been curtailed. ‘Externalities’ and ‘social costs’ are repeatedly used
to justify invasion of what is private.
A property right gives the exclusive right to determine how a
resource or asset is used, and to receive the incomes and services
flowing from it. Some property rights are not directly exercised by
their owners, especially in the case of companies and corporations in
which hired managers direct the use of the firm’s assets. Under a
system of private property rights the uses of property reflect private
preferences, not governmental priorities.
If property rights are loosely regarded as control over resources
then managers in governmental and corporate organisations have
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PROTECTION
some of these rights. Also there are job property rights, because
through contracts and legislation employees have entitlements vested
in their jobs and employers are limited in their control, for example,
through discrimination legislation.
Demsetz argued that property rights are fundamental to exchange,
as what is exchanged is two bundles of property rights. What these
rights are, he argued, amount to the rights to harm and benefit
others. As property rights exist only when there is a society, there are
both internal and external costs and benefits. To internalise an
externality there has to be a net benefit. Single-person ownership has
the advantage of making it easier to negotiate property rights with
others, but there can also be multiple-person ownership through a
publicly owned company/corporation which could have the benefits
of cost reduction.
Coase’s approach to the problem of environmental pollution shows
how powerful the concept of property rights can be. It can deal with
problems of social cost without the need for regulatory bodies under
a system of governmental interference.
For economic development to occur in the present state of the
world it is essential to establish the title to land. Without that there
cannot be permission to invest and no hope of returns. Further, it is
difficult to obtain credit without the collateral provided by property
ownership. Art, care and industry Hume saw to be the consequence
of individual property rights. Without the security of at least a long
lease, improvement is not worthwhile.
Increasingly as the role of government has expanded there has been
an interference with property rights. Privacy is invaded, for example
by allowing aircraft to fly over land; uses are limited to avoid social
spill-overs; rents are controlled and, under planning law, transferred
compulsorily to others whatever the owner’s wishes.
See also: tragedy of the commons
Further reading: Alchian and Demsetz 1973; Barzel 1997; Demsetz 1967; Foru-
botn and Pejovich 1972; Honore´ 1961; Hume 1975; Locke 1988; Soto 2000
PROTECTION
The policy of charging tariffs on imports and imposing other
restrictions, including quotas, to close an economy from outside
international competition.
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PUBLIC CHOICE
The principal reasons for imposing a tariff include raising indirect
tax revenue, reducing the domestic consumption of foreign goods
and services, maintaining economic independence, retaliating against
the tariffs of other countries and encouraging infant industries. The
last is often regarded as the only acceptable justification for protec-
tion, but although it is plausible to protect a young industry until its
output increases and unit costs fall, often infant industries cannot
shake off the help a tariff affords to stand on their own feet. Protec-
tion was a feature of the Soviet-type economies which traded with
each other but did not have free trade with the rest of the world. A
measure of protection can insulate a national economy from trade
shocks and make economic planning easier.
Extensive protection can have a devastating effect on world trade,
causing a widespread slump in national economies. This occurred
through the passing of the Smoot-Hawley Act in 1930 by the US
Congress. Repeated negotiations were necessary to restore free trade.
Later the General Agreement on Tariffs and Trade which led to the
World Trade Organisation substantially eliminated much protection.
Consumer protection is more innocent. By restricting the activities
of businesses it provides minimum quality standards for consumers
and their protection from injury.
Further reading: Gray 1985; Vousden 1990
PUBLIC CHOICE
An application of economic theory to politics in the form of analys-
ing non-market decision making.
The voting mechanisms used in committees and in whole coun-
tries where there are referenda to make a collective choice have dif-
ferent designs and outcomes. The simplest expression of the
collective will is when a decision is unanimous. It can take time to
reach unanimity, especially if incentives have to be devised and indi-
viduals persuaded into complete agreement to a proposition. If
unanimity is unachievable then a simple majority of half of the voters
plus one can be sought. There will be gainers and losers, so questions
of redistribution and compensation arise. The median voter rule
states that the pivotal voter when preferences are arranged in a con-
tinuum will decide the outcome. There will be an equilibrium if the
preferences are single-peaked, i.e. with only one maximum. Other
voting systems can follow the plurality rule of choosing who or what
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PUBLIC CHOICE
is ranked first by most voters. The Condorcet system is pairwise
elections following a majority principle. The Borda count gives m
candidates points ranging from 1 to m. The candidate ranked first in
the preferences of a voter gains m points, the second mÀ1. The
winner has the largest number of points. Instead of voting orally or
on paper, preferences can be shown by conduct, especially exit, such
as when high levels of taxation induce electors to move (the Tiebout
hypothesis).
It is assumed that voters are rational so they compare the
expected utility flows from each option. Also they act according
to self-interest.
The founders of present-day public choice theory are James
Buchanan, Gordon Tullock and Anthony Downs. Buchanan did not
regard governments and legislatures as full of altruistic people but as
coalitions of self-interested individuals. Schooled in American poli-
tics, he was well aware that regulations and tax laws are formulated
in pursuit of private interest, not the interests of the public as a
whole. Instead of investigating the old theme of market failure,
government failure concerned him. Rent seeking and wealth trad-
ing is the activity of legislators, not the selfless promotion of public
welfare.
A classic text of this branch of economics is Buchanan and Tul-
lock’s The Calculus of Consent: The Logical Foundations of Constitutional
Democracy (1962). They began by analysing the US constitution,
recovering the intentions of James Madison, its author, and examin-
ing different voting rules. They distinguished ordinary politics which
made decisions in legislatures from the different level of constitutional
politics which sets the rules for ordinary politics; ways in which the
voting system, for example through logrolling, can be used to benefit
particular interest groups. What the state ought to be concerned
them. They realised that Smith’s invisible hand is successful in
dealing with private goods but not with collective goods. An
inspiration for them was Wicksell in his dissertation of 1896 and its
implications for collective choice. They were concerned with
majority voting leading to decisions unfavourable to a substantial
portion of a population. Realising that it is difficult to get unanimous
agreement, they recommended qualified majorities or very large
majorities, far in excess of 50 per cent plus one.
Downs, in his An Economic Theory of Democracy, argued that the
public is largely ignorant of political issues – it would be costly for
them to learn – and their votes have little impact, so it is rational to
abstain from voting. Voters minimise the cost of acquiring information
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PUBLIC FINANCE
relevant to making political choices, with the consequence that the
democracy does not operate at maximum efficiency. Governments
come to represent the interests of producers, not consumers. Gov-
ernments are not altruistic but eager to obtain income, power and the
prestige of holding office. Also to get elected it is important to appeal
to the median voter. Tullock has been concerned with rent seeking,
looking first at groups who benefit through possessing a monopoly or
trade protection at the expense of the public at large.
Public choice theory exposes government failure, rather than
examining the more researched notion of market failure. It is part of
the twentieth-century critique of socialism. Also it has enriched the
study of decision making.
See also: social choice theory
Further reading: Buchanan and Tullock 1962; Downs 1957; Mueller 2003;
Peacock 1992; Tullock 1967a
PUBLIC FINANCE
The study of the sources of finance and the nature of the spending of
all levels of government and their agencies.
Public finance is one of the most ancient branches of economics.
Xenophon in his Ways and Means of Increasing the Revenue of Athens
wrote perhaps the first work exclusively on this subject. Increasingly
public finance has been interested in the provision of public goods
and responding to the existence of externalities.
Initially governments financed themselves by obtaining free ser-
vices under a feudal system, by plunder and by collecting simple
taxes. Indirect taxes on goods, especially on imports, had the simpli-
city of being easy to collect and less easy to evade. Income tax
became a permanent feature of the tax structure later – in Britain
briefly in 1435, 1450, 1798–1805 and then from 1842, and in the
USA in 1913 after the passing of the sixteenth amendment to the US
Constitution. Some governments can finance themselves if they pos-
sess assets such as oilfields which can be leased, but it is generally
through taxing and borrowing that finance is raised.
The spending undertaken will depend on the functions of gov-
ernment and of the level of government. A minimal state with few
activities other than defence, law and order, and a few public services
will require little tax revenue in peacetime unless it has accumulated a
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PUBLIC GOOD
large national debt. In the early twentieth century the spread of
democracy and the introduction of a welfare state with some measure
of redistribution of incomes and of services made government
expensive. New taxes were devised to raise the required revenue, for
example, on deceased persons’ estates and on activities such as emitting
carbons.
Public finance uses different techniques to achieve its goal of
financing programmes at minimum cost. Cost effectiveness studies
and programming budgeting have emerged as modern methods.
See also: fiscal federalism; fiscal policy; public choice; public sector;
taxation
Further reading: Buchanan 1975; Rosen 2005
PUBLIC GOOD
A good or service which is collectively provided and collectively
consumed; not a private good. They are both non-rival and non-
excludable.
Unlike private goods, public goods have non-rival consumption
in that one person’s consumption does not reduce another’s. They are
non-excludable in that all the individuals in a group have the good or
service provided for them – whether or not individuals approve of
the use of nuclear weapons as part of their national defence they still
get their alleged protection.
Mistakenly, education and health care are sometimes thought of as
public goods but they are mostly consumed by individuals. Lighthouses
used to be exemplars of public goods but there are cases of private
lighthouses which collected dues when ships went into the nearest
port. Defence and public health measures are the most clear cut exam-
ples, as a government collectively provides them and they are con-
sumed by the community at large rather than by private individuals.
Public goods are contrasted both with private goods, such as food
and clothing, and with club goods available to a group. A global
public good is available to all the peoples of the world, for example,
some forms of knowledge.
See also: clubs, theory of
Further reading: Head 1974; Loehr and Sandler 1978; Samuelson 1954
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PUBLIC SECTOR
QUANTITY THEORY OF MONEY
The array of organisations consisting of national, regional and local
governments, together with agencies and other organisations financed
by those levels of government.
Ownership or control brings enterprises within the ambit of this
sector. The public utility is a popular type of public enterprise. A
suspicion of the exploitative and fraudulent nature of some private
sector firms leads to a call for the government to be engaged in
commercial activities. In the nineteenth century in Britain many local
governments ran utilities, hence the expression ‘gas and water soci-
alism’. The fear that large companies have an undue power in a
national economy leads to the call for public control over the
‘commanding heights’ of the economy. If this change of ownership
occurs then the list for nationalisation usually includes energy, trans-
port, steel, health care and postal services.
As inclusion in the public sector is supposed to increase public
welfare it is usual to have different styles of management, price and
wage fixing and accountability than prevails in the private sector. The
public sector becomes the most regulated part of a national economy.
Running some public services such as health and education without
setting market prices runs into many problems of allocation and
rationing. For national income purposes a measure of output is
necessary which, if the service is free, has to be estimated as equal to
the sum of the inputs.
Dissatisfaction with the performance, especially financial, of the
public sector encouraged the privatisation of much of the public
sector of some countries from the 1980s.
Further reading: Lane 1993
QUANTITY THEORY OF MONEY
A theory relating the quantity of money in a national economy to
the national income.
Mercantilists made use of this idea, especially John Locke. Later the
theory was formalised by Irving Fisher as MV = PT where M is the
stock of money, V the velocity of circulation, P the general price
level, and T the volume of transactions. It was assumed that M was
determined exogenously, V was fixed by the slow moving commer-
cial habits of the population and T was also stable. This meant that
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RATIONALITY
the price level would move up and down through changes in the
money supply in the same direction. It is a tautology, stating that if
the velocity of circulation and volume of transactions are constant, an
increase in the quantity of money will be inflationary.
Later Pigou and his Cambridge contemporaries in the 1930s
reformulated the basic equation as M/P = kY where the left-hand
side shows the real stock of money and the demand for it being the
‘Cambridge constant’ k multiplied by real income.
Friedman in his restatement of the quantity theory, although
accused of merely adopting the Keynesian liquidity preference theory,
asserted that he was demonstrating that money does matter and lacks
neutrality. Mises, then Friedman, posited an ‘optimum quantity of
money’ which is the amount of money in existence at a particular
time, so changing the money supply is non-optimal.
Further reading: Blaug et al. 1995
RATIONALITY
The quality of economic behaviour based on reason.
To be rational requires agents to be deliberate rather than instinc-
tive in their actions. It is necessary for them to be able to understand
and process data relevant to the choice between alternatives. Also a
rational agent has to be able ‘to get it right’, for example, not be
unreasonable by inflicting pain and income loss on herself. Over time
the rational person will follow a course of action leading to some
definable outcome. It is difficult to be rational when simultaneously
one has several goals and an array of strategies. Rules can be devised
for acting appropriately in such circumstances.
Rationality is an element in individual decision-making models,
not the actions of collective entities. Rationality is often used as a
starting point for an economic model. Within the framework of an
ends and means analysis, rationality is a tool to choose the means and
achieve the ends. In economics the broad idea of rationality is given a
narrow instrumental sense. To work towards the goals of efficiency,
equity, growth and stability shows rationality.
The central assumption is that individuals will consistently pursue
courses of action which will result in the maximum gain to them.
The gain can be expressed in expected wealth or expected utility.
Rationality can exist at several levels: the abstract or theoretical,
decision making, the practical performance of tasks, the creation of a
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RATIONALITY
framework of rules or even the constitution of an economic system in
its search to provide maximum economic welfare. Rationality is
regarded as conforming to a standard. This gives it perhaps a nor-
mative quality, but more commonly the standard is a set of logical
requirements of consistency and coherence.
In neoclassical economics these elements are formally com-
bined. It is assumed that representative individuals act from self-
interest, have complete information and are deliberate in their
decision making. In the hands of many modern theorists, rationality
is reduced to a study of the self-interested individual’s attempt to
maximise utility, but rationality is appropriate also when altruism is
analysed. An altruistic social goal can be rational, as can helping other
individuals when there are associated goals for the giver.
Simon, an early exponent of rationality, discussed the ‘economic
man’ with stable preferences who will calculate how to reach the
highest state preferred. He noted that classically we can define
rational choice procedures in three ways. The maxi-min rule of
choosing the option with the worst payoff; the probabilistic rule of
maximising expected values; the certainty rule of choosing the
option with the largest payoff. Many bold assumptions have to be
made about information available, that payoffs can be measured
and that such calculations occur. Unlike human decision making,
which is often sequential, the rational economic agent can make all
these estimations of payoffs before a choice is made. For decision
making within organisations Simon preferred the idea of ‘approx-
imate rationality’ seeking a satisfactory aspirational level. Information
is gathered and a sequence of choices is made. Limited information
leads to limited rationality but the model is dynamic. Bounded
rationality is where human reasoning is exercised within some con-
straints. Decision makers are themselves limited in knowledge and
ability to process options. In fact computational ability becomes
more of a constraint than the rationality itself. This is an unambi-
tious account of what rationality can achieve. Bounded is contrasted
with perfect rationality. The usefulness of this approach is that
rationality is reduced to the more manageable notion of information
processing.
Rationality in decision making has taken the form of situational
analysis. Karl Popper devised this approach as the logical response of
individuals to the objective situation in which they are to be found.
The simplest case is of the single response, the single exit from a
situation. More complex modelling has considered multiple exit
situations. Neoclassical economics makes use of this approach.
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RAWLSIAN JUSTICE
A problem with models assuming rationality is that a goal expres-
sed in terms of utility raises problems of utility measurement. Given
the popularity of thinking of utility in terms of revealed preferences,
to be rational amounts to being consistent in choosing the better
rather than the inferior option. Rationality, however, has been much
employed in the theory of consumer behaviour, where cardinal utility
and perfect certainty are assumed.
Inevitably the assumption that behaviour is of the extreme max-
imising type is questioned, and the gentler assumption of satisficing,
of searching for a goal that is satisfactory rather than the best, is
asserted as more representative of human psychology. The quest for
efficiency might be abandoned for an easier life.
Traditional models of rationality are challenged by the view that
much decision making is not the consequence of deliberate weighing
up of a situation but the slavish following of rules. Inasmuch as the
rules are carefully thought out, there is more chance of being rational
by following what has been carefully devised.
A popular use of rationality is in the idea of rational expectations,
which take into account all information. This is a central feature of
New Classical Macroeconomics. In game theory rationality is cru-
cial: in fact without rationality there would be virtually no game
theory. Practical rationality enters into Bayesianism. Through using
probability calculations it is possible to test the rationality of beliefs.
Thus persons having the same information concerning an uncertain
proposition would arrive at the same probability.
See also: expectations
Further reading: Lipman 1995; Oakley 1999; Simon 1955
RAWLSIAN JUSTICE
Justice viewed as fairness, a theory outlined by John Rawls in his A
Theory of Justice; the core of an economic game in which society
makes judgements about social welfare.
The first principle is that everyone is entitled to as much liberty as
is compatible with the liberty of others. Also any social and economic
inequalities have to be to the advantage of all; positions and offices
will have unrestricted access as there is equality of opportunity. Under
a veil of ignorance of their social position, everyone decides the ori-
ginal position and cannot pursue self-interest. This veil will guarantee
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REAL BUSINESS CYCLE
an impartial pursuit of the common good. Using a ‘maximin’ prin-
ciple he argues that resources should be given to the worst off so that
they are as well off as they can be. This approach is in the tradition of
social contract theorists going back to Hobbes, Locke and Rousseau;
he argues that there is a hypothetical agreement that there will be
equality. Those least well off would be disproportionately favoured.
The cost of Rawls’ type of justice could be the destruction of
economic incentives. If the worst off get a better deal then there is
little point in striving. Paradoxically in helping the disadvantaged, in
the next period those advantaged now become disadvantaged. If
there is a veil of ignorance then there is no self-knowledge and pos-
sible difficulty in forming rules for a just society. Also, as with many
schemes for redistribution, there is for Rawls the problem of the
measurement of utility.
See also: equality; welfare economics
Further reading: Howe and Roemer 1981; Kukathas 1990; Rawls 1999
REAL BUSINESS CYCLE
Fluctuations in economic activity which have arisen from techno-
logical change rather than from monetary shocks or changes in
expectations.
John Muth and Robert Lucas invented this idea. Originally the
idea was concerned with fluctuations in the agricultural sector. Real
business cycle models have been used to mimic changes in the US
economy. RBC models provide explanations of macroeconomic
fluctuations by aggregating the decisions of representative firms and
households that have rational expectations and maximise objective
functions subject to technology and resource constraints. The
emphasis is on examining random changes in productivity, part of the
process of technical progress, which cause movements away from
trend real income growth: these changes are not evolutionary nor are
they inevitable. These technological shocks, which shift production
functions, are expected to lead to changes in output, hours of work
and productivity. It is difficult, however, to discover empirical exam-
ples of these shocks as they are expected to affect all sectors and all
factors of production. Kydland and Prescott in their statistical analyses
noted some surprising facts, such as prices rising in recessions and
falling in booms, and real wages rising in expansions of the economy.
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Critics argue that the RBC models are of limited usefulness as they
fail to explain real asset prices and major downturns such as in the
1930s. To place technological shocks at the centre of explanations of
cycles inevitably excites the criticism that a plethora of specific
explanations for specific ups and downs, such as major policy chan-
ges, are wrongly dismissed. Some technological shocks are too small
to explain some fluctuations in general economic activity.
The identification of a particular cycle often leads to recom-
mending particular counter-cyclical policies. It is more difficult to
create them to cope with real business cycles as they have random
causes.
See also: cycles; new classical economics
Further reading: King et al. 1988a, 1988b; Kydland and Prescott 1990; Long
and Plosser 1983; Lucas 1980
REGIONAL POLICY
A set of measures to improve the economic performance of a rela-
tively poor region within a national economy.
A regional problem requiring a policy response is often defined as a
state of low income and high unemployment. There are many
determinants of regional problems. National wage bargaining can
prevent the poorer areas from having the lower wages which would
attract an influx of capital. The exhaustion of natural resources,
especially in mining, can permanently reduce the economic oppor-
tunities for an area. The existence of a regional problem suggests a
disequilibrium within a national economy: thus the task of the policy
maker is to devise measures which will bring about interregional
convergence in key economic indicators.
Often labour mobility and capital mobility fail to bring about the
equalisation of factor rewards predicted by classical economics. Given
the sluggishness of factors of production to respond to changing
economic conditions, regional policy measures have been char-
acterised as taking work to the workers through capital mobility, or
taking the workers to work, labour mobility.
Regional policies have been devised both by national governments
and supranational organisations such as the European Union. A
policy can concentrate on providing the conditions for economic
revival, on improving the infrastructure so there is a transport network,
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sufficient housing and an educated workforce. Key firms can be set
up to encourage others to follow and together set up a ‘growth pole’.
Fiscal inducements can be offered to counter the costs of relocations.
Local taxation can be waived and investment allowances against
corporate taxation given. Individual workers can be helped with
transport, training and housing expenses.
Further reading: Vanhoove 1987
REGULATION
The control of firms, markets and households by governments and
their agencies.
Regulation always has aims. It can be in furtherance of macro-
economic policies such as monitoring prices to help with the control
of inflation through monetary and fiscal policies. It can be to advance
health and safety through banning activities, or allowing them to
occur only with safeguards. It can be part of a move towards the
creation of a utopia.
Regulators do not trust people. Behaviour has to be checked,
activities have to be inspected and more and more information col-
lected on human actions. In all countries there is an overall policy
choice between the loosest of laissez-faire controls to a level of
observing and controlling the public which leaves little personal
freedom, that only commands public support when there is national
danger such as an impending invasion or natural disaster.
Regulation takes many forms. There can be the collection of
information so that persons will behave better as they know they are
observed. Activities can be outlawed, such as home production of
alcoholic spirits: prohibition needs to be backed up with inspection.
Regulation can be detailed interference in management, stating who
can be employed on what terms, what investment can be undertaken
and how prices should be set for which markets.
Some of the oldest forms of regulation were of corn markets,
where the police would monitor dealing for its fairness, as high corn
prices could provoke civil unrest. Regulation is all-pervasive in the
command, planned economy of the old Soviet type, but other types
of economy have resorted to regulation in time of crisis, such as in the
USA in the early 1930s; in wartime when resources are scarce gov-
ernment regulation is common. Regulation is also popular for some
industries, such as public utilities, where a commission determines
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prices and the quality of service. As a form of government control it
is easier and cheaper to implement than taking industries into public
ownership.
The ideological stance of a government will determine the range
of regulated activities. Health concerns, including the consequences
of smoking tobacco, sensitivity to environmental issues and objections
to an unequal income distribution, have been prominent in justifying
new objects of regulation.
The costs of regulation are many and can be severe. The regulated
have to bear compliance costs. Resources which could have con-
ferred direct benefits on the population are used to run inspection
and enforcement offices.
Regulatory capture occurs where those regulated distort the reg-
ulatory process to their own benefit. A common example is where
firms in an industry persuade the regulators to restrict competition
for the benefit of the industry.
Further reading: Armstrong 1994; Posner 1975; Stigler 1971
RENT
Payment for the temporary occupation of land or buildings on it; a
surplus income accruing to a factor of production.
The payment of rent for the use of land is justified as a reward to
the owner for the risk of damage by a tenant and for the cost of
defending it from someone wishing to take possession or to damage
it. A landlord has possession under the property rights established
by the state where his land is located. In classical economics Smith
insisted that rent is a component of natural prices; Ricardo that it
was a consequence of product prices so that there was a reverse order
in the determination of rent.
James Anderson, Malthus and then Ricardo used a differential rent
theory. This asserts that as land can differ in location, especially its
position relative to an urban area, or be of varying fertility, its yield
varies too. Cultivation will continue until it reaches the marginal land
where the costs of labour and capital to obtain a crop just equal the
value of the produce. On the land of better quality or location than
the marginal land, a surplus revenue in excess of costs – rent – will
arise. With population growth more and more land is brought into
cultivation, with rent increasing on the superior land. The theory can
be challenged empirically, for example, the order in which land of
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RETURNS
new territories is cleared: for defensive reasons the less fertile land on
hill tops may be put to agriculture first.
‘Rent’ can be generalised as ‘economic rent’, as a return which
arises from the factor of production being in short supply. There is
the ‘rent of ability’ arising from a person having rare talents, for
example, in sport or entertainment. The more inelastic the supply,
the greater is the economic rent. Usually employment incomes can
be split into transfer earnings – what that person would obtain from
the next best employment – and economic rent.
Much attention is now paid to rent seeking behaviour, which is
obtaining an income other than through the processes of trade or
production, typically through having monopoly rights, or obtaining
special privileges from government as when tariff protection is gran-
ted to an industry. Seeking an income this way is often despised for
allowing private individuals to benefit at the expense of society at
large; in extreme cases it amounts to corruption.
Further reading: Krueger 1974; Tullock 1967a
RETURNS
Output relative to factor inputs.
In descriptions of production the rate of flows of inputs and con-
sequential outputs can be compared to see if they are the same or dif-
ferent. If output is rising faster than inputs, there are increasing returns,
if slower, diminishing returns but they are constant if they change at
the same rate. A pure return to a factor is calculated when a variable
input changes but the fixed input remains the same in quantity and
quality. In classical economics the principal example of returns is the
application of a variable amount of a composite of labour and capital
to a fixed amount of land. Diminishing returns occurred through soil
exhaustion. Adam Smith assumed there would be diminishing returns
in agriculture where division of labour would be impossible, partly
because of the seasons, and increasing returns in manufacturing.
To understand increasing returns an analysis of methods of pro-
duction is necessary. The more efficient use of capital equipment,
including maximising the hours of use through a shift system, leads to
higher productivity, increasing returns.
The nature of the returns will explain the shape of average total
cost curves. The familiar textbook case of those curves being U-
shaped, falling to a minimum then rising again past the optimum
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RISK AND UNCERTAINTY
production level, is a description of increasing returns giving rise to
diminishing returns. The widespread evidence of increasing productivity
in many industries suggests that the predominant type of returns is
increasing returns. Agriculture, once the exemplar of diminishing
returns, has become more and more productive.
See also: economies of scale and scope; production function
Further reading: Young 1928
RISK AND UNCERTAINTY
Risk is an outcome which can be calculated through measuring
probabilities; uncertainty concerns the unknown future.
There are many types of risk. If it is systemic risk, then it is asso-
ciated with a political event such as a change of government or a war,
and has a broad effect on many types of asset. If a specific risk is
unsystemic, it has a narrower effect, as when the profits and price of a
company’s shares are affected by a loss of market. Specific risks are
political or financial. If associated with the state of a particular nation
it is a country risk; if the consequence of policy changes it is political
risk. Financial risk can occur through anything which directly affects
the finances of a firm; hence credit risk, interest risk, foreign
exchange risk and market risk due to the volatility of trading.
Economic agents can have different attitudes towards risk: loving
it, being averse to it or being neutral. To minimise the losses which
can result from risk, insurance can be used so that risk is pooled
through premiums being paid to fund the payout to losers who suffer
the hazard which is the subject of insurance. But there are problems
with insurance. There can be adverse selection when the insured do
not disclose all the facts relevant to the risk because they are in a
high-risk category, so that the premium charged by the insurer can be
too low. The characteristics of the persons insured may be more
likely to lead to claims than those of the population in general. To
avoid adverse selection problems, insurance can be designed for dif-
ferent sub-groups. Being insured can make a person indulge in wilder
behaviour, thus giving rise to moral hazard; for example, a bank with
insured deposits could care less about the amount of loans it permits.
There will be a divergence between marginal private cost and mar-
ginal social cost. Risk is concerned with objective probabilities and
uncertainty with subjective probabilities. Possibly uncertain events
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RISK AND UNCERTAINTY
which can be grouped can be assigned an objective probability.
Knight associated risk calculations with a mechanical view of eco-
nomics which was too precise. Risk deals either with a priori prob-
abilities such as rolling a dice, or statistical probabilities based on
relative frequencies such as in life insurance. Because an investment
often has an unknown outcome, part of the return will have a risk
premium. This was recognised as a necessary inducement to investors
as far back as Adam Smith and JS Mill. In the capital asset pricing
model of Merton and others, risk is measured by the variance in the
expected return. Uncertainty is concerned with estimates where the
instances cannot be classified validly. With uncertainty, the future is
entirely unknown so it cannot be measured and be covered by
insurance. Profit, the residual of revenue after costs have been
deducted, occurs because of uncertainty: it is a reward for uninsurable
hazard. Keynes, writing in 1937 about his general theory of
employment, associated risk with Benthamite calculations of a con-
sequence of an action and his work with the uncertain situations
when the future is unknown. Shackle challenged the Keynesian view
and argued that uncertainty is a complex phenomenon, not merely a
world where probabilities cannot be calculated.
Heisenberg formulated in 1927 his ‘uncertainty principle’ that
there cannot be an absolute accuracy of measurement of the simul-
taneous relationship between a pair of related measurements. The
greater the uncertainty, the less exact the measurement. The major
case of uncertainty is in financial markets, where many prices and
rates of return cannot be estimated precisely. There is natural uncer-
tainty when a process is essentially random. Model uncertainty occurs
because of the assumptions, scope and structure of the model. Data
uncertainty arises from measurement and classificatory errors. This
kind of uncertainty is also known as ‘epistemic’. In game theory there
can be strategic uncertainty because of the information being private.
Subjective expected utility probability was developed by Ramsey
and others. Subjective beliefs are revealed by the bets actually made,
rather than intuition. Savage refined this attitude towards uncertainty by
combining a personal utility function showing the utilities from dif-
ferent outcomes of an uncertain event and a personal probability analysis.
The sum of the utilities multiplied by the probabilities is calculated. In
practice it is difficult to find individuals with consistent views of risk.
Decision theory has the problem of uncertainty central to making
a choice. A lottery is a principal example of such decision making. It
is concerned with expected values and standard deviations. The
axioms of the theory are that the preferences are ordered, transitive,
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ROBINSON CRUSOE ECONOMY
continuous, substitutable, monotonic (neither increasing or decreas-
ing) and decomposable. Modern views of uncertainty assert that it is
based not only on randomness but also on beliefs and behaviour. The
cultural norms of the society will obviously affect decision makers.
The sharp distinction between risk and uncertainty has been chal-
lenged. Friedman argued that human beings can attach probabilities
to every conceivable event. Also it is difficult to argue that risk is
always based on what is objective and uncertainty on what is subjective:
Knight rejected the view that everything is unique or absolutely
the same.
Further reading: Keynes 1937; Knight 1921; LeRoy and Singell 1987; Lupton
1999; Ramsey 1931; Savage 1954; Schmidt 1996; Sharpe 1964
ROBINSON CRUSOE ECONOMY
A self-sufficient economy of an isolated individual, first described in
Daniel Defoe’s novel Robinson Crusoe (1719).
Crusoe has been depicted as the model of self-interested man.
Marx in Das Kapital regarded Crusoe as a pre-capitalist man produ-
cing goods because they are useful rather than profitable. Crusoe’s
different activities can be regarded as different modes of human
labour. Crusoe keeps a record of the labour time expended on
average for producing specific quantities of products. Marx regarded
such an economy as ‘simple and transparent’.
Crusoe can also be regarded as both a consumer and a producer,
making choices between work and leisure. His economy is an
extreme case of isolation from the rest of society and the world, with
an isolated individual having to make all economic decisions. This
picture of a simple life is extensively used as a starting point in
explaining the theory of production. The process of rational utility
maximisation is also shown in this parable.
Further reading: Grapard 1995
SATIABILITY OF WANTS
The limit to consumption.
Bentham, Senior and several economists of the early nineteenth
century, noted that there is a law of diminishing marginal utility.
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SAVING
This means that when successive units of a particular good are con-
sumed by one person initially the next unit consumed may provide
greater satisfaction, but a point in this continued consumption will be
reached when each successive unit consumed pleases the consumer
less than the previous one. Because of this satiability of wants, greater
amounts of a good will only be purchased if the price is lower, a
reason for the downward sloping normal demand curve: Marshall
in his Principles of Economics, book III, chapter III, describes this
phenomenon.
This law is evident in consumption patterns of households. Given
there is a limit to the demand for goods such as food, as income
grows there is a switch from the consumption of necessities to taking
comforts then resorting to luxuries. Later there is a switch to consuming
services rather than goods, as was predicted in Petty’s law.
The phenomenon of satiability has been used in defence of income
redistribution. Those with large consumptions gain little satisfaction
at the margin so would lose little through a fall in income, but the
poorer with meagre intakes could still be gaining utility if income
were transferred to them.
SAVING
The portion of income not consumed; the portion of income set
aside for future consumption, and investment.
Savings can be undertaken by an individual person, by firms and
by governments. For individuals, saving is difficult when incomes
are low. A life cycle has been identified, with little saving until
middle age then much saving for retirement until saving drops
again. Firms often accumulate savings as they wait for investment
opportunities, or because of a cautious policy of gradually dis-
tributing dividends to shareholders so that there will always be
reserves to prevent a fall in dividends. Government saving is related
to cycles in the economy. A government intent on maintaining the
stability of an economy will have deficits, negative savings, in
recessions but savings in times of prosperity when public sector debt
can be reduced. There is the paradox of thrift, namely that saving is
a virtue but there is a limit to being virtuous as the fall in demand
will push the economy downward. In the macroeconomic theory
debates of the 1930s there was much debate about saving, as it had
to be clearly defined to be incorporated into a national accounting
framework.
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SAY’S LAW
Saving can be voluntary or forced, a phenomenon recognised by
writers as early as Thornton, Bentham and Malthus. A shortage of
consumer goods makes people save by default, possibly by a switch in
resources to producing capital goods. Inflation can reduce the
amount of real consumption. To explain how an ex-ante imbalance
between saving and investment becomes an ex-post balance under
the operation of the multiplier, it was argued by JM Keynes that at
each round of income generated, saving would be induced. In the
Soviet-type economy the high rate of investment reduces consump-
tion and forces household saving. In Britain during the Second
World War, under budgetary policy the government extracted saving
from taxpayers, as recommended by Keynes in his How to Pay for the
War. Shareholders can be forced to save by the boards of directors of
the companies they own as a result of a board decision to leave part
of post-tax corporate income undistributed.
The optimal rate of saving is discussed in contexts such as eco-
nomic growth theory. The Ramsey saving rule is that ‘the rate of
saving multiplied by the marginal utility of money should always be
equal to the amount by which the total rate of enjoyment of utility
falls short of the maximum possible rate of enjoyment’ (1928: 543).
Optimum saving as a proportion of the national income is the inverse
of the elasticity of marginal utility.
Further reading: Ramsey 1928
SAY’S LAW
The assertion that a national economy at the aggregate level in its
natural state is in equilibrium.
The law of markets, as its originator, the French economist Jean
Baptiste Say, called it, originated in his reply to a pamphlet by Wil-
liam Spence concerning the loss of trade between England and
France during the Napoleonic Wars. Say argued that there can never
be a general glut of production, for we do not buy goods with
money but with the proceeds of a sale. ‘Supply creates its own
demand’, so an economy in equilibrium will be at full employment.
The most fervent contemporary expounder of the law was James
Mill in Commerce Defended (1808). He admitted that there could be
excess supply of a particular commodity but not of all commodities.
If there is an excess supply of one good then there must be a defi-
ciency in the supply of another because overall the economy is
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SCARCITY
balanced annually. His son, JS Mill, in the second of his Some Unset-
tled Essays on Political Economy (‘Of the Influence of Consumption on
Production’) distinguished the law for a barter economy from a ver-
sion for a monetised economy. The great problem is that when the
economy becomes monetised prices are expressed in money, not
other goods, and the proceeds of a sale can be hoarded and not used
to buy other goods. He believed that the law held if produce were
distributed without miscalculation.
This was opposed strongly by Malthus and later by Keynes. Mal-
thus argued in his Principles of Political Economy, section III, that
commodities are not always exchanged for commodities, and that Say
was ignoring the principles of supply and demand through not tra-
cing the effects of a glut on lowering prices and supply. Demand
could fall through saving being preferred to consumption, or through
workers preferring indolence to the work which would increase
income. Keynes argued, in book I, chapter 2 of his General Theory of
Employment, Interest and Money, that the fallacy underlying Say’s law is
that there is a connection between deciding to abstain from con-
sumption today and deciding to provide for future consumption.
From the proposition that the demand price for output as a whole
equals the supply price stem the classical doctrines on thrift, laissez-
faire, unemployment and the quantity theory of money.
Further reading: Kates 2003
SCARCITY
The limited nature of most resources.
Scarcity has been called The Economic Problem. In classical
economics the assumption of a fixed amount of land is prominent,
for example, in Ricardo’s theory of rent and in Malthus’ principle of
population. Robbins, writing in the 1930s, defined economics as ‘the
study of scarce means which have alternative uses’ reflecting scarcity.
In an uncontrolled market scarcity is identified by the levels and
movements in prices. Because of scarcity, everything has an oppor-
tunity cost. In economics trade-offs are frequently encountered as
more of X is at the expense of less of Y. Lines downward sloping from
left to right illustrate scarcity and trade-offs in a diagram with X and
Y axes. Scarcity is a state of demand exceeding supply. This gives rise
to problems of allocation, which are usually resolved by free use of
the price mechanism or by rationing.
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SEARCH THEORY
Socialist critics of conventional economics dislike the notion of
scarcity, hence their opposition to Malthus’ population principle in
which subsistence limits population growth. Some types of scarcity
can be eliminated by increasing supply: for example, exploration to
discover further oil deposits, or training workers to reduce a skills
shortage. Changes in fashion can reduce demand and consequently
cause a profusion of unwanted goods. Traditionally land was regarded
as the scarce factor fixed in amount, but any factor, including skilled
labour and financial capital, can be scarce. Concern about the scarcity
problem has been revived through the growth of environmental
economics and the study of exhaustible resources.
See also: exhaustible resources; rent
SEARCH THEORY
An account of the behaviour of buyers and sellers in seeking to clear
markets.
The leading example of search is in the labour market where
workers search for job opportunities and employers for workers.
Stigler pioneered a neoclassical marginalist approach to search, stating
that search would continue in a labour market until the marginal
benefit from search equalled its marginal cost. A worker often has to
pay the costs of search – travel, buying appropriate clothes for inter-
views, preparing the curriculum vitae and engaging in correspon-
dence. The costs of search are a form of investment to the person
incurring them: either a worker or an employer through meeting
search expenses expects to obtain a positive rate of return. A shortage
of labour will encourage an employer to spend more on searching
greater distances for workers and to subsidise their private search
costs. There are strong arguments for subsidisation of search costs by
employers and retailers in order to adjust demand to supply. Gov-
ernments provide information to reduce the search costs of house-
holds; for example, in providing free job centres so that there will be
lower unemployment, and in producing literature on food to
improve health.
In a sense, in all product markets there is the constant search which
buyers and sellers participate in together. Search theory has also been
used in the study of money.
Further reading: Stigler 1962
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SELF-MANAGED ENTERPRISE
SEGMENTED LABOUR MARKET
The description of the labour market as a set of separated sub-markets.
This theory, initiated by JS Mill and JE Cairnes, asserted that the
labour market is fragmented into non-competing groups separated by
barriers to entry. Mill used it to explain the lower wages of women.
Labour is essentially heterogeneous in nature because of wide var-
iation in skills, education and native abilities. A labour market can
only be understood in a very generalised way if a detailed analysis is
not undertaken. Where the market is artificially divided to express
prejudices about workers’ personal characteristics, for example their
race, then poverty, wage differentials and discrimination arise.
Differences in income are found to have little justification and are
clearly the consequence of devices to restrict supply to sub-markets.
The segmentation might occur because of prejudice, custom, or the
practices of educational establishments and training institutions.
Because the sub-markets are sealed from each other, wages and
employment vary from part to part of the total market. The sub-
markets with barriers to entry will have restricted supply, which will
increase prices/wages and reduce output/the number employed. By
legislation artificial barriers can be outlawed, but physical barriers,
such as those separating local markets, will remain.
See also: discrimination
SELF-MANAGED ENTERPRISE
A form of producers’ cooperative.
Workers’ participation in management in its mildest forms can
range from consultation to their representation on boards of direc-
tors. The extreme case of ‘industrial democracy’ is where the man-
agement is conducted by the workforce as a whole, with the workers
on the board of directors and responsible for all financing, personnel,
production and marketing decisions; also known as autogestion. It
was a leading feature of the former Yugoslav economy and also
extensively practised, even in modern manufacturing factories, in the
Basque region of Spain. This type of enterprise has its ancestry in
communist or communitarian ideals.
Ideally, the absence of a tension between management and workers
will increase productivity and lead to fairer wages. But problems
abound for such enterprises, as many workers might be reluctant to
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SOCIAL CAPITAL
be involved in management. Also, as workers prefer any value-added
to be distributed in higher wages rather than assigned to investment,
the enterprise will become undercapitalised over time, unless depart-
ing workers can sell their equity shares; but if they do, then the
enterprise becomes a kind of joint stock company with outside
shareholders.
Further reading: George 1993; Vanek 1972
SOCIAL CAPITAL
The infrastructure of a country; the benefits accruing from social
interaction.
This form of capital in the traditional sense, sometimes called
overhead capital, referred to the infrastructure which made possible
the functioning of a society and an economy. Roads, railways, ports,
schools, hospitals and other public buildings are the principal exam-
ples. In some senses this is an informal kind of socialism, of benefit to
a community but with light central control.
Recently the concept has been extended to consider the informal
networks of society. It describes the cooperation of groups in joint
productive activities. This form of capital includes intangibles such as
traditions, neighbourliness, networks of friends and non-commercial
organisations, and excludes physical and human capital. Unlike the
private capital of households, it is held for the benefit of other
individuals. It shares with other types of capital durability and the
yielding of substantial returns. Social capital reduces the cost of
communication by making much of it informal. It also makes the
observance of contracts easier, as a major form of social capital is
trust. Where there is trust, transaction costs and monitoring costs
will be lower.
Further reading: Becker 1974; Field 2004
SOCIAL CHOICE THEORY
The rationale for making decisions for society at large when indivi-
duals have different and incompatible preferences.
To make any judgement about the state of a whole society requires
inquiry into social choice, taking into account the number of persons
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SOCIAL CHOICE THEORY
and number of possible states. This raises an adding-up problem
which has to be faced in many areas of economic policy and which
in any pursuit of the public interest has a long ancestry. Sen con-
sidered different dimensions to social choice, including committee
decisions when committee members have different views, social
welfare judgements about whether there will be a net benefit to
society, and normative indications for a society such as the meaning
of national income.
Early sketches of social choice theory originate in late eighteenth-
century France, when there was a conscious effort to institute
democracy. Using sophisticated approaches, Borda and Condorcet
began the modern analysis of this problem. Following Borda’s
method, if there are n options and each voter ranks her choice from
the least desirable 0 to the most (n À 1), the option with the highest
score is the winner. Under the Condorcet approach, if the candidates
are paired, the voters have to choose; of every pair the winner will
have been successful in all the votes. Another approach is the median
voter theorem, that the choice of the median voter is the equilibrium
voter, providing that there is only one peak in the distribution.
Bentham tried to decide upon the social good by adding together
satisfactions into the total utility for the whole community. There
are questions of the measurement of utility, essential if there were to
be aggregation from the individuals’ utilities to the total utility of a
community, and also whether to consider distribution of utility
within a community as well as the total. Interpersonal comparisons of
utilities are difficult if it is strictly asserted that utility is a personal
subjective state, except in cases of extreme wealth and poverty, unless
proxy measures of utility and comparisons of groups are tolerated.
Sen suggests ‘informational broadening’ (1999: 366).
To have a fair outcome, consistency has always been required in
this area of economics. Several problems have been identified. There
is the difficulty of following a principle of majority rule in decision
making, in that the majorities from difficult votes can be incompa-
tible, which is often the case when voters delegate to political parties
with large programmes the expression of their preferences. There is
also, in Arrow’s expression, the ‘impossibility’ of reconciling the
preferences of individuals. The conditions for a social welfare func-
tion were set out and debated.
Bergson made an early attempt to create a social welfare function,
setting out conditions for an increase in economic welfare so that an
increase in the national dividend or income would on average not
affect the poor more than the rich or vice versa.
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SOCIALISM
Arrow has four elements in his proof of the impossibility of social
choice. First, the universal domain criterion states that a vote is
rational only if it corresponds to one of the set of ordered pre-
ferences. Second, Pareto efficiency pronounces the voting system
irrational if the winning choice is not the preferred choice. Third,
non-dictatorship demands that the outcome cannot be dictated by a
single person. Fourth, there is independence from alternatives which
are not the subject of the vote.
Sen in 1977, in his assessment of Arrow, raises the problems of defi-
ciencies in information in the representation of interests, and the
difficulties of regarding binary choices as basic to social preferences.
Libertarians argue that there is a need to incorporate individual
rights into social choice theory, as explained by Wrigglesworth. This
right must be exercised by the person concerned. Society is better off
by recognising that right, but the right might lead to so much
damage that it should not be exercised, for example, promoting racial
hatred and that the right is just.
Further reading: Bergson 1938; Sen 1977, 1999; Wrigglesworth 1985
SOCIALISM
A creed based on collectivism; a cooperative form of organisation for
a community or an entire country; an alternative to capitalism.
This ancient idea can be traced at least as far back as Plato’s Republic
in which the elite guardians lived in common. The monastic life was
a later form of sharing. In the nineteenth century schemes of social-
ism abounded. Saint-Simon attempted a form of scientific socialism
in which national economies would be run by experts, a possible
inspiration for twentieth-century Leninism in Russia. More idealistic
community schemes are associated with Robert Owen, Charles
Fourier, William Thompson and John Bray. Later in the nineteenth
century a debate between revolutionary and gradualist socialism
began. JS Mill favoured the latter, as did the Fabian Society founded
in 1884.
Central to most of socialism is the desire to have all means of
production under the control of a collective entity, whether a gov-
ernment or a voluntary community. Also, a replacement for the
alleged anarchy of the market and the poverty of much of the
population is sought. This quest is justified in terms of producing a
fairer income distribution and less arduous working conditions.
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SOCIALISM
However, it is difficult at the state level to be both democratic and
fully socialist, as a multitude of political parties and political dissent
destroy unity. A critical free press is also a threat to socialism. At the
state level, various forms of planning have been advocated and
practised to replace the individualism inherent in the market.
Socialism at the level of the small community has often been
practised. Famous examples include the Israeli kibbutzim. Often these
seek a utopia with equal incomes, an abolition of the division of
labour and the pursuit of a set of religious or quasi-religious goals.
This concept has ancient roots with divergent recommendations.
Plato in his Republic wanted common ownership, but unlike many of
his successors, he advocated division of labour because of its promo-
tion of productivity. Thomas More, in his Utopia (1516), was
deliberately writing of an imaginary place in that ‘utopia’ in Greek
means ‘no place’. In his ideal community there was common own-
ership, and compulsory labour limited to six hours per day, alternat-
ing between work in the country and in the town every two years.
Labour and goods would be allocated by elected officials. Movement
around the country and the style of dress would be strictly controlled.
Eating would have to be in common. Later, many writers, including
Thomas Reid in his Practical Ethics, flirted with the idea of utopias.
Before Marx, socialist theories and proposals abounded in Britain
and France. Major themes of these socialist pioneers included the
view that labour was the only source of wealth, that capitalists
exploited the productive/working classes, that there should be greater
or complete equality of incomes, that there is an inverse relationship
between wages and profits, and that production should usually avoid
the division of labour. Agrarian writers, such as Spence in a lecture
on ‘The Real Rights of Man’ in 1775 at Newcastle upon Tyne,
advocated the common ownership of land. Charles Hall in The Effects
of Civilisation on the People in European States (1805) powerfully
anticipated later authors. He argued that what people produce should
belong to them and that workers receive only one eighth of the
national income so lose to those who do nothing. If resources are
used to produce manufactures for exports, fewer resources are avail-
able domestically to provide necessities for the poor. He recom-
mended a redistribution of land. Saint-Simon in his writings in the
1820s, including Catechisme des industriels (1823–26) advocated a ‘sci-
entific socialism’ of industrial associations run by scientists and econ-
omists. Detailed schemes for running socialist communities abounded.
Owen in his Report to the County of Lanark (1820) devised a blueprint
for new communities of 300 to 2,000 men, women and children
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SPATIAL ECONOMICS
with a mixture of agricultural and manufacturing work. Fourier, espe-
cially in his Social Destiny of Man (1840), drew up utopian schemes
which based production on human passions, including the desire for
change of activity. In his ideal community, or ‘phalanstery’, of 1,600
persons there would be no division of labour but inequalities of
incomes in the form of dividends. The Irish writer William
Thompson in his An Inquiry into the Principles of the Distribution of
Wealth Most Conducive to Human Happiness (1824) proposed mixed
manufacturing and agricultural communities of 500 to 2,000 inhabi-
tants. Owen was rare amongst these writers in putting his ideas into
practice in communities in Hampshire, England and Indiana, USA,
suffering heavy financial losses from his investments.
State capitalism, especially associated with the Soviet-type econ-
omy, required that the state own all the means of production and
operate the economy like a large multi-divisional firm. Marx in The
Communist Manifesto saw in the first stage of revolution the proletar-
iat, the wage earners, centralising all the means of production in their
hands and becoming the ruling class, using many of the methods of
capitalists. But this state would wither away through the abolition of
classes, so no class could oppress another. As the state is run by workers
for their benefit, there is no need for independent trade unions.
Market processes are not used for allocating goods and services, but
planning undertaken by administrators rationing what is available.
The socialist calculation debate considered how an economy under
socialism would be organised and if it would be more efficient. Mises
argued that proper pricing would be impossible if the state owned the
means of production. Hayek argued that too much information
would be needed under planning so it would be impracticable.
Further reading: Stiglitz 1990
SPATIAL ECONOMICS
A study of the consequences of the existence of physical space
between economic agents.
The physical separation of productions gives rise to transport and
transaction costs. They can create barriers to entry and lead to local
monopolies, which were common before good roads and railways
linked towns. The presence of distance reduced the amount of
information circulating about alternative suppliers, and enabled
firms to practise price discrimination against consumers.
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SPATIAL ECONOMICS
Early theories of location were those of von Thu¨nen and Lo¨sch.
Thu¨nen in 1826 described a city in an isolated state bounded by
wilderness. He drew a series of concentric rings on homogeneous
land, enclosing different agricultural activities, with perishable goods
being produced closer to the city. The city at the centre of the rings
would have the most population and hence most demand for pro-
duce. Land closer to the city would be more valuable. There are
echoes of the differential theory of rent which can be based on fer-
tility or location differences. Outlying producers would have to pay
their own transport costs to be competitive in the central market.
Christaller developed a theory of central places: places with central
functions which achieved their status through accommodating insti-
tutions of administration culture, religion, health care, entertainment,
culture, commerce, finance, and transport network hubs. The dis-
tribution of central places will depend on markets, traffic and the
degree to which places are separated. The optimal location for pro-
duction is defined by Weber as the place of minimum transport costs.
More complex theories have a broader concept of cost, recognising
the diminishing importance of location to some modern industries
and economic activities. Marshall was an early pioneer of the idea of
external economies for a firm arising from its location in a cluster of
similar producers.
Many economic theories have a spatial dimension. In the theory of
the firm there can be spatial monopolies because of transport costs
separating suppliers, and spatial oligopolies where dispersed firms
compete for the same group of customers. In the theory of distribu-
tion, spatial issues often arise. An important type of wage differential
is geographical or regional. In the theory of rent there can be differ-
ential rent because of either fertility or location. Because regional and
local governments have tax-raising powers, a tax burden will vary
from place to place. In the Tiebout hypothesis it is argued that there
will be fiscal mobility, so that individual taxpayers will move to that
area which has the preferred combination of publicly provided facil-
ities and taxation levels.
Policy responses to the existence of transport costs usually consist
of subsidising remote consumers, for example, by charging the same
price for postage stamps irrespective of delivery costs and the same
fare per mile for public transport so that the profits made from short
trips cross-subsidise the longer hauls. There can be central or local
government grants to help the locationally disadvantaged. Regional
policies aim to equalise the incomes and economic prospects of per-
sons at different locations.
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STABILISATION POLICY
Technical progress has reduced transport costs. The creation of
the internet and advanced electronic and telephonic communication
have made physical location of little importance. Increasingly there can
be footloose industries able to locate anywhere without disadvantage.
See also: migration and mobility
Further reading: Christaller 1966; Hoover 1948; Tiebout 1956; Weber 1929
STABILISATION POLICY
The combination of monetary, fiscal and other measures to reduce
the amplitude of cyclical swings in a national economy.
This policy concern can be traced back to the Swedish economist
Knut Wicksell, who argued that there would be a cumulative process
away from equilibrium: if the market rate exceeded the natural rate
of interest the economy would decline but there would be expansion
if the market rate were less. A disequilibrium could be rectified by
adjustments in banking policy to change the rate of interest.
In the mid-twentieth century, demand management, partly under
the influence of the Keynesian revolution, in the form of frequent
discretionary changes in national tax rates, interest rates and other
tools of government, was used to keep economies on their desired
track. Difficulties abounded in this attempt at ‘fine tuning’: data were
often late and full of inaccuracies; there were time lags in recognising
the need for action, taking action and obtaining the desired results;
and there was a paucity of capable forecasting models. Subsequently
other fashions in stabilisation policy emerged, especially when mon-
etarism was in vogue, along with policy rules such as aiming to have
a steady rate of growth of the money supply. Central bank indepen-
dence has attempted to make monetary policy independent of gov-
ernment so that stabilisation policy will be based more on economic
expertise than on political decision.
The most difficult task of stabilisation policy is when an economy
has virtually collapsed with hyperinflation, a worthless currency and a
stock market crash. An organisation such as the International Mone-
tary Fund can only recommend a drastic revision of public finances,
including large cuts in public expenditure, and a reformed currency,
perhaps even a new one.
Further reading: Stiglitz et al. 2006
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STOCKHOLM SCHOOL
STRUCTURAL ADJUSTMENT
A group of Swedish economists of the 1930s who provided a dis-
tinctive dynamic theory of macroeconomics and policy proposals to
revive depressed national economies.
The principal writers were heavily influenced by Wicksell, who set
out the conditions for price stability and monetary equilibrium,
describing the cumulative processes of contraction and expansion caused
by divergences between the natural and money rates of interest. Myrdal,
Ohlin and Lindahl were leading members of the school. Myrdal in set-
ting out the conditions for monetary equilibrium made the ex-ante
and ex-post distinction. Lindahl wanted to determine time functions or
curves based on the initial values of economic values and the condi-
tions determining the fluctuations in those values. He analysed plans
which express economic motives. In the process of planning different
changes have to be recognised: those caused by altered anticipations,
economic events, immediate and distant influences on planned actions,
and those which are so fundamental as to require a new plan. Unlike
their theoretical competitors in Cambridge, England centred on John
Maynard Keynes, they used period analysis, thereby avoiding compara-
tive statics. Independently Ohlin, for example, developed key concepts
such as the multiplier by tracing the effects of investment over several
periods and the speed of inventory adjustment; also he considered the
consequences of different methods of financing public works.
Their policy recommendations, especially those aiming to cure
unemployment, were closely related to the Social Democrats’ pro-
gramme, including public works. Lindahl, in his discussion of the
balancing of the budget, recommended that there should be an
ordinary budget consisting of current revenue and expenditure and
an extraordinary budget stating loans and capital expenditure. The
current budget would allocate money to the extraordinary so that
public works could be carried out. Taxation would rise and fall with
the prosperity of the economy.
Further reading: Jonung 1991; Lindahl 1939; Myrdal 1939; Ohlin 1937
STRUCTURAL ADJUSTMENT
The responses by the labour force and other factors of production to
changes in demand or supply, often resulting from an external shock
to a national economy.
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STRUCTURE OF AN ECONOMY
As a consequence of a decline in one industry or area and an
increase elsewhere, structural unemployment occurs in the old, and
shortages in the new parts of an economy. A frequent response is to
have training schemes to help the labour force to adjust. Much of
regional policy is concerned with structural adjustment. The pri-
vate costs of structural adjustment are often subsidised by unemploy-
ment allowances and other welfare payments. The biggest problem of
adjustment is where a country has predominantly old industries,
especially in manufacturing and mining, which cannot meet inter-
national competition.
A major shock, for example a change in the price of imported
energy, can necessitate massive changes, such as adopting different
technologies and reducing the level of activity in industries with a
high demand for electricity or oil. Awareness of global warming is
leading to calls for changes in the construction of buildings, type of
travel and many forms of production.
Structural adjustment programmes are a major part of the work of
supranational organizations. The International Monetary Fund often
demands free trade, a currency devaluation and balanced government
budgets. The European Union has sought a restructuring of agri-
culture through setting aside land and preventing over-production.
STRUCTURE OF AN ECONOMY
A set of relationships between parts of an economy.
Every national economy is built up from micro components,
from firms and households. What is occurring at the macro level can
only be understood by examining these micro foundations, because
economic agents exist at that micro level. With the growth of gov-
ernment there is also a governmental sector as well as households and
firms in an economy. As these three types of sector all produce for
themselves and others and consume from each other, there are bonds
which tie them into one structure.
The predominant way of analysing an economy is the matrix cel-
lular method in which the rows and columns of a table are used to
indicate how one component of an economy, for example, a region
or an industry, is related to the others. If this structure is stable then it
can be used for predictive purposes. The best known description of
this kind is Leontief ’s input-output matrix.
An economy can also be described as a building with foundations
supporting a superstructure, as when identifying key sectors and basic
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SUPPLY-SIDE ECONOMICS
activities. Deep structures can be identified by statistical and econo-
metric techniques to discover underlying relationships, as in identify-
ing different cycles in a national economy. Economics, like linguistics,
can view deep structures as unifying theoretical constructs. These
biological, architectural and statistical tools illuminate how an economy
functions.
Structures can be described by activity, listing the proportions of
output or employment in each activity. The state and private sectors
can be contrasted and the distinction between producing goods and
producing services noted. Structures can be static or dynamic: if the
latter, one part of the structure can drive forward change in the other
parts. A structure is especially dynamic if many of the sectors have an
investment character. Some structures are hidden, as is the case with
corporate ownership which is too interrelated and changing to be
obvious. The informal or unofficial economy is a disguised structure
where the separate ‘firms’ are concealed and the relationships
between the informal and formal sectors scarcely known.
Economic policies will affect the way in which an economy is
described structurally. In the Soviet-type economy there was a divi-
sion between defence and non-defence industries, with the former
receiving for reasons of international politics preferential access to
resources. The characteristics of labour will provide a basis for
describing an economy. Because a worker has a particular occupation,
industry and place of work, it is natural to speak of the occupational,
industrial and geographical structures of an economy. Imbalances in
any of these structures will suggest policy responses in terms of
training and regional policy.
National economies have traditional or modern structures. The
extent to which the modern prevails over the traditional has a crucial
effect on the overall economic growth rate. By abandoning an agri-
culturally dominant structure for industrialisation, growth rates have
soared in many Asian countries.
See also: dual economy
SUPPLY-SIDE ECONOMICS
A popular school of American economics in the 1980s, also known
as Reaganomics.
It emphasised the importance of low taxation to provide incen-
tives to workers and investors. A well-known tool of this type of
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SURPLUS VALUE
economics was the Laffer curve, which asserted that tax revenue
would rise to a maximum at a particular level of a tax rate, thus making
high tax rates pointless for a government. There have been empirical
tests to determine if the tax revenue-tax rate curve is of the predicted
shape: it is for some individual taxes, but it is not universally true.
This approach sought a regime of low taxation and a reliance on
monetary policy to run the national economy. It was a reaction to the
Keynesian-dominated approach which enthroned effective demand as
central to managing an economy. In a sense it was a revival of Say’s law.
Although largely concerned with macroeconomic policy, by
examining incentive mechanisms supply-side economics rooted gov-
ernment policy in microeconomics. Taxation proposals were linked to
a call for deregulation of industries to further increase post-tax incomes.
See also: taxation
Further reading: Bartlett and Roth 1984; Minford 1991
SURPLUS VALUE
A term in Marxian economics which measures the amount of
exploitation extracted from workers by capitalists.
Under merchant capitalism surplus value arises through a mer-
chant selling goods for more than they cost; under industrial capital-
ism, by lengthening the working day absolute surplus value in excess
of the subsistence needed for workers is created. There can also be
relative surplus value by labour productivity reducing the amount of
labour needed to produce subsistence, thus leaving a margin for the
capitalist. Instead of the national income being distributed as wages,
rent, interest and profit, it can be simply divided into wages and
surplus value. It was asserted that in the early stages of economic
development surplus value is mainly absolute in nature; later it is
chiefly relative.
The rate of surplus value, or rate of exploitation, is measured by
the ratio of surplus value to variable capital (the wages fund). Other
methods of measuring exploitation include seeing if workers have
wages at least equal to their marginal products.
See also: Marxian economics; value
Further reading: Walton 1972
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TAXATION
TAXATION
The array of charges levied by governments.
Taxes are direct if levied directly on persons, as is an income tax, or
indirect, such as a sales tax if the immediate object of taxation is
impersonal. A personal income tax can start after a tax-free allow-
ance, and can be different for lower and higher bands of income, or
be a flat tax with the same rate for all levels of income. If the amount
of tax taken rises at a faster rate than the taxpayer’s income, it is
progressive. The average rate of tax is the proportion of total income
paid in taxation; the marginal rate of tax the proportion of the last
unit of income levied as tax. If the marginal rate of tax on the last
unit of income is high, there can be a disincentive to supply labour,
although a higher marginal rate can be an incentive if the taxpayer
has a post-tax income goal. Indirect taxes can be lump sum or ad
valorem, i.e. related to the value of what is taxed. These taxes are
often regressive; since they are fixed in amount they absorb a higher
proportion of the pre-tax income of lower income groups.
Treasuries and finance ministries have imaginatively discovered
many things and activities which could be taxed: incomes in all their
variety, capital holdings and gains, imports, sales, value-added. Taxes
can be collected directly by government employees, or indirectly
when the permission to collect taxes is sold to a ‘tax farmer’ who has
a right to tax providing an agreed sum of revenue is handed to the
government.
Adam Smith (1976b) set out the ‘canons of taxation’:
I The subjects of every state ought to contribute towards the
support of the government, as nearly as possible, in propor-
tion to their respective abilities; that is, in proportion to the
revenue which they respectively enjoy under the protection
of the state.
II The tax which each individual is bound to pay ought to be
certain, and not arbitrary. The time of payment, the manner
of payment, the quantity to be paid, ought all to be clear and
plain to the contributor, and to every other person.
III Every tax ought to be levied at the time, or in the manner,
in which it is most likely to be convenient for the con-
tributor to pay it.
IV Every tax ought to be so contrived as both to take out and to
keep out of the pockets of the people as little as possible over
and above what it brings into the public treasury of the state.
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TAXATION
The first of these maxims raises the issue of fair taxation based on
ability to pay, which is ambiguous because this attempt at equality can
be based on absolute sacrifice, relative sacrifice, or marginal sacrifice.
Also Smith is suggesting a benefit tax, whereby the amount paid by
the taxpayer should be equal to the benefits received from the state.
The second, by requiring certainty in a tax system, avoids much
corruption, as can happen when a state contracts tax collecting out
to a tax farmer. The next maxim relieves some of the burden of
paying taxes, as the payment of taxes when income is received, for
example, at harvest time, avoids the need to borrow to pay taxes. The
fourth maxim concerns the efficiency of the tax system. As the goal
of taxing is to meet the demands of the state in executing its func-
tions, it should not be collecting taxes excessively to pay the costs of
administration.
Tax incidence is concerned with identifying the ultimate payers of
a tax. Partial equilibrium analysis shows the incidence on indivi-
duals; general equilibrium analysis shows the effect of a tax on the
economy as a whole. The tax can be shifted forward to the consumer
by raising prices, or backwards to the producer, leading to a fall in
demand for final and intermediate goods. Ricardo, in his Principles of
Political Economy and Taxation, provided a detailed analysis of the
incidence of a wide range of taxes, including whether national wealth
had been diminished by the heavier taxation levied during the
French Revolutionary and Napoleonic Wars. Liability to pay taxes
under legislation is statutory incidence; economic incidence shows
the effect of taxation on economic behaviour, especially the supply of
labour and of savings.
The relationship between economic growth and levels of taxa-
tion is of perennial interest. The structure of taxation between one
type of tax and another will affect incentive mechanisms and hence
productivity and growth of GDP. Scandinavian countries appear to
have enjoyed both. Singapore and Hong Kong flourished with little
taxation. In principle, heavy taxation will be opposed because of its
interference with personal liberty. A government’s priorities will not
necessarily be the same as individual taxpayers’. Nozick called taxa-
tion ‘forced labour’ for the government, so the idea of a Tax Free-
dom Day has emerged. If the total tax burden is 50 per cent of
national income, this day will occur in the middle of the tax year.
Taxation has long attracted reformers. To encourage work and
saving, a shift from direct and indirect taxation has been advocated at
least since Hobbes who, in Leviathan, proposed an expenditure tax.
Reform can be a process of simplification, of reducing the number of
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TECHNICAL PROGRESS
taxes and the rate structure so it is clearer to the taxpayer what is due.
The steepness of progression can be modified in case marginal tax
rates penalise effort. There can be tax competition between countries
in order to attract highly qualified labour and capital: a low tax
regime is called a ‘tax haven’. To avoid competition of this kind
schemes of tax harmonisation are negotiated between countries, as
has happened in the European countries on indirect taxation.
See also: fiscal policy; public finance
Further reading: Salanie´ 2003; Seligman 1895
TECHNICAL PROGRESS
Changes in methods of production and products over time.
Technical change is only possible as a consequence of inventions
being turned into innovations. An invention is crudely measured by a
patent statistic; an innovation can be measured by a diffusion rate.
Some inventions can be attributed to individuals or groups of experi-
menters; others emerged back in the mists of time. Their significance
varies according to impact on the body of knowledge of a science
and the production possibilities created. They can be new production
methods, materials or techniques of analysis. Innovations occur
through enterprising people and organisations embodying inventions
in their capital stocks and procedures. Often as a consequence of
competition there is an imperative to try new ideas. Also individuals
in pursuit of higher incomes and governments intent on promoting
economic growth will be keen to adopt technical innovations.
Technical change is the product of research and development
activity. It can be the output of individual researchers, university
departments, or industrial or government research laboratories. The
distribution of research activity will partly be determined by the
pattern of government expenditure and partly by the incentives to
undertake scientific inquiry. Patent protection is the method of
assigning the gains to owners of intellectual property, but can incur
legal expenditure which is too high for individuals. The prospect of
monopoly profits encourages research activity in industries such as
pharmaceuticals. The structure of industry is important. In a perfectly
competitive industry earning only normal profits, research activity is
only worthwhile at the level of the industry. Oligopolistic industries
have the means and the desire to invest heavily in the creation of new
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TERMS OF TRADE
processes and products. Monopolists have the perpetual possibility of
pursuing the same path.
Technical progress often involves a change in the relationship
between factors of production, especially the labour-capital ratio.
Many innovations are labour-saving because of a scarcity of particular
types of labour or a change in relative factor prices, wages and
interest, of labour and capital. In the nineteenth century this was
known as ‘the machinery question’. Ricardo concluded that workers
would suffer from the relatively increased use of capital. He argued
that the wage fund would shrink, thus reducing the demand for
labour. However, technical progress can be neutral so that economic
growth is not at the expense of labour.
Technical change in an economy can be effected by buying under
licence the technology of other countries, as has happened in suc-
cessful Asian manufacturing countries. The USA and the UK have
generated much of their own technology through investing in uni-
versity and industrial research laboratories.
See also: productivity
Further reading: Berg 1980; Sylos-Labini 1969
TERMS OF TRADE
The ratio of export prices to import prices expressed as a percentage.
Qualifications to this basic ratio have created a variety of terms of
trade measures. The simplest, the net barter, or commodity, terms of
trade, crudely divides the index of export prices by that for import
prices. Gross barter terms of trade show the ratios of quantities of
exports to imports. Income terms of trade constitute the ratio of the
value of exports to the price of imports. Also there are factorial terms
of trade: single factorial if the export price index is multiplied by a
productivity index and double if in addition the productivity of the
foreign exporting industries is also taken into account. The welfare
effects of trade can be considered by using this factorial approach.
It is the lament of poor countries that the terms of trade are against
them, evoking the policy response of protection to alter the ratios: by
imposing a tariff the demand for imports is reduced and the protected
country benefits.
Further reading: Travis 1964
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TIME IN ECONOMICS
TIME IN ECONOMICS
The elaboration of economic models and policies to incorporate the
constant flux in economic conditions.
In classical economics long periods of time were analysed as part
of a project on economic growth. Smith, Ricardo and Marx
looked at the relationship between wages, rent and profit as time
passed. There was a fear that economies could be heading to the
stationary state of zero economic growth. JS Mill, writing in his
Principles on the future of the working classes, was exceptional among
his contemporaries for questioning the benefits of continuous eco-
nomic growth if there were a suitable distribution of income.
Early economics concentrated on looking at the interaction of
economic variables at a point in time. The Cambridge economist
Marshall popularised static models which made use of ceteris paribus
assumptions, so that the world stood still to study economic problems
a bit at a time as a way of coping with change. In the early stages of
analysing an economic problem Marshall recommended the mechan-
ical approach of physics, using the concept of equilibrium and ceteris
paribus assumptions. In the later stages a biological and evolutionary
approach was suggested (without full explanation). He divided time
into different periods: the market day, the short term, the long term
and the secular long run. In the market day supply would be com-
pletely inelastic. Supply would be slightly elastic in the short period as
a consequence of using existing factors of production more inten-
sively, such as happens when workers do overtime and machines are
used continuously under a shift system. In the long period supply
becomes quite elastic, as new buildings can be erected, machines
purchased and workers trained and hired. In the secular long period,
population and technology change make the conditions of supply
unpredictable.
Time can also be considered with regard to demand. Habit and
custom can limit the extent to which consumers change their pre-
ferences. Fashion will only cause temporary aberrations from persis-
tent consumption patterns. Marshall recognised, in his Principles,
book III, chapter IV, that it takes time for consumers to accept sub-
stitutes and new products. Also there is a mutual interaction between
supply and demand. Unless suppliers produce something new there is
a lack of opportunity to change consumption. In a world of little
technical progress consumption patterns will be stable.
Gradually dynamic analysis came into economics. Robertson and
the Swedish economists of the 1930s such as Lindahl made use of
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TIME IN ECONOMICS
period analysis to trace by time period the effects of an income
change such as net investment.
Devices to include time explicitly include using diagrams with
shifting curves referring to different dates and the use of different
dates for variables in an equation, thus, for example, making current
aggregate consumption a function of the previous year’s income. Also
the technique of discounting allows incomes occurring at future dates
to be comparable by being measured at their present values. In
econometrics a central technique is the analysis of time series, those
lists of dates and contemporaneous values of variables.
Keynes is famous for producing an economics of the short term. In
A Tract on Monetary Reform (1923: ch. 3), he wrote
The long run is a misleading guide to current affairs. In the long
run we are all dead. Economists set themselves too easy, too
useless a task if in tempestuous seasons they can only tell us that
when the storm is past the ocean is flat again.
In the General Theory of Employment, Interest and Money (1936) Keynes
analysed the time preferences of individuals both in determining their
propensities to consume and their liquidity preferences. Decisions
about future consumption include whether to spend in future out of
current income or from savings. Interest is granted for parting with
liquidity for a time.
An examination of the trade or business cycle has always included
a division of time into phases of upswings, a peak, downturn, reces-
sion and recovery. JS Mill and Marx recognised this. JM Keynes
regarded the time element in the cycle as the time period before
recovery occurs. The length of a slump he related both to the dur-
ability of capital and to the positive or negative rate of growth of
population. In his monetary theory he asserted that money enables us
to link the present to the future.
If time is discrete it can be described in economic models as a
succession of points in time, or time periods, t, t + 1, t + 2, t + 3.
This is Newtonian time: movement along a line, hence being
described as a spatial view of time. Contrasted with this is dynamic or
real time, which sees time as a flow. Time is not in separate periods
because in the present we are also remembering the past and antici-
pating the future. It is a process with unpredictable change.
Ignorance of the future has given rise to much discussion of
expectations. The future can be the inevitable consequences of present
stable conditions, or a spontaneous occurrence entirely unintended.
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TRADE THEORY
The optimal inter-temporal allocation of resources was considered
by Ramsey in his 1928 study of savings. Creators of the overlapping
generations model also raise inter-temporal issues. Samuelson went
beyond the familiar economic transaction of all the agents in relation
at the same time, and considered trades between generations, using
the example of persons retiring at sixty-five years relative to their
successors. There is no assumption of the world having a definite
beginning or ending. This approach has been elaborated to extend to
several generations and many economic agents. It is important to
theories of capital and social security policies.
Conditions arising from time can vary within days as well as
between them. The pattern of demand varies between peak and off-
peak in transport and energy systems daily. This gives rise to the
problem of peak-load pricing, with different proposals to relate the
price structure to differences in marginal costs. Prices can get stuck in
time and hence are sticky prices, or change often with time so are
flexible prices.
In investment decisions there is always the temptation to choose
short-term gains rather than wait for a more distant and possibly larger
return. Economic policy making is often criticised for being too short-
term, notoriously in the case of demand management. However, there
is a case for policy having a large long-term view. JS Mill argued that
governments can have a more distant time horizon than private
investors, so the time factor will lead to infrastructure investment
being in the hands of governments. It is the essence of a laissez-faire
stance to argue that it is natural forces in the absence of government
intervention which gradually in an evolutionary way bring about
economic change. In the struggle to renew a national economy there
is evidence of the Darwinian theme of the survival of the fittest.
In economic policy making the short term is distinguished from
the medium term of three to five years; the long term usually receives
less attention but the consequences of climate change have forced
governments to look at a more distant horizon.
See also: equilibrium; expectations
Further reading: O’Driscoll and Rizzo 1985; Samuelson 1958
TRADE THEORY
Explanations of why and where countries trade.
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TRADE THEORY
Much of mercantilist thought was concerned with nations
becoming strong through trade, often protected by tariffs. The earlier
writers believed that trade was a zero-sum game so a gain could only
be made at the expense of another nation. They advocated a nation
pursuing a permanent balance of trade surplus and prohibited some
types of import. By the time of Mun in the seventeenth century it
was understood that a deficit in one bilateral trading relation could be
matched by a surplus elsewhere. Also trade concerned services such as
shipping as well as goods.
Adam Smith used an ‘absolute advantage’ theory of trade. He saw
international trade as a means of extending the division of labour
principle from the narrow confines of a single country to the world as
trade could provide a ‘vent for surplus’, an outlet for the extra output
of more productive workers. Trade was worthwhile as one country had
an absolute advantage in costs over another. Torrens and Ricardo
made famous the theory of comparative cost, or advantage, using as
an example a two country model of England and Portugal producing
two goods, cloth and wine, to show that even if Portugal could produce
everything more cheaply, trade could still be beneficial if the internal
cost ratios were different from country to country so that each country
would benefit from specialising in the good in which it was more
efficient. This theory assumed production under constant costs and
immobility of capital. JS Mill refined Ricardian theory by introducing
the law of reciprocal demand to indicate the terms at which trade
would be conducted and hence the sharing of the gains from trade.
The more sophisticated Heckscher-Ohlin model came to dominate
trade theory from the 1930s. Instead of considering only labour,
capital was introduced into the model. Assuming that there is perfect
competition, no transport costs, perfect mobility of factors of pro-
duction within but not between countries and production under
conditions of constant returns to scale, the theory predicted that a
country rich in capital would have a comparative advantage in capital
intensive goods, and similarly a labour plentiful country would do
better with labour intensive goods. Empirical research for the USA
using 1947 data produced the surprising result that the capital rich
America was exporting predominantly labour intensive goods: this
came to be known as the ‘Leontief paradox’ after Leontief, who
created input-output tables enabling him to test the theory.
International trade theory has broadened to incorporate many
aspects of market analysis and industrial organisation. As many
trade flows occur within multinational or transnational firms, to
understand modern trade these firms have to be analysed. Because
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TRADE (LABOR) UNION
economists have increasingly moved away from assumptions of per-
fect competition in their models, international trade under mono-
polistic and oligopolistic competition subject to increasing returns has
been taken into account.
Vernon presented a product cycle theory of trade. In it he asserted
that a newly invented product will be exported to increase the scale
of production and reduce unit costs. Initially there will be monopoly
profits because of the uniqueness of the new product. As the product
matures it will be met by imitated substitutes so that in time the
original country is importing the product. The volume of the
product traded depends on the phase of the product cycle. Initially
exports will be low, then there will be a progressive movement to
mass production for large markets, then in its old age its sales will be
overtaken by rivals.
Strategic trade theory argues that a country can improve its share of
trade by a mixture of tariffs and export subsidies, possibly under
imperfect competition, to realise increasing returns.
Krugman has recommended a new trade theory, hinted at by ear-
lier writers such as Grubel and Kravis, which replaces the compara-
tive cost introduced by Ricardo and Torrens. He has argued for the
inclusion of the assumptions of economies of scale, product differ-
entiation and imperfect competition into a trade theory. The goods
which are traded will already have a large domestic market. Increas-
ing returns gained from large production will make it easier to sell
abroad at a competitive price and have more competitive prices.
See also: development economics; mercantilism; multinational
corporation; price-specie flow mechanism
Further reading: Brander and Spencer 1984; Krugman 1980; Mun 1928;
Vernon 1966
TRADE (LABOR) UNION
A group of workers paying subscriptions to create an organisation to
negotiate wages and other conditions of work on their behalf through
collective bargaining. Originally in Britain ‘a trade union’ could
either be a group of workers or of employers; in the USA, a labor
union.
Entry to union membership is either voluntary, or compulsory
under a ‘closed shop’. The latter form, now fast vanishing, can be
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TRADE (LABOR) UNION
pre-entry with union membership a condition of applying for a job,
or post-entry requiring all workers to be union members within a
specified time of being employed. The incidence of unionisation, or
‘union density’, the proportion of a given labour force belonging to
a union, varies greatly from industry to industry and occupation to
occupation. Coal mining, transport and manufacturing were tradi-
tionally heavily unionised, so that when structural changes in modern
economies made the services sector more important unions found
their total membership declining. Public sector unions, organising
teachers, health care workers and administrators, have taken over
private sector unions in size. Traditionally, male workers were more
unionised than female, and full-time workers were more likely to join
than part-time ones. Unionisation levels are affected by the marginal
cost to a union of recruiting a new member; thus there is less
unionisation in industries with mainly small firms scattered over a
wide area.
Unions can be of benefit to employers. Orderly collective bar-
gaining can be less expensive than individual bargaining, which
repeats the negotiation of the same issues with worker after worker.
Also there can be greater worker satisfaction and productivity if a
labour force feels it is getting its just reward. If workers are repre-
sented, then it is easier to canvass workers’ views.
The perennial question concerning the effects and success of this
institution is ‘how much do wages rise through the existence of
unions?’ This union wage effect is difficult to measure if there is not a
similar group of workers as a comparator. The union wage premium
does vary cyclically. The employment effect is different, as it has long
been argued that unions exist to defend their existing members and
care little about the unemployment effects of wages being pushed too
high. Hence the use of ‘insider-outsider’ models: these emphasise the
selfish nature of union members who are happy to gain wages above
the competitive level, despite the impact on outsiders who are
unemployed.
Critics of unions argue that they are too concerned with protect-
ing job rights so are opposed to technical change, especially those
which attempt to increase productivity through reducing labour-
output ratios. ‘Featherbedding’ is the practice of having an excessive
amount of labour employed. The desire of modern economies to
have labour market flexibility does challenge the traditional rights of
trade union members to retain the same jobs and same range of tasks.
Further reading: Brown 1983
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TRAGEDY OF THE COMMONS
TRANSFER INCOME
The threat to the common good by the group of users of a resource.
The ‘commons’ can be agricultural land or any common resource
such as a public park, a lake, or even a city.
This is an application of the problem of common ownership versus
private ownership debated as long ago as Plato and Aristotle. With
common land, it is to the benefit of the users collectively if there is
conservation through attempting to optimise the grazing and other
agricultural activities on the land. However, individuals with access
can personally benefit by destructive behaviour for their own benefit.
The extent of the tragedy depends on the predominant use made of
the land. If a resource is renewable, such as woodland, then there can be
cycles in the state of a common resource. In the first phase the popu-
lation of users increases to the point of destroying the resource. This
causes that population to diminish. With less use over time the resource
will recover and when it has, the cycle will recommence. A parallel
case of oscillations is noted by Malthus in his Essay on Population.
In general, this tragedy can be diminished by a mutual agreement
of the users to restrain their use. By experimentation there can be a
gradual increase in the use of the common resource to establish the
optimum point of exploitation.
See also: altruism; exhaustible resources; property rights
Further reading: Hardin 1968
TRANSFER INCOME
A personal income derived not from productive activity but paid
under a welfare system or through a generous donation; an inter-
government grant.
In classical economics services were regarded as non-productive, so
the incomes accruing in that sector were not part of the national income
but transfers. Despite the decline of the distinction between productive
and non-productive income the distinction remains. The creation of the
welfare state has introduced new types of transfer income. The provision
of pensions for the elderly, the state financing of education, and the
offering of benefits to the unemployed and the sick have all increased
the volume of transfer incomes in many countries. Also the tempor-
ary or permanent migration of persons from poor to rich countries
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TRANSFER PRICING
has caused flows of remittances and other gifts within families. Large
firms and other organisations have many transfer incomes within
them which do not create an addition to their total income.
In national income accounting it is crucial to separate transfer
incomes from factor incomes, as national income is the sum of the
latter. To include transfer incomes would exaggerate the size of the
national income and make total incomes more than total production.
Internationally, transfer incomes have become important through
bilateral and multilateral aid and schemes to redeem debt. They raise
the question of dependency if the help continues for years.
Further reading: Mitchell 1991
TRANSFER PRICING
The internally administered prices used by firms for transactions
within themselves but not in external markets.
These are pervasive in multinational corporations as the reason for
the existence of such firms is to internalise what previously would have
been exchanges between separate firms. It is essential for accounting
purposes to fix prices on flows of goods and services between the parts
of a large firm, but it is difficult to get the pricing right. They will not
always represent market values: sub-components might never be traded
externally at all. In countries with a substantial amount of government
ownership of industry, transfer pricing is also extensively practised.
There is a temptation to choose prices to maximise post-tax cor-
porate income. Transfer prices could be set so that there is little profit
in high tax countries and most where tax rates are low. As high tax
countries often have generous welfare schemes, any loss of tax rev-
enue is resented. Increasingly, taxation authorities sought to make
transfer prices be more accurate reflections of the cost of production.
By national tax authorities insisting on firms using a transparent for-
mula to fix their transfer prices, it is possible to prevent the setting of
prices which do not cover costs and produce profits.
Further reading: Eccles 1985; Feinschreiber 2004
UNEMPLOYMENT
The non-employment of a factor of production, especially labour.
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UNEMPLOYMENT
Unemployed persons are part of the labour force. Their attachment
is the result of being engaged in job-search activity. Being unem-
ployed can also be regarded as a statistical phenomenon, a consequence
of the scheme for measuring unemployment. There are both the regis-
tered unemployed who are counted because of eligibility for welfare
benefits, and the unemployed identified through household surveys,
usually producing a higher number of unemployed. Both methods of
measurement are imperfect. Those on registers of the unemployed
might not be engaged in a genuine search for work but only be con-
cerned to receive financial benefit. Similarly the unemployed noted
in surveys might have only a vague attachment to the labour force.
There is also underemployment (also called hidden or disguised
unemployment). Persons in this category are employed in low pro-
ductivity jobs with little output. Principal examples of these are
agricultural workers in a less developed economy, workers guaranteed
a job under state capitalism, and workers protected by trade union
regulations which retain rigid job definitions. A method of identify-
ing underemployment is through comparing the labour-output ratio
of a particular firm or industry with a benchmark to see if labour is
being excessively used.
Unemployment can be viewed as stocks or flows. The labour
market is in a constant state of flux. Workers are taking up jobs, or
seeking employment as a consequence of leaving full-time employ-
ment, international migration or returning from a period of eco-
nomic inactivity. They leave to retire, endure an unemployment spell
before working again, emigrate abroad or stop working because of
receiving other sources of income, including welfare benefits. As a
consequence of this movement, at any point of time there will be a
stock of people without employment but seeking it, i.e. unemployed.
Unemployment is a disequilibrium phenomenon because the
supply of labour is greater than the demand for it. An extreme case of
disequilibrium is the existence simultaneously of job vacancies, an
unsatisfied demand for labour, and unemployment. This can be
viewed at the level of a national economy, or a region, or an
industry or occupation. The disequilibrium can occur because it takes
time for markets to clear: if this is the sole reason for unemployment
it is termed frictional unemployment and can be identified by its
short duration. Full employment is not zero unemployment but lar-
gely at the frictional unemployment level because of the inevitability
of slow clearing. The disequilibrium may persist longer because of a
permanent decline in demand for a type of labour, often because of a
major technological shift, as when there is a switch to a different type
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UNEMPLOYMENT
of transport, or a decline in natural resources – for example, when a
coal mine is exhausted. This is structural unemployment, and can
persist for an indefinite period but usually is curtailed by a government’s
policy response. Keynes identified unemployment at the aggregate
macroeconomic level as a disequilibrium, or low equilibrium phe-
nomenon. He called this involuntary unemployment; also known as
demand-deficient unemployment. The three types of unemployment,
frictional, structural and demand-deficient are classified according to
cause – the poor functioning of the labour market, the inappropriate
skills and abilities of the unemployed or the overall state of demand of
the economy. The rate of employment, or (100 À unemployment
rate) is used as a proxy for the state of demand in an economy.
Unemployment causes the unemployed a loss of income, status and
happiness, and the economy loses output. There are thus strong,
even absurd, proposals to reduce it. The mercantilists, wishing to
build strong states, deplored the waste caused by unemployment.
Although classical economists might be thought to be cavalier about
unemployment because Say’s law would naturally bring about full
employment, some, including Malthus, were concerned about the
post-war depression from 1815 caused by the return of soldiers and
sailors to the civilian labour market and the decline in manufacturing.
British and Swedish economists of the 1930s were determined to
devise policies to cure unemployment. In times of high unemploy-
ment public works schemes are recommended. Petty, a mercantilist,
went as far as suggesting the removal of Stonehenge from Salisbury
Plain to the Tower of London in order to create jobs. Keynes sug-
gested the Treasury employ workers to fill bottles with banknotes,
bury them and dig them up again. In practice more sensible schemes
can be undertaken, especially road building and other transport
schemes. As a high proportion, often at least half, of the stock of the
unemployed is unskilled, such public works projects are appropriate.
However, expenditure on public works is often criticised. In the
1920s and 1930s in the UK there was the ‘Treasury view’, later
known as ‘crowding-out’ because the increased taxation and higher
interest rates caused by paying for the extra public sector employ-
ment, would be matched by lower activity and employment in the
private sector so there would be no net gain in employment.
A closer examination of the labour market, and of the unem-
ployed, leads to specific employment policies. Frictional unemploy-
ment is blamed on the poor functioning of the labour market. As
there can be a poor publication of job vacancy data, from the late
nineteenth century UK labour exchanges, or job centres, provided at
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UTILITY
public expense advertisements of vacancies. For employers seeking
workers with scarce skills the search can be long and expensive.
Workers reluctant to move home or retrain can take a long time to
regain employment. Some frictional unemployment can occur because
workers choose to have an unemployment spell to rest or travel.
Responses to structural unemployment follow well trodden roads.
Vocational education and specific training programmes are recom-
mended, and regional policies advocated to revive blighted areas.
There can be some resentment from existing workers and their trade
unions if a training programme expands the labour supply and
depresses the wages of a particular occupation: for this reason training
is often only publicly provided in a narrow range of chronically
labour-short occupations.
General macroeconomic policies, chiefly monetary and fiscal, are
exercised to stimulate demand in an economy. If the low demand is
recurrent because of economic fluctuations it causes cyclical unem-
ployment. Different approaches to stabilise an economy at a particular
employment level include using monetary policy to achieve price
stability, or following a rule on the expansion of the money supply
under monetarism, or making frequent changes in taxes and interest
rates under deliberate demand management. Friedman and Phelps
argue that there is no demand-deficient unemployment and that
there is a natural rate of unemployment, combining frictional and
structural unemployment.
The concept of hysteresis, originally concerned with the properties of
ferric metals, has been used to account for the failure of unemployment
to return to an equilibrium rate. High unemployment persists because
higher demand leads to higher wages for existing workers, not more
work for the unemployed. At a time of expanding demand, if there
are also labour market reforms making labour more efficient, output
will grow faster than employment, allowing unemployment to persist.
See also: labour
Further reading: Casson 1981; Friedman 1968; Phelps 1968; Sinclair 1987;
Weiss 2001
UTILITY
The benefit received from consumption. This can be an objective
benefit in the sense of usefulness, or a subjective satisfaction. By the
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UTILITY
end of the eighteenth century the subjective was replacing an objective
view.
Because it was asserted that goods could have intrinsic value they
were of use. The properties of the objects themselves gave rise to
their usefulness. This meaning has lingered on in expressions such as
‘utility furniture’, which was functional rather than decorative.
Hutcheson, Smith’s teacher, in discussing price theory in his Short
Introduction to Moral Philosophy (1747: 209) referred to ‘some fitness in
the things to yield some use or pleasure in life; without this, they can
have no value’, using utility in an objective way and relating it to
value. In his An Introduction to the Principles of Morals and Legislation
(1789) Bentham set out the principle of utility as a standard to
approve or disapprove of every action. He too had the idea of utility
as something objective, a property of any object which produces
benefits, pleasures and happiness or prevents the opposite. The hap-
piness of the community cannot be divorced from that of an indivi-
dual. Thus government measures are based on utility if they promote
the net happiness of a community.
Gradually utility came to be regarded as a subjective matter, of
giving satisfaction irrespective of the nature of the good itself. Turgot
referred to ‘esteem value’ and the influence of utilitarianism began to
infiltrate economics. The notion of marginal utility was used by
many early nineteenth century economists, including Nassau Senior
of Oxford, noting the tendency for the marginal utility from con-
suming successive units of the same good to decline. In the ‘margin-
alist revolution’ of the 1870s, utility theories became central to
theories of value and exchange. Jevons translated value in use into
total utility, esteem into final degree (i.e. marginal) and purchasing
power into the ratio of exchange. Contrasted with utility is disutility,
which even Smith in The Wealth of Nations recognised as a phenom-
enon, as labour does entail ‘toil and trouble’; Jevons also used dis-
utility in his theory of labour.
The measurement of utility has long been sought, as this would
make possible interpersonal comparisons of the consequences of there
being different amounts of goods or wealth or income per person.
Bentham, in his pain and pleasure felicific calculus, argued that the
value of pleasure and pain depends on seven circumstances: intensity,
duration, certainty or uncertainty, propinquity or remoteness,
fecundity (the chance of being followed by similar feelings), purity
(unlikely to be followed by opposite feelings), and the extent (how
many persons are affected). Jevons used only the first four of these in
looking at the dimensions of utility. Direct measures of utility are
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VALUE
difficult, although bodily behaviour hints at it through sounds emit-
ted and facial expressions. An indirect measure is the behaviour
resulting from receiving pain or pleasure expressed in purchasing
goods or undertaking tasks. Jevons, following Senior, regarded utility
as the relation between things and pain or pleasure and made the
distinction between total and marginal utilities.
The distinction between cardinal and ordinal utility is that cardin-
alists assert that satisfaction can be measured in numbers of utils,
whereas ordinalists argue that we can only rank our satisfactions as
first, second and so forth. Samuelson popularised the idea of revealed
preference in the form of examining consumer responses to changes
in incomes and prices. Once the preferences were known, it was
possible to plot combinations of two goods on indifference curves.
Later, expected utility became a key concept in microeconomics: it is
concerned with summing probable utilities.
Edgeworth and Pareto introduced the device of the indifference
curve to represent different combinations of two goods which would
yield the same amount of utility. The slope of the curve measures the
marginal rate of substitution between the two commodities. Instead
of speaking of diminishing marginal utility, in this diagram the prin-
ciple illustrated is the diminishing rate of substitution.
The idea of expected utility is extensively used in modern eco-
nomics. Building on the idea of ordinal utility and ranking of pre-
ferences, uncertain payoffs are ranked according to the expected
utility of their outcomes. This is based on the von Neuman-Mor-
genstern utility function, which shows an individual ranking payoffs
according to expected utilities.
See also: happiness; price
Further reading: Majumdar 1961; Samuelson 1938
VALUE
The fundamental worth or price of a good or service.
The discussion of the origin and nature of value can be traced to
Ancient Greece. Aristotle used the durable distinction between value
in use and value in exchange (market price) which continued to be a
tool in the hands of Smith, Ricardo and Marx. Increasingly main-
stream Western economics became interested only in the price theory
aspect of the value debate.
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VALUE
Smith noted that a good could have value in exchange but little
value in use. He employed the aged ‘water and diamonds paradox’,
pointing out that water is useful but commands a low price, whereas
diamonds are high in price but have little use. Neoclassical economists
were to deal with this paradox by mentioning that diamonds have a
higher marginal utility, the basis for a price. In a sense the classical
economists had no need to debate this issue as there was an awareness,
as shown in the later published Lectures on Jurisprudence of Smith that
diamonds command a higher price because of their relative scarcity.
The establishment of an exchange economy makes necessary the
valuation of what is marketed. Earlier writers of the Middle Ages,
including Aquinas and Duns Scotus, debated the nature of a just
price (‘justum pretium’). It corresponded to a common estimation,
which included a measure of market determination. It had to be in
accord with a hierarchical society. Later, in order to check whether
there is unfairness in the prices set there has often been a desire for an
intrinsic value as a standard, although this has long been considered a
futile quest. The principal candidate for intrinsic value is the basic
cost of production. Petty attempted a land and labour theory of value
in his statement ‘Labour is the father of material-wealth, the earth is
its mother’, but it was left to Richard Cantillon to show that a value
could be alternatively expressed in units of land or labour by linking
the value of labour to the amount of land needed to sustain a
labourer’s family. Smith argued that land, labour and capital all have
natural prices and the sum of them will equal the natural prices of
goods. The natural value will be the ‘central price’ around which
market prices will fluctuate as demand changes. Supply considerations
will determine natural prices; changes in demand will cause market
prices to diverge from natural prices. Smith considered three senses of
labour – labour disutility (the toil and trouble of production), the
labour commanded (the labour we obtain from others through
exchange), and labour quantity – to produce three separable labour
theories. Both Ricardo and Marx reduced capital to labour and
removed rent as a cost of production, thus making labour the only cost.
Ricardo regarded utility as a necessary condition for value in
exchange, but argued that only in a few cases, such as rare statues and
pictures, would scarcity be the sole determinant of value; for other
commodities their value is regulated by the quantity of labour. He
assumed that skill and intensity of labour had no effect, and differing
lengths of time to bring goods to market could only affect relative
values by 6 per cent or 7 per cent, hence Stigler referred to Ricardo’s
theory as the ‘93% labour theory of value’.
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VALUE
Marx built on Ricardian theory. In the first volume of Capital he
stated that use value depends on the physical properties of the com-
modity concerned which are realised in consumption, but exchange
value is relative and varies from time to time and place to place. He
argued that in exchange the common factor in the items exchanged
is labour. To avoid the idea that workers lazy and lacking in skill
would produce more valuable goods because they took more time to
produce, he introduced the notion of ‘socially necessary labour time’
based on normal production and average degree of skill and intensity
of labour. Ignoring differences in human ability, he argued that skill is
the product of training so complex labour can be reduced to simple
labour.
As economics moved from classical to neoclassical forms there was
a violent rejection of labour theories. Jevons argued that when
labour is spent in production it is lost and gone forever and no
longer has an influence on current price. What counted was the
subjective utility, the balance of pleasure over pain, of the exchanging
parties. Marshall, however, consciously attempted to combine in his
theory of exchange value the Ricardo/JS Mill view with Jevons’,
creating his own ‘scissors diagrams’ to represent graphically demand
and supply schedules in his theory of price.
Value can be regarded as the consequence of the activity of valuing.
This volitional theory of value was employed by Commons in his
Institutional Economics. He looked at the opinions of judges of the US
Supreme Court to obtain an idea of reasonable value. This meant that
the theory of value would be constructed out of the habits and cus-
toms of social life. This permits a transition from an individualistic
approach to value to a social theory of value. Thus value is a con-
sequence of social activity, not of pleasure and pain.
Special cases of value abound. Value-added is the difference
between the monetary amount received for output and the monetary
amount paid for inputs at each stage of production. The gross
domestic product is the sum of the value-added for each industry of
that national economy. Contingent values are not produced by the
workings of a market but by other forms of estimation; for example,
the use of a survey to learn how much landowners appreciate a
beautiful view.
See also: price; utility
Further reading: Brookshire et al. 1976; Commons 1990; Marx 1976; Ricardo
1821; Smith 1976; Stigler 1966
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WEALTH
WEALTH
What is owned; the stock of assets existing at a point in time; happi-
ness and well-being.
As households, firms and governments have distinct legal person-
alities, they can own property. Wealth must always be distinguished
from income, despite income when saved over time becoming a
wealth accumulation. In the case of a firm its balance sheet shows its
assets and liabilities at a point in time; its profit-and-loss account
shows net income over a time period.
Wealth means abundance, the opposite to scarcity. Ruskin coined
the term ‘illth’ as the opposite of wealth. How much one needs to be
wealthy will be heavily conditioned by time, place and culture. What
is central to the idea is that there are no material constraints on the
action of a person. Usually this is possible only for a few people in a
population, unless it is a small country with disproportionate resour-
ces such as large oil reserves.
Measuring wealth is complex because of the changing physical
condition of goods, the hiding of assets to avoid taxation, the
intangibility of some of them (for example, goodwill), different
market valuations and controversy over what should be included.
Given such problems it is difficult to have wealth as a tax base, so
capital taxes are more expensive to collect than income or sales taxes,
and sometimes not worth the trouble. Household members give the
fullest indication of wealth when they die. Firms, however, through
their balance sheets, have to record their assets and liabilities on a
particular day. Governments have an even greater task of measure-
ment, as many of their assets have not received a market evaluation.
The acquisition of wealth comes in different ways. It can be
inherited, produced spontaneously by nature, the result of coopera-
tion of labour and other factors of production, stolen, or the con-
sequence of changes in market opinions. Wealth creation usually
means a conscious attempt to increase the rate of investment because
of taking the long view. Governments with a policy of economic
growth will encourage the growth of physical and human capital.
The earlier mercantilists saw the accumulation of wealth as the goal
of a state, but the classical economists, especially Adam Smith, had
the different welfare concept of increasing income in the form of
annual produce as an aim. At lower levels of income, wealth will be
mainly regarded as physical goods, as such are needed to meet the
physical needs of food, housing and clothing. When income reaches
a higher level, various psychological yearnings can receive attention,
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WELFARE ECONOMICS
thus wealth will include being entertained, and finding peace and
happiness.
Well-being is a slippery concept: like utility, much of it is valued
subjectively. There are generally agreed prerequisites for well-being,
including living in a place not affected by war or crime, being fit and
healthy, and having friends. Difficulties arise with non-material
sources of satisfaction.
Wealth taxation is imposed either to attempt a greater measure of
equality or to have an extra source of taxation. It is always con-
troversial, as it affects the structure of power in a society and leads to
difficult problems of asset valuation. The most common type of this
taxation is at the time of death when an inventory has to be made
and the resources to pay the tax exist. Taxation of the wealth of the
living can be punitive if it means the abandonment of a home or
business to pay it.
See also: capital theory; economic welfare; happiness; national income;
poverty; scarcity; utility
Further reading: Brenner et al. 1988; Cannan 1948
WELFARE ECONOMICS
A study of the determinants of individual or social welfare.
Individual welfare is personal satisfaction, and is measured by some
form of utility. The allocative efficiency of individual welfare is con-
sidered, with its consequences for income distribution. Increas-
ingly welfare economics has been concerned with the notion of
maximising or minimising social welfare, the meaning of optimum
conditions, and whether they are products of perfect competition,
and how welfare can be achieved under different types of economic
system and policy.
An early treatise on welfare economics in the neoclassical tradition,
Pigou’s The Economics of Welfare (1920), regarded economic welfare as
a component of total welfare, that part of social welfare which could
be measured in monetary terms. In an early exercise in national
income accounting he considered the nature of total output, which
he called ‘the national dividend’. He contrasted the marginal private
and marginal social products of the use of resources and considered
how they could be equalised. A divergence between the two pro-
ducts occurs as the owners of land and capital receive what is the due
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WELFARE ECONOMICS
of workers. Some transfers from the rich to the poor were recom-
mended and a minimum income for the existing population. Much
of the welfare problem he identified was associated with the opera-
tion of the labour market. He assumed there was a law of dimin-
ishing marginal utility in operation, and that those who suffered
from a scheme of redistribution had to be compensated. Marginal
methods have also been used to set out the conditions for an opti-
mum output which would require resources be shifted within a
national economy until marginal physical products were equalised.
Pareto optimality states that there will be an improvement in eco-
nomic welfare if everyone is better off without anyone being worse
off. For this state of welfare to occur, it is necessary that all con-
sumers have the same marginal rate of substitution in consumption;
all producers have the same marginal rate of transformation in pro-
duction; for all production processes marginal cost equals marginal
revenue; and there is equality between the marginal rates of sub-
stitution in consumption and the marginal rates of transformation in
production.
The ‘New Welfare Economics’, starting in 1939 in Economic Journal
debates, was concerned with compensation tests. Harrod raised the
case of England benefiting from free trade corn after the abolition of
the Corn Laws in 1846 despite landlords losing out. Kaldor suggested
that in such cases the government should subsidise the losers. Hicks
argued that there could be optimality providing the marginal rates of
substitution between consumers and producers was the same. Analysis
was aided by the introduction of community indifference curves to
show relative preferences at different levels of utility. Under the
Kaldor-Hicks test, social welfare will be increased if there is an
opportunity for the better off to compensate the worse off. Hicks also
considered a compensation for firms under imperfect competition by
redistributing producer’s surplus to the loser.
The philosophical foundations of welfare economics have had
many investigators. Little was concerned with the problem of ascer-
taining whether there is an increase in welfare if tastes are changing,
and how to avoid welfare judgements when stating there is an
increase in welfare. His contemporaries appeared to ignore income
distribution.
Social welfare can be regarded as the aggregate of individual wel-
fares, or of some collective entity. A ‘Benthamite welfare function’
consist of the sum of individual utilites, reflecting his principle of the
‘greatest happiness for the greatest number’. A long-running debate
contrasts cardinal with ordinal utility. The cardinal variety states that
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WELFARE ECONOMICS
numbers of ‘utils’ can be measured for each act of consumption;
ordinal utility, less ambitiously, asserts that preferences can be ordered
or ranked.
Applications of welfare economics include the cost-benefit ana-
lysis of public investments, the study of social cost in environ-
mental economics, and the application of social welfare functions
to policy research.
See also: consumer’s surplus; public choice; social choice theory
Further reading: Graaff 1957; Hicks 1939; Kaldor 1934; Little 1957; Nath
1969; Pigou 1932
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Names Index
Aftalion, Albert 1874–1956: 3
Akerlof, George Arthur b. 1940: 119
Alchian, Armon A b.1914: 83, 121
Anderson, James 1739–1808: 20, 180
Aquinas, Thomas 1225–74: 218
Aristotle 384–322 BC: 20, 31, 55, 76,
81, 136, 143, 164, 211, 217
Arrow, Kenneth J b.1921: 60, 110–11,
191–92
Bailey, Samuel 1791–1870: 159
Baran, Paul 1910–64: 137
Barro, Robert J b.1944: 103, 152
Bauer, Peter Thomas 1915-:2002: 49
Baumol, William J b.1922: 41–124
Becker, Gary S b.1930: 51, 93
Bentham, Jeremy 1748–1832: 101,
133, 184, 186, 191, 216
Bergson, Abram b.1914: 191
Bertrand, Joseph LF 1822–1900: 28
Boehm, Bawerk, Eugen von
1851–1914: 9, 16, 18
Bliss, Christopher JE b.1940: 18
Boisguilbert, Pierre Le Pesant,
Seigneur de 1646–1714: 130
Borda, Jean Charles de 1733–99:
170–91
Boulding, Kenneth E 1910–93: 4, 53,
83
Bowen, William Gordon b.1933: 41
Bray, John Francis 1809–95: 192
Buchanan, James M b.1919: 6, 10,
37, 170
Cagan, Philip b.1927: 87
Cairnes, John Elliot 1829–75: 62, 189
Cannan, Edwin 1861–1935: 58
Cantillon, Richard 1680–1734: 57,
62, 64, 73, 109, 129, 132, 148,
162, 218
Carlyle, Thomas 1795–1881: 73
Cass, David b.1937: 60
Cassel, Gustav 1866–1945: 85
Chamberlin, Edward H 1899–1967:
28
Chenery, Hollis B b.1918: 28
Child, Josiah 1630–99: 138
Christaller, Walter 1899–1963: 195
Clark, Colin G 1905–89: 146
Clark, John Maurice 1884–1963: 3
Clower, Robert b.1926: 143
Coase, Ronald b.1910: 23–24, 89,
94, 121, 168
Cobb, Charles W: 1858–1932 60, 164
Coddington, Alan 1941–82: 126
Colbert, Jean Baptiste 1619–83:
130–38
Collard, David A b.1937: 6
Commons, John Rogers 1862–1945:
121, 168
Comte, Auguste 1798–1857: 5
Condorcet, MJA Nicolas de Caritat,
Marquis de 1743–94: 170, 191
Cournot, Antoine Augustin 1801–77:
28
Darwin, Charles 1819–92: 91
Davidson, Paul b. 1930: 88
Demsetz, Harold b.1930: 21, 168
Denison, Edward F b.1915: 165
Dobb, Maurice H 1900–976: 137
Domar, Evsey D 1914–97: 59
241
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NAMES INDEX
Douglas, Paul H 1892–1976: 60, 164
Downs, Anthony b.1930: 170
Duns Scotus c.1266–1308: 218
Dupont de Nemours, Pierre Samuel
1739–1817: 154
Dupuit, A Jules E 1804–66: 29, 39,
64, 133, 149
Edgeworth, Francis Ysidoro
1845–1926: 31, 34, 67, 217
Ely, Richard T 1854–1943: 121
Euler, Leonard 1707–83: 31
Fisher, Irving 1867–1947: 87, 173
Fleetwood, William 1656–1723: 161
Fourier, Charles 1772–1837: 34, 192,
194
Frank, Andre Gunder b.1929: 137
Friedman, Milton 1912–2006: 63,
131, 141, 174, 184
Garegnani, Pierangelo b.1930: 19, 151
Gervaise, Isaac 1680–1720: 162
Giffen, Robert 1837–1910: 161
Glimcher, Paul W: 152
Gossen, Hermann Heinrich 1810–58:
133
Granger, Clive WJ b.1934: 132
Gray, John 1799–1850: 102
Greenspan, Alan b.1926: 15
Grubel, Herbert G b.1934: 209
Haberler, Gottfried 1900–995: 10
Hahn, Frank H b.1925: 18
Hall, Charles 1745–1825: 193
Harcourt, Geoffrey C b.1931: 151
Harrod, Roy F 1900–978: 59, 222
Hayek, Friedrich August von
1889–1992: 10, 11, 17, 67, 118,
124, 131, 143, 194
Heckscher, Eli F 1879–1952: 149,
208
Hegel, WF 1770–1831: 135
Heisenberg, Werner 1901–76: 183
Hicks, John Richard 1904–89: 3, 46,
125, 127, 130, 150, 222
Hirsch, Fred 1931–78: 31
Hobbes, Thomas 1588–1679: 82, 98,
167, 177, 202
Hotelling, Harold 1895–1973: 85
Hume, David 1711–76: 81, 111, 116,
138, 143, 162, 167–68
Hutcheson, Francis 1694–1746: 31,
101, 216
Jenkin, HC Fleeming 1833–85: 48
Jennings, Richard 1814–91: 133
Jevons, William Stanley 1835–82: 22,
30, 34, 64, 81, 102, 129, 133, 149,
162, 216–17, 219
Juglar, Clement 1819–1905: 46
Kahn, Richard F 1905–89: 146
Kaldor, Nicholas 1908–86: 60, 222
Kalecki, Michal 1899–1970: 151
Keynes, John Maynard 1883–1946:
20, 30, 46, 53, 63, 70, 78, 87, 96,
105, 121–22, 125–27, 129, 143,
146, 150, 183, 186–87, 197,
206,214
Keynes, John Neville 1852–1949: 63
Kirzner, Israel M b.1930: 10, 73
Kitchin, Joseph 1861–1932: 45
Kiyotaki, Nobohiro b.1955: 144
Klein, Lawrence R b.1920: 126
Knight, Frank H 1885–1972: 131, 183
Kondratieff, Nikolai D 1892–1931: 46
Koopmans, Tjalling C 1910–85: 60
Kravis, Irving B 1916–92: 209
Krugman, Paul R b.1953: 209
Kuhn, Thomas 1922–96: 63–64
Kuznets, Simon 1901–85: 46, 148
Kydland, Finn E b.1943: 177
Lachmann, Ludwig M 1906–90: 10
Laffer, Arthur B b.1940: 200
Laidler, David EW b.1938: 126
Lakatos, Imre 1922–74: 63–64
Lancaster, Kelvin J 1924–99: 30
Le Chatelier, Henri 1850–1936: 78
Leibenstein, Harvey 1922–92: 70
Leijonhuvud, Axel b.1933: 126
Leontief, Wassily 1906–99: 120, 208
Lewis, William Arthur 1915–90:
49–60
Lindahl, Erik R 1891–1960: 197, 205
Little, Ian MD b.1918: 222
Lloyd, William F 1795–1852: 133
Locke, John 1632–1704: 167. 173,
177
242
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Lo¨sch, August 1906–45: 195
Lucas, Robert E b. 1937: 152–53,
177
Machlup, Fritz 1902–83: 10
Malthus, Thomas Robert 1766–1834:
19–21, 37, 46, 53, 57, 59, 62, 122,
165, 180, 186–88, 211, 214
Mankiw, Nicholas Gregory b. 1958:
127
Marshall, Alfred 1842–1924: 22,
29–30, 39, 41, 53, 62, 68, 71, 78,
81, 83, 90, 96, 103 126, 149, 158,
185, 195, 205, 219
Marx, Karl 1818–83: 16, 17, 19–20,
38, 46, 50, 82–83, 135–37, 166,
184, 193–94, 205–6, 217–19
McCloskey, Deirdre N [Donald]
b.1942: 65
Meade, James E 1907–95: 80, 90,
127, 157
Meek, Ronald L 1917–78: 137
Menger, Carl 1840–1921: 9, 18,
133–34, 149
Merton, Robert C b.1944: 183
Mill, James 1773–1836: 186
Mill, John Stuart 1806–73: 19, 21,
46, 51, 58, 62, 71, 81, 157, 159,
183, 187, 189, 192, 205–7, 208,
219
Mirabeau, Victor de Riqueti,
Marquis de 1749–91: 154
Mirrlees, James A b.1936: 60
Mises, Ludwig von 1881–1973: 10,
131, 174, 194
Mitchell, Wesley C 1874–1948: 45
Modigliani, Franco 1918–2003: 150
Montchre´tien, Antoine de
c.1575–1621: 157
Moore, John H Hardman b.1954: 144
More, Thomas 1478–1535: 193
Morgenstern, Oscar 1902–76: 10, 98,
217
Mun, Thomas 1571–1641: 71, 138,
208
Mundell, Robert G b.1930: 43
Muth, John b.1930: 87, 177
Myint, Hla b.1920: 49–50
Myrdal, Gunnar 1898–1987: 49–50,
84, 87, 96, 197
NAMES INDEX
Nash, John F b.1928: 80, 99, 152
Nelson, Richard R b.1930: 83
Neuman, John von 1903–57: 10, 98,
217
Newton, Isaac 1642–1727: 64
Nicholson, Joseph Shield 1850–1927:
109
Nordhaus William D b. 1941: 156
Nozick, Robert 1938–2002: 202
Ohlin, Bertil G 1899–1979: 63, 149,
197, 208
Okun, Arthur M 1928–80: 77
Owen, Robert 1771–1858: 34, 130,
192–93
Pareto, Vilfredo 1848–1923: 67, 217,
222
Pasinetti, Luigi L b.1930: 19, 151
Patinkin, Don 1922–95: 126
Peacock, Alan Turner b.1922: 41
Pesaran, M Hashem b. 1946: 88
Petty, William 1623–87: 19, 49, 109,
138, 148, 185, 214, 218
Phelps, Edmund S b. 1933: 215
Phillips, AWilliam H 1914–75: 116,
152
Pigou, Arthur Cecil 1877–1959: 24,
89–90, 174, 221
Plato c.427–347 BC: 98, 192–93, 211
Polanyi, Karl 1886–1964: 56
Ponzi, Carlo 1882–1949: 15
Popper, Karl 1902–93: 64, 66 175
Prebisch, Raul 1901–85: 49
Prescott, Edward C b. 1940: 177
Quesnay, Francois 1694–1774: 120,
132, 148, 154–55
Quincey, Thomas de 1785–1859:118,
166
Ramsey, Frank P 1903–30: 60, 183,
186
Rawls, John 1921–2002: 176–77
Reid, Thomas 1710–96: 193
Resnick, Stephen A b. 1938: 50
Ricardo, David 1772–1823: 19–21,
38, 64, 74, 132–33, 136–37, 148,
150, 165–66, 180, 187, 202, 205,
207–9, 217–19
243
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NAMES INDEX
Robbins, Lionel C 1898–1984: 63,
187
Robertson, Dennis H 1890–1963:
63, 126, 205
Robinson, Joan 1903–83: 19, 28,
127, 137, 151
Rosenstein-Rodan, Paul N 1902–85:
10, 49–50
Rostow, Walt W b.1916: 59
Rothbard, Murray N b.1926: 10
Rothschild, Emma b. 1948: 124
Rousseau, Jean-Jacques 1712–88: 82,
177
Rubinstein, Ariel b.1951: 99
Ruskin, John 1819–1900: 41, 220
Saint Simon, Claude Henri de
Rouvroy, Comte de 1760–1825:
192–93
Samuelson, Paul A b.1915: 18, 82,
149, 207
Sargent, Thomas J b. 1943: 152
Savage, Leonard 1917–71: 183
Say, Jean-Baptiste 1767–1832: 53,
126, 186, 214
Schultz, Theodore W 1902–98: 19,
109
Schumpeter, Joseph 1883–1950: 10, 83
Schwartz, Anna J b.1915: 141
Scrope, George Jules Poulett
1797–1876: 161
Sen, Amartya K b.1933: 49–50,
191–92
Senior, Nassau William 1790–1864:
19–21, 62, 133, 149, 166, 184,
216–17
Shackle, George LS 1903–92: 10, 87,
183
Simon, Herbert A 1916–2001: 173
Singer, Hans W 1910–2006: 49–50
Smith, Adam 1723–90: 16–17, 19–20,
30, 44, 49, 54–55, 57, 59, 62, 67,
78, 81, 83, 97, 106, 109, 111,
122–23, 129, 133, 136, 138, 143,
151, 155, 157, 159, 163, 165–67,
170, 180–81, 183, 210–12, 205,
208, 216–18, 220
Smuts, Jan Christiaan 1870–1950: 105
Solow, Robert M b.1924: 18, 60
Spence, Thomas 1750–1814: 186,
193
Spencer, Herbert 1820–1903: 83
Sraffa, Piero 1898–1983: 19, 150–51
Steuart, James 1713–80: 57, 62, 78,
138, 157
Stigler, George John 1911–91: 131,
188, 218
Stone, Richard 1913–91: 148
Sweezy, Paul M b.1910: 137
Swift, Jonathan 1667–1745: 103
Thompson, William 1775–1833:
192, 194
Thornton, Henry 1760–1815: 39,
116, 186
Thu¨nen, Johann Heinrich von
1780–1850: 195
Tiebout, Charles M 1924–68: 195
Torrens, Robert 1780–1864: 21,
218–19
Tullock, Gordon b.1922: 111, 170
Turgot, Anne-Robert-Jacques
1727–81: 154, 216
Vanek, Jaroslav b.1930: 149
Veblen, Thorstein 1857–1929: 31,
50, 105, 121
Vernon, Raymond b.1913: 209
Vickrey, William 1914–96: 8
Viner, Jacob 1892–1970: 131
Wallace, Neil b.1939: 144, 152
Wallace, Robert 1697–1771: 57
Walras, ME Le´on 1834–1910: 35, 78,
133–34, 149
Weber, Max 1864–1920: 195
Whately, Richard 1787–1863: 82
Wicksell, Knut 1851–1926: 46, 53,
196–97
Wieser, Friedrich von 1851–1926: 9,
37
Williamson, Oliver E b.1932: 121
Winter, Sidney G b.1935: 83
Wrigglesworth, John: 192
Xenophon c.420–355: 54, 55, 171
244
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Subject Index
Note: page numbers in bold indicate the entry for a subject.
ability to pay 202
absolute advantage theory of trade
208
absolute concentration 56
absolute income 31
absolute poverty 158
absolute surplus value 200
abstinence 166
abstract labour 130
accelerator 3
accounting balance 11
accounting cost 36
accounting model 65
ad valorem tax 201
adding-up problem 191
adverse selection 33, 182
aggregate concentration 56
aggregate demand 79, 146, 152
aid 3–5
alienation 16–17, 136, 167
allocative efficiency 69–70, 221
alternative cost 37
altruism 5–6
anarchy 132
Anglo-Saxon capitalism 18
anti-competitive practice 29
antitrust 28, 35, 57, 114
arbitrage 7
arbitration 33, 116
asymmetric information 31, 119,
130
atomistic competition 105
auction 7–8
Austrian economics 9–11
average cost 37
average cost pricing 160
average efficiency 69
average rate of tax 201
average revenue 159–60
balance of payments 11–12
balanced budget 197
balanced budget multiplier 146
bank asset 14
bank balance sheet 14
Bank Charter Act 1844 21
bank liability 14
Bank of England 12
banking 12–14
barrier to entry 27–28, 86, 114, 189,
194,
barter 56, 66, 86, 142, 144, 159
barter economy 34, 187
bastard Keynesianism 127
Bayesian equilibrium 80
behavioural economics 88
Benthamite welfare function 222
big push 49
bimetallism 44
black economy 117, 148
Borda count 170, 191
bounded rationality 175
brain drain 109, 139
branch banking 13
Bretton Woods 43
bubble 14–16
budgetary policy 186
business cycle 46
canons of taxation 201–2
capital 3–4, 18–19, 36, 46, 112, 136,
164, 166, 218
245
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SUBJECT INDEX
capital asset pricing model 183
capital controversies 18–19
capital good 9–10
capital reversing 19
capitalism 16–18, 36, 46, 112, 136,
164, 166, 218
capital-output ratio 3
capital theory 18–19
cardinal utility 176, 217
ceiling 3, 46
central bank 12–14, 21, 42–43, 84,
121, 123, 127, 135–37, 157, 192,
200
central bank independence 13, 142, 196
central planning 56, 118, 160
central price 159
ceteris paribus 68, 78, 89, 205
characteristics theory of consumer
demand 30
Chicago School 131
circular flow of income 120, 148,
151, 154
classical economics 19–22
closed shop 209–10
club good 22
clubs, theory of 22–23
Coase theorem 23–24
Cobb-Douglas function 60, 164
cobweb 24–25, 79, 87
collective bargaining 25–26, 32, 129,
166, 209
collective good 170
commodity fetishism 56
commodity terms of trade 204
common currency 43
common external tariff 44
common resource 211
comparative advantage theory of
trade 208
comparative cost theory 208
comparative economic systems 26
comparative statics 63, 149
competition and monopoly 27–29
competition law 29
competition of capitals 118,166
compliance cost 180
concentration 56–57, 114–15, 124
concrete labour 130
Condorcet system 170, 191, 193
conspicuous consumption 31
constant capital 136
consumer behaviour 149, 176
consumer cooperative 34
consumer equilibrium 9, 30, 133,
153
consumer protection 169
consumer sovereignty 31, 131
consumer theory 31–33
consumer’s surplus 29–30
consumption 30–31
consumption function 30, 126
contract curve 31, 34
contract theory 31–33
convergence hypothesis 26
cooperation 34
core 34–35
Corn Laws 222
corruption 35–36
Corruption Perception Index 36
cost 36–38
cost accounting 38
cost-benefit analysis 39
cost curve 37, 68–69, 181
cost-effectiveness analysis 38
cost of living 38
cost of production theory 9, 38, 218
credit 39–40, 127, 168
credit crunch 40
credit multiplier 146
credit rationing 40, 127
credit union 40
cross price elasticity 71
cultural economics 40–42
cumulative process 197
currency 42–44, 84, 143, 156
customs union 44–45
cycles 45–47
debt 47–48
debt trap 47, 51
decision theory 183–84
de-industrialisation 25
demand curve 48, 185
demand-deficient unemployment 215
demand for money 143–44
demand management 131, 196
demographic transition 58
demography see economic
demography
dependency ratio 58
246
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deprivation index 158
deregulation 14, 200
developing country 49
development economics 48–51
differential rent theory 20, 180
diminishing returns 54, 60, 181
direct taxation 201–2
discrimination 51–52
diseconomy of scale 68, 90, 94
disequilibrium 58, 79, 126, 128, 178,
196, 213–14
disequilibrium economics 52–54
disguised unemployment 213
disintermediation 14
disutility 218
division of labour 54, 100, 136, 165,
181, 193–94, 208
dominant firms ratio 56
double coincidence of wants 142,
144
double factorial terms of trade 204
dual economy 55
duopoly 27–28, 99
economic anthropology 55–56
economic concentration 56–57
economic cost 36
economic demography 57–59
economic development 59
economic freedom 97
economic growth 59–61
economic integration 61–62
economic man see homo economicus
economic methodology 62–64
economic modelling 64–65
economic problem 187
economic rent 181
economics as rhetoric 65–66
economics of transition 26
economic system 66–67, 105, 118, 175
economic underdevelopment 49
economic union 42, 44
economic welfare 67, 102, 191, 221
economies of scale and scope 68
effective demand 103, 126, 200
efficiency 68–70
egalitarianism 76, 129, 158
elasticity 70–71
elasticity of substitution 71, 164
employers’ organisation 25, 209
SUBJECT INDEX
employment multiplier 146
employment rate 214
endogenous growth theory 60
energy economics 71–72
entrepreneur 72–73
environmental economics 73–75
equality 75–78
equilibrium 78–80
equilibrium model 65
equity 76
ethics and economics 80–82
Euler equation 31
Euro 43
evolutionary economics 82–84
ex ante ex post 84
exchange economy 34–35, 67, 106,
218
exchange rate 84–85
exhaustible resources 85–86
expectations 86–88
expected utility 183, 217
experimental economics 88–89
exploitation 17, 82, 85, 136, 154,
164, 200
extensibility of demand 71
external economy 68, 90, 195
externality 89–91
factor cost 148
factor distribution of incomes 112
factor income 148, 212
factor input 181
factor mobility 20, 43
factor of production 16, 18, 36–37,
71–72, 90, 128
factor price 9, 38, 159
factorial terms of trade 204
Factory Acts 21
fair taxation 202
family, economics of 92–93
featherbedding 210
felicific calculus 216
feminist economics 107
fiat money 142
fine tuning 192
firm 93–94
fiscal federalism 95
fiscal policy 95–96
fixed cost 37
fixed exchange rate 84
247
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SUBJECT INDEX
fixed price, flex price 96–97
flexible labour 18, 129
floor 3, 46
forced labour 202
foreign trade multiplier 146
free banking 14
freedom 97
free enterprise 97
free trade 21, 97
frictional unemployment 214–15
fringe benefit 128
full employment 127, 213
functions of money 143
game theory 97–100
GDP 49, 67, 103, 147
gender analysis of occupations 108
general equilibrium 8, 78, 91, 134,
202
general training 110
Giffen good 160
Gini coefficient 57, 76, 113
globalisation 100–101
global public good 172
glut 186
gold bullion standard 43
gold exchange standard 44
gold standard 43–44
goldsmith banking 12
government failure 170–71
Granger causality 132
grant 3–4
gross barter terms of trade 204
gross domestic product see GDP
growth pole 49, 179
growth theory see economic growth
happiness 101–3
hard currency 42–43
health economics 104–5
Heckscher-Ohlin trade theory 208
hidden unemployment 213
holism 105–6
home economics 108
homo economicus 106
horizontal discrimination 51
household behaviour 107–8
human capital 109–10
hyperinflation116
hysteresis 215
illth 220
immigration 140
imperfect competition 28, 209
imperialism, theory of 50
implicit contract 33
import quota 168
impossibility theorem 110–11
incentives 111–12
income distribution 112–13
income effect 160
income elasticity 71
incomes policy 113–14
increasing returns 10, 54, 181–82
indicative planning 155–56
indifference curve 217
indirect taxation 72, 148, 171,
201–2
individual welfare 221
individualism 105, 193
industrial capitalism 16, 200
industrial concentration 56
industrial democracy 189
industrial organisation 114–15
industrial relations 115–16
industrial structure 83, 86, 114,
121
inefficient market 15
inequality 76–78, 113
inflation 116–17, 141, 152, 156,
161
informal economy 117–18
information 118–19
innovation 119–20, 203–4
input-output analysis 120
inside and outside money 142
institutional economics 121
insurance 182–83
interest rate 121–22
internal economy 68, 168
internalising an externality 91
International Monetary Fund 13, 42,
44, 49, 198
intrinsic value 142, 216–17
invention 119–20, 203
investment 122–23
investment appraisal 39
invisible hand 123–24
involuntary unemployment 214
is/ought distinction 81
IS-LM model 125
248
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job search 128, 188
Juglar cycle 46
just price 218
Kaldor-Hicks test 222
key firm 179
key rate 129
Keynesianism 125–27
kinked oligopoly demand curve 28
Kitchin cycle 45–46
Kondratieff cycle 46
Kuznets cycle 46
labor union 209–10
labour 128–30
labour command theory 218
labour costs 128, 145
labour demand 128
labour disutility theory 218
labour force 128
labour force participation 128
labour market 25, 31, 41, 51, 77–78,
128–30, 139, 188–89, 214
labour market flexibility 96, 129, 210
labour productivity 165, 200
labour quantity theory 218
labour standard 130
labour supply 107, 128, 138
labour theory of value 133, 218
labour’s share 128
Laffer curve 200
laissez-faire 130
land 9, 16, 36, 73–75, 91, 109, 155,
167–68, 180–81, 187, 193, 195,
211
land and labour theory of value 218
Laspeyres index 161
law of diminishing marginal utility
184–85, 222
law of markets 186
law of reciprocal demand 208
laws of distribution 62
laws of production 62
Leontief paradox 208
libertarian economics 131–32
liquidity 12–14, 21, 42, 122, 125, 141
liquidity preference 46, 126, 174, 206
loanable funds theory 122
location theory 195
Lorenz curve 57, 76, 113
SUBJECT INDEX
lottery 183
Lucas supply function 152
lump sum tax 201
macroeconomic forecasting 132–33
majority rule 169–70
majority voting 111, 170
managerial capitalism 26
marginal cost 50, 134, 159
marginal cost pricing 134, 160
marginal efficiency of capital 70, 126
marginal private product 182, 221
marginal productivity 19, 149
marginal rate of substitution 217, 222
marginal rate of tax 201
marginal rate of transformation 222
marginal revenue 60, 133, 159
Marginal Revolution 11, 133, 149
marginal social product 221
marginal utility 9, 133–34, 149, 186,
216, 218
marginalism 133–34
market 134–35
market clearing 128, 135
market failure 124, 130, 135
market forces 38, 135
market price 20, 38, 82, 148, 173,
217
market rigidities 129, 152
market structure 27, 29, 93
Markov analysis 140
Marshallian economics 63
Marxian economics 135–37
maxi-min 175
median voter 169, 171, 191
medium of exchange 42, 116,
143–44
mercantilism 137–38
merchant capitalism 16, 200
mergers 7, 29, 61, 86, 115, 145
merit good 138–39
micro-credit 40
migration and mobility 139–40
minimal state 132, 171
minimum supply price 111
minimum wage 96, 129
mixed bundling 33
mixed economy 26, 66
mobility see migration and mobility
monetarism 140–41
249
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SUBJECT INDEX
monetary base 12, 141, 146
monetary equilibrium 197
monetary policy 141–42
monetary system 50, 144
monetised economy 67, 187
money 142–44
money multiplier 12, 146
money supply 44, 116–17, 141,
143–44, 174, 196
monitoring cost 190
monopolistic competition 28
monopoly see competition and
monopoly
monopoly capitalism 136
monopoly profits 50, 203
moral hazard 33, 111, 182
motility 140
multinational corporation 145–46
multiplier 146–47
NAIRU 116
Nash equilibrium 80, 99, 152
national dividend 221
national economy 147
national income 147–48
nationalised industry 163
natural increase 58
natural price 20, 159, 180, 218
natural rate of growth 60
natural rate of unemployment 215
natural value 218
Navigation Acts 21
neo/new Keynesianism 127
neo-classical dichotomy 150
neoclassical economics 148–50
neo-Marxism 137, 157
neo-mercantilism 138
neo-Ricardian economics 150–51
net barter terms of trade 204
net investment 3
net migration 58
network efficiency 69
neuroeconomics 151–52
new classical economics 152–53
new institutional economics 121
new political economy 153
New Welfare Economics 222
non-accelerating inflation rate of
inflation see NAIRU
non-profit enterprise 154
normal good 71, 161
normative economics 81
oligopoly 9, 27–28, 115, 119, 195
open market operations 141
open systems theory 53
opportunity cost 9, 24, 36–37, 97,
138
optimal currency area 43
optimal rate of saving 186
optimum firm 37
optimum population 58
ordinal utility 217, 223
organic development strategy 49
overhead capital 190
ownership 26, 163, 167
Paasche index 161
paradigm 63–64
paradox of thrift 185
Pareto optimality 69, 222
partial equilibrium 48, 62, 78, 88,
202
patent protection 29
pension 128, 211
perfect competition 17, 24, 27–28,
34, 98, 118, 221
period analysis 63, 65, 84, 197, 206
permanent consumption 31
permanent income 31
personal distribution of income 112
Petty’s Law 185
Phillips curve 116, 152
Physiocracy 154–55
planning 155–56
political business cycle 156–57
political economy 157–58
pollution 24, 67, 73–75, 89–91, 168
Ponzi scheme 15
Poor Laws 21
popular capitalism 16
population see economic demography
population principle 51, 188
positive discrimination 51–52
positive economics 81
post-Keynesianism 125, 127
poverty 158–59
poverty trap 158
precautionary demand for money 143
price 159–61
250
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price discrimination 52, 160
price elasticity of demand 71
price index 161–62
price mechanism 26, 187
price signal 52
price-specie flow mechanism 162
prices policy 113
price stability 196
primary employment 146
primary migration 139
prime cost 37
principal-agent 33, 35, 111
private cost 90, 182
private good 22, 170, 172
privatisation 162–64
privatisation of money 142–43
producer cooperative 26, 34
producer’s surplus 30
product cycle theory of trade 209
product differentiation 28
production function 164–65
production possibility line 36
productive efficiency 69
productivity 165
profit 166
profit-maximising firm 93, 159
progressive taxation 201
property rights 166–68
protection 168–69
proxy price 39
psychic cost 140
public choice 169–71
public enterprise 69, 173
public finance 171–72
public good 172
public sector 173
public works 20–21, 126, 138, 197,
214
purchasing power 216
purchasing power parity 85
push-pull factors 140
quantity theory of money 173–74
quasi-fixed cost 37
quota 168
Ramsey saving rule 186
rational expectations 87–88, 127,
152, 176–77
rationality 174–76
SUBJECT INDEX
Rawlsian justice 176–77
Reaganomics 199
real balance effect 126
real bills doctrine 143
real business cycle 177–78
real time 206
reciprocal demand 208
recontracting 34
regional policy 178–79
regulation 179–80
regulatory capture 180
relative concentration 56
relative income 31
relative poverty 158
relative surplus value 200
rent 180–81
replacement population 139
reserve currency 42
residuum 158
re-switching 19
retail banking 13
retail price index 116, 161–62
returns 181–82
revealed preference 176, 217
Ricardian equivalence 152–53
risk and uncertainty 182–84
Robinson Crusoe economy 184
roundabout method of production 9,
16
sacrifice 36
Samaritan’s Dilemma 6
satiability of wants 184–85
saving 185–86
Say’s Law 186–87
scarcity 186–87
scientific socialism 192
search cost 188
search theory 188
secondary employment 146
secondary migration 139
segmented labour market 189
seignorage 44
self interest 5–6, 17, 21, 81, 106, 123,
148, 170, 175–76, 184
self-managed enterprise 189–90
selling cost 28
shadow economy 35, 147
shadow price 39
single currency 43
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SUBJECT INDEX
single factorial terms of trade 204
social capital 190
social choice theory 190–92
social contract 131
social cost 5, 23–24, 37–38, 73, 90,
167–68, 182
social optimum 70
social welfare function 110, 149, 153,
176, 191, 222
socialism 192–94
socialist calculation 10, 194
socially necessary labour time 136
soft currency 42–43
sovereign debt 47, 153
Soviet type economy 26, 147, 186,
194, 199
spatial economics 194–96
spatial monopoly 195
spatial oligopoly 196
special drawing right 42
specific training 110
speculation 14–15
speculative demand for money 96,
143–44
spontaneous economy 131
spontaneous order 4, 10, 17, 67, 105,
119, 121, 124, 131
stabilisation policy 196
stages theory 49, 55, 59, 83, 135
stagflation 117
standard commodity 151
state capitalism 16–17, 194, 213
static model 205
sticky price 127, 207
stochastic model 65, 133
Stockholm School 197
strategic trade theory 209
strikes 115–16
structural adjustment 197–98
structural disequilibrium 53
structural forecasting 133
structural unemployment 198, 214–15
structure of an economy 198–99
structure-conduct-performance 114
subjective utility 215–16
substitution effect 160–61
sunspot equilibrium 80
supplementary cost 37
supply elasticity 71, 205
supply side economics 199
surplus value 200
sustainable development 50
tableau e´conomique 120, 132, 154
take-off 59
tariff 44, 168–69, 204, 208–9
tatonnement 8
taxation 201–3
tax competition 203
Tax Freedom Day 202
tax haven 203
tax incidence 202
technical efficiency 69
technical progress 203–4
term structure of interest rates 122
terms of trade 204
thrift 185
Tiebout hypothesis 195
time in economics 205–7
time series 48, 132–33, 141, 206
total utility 216
trade creation 44–45
trade cycle see cycles
trade diversion 45
trade theory 207–9
trade union 209–10
tragedy of the commons 211–12
training 110
transaction cost 8, 24–25, 43, 190,
194
transactions demand for money 143
transfer income 211–12
transfer pricing 212
transformation problem 136
transitory consumption 31
transitory income 31
transmission mechanism 141
Treasury view 214
tropism 56
trust 34, 39, 119, 129, 142, 144, 179,
190
uncertainty see risk and uncertainty
underdevelopment 49–50
underground economy 147
unemployment 212–15
union density 210
union wage effect 210
unionisation 210
unit banking 13
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unofficial economy 117
usury 12, 96, 122
util 217
utilitarianism 101–2
utility 215–17
utopia 15, 34, 193–94
value 217–19
variable capital 136, 200
variable cost 37
velocity of circulation 173
vertical discrimination 51
volatility test 15
volitional theory of value 219
wage differentials 20, 77, 109, 113,
129, 158, 189, 195
SUBJECT INDEX
wage fund 18, 200
wages 20, 23, 27, 51–52, 70, 78,
111–13, 116, 128–29, 150,
189–90, 193, 200, 209–10
warranted rate of growth 60
water and diamonds paradox 18
wave theory of migration 139
wealth 220–21
welfare economics 221–23
welfare state 129, 172, 198
well-being 81, 102–3, 220–21
wholesale banking 13
workers’ participation in
management 189
World Bank 4, 13
X-efficiency 70
253