Absolute advantage
This is the simplest yardstick of economic performance. If
one person, firm or country can produce more of something with the same amount
of effort and resources, they have an absolute advantage over other producers.
Being the best at something does not mean that doing that thing is the best way
to use your scarce economic resources. The question of what to specialise
in--and how to maximise the benefits from international trade--is best decided
according to comparative advantage. Both absolute and comparative advantage may
change significantly over time.
Adaptive expectations
A theory of how people form their views about the future
that assumes they do so using past trends and the errors in their own earlier
predictions. Contrast with rational expectations.
Adverse selection
When you do business with people you would be better off
avoiding. This is one of two main sorts of market failure often associated with
insurance. The other is moral hazard. Adverse selection can be a problem when
there is asymmetric information between the seller of insurance and the buyer;
in particular, insurance will often not be profitable when buyers have better
information about their risk of claiming than does the seller. Ideally,
insurance premiums should be set according to the risk of a randomly selected
person in the insured slice of the population (55-year-old male smokers, say).
In practice, this means the average risk of that group. When there is adverse
selection, people who know they have a higher risk of claiming than the average
of the group will buy the insurance, whereas those who have a below-average
risk may decide it is too expensive to be worth buying. In this case, premiums
set according to the average risk will not be sufficient to cover the claims
that eventually arise, because among the people who have bought the policy more
will have above-average risk than below-average risk. Putting up the premium
will not solve this problem, for as the premium rises the insurance policy will
become unattractive to more of the people who know they have a lower risk of
claiming. One way to reduce adverse selection is to make the purchase of
insurance compulsory, so that those for whom insurance priced for average risk
is unattractive are not able to opt out.
Advertising
Many firms advertise their goods or services, but are they
wasting economic resources? Some economists reckon that advertising merely
manipulates consumer tastes and creates desires that would not otherwise exist.
By increasing product differentiation and encouraging brand loyalty advertising
may make consumers less price sensitive, moving the market further from perfect
competition towards imperfect competition (see monopolistic competition) and
increasing the ability of firms to charge more than marginal cost. Heavy
spending on advertising may also create a barrier to entry, as a firm entering
the market would have to spend a lot on advertising too.
However, some economists argue that advertising is
economically valuable because it increases the flow of information in the
economy and reduces the asymmetric information between the seller and the
consumer. This intensifies competition, as consumers can be made aware quickly
when there is a better deal on offer.
Agency costs
These can arise when somebody (the principal) hires somebody
else (the agent) to carry out a task and the interests of the agent conflict
with the interests of the principal. An example of such principal-agent
problems comes from the relationship between the shareholders who own a public
company and the managers who run it. The owners would like managers to run the firm
in ways that maximise the value of their shares, whereas the managers' priority
may be, say, to build a business empire through rapid expansion and mergers and
acquisitions, which may not increase their firm's share price.
One way to reduce agency costs is for the principal to
monitor what the agent does to make sure it is what he has been hired to do.
But this can be costly, too. It may be impossible to define the agent's job in
a way that can be monitored effectively. For instance, it is hard to know whether
a manager who has expanded a firm through an acquisition that reduced its share
price was pursuing his own empire-building interests or, say, was trying to
maximise shareholder value but was unlucky.
Another way to lower agency costs, especially when
monitoring is too expensive or too difficult, is to make the interests of the
agent more like those of the principal. For instance, an increasingly common
solution to the agency costs arising from the separation of ownership and
management of public companies is to pay managers partly with shares and share
options in the company. This gives the managers a powerful incentive to act in
the interests of the owners by maximising shareholder value. But even this is
not a perfect solution. Some managers with lots of share options have engaged
in accounting fraud in order to increase the value of those options long enough
for them to cash some of them in, but to the detriment of their firm and its
other shareholders. See, for example, Enron.
Agricultural policy
Countries often provide support for their farmers using
trade barriers and subsidy because, for example:
·
domestic agriculture, even if it is inefficient
by world standards, can be an insurance policy in case it becomes difficult (as
it does, for example, in wartime) to buy agricultural produce from abroad;
·
farmers groups have proved adept at lobbying;
·
politicians have sought to slow the depopulation
of rural areas;
·
agricultural prices can be volatile, as a result
of unpredictable weather, among other things; and
·
financial support can provide a safety net in
unexpectedly severe market conditions.
Broadly speaking, governments have tried two methods of
subsidising agriculture. The first, used in the United States during the 1930s
and in the UK before it joined the European Union, is to top up farmers'
incomes if they fall below a level deemed acceptable. Farmers may be required
to set aside some of their land in return for this support. The second is to
guarantee a minimum level of farm prices by buying up surplus supply and
storing or destroying it if prices would otherwise fall below the guaranteed
levels. This was the approach adopted by the EU when it set up its Common
Agricultural Policy. To keep down the direct cost of this subsidy the EU used
trade barriers, including import levies, to minimise competition to EU farmers
from produce available more cheaply on world agriculture markets. Recent
American farm-support policy has combined income top-ups and some guaranteed
prices.
As most governments have become more committed to
international trade, such agricultural policies have come under increasing
attack, although the free trade rhetoric has often run far ahead of genuine
reform. In 2003, rich countries together spent over $300 billion a year
supporting their farmers, more than six times what they spent on foreign AID.
Finding a way to end agricultural support had become by far the biggest
remaining challenge for those trying to negotiate global free trade.
Agriculture
Farming around the world continues to become more productive
while generally accounting for a smaller share of employment and national
income, although in some poor countries it remains the sector on which the
country and its people depend. Farming, forestry and fishing in 1913 accounted for
28% of employment in the United States, 41% in France and 60% in Japan, but
only 12% in the UK. Now the proportion of the workforce employed in such
activities has dropped below 6% in these and most other industrialised
countries.
The total value of international trade in agriculture has
risen steadily. But the global agriculture market remains severely distorted by
trade barriers and government subsidy, such as the european union's Common
agricultural policy.
Altruism
It is often alleged that altruism is inconsistent with
economic rationality, which assumes that people behave selfishly. Certainly,
much economic analysis is concerned with how individuals behave, and homo
economicus (economic man) is usually assumed to act in his or her
self-interest. However, self-interest does not necessarily mean selfish. Some
economic models in the field of behavioural economics assume that
self-interested individuals behave altruistically because they get some
benefit, or utility, from doing so. For instance, it may make them feel better
about themselves, or be a useful insurance policy against social unrest, say.
Some economic models go further and relax the traditional assumption of fully
rational behaviour by simply assuming that people sometimes behave
altruistically, even if this may be against their self-interest. Either way,
there is much economic literature about charity, international aid, public
spending and redistributive taxation.
Amortisation
The running down or payment of a loan by instalments. An
example is a repayment mortgage on a house, which is amortised by making
monthly payments that over a pre-agreed period of time cover the value of the
loan plus interest. With loans that are not amortised, the borrower pays only
interest during the period of the loan and then repays the sum borrowed in
full.
Animal spirits
The colourful name that keynes gave to one of the essential
ingredients of economic prosperity: confidence. According to Keynes, animal
spirits are a particular sort of confidence, "naive optimism". He
meant this in the sense that, for entrepreneurs in particular, "the
thought of ultimate loss which often overtakes pioneers, as experience
undoubtedly tells us and them, is put aside as a healthy man puts aside the
expectation of death". Where these animal spirits come from is something
of a mystery. Certainly, attempts by politicians and others to talk up
confidence by making optimistic noises about economic prospects have rarely
done much good.
Antitrust
government policy for dealing with monopoly. Antitrust laws
aim to stop abuses of market power by big companies and, sometimes, to prevent
corporate mergers and acquisitions that would create or strengthen a
monopolist. There have been big differences in antitrust policies both among
countries and within the same country over time. This has reflected different
ideas about what constitutes a monopoly and, where there is one, what sorts of
behaviour are abusive.
In the United States, monopoly policy has been built on the
Sherman Antitrust Act of 1890. This prohibited contracts or conspiracies to
restrain trade or, in the words of a later act, to monopolise commerce. In the
early 20th century this law was used to reduce the economic power wielded by
so-called "robber barons", such as JP Morgan and John D. Rockefeller,
who dominated much of American industry through huge trusts that controlled
companies' voting shares. Du Pont chemicals, the railroad companies and
Rockefeller's Standard Oil, among others, were broken up. In the 1970s the
Sherman Act was turned (ultimately without success) against IBM, and in 1982 it
secured the break-up of AT&T's nationwide telecoms monopoly.
In the 1980s a more laissez-faire approach was adopted,
underpinned by economic theories from the chicago school. These theories said
that the only justification for antitrust intervention should be that a lack of
competition harmed consumers, and not that a firm had become, in some
ill-defined sense, too big. Some monopolistic activities previously targeted by
antitrust authorities, such as predatory pricing and exclusive marketing
agreements, were much less harmful to consumers than had been thought in the
past. They also criticised the traditional method of identifying a monopoly,
which was based on looking at what percentage of a market was served by the
biggest firm or firms, using a measure known as the herfindahl-hirschman index.
Instead, they argued that even a market dominated by one firm need not be a
matter of antitrust concern, provided it was a contestable market.
In the 1990s American antitrust policy became somewhat more
interventionist. A high-profile lawsuit was launched against Microsoft in 1998.
The giant software company was found guilty of anti-competitive behaviour,
which was said to slow the pace of innovation. However, fears that the firm
would be broken up, signalling a far more interventionalist American antitrust
policy, proved misplaced. The firm was not severely punished.
In the UK, antitrust policy was long judged according to
what policymakers decided was in the public interest. At times this approach
was comparatively permissive of mergers and acquisitions; at others it was less
so. However, in the mid-1980s the UK followed the American lead in basing
antitrust policy on whether changes in competition harmed consumers. Within the
rest of the european union several big countries pursued policies of building
up national champions, allowing chosen firms to enjoy some monopoly power at
home which could be used to make them more effective competitors abroad.
However, during the 1990s the European Commission became increasingly active in
antitrust policy, mostly seeking to promote competition within the EU.
In 2000, the EU controversially blocked a merger between two
American firms, GE and Honeywell; the deal had already been approved by
America's antitrust regulators. The controversy highlighted an important issue.
As globalisation increases, the relevant market for judging whether market
power exists or is being abused will increasingly cover far more territory than
any one single economy. Indeed, there may be a need to establish a global
antitrust watchdog, perhaps under the auspices of the world trade organisation.
Appreciation
A rise in the value of an asset and the opposite of
depreciation. When the value of a currency rises relative to another, it
appreciates.
Arbitrage
Buying an asset in one market and simultaneously selling an
identical asset in another market at a higher price. Sometimes these will be
identical assets in different markets, for instance, shares in a company listed
on both the London Stock Exchange and New York Stock Exchange. Often the assets
being arbitraged will be identical in a more complicated way, for example, they
will be different sorts of financial securities that are each exposed to
identical risks.
Some kinds of arbitrage are completely risk-free-this is
pure arbitrage. For instance, if EUROS are available more cheaply in dollars in
London than in New York, arbitrageurs (also known as arbs) can make a risk-free
PROFIT by buying euros in London and selling an identical amount of them in New
York. Opportunities for pure arbitrage have become rare in recent years, partly
because of the GLOBALISATION of FINANCIAL MARKETS. Today, a lot of so called
arbitrage, much of it done by hedge funds, involves assets that have some
similarities but are not identical. This is not pure arbitrage and can be far
from risk free.
Arbitrage pricing
theory
This is one of two influential economic theories of how
assets are priced in the financial markets. The other is the capital asset
pricing model. The arbitrage pricing theory says that the price of a financial
asset reflects a few key risk factors, such as the expected rate of interest,
and how the price of the asset changes relative to the price of a portfolio of
assets. If the price of an asset happens to diverge from what the theory says
it should be, arbitrage by investors should bring it back into line.
Asian crisis
During 1997-98, many of the East Asian tiger economies
suffered a severe finanical and economic crisis. This had big consequences for
the global financial markets, which had become increasingly exposed to the
promise that Asia had seemed to offer. The crisis destroyed wealth on a massive
scale and sent absolute poverty shooting up. In the banking system alone,
corporate loans equivalent to around half of one year's GDP went bad - a
destruction of savings on a scale more usually associated with a full-scale
war. The precise cause of the crisis remains a matter of debate. Fingers have
been pointed at the currency peg adopted by some countries, and a reduction of
capital controls in the years before the crisis. Some blamed economic
contagion. The crisis brought an end to a then widespread belief that there was
a distinct "Asian way" of capitalism that might prove just as
successful as capitalism in America or Europe. Instead, critics turned their
fire on Asian cronyism, ill-disciplined banking and lack of transparency. In
the years following the crisis, most of the countries involved have introduced
reforms designed to increase transparency and improve the health of the banking
system, although some (such as South Korea) went much further than others (such
as Indonesia).
Assets
Things that have earning power or some other value to their
owner.
Asymmetric
information
When somebody knows more than somebody else. Such asymmetric
information can make it difficult for the two people to do business together,
which is why economists, especially those practising game theory, are
interested in it. Transactions involving asymmetric (or private) information
are everywhere. A government selling broadcasting licences does not know what
buyers are prepared to pay for them; a lender does not know how likely a
borrower is to repay; a used-car seller knows more about the quality of the car
being sold than do potential buyers. This kind of asymmetry can distort
people's incentives and result in significant inefficiencies.
Asymmetric shock
When something unexpected happens that affects one economy
(or part of an economy) more than the rest. This can create big problems for
policymakers if they are trying to set a macroeconomic policy that works for
both the area affected by the shock and the unaffected area. For instance, some
economic areas may be oil exporters and thus highly dependent on the price of
oil, but other areas are not. If the oil price plunges, the oil-dependent area
would benefit from policies designed to boost demand that might be unsuited to
the needs of the rest of the economy. This may be a constant problem for those
responsible for setting the interest rate for the euro given the big
differences--and different potential exposures to shocks--among the economies
within the euro zone.
Auctions
Going, going, gone. Holding an auction can be an extremely
efficient way for a seller to set the price of its products, especially if it
does not have much information about how much people may be willing to pay for
them. Auctions fascinate economists, especially those who specialise in game
theory. They have long been a feature of the sale of art and antiques in the
rooms of firms such as Sotheby's and Christie's. But in recent years they have
played a growing role in other parts of the economy, ranging from the
allocation of government-controlled broadcasting bandwidth to the awarding of
work to subcontractors by governments and big firms using competitive
tendering, and even more recently the sale of goods over the Internet.
An English auction is the most familiar. Bidders compete to
offer higher prices and drop out until only one remains. In a Dutch auction,
the auctioneer calls out a high price then keeps lowering it until there is a
buyer. There are various forms of sealed bid auctions. In a first price sealed
bid, each buyer submits a price in a sealed envelope and all bids are opened
simultaneously, with the highest offer winning. In a second (or third, fourth,
and so on) price sealed bid, the highest bidder wins but pays only the second
(third, fourth) highest price bid.
An English or Dutch auction will work well for a seller if
there is more than one serious bidder, as competition will ensure that the
price is set at the level at which it is not worth more to any other bidder but
the winner. Indeed, in a competitive auction the successful bidder may end up
offering more than what is being auctioned is actually worth. This is known as
the winner's curse.
Which method will generate the best price for the seller
depends on how many bidders take part and how well informed they are.
Unfortunately for the seller, this information is not always available before
the auction takes place.
Austrian economics
A brand of neo-classical economics established in Vienna
during the late 19th century and the first half of the 20th century. It was
strongly opposed to Marxism and, more broadly, to the use of economic theories
to justify government intervention in the economy. Prominent members included
Friedrich hayek, Joseph schumpeter and Ludwig von Mises. It gave birth to the
definition of economics as the science of studying human behaviour as a
relationship between ends and scarce means that have alternative uses. Austrian
economic thinking was characterised by attributing all economic activity,
including the behaviour of apparently impersonal institutions, to the wishes
and actions of individuals. It did this by examining choices in terms of their
opportunity cost (that is, what is the next best use of resources to that which
is being considered?) and by analysing the impact of timing on decision making.
Hayek correctly predicted the failure of Soviet-style
central planning. His ideas are said to have inspired many of the free-market
reforms carried out during the 1980s in the United States under Ronald Reagan
and in the UK under Margaret Thatcher. Schumpeter developed a theory of
innovation and economic change characterised by the phrase creative
destruction.
Autarky
The idea that a country should be self-sufficient and not
take part in international trade. The experience of countries that have pursued
this Utopian ideal by substituting domestic production for imports is an
unhappy one. No country has been able to produce the full range of goods
demanded by its population at competitive prices. Indeed, those that have tried
to do so have condemned themselves to inefficiency and comparative poverty,
compared with countries that engage in international trade.
Average
A number that is calculated to summarise a group of numbers.
The most commonly used average is the mean, the sum of the numbers divided by
however many numbers there are in the group. The median is the middle value in
a group of numbers ranked in order of size. The mode is the number that occurs
most often in a group of numbers. Take the following group of numbers: 1, 2, 2,
9, 12, 13, 17
The mean is 56/7=8,
The median is 9,
The mode is 2
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