Game theory
Game theory is a technique for analysing how
people, firms and governments should behave in strategic situations (in which
they must interact with each other), and in deciding what to do must take into
account what others are likely to do and how others might respond to what they
do. For instance, competition between two firms can be analysed as a game in
which firms play to achieve a long-term competitive advantage (perhaps even a
monopoly). The theory helps each firm to develop its optimal strategy for, say,
pricing its products and deciding how much to produce; it can help the firm to
anticipate in advance what its competitor will do and shows how best to respond
if the competitor does something unexpected. It is particularly useful for
understanding behaviour in monopolistic competition.
In
game theory, which can be used to describe anything from wage negotiations to
arms races, a dominant strategy is one that will deliver the best results for
the player, regardless of what anybody else does. One finding of game theory is
that there may be a large first-mover advantage for companies that beat their
rivals into a new market or come up with an innovation. One special case
identified by the theory is the zero-sum game, where players see that the total
winnings are fixed; for some to do well, others must lose. Far better is the
positive-sum game, in which competitive interaction has the potential to make
all the players richer. Another problem analysed by game theorists is the
prisoners' dilemma.
GDP
Gross
domestic product, a measure of economic activity in a country. It is calculated
by adding the total value of a country's annual output of goods and services.
GDP = private consumption + investment + public spending + the change in
inventories + (exports - imports). It is usually valued at market prices; by
subtracting indirect tax and adding any government subsidy, however, GDP can be
calculated at factor cost. This measure more accurately reveals the income paid
to factors of production. Adding income earned by domestic residents from their
investments abroad, and subtracting income paid from the country to investors
abroad, gives the country's gross national product (GNP).
The
effect of inflation can be eliminated by measuring GDP growth in constant real
prices. However, some economists argue that hitting a nominal gdp target should
be the main goal of macroeconomic policy. This is because it would remind
policymakers to take into account the effect of their decisions on inflation,
as well as on growth. GDP can be calculated in three ways. The income method
adds the income of residents (individuals and firms) derived from the
production of goods and services. The output method adds the value of output
from the different sectors of the economy. The expenditure method totals
spending on goods and services produced by residents, before allowing for
depreciation and capital consumption. As one person's output is another
person's income, which in turn becomes expenditure, these three measures ought
to be identical. They rarely are because of statistical imperfections.
Furthermore, the output and income measures exclude unreported economic
activity that takes place in the black economy but that may be captured by the
expenditure measure.
GDP
is disliked as an objective of economic policy by some because it is not a
perfect measure of welfare. It does not include aspects of the good life such
as some leisure activities. Nor does it include economically valuable
activities that are not paid for, such as parents teaching their children to
read. But it does include some things that lower the quality of life, such as
activities that damage the environment.
Gearing
A
company's debt expressed as a percentage of its equity; also known as leverage.
(See also capital structure and leveraged buy-out.)
General Agreement on Tariffs and
Trade
Or
GATT, the vehicle for promoting international free trade, through a series of
rounds of negotiations between the governments of trading countries. The first
GATT round began in 1945. The last led to the establishment of the world trade
organisation in 1995.
General equilibrium
Economic
perfection. This is when demand and supply are in balance (the market is in
equilibrium) for each and every good and service in the economy. Nobody thinks
that real-world economies can ever be that perfect; at best there is
"partial equilibrium". But most economists think that general
equilibrium is something worth aspiring to.
Generational accounting
A
relatively new way of analysing fiscal policy by identifying the financial
costs and benefits of government policies to people of different ages, now
living or yet to be born. Fiscal policy can distribute resources between
different generations, sometimes deliberately and often inadvertently. At any
moment in time, one generation may be in work and paying taxes that support
other generations (those at school or retired) that are not working. Over its
lifetime, one generation's mix of taxes paid and benefits received may differ
sharply from that of another generation. Politicians are often tempted to
ignore the needs of future generations (who, clearly, cannot vote at the time)
in order to win the support of current generations, for instance by borrowing
heavily to fund current spending. More fundamentally, because it incorporates
all the tax and spending, current and future, to which a government is
committed, generational accounting is a much better guide to whether fiscal
policy is sustainable than measures such as the budget deficit, which looks
only at taxes and spending in the current year.
Giffen goods
Named
after Robert Giffen (1837-1910), a good for which demand increases as its price
rises. But such goods may not exist in the real world.
Gilts
Shorthand
for gilt-edged securities, meaning a safe bet, at least as far as receiving
interest and avoiding default goes. The price of gilts can vary considerably
over time, however, creating a degree of risk for investors. Usually the term
is applied only to government bonds.
Gini coefficient
An
inequality indicator. The Gini coefficient measures the inequality of income
distribution within a country. It varies from zero, which indicates perfect
equality, with every household earning exactly the same, to one, which implies
absolute inequality, with a single household earning a country's entire income.
Latin America is the world's most unequal region, with a Gini coefficient of
around 0.5; in rich countries the figure is closer to 0.3.
Global public goods
Public
goods that cannot be provided by one country acting alone but only by the joint
efforts of many (strictly, all) countries. Some economists, along with global
institutions such as the UN, reckon that such goods include international law
and law enforcement, a stable global financial system, an open trading system,
health, peace and enviromental sustainability.
Globalisation
A
buzz word that refers to the trend for people, firms and governments around the
world to become increasingly dependent on and integrated with each other. This
can be a source of tremendous opportunity, as new markets, workers, business
partners, goods and services and jobs become available, but also of competitive
threat, which may undermine economic activities that were viable before
globalisation.
The
term first surfaced during the 1980s to characterise huge changes that were
taking place in the international economy, notably the growth in international
trade and in flows of capital around the world. Globalisation has also been used
to describe growing income inequality between the world's rich and poor; the
growing power of multinational companies relative to national government; and
the spread of capitalism into former communist countries. Usually, the term is
synonymous with international integration, the spread of free markets and
policies of liberalisation and free trade. The process is not the result simply
of economic forces. The decisions of policymakers have also played an important
part, although not all governments have embraced the change warmly.
The
driving force of globalisation has been multinational companies, which since
the 1970s have constantly, and often successfully, lobbied governments to make
it easier for them to put their skills and capital to work in previously
protected national markets. Firms enjoying some national protection, and their
(often unionised) workers, have been some of the main opponents of
globalisation, along with advocates of fair trade.
Despite
all the talk of globalisation during the 1990s, in some respects the world
economy was more integrated in the late 19th century. The labour market was
certainly more global. For example, the flow of people out of Europe, 300,000
people a year in the mid-19th century, reached 1m a year after 1900. Now governments
are much fussier about immigration, and people are no longer free to migrate as
they wish. As for capital markets, only in the 1990s did international capital
flows, relative to the size of the world economy, recover to the levels of the
few decades before the first world war.
This
early globalised economy did not last for long, however. Between the two world
wars, the flows of trade, capital and people collapsed to a trickle. Even
before the first world war, governments started to put up the shutters against
migrants and imports. Could such a backlash against globalisation happen again?
GNI
Short
for gross national income, a term now used instead of gnp in national accounts.
GNP
Short
for gross national product, another measure of a country's economic
performance. It is calculated by adding to gdp the income earned by residents
from investments abroad, less the corresponding income sent home by foreigners
who are living in the country.
Gold standard
A
monetary system in which a country backs its currency with a reserve of gold,
and allows currency holders to exchange their notes and coins for gold. For
many years up to 1914, most of the world's leading currencies had their
exchange rate determined by the gold standard. The economic disruption
resulting from the first world war led the combatants to abandon the link to
gold. The UK (with others) returned to the gold standard in 1925, before quitting
it for good in 1931. The widespread use of the gold standard ended during
1930-33 as a result of global depression and large cuts in international
lending. The United States left the gold standard in 1933 and partially
returned to it in 1934. After the second world war, a limited form of gold
standard continued but only directly applied to the dollar; other major
currencies had their exchange rates fixed to the dollar under the bretton woods
arrangements. The dollar was finally cut loose from the gold standard in 1971.
Golden rule
Over
the economic cycle, a government should borrow only to invest and not to
finance current spending. This rule is certainly a prudent approach to fiscal
policy, provided that governments are honest in describing spending as investment,
that they invest in appropriate things and do so efficiently, and that they are
careful to avoid crowding out superior private investment. But there are other
fiscal policy options that may make as much sense. See, for example, balanced
budget.
Government
There
are few more hotly debated topics in economics than what role the state should
play in the economy. Plenty of economists provided intellectual support for
state intervention during the era of big government, particularly from the
1930s to the 1980s. keynesians argued that the state should manage the amount
of demand in the economy to maintain full employment. Others advocated a
command economy, in which the government would decide price levels, oversee the
allocation of scarce resources and run the most important parts of the economy
(the "commanding heights") or, in communist countries, the entire
economy. The role of the state increased at the expense of market forces.
Economists provided plenty of examples of market failure that seemed to justify
this.
Since
the 1950s, there has been growing evidence that government intervention can
also be flawed, and can often impose even greater costs on an economy than
market failure. One reason is that when a government acts, it usually does so
as a monopoly, with all the attendant economic inefficiencies this implies.
In
practice, policies of Keynesian demand management often resulted in inflation,
and thus lost much of their credibility. There was growing concern that public
investment was crowding out superior private investment, and that other public
spending on things such as health care, education and pensions was similarly
discouraging private provision. Government management of commercial enterprises
was often seen to be inefficient and, starting in the 1980s, nationalisation
gave way to privatisation. Even when the state was not directly responsible for
economic activity, but instead set the rules governing private behaviour, there
was evidence of regulatory failure. High rates of taxation started to
discourage people and companies from undertaking economic activities that
would, without the tax, have been profitable; wealth creation suffered.
Most
economists agree that there is a need for some government role in the economy.
A market economy can function only if there is an adequate legal system, and,
in particular, clearly defined, enforceable property rights. The legal system
is probably an example of what economists call a public good (although the
existence in many countries and industries of some self-regulation shows it is
not always so).
Although
politicians in many countries spent most of the period since 1980 talking about
the need to reduce the role of the state in the economy, and in many cases
introduced policies of privatisation, deregulation and liberalisation to help
this happen, public spending has continued to increase as a share of gdp.
Within the oecd, public spending accounted for a larger slice of GDP in 2002
than in 1990, which was in turn higher than in 1980. Indeed, it has risen
during every decade since the start of the 20th century. One reason was that
governments had to honour spending commitments on pensions and health care made
by previous generations of politicians.
Government expenditure
Spending
by national and local government and some government-backed institutions. See
fiscal policy, golden rule and budget.
Greenspan, Alan
The
most famous of all central bank bosses, so far. A former jazz musician turned
economist, he became chairman of the board of governors of America's Federal
Reserve in 1987, shortly before Wall Street crashed. In 2003, he was
reappointed until 2005. He won admirers for delivering monetary policy that
helped to bring down inflation and create the conditions for strong economic
growth. Some people considered him the nearest thing capitalism had to God. In
1996, he famously wondered aloud whether rising share prices were the result of
"irrational exuberance". Economists debate whether history will judge
him a failure because he did not prevent the growth of a huge bubble in
America's economy.
Gresham's law
Bad
money drives out good. One of the oldest laws in economics, named after Sir
Thomas Gresham, an adviser to Queen Elizabeth I of England. He observed that
when a currency has been debased and a new one is introduced to replace it, the
new one will be hoarded and effectively taken out of circulation, while the old
one will continue to be used for transactions, to be got rid of as fast as
possible.
Growth
What
economic activity is all about, but how can it be made to happen? Economists
have plenty of theories, but none of them has all the answers.
Adam
smith attributed growth to the invisible hand, a view shared by most followers
of classical economics. neo-classical economics had a different theory of
growth, devised by Robert Solow during the 1950s. This argued that a sustained
increase in investment increases an economy's growth rate only temporarily: the
ratio of capital to labour goes up, the marginal product of capital declines
and the economy moves back to a long-term growth path. output will then
increase at the same rate as the growth in the workforce (quality-adjusted, in
later versions) plus a factor to reflect improvements in productivity.
This
theory predicts specific relationships among some basic economic statistics.
Yet some of these predictions fail to fit the facts. For example, income
disparities between countries are greater than the differences in their savings
rates would suggest. Moreover, although the model says that economic growth
ultimately depends on the rate of technological change, it fails to explain
exactly what determines this rate. Technological change is treated as
exogenous.
Some
economists argued that doing this ignored the main engine of growth. They
developed a new growth theory, in which improvements in productivity were
endogenous, meaning that they were the result of things taking place within the
economic model being used and not merely assumed to happen, as in the neo-classical
models. Endogenous growth was due, in particular, to technological innovation
and investments in human capital. In looking for explanations for differences
in rates of growth, including between rich and developing countries, the new
growth theory concentrates on what the incentives are in an economy to create
additional human capital and to invent new products.
Factors
determining these incentives include government policies. Countries with
broadly free-market policies, in particular free trade and the maintenance of
secure property rights, typically have higher growth rates. Open economies have
grown much faster on average than closed economies. Higher public spending
relative to gdp is generally associated with slower growth. Also bad for growth
are high inflation and political instability.
As
countries grew richer during the 20th century annual growth rates declined, as
a result of diminishing returns to capital. By 1990, most developed countries
reckoned to have long-term trend growth rates of 2-2.5% a year. However, during
the 1990s, growth rates started to rise, especially in the United States. Some
economists said this was the result of the birth of a new economy based on a
revolution in productivity, largely because of rapid technological innovation
but also (perhaps directly stemming from the spread of new technology) to
increases in the value of human capital.
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