Pareto
efficiency
A
situation in which nobody can be made better off without making somebody else
worse off. Named after vilfredo Pareto (1843–1923), an Italian economist. If an
economy’s resources are being used inefficiently, it ought to be possible to
make somebody better off without anybody else becoming worse off. In reality,
change often produces losers as well as winners. Pareto efficiency does not
help judge whether this sort of change is economically good or bad.
Paris
Club
The
name given to the arrangements through which countries reschedule their
official debt; that is, money borrowed from other governments rather than banks
or private firms. The club is based on avenue kléber in Paris. Its members are
the 19 founders of the OECD as well as Russia. Other institutions such as the World
Bank attend in an informal role. Rescheduling requires the consensus agreement
of members and must not favour one creditor nation over another. Private debt
rescheduling takes place through the London club.
Patents
In
1899 the commissioner of the American office of patents recommended that his
office be abolished because “everything that can be invented has been
invented”. The fact that there has been so much innovation during the
subsequent 100 years may owe something to the existence of patents. Economists
reckon that if people are going to spend the time and money needed to think up
and develop new products, they need to be fairly confident that if the idea
works they will earn a decent profit. Patents help achieve this by granting the
inventor a temporary monopoly over the idea, to stop it being stolen by
imitators who have not borne any of the development risk and costs. Like any
monopoly, patents create inefficiency because of the lack of competition to
produce and sell the product. So economists debate how long patent protection
should last. There is also debate about which sorts of innovation require the
encouragement of a potential monopoly to make them happen. Furthermore, the
pace of innovation in some industries has sharply reduced the number of years
during which a patent is valuable. Some economists say that this shows that
patents do not play a large part in the process of innovation.
Path
dependence
History
matters. Where you have been in the past determines where you are now and where
you can go in future. Indeed, even small, apparently trivial, differences in
the path you have taken can have huge consequences for where you are and can
go. In economics, path dependence refers to the way in which apparently
insignificant events and choices can have huge consequences for the development
of a market or an economy.
Economists
disagree over how widespread path dependence is, and whether it is a form of
market failure. One focus of this debate is the QWERTY keyboard. Some argue
that the QWERTY design was deliberately made slow to use so as to overcome a
jamming-at-speed problem in early typewriters. Much faster alternative layouts
of keys have failed to prosper, even though the anti-jamming rationale for QWERTY
has been defunct for years. Others say that the QWERTY system is as efficient a
layout of keys as any other and that its success is a triumph of market forces.
Having invested in learning to make and use the QWERTY keyboard, it makes no
economic sense to switch to an alternative that is no better than QWERTY.
Peak
pricing
When
capacity is fixed and demand varies during a time period, it may make sense to
charge above-average prices when demand peaks. Because this will divert some
peak demand to cheaper off-peak periods, it will reduce the total amount of
capacity needed at the peak and reduce the amount of capacity lying idle at
off-peak times, thus resulting in a more efficient use of resources. Peak
pricing is common in services with substantial fixed capacity, such as
electricity supply and rail transport, as anybody who pays higher fares to
travel during rush hours knows only too well.
Percentage
point
A
unit of size, a one-hundredth of the total. Not to be confused with percentage
change. When something increases by 1 percentage point this may be quite
different from a 1% increase. For instance, if gdp grew last year by 1% and
this year by 2%, the growth rate this year increased by 1 percentage point
compared with last year (the difference between 1% and 2%) and also by 100% (2%
is double 1%). A 1% increase would mean that the growth rate this year was only
1.01%.
Percentile
Part
of the “ile” family that signposts positions on a scale of numbers. The top
percentile on, say, the distribution of income, is the richest 1% of the
population.
Perfect
competition
The
most competitive market imaginable. Perfect competition is rare and may not
even exist. It is so competitive that any individual buyer or seller has a
negligible impact on the market price. Products are homogeneous. Information is
perfect. Everybody is a price taker. Firms earn only normal profit, the bare
minimum profit necessary to keep them in business. If firms earn more than that
(excess profits) the absence of barriers to entry means that other firms will
enter the market and drive the price level down until there are only normal
profits to be made. Output will be maximised and price minimised. Contrast with
monopolistic competition, oligopoly and, above all, monopoly.
Permanent
income hypothesis
Over
their lives, people try to spread their spending more evenly than their income.
The permanent income hypothesis, developed by Milton Friedman, says that a
person's spending decisions are guided by what they think over their lifetime
will be their average (also known as permanent) income. A sharp increase in
short-term income will not result in an equally sharp increase in short-term
consumption. What if somebody unexpectedly comes into money, say by winning the
lottery? The permanent income hypothesis suggests that people will save most of
any such windfall gains. Reality may be somewhat different.
Phillips
curve
In
1958, an economist from New Zealand, a.w.h. Phillips (1914-75), proposed that
there was a trade-off between inflation and unemployment: the lower the
unemployment rate, the higher was the rate of inflation. Governments simply had
to choose the right balance between the two evils. He drew this conclusion by
studying nominal wage rates and jobless rates in the UK between 1861 and 1957,
which seemed to show the relationship of unemployment and inflation as a smooth
curve.
Economies
did seem to work like this in the 1950s and 1960s, but then the relationship
broke down. Now economists prefer to talk about the nairu, the lowest rate of
unemployment at which inflation does not accelerate.
Pigou
effect
Named
after Arthur pigou (1877-1959), a sort of wealth effect resulting from
deflation. A fall in the price level increases the real value of people's
savings, making them feel wealthier and thus causing them to spend more. This
increase in demand can lead to higher employment.
Plaza
Accord
On September
22nd 1985, finance ministers from the world's five biggest economies - the
united states, japan, west germany, france and the uk - announced the plaza
accord at the eponymous new york hotel. Each country made specific promises on
economic policy: the united states pledged to cut the federal deficit, japan
promised a looser [economics-term key-"monetary policy"] monetary
policy[/economics-term] and a range of financial-sector reforms, and germany
proposed tax cuts. All countries agreed to intervene in currency markets as
necessary to get the dollar down. Perhaps not surprisingly, not all the
promises were kept (least of all the American one on deficit cutting), but even
so the plan turned out to be spectacularly successful. By the end of 1987, the
dollar had fallen by 54% against both the d-mark and the yen from its peak in February
1985. This sharp drop led to a new fear: of an uncontrolled dollar plunge. So
in 1987 another big international plans, the louvre accord was hatched to
stabilise the dollar. Again specific policy pledges were made (the United
States to tighten fiscal policy, japan to loosen monetary policy). Again the
participants promised currency intervention if major currencies moved outside
an agreed, but unpublished, set of ranges. The dollar promptly rose.
Population
At
the beginning of the 20th century the population of the world was 1.7 billion.
At the end of that century, it had soared to 6 billion. Recent estimates
suggest that it will be nearly 8 billion by 2025 and 9.3 billion by 2050.
Almost all of this increase is forecast to occur in the developing regions of Africa,
Asia and Latin America. For what economists have had to say about this, see
demographics.
Positional
goods
Things
that the joneses buy. Some things are bought for their intrinsic usefulness,
for instance, a hammer or a washing machine. Positional goods are bought
because of what they say about the person who buys them. They are a way for a
person to establish or signal their status relative to people who do not own
them: fast cars, holidays in the most fashionable resorts, clothes from trendy
designers. By necessity, the quantity of these goods is somewhat fixed, because
to increase supply too much would mean that they were no longer positional.
What would own a rolls-royce say about you if everybody owned one? Fears that
the rise of positional goods would limit growth, since by definition they had
to be in scarce supply, have so far proved misplaced. Entrepreneurs have come
up with ever more ingenious ways for people to buy status, thus helping
developed economies to keep growing.
Positive
economics
Economics
that describes the world as it is, rather than trying to change it. The
opposite of normative economics, which suggests policies for increasing
economic welfare.
Poverty
The
state of being poor, which depends on how you define it. One approach is to use
some absolute measure. For instance, the poverty rate refers to the number of
households whose income is less than three times what is needed to provide an
adequate diet. (Though what constitutes adequate may change over time.) Another
is to measure relative poverty. For instance, the number of people in poverty
can be defined as all households with an income of less than, say, half the
average household income. Or the (relative) poverty line may be defined as the
level of income below which is, say, the poorest 10% of households. In each
case, the dividing line between poverty and not-quite poverty is somewhat
arbitrary.
As
countries get richer, the number of people in absolute poverty usually gets
smaller. This is not necessarily true of the numbers in relative poverty. The
way that relative poverty is defined means that it is always likely to identify
a large number of impoverished households. However rich a country becomes,
there will always be 10% of households poorer than the rest, even though they
may live in mansions and eat caviar (albeit smaller mansions and less caviar
than the other 90% of households).
Poverty
trap
Another
name for the unemployment trap.
Precautionary
motive
Keeping
some money handy, just in case. One of three motives for holding money identified
by keynes, along with the transactional motive (having the cash to pay for
planned purchases) and the speculative motive (you think asset prices are going
to fall, so you sell your assets for cash).
Predatory
pricing
Charging
low prices now so you can charge much higher prices later. The predator charges
so little that it may sustain losses over a period of time, in the hope that
its rivals will be driven out of business. Clearly, this strategy makes sense
only if the predatory firm is able eventually to establish a monopoly. Some
advocates of anti-dumping policies say that cheap imports are examples of
predatory pricing. In practice, the evidence gives little support for this
view. Indeed, in general, predatory pricing is quite rare. It is certainly much
less common in practice than it might appear from the propaganda of firms that
are under pricing pressure from more efficient competitors.
Price
In
equilibrium, what balances supply and demand? The price charged for something
depends on the tastes, income and elasticity of demand of customers. It depends
on the amount of competition in the market. Under perfect competition, all
firms are price takers. Where there is a monopoly, or firms have some market
power, the seller has some control over the price, which will probably be
higher than in a perfectly competitive market. By how much more will depend on
how much market power there is, and on whether the firm(s) with the market
power are committed to profit maximisation. In some cases, firms may charge
less than the profit-maximising price for strategic or other reasons.
Price
discrimination
When
a firm charges different customers different prices for the same product. For
producers, the perfect world would be one in which they could charge each
customer a different price: the price that each customer would be willing to
pay. This would maximise producer surplus. This cannot happen, not least
because sellers do not know how much any individual would pay.
Yet
some price discrimination is possible if an overall market can be segmented
into somewhat separate markets and the equilibrium price in each of these
markets is different, perhaps because of differences in consumer tastes,
perhaps because in some segments the firm enjoys some market power. But this
will work only if the market segments can be kept apart. If it is possible and
profitable to buy the product in a low-price segment and resell it in a
high-price segment, then price discrimination will not last for long.
Price
elasticity
A
measure of the responsiveness of demand to a change in price. If demand changes
by more than the price has changed, the good is price-elastic. If demand
changes by less than the price, it is price-inelastic. Economists also measure
the elasticity of demand to changes in the income of consumers.
Price
regulation
When
prices of, say, a public utility are regulated, giving producers an incentive
to maximise their profits by reducing their costs as much as possible. Contrast
with rate of return regulation.
Price/earnings
ratio
A
crude method of judging whether shares are cheap or expensive; the ratio of the
market price of a share to the company's earnings (profit) per share. The
higher the price/earnings (p/e) ratio, the more investors are buying a
company's shares in the expectation that it will make larger profits in future
than now. In other words, the higher the p/e ratio, the more optimistic
investors are being.
Prisoners'
dilemma
A
favourite example in game theory, which shows why co-operation is difficult to
achieve even when it is mutually beneficial. Two prisoners have been arrested
for the same offence and are held in different cells. Each has two options:
confess, or say nothing. There are three possible outcomes. One could confess
and agree to testify against the other as state witness, receiving a light
sentence while his fellow prisoner receives a heavy sentence. They can both say
nothing and may be lucky and get light sentences or even be let off, owing to
lack of firm evidence. Or they may both confess and probably get lighter
individual sentences than one would have received had he said nothing and the
other had testified against him. The second outcome would be the best for both
prisoners. However, the risk that the other might confess and turn state
witness is likely to encourage both to confess, landing both with sentences
that they might have avoided had they been able to co-operate in remaining
silent. In an oligopoly, firms often behave like these prisoners, not setting
prices as high as they could do if they only trusted the other firms not to
undercut them. As a result, they are worse off.
Private
equity
When
a firm’s shares are held privately and not traded in the public markets.
Private equity includes shares in both mature private companies and, as venture
capital, in newly started businesses. As it is less liquid than publicly traded
equity, investors in private equity expect on average to earn a higher equity
risk premium from it.
Privatisation
Selling
state-owned businesses to private investors. This policy was associated
initially with Margaret thatcher's government in the 1980s, which privatised
numerous companies, including public utility businesses such as British telecom,
british gas, and electricity and water companies. During the 1990s,
privatisation became a favourite policy of governments all over the world.
There
were several reasons for the popularity of privatisation. In some instances,
the aim was to improve the performance of publicly owned companies. Often
nationalisation had failed to achieve its goals and had become increasingly
associated with poor service to customers. Sometimes privatisation was part of
transforming a state-owned monopoly into a competitive market, by combining
ownership transfer with deregulation and liberalisation. Sometimes
privatisation offered a way to raise new capital for the firm to invest in
improving its service, money that was not available in the public sector
because of constraints on public spending. Indeed, perhaps the main attraction
of privatisation to many politicians was that the proceeds from it could ease
the pressure on the public purse. As a result, they could avoid (in the
short-term) doing the more painful things necessary to improve the fiscal
position, such as raising taxes or cutting public spending.
Probability
How
likely something is to happen, usually expressed as the ratio of the number of
ways the outcome may occur to the number of total possible outcomes for the
event. For instance, each time you throw a dice there is six possible outcomes,
but in only one of these can a six come up. Thus the probability of throwing a
six on any given throw is one in six. The fact that you threw a six last time
does not alter the one-in-six probability of throwing a six next time.
Producer
surplus
The
difference between what a suppliers is paid for a good or service and what it
cost to supply. Added to consumer surplus, it provides a measure of the total
economic benefit of a sale.
Production
function
A
mathematical way to describe the relationship between the quantity of inputs
used by a firm and the quantity of output it produces with them. If the amount
of inputs needed to produce one more unit of output is less than was needed to
produce the last unit of output, then the firm is enjoying increasing returns
to scale (or increasing marginal product). If each extra unit of output
requires a growing amount of inputs to produce it, the firm faces diminishing
returns to scale (diminishing marginal product).
Productivity
The
relationship between inputs and output, which can be applied to individual
factors of production or collectively. Labour productivity is the most widely
used measure and is usually calculated by dividing total output by the number
of workers or the number of hours worked. Total factor productivity attempts to
measure the overall productivity of the inputs used by a firm or a country.
Alas,
the usefulness of productivity statistics is questionable. The quality of
different inputs can change significantly over time. There can also be
significant differences in the mix of inputs. Furthermore, firms and countries
may use different definitions of their inputs, especially capital.
That
said, much of the difference in countries' living standards reflects
differences in their productivity. Usually, the higher productivity is the
better, but this is not always so. In the UK during the 1980s, labour
productivity rose sharply, leading some economists to talk of a 'productivity
miracle'. Others disagreed, saying that productivity had risen because
unemployment had risen - in other words, the least productive workers had been
removed from the figures on which the average was calculated.
There
was a similar debate in the United States starting in the late 1990s.
Initially, economists doubted that a productivity miracle was taking place. But
by 2003, they conceded that during the previous five years the United States
enjoyed the fastest productivity growth in any such period since the Second
World War. Over the whole period from 1995, labour productivity growth averaged
almost 3% a year, twice the average rate over the previous two decades. That
did not stop economists debating why the miracle had occurred.
Profit
The
main reason firms exist. In economic theory, profit is the reward for risk
taken by enterprise, the fourth of the factors of production - what is left
after all other costs, including rent, wages and interest. Put simply, profit
is a firm's total revenue minus total cost.
Economists
distinguish between normal profit and excess profit. Normal profit is the
opportunity cost of the entrepreneur, the amount of profit just sufficient to
keep the firm in business. If profit is any lower than that, then enterprise
would be better off engaged in some alternative economic activity. Excess
profit, also known as super-normal profit, is profit above normal profit and is
usually evidence that the firm enjoys some market power that allows it to be
more profitable than it would be in a market with perfect competition.
Profit
margin
A
firm’s profit expressed as a percentage of its turnover or sales.
Profit
maximisation
The
presumed goal of firms. In practice, business people often trade off making as
much profit as possible against other goals, such as building business empires,
being popular with staff and enjoying life. The growing popularity in recent
years of paying bosses with shares in their firm may have reduced the agency
costs that arise because they are the hired hands of shareholders, making them
more likely to pursue profit maximisation.
Progressive
taxation
Taxation
that takes a larger proportion of a taxpayer's income the higher the income is.
Propensity
Economics
abounds with propensities to do various things: consume, save, invest, import,
and so on. In each case, it is important to distinguish between the average
propensity and the marginal one. The average propensity to consume is simply
total consumption divided by total income. The marginal propensity to consume
measures how much of each extra dollar of income is consumed: the percentage
change in consumption divided by the percentage change in income. The value of
the marginal propensity to consume, which determines the multiplier, is harder
to predict than the value of the average propensity to consume.
Property
rights
Essential
to any market economy. To trade, it is essential to know that the person
selling a good or service owns it and that ownership will pass to the buyer.
The stronger and clearer property rights are, the more likely it is that trade
will take place and that prices will be efficient. If there are no property
rights over something there can be severe consequences. A solution to the
costly externality of clean air being polluted may be to establish property rights
over the air, so that the owner can charge the polluter to pump smoke into the
atmosphere.
Private
property rights are often more economically efficient than common ownership.
When people do not own something directly, they may have little incentive to
look after it. Strikingly, in Russia after communism, the establishment of a
well-functioning market economy proved difficult, partly because it was unclear
who owned many of the country's resources, and those property rights that did
exist often counted for little. Businesses would often have their products
stolen by criminal gangs or be forced to hand over most of their profits in
protection money. It is no coincidence that an effective judicial system, as
well as property rights for it to enforce, is a feature of all advanced market
economies.
That
said, nowhere are property rights absolute. For instance, taxation is a clear
example of the state infringing taxpayers' ownership of their money. The
economic cost of infringing property rights underlines how important it is that
governments think carefully about the consequences for economic growth of their
tax policies.
Prospect
theory
A
theory of 'irrational' economic behaviour. Prospect theory holds that there are
recurring biases driven by psychological factors that influence people's
choices under uncertainty. In particular, it assumes that people are more
motivated by losses than by gains and as a result will devote more energy to
avoiding loss than to achieving gain. The theory is based on the experimental
work of two psychologists, Daniel kahneman (who won a nobel prize for economics
for it) and amos tversky (1937-96). It is an important component of behavioural
economics.
Protectionism
Opposition
to free trade. Although intended to protect a country's economy from foreign
competitors, it usually makes the protected country worse off than if it
allowed international trade to proceed without hindrance from trade barriers
such as quotas and tariffs.
Public
goods
Things
that can be consumed by everybody in a society, or nobody at all. They have
three characteristics. They are:
Non-rival
- one person consuming them does not stop another person consuming them;
Non-excludable
- if one person can consume them, it is impossible to stop another person
consuming them;
Non-rejectable
- people cannot choose not to consume them even if they want to.
Examples
include clean air, a national defence system and the judiciary. The combination
of non-rivalry and non-excludability means that it can be hard to get people to
pay to consume them, so they might not be provided at all if left to market
forces. Thus public goods are regarded as an example of market failure, and in
most countries they are provided at least in part by government and paid for
through compulsory taxation.
Public
spending
Spending
by national and local government and some government-backed institutions. See
fiscal policy, golden rule and budget.
Public
utility
A
firm providing essential services to the public, such as water, electricity and
postal services, usually involving elements of natural monopoly. Food is essential,
but because it is provided in a competitive market, food supply is not usually
regarded as a public utility. Because public utilities have some monopoly
power, they are typically subject to some regulation by government, such as
price controls and perhaps an obligation to provide their services to
everybody, even to those who cannot afford to pay a market price (the universal
service obligation). Public utilities are often owned by the state, although
this has become less common as a result of privatisation.
Public-private
Using
private firms to carry out aspects of government. This has become increasingly
popular since the early 1980s as governments have tried to obtain some of the
benefits of the private sector without going as far as full privatisation. The
gains have been greatest when services have been allocated to private firms
through competitive bidding. They have been smallest, and arguably even
negative, in cases when the main contribution of the private firm has been to
raise finance. That is because governments can usually borrow more cheaply than
private firms, so when they ask them to raise money the question that springs
to mind is: are they doing this to make their public borrowing look smaller?
Purchasing
power parity
A
method for calculating the correct value of a currency, which may differ from
its current market value. It is helpful when comparing living standards in
different countries, as it indicates the appropriate exchange rate to use when
expressing incomes and prices in different countries in a common currency.
By
correct value, economists mean the exchange rate that would bring demand and
supply of a currency into equilibrium over the long-term. The current market
rate is only a short-run equilibrium. Purchasing power parity (ppp) says that
goods and services should cost the same in all countries when measured in a
common currency.
Ppp
is the exchange rate that equates the price of a basket of identical traded
goods and services in two countries. Ppp is often very different from the
current market exchange rate. Some economists argue that once the exchange rate
is pushed away from its ppp, trade and financial flows in and out of a country
can move into disequilibrium, resulting in potentially substantial trade and
current account deficits or surpluses. Because it is not just traded goods that
are affected, some economists argue that ppp is too narrow a measure for
judging a currency's true value. They prefer the fundamental equilibrium
exchange rate (feer), which is the rate consistent with a country achieving an
overall balance with the outside world, including both traded goods and
services and capital flows.
