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Economics Terms A-Z – Flashcards

Suzette Hendon

8 July 2022

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the ability to produce more of a given product using a given amount of resources

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Absolute advantage

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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.

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Adverse selection

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A paid form of communication sent out by a business about a product or service. - manipulates consumer tastes and creates desires that would not otherwise exist. VS. - increases the flow of information in the economy and reduces the asymmetric information between the seller and the consumer.

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Advertising

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Behaviors that benefit other people and for which there is no discernable extrinsic reward, recognition, or appreciation.

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Altruism

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The running down or payment of a loan by instalments.

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Amortisation

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A situation in which one party in a transaction has more or superior information compared to another.

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Asymmetric information

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How firms keep out competition--an important source of incumbent advantage. There are four main sorts of barriers. *A firm may own a crucial resource, such as an oil well, or it may have an exclusive operating licence, for instance, to broadcast on a particular radio wavelength. *A big firm with economies of scale may have a significant competitive advantage because it can produce a large output at lower costs than can a smaller potential rival. *An incumbent firm may make it hard for a would-be entrant by incurring huge sunk costs, spending lots of money on things such as advertising, which any rival must match to compete effectively but which have no value if the attempt to compete should fail. *Powerful firms can discourage entry by raising exit costs, for example, by making it an industry norm to hire workers on long-term contracts, which make firing an expensive process.

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Barriers to entry (or exit)

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Paying for goods or services with other goods or services, instead of with money.

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Barter

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One one-hundredth of a percentage point. Small movements in the interest rate, the exchange rate and bond yields are often described in terms of basis points. If a bond yield moves from 5.25% to 5.45%, it has risen by 20 basis points.

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Basis point

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An investor who thinks that the price of a particular security or class of securities (shares, say) is going to fall; the opposite of a bull.

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Bear

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A branch of economics that concentrates on explaining the economic decisions people make in practice, especially when these conflict with what conventional economic theory predicts they will do.

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Behavioural economics

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underground economy. Such transactions do not normally show up in the figures for GDP, so the black economy may mean that a country is much richer than the official data suggest.

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Black economy

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A bond is an interest-bearing security issued by governments, companies and some other organisations. A bond's yield is the interest rate (or coupon) paid on the bond divided by the bond's market price.

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Bonds

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A theory of human decision making that assumes that people behave rationally, but only within the limits of the information available to them. Because their information may be inadequate (bounded) they make take decisions that appear to be irrational according to traditional theories about homo economicus (economic man).

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Bounded rationality

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When the price of an asset rises far higher than can be explained by fundamentals, such as the income likely to derive from holding the asset.

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Bubble

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An investor who expects the price of a particular security to rise; the opposite of a bear.

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Bull

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Boom and bust. The long-run pattern of economic growth and recession.

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Business cycle

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A market in which supply seems plentiful and prices seem low; the opposite of a seller's

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Buyer's market

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FIRMS used to be reluctant to launch new products and SERVICES that competed with what they were already doing, as the new thing would eat into (cannibalise) their existing business. In today's innovative, technology-intensive economy, however, a willingness to cannibalise is more often seen as a good thing. This is because INNOVATION often takes the form of what economists call creative destruction (see SCHUMPETER), in which a superior new product destroys the market for existing products. In this environment, the best course of action for successful firms that want to avoid losing their market to a rival with an innovation may be to carry out the creative destruction themselves.

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Cannibalise

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MONEY or assets put to economic use, the life-blood of CAPITALISM. Economists describe capital as one of the four essential ingredients of economic activity, the FACTORS OF PRODUCTION, along with LAND, LABOUR and ENTERPRISE. Production processes that use a lot of capital relative to labour are CAPITAL INTENSIVE; those that use comparatively little capital are LABOUR INTENSIVE. Capital takes different forms. A firm's ASSETS are known as its capital, which may include fixed capital (machinery, buildings, and so on) and working capital (stocks of raw materials and part-finished products, as well as money, that are used up quickly in the production process). Financial capital includes money, BONDS and SHARES. HUMAN CAPITAL is the economic wealth or potential contained in a person, some of it endowed at birth, the rest the product of training and education, if only in the university of life. The invisible glue of relationships and institutions that holds an economy together is its social capital.

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Capital

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When CAPITAL flows rapidly out of a country, usually because something happens which causes investors suddenly to lose confidence in its economy. This is often associated with a sharp fall in the EXCHANGE RATE of the abandoned country's currency.

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Capital flight

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In any period, the economies of countries that start off poor generally grow faster than the economies of countries that start off rich. As a result, the NATIONAL INCOME of poor countries usually catches up with the national income of rich countries. New technology may even allow DEVELOPING COUNTRIES to leap-frog over industrialised countries with older technology. This, at least, is the traditional economic theory. In recent years, there has been considerable debate about the extent and speed of convergence in reality. One reason to expect catch-up is that workers in poor countries have little access to CAPITAL, so their PRODUCTIVITY is often low. Increasing the amount of capital at their disposal by only a small amount can produce huge gains in productivity. Countries with lots of capital, and as a result higher levels of productivity, would enjoy a much smaller gain from a similar increase in capital. This is one possible explanation for the much faster GROWTH of Japan and Germany, compared with the United States and the UK, after the second world war and the faster growth of several Asian 'tigers', compared with developed countries, during the 1980s and most of the 1990s.

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Catch-up effect

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(Latin) Other things being equal.

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Ceteris paribus

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The dominant theory of economics from the 18th century to the 20th century, when it evolved into NEO-CLASSICAL ECONOMICS. Classical economists, who included Adam SMITH, David RICARDO and John Stuart Mill, believed that the pursuit of individual self-interest produced the greatest possible economic benefits for society as a whole through the power of the INVISIBLE HAND. They also believed that an economy is always in EQUILIBRIUM or moving towards it. Equilibrium was ensured in the LABOUR market by movements in WAGES and in the CAPITAL market by changes in the rate of INTEREST. The INTEREST RATE ensured that total SAVINGS in an economy were equal to total INVESTMENT. In DISEQUILIBRIUM, higher interest rates encouraged more saving and less investment, and lower rates meant less saving and more investment. When the DEMAND for labour rose or fell, wages would also rise or fall to keep the workforce at FULL EMPLOYMENT. In the 1920s and 1930s, John Maynard KEYNES attacked some of the main beliefs of classical and neo-classical economics, which became unfashionable. In particular, he argued that the rate of interest was determined or influenced by the speculative actions of investors in BONDS and that wages were inflexible downwards, so that if demand for labour fell, the result would be higher UNEMPLOYMENT rather than cheaper workers.

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Classical economics

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An ASSET pledged by a borrower that may be seized by a lender to recover the value of a loan if the borrower fails to meet the required INTEREST charges or repayments.

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Collateral

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The ability of an individual, firm, or country to produce a good or service at a lower opportunity cost than other producers. Reason why trade is beneficial

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Comparative advantage

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When you buy a computer, you will also need to buy software. Computer hardware and software are therefore complementary goods: two products, for which an increase (or fall) in DEMAND for one leads to an increase (fall) in demand for the other. Complements are the opposite of SUBSTITUTE GOODS. For instance, Microsoft Windows-based personal computers and Apple Macs are substitutes.

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Complementary goods

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If a deposit account of $100 earns an INTEREST RATE of 10% a year, then at the end of the year the account will contain $110. If all of that money is left in the account, then the 10% interest will be paid on the $110, so at the end of the second year $11 of interest will be added, making $121 in all. This is known as compound interest. By contrast, SIMPLE INTEREST pays the 10% only on the original sum in the account.

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Compound interest

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A method of reaching economic decisions by comparing the costs of doing something with its benefits.

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Cost-benefit analysis

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occurs when the introduction of new products and technologies leads to the end of other industries and jobs (Schumpeter)

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Creative destruction

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the ability of a customer to obtain goods or services before payment, based on the trust that payment will be made in the future.

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Credit

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A lender, whether by making a loan, buying a BOND or allowing MONEY owed now to be paid in the future.

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Creditor

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The extent to which the value and impact of a tax, tax relief or SUBSIDY is reduced because of its side-effects.

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Deadweight cost/loss

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Failure to fulfil the terms of a loan agreement. For example, a borrower is in default if he or she does not make scheduled INTEREST payments on a loan or fails to pay off the loan at the agreed time.

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Default

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A fall in the value of an ASSET or a currency; the opposite of APPRECIATION.

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Depreciation

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The more you have, the smaller is the extra benefit you get from having even more. This underpins the CATCH-UP EFFECT, whereby there is (supposedly) convergence between the rates of GROWTH of DEVELOPING COUNTRIES and developed ones.

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Diminishing returns

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Distributing funds among a variety of investments to minimize overall risk. Not putting all your eggs in one basket.

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Diversification

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People are better off specialising than trying to be jacks of all trades and ending up masters of none. The logic of dividing the workforce into different crafts and professions is the same as that underpinning the case for FREE TRADE: everybody benefits from doing those things in which they have a COMPARATIVE ADVANTAGE and using INCOME from doing so to meet their other needs.

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Division of labour

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The part of a company's PROFIT distributed to shareholders.

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Dividend

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Selling something for less than the cost of producing it.

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Dumping

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Mathematics and sophisticated computing applied to ECONOMICS. Econometricians crunch data in search of economic relationships that have STATISTICAL SIGNIFICANCE. Sometimes this is done to test a theory; at other times the computers churn the numbers until they come up with an interesting result.

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Econometrics

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A statistic used for judging the health of an economy, such as GDP per head, the rate of UNEMPLOYMENT or the rate of INFLATION. Subject to revision.

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Economic indicator

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At the heart of economic theory is homo economicus, the economist's model of human behaviour.

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Homo Economicus

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The most concise, non-abusive, definition is the study of how society uses its scarce resources.

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Economics

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Bigger is better. In many industries, as output increases, the AVERAGE cost of each unit produced falls. One reason is that overheads and other FIXED COSTS can be spread over more units of OUTPUT. However, getting bigger can also increase average costs (diseconomies of scale) because it is more difficult to manage a big operation, for instance.

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Economies of scale

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Getting the most out of the resources used.

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Efficiency

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WAGES that are set at above the market clearing rate so as to encourage workers to increase their PRODUCTIVITY.

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Efficiency wages

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A measure of the responsiveness of one variable to changes in another. Economists have identified four main types. PRICE ELASTICITY measures how much the quantity of SUPPLY of a good, or DEMAND for it, changes if its PRICE changes. If the percentage change in quantity is more than the percentage change in price, the good is price elastic; if it is less, the good is INELASTIC. INCOME elasticity of demand measures how the quantity demanded changes when income increases. Cross-elasticity shows how the demand for one good (say, coffee) changes when the price of another good (say, tea) changes. If they are SUBSTITUTE GOODS (tea and coffee) the cross-elasticity will be positive: an increase in the price of tea will increase demand for coffee. If they are COMPLEMENTARY GOODS (tea and teapots) the cross-elasticity will be negative. If they are unrelated (tea and oil) the cross-elasticity will be zero. Elasticity of substitution describes how easily one input in the production process, such as LABOUR, can be substituted for another, such as machinery.

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Elasticity

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Inside the economic model vs. Outside the model

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Endogenous vs. Exogenous

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People generally spend a smaller share of their BUDGET on food as their INCOME rises. Ernst Engel, a Russian statistician, first made this observation in 1857. The reason is that food is a necessity, which poor people have to buy. As people get richer they can afford better-quality food, so their food spending may increase, but they can also afford LUXURIES beyond the budgets of poor people. Hence the share of food in total spending falls as incomes grow.

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Engel's law

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The first factor of production is land, but this includes any natural resource used to produce goods and services. This includes not just land, but anything that comes from the land. Some common land or natural resources are water, oil, copper, natural gas, coal, and forests. Land resources are the raw materials in the production process. These resources can be renewable, such as forests, or nonrenewable such as oil or natural gas. The income that resource owners earn in return for land resources is called rent.

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Land

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The second factor of production is labor. Labor is the effort that people contribute to the production of goods and services. Labor resources include the work done by the waiter who brings your food at a local restaurant as well as the engineer who designed the bus that transports you to school. It includes an artist's creation of a painting as well as the work of the pilot flying the airplane overhead. If you have ever been paid for a job, you have contributed labor resources to the production of goods or services. The income earned by labor resources is called wages and is the largest source of income for most people.

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Labor

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The fourth factor of production is entrepreneurship. An entrepreneur is a person who combines the other factors of production - land, labor, and capital - to earn a profit. The most successful entrepreneurs are innovators who find new ways produce goods and services or who develop new goods and services to bring to market. Without the entrepreneur combining land, labor, and capital in new ways, many of the innovations we see around us would not exist.

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Entrepreneurship

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The third factor of production is capital. Think of capital as the machinery, tools and buildings humans use to produce goods and services. Some common examples of capital include hammers, forklifts, conveyer belts, computers, and delivery vans. Capital differs based on the worker and the type of work being done. For example, a doctor may use a stethoscope and an examination room to provide medical services. Your teacher may use textbooks, desks, and a whiteboard to produce education services. The income earned by owners of capital resources is interest.

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Capital (example)

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When SUPPLY and DEMAND are in balance. At the equilibrium PRICE, the quantity that buyers are willing to buy exactly matches the quantity that sellers are willing to sell.

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Equilibrium

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There are two definitions in ECONOMICS. 1 The capital of a firm, after deducting any liabilities to outsiders other than shareholders, who are typically the legal owners of the firm's equity. This ownership right is the reason SHARES are also known as equities. 2 Fairness. Dividing up the economic pie. Economists have been particularly interested in this with regard to how systems of TAXATION work. They have examined whether taxes treat fairly people with the same ability to pay (HORIZONTAL EQUITY) and people with different abilities to pay (VERTICAL EQUITY). Welfare economics.

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Equity

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The extra reward investors get for buying a SHARE over what they get for holding a less risky ASSET, such as a government BOND.

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Equity risk premium

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What people assume about the future, especially when they make decisions. Economists debate whether poeple have irrational or rational expectations, or adaptive expectations that change to reflect learning from past mistakes.

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Expectations

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A tax on what people spend, rather than what they earn or their wealth. Economists often regard it as more efficient than other taxes because it may discourage productive economic activity less; it is not the creating of INCOME and wealth that is taxed, but the spending of it. It can be a form of INDIRECT TAXATION, added to the PRICE of a good or service when it is sold, or DIRECT TAXATION, levied on people's income minus their SAVINGS over a year.

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Expenditure tax

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An economic side-effect. Externalities are costs or benefits arising from an economic activity that affect somebody other than the people engaged in the economic activity and are not reflected fully in PRICES. For instance, smoke pumped out by a factory may impose clean-up costs on nearby residents; bees kept to produce honey may pollinate plants belonging to a nearby farmer, thus boosting his crop. Because these costs and benefits do not form part of the calculations of the people deciding whether to go ahead with the economic activity they are a form of MARKET FAILURE, since the amount of the activity carried out if left to the free market will be an inefficient use of resources. If the externality is beneficial, the market will provide too little; if it is a cost, the market will supply too much. Negative (Regulation), Positive (Subsidy)

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Externality

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The ingredients of economic activity: land, labour, capital and enterprise.

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Factors of production

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an institution that oversees the banking system and regulates the money supply

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Central Bank

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America's central bank. Set up in 1913, and popularly known as the Fed, the system divides the United States into 12 Federal Reserve districts, each with its own regional Federal Reserve bank. These are overseen by the Federal Reserve Board, consisting of seven governors based in Washington, DC. monetary policy is decided by its Federal Open Market Committee.

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Federal Reserve System

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Certificate of ownership of a financial asset, such as a bond or a share.

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Financial instrument

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A middleman. An individual or institution that brings together investors (the source of funds) and users of funds (such as borrowers). (FundWell)

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Financial intermediary

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A favourite government policy in the keynesian-dominated 1950s and 1960s, involving frequent adjustments to fiscal policy and/or monetary policy to alter the level of demand to keep the economy growing at a steady rate. The trouble was and is, partly because of the inadequacies of economic forecasting, that these frequent adjustments were and are often mistaken, making the economy's growth path more, rather than less, erratic. In the 1990s, fine tuning was increasingly shunned by central banks and governments, which stopped trying to manage short-term demand and instead aimed to pursue long-term macroeconomic goals, which required fewer adjustments to policy. Or so they claimed. In practice, there continued to be some attempted fine tuning.

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Fine tuning

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The early bird gets the worm. game theory shows that being the first to enter a market or to introduce an innovation can be a huge advantage, not just because the first firm in can erect barriers to entry, but also because potential rivals may be discouraged from committing the resources necessary to compete successfully. However, this advantage may sometimes be cancelled out by the benefits enjoyed by followers, such as the chance to avoid--and learn from--the mistakes made by the first mover.

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First-mover advantage

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A nice little earner for the state. Fiscal drag is the tendency of revenue from taxation to rise as a share of GDP in a growing economy. Tax allowances, progressive tax rates and the threshold above which a particular rate of tax applies usually remain constant or are changed only gradually. By contrast, when the economy grows, income, spending and corporate profit rise. So the tax-take increases too, without any need for government action. This helps slow the rate of increase in demand, reducing the pace of growth, making it less likely to result in higher inflation. Thus fiscal drag is an automatic stabiliser, as it acts naturally to keep demand stable.

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Fiscal drag

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One of the two instruments of macroeconomic policy; monetary policy's side-kick. It comprises public spending and taxation, and any other government income or assistance to the private sector (such as tax breaks). It can be used to influence the level of demand in the economy, usually with the twin goals of getting unemployment as low as possible without triggering excessive inflation.

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Fiscal policy

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Production costs that do not change when the quantity of output produced changes, for instance, the cost of renting an office or factory space.

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Fixed costs

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Going public. When shares in a company are sold to the public for the first time through an initial public offering. The number of shares sold by the original private investors is called the "float". Also, when a bond issue is sold in the financial markets.

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Flotation

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Best guesses about the future. Despite complex economic theories and cutting-edge econometrics, the forecasts economists make are often badly wrong. Indeed, following economic forecasts has been likened to driving a car blindfolded, following directions given by a person who is looking out of the back window.

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Forecasting

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Investing directly in production in another country, either by buying a company there or establishing new operations of an existing business. This is done mostly by companies as opposed to financial institutions, which prefer indirect investment abroad such as buying small parcels of a country's supply of shares or bonds. Now economists typically regard FDI and trade as complementary. Mergers and acquisitions are a significant form of FDI. For instance, in 1997, more than 90% of FDI into the United States took the form of mergers rather than of setting up new subsidiaries and opening factories.

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Foreign direct investment

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Getting the benefit of a good or service without paying for it, not necessarily illegally. This may be possible because certain types of goods and services are actually hard to charge for--a firework display, for instance. Another way to look at this may be that the good or service has a positive externality. However, there can sometimes be a free-rider problem, if the number of people willing to pay for the good or service is not enough to cover the cost of providing it. In this case, the good or service might not be produced, even though it would be beneficial for the economy as a whole to have it. public goods are often at risk of free riding; in their case, the problem can be overcome by financing the good by imposing a tax on the entire population.

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Free riding

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The ability of people to undertake economic transactions with people in other countries free from any restraints imposed by governments or other regulators.

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Free trade

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That part of the jobless total caused by people simply changing jobs and taking their time about it, because they are spending time on job search or are taking a break before starting with a new employer. There is likely to be some frictional unemployment even when there is technically full employment, because most people change jobs from time to time.

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Frictional unemployment

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A fierce advocate of free markets, Mr Friedman argued for monetarism at a time when keynesian policies were dominant. He argues that the problems of inflation and short-run unemployment would be solved if the Federal Reserve had to increase the money supply at a constant rate.

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Friedman, Milton

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You can't tell them apart. Something is fungible when any one single specimen is indistinguishable from any other. Somebody who is owed $1 does not care which particular dollar he gets. Anything that people want to use as money must be fungible, whether it be gold bars, beads or shells.

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Fungible

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Jobs for all that want them. This does not mean zero unemployment because at any point in time some people do not want to work. Also, because some people are always between jobs, there will usually be some frictional unemployment. Full employment means that everyone who wants work and is willing to work at the market wage is in work. Most governments aim to achieve full employment, although nowadays they rarely try to lower unemployment below the nairu: the lowest jobless rate consistent with stable, low inflation.

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Full employment

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the lowest unemployment rate consistent with stable, low inflation

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NAIRU (non-accelerating inflation rate of unemployment)

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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. 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.

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Game theory

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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).

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GDP

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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.

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General Agreement on Tariffs and Trade (GATT)

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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.

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General equilibrium

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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.

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Giffen goods

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An inequality indicator. The Gini coefficient measures the inequality of income distribution within a country. 0 = perfect equality, with every household earning exactly the same 1 = 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.

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Gini coefficient

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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.

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Globalisation

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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.

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GNP

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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.

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Golden rule

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Spending by national and local government and some government-backed institutions.

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Government expenditure

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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.

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Gresham's law

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Adam smith attributed growth to the invisible hand, a view shared by most followers of classical economics

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Growth (Classical Economics)

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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.

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Growth (Neo-Classical Economics)

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MONEY you can trust. A hard currency is expected to retain its value, or even benefit from APPRECIATION, against softer currencies. This makes it a popular choice for people involved in international transactions.

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Hard currency

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An ancient system of moving money based on trust. It predates western bank practices. Although it is now more associated with the Middle East, a version of hawala existed in China in the second half of the Tang dynasty (618-907), known as fei qian, or flying money. In hawala, no money moves physically between locations; nowadays it is transferred by means of a telephone call or fax between dealers in different countries. No legal contracts are involved, and recipients are given only a code number or simple token, such as a low-value banknote torn in half, to prove that money is due. Over time, transactions in opposite directions cancel each other out, so physical movement is minimised. Trust is the only capital that the dealers have. With it, the users of hawala have a worldwide money-transmission service that is cheap, fast and free of bureaucracy.

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Hawala

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Hayek argued that the business cycle originated from expanded CREDIT CREATION by BANKS, which was followed by FIRMS and people making mistaken CAPITAL investments in producing things for which the market turns out to be smaller (or larger) than expected. But after an initially enthusiastic reception, the Austrian business-cycle theory lost out in policy debates to Keynes's General Theory.

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Hayek, Friedrich

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Reducing your risks. Hedging involves deliberately taking on a new RISK that offsets an existing one, such as your exposure to an adverse change in an EXCHANGE RATE, INTEREST RATE or COMMODITY PRICE.

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Hedge

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These bogey-men of the FINANCIAL MARKETS are often blamed, usually unfairly, when things go wrong. There is no simple definition of a hedge fund (few of them actually HEDGE). But they all aim to maximise their absolute returns rather than relative ones; that is, they concentrate on making as much MONEY as possible, not (like many mutual funds) simply on outperforming an index. Although they are often accused of disrupting financial markets by their SPECULATION, their willingness to bet against the herd of other investors may push security prices closer to their true fundamental values, not away.

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Hedge funds

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One way to keep TAXATION fair. Horizontal equity means that people with a similar ability to pay taxes should pay the same amount.

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Horizontal equity

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Merging with another firm just like yours, for example, two biscuit makers becoming one. Contrast with VERTICAL INTEGRATION, which is merging with a firm at a different stage in the SUPPLY chain. Horizontal integration often raises ANTITRUST concerns, as the combined firm will have a larger market share than either firm did before merging.

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Horizontal integration

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Money that is held in one currency but is liable to switch to another currency at a moment's notice in search of the highest available RETURNS, thereby causing the first currency's EXCHANGE RATE to plummet. It is often used to describe the money invested in currency markets by speculators.

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Hot money

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Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation, nicknamed, respectively.

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Fannie Mae and Freddie Mac

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The stuff that enables people to earn a living. Human capital can be increased by investing in education, training and health care. Economists increasingly argue that the accumulation of human as well as physical CAPITAL (plant and machinery) is a crucial ingredient of economic GROWTH, particularly in the NEW ECONOMY. Theory not based on empirical evidence, because human capital is difficult to measure.

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Human capital

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The 'good life' guide. Calculated since 1990 by the United Nations Development Programme, the Human Development Index quantifies a country's development in terms of such things as education, length of life and clean water, as well as INCOME.

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Human Development Index (HDI)

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Very rapid inflation, wreaks havoc. Typically, hyper-inflation quickly leads to a complete loss of confidence in a country's currency, and causes people to search for other forms of MONEY that are a better store of value. These may include physical ASSETS, GOLD and foreign currency. Hyper-inflation might be easier to live with if it was stable, as people could plan on the basis that prices would rise at a fast but predictable rate. However, there are no examples of stable hyper-inflation, precisely because it occurs only when there is a crisis of confidence across the economy, with all the behavioural unpredictability this implies. Happening in Venezuela right now.

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Hyper-inflation

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Earmarking taxes for a specific purpose. It may be a clever way to get around public hostility to paying more in TAXATION. If people are told that a specific share of their INCOME TAX will go to some popular cause, say education or health, they may be more willing to cough up. At the very least they may be forced to make more informed decisions about the trade-offs between taxes and public SERVICES. There is a downside, however. Hypothecated taxes may tie the hands of a GOVERNMENT at times when the hypothecated revenue could be spent to better effect elsewhere in the public sector. Conversely, and perhaps more likely, hypothecated taxes may prove to be less hypothecated than the public is led to believe. Civil servants, doubtless under pressure from their political bosses, can usually find ways to fudge the definition of the specific purpose for which a tax is hypothecated, letting government regain control over how the MONEY is spent.

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Hypothecation

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Lagging; slow to respond. Traditionally, economists believed that high UNEMPLOYMENT was a cyclical phenomenon. Eventually, unemployment would cause people to lower their wage demands, and so new job opportunities would arise and unemployment would fall. More recently, however, economists have suggested that some unemployed people, especially the long-term jobless, can display hysteresis. They find it hard, perhaps impossible, to return to work, even when jobs become available. For instance, unemployed workers may gradually lose the motivation, self-confidence or the self-discipline, needed to get to the workplace and fulfil job requirements. Or their skills may become outdated and redundant. State benefits for the jobless may contribute to this hysteresis by making it easier from them to stay out of work.

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Hysteresis

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Founded in 1919 as part of the Treaty of Versailles, which created the League of Nations. In 1946, it became the first specialised agency of the UN. Based in Geneva, it formulates international LABOUR standards, setting out desired minimum rights for workers: freedom of association; the right to organise and engage in collective bargaining; equality of opportunity and treatment; and the abolition of forced labour. It also compiles international labour statistics. One reason for its formation was the hope that international labour standards would stop countries using lower standards to gain a COMPETITIVE ADVANTAGE.

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International Labour Organisation (ILO)

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the IMF became more involved with its member countries' economic policies, doling out advice on FISCAL POLICY and MONETARY POLICY as well as microeconomic changes such as PRIVATISATION, of which it became a forceful advocate. In the 1980s, it played a leading part in sorting out the problems of DEVELOPING COUNTRIES' mounting DEBT. More recently, it has several times co-ordinated and helped to finance assistance to countries with a currency crisis. The Fund has been criticised for the CONDITIONALITY of its support, which is usually given only if the recipient country promises to implement IMF-approved economic reforms. Unfortunately, the IMF has often approved 'one size fits all' policies that, not much later, turned out to be inappropriate. It has also been accused of creating MORAL HAZARD, in effect encouraging governments (and FIRMS, BANKS and other investors) to behave recklessly by giving them reason to expect that if things go badly the IMF will organise a bail-out. Indeed, some financiers have described an INVESTMENT in a financially shaky country as a 'moral-hazard play' because they were so confident that the IMF would ensure the safety of their MONEY, one way or another. Following the economic crisis in Asia during the late 1990s, and again after the crisis in Argentina early in this decade, some policymakers argued (to no avail) for the IMF to be abolished, as the absence of its safety net would encourage more prudent behaviour all round. More sympathetic folk argued that the IMF should evolve into a global LENDER OF LAST RESORT.

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IMF Short for International Monetary Fund, referee and, when the need arises, rescuer of the world's FINANCIAL SYSTEM.

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See MONOPOLISTIC COMPETITION and OLIGOPOLY.

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Imperfect competition

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Purchases of foreign goods and SERVICES; the opposite of EXPORTS.

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Imports

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The flow of MONEY to the FACTORS OF PRODUCTION: WAGES to LABOUR; PROFIT to ENTERPRISE and CAPITAL; INTEREST also to capital; RENT to LAND. Wages left for spending after paying taxes is known as disposable INCOME.

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Income

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A change in the DEMAND for a good or service caused by a change in the INCOME of consumers rather than, say, a change in consumer tastes. Contrast with SUBSTITUTION EFFECT.

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Income effect

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A much-loathed method of TAXATION based on earnings. In most countries, people do not pay it until their INCOME exceeds a minimum threshold, and richer people pay a higher rate of income tax than poorer people.

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Income tax

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The importance of being there already. FIRMS that are in a market can have a significant COMPETITIVE ADVANTAGE over aspiring entrants to that market, for instance, through having the opportunity to erect barriers to entry.

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Incumbent advantage

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Economists love to compile indices aggregating lots of individual data, so they can analyse broad trends in the behaviour of an economy. The main challenges in compiling an index are what, exactly, to include in it and what weight to give the different things that are included. A particularly tricky question is how to change an index over time. INFLATION is measured by an index of consumer (retail) PRICES. There are indices of all sorts of things that are bought and sold of which perhaps the best known are share price indices like the Dow Jones Industrial Average or FTSE-100.

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Index numbers

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A curve that joins together different combinations of goods and SERVICES that would each give the consumer the same amount of satisfaction (UTILITY). In other words, consumers are indifferent to which of the combinations they get.

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Indifference curve

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Taxes that do not come straight out of a person's pay packet or ASSETS, or out of company PROFIT. For example, a CONSUMPTION tax, such as VALUE-ADDED tax (see EXPENDITURE TAX). Contrast with DIRECT TAXATION, such as INCOME TAX. Indirect taxation has become increasingly popular with politicians because it may be less noticeable to people paying it than income tax and is harder to avoid paying.

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Indirect taxation

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When the SUPPLY or DEMAND for something is insensitive to changes in another variable, such as PRICE.

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Inelastic

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Equality of opportunity, which, in theory, should make a difference to growth, because it is about giving people the chance to make the most of their HUMAN CAPITAL, is probably beyond the ability of statisticians to analyse rigorously. The most often used measure of income inequality is the GINI COEFFICIENT. The evidence suggests that extreme poverty is more likely to slow growth than income inequality itself. This is because very poor people cannot buy the education they need to enable them to become richer and their children may be forced to forgo schooling in order to work for money.

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Inequality

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Products that are less in demand as consumers get richer. For NORMAL GOODS, DEMAND increases as consumers have more to spend.

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Inferior goods

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Rising PRICES, across the board. Inflation means less bang for your buck, as it erodes the purchasing power of a unit of currency. Inflation usually refers to CONSUMER PRICES, but it can also be applied to other prices (wholesale goods, WAGES, ASSETS, and so on). It is usually expressed as an annual percentage rate of change on an INDEX NUMBER. For much of human history inflation has not been an important part of economic life. Inflation would not do much damage if it were predictable, as everybody could build into their decision making the prospect of higher prices in future. In practice, it is unpredictable, which means that people are often surprised by price increases. This reduces economic efficiency, not least because people take fewer risks to minimise the chances of suffering too severely from a PRICE SHOCK. The faster the rate of inflation, the harder it is to predict future inflation. Indeed, this uncertainty can cause people to lose confidence in a currency as a store of value. This is why HYPER-INFLATION is so damaging.

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Inflation

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The goal of monetary policy in many countries is to ensure that inflation is neither too high nor too low.

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Inflation target

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The oil that keeps the economy working smoothly. Economic EFFICIENCY is likely to be greatest when information is comprehensive, accurate and cheaply available. Many of the problems facing economies arise from people making decisions without all the information they need. One reason for the failure of the COMMAND ECONOMY is that GOVERNMENT planners were not good at gathering and processing information. Adam SMITH's metaphor of the INVISIBLE HAND is all about how, in many cases, free markets are much more efficient at processing information on the needs of all the participants in an economy than is the visible, and often dead, hand of state planners. ASYMMETRIC INFORMATION, when one party to a deal knows more than the other party, can be a serious source of inefficiency and MARKET FAILURE. Uncertainty can also impose large economic costs. The internet, by greatly increasing the availability and lowering the price of information, is helping to boost economic efficiency. But there are inefficiencies the internet will not be able to solve. Uncertainty will remain a huge source of economic inefficiency. Alas, potentially the most useful information, about what will happen in the future, is never available until it is too late.

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Information

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The economic arteries and veins. Roads, ports, railways, airports, power lines, pipes and wires that enable people, goods, commodities, water, energy and INFORMATION to move about efficiently. Increasingly, infrastructure is regarded as a crucial source of economic COMPETITIVENESS. INVESTMENT in infrastructure can yield unusually high returns because it increases people's choices: of where to live and work, what to consume, what sort of economic activities to carry out, and of other people to communicate with. Some parts of a country's infrastructure may be a NATURAL MONOPOLY, such as water pipes. Others, such as traffic lights, may be PUBLIC GOODS. Some may have a NETWORK EFFECT, such as telephone cables. Each of these factors has encouraged GOVERNMENT provision of infrastructure, often with the familiar downsides of state intervention: bad planning, inefficient delivery and CORRUPTION.

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Infrastructure

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A vital contributor to economic GROWTH. The big challenge for FIRMS and governments is to make it happen more often. Although nobody is entirely sure why innovation takes place, new theories of ENDOGENOUS growth try to model the innovation process, rather than just assume it happens for unexplained, EXOGENOUS reasons. The role of incentives seems to be particularly important. Although some innovations are the result of scientists and others engaged in the noble pursuit of knowledge, most, especially their commercial applications, are the result of entrepreneurs seeking PROFIT. To encourage innovation, innovators must be allowed to make a decent profit, otherwise they will not incur the RISK and expense of trying to come up with useful innovations. Most countries have PATENTS and other laws protecting intellectual property, which allow innovators to enjoy a (usually temporary) MONOPOLY over their innovation. Economists disagree over how long that protection should last, given the inefficiencies that result from any monopoly.

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Innovation

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Insider trading involves using INFORMATION that is not in the public domain but that will move the PRICE of a share, BOND or currency when it is made public. An insider trade takes place when someone with privileged, confidential access to that information trades to take advantage of the fact that prices will move when the news gets out. This is frowned on because investors may lose confidence in FINANCIAL MARKETS if they see insiders taking advantage of advantageous ASYMMETRIC INFORMATION to enrich themselves at the expense of outsiders.

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Insider Trading

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The big hitters of the FINANCIAL MARKETS: pension funds, fund-management companies, INSURANCE companies, investment BANKS, HEDGE FUNDS, charitable endowment trusts. In the United States, around half of publicly traded SHARES are owned by institutions and half by individual investors.

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Institutional investors

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In economic terms, anything used to reduce the downside of RISK. In its most familiar form, insurance is provided through a policy purchased from an insurance company. But a fuller definition would also include, say, a financial SECURITY (or anything else) used to HEDGE, as well as assistance available in the event of disaster. It could even be provided by the GOVERNMENT, in various ways, including WELFARE payments to sick or poor people and legal protection from CREDITORS in the event of BANKRUPTCY. Conventional insurance works by pooling the risks of many people (or FIRMS, and so on), all of whom might claim but in practice only a few actually do. The cost of providing assistance to those that claim is spread over all the potential claimants, thus making the insurance affordable to all. Despite the enormous attraction of insurance, private markets in insurance often work badly, or not at all. Economists have identified three main reasons for this. Private firms are unwilling to provide insurance if they are uncertain about the likely cost of providing sufficient cover, especially if it is potentially unlimited. MORAL HAZARD & ADVERSE SELECTION. Insurers have found ways of reducing the impact of these problems. For example, to counter adverse selection, they set higher health-insurance rates for people who smoke. To limit moral hazard, they offer reduced premiums to people who agree to pay the first so-many dollars or pounds of any claim. An efficient system of insurance, in its broadest sense, can contribute to economic GROWTH by encouraging entrepreneurial risk taking and by enabling people to choose which risks they take and which they protect themselves against.

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Insurance

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Valuable things, even though you cannot drop them on your foot - an idea, say, especially one protected by a PATENT; an effective corporate culture; HUMAN CAPITAL; a popular brand.

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Intangible assets

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The part of a country's or a firm's CAPITAL or an individual's HUMAN CAPITAL that consists of ideas rather than something more physical. It can often be protected through PATENTS or other intellectual property laws.

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Intellectual capital

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The cost of borrowing, which compensates lenders for the RISK they take in making their money available to borrowers. Without interest there would be little lending and thus a lot less economic activity.

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Interest

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INTEREST is usually expressed at an annual rate: the amount of interest that would be paid during a year divided by the amount of money loaned. Developed economies offer many different interest rates, reflecting the length of the loan and the riskiness and wealth of the borrower.

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Interest rate

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A helping hand for poor countries from rich countries. This, at least, is the intention. In practice, in many cases aid has done little good for its intended recipients (improved health care is a notable exception) and has sometimes made matters worse. Poor countries that receive lots of aid grow no faster, on average, than those that receive very little. By contrast, perhaps the most successful aid programme ever - the MARSHALL PLAN for rebuilding Europe after the second world war - involved rich countries giving to other hitherto rich countries. Why has aid achieved so little? Donations have often ended up in the OFFSHORE BANK accounts of corrupt politicians and officials in poor countries. MONEY has often been given with strings attached, so that much of this 'tied' aid is spent on companies and corrupt politicians and officials in the donor country. War has ravaged many potentially beneficial aid projects. Moreover, some aid has been motivated by political goals - for example, shoring up anti-communist governments - rather than economic ones. The lesson of history is that aid will often be wasted unless it is carefully aimed at countries with a genuine commitment to sound economic management. Analysis by the WORLD BANK sorted 56 aid-receiving countries by the quality of their economic management. Those with good policies (low INFLATION, a BUDGET surplus and openness to trade) and good institutions (little CORRUPTION, strong rule of law, effective bureaucracy) benefited from the aid they received. Those with poor policies and institutions did not. This accounts for the growing popularity of CONDITIONALITY in aid.

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International aid

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When CENTRAL BANKS try to influence an EXCHANGE RATE by buying the currency they want to appreciate and selling the one they want to weaken. The evidence seems to suggest that it is at best a short-term measure. In the longer term, governments probably do not have the resources to beat MARKET FORCES.

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Intervention

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Putting MONEY to work, in the hope of making even more money. Investment takes two main forms: direct spending on buildings, machinery and so forth, and indirect spending on financial SECURITIES, such as BONDS and SHARES. The more of its GDP a country invests, the faster its economy should grow.

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Investment

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Adam SMITH's shorthand for the ability of the free market to allocate FACTORS OF PRODUCTION, goods and SERVICES to their most valuable use. If everybody acts from self-interest, spurred on by the PROFIT motive, then the economy will work more efficiently, and more productively, than it would do were economic activity directed instead by some sort of central planner. It is, wrote Smith, as if an 'invisible hand' guides the actions of individuals to combine for the common good. Smith recognised that the invisible hand was not infallible, however, and that some GOVERNMENT action might be needed, such as to impose ANTITRUST laws, enforce PROPERTY RIGHTS, and to provide policing and national defence.

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Invisible hand

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EXPORTS and IMPORTS of things you cannot touch or see: SERVICES, such as banking or advertising and other intangibles, such as copyrights. Invisible trade accounts for a growing slice of the value of world trade.

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Invisible trade

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Investment from abroad; the opposite of OUTWARD INVESTMENT

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Inward investment

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The shape of the trend of a country's trade balance following a DEVALUATION. A lower EXCHANGE RATE initially means cheaper EXPORTS and more expensive IMPORTS, making the current account worse (a bigger DEFICIT or smaller surplus). After a while, though, the volume of exports will start to rise because of their lower PRICE to foreign buyers, and domestic consumers will buy fewer of the costlier imports. Eventually, the trade balance will improve on what it was before the devaluation. If there is a currency APPRECIATION there may be an inverted J-curve. The British pound is currently being devalued due to the Brexit.

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J-curve

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The time taken to find a new job. Because some people will devote all their time to this search, there will always be some FRICTIONAL UNEMPLOYMENT, even when there is otherwise FULL EMPLOYMENT.

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Job search

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Some products or production processes have more than one use. For instance, cows can both provide milk and be eaten. If farmers increase the number of cows they own in response to an increase in DEMAND for milk, they are also likely to increase, a little later, the supply of meat, causing beef prices to fall.

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Joint supply

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A much quoted, great British economist, not famous for holding the same opinion for long. Born in 1883, he studied at Cambridge but came to reject much of the CLASSICAL ECONOMICS and NEO-CLASSICAL ECONOMICS associated with that university. Keynes helped set up the BRETTON WOODS framework, but he is best known for his General Theory of Employment, Interest and Money, published in 1936 in the depths of the Great Depression. This invented modern MACROECONOMICS. It argued that economies could sometimes be stable (in EQUILIBRIUM) even when they did not have FULL EMPLOYMENT, but that a GOVERNMENT could remedy this under-employment problem by increasing PUBLIC SPENDING and/or reducing TAXATION, thereby increasing the level of aggregate DEMAND in the economy. Many politicians picked up on these ideas. As President Richard Nixon observed in 1971, 'We are all Keynesians now.' However, it is much debated whether Keynes would have supported the way many of them put his thoughts into practice. Keynes identified the economic importance of ANIMAL SPIRITS. Making and losing fortunes in the FINANCIAL MARKETS led him to refer to the 'casino CAPITALISM' of the stockmarket. He also noted that 'there is nothing so dangerous as the pursuit of a rational INVESTMENT policy in an irrational world'. He had an amusingly accurate view of the impact and transmission of economic ideas: 'Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist.' As for the frequency with which his opinions would evolve: 'When the facts change, I change my mind - what do you do, sir?' 'In the long run we are all dead,' he said. For him, the long run was 1946.

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Keynes, John Maynard

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A branch of ECONOMICS, based, often loosely, on the ideas of KEYNES, characterised by a belief in active GOVERNMENT and suspicion of market outcomes. It was dominant in the 30 years following the second world war, and especially during the 1960s, when FISCAL POLICY became bigger-spending and looser in most developed countries as policymakers tried to kill off the BUSINESS CYCLE. During the 1970s, widely blamed for the rise in INFLATION, Keynesian policies gradually gave way to monetarism and microeconomic policies that owed much to the NEO-CLASSICAL ECONOMICS that Keynes had at times opposed. Even so, the idea that PUBLIC SPENDING and TAXATION have a crucial role to play in managing DEMAND, in order to move towards FULL EMPLOYMENT, remained at the heart of MACROECONOMIC POLICY in most countries, even after the monetarist and supply-side revolution of the 1980s and 1990s. Recently, a school of new, more pro-market Keynesian economists has emerged, believing that most markets work, but sometimes only slowly.

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Keynesian

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Corrupt, thieving GOVERNMENT, in which the politicians and bureaucrats in charge use the powers of the state to feather their own nests. Russia in the years immediately after the fall of COMMUNISM was a clear-cut example, with Mafia-friendly GOVERNMENT members allocating themselves valuable SHARES during the PRIVATISATION of state-owned companies, accepting bribes from foreign businesses, not collecting taxes from "helpful" companies and siphoning off INTERNATIONAL AID into their personal OFFSHORE BANK accounts.

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Kleptocracy

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One of the FACTORS OF PRODUCTION, with LAND, CAPITAL and ENTERPRISE. Among the things that determine the supply of labour are the number of able people in the POPULATION, their willingness to work, labour laws and regulations, and the health of the economy and FIRMS. DEMAND for labour is also affected by the health of the economy and firms, labour laws and regulations, as well as the PRICE and supply of other factors of production. In a perfect market, WAGES (the price of labour) would be determined by SUPPLY and demand. But the labour market is often far from perfect. Wages can be less flexible than other prices; in particular, they rarely fall even when demand for labour declines or supply increases. This wage rigidity can be a cause of UNEMPLOYMENT.

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Labour

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A production process that involves comparatively large amounts of LABOUR; the opposite of CAPITAL INTENSIVE.

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Labour intensive

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A flexible LABOUR market is one in which it is easy and inexpensive for FIRMS to vary the amount of labour they use, including by changing the hours worked by each employee and by changing the number of employees. This often means minimal REGULATION of the terms of employment (no MINIMUM WAGE, say) and weak (or no) trade UNIONS. Such flexibility is characterised by its opponents as giving firms all the power, allowing them to fire employees at a moment's notice and leaving workers feeling insecure. Opponents of labour market flexibility claim that labour laws that make workers feel more secure encourage employees to invest in acquiring skills that enable them to do their current job better but that could not be taken with them to another firm if they were let go. Supporters claim that it improves economic EFFICIENCY by leaving it to MARKET FORCES to decide the terms of employment. *Broadly speaking, the evidence is that greater flexibility is associated with lower rates of UNEMPLOYMENT and higher GDP per head.

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Labour market flexibility

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The notion that the value of any good or service depends on how much LABOUR it uses up. First suggested by ADAM SMITH, it took a central place in the philosophy of KARL MARX. Some neo-classical economists disagreed with this theory, arguing that the PRICE of something was independent of how much labour went into producing it and was instead determined solely by SUPPLY and DEMAND.

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Labour theory of value

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Upside-down U curve relating average tax rate to total tax revenue Legend has it that in November 1974 Arthur Laffer, a young economist, drew a curve on a napkin in a Washington bar, linking AVERAGE tax rates to total tax revenue. Initially, higher tax rates would increase revenue, but at some point further increases in tax rates would cause revenue to fall, for instance by discouraging people from working. The curve became an icon of supply-side ECONOMICS. Some economists said that it proved that most governments could raise more revenue by cutting tax rates, an argument that was often cited in the 1980s by the tax-cutting governments of Ronald Reagan and Margaret Thatcher. Other economists reckoned that most countries were still at a point on the curve at which raising tax rates would increase revenue. The lack of empirical evidence meant that nobody could really be sure where the United States and other countries were on the Laffer curve. However, after the Reagan administration cut tax rates revenue fell at first. American tax rates were already low compared with some countries, especially in continental Europe, and it remains possible that these countries are at a point on the Laffer curve where cutting tax rates would pay.

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Laffer curve

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Old news. Some economic statistics move weeks or months after changes in the BUSINESS CYCLE or INFLATION. They may not be a reliable guide to the current state of an economy or its future path. Contrast with LEADING INDICATORS.

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Lagging indicators

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Let-it-be ECONOMICS: the belief that an economy functions best when there is no interference by GOVERNMENT. It can be traced to the 18th-century French physiocrats, who believed in government according to the natural order and opposed MERCANTILISM. ADAM SMITH and others turned it into a central tenet of CLASSICAL ECONOMICS, as it allowed the INVISIBLE HAND to operate efficiently. (But even they saw a need for some limited government role in the economy.) In the 19th century, it inspired the British political movement that secured the repeal of the Corn Laws and promoted FREE TRADE, and gave birth to The Economist in 1843. In the 20th century, laissez-faire was often seen as synonymous with supporting MONOPOLY and allowing the BUSINESS CYCLE to boom and bust, and it came off second best against KEYNESIAN policies of interventionist government. However, mounting evidence of the inefficiency of state intervention inspired the free market policies of Ronald Reagan and Margaret Thatcher in the 1980s, both of whom stressed the importance of laissez-faire.

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Laissez-faire

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One of the FACTORS OF PRODUCTION, along with LABOUR, CAPITAL and ENTERPRISE. Pending colonisation of the moon, it is in fairly fixed SUPPLY. Marginal increases are possible by reclaiming land from the sea and cutting down forests (which may impose large economic costs by damaging the environment), but the expansion of deserts may slightly reduce the amount of usable land. Owners earn MONEY from land by charging RENT.

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Land

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Henry George, a 19th-century American economist, believed that taxes should be levied only on the value of LAND, not on LABOUR or CAPITAL. This 'single tax', he asserted in his book, PROGRESS AND POVERTY, would end UNEMPLOYMENT, POVERTY, INFLATION and INEQUALITY. Many countries levy some tax on land or property values, although George's single tax has never been fully implemented. This is mainly because of fears that it would drive down land PRICES too much or discourage efforts to improve the quality (that is, the economic value) of land. George addressed this concern by arguing that the tax should be levied only against the value of 'unimproved' land. Certainly, a land tax has obvious advantages: it is simple and cheap to levy; evasion is all but impossible; and it penalises owners who do not put their land to work.

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Land tax

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Laws can be an important source of economic EFFICIENCY - or inefficiency. Early economists such as ADAM SMITH often wrote about the economic impact of legal matters. But ECONOMICS subsequently focused more narrowly on things monetary and commercial. It was only in the 1940s and 1950s, at the University of Chicago Law School, that the discipline of law and economics was born. It is now a substantial branch of economics and has had an impact beyond the ivory towers. The "economics" of law and economics is firmly in the LIBERAL ECONOMICS camp, favouring free markets and arguing that REGULATION often does more harm than good. It stresses the economic value of having clear, enforceable PROPERTY RIGHTS, and of ensuring that these can be bought and sold. It has encouraged many ANTITRUST policymakers to focus on maximising consumer WELFARE, rather than, say, protecting small FIRMS or opposing big ones just because they are big. It has also ventured into broader sociological issues, for instance, analysing the economic causes of criminality and how to structure legal incentives to reduce crime.

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Law and economics

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Economic crystal balls. Also known as cyclical indicators, these are groups of statistics that point to the future direction of the economy and the BUSINESS CYCLE. Certain economic variables, fairly consistently, precede changes in GDP and certain others precede changes in INFLATION. In some countries, statisticians combine the various different leading indicators into an overall leading index of economic GROWTH or inflation. However, there is not necessarily any causal relationship between the leading indicators and what they are predicting, which is why, like other crystal balls, they are fallible. Contrast with LAGGING INDICATORS.

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Leading indicators

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One of the main functions of a CENTRAL BANK. When financially troubled BANKS need cash and nobody else will lend to them, a central bank may do so, perhaps with strings attached, or even by taking control of the troubled bank, closing it or finding it a new owner. This role of the central bank makes CREDIT CREATION easier by increasing confidence in the banking system and minimising the RISK of a bank run by reassuring depositors that their MONEY is safe. However, it also creates a potential MORAL HAZARD: that banks will lend more recklessly because they know they will be bailed out if things go wrong.

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Lender of last resort

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Buying a company using borrowed MONEY to pay most of the purchase PRICE. The DEBT is secured against the ASSETS of the company being acquired. The INTEREST will be paid out of the company's future cashflow. Leveraged buy-outs (LBOs) became popular in the United States during the 1980s, as public DEBT markets grew rapidly and opened up to borrowers that would not previously have been able to raise loans worth millions of dollars to pursue what was often an unwilling target. Although some LBOs ended up with the borrower going bust, in most cases the need to meet demanding interest bills drove the new managers to run the firm more efficiently than their predecessors. For this reason, some economists see LBOs as a way of tackling AGENCY COSTS associated with corporate governance.

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Leveraged buy-out

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LAISSEZ-FAIRE CAPITALISM by another name.

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Liberal economics

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A policy of promoting LIBERAL ECONOMICS by limiting the role of GOVERNMENT to the things it can do to help the market economy work efficiently. This can include PRIVATISATION and DEREGULATION.

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Liberalisation

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Human life is priceless. But this has not stopped economists trying to put a financial value on it. One reason is to help FIRMS and policymakers to make better decisions on how much to spend on costly safety measures designed to reduce the loss of life. Another is to help insurers and courts judge how much compensation to pay in the event of, say, a fatal accident. One way to value a life is to calculate a person's HUMAN CAPITAL by working out how much he or she would earn were they to survive to a ripe old age. This could result in very different sums being paid to victims of the same accident. After an air crash, probably more MONEY would go to the family of a first-class passenger than to that of someone flying economy. This may not seem fair. Nor would using this method to decide what to spend on safety measures, as it would mean much higher expenditure on avoiding the death of, say, an investment banker than on saving the life of a teacher or coal miner. It would also imply spending more on safety measures for young people and being positively reckless with the lives of retired people. Another approach is to analyse the risks that people are voluntarily willing to take, and how much they require to be paid for taking them. Taking into account differences in WAGES for high death-risk and low death-risk jobs, and allowing for differences in education, experience, and so on, it is possible to calculate roughly what value people put on their own lives. In industrialised countries, most studies using this method come up with a value of $5m-10m.

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Life

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An attempt to explain the way that people split their INCOME between spending and saving, and the way that they borrow. Over their lifetime, a typical person's income varies by far more than how much they spend. On AVERAGE, young people have low incomes but big spending commitments: on investing in their HUMAN CAPITAL through education and training, building a family, buying a home, and so on. So they do not save much and often borrow heavily. As they get older their income generally rises, they pay off their mortgage, the children leave home and they prepare for retirement, so they sharply increase their saving and INVESTMENT. In retirement, their income is largely or entirely from state benefits and the saving and investment they did when working; they spend most or all of their income, and, by selling off ASSETS, often spend more than their income. Broadly speaking, this theory is supported by the data, though some economists argue that young people do not spend as much as they should on, say, being educated, because lenders are reluctant to extend CREDIT to them. One puzzle is that people often have substantial assets left when they die. Some economists say this is because they want to leave a generous inheritance for their relatives; others say that people are simply far too optimistic about how long they will live.

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Life-cycle hypothesis

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How easily an ASSET can be spent, if so desired. Cash is wholly liquid. The liquidity of other assets is usually less; how much less may be measured by the ease with which they can be exchanged for cash (that is, liquidated). Public FINANCIAL MARKETS try to maximise the liquidity of assets such as BONDS and EQUITIES by providing a central meeting place (the exchange) in which would-be buyers and sellers can easily find each other.

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Liquidity

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The proportion of their ASSETS that FIRMS and individuals choose to hold in varying degrees of LIQUIDITY. The more cash they have, the greater is their desire for liquidity.

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Liquidity preference

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When MONETARY POLICY becomes impotent. Cutting the rate of INTEREST is supposed to be the escape route from economic RECESSION: boosting the MONEY SUPPLY, increasing DEMAND and thus reducing UNEMPLOYMENT. But KEYNES argued that sometimes cutting the rate of interest, even to zero, would not help. People, BANKS and FIRMS could become so RISK AVERSE that they preferred the LIQUIDITY of cash to offering CREDIT or using the credit that is on offer. In such circumstances, the economy would be trapped in recession, despite the best efforts of monetary policymakers.

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Liquidity trap

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When we are all dead, according to KEYNES. Unimpressed by the thrust of CLASSICAL ECONOMICS, which said that economies have a long-run tendency to settle in EQUILIBRIUM at FULL EMPLOYMENT, he wanted economists to try to explain why in the short run economies are so often in DISEQUILIBRIUM, or in equilibrium at high levels of UNEMPLOYMENT.

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Long run

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One of the best-known fallacies in ECONOMICS is the notion that there is a fixed amount of work to be done - a lump of LABOUR - which can be shared out in different ways to create fewer or more jobs. For instance, suppose that everybody worked 10% fewer hours. FIRMS would need to hire more workers. Hey presto, UNEMPLOYMENT would shrink. In 1891, an economist, D.F. Schloss, described such thinking as the lump of labour fallacy because, in reality, the amount of work to be done is not fixed. GOVERNMENT-imposed restrictions on the amount of work people may do can actually reduce the EFFICIENCY of the labour market, thereby increasing UNEMPLOYMENT. Shorter hours will create more jobs only if weekly pay is also cut (which workers are likely to resist) otherwise costs per unit of output will rise. Not all labour costs vary with the number of hours worked. FIXED COSTS, such as recruitment and training, can be substantial, so it will cost a firm more to hire two part-time workers than one full-timer. Thus a cut in the working week may raise AVERAGE costs per unit of OUTPUT and cause firms to buy fewer total hours of labour. A better way to reduce unemployment may be to stimulate DEMAND and so increase output; another is to make the labour market more flexible, not less.

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Lump of labour fallacy

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A tax that is the same amount for everybody, regardless of INCOME or wealth. Some economists argue that this is the most efficient form of TAXATION, as it does not distort incentives and thus it has no DEADWEIGHT COST. This is because each person knows that whatever they do they will have to pay the same amount. It is also cheap to administer, as there is no complex process of measuring each person's INCOME and ASSETS in order to calculate their tax bill. However, because rich and poor people pay the same, the tax may be perceived as unfair - as Margaret Thatcher found out when she introduced a lump-sum 'poll tax', a decision that was later to play a large part in her ousting as British prime minister.

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Lump-sum tax

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Goods and SERVICES that have a high ELASTICITY of DEMAND. When the PRICE of, say, a Caribbean holiday rises, the number of vacations demanded falls sharply. Likewise, demand for Caribbean holidays rises significantly as AVERAGE INCOME increases, certainly by more than demand for many NORMAL GOODS. Contrast this with necessities, such as milk or bread, which people usually demand in quite similar quantities whatever their income and whatever the price.

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Luxuries

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Top-down policy by GOVERNMENT and CENTRAL BANKS, usually intended to maximise GROWTH while keeping down INFLATION and UNEMPLOYMENT. The main instruments of macroeconomic policy are changes in the rate of INTEREST and MONEY SUPPLY, known as MONETARY POLICY, and changes in TAXATION and PUBLIC SPENDING, known as FISCAL POLICY. The fact that unemployment and inflation often rise sharply, and that growth often slows or GDP falls, may be evidence of poorly executed macroeconomic policy. However, BUSINESS CYCLES may simply be an unavoidable fact of economic life that macroeconomic policy, however well conducted, can never be sure of conquering.

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Macroeconomic policy

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The big picture: analysing economy-wide phenomena such as GROWTH, INFLATION and UNEMPLOYMENT. Contrast with MICROECONOMICS, the study of the behaviour of individual markets, workers, households and FIRMS. Although economists generally separate themselves into distinct macro and micro camps, macroeconomic phenomena are the product of all the microeconomic activity in an economy. The precise relationship between macro and micro is not particularly well understood, which has often made it difficult for a GOVERNMENT to deliver well-run MACROECONOMIC POLICY.

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Macroeconomics

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Making things like cars or frozen food has shrunk in importance in most developed countries during the past half century as SERVICES have grown. At the same time, manufacturing has grown in importance in DEVELOPING COUNTRIES. Mostly, the shift from manufacturing to services (as with the earlier shift from agriculture to manufacturing) reflects progress into jobs that create more UTILITY, this time for real women as well as real men, which may explain why it is happening first in richer countries.

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Manufacturing

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The difference made by one extra unit of something. Marginal revenue is the extra revenue earned by selling one more unit of something. The marginal PRICE is how much extra a consumer must pay to buy one extra unit. Marginal UTILITY is how much extra utility a person gets from consuming (or doing) an extra unit of something. The marginal product of LABOUR is how much extra OUTPUT a firm would get by employing an extra worker, or by getting an existing worker to put in an extra hour on the job. The marginal PROPENSITY to consume (or to save) measures by how much a household's CONSUMPTION (SAVINGS) would increase if its INCOME rose by, say, $1. The marginal tax rate measures how much extra tax you would have to pay if you earned an extra dollar. The marginal cost (or whatever) can be very different from the AVERAGE cost (or whatever), which simply divides total costs (or whatever) by the total number of units produced (or whatever). A common finding in MICROECONOMICS is that small incremental changes can matter enormously. In general, thinking 'at the margin' often leads to better economic decision making than thinking about the averages. ALFRED MARSHALL, the father of NEO-CLASSICAL ECONOMICS, based many of his theories of economic behaviour on marginal rather than average behaviour. For instance, given certain plausible assumptions, a profit-maximising firm will increase production up to the point where marginal revenue equals marginal cost. This is because if marginal revenue exceeded marginal cost, the firm could increase its PROFIT by producing an extra unit of output. Alternatively, if marginal cost exceeded marginal revenue, the firm could increase its profit by producing fewer units of output. In all walks of life, a basic rule of rational economic decision making is: do something only if the marginal utility you get from it exceeds the marginal cost of doing it.

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Marginal

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The market value of a company's SHARES: the quoted share PRICE multiplied by the total number of shares that the company has issued.

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Market capitalisation

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When a market left to itself does not allocate resources efficiently. Interventionist politicians usually allege market failure to justify their interventions. Economists have identified four main sorts or causes of market failure. The abuse of MARKET POWER, which can occur whenever a single buyer or seller can exert significant influence over PRICES or OUTPUT (see MONOPOLY and MONOPSONY). EXTERNALITIES - when the market does not take into account the impact of an economic activity on outsiders. For example, the market may ignore the costs imposed on outsiders by a firm polluting the environment. PUBLIC GOODS, such as national defence. How much defence would be provided if it were left to the market? Where there is incomplete or ASYMMETRIC INFORMATION or uncertainty. Abuse of market power is best tackled through ANTITRUST policy. Externalities can be reduced through REGULATION, a tax or subsidy, or by using property rights to force the market to take into account the WELFARE of all who are affected by an economic activity. The SUPPLY of public goods can be ensured by compelling everybody to pay for them through the tax system.

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Market failure

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Shorthand for the pressures from buyers and sellers in a market, rather than those coming from a GOVERNMENT planner or from REGULATION.

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Market forces

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When one buyer or seller in a market has the ability to exert significant influence over the quantity of goods and SERVICES traded or the PRICE at which they are sold. Market power does not exist when there is PERFECT COMPETITION, but it does when there is a MONOPOLY, MONOPSONY or OLIGOPOLY.

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Market power

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Probably the most successful programme of INTERNATIONAL AID and nation building in history. It was named after General George Marshall, an American secretary of state, who at the end of the second world war proposed giving aid to Western Europe to rebuild its war-torn economies. North America gave around 1% of its GDP in total between 1948 and 1952; most of it came from the United States and the rest from Canada. The Americans left it to the Europeans to work out the details on allocating aid, which may be why, according to most economic analyses, it achieved more success than latter day aid programmes in which most of the decisions on how the MONEY is spent are made by the donors. The main institution through which aid was administered was the Organisation for European Economic Co-operation (OEEC), which in 1961 became the OECD. Nowadays, whenever there is a proposal for the international community to rebuild an economy damaged by war, such as Iraq's in 2003, you are sure to hear the phrase 'new Marshall Plan'.

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Marshall Plan

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A British economist (1842-1924), who developed some of the most important concepts in MICROECONOMICS. In his best-known work, Principles of Economics, he retained the emphasis on the importance of costs, which was standard in CLASSICAL ECONOMICS. But he added to it, helping to create NEO-CLASSICAL ECONOMICS, by explaining that the OUTPUT and PRICE of a product are determined by both SUPPLY and DEMAND, and that MARGINAL costs and benefits are crucial. He was the first economist to explain that demand falls as price increases, and that therefore the DEMAND CURVE slopes downwards from left to right. He was also first with the concept of PRICE ELASTICITY of demand and CONSUMER SURPLUS.

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Marshall, Alfred

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The tendency for subsequent observations of a random variable to be closer to its mean than the current observation. For example, if the current number is 7, the average is 5, and there is mean reversion, then the next observation is likelier to be 6 than 8.

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Mean reversion

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Somewhere between SHORT-TERMISM, which is bad, and the LONG RUN, lies the hallowed ground of the medium term - far enough away to discourage myopic behaviour by decision makers but close enough to be meaningful. But not many governments say exactly how long they think the medium term is.

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Medium term

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How much it costs to change PRICES. Just as a restaurant has to print a new menu when it changes the price of its food, so many other FIRMS face a substantial outlay each time they cut or raise what they charge. Such menu costs mean that firms may be reluctant to change their prices every time there is a shift in the balance of SUPPLY and DEMAND, so there will be STICKY PRICES and the market for their OUTPUT will be in DISEQUILIBRIUM. The Internet may sharply reduce menu costs as it allows prices to be changed at the click of a mouse, which may improve EFFICIENCY by keeping markets more often in EQUILIBRIUM.

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Menu costs

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When two businesses join together, either by merging or by one company taking over the other. There are three sorts of mergers between FIRMS: HORIZONTAL INTEGRATION, in which two similar firms tie the knot; VERTICAL INTEGRATION, in which two firms at different stages in the SUPPLY chain get together; and DIVERSIFICATION, when two companies with nothing in common jump into bed. These can be a voluntary marriage of equals; a voluntary takeover of one firm by another; or a hostile takeover, in which the management of the target firm resists the advances of the buyer but is eventually forced to accept a deal by its current owners. For reasons that are not at all clear, merger activity generally happens in waves. One possible explanation is that when SHARE PRICES are low, many firms have a MARKET CAPITALISATION that is low relative to the value of their ASSETS. This makes them attractive to buyers (see TOBIN). In theory, the different sorts of mergers have different sorts of potential benefits. However, the damning lesson of merger waves stretching back over the past 50 years is that, with one big ex ception - the spate of LEVERAGED BUY-OUTS in the United States during the 1980s - they have often failed to deliver benefits that justify the costs.

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Mergers and acquisitions

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The study of the individual pieces that together make an economy. Contrast with MACROECONOMICS, the study of economy-wide phenomena such as GROWTH, INFLATION and UNEMPLOYMENT. Microeconomics considers issues such as how households reach decisions about CONSUMPTION and SAVING, how FIRMS set a PRICE for their OUTPUT, whether PRIVATISATION improves EFFICIENCY, whether a particular market has enough COMPETITION in it and how the market for LABOUR works.

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Microeconomics

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A minimum rate of pay that FIRMS are legally obliged to pay their workers. Most industrial countries have a minimum wage, although certain sorts of workers are often exempted, such as young people or part-timers. Most economists reckon that a minimum wage, if it is doing what it is meant to do, will lead to higher UNEMPLOYMENT than there would be without it. The main justification offered by politicians for having a minimum wage is that the wage that would be decided by buyers and sellers in a free market would be so low that it would be immoral for people to work for it. So the minimum wage should be above the market-clearing wage, in which case fewer workers would be demanded at that wage than would be hired at the market wage. How many fewer will depend on how far the minimum wage is above the market wage. Some economists have challenged this simple SUPPLY and DEMAND model. Several empirical studies have suggested that a minimum wage moderately above the free-market wage would not harm employment much and could (in rare circumstances) potentially raise it. These studies are not widely accepted among economists. Whatever it does for those in work, a minimum wage cannot help the majority of the very poorest people in most countries, who typically have no job in which to earn a minimum wage.

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Minimum wage

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The sum of a country's INFLATION and UNEMPLOYMENT rates. The higher the score, the greater is the economic misery.

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Misery index

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A market economy in which both private-sector FIRMS and firms owned by GOVERNMENT take part in economic activity. The proportions of public and private enterprise in the mix vary a great deal among countries. Since the 1980s, the public role in most mixed economies declined as NATIONALISATION gave way to PRIVATISATION.

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Mixed economy

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The easier it is for the FACTORS OF PRODUCTION to move to where they are most valuable, the more efficient the allocation of the world's scarce resources is likely to be and the faster GDP will grow. Can you sometimes have too much mobility? Certainly, some DEVELOPING COUNTRIES have suffered from HOT MONEY rushing into and then out of their markets.

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Mobility

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When economists make a number of simplified assumptions about how the economy, or some part of it, behaves, and then see what this implies in various different scenarios. MILTON FRIEDMAN argued that economic models should not be judged on the basis of the validity of their assumptions, but on the accuracy of their predictions. An expert billiards player, he said, may not know the laws of physics, but acts as if he knows such laws. So his behaviour could be predicted accurately with a model that assumes he knows the laws of physics. Likewise, the behaviour of people making economic decisions may be accurately predicted by a model that assumes their goal is, say, PROFIT MAXIMISATION, even if they are not actually conscious of this being their goal. The more complex the thing being modelled, the harder it is to get right. Economic FORECASTING has a poor overall track record. The more microeconomic the thing being modelled, the more likely it is that a model can be designed that will deliver accurate predictions.

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Modelling

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One of the most important and influential economic theories about finance and INVESTMENT. Modern portfolio theory is based upon the simple idea that DIVERSIFICATION can produce the same TOTAL RETURNS for less RISK. Combining many financial ASSETS in a portfolio is less risky than putting all your investment eggs in one basket. The theory has four basic premises. - Investors are RISK AVERSE. - SECURITIES are traded in efficient markets. - Risk should be analysed in terms of an investor's overall portfolio, rather than by looking at individual assets. - For every level of risk, there is an optimal portfolio of assets that will have the highest EXPECTED RETURNS. All of this seems comparatively straightforward now, except perhaps the bit about efficient markets. But it was shocking when it was put forward in the early 1950s by Harry Markowitz, who later won the Nobel prize for it.

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Modern portfolio theory

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Control the MONEY SUPPLY, and the rest of the economy will take care of itself. A school of economic thought that developed in opposition to post-1945 KEYNESIAN policies of DEMAND management, echoing earlier debates between MERCANTILISM and CLASSICAL ECONOMICS. Monetarism is based on the belief that INFLATION has its roots in the GOVERNMENT printing too much MONEY. It is closely associated with Milton MILTON FRIEDMAN, who argued, based on the QUANTITY THEORY OF MONEY, that government should keep the MONEY SUPPLY fairly steady, expanding it slightly each year mainly to allow for the natural GROWTH of the economy. If it did this, MARKET FORCES would efficiently solve the problems of INFLATION, UNEMPLOYMENT and RECESSION. Monetarism had its heyday in the early 1980s, when economists, governments and investors pounced eagerly on every new money-supply statistic, particularly in the United States and the UK.

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Monetarism

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Changes in the MONEY SUPPLY have no effect on real economic variables such as OUTPUT, real INTEREST rates and UNEMPLOYMENT. If the CENTRAL BANK doubles the money supply, the PRICE level will double too. Twice as many dollars means half as much bang for the buck. This theory, a core belief of CLASSICAL ECONOMICS, was first put forward in the 18th century by David Hume. He set out the classical dichotomy that economic variables come in two varieties, nominal and real, and that the things that influence nominal variables do not necessarily affect the real economy. Today few economists think that pure monetary neutrality exists in the real world, at least in the short run. Inflation does affect the real economy because, for instance, there may be STICKY PRICES or MONEY ILLUSION.

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Monetary neutrality

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Makes the world go round and comes in many forms, from shells and beads to GOLD coins to plastic or paper. It is better than BARTER in enabling an economy's scarce resources to be allocated efficiently. Money has three main qualities: as a medium of exchange, buyers can give it to sellers to pay for goods and services; as a unit of account, it can be used to add up apples and oranges in some common value; as a store of value, it can be used to transfer purchasing power into the future. A farmer who exchanges fruit for money can spend that money in the future; if he holds on to his fruit it might rot and no longer be useful for paying for something. INFLATION undermines the usefulness of money as a store of value, in particular, and also as a unit of account for comparing values at different points in time. HYPER-INFLATION may destroy confidence in a particular form of money even as a medium of exchange. Measures of LIQUIDITY describe how easily an ASSET can be exchanged for money (the easier this is, the more liquid is the asset).

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Money

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When people are misled by INFLATION into thinking that they are getting richer, when in fact the value of MONEY is declining. Whether, and how much, people are fooled by inflation is much debated by economists. Money illusion, a phrase coined by KEYNES, is used by some economists to argue that a small amount of inflation may not be a bad thing and could even be beneficial, helping to "grease the wheels" of the economy. Because of money illusion, workers like to see their nominal WAGES rise, giving them the illusion that their circumstances are improving, even though in real (inflation-adjusted) terms they may be no better off. During periods of high inflation double-digit pay rises (as well as, say, big increases in the value of their homes) can make people feel richer even if they are not really better off. When inflation is low, GROWTH in real incomes may hardly register.

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Money illusion

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Any market where MONEY and other liquid ASSETS (such as TREASURY BILLS) can be lent and borrowed for between a few hours and a few months. Contrast with CAPITAL MARKETS, where longer-term CAPITAL changes hands.

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Money markets

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The amount of MONEY available in an economy. Although it is a poor predictor of inflation, monetary growth can be a handy LEADING INDICATOR of economic activity. In many countries, there is a clear link between the growth of the real broad-money supply and that of real GDP.

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Money supply

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In monopolistic competition, there are fewer firms than in a perfectly competitive market and each can differentiate its products from the rest somewhat, perhaps by ADVERTISING or through small differences in design. These small differences form BARRIERS TO ENTRY. As a result, firms can earn some excess profits, although not as much as a pure monopoly, without a new entrant being able to reduce PRICES through COMPETITION. Prices are higher and OUTPUT lower than under perfect competition.

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Monopolistic Competition

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When the production of a good or service with no close substitutes is carried out by a single firm with the MARKET POWER to decide the PRICE of its OUTPUT. Contrast with PERFECT COMPETITION, in which no single firm can affect the price of what it produces. Typically, a monopoly will produce less, at a higher price, than would be the case for the entire market under perfect competition. It decides its price by calculating the quantity of output at which its MARGINAL revenue would equal its marginal cost, and then sets whatever price would enable it to sell exactly that quantity.

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Monopoly

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A market dominated by a single buyer. A monopsonist has the MARKET POWER to set the PRICE of whatever it is buying (from raw materials to LABOUR). Under PERFECT COMPETITION, by contrast, no individual buyer is big enough to affect the market price of anything.

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Monopsony

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One of two main sorts of MARKET FAILURE often associated with the provision of INSURANCE. The other is ADVERSE SELECTION. Moral hazard means that people with insurance may take greater risks than they would do without it because they know they are protected, so the insurer may get more claims than it bargained for.

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Moral hazard

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Equal treatment, at least, in international trade. If country A grants country B the status of most-favoured nation, it means that B's EXPORTS will face TARIFF that are no higher (and also no lower) than those applied to any other country that A calls a most-favoured nation. This will be the most favourable tariff treatment available to IMPORTS. Most-favoured nation treatment is one of the most important building blocks of the international trading system.

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Most-favoured nation

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Shorthand for the way in which a change in spending produces an even larger change in INCOME. For instance, suppose a GOVERNMENT loosens FISCAL POLICY, increasing net PUBLIC SPENDING by pumping an extra $10 billion into education. This has an immediate effect by increasing the income of teachers and of people who sell educational supplies or build or maintain schools. These people will in turn spend some of their extra money, putting more cash into the pockets of others, who spend some of it, and so on. In theory, this process could continue indefinitely, in which case the multiplier would have an infinite value. In practice, most people save some of their extra income rather than spend it. How much they spend will depend on their MARGINAL PROPENSITY to consume. The value of the multiplier can be calculated by this formula: multiplier = 1 / (1 - marginal propensity to consume) If the marginal propensity to consume is 0.5 (50 cents of an extra dollar), the multiplier is 2. In practice, it is often hard to measure the multiplier effect, or to predict how it will respond to, say, changes in MONETARY POLICY or fiscal policy.

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Multiplier

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Short for North American Free-Trade Agreement. In 1993, the United States, Mexico and Canada agreed to lower the barriers to trade among the three economies. The formation of this regional TRADE AREA was opposed by many politicians in all three countries. In the United States and Canada, in particular, there were fears that NAFTA would result in domestic job losses to cheaper locations in Mexico. In the early years of the agreement, however, most studies found that the economic gains far outweighed any costs.

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NAFTA

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An important concept in GAME THEORY, a Nash equilibrium occurs when each player is pursuing their best possible strategy in the full knowledge of the strategies of all other players. Once a Nash equilibrium is reached, nobody has any incentive to change their strategy. It is named after John Nash, a mathematician and Nobel prize-winning economist.

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Nash equilibrium

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Creating a country that works out of one that does not - because the old order has collapsed (as in the former Soviet Union), or been destroyed by war (Iraq), or never really functioned in the first place (Afghanistan). To transform a failed country can involve establishing order through the rule of law and creating legitimate government and other effective social institutions, as well as a credible currency and a functioning market economy. Nation building is rarely easy, and often fiendishly difficult, especially where there are deep ethnic, religious or political divisions in the population or the country has no history of ever functioning effectively. Outside expertise, such as from the world bank, and money (as in, most famouly, the Marshall Plan) can help, but they are no guarantee of success.

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Nation building

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Shorthand for everything that is produced, earned or spent in a country

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National income

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When a GOVERNMENT takes ownership of a private-sector business. The performance of nationalised firms has often, but not always, been poor compared with their private-sector counterparts.

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Nationalisation

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When a MONOPOLY occurs because it is more efficient for one firm to serve an entire market than for two or more FIRMS to do so, because of the sort of ECONOMIES OF SCALE available in that market. A common example is water distribution, in which the main cost is laying a network of pipes to deliver water. One firm can do the job at a lower AVERAGE cost per customer than two firms with competing networks of pipes. Monopolies can arise unnaturally by a firm acquiring sole ownership of a resource that is essential to the production of a good or service, or by a government granting a firm the legal right to be the sole producer. Other unnatural monopolies occur when a firm is much more efficient than its rivals for reasons other than economies of scale. Unlike some other sorts of monopoly, natural monopolies have little chance of being driven out of a market by more efficient new entrants. Thus REGULATION of natural monopolies may be needed to protect their captive consumers.

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Natural monopoly

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A controversial phrase, which actually means little more than the lowest rate of UNEMPLOYMENT at which the jobs market can be in stable EQUILIBRIUM. Synonymous with NAIRU.

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Natural rate of unemployment

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A way of building redistribution into the TAXATION system by taking MONEY from people with high incomes and paying it to people with low incomes. Because it takes place automatically through the tax system, it may attach less stigma to the receipt of financial help than some other forms of WELFARE assistance. However, it may also discourage recipients from working to increase their INCOME (see POVERTY TRAP), which is why some countries have introduced a form of negative income tax that is available only to the working poor. In the United States, this is known as the earned income tax credit.

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Negative income tax

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The school of ECONOMICS that developed the free-market ideas of CLASSICAL ECONOMICS into a full-scale model of how an economy works. The best-known neo-classical economist was ALFRED MARSHALL

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Neo-classical economics

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A measure used to help decide whether or not to proceed with an INVESTMENT. Net means that both the costs and benefits of the investment are in cluded. To calculate net present value (NPV), first add together all the expected benefits from the investment, now and in the future. Then add together all the expected costs. Then work out what these future benefits and costs are worth now by adjusting future cashflow using an appropriate DISCOUNT RATE. Then subtract the costs from the benefits. If the NPV is negative, then the investment cannot be justified by the EXPECTED RETURNS. If the NPV is positive, it can, although it pays to make comparisons with the NPVs of alternative investment opportunities before going ahead.

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Net present value (NPV)

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When the value of a good to a consumer changes because the number of people using it changes. For instance, owning a phone becomes more valuable as more people are plugged into the telephone network. Network effects are sometimes called network EXTERNALITY, although this implies, often wrongly, that the benefits from being part of a network are a sort of MARKET FAILURE. They give a huge COMPETITIVE ADVANTAGE to the firm that owns the network. This INCUMBENT ADVANTAGE arises because a new entrant must persuade people to join a network that starts with fewer members, and thus may be less valuable to them than the network they are currently in. This is why markets for products with network effects are often dominated by only a few firms or a single MONOPOLY. Some economists argue that many recent technological innovations, notably the Internet, have large positive network effects, which make possible much higher PRODUCTIVITY and growth than in the past.

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Network effect

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The value of anything expressed simply in the MONEY of the day. Since INFLATION means that money can lose its value over time, nominal figures can be misleading when used to compare values in different periods. It is better to compare their real value, by adjusting the nominal figures to remove the inflationary distortions.

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Nominal value

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Trying to win business from rivals other than by charging a lower PRICE. Methods include ADVERTISING, slightly differentiating your product, improving its quality, or offering free gifts or discounts on subsequent purchases. Non-price competition is particularly common when there is an OLIGOPOLY, perhaps because it can give an impression of fierce rivalry while the FIRMS are actually colluding to keep prices high.

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Non-price competition

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When average INCOME increases, the DEMAND for normal goods increases, too. The opposite of INFERIOR GOODS.

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Normal goods

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Economics that tries to change the world, by suggesting policies for increasing economic WELFARE. The opposite of POSITIVE ECONOMICS, which is content to try to describe the world as it is, rather than prescribe ways to make it better.

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Normative economics

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A statement that is being put to the test. In ECONOMETRICS, economists often start with a null hypothesis that a particular variable equals a particular number, then crunch their data to see if they can prove or disprove it, according to the laws of STATISTICAL SIGNIFICANCE. The null hypothesis chosen is often the reverse of what the experimenter actually believes; it may be put forward to allow the data to contradict it.

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Null hypothesis

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The Organisation for Economic Co-operation and Development, a Paris-based club for industrialised countries and the best of the rest. It was formed in 1961, building on the Organisation for European Economic Co-operation (OEEC), which had been established under the MARSHALL PLAN. By 2003, its membership had risen to 30 countries, from an original 20. Together, OECD countries produce two-thirds of the world's goods and SERVICES.

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OECD

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Where the usual rules of a person or firm's home country do not apply. It can be literally offshore, as in the case of investors moving their MONEY to a Caribbean island TAX HAVEN. Or it can be merely legally offshore, as in the case of certain financial transactions that take place within, say, the City of London, which are deemed for regulatory purposes to have taken place offshore.

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Offshore

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A description of what happens to UNEMPLOYMENT when the rate of GROWTH of GDP changes, based on empirical research by Arthur Okun (1928-80). It predicts that if GDP grows at around 3% a year, the jobless rate will be unchanged. If it grows faster, the unemployment rate will fall by half of what the growth rate exceeds 3% by; that is, if GDP grows by 5%, unemployment will fall by 1 percentage point. Likewise, a lesser, say 2%, increase in GDP would be associated with a half a percentage point increase in the jobless rate. This relationship is not carved in stone, as it merely reflects the American economy during the period studied by Okun. Even so, in most econo mies Okun's Law is a reasonable rule of thumb for estimating the likely impact on jobs of changes in OUTPUT.

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Okun's law

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When a few FIRMS dominate a market. Often they can together behave as if they were a single MONOPOLY, perhaps by forming a CARTEL. Or they may collude informally, by preferring gentle NON-PRICE COMPETITION to a bloody PRICE war. Because what one firm can do depends on what the other firms do, the behaviour of oligopolists is hard to predict. When they do compete on price, they may produce as much and charge as little as if they were in a market with PERFECT COMPETITION.

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Oligopoly

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The Organisation of Petroleum Exporting Countries, a CARTEL set up in 1960 that wrought havoc in industrialised countries during the 1970s and early 1980s by forcing up oil prices (which quadrupled in a few weeks during 1973-74 alone), resulting in high INFLATION and slow GROWTH.

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OPEC

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An economy that allows the unrestricted flow of people, CAPITAL, goods and SERVICES across its borders; the opposite of a CLOSED ECONOMY.

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Open economy

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CENTRAL BANKS buying and selling SECURITIES in the open market, as a way of controlling INTEREST rates or the GROWTH of the MONEY SUPPLY. By selling more securities, they can mop up surplus MONEY; buying securities adds to the money supply. The securities traded by central banks are mostly GOVERNMENT BONDS and TREASURY BILLS, although they sometimes buy or sell commercial securities.

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Open-market operations

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The true cost of something is what you give up to get it. This includes not only the money spent in buying (or doing) the something, but also the economic benefits (UTILITY) that you did without because you bought (or did) that particular something and thus can no longer buy (or do) something else. For example, the opportunity cost of choosing to train as a lawyer is not merely the tuition fees, PRICE of books, and so on, but also the fact that you are no longer able to spend your time holding down a salaried job or developing your skills as a footballer. These lost opportunities may represent a significant loss of utility. Going for a walk may appear to cost nothing, until you consider the opportunity forgone to use that time earning money. Everything you do has an opportunity cost (see SHADOW PRICE). ECONOMICS is primarily about the efficient use of scarce resources, and the notion of opportunity cost plays a crucial part in ensuring that resources are indeed being used efficiently.

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Opportunity cost

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As good as it gets, given the constraints you are operating within. For the concept of optimum to mean anything, there must be both a goal, say, to maximise economic WELFARE, and a set of constraints, such as an available stock of scarce economic resources. Optimising is the process of doing the best you can in the circumstances.

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Optimum

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The fruit of economic activity: whatever is produced by using the FACTORS OF PRODUCTION.

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Output

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How far an economy's current OUTPUT is below what it would be at full CAPACITY.

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Output gap

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Shifting activities that used to be done inside a firm to an outside company, which can do them more cost-effectively. Big firms have outsourced a growing amount of their business since the early 1990s, including increasingly offshoring work to cheaper employees at firms in countries such as India. This has become politically controversial in countries that lose jobs as a result of offshoring. However, a firm that outsources can improve its efficiency by focusing on those activities in which it can create the most value; the firm to which it outsources can also increase efficiency by specialising in that activity. That, at least, is the theory. In practice, managing the outsourcing process can be tricky, particularly for more complex activities.

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Outsourcing

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In the case of drugs, those that can be purchased without a prescription from a doctor. In the case of financial SECURITIES, those that are bought or sold through a private dealer or BANK rather than on a financial exchange.

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Over the counter

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When an economy is growing too fast and its productive CAPACITY cannot keep up with DEMAND. It often boils over into INFLATION.

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Overheating

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The common tendency of PRICES in FINANCIAL MARKETS initially to move further than would seem strictly necessary in response to changes in the fundamentals that should, in theory, determine value. One reason may be that in the absence of perfect INFORMATION, investors move in herds, rushing in and out of markets on rumour.

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Overshooting

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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.

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Pareto efficiency

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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.

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Paris Club

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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.

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Patents

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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. (QWERTY keyboard)

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Path dependence

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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. Uber surge/peak pricing

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Peak pricing

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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%.

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Percentage point

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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.

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Perfect competition

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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.

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Permanent income hypothesis

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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.

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Phillips curve

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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.

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Pigou effect

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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 owning 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.

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Positional goods

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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.

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Positive economics

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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).

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Precautionary motive

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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.

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Predatory pricing

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What consumers want

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Preference

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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

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Price

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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.

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Price discrimination

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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.

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Price elasticity

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The process by which markets set PRICES.

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Price mechanism

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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.

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Price regulation

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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.

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Price/earnings ratio

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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.

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Prisoners' dilemma

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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.

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Private equity

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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.

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Privatisation

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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 are 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

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Probability

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The difference between what a supplier 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.

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Producer surplus

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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).

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Production function

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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.

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Productivity

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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.

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Profit

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A firm's PROFIT expressed as a percentage of its turnover or sales.

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Profit margin

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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.

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Profit maximisation

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TAXATION that takes a larger proportion of a taxpayer's INCOME the higher the income is.

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Progressive taxation

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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.

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Propensity

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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.

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Property rights

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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).

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Prospect theory

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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. (See also global public goods.)

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Public goods

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A firm providing essential services to the public, such as water, electricity and postal services, usually involving elements of NATURAL MONOPOLY.

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Public utility

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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?

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Public-private

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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. (See BIG MAC INDEX.)

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Purchasing power parity

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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.

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Agency costs

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The foundation stone of MONETARISM. The theory says that the quantity of MONEY available in an economy determines the value of money. Increases in the MONEY SUPPLY are the main cause of INFLATION. This is why Milton FRIEDMAN claimed that 'inflation is always and everywhere a monetary phenomenon'. The theory is built on the Fisher equation, MV = PT, named after Irving Fisher (1867-1947). M is the stock of money, V is the VELOCITY OF CIRCULATION, P is the average PRICE level and T is the number of transactions in the economy. The equation says, simply and obviously, that the quantity of money spent equals the quantity of money used. The quantity theory, in its purest form, assumes that V and T are both constant, at least in the short-run. Thus any change in M leads directly to a change in P. In other words, increase the money supply and you simply cause inflation. In the 1930s, KEYNES challenged this theory, which was orthodoxy until then. Increases in the money supply seemed to lead to a fall in the velocity of circulation and to increases in real INCOME, contradicting the classical dichotomy (see MONETARY NEUTRALITY). Later, monetarists such as Friedman conceded that V could changein response to variations in M, but did so only in stable, predictable ways that did not challenge the thrust of the theory. Even so, monetarist policies did not perform well when they were applied in many countries during the 1980s, as even Friedman has since conceded.

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Quantity theory of money

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Market failure? Not necessarily. Usually a queue reflects a PRICE that is set too low, so that DEMAND exceeds SUPPLY, so some customers have to wait to buy the product. But a queue may also be the result of deliberate rationing by a producer, perhaps to attract attention - by a restaurant that wants to appear popular, say. Customers may regard a queue, such as a waiting list for health treatment, as a fairer way to distribute the product than using the PRICE MECHANISM.

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Queueing

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A form of PROTECTIONISM. A country imposes limits on the number of goods that can be imported from another country. For instance, France may limit the number of cars imported from Japan to, say, 20,000 a year. As a result of limiting SUPPLY, the PRICE of the imported good is higher than it would be under FREE TRADE, thus making life easier for domestic producers.

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Quota

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The number of people of working age without a job is usually expressed as an unemployment rate, a percentage of the workforce. This rate generally rises and falls in step with the BUSINESS CYCLE--cyclical unemployment. But some joblessness is not caused by the cycle, being STRUCTURAL UNEMPLOYMENT. There are also VOLUNTARY UNEMPLOYMENT and involuntary unemployment. Some people who are not in work have no interest in getting a job and probably should not be regarded as part of the workforce. Others choose to be out of work briefly while they look for, or are waiting to start, a new job. This is known as FRICTIONAL UNEMPLOYMENT. In the 1950s, the PHILLIPS CURVE seemed to show that policymakers could reduce unemployment by having higher INFLATION. Economists now say there is a NAIRU (non-accelerating inflation rate of unemployment). In most markets, PRICES change to keep SUPPLY and DEMAND in EQUILIBRIUM; in the LABOUR market, wages are often sticky, being slow to fall when demand declines or supply increases. In these situations, unemployment often increases. One way to tackle this may be to boost demand. Another is to increase LABOUR MARKET FLEXIBILITY.

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Unemployment

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When unemployed people who receive benefits, either from the GOVERNMENT or from private CHARITY, are deterred from taking a new job because the reduction or removal of benefit if they do will make them worse off. Also known as the POVERTY TRAP, it can be addressed, to an extent, by continuing to pay benefit for a while to unemployed people returning to work.

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Unemployment trap

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Charging INTEREST, or, at least, an exorbitant rate of interest. Plato and Aristotle reckoned that charging interest was 'contrary to the nature of things'; Cato considered it on a par with homicide. For many centuries, the Catholic Church regarded as sinful the charging of any interest by lenders and it was not allowed in Catholic countries, although Jews were exempted, provided they did not charge excessive rates. According to Pope Benedict XIV, in 1745, interest should be regarded as a sin because "the creditor desires more than he has given". In most modern economies, interest is recognised as a crucial part of the economic system, a reward to the lender for the RISK taken in making a loan. Even so, most developed countries have some form of usury law imposing limits on how high interest charges can be. These aim to protect borrowers from being exploited by unscrupulous loan sharks.

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Usury

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Economist-speak for a good thing; a measure of satisfaction. (See also WELFARE.) Underlying most economic theory is the assumption that people do things because doing so gives them utility. People want as much utility as they can get. However, the more they have, the less difference an additional unit of utility will make - there is diminishing MARGINAL utility. Utility is not the same as utilitarianism, a political philosophy based on achieving the greatest happiness of the greatest number.

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Utility

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This usually refers to FIRMS, where it is defined as the value of the firm's OUTPUT minus the value of all its inputs purchased from other firms. It is therefore a measure of the PROFIT earned by a particular firm plus the wages it has paid. As a rule, the more value a firm can add to a product, the more successful it will be. In many countries, the main form of INDIRECT TAXATION is value-added tax, which is levied on the value created at each stage of production. However, it is paid, ultimately, by whoever consumes the finished product. Another definition of value added refers to the change in the overall economic value of a company. This takes into account changes in the combined value of its SHARES, ASSETS, DEBT and other liabilities. Part of the pay of company bosses is often linked to how much economic value is added to the company under their management.

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Value added

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Value at risk models, widely used for RISK MANAGEMENT by BANKS and other financial institutions, use complex computer algorithms to calculate the maximum that the institution could lose in a single day's trading. These models seem to work well in normal conditions but not, alas, during financial crises, which is arguably when it is most necessary to know how much value is at RISK.

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Value at risk

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Part of a firm's production costs that changes according to how much OUTPUT it produces. Contrast with FIXED COSTS. Examples include some purchases of raw materials and workers' overtime payments. In the long run, most costs can be varied.

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Variable costs

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The speed with which MONEY whizzes around the economy, or, put another way, the number of times it changes hands. Technically, it is measured as GNP divided by the MONEY SUPPLY (pick your own definition). It is an important ingredient of the QUANTITY THEORY OF MONEY.

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Velocity of circulation

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PRIVATE EQUITY to help new companies grow. A valuable alternative source of finance for ENTREPRENEURS, who might otherwise have to rely on a loan from a probably RISK AVERSE bank manager. The United States has by far the world's biggest venture capital industry. Some economists reckon that this is why more innovative new firms have become successful there. As legend has it, with a bright idea, a garage to work in and some venture capital, anybody can create a Microsoft. However, the bursting of the dotcom bubble in 2000 threw American venture capital into a severe recession, damaging its reputation for financing profitable innovation.

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Venture capital

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One way to keep TAXATION fair. Vertical equity is the principle that people with a greater ability to pay should hand over more tax to the GOVERNMENT than those with a lesser ability to pay.

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Vertical equity

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Merging with a company at a different stage in the production process, for instance, a car maker merging with a car retailer or a parts supplier. Unlike HORIZONTAL INTEGRATION, it is likely to raise ANTITRUST concerns only if one of the companies already enjoys some MONOPOLY power, which the deal might allow it to extend into a new market.

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Vertical integration

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Physical EXPORTS and IMPORTS, such as coal, computer chips and cars. Also known as merchandise trade. Contrast with INVISIBLE TRADE.

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Visible trade

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The most widely accepted measure of risk in financial markets is the amount by which the price of a security swings up and down. The more volatile the price, the riskier is the security. Not least because there is no obvious alternative, economists often use past volatility to forecast the future risk of a security. However, as the saying goes, past results are not necessarily guides to future performance.

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Volatility

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Unemployment through opting not to work, even though there are jobs available. This is the joblessness that remains when there is otherwise FULL EMPLOYMENT. It includes FRICTIONAL UNEMPLOYMENT as a result of people changing jobs, people not working while they undertake JOB SEARCH and people who just do not want to work.

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Voluntary unemployment

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The difference between basic pay and total earnings. Wage drift consists of things such as overtime payments, bonuses, PROFIT share and performance-related pay. It usually increases during periods of strong GROWTH and declines during an economic downturn.

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Wage drift

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The PRICE of LABOUR. In theory, wages ought to change so that the SUPPLY and DEMAND in the labour market are always in EQUILIBRIUM. In practice, wages are often sticky, especially in a downward direction: when demand for labour falls, wages do not fall. In this situation, the fall in demand results in higher involuntary UNEMPLOYMENT. Trade UNIONS may use collective bargaining to keep wages above the market-clearing rate. Furthermore, many governments impose a MINIMUM WAGE that employers must pay. FIRMS may choose to pay above the equilibrium wage to increase the PRODUCTIVITY of workers. Such so-called EFFICIENCY WAGES may make workers less likely to join another firm, so cutting the employer's hiring and training costs. They may encourage workers to do a better job. They may also attract a higher quality of worker than wages at the market-clearing rate; better workers may have a higher RESERVATION WAGE (the lowest wage for which they are willing to work) than the market-clearing equilibrium. In recent years, employers have tried to reduce wage stickiness by increasing the proportion of pay that is linked to the performance of their firm. Thus if falling demand reduces the employer's PROFIT the pay of its employees falls automatically, so it does not have to lay off as many workers as it otherwise would. Performance-related wages can also reduce AGENCY COSTS by giving hired hands a stronger incentive to do a good job.

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Wages

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As people get wealthier, they consume more. This wealth effect has important consequences for MONETARY POLICY. When there is an INTEREST RATE increase, future INCOME from ASSETS such as EQUITIES must be discounted at a higher rate than before. As a result their owners feel poorer and spend less. A cut in interest rates has the opposite effect. Economists disagree on the wealth ELASTICITY of CONSUMPTION: how much consumer spending would rise if wealth increased by, say, 1%. Different consumers may have different wealth elasticity. If most of the increase in wealth goes to poorer people this may have a different wealth effect than if most of it went to people who are already wealthy. The source of the wealth increase may also matter. If SHARE PRICES rise or interest rates fall, consumers may be slow to spend out of their increased wealth if they think the increase may be temporary. However, if they think a sharp rise in share prices is permanent and the stockmarket then tumbles, the result may be that consumption falls by enough to cause a RECESSION. The wealth effect of rising HOUSE PRICES is particularly uncertain.

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Wealth effect

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In most countries, the majority of wealth is concentrated in a fairly small number of hands. This makes a wealth tax appealing to politicians, as it should allow substantial amounts of revenue to be raised from comparatively few people, allowing the TAX BURDEN on the majority of the POPULATION to be kept down. It also appeals because it promotes meritocracy by making it harder to be born with a silver spoon in your mouth. A wealth tax reduces the disparities in wealth rather than INCOME that are the biggest determinant of how the scales are weighted for succeeding generations. What could be better than a tax that produces lots of money for the GOVERNMENT and strikes most voters as being extremely fair? Wealth taxes come in two main forms. CAPITAL transfer taxes are levied when wealth changes hands, either at death (inheritance tax) or through donation (gift tax). Annual wealth taxes are levied each year as a fraction of the taxpayer's net worth. Some people regard CAPITAL GAINS tax as a wealth tax, but, strictly speaking, it is a tax on the income earned on capital, rather than a wealth tax on the capital itself.

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Wealth tax

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At the start of the 21st century, the total OUTPUT of the American economy weighed roughly the same as it did 100 years earlier. Yet the value of that output, in REAL TERMS, was 20 times greater. Output is increasingly weightless, produced from INTELLECTUAL CAPITAL rather than physical materials. Production has shifted from steel, heavy copper wire and vacuum tubes to microprocessors, fine fibre-optic cables and transistors. SERVICES have increased their share of GDP. This weightless or dematerialised economy, most economists agree, is not just lighter but also more efficient.

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Weightless economy

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Americans use welfare as shorthand for GOVERNMENT handouts to the poor. Economists use it to describe the well being of an individual or society, as in 'Are tax cuts welfare-enhancing?'. This is economist-speak for 'Will tax cuts improve the overall well being of the country?'

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Welfare

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Economics with a heart. The study of how different forms of economic activity and different methods of allocating scarce resources affect the well being of different individuals or countries. WELFARE economics focuses on questions about EQUITY as well as EFFICIENCY.

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Welfare economics

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Active LABOUR market policies, in which GOVERNMENT handouts to the unemployed come with strings attached, designed to get the recipient off welfare and back to work as quickly as possible.

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Welfare to work

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INCOME you do not expect, such as winning a lottery prize. Economists have long argued about whether people are likely to save such windfalls or spend them. According to the PERMANENT INCOME HYPOTHESIS, favoured by most economists, people save the lion's share of windfall gains. But real life often contradicts this; ask any lottery winner.

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Windfall gains

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A controversial concept, often used by politicians to justify imposing a TAX on PROFIT that in theory is earned unexpectedly, through circumstances beyond the control of the company concerned, and is thus deemed undeserved and ripe for the taking by the tax authorities. As the profits were neither expected nor a result of the efforts of the firm, taxing them should not harm the firm's incentives to maximise future profits. The problem comes when greedy politicians start claiming that profits are windfalls when in fact they are deserved and expected. Then taxing them sends a signal to FIRMS that they should not try too hard to make profits, as if they do too well they will not get to keep the profits anyway. If this became widely believed, effort would probably decline and economic GROWTH would be slower.

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Windfall profit

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No time for losers. In certain jobs, the market pays individuals not according to their absolute performance but according to their performance relative to others. The INCOME of window cleaners depends upon how many windows they clean, but investment bankers' pay may depend upon their performance ranking. Slightly more talented window cleaners will make only a small difference to the transparency of their customers' windows, but in the markets for selling BONDS that slight edge can mean everything. Rewards at the top are therefore disproportionately high, and rewards below the top are disproportionately low. People in these professions are often willing to work for very little just to have the chance to compete for the top job and the jackpot that comes with it.

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Winner-takes-all markets

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A tax that is collected at source, before the taxpayer has seen the INCOME or CAPITAL to which the tax applies. In other words, that part of the income or capital due in tax is withheld from the taxpayer, who therefore cannot easily avoid paying the tax. Withholding taxes are frequently imposed on INTEREST and DIVIDENDS.

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Withholding tax

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Producing OUTPUT at the minimum possible cost. This is not enough to ensure the best sort of economic EFFICIENCY, which maximises society's total CONSUMER plus PRODUCER SURPLUS, because the quantity of output produced may not be ideal. For instance, a MONOPOLY can be an X-efficient producer, but in order to maximise its PROFIT it may produce a different quantity of output than there would be in a surplus-maximising market with PERFECT COMPETITION.

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X-efficiency

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The annual income from a SECURITY, expressed as a percentage of the current market PRICE of the security. The yield on a SHARE is its DIVIDEND divided by its price. A BOND yield is also known as its INTEREST RATE: the annual coupon divided by the market price.

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Yield

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Shorthand for comparisons of the INTEREST RATE on GOVERNMENT BONDS of different maturity. If investors think it is riskier to buy a bond with 15 years until it matures than a bond with five years of life, they will demand a higher interest rate (YIELD) on the longer-dated bond. If so, the yield curve will slope upwards from left (the shorter maturities) to right. It is normal for the yield curve to be positive (upward sloping, left to right) simply because investors normally demand compensation for the added RISK of holding longer-term SECURITIES. Historically, a downward-sloping (or inverted) yield curve has been an indicator of RECESSION on the horizon, or, at least, that investors expect the CENTRAL BANK to cut short-term interest rates in the near future. A flat yield curve means that investors are indifferent to maturity risk, but this is unusual. When the yield curve as a whole moves higher, it means that investors are more worried that INFLATION will rise for the foreseeable future and therefore that higher interest rates will be needed. When the whole curve moves lower, it means that investors have a rosier inflationary outlook. Even if the direction (up or down) of a yield curve is unchanged, useful information can be gleaned from changes in the SPREADS between yields on bonds of different maturities and on different sorts of bonds with the same maturity (such as government bonds versus corporate bonds, or thinly traded bonds versus highly liquid bonds).

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Yield curve

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A way of comparing the performance of BONDS and SHARES. The gap is defined as the AVERAGE YIELD on equities minus the average yield on bonds. Because shares are usually riskier investments than bonds, you might expect them to have a higher yield. In practice, the yield gap is often negative, with bonds yielding more than equities. This is not because investors regard equities as safer than bonds (see EQUITY RISK PREMIUM). Rather, it is that they expect most of the benefit from buying shares to come from an increase in their PRICE (CAPITAL appreciation) rather than from DIVIDEND payments. Bond investors usually expect more of their gains to come from coupon payments. They also worry that INFLATION will erode the REAL VALUE of future coupons, making them value current payments more highly than those due in years to come. Moreover, the usefulness of the dividend yield as a guide to the performance of shares has declined since the early 1990s, as increasingly companies have chosen to return cash to shareholders by buying back their own shares rather than paying out bigger dividends.

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Yield gap

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When the gains made by winners in an economic transaction equal the losses suffered by the losers. It is identified as a special case in GAME THEORY. Most economic transactions are in some sense positive-sum games. But in popular discussion of economic issues, there are often examples of a mistaken zero-sum mentality, such as "PROFIT comes at the expense of WAGES", "higher PRODUCTIVITY means fewer jobs", and "IMPORTS mean fewer jobs here".

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Zero-sum game

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An indicator of the reliability of a relationship identified by REGRESSION ANALYSIS. An R2 of 0.8 indicates that 80% of the change in one variable is explained by a change in the related variable.

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R squared

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Impossible to predict the next step. EFFICIENT MARKET THEORY says that the PRICES of many financial ASSETS, such as SHARES, follow a random walk. In other words, there is no way of knowing whether the next change in the price will be up or down, or by how much it will rise or fall. The reason is that in an efficient market, all the INFORMATION that would allow an investor to predict the next price move is already reflected in the current price. This belief has led some economists to argue that investors cannot consistently outperform the market. But some economists argue that asset prices are predictable (they follow a non-random walk) and that markets are not efficient.

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Random walk

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A way to measure economic success, albeit one that can be manipulated quite easily. It is calculated by expressing the economic gain (usually PROFIT) as a percentage of the CAPITAL used to produce it.

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Rate of return

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An approach to REGULATION often used for a PUBLIC UTILITY to stop it exploiting MONOPOLY power. A public utility is forbidden to earn above a certain RATE OF RETURN decided by the regulator. In practice, this often encourages the utility to be inefficient, slow to innovate and quick to spend money on such things as big offices and executive jets, to keep down its PROFIT and thus the rate of return. Contrast with PRICE REGULATION.

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Rate of return regulation

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A guide to the riskiness of a FINANCIAL INSTRUMENT provided by a ratings agency, such as Moody's, Standard and Poor's and Fitch IBCA. These measures of CREDIT quality are mostly offered on marketable GOVERNMENT and corporate DEBT. A triple-A or A++ rating represents a low risk of DEFAULT; a C or D rating an extreme risk of, or actual, default. Debt PRICES and YIELDS often (but not always) reflect these ratings.

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Ratings

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How some economists believe that people think about the future. Nobody can predict the future perfectly; but rational expectations theory assumes that, over time, unexpected events (SHOCKS) will cancel out each other and that on average people's expectations about the future will be accurate. This is because they form their expectations on a rational basis, using all the INFORMATION available to them optimally, and learn from their mistakes. This is in contrast to other theories of how people look ahead, such as ADAPTIVE EXPECTATIONS, in which people base their predictions on past trends and changes in trends, and BEHAVIOURAL ECONOMICS, which assumes that expectations are somewhat irrational as a result of psychological biases.

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Rational expectations

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Falling INFLATION and INTEREST rates lead to higher spending (see WEALTH EFFECT).

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Real balance effect

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An EXCHANGE RATE that has been adjusted to take account of any difference in the rate of INFLATION in the two countries whose currency is being exchanged.

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Real exchange rate

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The INTEREST RATE less the rate of INFLATION.

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Real interest rate

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Broadly speaking, a period of slow or negative economic GROWTH, usually accompanied by rising UNEMPLOYMENT. Economists have two more precise definitions of a recession. The first, which can be hard to prove, is when an economy is growing at less than its long-term trend rate of growth and has spare CAPACITY. The second is two consecutive quarters of falling GDP.

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Recession

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Not lending to people in certain poor or troubled neighbourhoods - drawn with a red line on a map - simply because they live there, regardless of their CREDIT-worthiness judged by other criteria.

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Redlining

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Number-crunching to discover the relationship between different economic variables. The findings of this statistical technique should always be taken with a pinch of salt. How big a pinch can vary considerably and is indicated by the degree of STATISTICAL SIGNIFICANCE and R SQUARED. The relationship between a dependent variable (GDP, say) and a set of explanatory variables (DEMAND, INTEREST rates, CAPITAL, UNEMPLOYMENT, and so on) is expressed as a regression equation.

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Regression analysis

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A tax that takes a smaller proportion of INCOME as the taxpayer's income rises, for example, a fixed-rate vehicle tax that eats up a much larger slice of a poor person's income than a rich person's income. This goes against the principle of VERTICAL EQUITY, which many people think should be at the heart of any fair tax system.

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Regressive tax

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Exploiting loopholes in REGULATION, and perhaps making the regulation useless in the process. This is often done by international investors that use DERIVATIVES to find ways around a country's financial regulations.

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Regulatory arbitrage

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People often care more about their relative well being than their absolute well being. Someone who prefers a $100 a week pay rise when a colleague gets $50 to both of them getting a $200 increase, for example. Poor people may consume more of their INCOME than rich people do because they want to reduce the gap in their CONSUMPTION levels. The relative income hypothesis, set out by James Duesenberry, says that a household's consumption depends partly on its income relative to other families. Contrast with PERMANENT INCOME HYPOTHESIS.

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Relative income hypothesis

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Confusingly, rent has two different meanings for economists. The first is the commonplace definition: the INCOME from hiring out LAND or other durable goods. The second, also known as economic rent, is a measure of MARKET POWER: the difference between what a FACTOR OF PRODUCTION is paid and how much it would need to be paid to remain in its current use. A soccer star may be paid $50,000 a week to play for his team when he would be willing to turn out for only $10,000, so his economic rent is $40,000 a week. In PERFECT COMPETITION, there are no economic rents, as new FIRMS enter a market and compete until PRICES fall and all rent is eliminated. Reducing rent does not change production decisions, so economic rent can be taxed without any adverse impact on the real economy, assuming that it really is rent.

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Rent

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Cutting yourself a bigger slice of the cake rather than making the cake bigger. Trying to make more money without producing more for customers. Classic examples of rent-seeking, a phrase coined by an economist, Gordon Tullock, include: a protection racket, in which the gang takes a cut from the shopkeeper's PROFIT; a CARTEL of FIRMS agreeing to raise PRICES; a UNION demanding higher WAGES without offering any increase in PRODUCTIVITY; lobbying the GOVERNMENT for tax, spending or regulatory policies that benefit the lobbyists at the expense of taxpayers or consumers or some other rivals. Whether legal or illegal, as they do not create any value, rent-seeking activities can impose large costs on an economy.

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Rent-seeking

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What it would cost today to replace a FIRM's existing ASSETS.

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Replacement cost

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The fertility rate required in a country to keep its population steady.

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Replacement rate

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The minimum EXPECTED RETURN you require from an INVESTMENT to be willing to go ahead with it.

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Required return

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Changing the payment schedule for a DEBT by agreement between borrower and lender. This is usually done when the borrower is struggling to make payments under the original schedule.

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Rescheduling

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The lowest WAGE for which a person will work.

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Reservation wage

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The fraction of its deposits that a BANK holds as RESERVES.

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Reserve ratio

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Regulations governing the minimum amount of RESERVES that a BANK must hold against deposits.

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Reserve requirements

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This is the notion that what you want is revealed by what you do, not by what you say. Actions speak louder than words.

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Revealed preference

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The process of bearing the RISK you want to bear, and minimising your exposure to the risk you do not want. This can be done in several ways: not doing things that carry a particular risk; HEDGING; DIVERSIFICATION; and buying INSURANCE.

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Risk management

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The extra RETURN that investors require to hold a risky ASSET instead of a risk-free one; the difference between the EXPECTED RETURNS from a risky INVESTMENT and the risk-free rate.

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Risk premium

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Protection from the rough seas of REGULATION. Laws and regulations often include a safe harbour clause that sets out the circumstances in which otherwise regulated FIRMS or individuals can do something without regulatory oversight or interference.

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Safe harbour

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Settling for what is good enough, rather than the best that is possible. This may occur in any situation in which decision makers are trying to pursue more than one goal at a time. CLASSICAL ECONOMICS and NEO-CLASSICAL ECONOMICS assume that individuals, FIRMS and GOVERNMENTS try to achieve the OPTIMUM, best possible outcome from their decisions. Satisficing assumes they decide for each goal a level of achievement that would be good enough and try to find a way to achieve all of these sub-optimal goals at once. This approach to decision making is commonplace in behavioural economics. It can be regarded as a realist's theory of how decisions are taken. The concept was invented by Herbert Simon (1916-2001), a Nobel prize-winning economist, in his book, Models of Man, in 1957.

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Satisficing

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Any INCOME that is not spent. Ultimately, savings are the source of INVESTMENT in an economy, although domestic savings may be supplemented by CAPITAL from foreign savers or themselves be invested abroad.

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Savings

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The ease with which the SUPPLY of an economic product or process can be expanded to meet increased DEMAND. Recent technological advances have led some economists to talk about the growing importance of instant scalability. For example, once a piece of software has been written it can be made available in an instant over the Internet to unlimited numbers of users for almost no cost. This potentially allows a new product to enter and win market share far more quickly than ever before, intensifying COMPETITION and perhaps accelerating the process of creative destruction

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Scalability

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Supplies of the FACTORS OF PRODUCTION are not unlimited. This is why choices have to be made about how best to use them. In economic terms, it means simply that needs and wants exceed the resources available to meet them, which is as common in rich countries as in poor ones.

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Scarcity

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Testing your plans against various possible scenarios to see what might happen should things not go as you hope. Scenario analysis is an important technique in RISK MANAGEMENT, helping FIRMS and especially financial institutions to ensure that they do not take on too much RISK. Its usefulness does of course depend on risk managers coming up with the right scenarios.

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Scenario analysis

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The cost of finding what you want. The economic cost of buying something is not simply the PRICE you pay. Finding what you want and ensuring that it is competitively priced can be expensive, be it the financial cost of physically getting to a marketplace or the OPPORTUNITY COST of time spent fact-finding. Search costs mean that people often take decisions without all the relevant INFORMATION, which can result in inefficiency. Technological changes such as the internet may sharply reduce search costs, and thus lead to more efficient decision making.

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Search costs

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There are seasonal patterns in many economic activities; for instance, there is less construction in winter than in summer, and spending in shops soars as Christmas approaches. To reveal underlying trends, statistics reflecting only part of the year are often adjusted to iron out seasonal variations.

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Seasonally adjusted

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As we do not live in a perfect world, how useful are economic theories based on the assumption that we do? Second-best theory, set out in 1956 by Richard Lipsey and Kelvin Lancaster (1924-99), looks at what happens when the assumptions of an economic model are not fully met. They found that in situations where not all the conditions are met, the second-best situation - that is, meeting as many of the other conditions as possible - may not result in the OPTIMUM solution. Indeed, reckoned Lipsey and Lancaster, in general, when one optimal equilibrium condition is not satisfied all of the other equilibrium conditions will change.

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Second-best theory

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Financial contracts, such as BONDS, SHARES or DERIVATIVES, that grant the owner a stake in an ASSET. Such securities account for most of what is traded in the FINANCIAL MARKETS.

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Securities

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A market in which the seller seems to have the upper hand and so can charge a higher PRICE than in a BUYER'S MARKET.

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Seller's market

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The order in which CREDITORS are entitled to be repaid. In the event of a BANKRUPTCY, senior DEBT must be paid off before junior debt. Because junior debt has a lower chance of being repaid than senior debt, it carries more RISK, and thus typically pays a higher YIELD.

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Seniority

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Shorthand for implementing economic reforms in the right order. In recent years, this has become a hot topic in development economics.

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Sequencing

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Products of economic activity that you can't drop on your foot, ranging from hairdressing to websites.

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Services

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The true economic PRICE of an activity: the OPPORTUNITY COST. Shadow prices can be calculated for those goods and SERVICES that do not have a market price, perhaps because they are set by GOVERNMENT. Shadow pricing is often used in COST-BENEFIT ANALYSIS, where the whole purpose of the analysis is to capture all the variables involved in a decision, not merely those for which market prices exist.

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Shadow price

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Putting shareholders first; the notion that all business activity should aim to maximise the total value of a company's SHARES. Some critics argue that concentrating on shareholder value will be harmful to a company's other STAKEHOLDERS, such as employees, suppliers and customers.

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Shareholder value

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A rough guide to whether the rewards from an INVESTMENT justify the RISK, invented by Bill Sharpe, a winner of the NOBEL PRIZE FOR ECONOMICS and co-creator of the CAPITAL ASSET PRICING MODEL. You simply divide the past RETURN on the investment (less the RISK-FREE RATE) by its STANDARD DEVIATION, the simplest measure of risk. The higher the Sharpe ratio is the better, that is, the greater is the return per unit of risk. However, as it is a backward-looking measure, based on what an investment has done in the past, the Sharpe ratio does not guarantee similar performance in future.

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Sharpe ratio

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An unexpected event that affects an economy

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Shock

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Selling a SECURITY, such as a SHARE, that you do not currently own, in the expectation that its PRICE will fall by the time the security has to be delivered to its new owner. If the price does fall, you can buy the security at the lower price, deliver it to whoever you sold it to and make a PROFIT. The RISK is that the price rises, leaving you with a loss.

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Shorting

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A solution to one of the biggest sources of MARKET FAILURE: ASYMMETRIC INFORMATION. Often the biggest problem facing sellers is how to convince buyers that what they are selling is as good as they say it is. This problem arises in situations where the qualities of the thing being sold cannot be observed easily by buyers, who thus fear that sellers may be conning them. In such situations, an answer may be for sellers to do something that shows they mean what they say about quality. This something is what economists call signalling. Going to a leading university might be worth far more for what it signals to prospective employers about your abilities than for what you learn as a student.

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Signalling

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INTEREST calculated only on the initial amount borrowed or invested. Contrast with COMPOUND INTEREST.

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Simple interest

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The founder of ECONOMICS as we know it. Born in Kirkcaldy, Fife, Adam Smith (1723-90) was educated at Glasgow and Oxford, and in 1751 became professor of logic at Glasgow University. Eight years later he made his name by publishing the THEORY OF MORAL SENTIMENTS. His 1776 book, An Inquiry into the Nature and Causes of the Wealth of Nations, is the bible of CLASSICAL ECONOMICS. He emphasised the role of specialisation (the DIVISION OF LABOUR), TECHNICAL PROGRESS and CAPITAL INVESTMENT as the main engines of economic GROWTH. Above all, he stressed the importance of the INVISIBLE HAND, the way in which self-interest pursued in free markets leads to the most efficient use of economic resources and makes everybody better off in the process.

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Smith, Adam

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The overall impact of an economic activity on the WELFARE of society. Social benefits/costs are the sum of private benefits/costs arising from the activity and any EXTERNALITIES.

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Social benefits/costs

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The amount of community spirit or trust that an economy has gluing it together. The more social capital there is, the more productive the economy will be. Yet, curiously, one of the best-known books to address the role of social capital, "Bowling Alone", by Robert Putnam of Harvard University, pointed out that Americans were far less likely to be members of community organisations, clubs or associations in the 1990s than they were in the 1950s. He illustrated his thesis by charting the decline of bowling leagues. Yet the American economy has gone from strength to strength. This has led some economists to question whether social capital is really as important as the theory suggests, and others to argue that membership of bowling leagues and other community organisations is simply not a good indicator of the amount of social capital in a country.

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Social capital

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