The Economics Book - Dorling Kindersley

London: A major global financial center and home to many multinational companies.

New York: A global center for trade, finance, culture, and international diplomacy. It is a leading city of the world economy.

Melbourne: A cultural, cosmopolitan city known for its music scene, cafes and restaurants, shopping, and sports. It is a center of finance in the Asia-Pacific region.

Munich: A center of art, culture, technology, finance, tourism in Germany. It is home to many international corporations.

Delhi: The capital city of India and an important center of culture, history, and politics. It has emerged as an important hub for trade and commerce. Delhi has a fast-growing economy based on commerce, finance, technology, and tourism.

Famine can happen

even in good harvests

The economics of

happiness

Entitlement theory

Businesses pay more

than the market wage

Incentives and wages

Real wages rise during

a recession

Sticky wages

Finding a job is like

finding a partner or a

house

Searching and

matching

The biggest challenge

for collective action is

climate change

Economics and

the environment

Pessimism can destroy

healthy banks

Bank runs

GDP ignores women

Gender and economics

Savings gluts abroad

fuel speculation at home

Global savings imbalances

The economy is chaotic

even when individuals

are not

Complexity and chaos

Social networks are

a kind of capital

Social capital

Education is only a

signal of ability

Signaling and screening

The East Asian state

governs the market

Asian Tiger economies

Beliefs can trigger

currency crises

Speculation and
currency devaluation

Auction winners pay

over the odds

The winner’s curse

Stable economies contain

the seeds of instability

Financial crises

Trade and geography

Comparative advantage

is an accident

Like steam, computers

have revolutionized

economies

Technological leaps

We can kick-start poor

economies by writing

off debt

International debt relief

The housing market

mirrors boom and bust

Housing and the

economic cycle

From ancient times through the 17th century, economic thinking was mainly normative—concerned with how an economy should work. Philosophers argued for certain principles based on morality or ethics, rather than scientifically analyzing how the system did work.

As city-states developed and international trade grew in the 15th and 16th centuries, a new merchant class emerged. Governments adopted mercantilist policies aimed at increasing exports to accumulate wealth.

In the 17th century, some thinkers began taking a more scientific approach to analyzing trade and economies. William Petty measured economic activity statistically. The French physiocrats saw the economy as a whole system and analyzed the flow of money between sectors. Their “macroeconomic” approach was a first.

Thinkers also debated the sources of wealth and role of government. Some argued that trade or agriculture were most important, while others said labor created wealth. There were arguments for and against free trade and government intervention.

By the mid-18th century, political economy was developing as a new science concerned with how economies function in reality rather than how they should work in theory. Philosophers and economists aimed to understand the system scientifically.

The emergence of international trade, new wealthy merchant classes, early companies and stock markets all contributed to the development of economic thinking in this period. As economies grew more complex, there was an increasing need to understand how they worked.

• According to prevailing economic theory, the price of anything is simply the market price—the price people are prepared to pay. For market economists there is no moral dimension to price.

• But for medieval communities and philosophers like Thomas Aquinas, there was a moral dimension. To avoid “unjust” prices:

› Profit should not be excessive, because avarice is a sin. › No deception can be involved in setting the value of goods. › The buyer must freely accept the price.

• Traders need to make a profit to supply goods. But if they push prices higher than people are prepared to pay, people stop buying and merchants are forced to lower prices.

• Market economists consider the marketplace to be the only way to establish price. Nothing, not even gold, has an intrinsic value. Price is simply what the buyer freely agrees to pay.

• The issues of price and morality are still discussed today in debates over CEO pay, minimum wage, and market regulation. Free market economists reject interference, while others argue for it on moral or economic grounds.

• Banking has a long history, but modern banking emerged in 14th-century Italy.

• The Medici Bank of Florence pioneered many banking practices still used today. It grew very large, with branches across Europe.

• The Medici Bank succeeded by taking advantage of economies of scale, diversifying risks, and transforming assets.

• Economies of scale mean average costs fall as a bank’s size increases. The Medici Bank could draw up many contracts at low cost.

• Diversifying risks means spreading lending across borrowers, locations, and investments. Local Medici partners shared risks and profits.

• Asset transformation means turning deposits into loans. The Medici Bank gathered large deposits and lent the money to merchants.

• The Medici Bank made high profits by multiplying modest capital through large-scale deposit-taking and lending.

• These concepts—economies of scale, risk diversification, and asset transformation—remain fundamental to banking today.

The key idea here is that

this turbulent period he lost

Europe. This was increasing the

an increase in the amount of money

both his homes and much

money supply and putting upward

in circulation (the money supply)

of his property. He died in

pressure on prices—the first full

leads to a predictable rise in the

Laon in 1596.

statement of the quantity theory of

general price level (inflation).

money. According to this theory,

This is because more money

if the amount of money circulating

means people have more to spend,

in an economy increases, while the

so demand goes up and sellers can

growth of actual goods and services

raise their prices. The mechanism

remains unchanged, it will lead to

that makes this happen is that the

inflation. This is because there is

amount of money in circulation

more money to spend chasing the

multiplies as people spend, lend,

Bodin’s works include The

same amount of goods.

and borrow. So an increase by the

Six Books of the Commonwealth

Bodin rejected other popular

central bank puts money in the

(1576) and Universae Naturae

handful of people, who then lend

Theatrum (“Theater of

it out again, and it is spent and

Universal Nature,” 1596).

re-spent, raising prices across

His Method for the Easy

inflation theories of the time, such as greedy workers demanding higher wages; excessive luxury and social

Bodin’s major works

Understanding of History

the economy. This is known as

(1566) pioneered a critical,

the “multiplier effect.”

analytical approach to history.

32 IN CONTEXT

ECONOMICS SUMMARY

Production, consumption, and income EMPLOYMENT AND PRODUCTION

CONSUMPTION AND CHOICE

• Labor is the effort people make in return for wages. • Capital means the tools and equipment used in production, while raw materials refers to the natural or partly processed materials required to make goods and provide services. • Production focuses on how much is being made and how efficiently. • Productivity depends on factors like technological progress, division and specialization of labor, and human capital (education and skills), as well as supply of resources. • Unemployment occurs when the supply of labor exceeds demand. Frictional unemployment occurs when people are between jobs, while seasonal unemployment arises due to seasonal industries. Structural unemployment exists when workers lack skills that match the jobs available. Cyclical unemployment results from economic downturns.

• Consumers must make choices due to scarcity and limited income. • Utility is the satisfaction people gain from consumption of goods and services. The concept of marginal utility describes how utility gains tend to decrease with each added unit of consumption. • Prices are determined by the supply and demand of goods and services. A lower price means increased demand and higher supply; a higher price has the opposite effect. • Elasticity measures how sensitive supply or demand is to changes in price or other factors. • Income elasticity measures how consumption changes with income. Inferior goods have an income elasticity of less than 1, while normal goods have an elasticity of 1 and luxury goods have an elasticity greater than 1. • Time preference refers to people’s preference for current over future consumption. Interest rates reflect people’s willingness to consume now or in the future and influence the allocation of resources. • Opportunity cost is the value of the next best alternative forgone. Marginal cost measures the incremental impact of producing one more unit of a good or service. • Risk and uncertainty lead to imperfect information in markets. There are costs and benefits to acquiring information to reduce this asymmetry.

Income and wealth • The factors of production (labor, capital, raw materials, and enterprise) generate income in an economy. • The types of income include:

• Wages and salaries: payment for labor.
• Rent: payment for use of land and buildings.
• Interest: payment made on borrowed money.
• Profit: reward for entrepreneurship and risk-taking.
• Dividends: distribution of profits to shareholders. • Wealth is the accumulated stock of assets – it generates income and influences consumption. Income inequality refers to the gap between rich and poor. • The distribution of income and wealth depends on the economic system and policies, as well as social and demographic factors. • GDP, GNP, and NNP measure the total market value of goods and services produced within a country’s borders, abroad or domestically owned, or available to citizens respectively. GDP per capita measures average income.

Government and policy • Governments can influence markets through both monetary policy (controlling money supply and interest rates) and fiscal policy (taxation and public spending). • Public goods are non-excludable and non-rival. They result in market failure due to free riding, so government provides them. • Externalities are the positive or negative spillover effects of economic activity that impact third parties. They also lead to market failure, requiring government intervention. • Regulations aim to protect the public good, correct externalities and market failure, and promote competition. Deregulation removes controls and allows free market competition. • The public sector includes state-provided goods and services. The size and role of government depends on ideological views about state intervention versus free markets.

LET TRADING BEGIN 33

In Depth Employment and production

with net investment, determines the

human capital through education and

trade-off between current consumption

training, boosting workforce productivity

and saving for the future. The supply of

over time. Investment in physical and

capital goods depends on current and

technological capital enables greater

past saving. This capital-accumulation

efficiency in production processes.

Production translates natural resources,

process increases capital per worker,

Collectively, these factors determine a

raw materials, labor, and capital into

boosting labor productivity and wages.

country’s production possibility frontier

goods and services that meet human

Division of labor and specialization

needs and wants. Labor refers to the

increase workforce productivity through

effort and skills people contribute.

repetition, dexterity, and innovation.

The law of comparative advantage means that people and countries gain

Advances in technology arise from

Capital means the tools, equipment,

by specializing in what they produce

science and entrepreneurship. They take

and infrastructure used in production.

most efficiently. However, there are

time to spread through the economy,

Labor and capital combine to

also benefits from diversity of skills.

so catch-up growth is possible. But

drive economic growth and rising

Technological progress boosts

living standards over the long run.

productivity through time-saving

People’s willingness to consume now

inventions, automation, and improved

or save for the future, when combined

processes. Investment in education and

risks include technology-driven unemployment and greater inequality. GDP refers to the total market value of all final goods and services produced in an economy in a given year. GDP growth depends on growth in aggregate demand,

training increases skills and innovation

Unemployment and inflation

supply, and productivity. In the long run,

in the workforce. This enhances

Natural rate of unemployment

sustainable real GDP growth depends on

Factors determining a country’s GDP

increases in aggregate supply through investment, skills development, R&D, and technological progress.

Demand factors

Supply factors

• Consumer spending • Business investment • Government spending • Net exports

• Labor supply, education, experience • Capital stock: tools, infrastructure • Technology: processes, automation • Natural resources • Entrepreneurship

Productivity factors • Efficiency • Innovation • Division of labor • Competition • scale effects

Consumption and choice

and change their behavior. Firms adjust

Utility refers to the satisfaction people

the prices or quality of goods and

When aggregate demand in an

gain from the consumption of goods

services to maximize profit from sales.

economy falls below potential output

and services. The law of diminishing

Equilibrium price and quantity occur

(or the full employment level of output),

marginal utility shows that utility

where supply and demand balance.

the economy can experience a recession

gains decrease with each additional

with rising unemployment and spare

unit consumed. This influences how

Price elasticity measures how demand

capacity. A negative output gap opens

people allocate their limited incomes and

or supply respond to a change in price.

up. Conversely, when aggregate demand

budgets based on needs and wants.

untries involved in trade:

Because the needs of one

tariffs on imports and subsidizing

country are supplied by

exports. The English economist

the produce of another,

Thomas Mun summarized this

and the exchange is for

view in A Discourse of Trade from

their mutual advantage.

England unto the East Indies (published 1621): “The wealth of a nation consisteth

Adam Smith

• Mercantilism (16th–18th century): A country’s wealth depends on accumulating gold and silver. This means maximizing exports, minimizing imports, and maintaining a trade surplus. • Key thinker: Thomas Mun argued that exports bring in gold while imports cause gold to be lost. A country should preserve its stock of gold by restricting imports. • Adam Smith (1776) challenged mercantilism, arguing that trade benefits all countries. He said that countries should specialize in what they are best at producing. Trade allows them to exchange these specialized goods, increasing wealth for all. • Free trade vs. protectionism: There is debate over whether countries should impose tariffs and quotas to protect domestic producers (protectionism) or remove trade barriers (free trade). Proponents of free trade argue it promotes economic growth and helps developing countries. Critics argue it can hurt domestic workers and industries. • Key events: The growth of global trade from the 16th century led to the rise of mercantilism. Adam Smith’s Wealth of Nations (1776) promoted free trade. The 19th century saw increased trade protectionism. After World War II, the General Agreement on Tariffs and Trade (GATT) reduced tariffs and the World Trade Organization (WTO) promoted free trade. Critics argue global trade imbalances can impact jobs and the economy.

in its plenty of gold, silver, and other treasure.”

Free trade versus protectionism

The notion that trade should aim to boost

Adam Smith’s Wealth of Nations (1776) attacked

exports and limit imports dominated economic

mercantilism. Smith insisted that gold is not

thought until the Scottish economist Adam Smith

wealth. A nation’s prosperity depends on the

challenged it in his seminal book The Wealth of

goods produced and services generated in its

Nations (1776). Smith argued that restricting

economy. He insisted that trade is a mutually

trade placed an artificial brake on economic

beneficial exchange that enriches all the nations

growth and prosperity. Far from depleting a

involved. The system works because products and

nation’s wealth, he believed, trade spreads

specialized skills are not evenly distributed

investment and prosperity to all trading partners.

around the world. Countries can produce some

According to Smith, the flow of trade between

goods more efficiently than others. By specializing in what they make best and trading with each other, all countries benefit. This free-market argument was not accepted overnight, and the debate over protectionism versus free trade has continued ever since. Protectionists argue that tariffs and quotas are needed to protect domestic producers against cheaper imports, saving jobs. Critics argue that this merely reduces consumer choice and raises prices. Free trade, on the other hand, promotes competition and economic growth for all nations involved, including developing countries. But free trade can also worsen trade deficits, hurting workers in industries undercut by cheap imports.

The 18th-century painting above (1786) depicts the thriving

shipping trade of the English port

of Liverpool, a hub for transatlantic

trade. Adam Smith’s ideas helped

spark a commercial and intellectual

revolution that shifted economic

thought away from mercantilism.

36 THE QUANTITY THEORY OF MONEY

summary: The idea of public companies developed to share the risks of overseas trade. Instead of individual merchants funding voyages, joint-stock companies allowed many investors to put money into a business in return for shares of the profits. An early example was the British East India Company, founded in 1599. By the mid-1600s, the EIC had more than 1,600 shareholders and dominated trade with India and China. The joint-stock structure allowed it to raise large amounts of capital, with investors able to buy and sell shares. This model, defended by economist Josiah Child, inspired modern public companies and stock exchanges.

of wealth circulate

• The economy consists of flows of money and goods between sectors.

without restraint.

• The physiocrats believed the agricultural sector was the most important. They focused on the “real economy” creating goods and services, not finance or banking.

François Quesnay

• Quesnay’s “Economic Table” model showed how money and goods circulate in loops between landowners, farmers, and artisans. Farmers produce a surplus, enabling rent and taxes.

• The physiocrats argued for free trade and low taxes to allow the “natural order” of the economy to function. They believed the economy was self-regulating if left alone.

• The circulation of money through the economy creates a “multiplier effect.” Spending becomes revenue, generating more spending and so on. This stimulates overall activity and wealth creation.

• Quesnay analyzed the economy by breaking it into parts and studying the relationships between sectors. His model included inputs, outputs, and interdependencies. He showed how over-taxing farmers could reduce investment and slow the whole economy.

• The physiocrats influenced later thinkers like Adam Smith, but their belief in agriculture as the sole source of wealth was too narrow. Manufacturing and services were also shown to produce surpluses.

Street lights are an example of a public good because:

• One person’s use of street lighting does not diminish another’s enjoyment of it (non-rivalry).

• It is difficult to stop people from benefiting from street lighting (non-excludability).

• Private individuals never pay for street lights.

Private firms do not provide street lights since they can’t stop non-payers from using them.

Essential public goods are usually provided by the government, because:

• They are difficult for private firms or individuals to supply profitably due to free-riding.

• Although there is demand for these goods, private markets may not be able to satisfy this demand.

• Governments fund the provision of public goods through taxation.

The philosopher David Hume recognized that markets can fail to provide public goods. Governments have a responsibility to provide public goods like national defense, but there is debate over how extensive this responsibility should be.

Patents, copyright, and trademarks were developed to protect intellectual property and encourage innovation. They aim to overcome the problem of non-excludability for new knowledge and discoveries.

that people weigh the costs and

applies to real human

benefits of choices and select the

behavior at all. In reality, people

option that maximizes their net

make many decisions impulsively

benefit. Benefits are things such

or irrationally, and are influenced

as increased satisfaction, pleasure,

by emotions, cognitive biases,

or utility. Costs are any negative

social pressures, and other

consequences, such as increased

psychological factors that have

risk, decreased utility, or loss of

little to do with rational choice.

resources (money, time, effort).

Others argue that its key

Considering both objective facts,

insight—that self-interest is a key

• The idea of the “economic man” assumes that individuals act rationally and in self-interest.

• It was developed by Adam Smith, who argued that self-interest, not benevolence, motivates economic behavior.

• According to this view, people weigh costs and benefits to maximize personal benefit and utility.

• Critics argue the theory does not fully reflect real human behavior, which is often irrational or influenced by psychology and social factors.

• However, the theory’s insight that self-interest is a key motivator remains influential in economics.

such as prices, as well as subjective values, such as personal preferences, people choose the option that yields the highest net benefit.

motivator of human behavior— remains profoundly insightful. It continues to underlie much thinking in economics and business today, even if it does not

However, rational choice theory

fully capture the complexity of

has its limits. People may pursue

human decision making. ■

goals that seem irrational in

Adam Smith argued that free markets, guided by individuals acting in their own self-interest, lead to orderly and fair outcomes.

He said that:

1. The invisible hand of the market brings order. Every individual acts out of self-interest, but competition between them leads their self-interested actions to benefit society as a whole. This produces the goods that people want at fair prices.

2. Fair prices emerge. The natural price of a good reflects the costs of producing it. If demand rises above supply, the price will increase, attracting new suppliers. Competition will then drive the price back down to its natural level. If demand falls, wages and prices will drop until a new equilibrium is reached.

3. Government intervention should be minimal. Smith believed in “natural liberty” and laissez-faire—leaving business alone. The government’s role was limited to defense, justice, and public goods like roads.

4. The market system is essentially optimistic. Smith saw society as functioning well through the “invisible hand.” By contrast, others like Hobbes and Malthus saw only disorder or disaster without strong authority. Marx predicted revolution.

Smith’s views have been very influential but have also faced some criticism. The market may only serve the rich, ignore the poor, or feed undesirable habits. Competition is not always sufficient, and governments often intervene to promote fairness. But Smith helped establish the idea of the market as a self-regulating system that can benefit society.

1776 An Inquiry into the Nature

foresaw the crisis, has suggested

•Adam Smith described a market system coordinated by an “invisible

and Causes of the Wealth

that economics needs a synthesis

hand.” Individuals pursuing their own self-interest are guided by the price

that harnesses market forces while

system to benefit society.

of Nations

minimizing the damage that can

•Competition in free markets drives prices to a “natural level” that reflects the costs of production. Monopolies distort the price system.

results from excessive behavior of free markets. Economics, it seems, still struggles between the invisible

•The economy grows through division of labor and accumulation of capital.

hand and government guidance.

Economic growth boosts real wages and standards of living over time.

As Smith recognized, the invisible

•Land, labor, and capital are interdependent and each earns its “fair” re-

hand is a powerful mechanism,

turn—rent, wages, and profit respectively. Money circulates between

but it needs careful regulation and

them in a “circular flow.”

steering to produce the best overall

•The classical school founded by Smith focused on laissez-faire and free markets. Theory later took a “neoclassical” mathematical form.

outcomes. The debate goes on.

•The issue of laissez-faire v. government intervention divides economists. Financial crises intensify the debate. A synthesis may be needed. •Smith did not foresee the degree of inequality that can arise in free markets today. His vision assumed more fairness and social cohesion.

1762: Published Lectures on Jurisprudence, Smith’s first major work. 1776: Published An Inquiry into the Nature and Causes of the Wealth of Nations, Smith’s famous work that provided the theoretical basis for free market capitalism.

Stiglitz criticized “free market fundamentalism” and argued that it contributed to the 2008 financial crisis.

population of Malthus’s time but

The Malthusian trap

had avoided poverty. However,

• P opulation growth outstrips

dooms society to poverty as

growth in the food supply. This

Malthus’s ideas still apply in parts

population growth always

imbalance causes living standards

of the developing world, where

outpaces growth in the supply

to fall. However, lower living

rapid population growth strains

of resources such as food.

standards also cause birth rates to

the resources available. And even

fall, stabilizing population size.

in developed nations, some fear

• Lower living standards and

reduced food supply increase

that continued growth threatens

• T his cycle traps most people in

mortality, lowering population

poverty with just enough resources

growth, and stabilizing society.

to survive. Any temporary boost

the world’s long-term sustainability if solutions are not found. ■

Malthus was wrong

in living standards is soon choked

• P oor relief (welfare) only

Malthus did not foresee how

off by renewed population

encourages the poor to have

technological progress would

growth. This is the Malthusian

more children, worsening poverty.

dramatically boost agricultural

trap.

yields in the 19th century. This

• This bleak view opposed reform to raise living standards.

70

THE INVISIBLE HAND

GUIDES FREE MARKETS

THE SELF-REGULATING MARKET

When individuals pursue their own self-interest, they are guided as if by

IN CONTEXT

the invisible hand in a direction that benefits society. This insight formed

FOCUS

the basis of Adam Smith’s theory of the self-regulating free market.

Markets and choice

Free markets harness human nature

KEY THINKER

Smith believed that all humans have a natural instinct to better their own

Adam Smith (1723–90)

condition. In free markets where private individuals make their own choices based on self-interest, this instinct benefits society as a whole.

Smith compared the market mechanism to an invisible hand guiding participants.When a

BEFORE

buyer and seller strike a deal in a

17th century The idea

free market, both parties gain

that the free operation

something of benefit.Repeated

of the market mechanism

millions of times, voluntary

can benefit society takes root.

exchanges between self-interested individuals help ensure that

resources are allocated efficiently, and that society prospers.

1744 French economist Jean François Melon argues that

An invisible check on behavior Another insight was that buyers would reward responsible

and fair behavior by a business, and punish irresponsible actions by withdrawing custom.Smith said that to secure the public

approval, every individual… is obliged… to accommodate himself… to the greater good of society. In this way,the market

exerts an invisible check upon behavior. However,Smith also

market forces, not government

planning, will achieve general prosperity and happiness.

AFTER

1801 British economist

Thomas Malthus argues that

population growth cancels

out any benefits from free

markets, keeping society poor.

1930 British economist John

acknowledged the need for laws against the conspiracy and

Maynard Keynes argues that

combination of manufacturers, unfair practises such as price fixing

governments must intervene

which undermine a free market.

in market economies to boost

demand and employment.

1946 Austrian philosopher

Every individual… is

Karl Popper argues that the

obliged… to accommodate

free market is an “open society”

himself… to the greater

that best fosters reason,

good of society.

creativity, and prosperity.

Adam Smith Adam Smith, who proposed the idea of the invisible hand. Smith believed that individuals pursuing self-interest in free markets benefit society as a whole.

Human beings have a natural instinct to better their own condition—what Smith called self-love. He believed that if individuals are left free to pursue this instinct by making their own choices in a free market based on self-interest, the result—as if guided by an invisible hand—benefits society as a whole.

Smith gives the example of a butcher, a baker, and a brewer who provide dinner out of self-interest but also serve the public good. Their self-interested actions, multiplied among all participants in the economy, allocate resources and distribute goods efficiently.

Buyers and sellers are guided by prices to act in a way that maximizes benefit for all.

For Smith, free and fair competition is crucial, and regulation may be needed to prevent “combinations” that undermine competition, such as price fixing. But he argues that the free market itself “exerts an invisible check” on behavior, as businesses seek public approval to maximize sales.

Smith acknowledges cases where the market fails or provides perverse outcomes, but he sees the self-regulating free market based on individuals following their self-interest as the system that, overall and in the long run, benefits the whole of society. Government intervention should be kept to a minimum. This view forms the basis of free market economic theory.

the benefits of antitrust laws,

toward antitrust laws in the first

• Cartels form when a few suppliers in an

arguing that governments cannot

place, and while economists may

oligopoly cooperate rather than compete.

always determine which business

have theoretical reservations

They act like a monopoly to fix high prices

practices harm the consumer and

about their efficacy, cartels and

and restrict output.

which benefit efficiency. However,

collusion remain politically and

• Cartels are hard to establish and maintain

antitrust activity has become more

socially unacceptable.

accepted as a way of protecting

because members are tempted to cheat by increasing output and cutting prices.

consumers. In 2011, for example,

• A cartel requires mechanisms to monitor

the European Commission

members and enforce agreements, often

imposed large fines on 17 airlines

with the most powerful member acting

found guilty of price-fixing for air

as enforcer.

cargo. Similarly, Virgin Atlantic,

• Cartels are generally considered harmful and

which had first blown the whistle

are discouraged or outlawed by antitrust laws. • Nevertheless, cartels continue to form in some markets and collusion is difficult to prevent completely.

74 CARTELS AND COLLUSION

Government borrowing and taxation David Ricardo argued that it makes no difference to the economy whether a government chooses to tax now or borrow now and tax later to finance its spending. He claimed that rational taxpayers will anticipate future taxes resulting from current borrowing and set aside savings to pay for them. This argument is known as Ricardian equivalence. While theoretically plausible, it makes assumptions about taxpayer rationality and foresight that may not reflect reality. The theory has nevertheless been used by some economists to argue against Keynesian policies of government spending to boost demand.

The theory of comparative advantage shows how countries can benefit from trade even when one country is more efficient in producing all goods. It was proposed by David Ricardo in 1817.

Ricardo argued that countries should specialize in producing goods that they can make relatively cheaply and efficiently, and trade for other goods. Even if a country can produce all goods more efficiently than another, it is still in its interest to focus on those it is best at, and trade for the rest.

For example, say Country A takes 2 hours to make a shirt and 4 hours to make a smartphone. Country B takes 3 hours to make a shirt and 6 hours to make a smartphone. Country A is more efficient at making both goods. But Country A’s comparative advantage is in shirts, and Country B’s comparative advantage is in smartphones.

It is in the interests of both countries to specialize and trade. If Country A specializes in shirts, in 2 hours it can make 1 shirt to trade for Country B’s smartphone. Country B can now make smartphones for 3 hours and trade for Country A’s shirts. Both are better off. Without trade, Country A would have to spend 4 hours making a smartphone, and Country B would need 6 hours.

Even though Country A is more efficient overall, by using its comparative advantage in shirts and trading with Country B, it ends up with both a shirt and a smartphone in just 2 + 2 = 4 hours. Without trade, it would have taken 2 + 4 = 6 hours to make the same goods. Both countries gain from trade through exploiting their comparative advantages.

The theory of comparative advantage shows that international trade benefits all countries, as they can focus on what they do most efficiently and gain access to goods and services they could not easily produce themselves. It provides an economic argument for free trade between nations.

• David Ricardo developed Adam Smith’s theory of absolute advantage by proposing the theory of comparative advantage.
• Comparative advantage suggests that countries should specialize in producing goods and services that they can produce most efficiently and then trade with other countries for other needs. This makes both countries better off through increased total production and lower prices.
• The Swedish economists Eli Heckscher and Bertil Ohlin built on Ricardo’s theory by arguing that a country’s comparative advantage depends on its relative abundance of capital and labor. Capital-rich countries have a comparative advantage in capital-intensive goods while labor-rich countries have a comparative advantage in labor-intensive goods.
• Despite the overall benefits of trade, there can be short-term losers, leading to opposition to free trade. Politicians often impose protectionist policies to support specific industries at the cost of economic efficiency.
• There is debate over whether developing countries always benefit from free trade due to market failures and lack of economic institutions. Rapid trade liberalization can be disruptive, at least in the short run.
• There are tensions between the theoretical benefits of comparative advantage and its real-world outcomes. While society as a whole may benefit, some groups may be left worse off, at least temporarily.

If there are just two competing firms (a duopoly) producing identical goods:

• Each firm knows that the other firm’s output will affect their own profits.
• Each firm reacts by selecting its best output given the level of output the other firm chooses (plotted on the rival’s reaction curve).
• This results in a stable equilibrium at the intersection of the two reaction curves, where neither firm has an incentive to change its output.
• At the equilibrium, output will be lower and price higher than under perfect competition. This benefits the firms but harms consumers and society.
• The outcome depends on whether the firms compete on quantity (Cournot model) or price (Bertrand model). Competition on price leads to an outcome closer to perfect competition.

The key factors are:

1. Limited competition (only two firms) - this gives market power and the ability to influence the market
2. Interdependence (each firm reacts to the other’s actions)
3. The nature of competition (on quantity or price) determines how close the outcome is to perfect competition

The effects are:

1. Lower output and higher prices than perfect competition
2. Profits for the firms but lost benefit for consumers and society
3. The Cournot model (competition on quantity) leads to a less competitive outcome than the Bertrand model (price competition)

So in summary, with limited competition between interdependent firms, the free market may not maximize social welfare. Each firm pursues its own interests, but the combined effect can be detrimental. The extent of this depends on the firms’ strategic variable and nature of competition.

John Stuart Mill analyzed the impact of monopolies and lack of competition. He argued that monopolies and collusion between firms can allow them to charge higher prices, hurting consumers. Mill also recognized that monopolies can emerge in labor markets, not just goods markets. For example, skilled professions that require expensive training can act as monopolies, allowing workers to demand higher wages. Mill pointed out that railways exhibited monopoly power in his time because routes were impractical to duplicate, allowing companies to set high fares.

In summary, Mill:

1. Argued that monopolies and collusion lead to higher consumer prices.

2. Observed that monopolies can emerge in labor markets as well as goods markets. Skilled professions that require expensive training are an example.

3. Used railways as an example of a monopoly industry that could charge high prices due to lack of competition.

4. Recognized that barriers to entry, like expensive infrastructure or training requirements, enable the emergence of monopolies.

Does this summary accurately reflect Mill’s analysis of monopolies? Let me know if you would like me to clarify or expand the summary.

• Economic bubbles refer to a sharp rise and fall in asset prices, such as shares, property, or commodities, that is not justified by the actual value of the underlying assets. In a bubble, speculative frenzy and herd behavior drive prices upward but the bubble eventually bursts.

• One of the earliest examples was the Dutch tulip mania of the 1630s. Rare tulip bulbs traded for extraordinarily high prices before the bubble burst in 1637, ruining many investors.

• The dot-com bubble of the 1990s and early 2000s saw technology company shares soar before crashing. Investors got caught up in hype about the transformative power of the internet.

• Herd behavior and speculation, rather than real changes in value, fuel bubbles. People see prices rising and rush in, hoping to make a profit. But the bubble bursts when investors realize the hype is not justified.

• Bubbles tend to recur because human psychology and behavior do not change. But understanding their causes may help policymakers reduce their size and impact.

• The hallmarks of a bubble include a rapid rise in asset prices, speculation, and hype not matched by economic fundamentals. But bubbles are hard to identify definitively before they burst.

That covers the key aspects of economic bubbles, including examples, causes, characteristics, and potential policy responses. Let me know if you would like me to explain anything in the summary in more detail.

• Karl Marx believed capitalism contained within it the seeds of its own destruction.

• He saw history as progressing through a series of economic systems, each containing contradictions that led to its replacement. Capitalism would be replaced by communism.

• Capitalism is based on the private ownership of the means of production by the bourgeoisie. The bourgeoisie exploits the proletariat, who sell their labor for wages.

• The profit motive leads the bourgeoisie to maximize profits by minimizing wages and improving efficiency. This results in worker alienation and hardship.

• Competition leads to overproduction and economic crises that cause instability and hardship, especially for workers. Crises become more frequent over time.

• Eventually, the proletariat will realize their position, unite, and overthrow the bourgeoisie in a revolution. They will take control of the means of production.

• At first, this will lead to a “dictatorship of the proletariat” and socialism. But eventually all private property and classes will be abolished, leading to a classless communist society.

• Marx believed communism was the inevitable next stage of progress after capitalism. Revolution was necessary to transition from one system to the next.

Here is a summary of the key ideas relating to ion and monopoly:

Ion:

• The value of a product comes from the effort needed to make it. This is known as the labor theory of value, proposed by Karl Marx.

• Marx argued that by adding labor to natural resources, raw materials are created. Adding labor to raw materials and machines creates goods and commodities.

• The amount of labor used to produce a good is proportional to its value. The value represents the “congealed” lump of labor the good contains.

Monopoly:

• A monopoly refers to when a single firm controls an entire market for a particular product or service. Monopolies often exploit consumers by restricting output and raising prices.

• In contrast, capitalism relies on competition between producers. As producers compete, some fail and go bankrupt, while others gain control of a larger share of the market. This can lead to fewer, larger firms and concentration of wealth.

• Marx argued that capitalism contains inherent contradictions that will lead to its downfall. He believed monopolies and increasing inequality were examples of these contradictions.

• Most modern economies have elements of both capitalism and socialism (mixed economies) with some government intervention and public ownership of means of production. Pure capitalist or communist systems are rare.

That covers the key ideas around ion (the labor theory of value) and monopoly (control of markets), as proposed by Karl Marx. Let me know if you would like me to explain anything in the summary in more detail.

and consumer reach equilibrium

• Producers supply goods to meet consumer demand. As supply increases, prices fall.

is the market price.

• Demand depends on price and consumer tastes. As prices rise, demand typically falls. But demand can also increase if a product becomes more fashionable.

• Equilibrium is reached when supply and demand are balanced at a price acceptable to both producers and consumers. This equilibrium price depends on many factors, including the size of the market and time.

• The equilibrium price is found at the intersection of the supply and demand curves. Below this price, supply exceeds demand; above this price, demand exceeds supply.

• Producers have little control over the market price and must accept what the market determines based on supply and demand. They can try to influence demand through advertising and marketing.

• There is a limit to how low prices can fall to stimulate demand. At some point, consumers meet their needs and demand levels off.

• The supply curve shows how much producers will supply at each price. It depends on the costs of production. As costs rise, supply falls.

• The demand curve shows how much consumers will demand at each price. As price falls, demand typically rises. But demand also depends on consumer tastes and preferences.

Giffen goods:

had observed that some inferior

economist Alfred Marshall outlines

goods—those to which people turn

the theory of supply, demand,

The original exceptions

ironically tend to increase in price

nicely when their incomes drop—

and equilibrium pricing.

to the rules of supply and

when their prices go up. He named

ironically experience a rise in

demand were identified by the

this the Giffen paradox, after his

AFTER

British economist Robert Giffen.

contemporary Sir Robert Giffen.

shaped by those laws. Marshall

the idea of Giffen goods is

saw them as fascinating

challenged repeatedly from the

exceptions that proved the rule.

1920s onward. Some economists

The theory suggests there is a

claim empirical evidence for their

strong influence of a price increase

existence is weak or nonexistent.

on the quantity of goods demanded

To understand how Giffen goods could exist, it helps to understand some basic principles of consumer choice theory. According to the

Giffen goods are inferior goods for which a price

law of demand, when the price of

increase leads to an increase

a normal good rises, the quantity

in demand. This paradoxical

demanded of it falls, since its

behavior arises because the

higher price makes consumers

price effect outweighs the

worse off and they are less able to

substitution effect for

Giffen goods.

Marshall posits these exceptions force economists to refine their theories to account for subtleties and complexities in human behavior.

afford the good. However, there is also a substitution effect: when a good’s price rises, consumers tend to substitute away from that good toward cheaper alternatives. For normal goods, the income effect dominates so demand falls overall. But for some inferior goods, the

Economists have debated whether

and a diminished influence of a

substitution effect can be weak,

Giffen behavior actually exists

price decline on quantity demanded.

and the income effect prevails:

or is merely theoretical. The

Giffen goods therefore represent a

consumers buy more of the good

primary explanation offered for

limited set of exceptional goods.

despite its higher price because

observed Giffen effects is that they

their income has fallen and they

arise due to specific market and

cannot afford better alternatives.

cultural conditions and irregular Under these circumstances, an

demand relationships, rather than

increase in the price of the inferior

a fundamental contradiction of

good can prompt consumers to

standard theories of demand.

buy more of it, not less—a seeming contradiction of the law

so-called Giffen goods—those

of demand. But their choice is still

INDUSTRIAL AND ECONOMIC REVOLUTIONS 117

1844 British economist Nassau William Senior outlines the income effect

and substitution effect on demand.

■ Léon Walras proposed a theory of general equilibrium to describe how supply, demand, and prices interact across an entire economy.

■ Walras focused on how exchanges in markets work and how the prices of goods, the quantities offered, and the demand for them interact. He believed value depends on rareté—how intensely something is needed.

■ Walras used mathematical models to show how, as prices change, supply and demand adjust until they match, bringing the market into equilibrium. This balance reflects simple forces, like shortages causing prices to rise and surpluses causing prices to fall.

■ Where there are shortages, prices rise, demand falls, and supply rises. Where there are surpluses, prices fall, demand rises, and supply falls. The economy as a whole tends toward equilibrium if free to do so.

■ For Walras, equilibrium meant all markets in the economy were balanced. Excess demand (or supply) in one market creates excess supply (or demand) in others. So the total excess demand across all markets = zero.

The key message is that the level of demand for a product depends on the type of good

as superior goods, where demand

policy of agricultural

luxury goods such as alcohol and

rises more than proportionately

protectionism. Engel argued

tobacco rose more quickly. This is

with income. Inferior goods are

that free trade was essential

rational behavior because as our

where demand actually falls as

income rises we can devote more of

income rises. Typically, inferior

it to the finer things in life. Engel’s

goods are basic necessities for

law points to three types of goods:

which we substitute higher quality

• Inferior goods: As income

goods as we get wealthier.

rises, demand falls. For example,

Knowing how the level of

white bread.

demand for different goods

for economic prosperity. He died in Dresden in 1896.

• Normal goods: As income rises,

responds to changes in income

demand rises. For example, rice

is very useful in helping firms

or cars.

target consumers and price

• Superior goods: As income

their products appropriately.

rises, demand rises more than

Understanding the income-

Engel’s law

proportionately. For example,

elasticity of demand for goods

As incomes rise:

designer clothes or holidays.

is just as important for marketers

• Demand for inferior goods falls • Demand for normal goods rises • Demand for superior goods rises more than proportionately

Engel’s insight is useful for

as price-elasticity. Engel’s work

understanding consumer behavior.

in this area, particularly his law

While necessary items make up a

showing how food dominates the

large part of poorer families’

budgets of poorer households,

budgets, more discretionary

provided early insights into the

spending on luxuries becomes

study of consumer behavior that

possible as income grows.

remain highly relevant today.

In the long run, therefore, the

The model assumes perfect

“natural price” or “normal profit”

competition—many buyers and sellers,

equates to the costs of production.

homogeneous products, perfect information,

That means that just enough firms

free entry and exit.

are in the market to satisfy demand,

are so many firms in the market and entry is so easy that firms have no choice over price (they

and they earn just enough profit to

“take” it) unless they want to sell nothing. The market price is determined by demand and supply.

stay in the industry. Thus, according

Profits above normal attract entry, reducing price. In the long run, profits fall to a normal level.

to Marshall, “in the long run the

The model shows how competition drives economic efficiency, as resources are allocated to their

normal price [or natural price] of a

most valued uses.

thing tends to equality with its cost

Some argue the model is unrealistic as few markets are perfectly competitive. But it provides an

of production” in a competitive

ideal “baseline” against which to assess real-world markets.

market. Only at this point is profit

The theory shapes views on regulation, competition policy, and optimal market size. But critics

maximized in the long run.

say it takes too narrow a view of costs, benefits, and the public good.

Criticisms and influence

The perfectly competitive model is criticized as unrealistic because few, if

Economies of scale refer to the fact that the cost per unit of output tends to fall as the scale of production increases. As firms get bigger, they are able to take advantage of efficiencies such as the division of labor, specialization, and new technologies.

Alfred Marshall explored this idea in his Principles of Economics. He noted that as firms increase production by hiring more workers, their costs will initially rise. But over the long run, if they are able to expand their factories and machinery, their average costs will fall due to efficiencies.

Economist Alfred Chandler showed how large corporations benefited from economies of scale. They were able to afford investments in management, organization, and technology that increased productivity and drove down costs. This enabled the rise of mass production and improved standards of living.

In short, bigger scale allows for greater specialization and lower unit costs. But diseconomies of scale, like increased bureaucracy, can also set in if a firm grows too large. There is typically an optimal size at which average costs are minimized.

The idea of conspicuous consumption was proposed by the US economist Thorstein Veblen in 1899. He argued that people consume luxury goods and leisure not just to satisfy their needs but also to display their social status and gain the esteem of others. This behavior is driven more by psychological factors like status-seeking than by rational self-interest. Veblen coined the term “conspicuous consumption” to describe the lavish spending of the very wealthy in order to showcase their affluence. Today, luxury brands that people buy mainly to impress others are known as “Veblen goods.” Veblen believed that societies can get caught in a “relative consumption trap” where overall well-being does not increase even as more people consume expensive status goods.

• Before industrialization, most thought poverty was due to bad luck or circumstances outside one’s control. Society distinguished between the “deserving” poor (old, young, sick) and “undeserving” poor (beggars).

• With industrialization, the view changed and many blamed the poor for their condition.

• Modern high-income nations devote 30-50% of spending to welfare and social transfers to help the poor. This recognizes that poverty is often due to circumstances outside one’s control.

• Amartya Sen argued poverty should be viewed as a lack of “entitlements” like education, healthcare, and job opportunities—not just low income. Lack of entitlements leads to a cycle of poverty that is hard to escape through one’s own efforts.

• Poverty persists in developing nations where people lack access to education, healthcare, property rights, and job opportunities. This makes it very difficult for the poor to improve their situation.

• Measures like the UN Millennium Development Goals aim to improve access to entitlements and break the cycle of poverty, based on the view that poverty is primarily due to unfortunate circumstances, not individual faults.

The key message is that poverty is often the result of a lack of access to entitlements that are outside of one’s control. The “undeserving poor” make up a small fraction; for most, poverty is a matter of bad luck and circumstance. Social programs and policy aim to remedy this by improving access to essential entitlements.

• In 1920, economist Ludwig von Mises argued that socialism could not function efficiently without free market prices to guide economic decision making and investment.

• Under socialism, the state owns the means of production. Without prices and profits, there is little information or incentive for efficient production and investment.

• Modern economies are too complex for a central planning committee to determine what and how much should be produced to match demand. They lack the information provided by market prices and competition.

• Market prices reflect the demands and valuations of all participants, as well as feasible production techniques. They provide a common unit to evaluate costs and benefits. Money is essential for this.

• Alternatives to market prices, like labor time, fail to reflect scarcity and economic feasibility. Trial-and-error can’t replicate market competition.

• The Soviet economy struggled despite attempts at reform. There were shortages, surpluses, and inefficient production. This illustrated the problems with central planning that von Mises identified.

• The debate between capitalism and socialism over economic calculation and coordination came to be known as the “socialist calculation debate.” Von Mises’s critique remains influential.

• The collapse of the Soviet Union and transition of China and others toward market reforms validated many of the critiques of central planning.

• Joseph Schumpeter argued that capitalism progresses through “creative destruction.”

• New entrepreneurs introduce innovations that create new markets and new profits.

• These innovations disturb the existing economic system and threaten established firms and jobs.

• Although the innovations may initially grow the market, imitators soon copy them, profits fall, and the market stagnates.

• Recessions then clear away the stagnant firms and markets, making way for new entrepreneurs and innovations.

• Schumpeter saw entrepreneurs, not capital or labor, as the driving force of capitalism. They take risks to introduce innovations in uncertain conditions.

• Recent analysts distinguish between “sustaining” innovations that improve existing products and “disruptive” innovations that transform markets.

• Examples of disruptive innovations include the iPod/iTunes combination that revolutionized the music market.

• Although painful, creative destruction is vital for economic progress. Government intervention to protect jobs can hamper this progress.

Here is a summary of Keynesian economics:

• John Maynard Keynes published his influential book The General Theory in 1936.

• It challenged the classical view that free markets will naturally achieve full employment.

• Keynes argued that aggregate demand in the macroeconomy could fall short of aggregate supply, leading to unemployment.

• Unemployment arises from a lack of demand in the overall economy, not from people’s choices or from market imperfections.

• Wages are “sticky” and do not quickly fall to match lower demand, so unemployment persists.

• Government intervention is needed to boost demand and push the economy back to full employment.

• Fiscal and monetary policy, like government spending and changing interest rates, can be used to stimulate demand.

• Keynes’s theories provided the rationale for active government policymaking to stabilize the business cycle.

• His work was very influential and led to decades of Keynesian economic policies after World War II.

• Prior to the Great Depression of the 1930s, poverty rather than unemployment was seen as the major economic problem. Unemployment was viewed as largely voluntary, caused by the faults and choices of individuals.

• The concept of “involuntary unemployment” emerged in the early 20th century. This meant unemployment caused by economic conditions outside individuals’ control.

• According to Keynes, the Great Depression showed that free markets could not always quickly correct involuntary unemployment. He argued for government stimulus spending to increase demand and spur job creation.

• Keynes suggested that wages were “sticky”—unwilling to fall enough in recessions to restore full employment. Workers could not price themselves into new jobs by accepting much lower pay.

• Keynes said the overall level of demand in the economy determined the number of people employed. In economic downturns, a lack of demand trapped workers and firms in a cycle of falling production and job loss.

• Government spending could break this cycle by boosting demand, production, job creation, income, and further demand. The means of spending—even burying money in bottles—did not matter. The boosted economic activity would lead firms to hire again.

• After Keynes, economists developed his ideas into more formal models. But modern views suggest Keynes focused more on uncertainty and instability than these models convey. Keynes also paid more attention to problems of low wages and inequality than is often recognized.

• Efficiency wage theory suggests firms may resist cutting wages in recessions because lower pay could reduce worker motivation and productivity. Broad-based inflation may be preferred as a means of adjusting real wages.

There is always an element of risk or uncertainty in any business venture or investment. Before acting, individuals have to weigh the possible outcomes and returns against their probabilities to calculate expected utility. The safer option is usually preferred unless the riskier option offers a significantly higher return. The level of risk that people are prepared to accept depends on their risk preferences, ranging from risk-loving to risk-averse.

Frank Knight distinguished between risk, where probabilities are known, and uncertainty, where they are not. While risk can be insured against and measured mathematically, uncertainty cannot. Profit arises when firms accept uncertainty. Knight studied the relationship between risk, uncertainty, and profit.

Decisions about employment, investment, insurance, and lending all involve risk and uncertainty. Although research and experience can help in assessing risk, some uncertainty will always remain. There is a spectrum of risk preferences in the population. Even the risk-averse may accept more risk if the potential return is high enough.

The key points are:

• There are degrees of risk and uncertainty in economics.

• Risk can be mathematically measured but uncertainty cannot.

• Profit arises from accepting uncertainty.

• There is a range of risk preferences from risk-loving to risk-averse.

• Many economic decisions involve weighing risk against return.

• Although risk can be assessed, some uncertainty will always remain.

the Early Empires

• Economists typically assume that people act rationally to maximize economic gain.

• Karl Polanyi argued that economies are embedded in culture and society. People are social beings who desire status and act according to cultural norms.

• In traditional societies like the Trobriand Islands, the economy was driven by cultural practices like gift-giving, not the profit motive. People gained status by generous gift-giving, not accumulating wealth.

• Polanyi said that as societies modernized, cultural and social factors remained the main drivers of economic life. Even in modern economies, a large part of production is non-market.

• Polanyi argued that modern markets disrupt social structures. Where markets expand, social upheaval follows.

• Economists like Avner Offer have provided evidence that non-economic and social factors, like gift-giving, play an important role in modern economies.

meaning of resources to

wants and limited means is at the

include knowledge and skills.

heart of economics, according to

2000 Indian economist

Robbins. Economic choices have to

Amartya Sen publishes

be made to allocate scarce resources

Development as Freedom,

in the face of competing needs.

arguing that economics

Economics is concerned with

should focus on increasing

studying human behavior as

people’s freedoms and

people strive to reconcile their

capabilities, not just their

unlimited wants with scarce

standard of living.

resources. In essence, it investigates

Lionel Robbins defined economics as the science of scarce resources. He believed that the unlimited wants of humans come up against the scarcity of resources available to satisfy them. This gives rise to the economic problem: how best to use limited resources to satisfy human needs and desires. In Robbins’ view, economics investigates how societies can make choices to allocate scarce resources efficiently.

Though widely accepted, some argue Robbins’ definition is too narrow. They believe economics should consider how societies generate more resources over time, not just allocate existing ones. Others say economics should aim to increase people’s freedoms and capabilities, not just their material standard of living. However, Robbins’ emphasis on scarcity and choice remains central to how most economists view their discipline.

mainstream consensus emerged

law and economics.

• Friedrich Hayek argued that free markets should be preserved to protect a free society.

around free markets, deregulation,

He joined the University of

• He said that centrally planned economies inevitably lead to dictatorship because they curb individual freedom

and modest government. This

Vienna in 1921, where he was

prevail over shortages and surpluses. They rely on coercion to impose planners’ decisions on society.

came to be known as neoliberalism.

strongly influenced by Ludwig

• Hayek said that markets distribute resources efficiently because individuals and firms have localized knowledge about their own situations. Prices arise from individuals exchanging this information and reflect the knowledge in society as a whole.

von Mises and joined the Austrian

• He believed that any attempt to restrain the spontaneous order of markets threatens liberty and reverts society to more primitive forms of organization. Governments should only act to preserve free markets and the rule of law.

Hayek’s influence grew from the

• Hayek’s views contributed to the rise of neoliberalism—the mainstream support for free markets, deregulation, and limited government intervention that emerged in the late 20th century.

1970s onward. With the apparent

School. He moved to the London

failures of Keynesian demand

• In The Road to Serfdom (1944), Hayek argued that the more governments plan economies, the more totalitarian they become. Planning is doomed to fail but relies on increasing coercion.

management and the oil crises

School of Economics in 1931.

of the 1970s, policymakers

During World War II Hayek wrote

turned to controlling inflation

The Road to Serfdom, arguing

and deregulation. His Nobel

against socialism and economic

Prize in 1974 acknowledged his

planning. He spent his later

pioneering role in reviving free

years at the University of

market thought. Hayek died in

Freiburg, Germany, and the

Freiburg, Germany, in 1992 at

University of Chicago.

the age of 93.

of society in order to preserve liberty. Free markets are the only means by which the knowledge and localized decisions of individuals can

and to coordinate the complex range of choices in a modern economy.

for half price.” Third degree price

studied economics at

• Firms want to maximize profits by charging higher prices when possible.

discrimination is where different

Cambridge University, one of

• Price discrimination means charging different prices for the same good or

groups of customers are charged

the few women economists of

different prices, for example, student

her generation. She was a

discounts or cheaper train fares for

leading figure in the Cambridge

the elderly. It requires that different

economists’ opposition to

groups of consumers can be separated

neoclassical economics in

and prevented from reselling the

the 1930s. Her criticisms of

good to each other.

neoclassical price theory led

service to different groups of customers. • It allows firms to gain extra profits from customers willing to pay more. • It usually requires some degree of monopoly power. Firms need to be able to separate customers and prevent resale between groups.

her to propose imperfect

Optimizing profits

competition as an alternative.

Price discrimination allows a firm to optimize its profits. Firms

During World War II, Robinson

usually want to sell their goods at

worked for the Ministry of

the highest price they can, while

Economic Warfare, advising

still achieving a reasonable level

on economic sanctions against

of sales to different groups of

the Axis powers. She spent

consumers. They are balancing the

most of her career at Cambridge,

strategy that will generate the most

where she became its first female

revenue. Price discrimination can

professor in 1965. She died in

increase the efficiency of a market

Cambridge in 1983.

by allowing more consumers to buy a good and encouraging greater

Key works

output, but it can also lead to

1933 The Economics of Imperfect

unfairness if some groups are charged

Competition

higher prices due to less elastic

1942 An Essay on Marxian

demand. Discrimination that exploits

Economics

addictions or urgent needs is often

1960 Essays in the Theory of

seen as unethical. ■

Economic Growth

182

BREAKING UP IS HARD

TO DO

ANTI-TRUST POLICY

IN CONTEXT

Markets may become

Freedom from monopoly is essential

FOCUS

dominated by a few

for true competition, but how far

Competition policy

large firms that crowd

should governments go in intervening

KEY THINKER

out competitors.

to curb market power? Too much

This can reduce

intervention risks damaging efficiency

innovation and raise

and innovation. When should a

Joseph Schumpeter (1883-1950)

BEFORE

prices for consumers.

company be broken up?

1890 US Sherman Antitrust Act aims to curb monopolies and

promote competition.

Firms can achieve economies

1893 US economist Richard Ely

of scale, but they are also

argues that large firms are

motivated by a thirst for

not necessarily bad.

dominance and power.

Freedom from monopoly

requires anti-trust

policy and regulation.

1920 US economist Horace

White argues against breaking

up firms, saying size doesn’t always mean less competition.

AFTER

Heavy-handed action may

1965 US economist George

do more harm than good,

Stigler says regulation often

stifling innovation. The

favours producers, not

key is balancing long-

consumers. Better to limit

run benefits of innovation

government intervention.

against short-term costs

1978 US economists Oliver

of market power.

Williamson and Michael Porter

propose limiting anti-trust action The Austrian-American economist Joseph Schumpeter argued that large firms and market dominance were often necessary for radical innovation. New products and processes would arrive in “bursts of creative destruction” that disrupted older, less efficient firms. So long as there was still some threat of competition, dominant firms would continue to innovate.

WAR AND DEPRESSIONS 183

See also: Effects of limited competition 90–91 ■ Monopolies 92–97 ■ Price discrimination 180–81 ■ Regulation and deregulation 278–85 ■ Innovation 304–307

Market power vs. innovation

Anti-trust policy aims to promote

competition by limiting the market

power of large firms. But large firms

also have advantages for innovation,

such as resources for research and

development (R&D). The economist

rules are a US phenomenon, but

similar concerns apply elsewhere.

Breaking up firms risks losing

economies of scale and scope, and

the knowledge benefits of corporate

integration. Intervening in mergers

may limit synergies from combining

complementary assets. Banning

certain agreements can also reduce

Joseph Schumpeter argued that some

cooperation needed for innovation.

degree of market power was necessary

Yet not intervening risks higher

to motivate firms’ investment in radical

prices, less choice and innovation.

new technologies that would eventually

Governments need to strike a balance,

disrupt the market. Breaking up firms too

judging the impact of policies on

aggressively could reduce innovation.

both static efficiency (lower prices)

The key is balancing short-term costs to

and dynamic efficiency ( innovation).

competition against long-term benefits

Policies may need adapting as markets

of more rapid technical progress.

change. Breaking up firms should be

The question of appropriate

a last resort, used only for the most

anti-trust policy continues to be

dominant “super-monopolies” that

debated. The US Sherman Act of

show no signs of innovation. ■

1890, and subsequent anti-trust Joseph Schumpeter

The Austrian economist Joseph

His vision of capitalism as an

Alois Schumpeter was born

“evolutionary process” driven by

in 1883. He held chairs at the

innovation and “creative destruction”

universities of Czernowitz, Graz,

has enduring influence. During the

and Bonn before moving to Harvard

Great Depression, however, Schumpeter

in 1932, where he remained until

opposed Keynesian stimulus policies.

his death in 1950.

After a period of relative neglect,

Schumpeter was among the first economists to highlight the importance

Schumpeter’s work gained new

of innovation and entrepreneurship

prominence from the 1990s. He

for economic growth. His Theory of

is seen as a key thinker on the

Economic Development (1912) described

relationship between innovation,

the circular flow of economic life

competition, and growth.

being disrupted by innovative entrepreneurs. New goods, methods of production, and forms of industrial organization

Key works

were driven by the ambition and efforts

1912 The Theory of Economic

of business pioneers seeking temporary

Development

monopoly profits: this was the process

1942 Capitalism, Socialism and

of “creative destruction.”

Democracy

184

SUPPLY AND DEMAND GO GLOBAL

INTERNATIONAL TRADE

IN CONTEXT

CHINESE SILK BOOM - AND - BUST

FOCUS Trade between nations KEY THINKERS

Gottfried Haberler (1900–95)

When an economy is opened

Chinese goods. Markets adapt prices

International trade has

Eli Heckscher (1879–1952)

up to global trade, it experiences

and production, and trade volumes

grown massively since

changes to supply and demand.

increase in response to comparative

the early 20th century.

advantage. In the long run, living

Producers gain access to larger

standards rise.

foreign markets; consumers have

BEFORE

Bertil Ohlin

(1899–1979)

1776 Adam Smith argues for free trade based on

The Haberler-Heckscher-Ohlin

comparative advantage.

model sees nations specializing in and

more choice of cheaper imported

1856 British economist Henry

Comparative

goods. Adjusting to these changes in

exporting goods that rely on factors of

Sidgwick says free trade

advantage determines

supply and demand benefits all.

production they have in abundance, such

depends on similarities between nations, not absolute advantage.

how countries will specialize and trade.

as low-cost labor or natural resources.

1900 British economist Alfred

Marshall says firms have a

In the short run, imports can hurt

In the wake of World War II, nations realized the need to cooperate economically to ensure stability and growth. This led to the Bretton Woods agreements of 1944, which established the International Monetary Fund (IMF) and the World Bank.

The Bretton Woods system replaced the gold standard, which had broken down during World War I, with a system of fixed exchange rates pegged to the US dollar. The US dollar, in turn, was convertible to gold at $35 per ounce. The new system provided exchange rate stability and economic integration, facilitating the postwar economic recovery in Europe and Japan.

The Bretton Woods system lasted until the early 1970s, when the US suspended the convertibility of dollars into gold. The system transitioned into the current system of floating exchange rates, in which currency values are determined by the foreign exchange market based on supply and demand.

The Bretton Woods conference and agreements were a pivotal moment that shaped the postwar global economic order. They demonstrated the value of international cooperation on economic matters and led to greater global economic integration. However, the system was imperfect, relying too heavily on the US, and ultimately broke down due to macroeconomic stresses and policy failures. Still, Bretton Woods represented an important first step toward today’s globally integrated economy.

The key lesson is that international cooperation on economic matters can provide substantial benefits, but any system requires flexibility and shared responsibility to be sustainable in the long run. Bretton Woods achieved a great deal, but its collapse highlights the need for policymakers to design systems that can adapt to changing circumstances. Overall, Bretton Woods should be seen as a pioneering model for global economic governance.

In the postwar period, economists explored how poor countries could achieve economic growth and development. Some, like Paul Rosenstein-Rodan, argued that developing countries needed a “big push”—simultaneous large-scale investments in many sectors of the economy. This is because different industries are complementary and interdependent. For example, a factory needs power and transport infrastructure to be viable, while infrastructure needs industries to provide demand.

If investments are made together across many sectors, this can lead to a “take-off” into self-sustaining growth. Countries would progress through stages, from traditional societies to developed consumer economies. The economist Walt Rostow described this process of development.

The key challenge was how to fund and coordinate the necessary investments for balanced, multisectoral growth. Some economists, like Ragnar Nurkse, proposed government planning and direction of resources to achieve this. In contrast, others argued for free markets and private investment. There were also debates over the role of foreign aid and investment.

In summary, development economists explored how coordination problems could be overcome to enable poor countries to industrialize and raise living standards. The idea of simultaneous, interlinked investments across the economy—the “big push”—was seen as central to starting the process of development.

• According to expected utility theory, rational decision makers weigh the utility and probability of outcomes to choose the best option.

• But in practice, people’s choices are influenced by irrelevant alternatives. They change their preferences when new options are added, even if those options are irrelevant.

• This contradicts the assumption that people make rational choices based only on the outcomes themselves.

• The theory of expected utility was proposed in 1944 by von Neumann and Morgenstern. Later work built on this, but behavioral experiments revealed discrepancies between the theory and actual human decision making.

• Behavioral economics emerged in the 1980s to incorporate insights from psychology into economic modeling of human behavior.

Here is a summary of monetarist policy:

• Milton Friedman argued that money supply has a large, predictable effect on the economy. He believed governments should focus on controlling the money supply rather than manipulating interest rates or government spending.

• Friedman argued that people distinguish between permanent income (long-term earnings) and transitory income (short-term fluctuations). Permanent income determines consumption, while transitory income does not.

• Friedman proposed that the demand for money depends on several factors, including people’s budgets, the relative price of money compared to other goods, and tastes. He argued that if certain factors like the velocity of money and number of transactions remain constant, a higher money supply will lead to higher prices. In the long run, money only affects prices, not real economic activity.

• Friedman argued that there is a “natural” rate of unemployment below which inflation will accelerate. Government policy cannot push unemployment below this natural rate without causing inflation. Unemployment results from the slow adjustment of wages and prices, not a lack of demand.

• Friedman believed that inflation reduces economic efficiency and should be avoided. Modest, steady growth in the money supply is the best way to keep inflation low while allowing for economic growth. Monetary policy should aim for price stability rather than trying to manipulate real economic variables.

• In summary, monetarists believe governments should focus on controlling the money supply to promote price stability, rather than using fiscal policy to manage the real economy. Money supply, not demand, drives economic changes.

The Phillips Curve shows an inverse relationship between inflation and unemployment. When inflation is low, unemployment tends to be high. As inflation rises, unemployment falls. Governments realized they faced a trade-off between higher inflation or lower unemployment.

In the 1970s, the stable Phillips Curve relationship appeared to break down as stagflation emerged, with rising inflation and unemployment together. Milton Friedman argued this happened because governments had raised inflationary expectations. Their attempts to reduce unemployment had only pushed up inflation.

Friedman’s analysis undermined Keynesian economics. Governments turned to supply-side policies rather than demand management.

• Institutions matter in economics because they shape human interaction and behavior. They provide the framework for economic activity.

• Institutions are the laws, customs, and traditions of a society. They include both formal rules and informal norms.

• Economist Douglass North defined institutions as the “humanly devised constraints that shape human interaction.” They set the “rules of the game” for economies.

• Good institutions promote economic and social progress by enabling efficient markets, trade, and innovation. Bad institutions hamper progress by discouraging these activities.

• Institutional economists argue that to understand economic performance, we must understand institutions and how they emerge and change over time. Standard economics often takes institutions for granted.

• Examples of key institutions include property rights, the legal system, social norms around trust and cooperation, the education system, and political structures.

• Institutions are shaped by history and culture. They evolve over long periods of time and are difficult to change quickly.

• There is debate over which institutions are most significant for economic growth and how policy can influence institutional change. Institutions are complex, interconnected systems.

That’s the essence of the concept of institutions and their importance in economics according to institutional economists. Please let me know if you would like me to explain anything in the summary in more detail.

• Mainstream economics developed rigorous mathematical models of individual behavior and markets. These models were influenced by developments in the natural sciences.

• A key claim was that value is subjective and depends on individuals’ preferences and resources (the marginalist revolution). This allowed new ways of analyzing markets.

• A key question was whether free markets lead to optimal or “efficient” outcomes, as Adam Smith had claimed. The theoretical work of economists like Léon Walras, Gérard Debreu, and Kenneth Arrow suggested that under certain restrictive assumptions, free markets can achieve an efficient equilibrium.

• However, these models require many unrealistic assumptions, like perfect information, rational self-interested behavior, no transaction costs, etc. Relaxing these assumptions shows that markets often fail to achieve efficiency or optimal social outcomes.

• These findings supported arguments for government intervention to correct market failures and improve social welfare. But economists disagree on how extensive that intervention should be.

• Real-world markets are very complex, and mathematical models provide limited insight into how they function or how policy might influence them. Simple theoretical models should not be used as a rigid blueprint for policy.

• There is no consensus on how to define or measure social welfare, or on the appropriate balance between efficiency and fairness. Individual freedom and social equity are complex, contested values.

That covers the essence of the arguments around free markets, efficiency, and welfare in mainstream postwar economics. The key takeaway is that simple theoretical models suggest free markets can be efficient, but in reality, markets are complex, policy implications are unclear, and there are debates around values as well as economics.

• Markets are efficient when supply and demand are balanced, reflecting consumers’ preferences and limited resources.

• Gérard Debreu and Kenneth Arrow proved that under certain assumptions, markets can lead to an optimal outcome.

• Their “welfare theorems” show that markets can be Pareto efficient, where no one can be made better off without making someone else worse off.

• However, their theorems rely on unrealistic assumptions like perfect competition, rational consumers, no externalities, and perfect information.

• In reality, there are market failures like monopolies, pollution, and lack of information that prevent efficiency.

• Their work formed the basis of post-WWII economics and macroeconomic models, though these have been criticized recently for failing to predict crises like the 2008 financial crash.

• In social choice theory, Arrow examined voting systems to see if they can reflect individual preferences. He found that no system is perfect and they are subject to paradoxes.

• To evaluate a society’s well-being, we must consider individuals’ values. We need a system to make collective decisions about society’s welfare.

• Arrow aimed to find a fair system where social choices reflect individuals’ orderings of preferences. But he proved that no voting system can satisfy basic reasonable conditions.

• His “impossibility theorem” shows that a fair voting system is logically impossible. There will always be situations where the outcome does not match individuals’ true preferences.

• Economist Richard Easterlin argued in 1974 that increasing GDP and income do not necessarily lead to higher happiness and well-being in society.

• GDP measures the total income and output of an economy but does not reflect overall social welfare. There are other factors like relationships and life satisfaction that determine happiness.

• The concept of the “hedonic treadmill” suggests that people quickly adapt to higher levels of income and material well-being, and happiness remains largely unchanged.

• Once basic needs are met, increasing GDP and consumption may not increase happiness due to factors like envy, status anxiety, and overconsumption.

• Alternative measures like the Happy Planet Index have been proposed to measure well-being and sustainability more holistically than GDP alone.

• There is an ongoing debate about the link between economic growth, income, consumption and happiness or life satisfaction. Economists argue we should maximize happiness and well-being, not just income and GDP.

The theory of the second best states that when some market imperfections cannot be removed, attempts to correct other imperfections may make the overall situation worse. Markets are interlinked, and governments should not assume that policies which theoretically improve efficiency will have the desired effect in practice. Real-world economies contain many permanent distortions, so there may be no “first-best” solution available. The best option may be to leave some imperfections in place.

Policies should not be based on abstract theory alone. They require an understanding of how all the markets in an economy interact with one another. Governments should act cautiously when correcting imperfections, as their interventions may worsen the effects of distortions that cannot be removed.

The key argument is that in some circumstances, the least imperfect option may appear imperfect according to theory. But it achieves the best outcome available given the constraints of existing market failures. The theory emphasizes the complexity of real economies compared with theoretical models. No market operates in isolation, so policies aimed at improving one market may have unforeseen effects on others.

There are two imperfections in the market:

1. A monopolist is causing pollution.

2. Both the monopoly and the pollution are imperfections in the market.

The government has two choices to fix these issues:

1. Remove the monopoly and replace it with competing firms. However, this could make the pollution much worse.

2. Do nothing. This is the least bad solution but does not fix the underlying issues.

In summary, there are imperfections in the market that need to be addressed, but the solutions also have drawbacks that could make the situation worse. The least harmful option may be to do nothing, although this does not actually solve the problems.

• Globalization refers to the integration of markets across countries.

• Economic globalization has waxed and waned depending on policy choices and technology.

• Market integration means prices converge across locations. This happens as transportation costs fall.

• Governments can erect trade barriers like tariffs which impede globalization. The Smoot-Hawley tariff worsened the Great Depression.

• Technology like new transportation methods has enabled greater globalization over time. Some see globalization as inevitable due to technology.

• However, globalization also depends on policy choices. Governments can put up trade barriers. Globalization is not irreversible.

• Complete globalization would require harmonizing institutions like property rights across countries. But this may be undesirable and unfeasible.

• Dani Rodrik argues there is a “trilemma” between globalization, national sovereignty, and democracy. We can’t have all three simultaneously.

• Liberalizing capital markets has enabled greater globalization but also raises financial instability risks.

• In summary, globalization depends on both technology and policy choices. While technology provides opportunities for globalization, policy barriers can curb globalization. Globalization faces trade-offs with national sovereignty and democracy.

Game theory is a mathematical framework for analyzing strategic interactions between decision makers. It asks the question: what should I do, given what I think the other participants will do?

Game theory typically considers a “game” to be any situation in which multiple decision makers interact. The key focus is on how rational and self-interested players should behave to maximize their payoffs, given their expectations about what the other players will do. By analyzing the optimal strategies and outcomes for different types of games, game theory provides insight into complex real-world interactions and situations involving cooperation, competition, and conflict.

The seminal work in game theory was John Nash’s 1950 PhD thesis, in which he defined and analyzed non-cooperative games in which each player acts independently. Nash’s research focused on games where players had to choose between cooperative and non-cooperative strategies. His insights showed that in some games, players can obtain higher payoffs by cooperating, while in others competition is optimal. This helped economists and other social scientists understand how cooperation emerges and breaks down in society.

Since the 1950s, game theory has been used to analyze a wide range of social, political, and economic phenomena. It has many applications in fields such as economics, political science, evolutionary biology, and philosophy. Game theory provides a mathematical framework for modeling strategic interactions between rational decision makers.

That’s a high-level overview of the key concepts in game theory and its applications. Let me know if you would like me to elaborate on any part of the summary.

• In 1944, John von Neumann and Oskar Morgenstern published Theory of Games and Economic Behavior.

They analyzed cooperative games where players could communicate to find solutions that benefitted both parties.

• In the 1950s, mathematician John Nash extended this work to non-cooperative games where players make independent

decisions. Nash identified the “Nash equilibrium” as the state where neither player wants to change their strategy given

what the other player is doing.

• An example is the “prisoner’s dilemma” game created in 1950. Two prisoners must decide whether to betray the other. The

Nash equilibrium is for both to betray, even though cooperating would benefit them more.

• The RAND Corporation employed scientists to study strategic decision making during the Cold War. They devised cruel

non-cooperative games like “So Long Sucker.” The iterative “prisoner’s dilemma” became known as the “peace-war game” used

to analyze the arms race.

• Real-world experiments found people cooperate more than predicted. But Nash argued only betrayal is the true equilibrium.

• John Nash made seminal contributions to game theory but struggled with schizophrenia for much of his life.

Dependency theory argues that rich, developed countries exploit poor, developing countries through unfair trade and economic policies. These policies are designed to benefit the rich countries and protect their dominance, not help the poor countries develop.

For example, while free trade and open markets are said to help economies grow, dependency theorists argue this only really benefited today’s rich countries when they were developing. For poor countries today, these policies often mean rich countries take advantage of them through unequal trading terms and relationships.

This exploitation causes poor economies to stagnate or shrink, even as rich countries continue to get richer. In other words, rich countries actively impoverish poor countries in order to preserve their own wealth and power. Dependency theory sees the global economy as a system that perpetuates the poverty of poor countries and the dominance of rich countries.

The key proponent of dependency theory was Andre Gunder Frank. He argued that the economic policies and development strategies pushed by Western countries and institutions like the IMF and World Bank were not meant to actually help poor countries develop. Rather, they preserved the global divide between the dominant rich countries of the “core” and the dependent poor countries of the “periphery.”

In summary, dependency theory holds that the poverty of poor countries is not accidental but is instead the result of systematic exploitation by rich, developed countries. The global economic system is rigged to benefit the rich at the expense of the poor.

Here are the key ideas summarized:

• Early economic models assumed that people form “adaptive expectations”—they base their expectations of the future solely on past events.

• The theory of “rational expectations” proposed that people make predictions about the future using all available information. They anticipate the effects of events like government policy changes and adjust their behavior accordingly.

• Under rational expectations theory, governments cannot influence the economy through policy changes in the long run because people’s expectations and behaviors adapt.

• The theory implies that there is no long-run trade-off between inflation and unemployment. Unemployment depends on the productive capacity of the economy. Inflation depends on growth in the money supply.

• The theory of rational expectations emphasizes that people are not easily fooled in markets. They make educated predictions of future events rather than just following past patterns.

• The theory suggests that government policy aimed at stimulating demand will only have temporary effects. Once people anticipate the effects, the policy becomes ineffective.

• The rational expectations revolution contributed to the decline of Keynesian demand management policies. Policy makers had to find new ways to stabilize economies.

That covers the key elements of the theory of rational expectations and its implications. Let me know if you would like me to explain anything in the summary in more detail.

• Economies that are highly integrated can benefit from a single currency
• A single currency removes exchange rate fluctuations and transaction costs
• The economic shocks and business cycles of integrated economies tend to be synchronized
• The euro currency was introduced in Europe to facilitate trade and economic integration between European nations

Let me know if you would like me to elaborate on any part of the summary.

• The Bretton Woods system established in 1944 regulated global finance until the early 1970s. It was based on fixed exchange rates to promote trade and stability.

• In the 1960s, economist Robert Mundell analyzed the idea of an “optimal currency area”—a region that would benefit from a shared currency. The key factors were economic integration, similar business cycles, and mechanisms to redistribute funds between regions.

• The European Union introduced the euro single currency in 1999 to facilitate trade between member states. The eurozone crisis after 2008 revealed flaws, as northern and southern Europe had different economies and business cycles but lacked redistribution.

• For a currency area to succeed, its regions should have flexible markets, mobile labor and capital, synchronized business cycles, and fiscal transfers between surplus and deficit areas. The eurozone lacked some of these, making crisis more likely.

• The concept of an optimal currency area suggests that for maximum benefit, a shared currency should cover an area with strong economic integration and similar cycles, not necessarily a nation-state. Small regions that cross borders may benefit.

• The crisis revealed a north-south split, with Germany running trade surpluses as southern nations fell into deficit. Without redistribution, these imbalances accumulated as debt until crisis hit.

The key argument is that for a shared currency to function well and maximize benefit, the area it covers should have certain economic characteristics—especially mechanisms to redistribute funds between regions. In theory, a currency area could be of any size, but its makeup is more important than its boundaries. The problems of the eurozone show what can happen without these mechanisms.

Here is a summary in 15 words:

Keynesian policies faltered in 1970s. Monetarists advocated free markets. Conservatives deregulated, prioritizing inflation over jobs.

• In the 1970s, fixed exchange rates and tight financial regulation came under pressure.

• Derivatives are financial contracts based on the value of an underlying asset like commodities. They allow risk to be managed but also enable speculation.

• Fischer Black, Myron Scholes, and Robert Merton developed a model to price options, a type of derivative. Their model assumed efficient markets, the ability to hedge all risk, and a normal distribution of price changes.

• Their model allowed derivatives to be traded on a large scale. It paved the way for huge growth in derivatives markets.

• Derivatives can be used to hedge risk but also enable speculation on a large scale due to leverage (the ability to control large amounts with little money).

• Exchanges started offering derivatives in the 19th century but governments often banned or restricted them due to fears of speculation. Restrictions were lifted in the 1970s, leading to large derivatives markets.

The key point is that Black, Scholes, and Merton’s model provided the intellectual justification and mathematical toolkit for massive expansion of derivatives markets. Their assumptions suggested risk could be managed and speculation was rational. In reality, derivatives contributed to increased financial instability.

Here is a summary of the key ideas:

the cost of the programs, and focus

of proceeding to stage 2. At stage 2,

and program D, which offers

• People do not always make rational decisions that maximize their utility. Their

only on the lives saved, a different

would you prefer a certain gain

a one-third chance of saving

choices depend on psychological factors like how options are framed and whether they

result can be expected. When

of $1,500 or a two-thirds chance

600 people versus a two-thirds

face potential gains or losses.

the problem is framed in this way,

of winning $3,000?

chance of no one being saved,

• People tend to be risk-averse when facing gains but risk-seeking when facing losses.

most people will choose program B:

They dislike losses more than they like equivalent gains.

they focus on the chance of saving

• Common sense suggests that tax cuts reduce government revenue. However, some economists argue that this is not always the case.

• According to “supply-side” economists, cutting taxes can actually increase economic activity and government revenue. This is because lower taxes encourage people to work more, and companies to produce more. The increased economic activity then boosts the total tax take.

• The idea is illustrated by the Laffer curve. This shows that at tax rates of 0 percent and 100 percent, the government will receive no revenue. In between, there is a tax rate that maximizes revenue.

•Supply-side economists argued that high tax rates in the 1970s had pushed economies to the right of this peak. Tax cuts could therefore boost growth and revenues.

• Very high tax rates can also encourage tax avoidance and drive high-income individuals and investment away to “tax havens”. These are countries with low or no taxes, formed to attract foreign money.

• There was debate over where each country’s maximum revenue point on the Laffer curve lies. Supporters of tax cuts argued the economy was to the right of the peak, so cuts would raise revenue. Critics argued the opposite.

• The supply-side argument is that the best way to boost growth is by improving conditions for producers—cutting taxes, regulations, and subsidies. This is meant to enhance economic efficiency and the overall tax take.

• The supply side of the economy refers to producers, as opposed to the demand side which refers to consumers. Supply-side policies aim to stimulate production and economic expansion.

Does this summary accurately reflect the key ideas and arguments discussed? Let me know if you would like me to clarify or expand on any part of the summary.

• Buyers have less information about product quality than sellers. This is known as “asymmetric information.”

• Uncertainty caused by asymmetric information can lead buyers to drop the prices they are willing to pay.

• In the market for used cars, this can mean “lemons” (low-quality cars) drive out good cars, causing the market to fail.

• In insurance markets, this is known as “adverse selection,” where companies struggle to identify high-risk customers. They may have to raise premiums for all to account for the costs of insuring lemons.

• Markets can adjust to deal with these problems, e.g. through guarantees, screening of customers, or signaling of product quality. But asymmetric information continues to create inefficiencies.

The key ideas in complexity and chaos theory that challenge standard economics are:

1. Nonlinearity. Tiny changes in initial conditions can lead to large, unpredictable changes in outcomes. This is known as sensitivity to initial conditions or the “butterfly effect.”

2. Emergence. The macro behavior of a system emerges from the micro interactions between components and cannot be deduced from the properties of the components.

3. Self-organization. Order arises spontaneously from the local interactions between components. There is no planner or central controller.

4. Path dependence. The evolution of a system depends on its history and initial conditions. There are multiple possible paths, not a single equilibrium.

5. Power laws. Many systems exhibit scale-free behavior where large events are not exponentially less likely than small ones. This gives rise to fat tails and black swans.

6. Feedback. The outputs of a system feed back as inputs, creating loops that can amplify effects. Positive feedback leads to increasing returns; negative feedback stabilizes a system.

7. Adaptation. The components of a complex system—people, firms, technologies—adapt and coevolve with each other in an endless, open-ended process of change.

So in summary, while individuals may behave rationally and predictably, the economy as a whole can exhibit chaotic, unpredictable behavior due to the complex interactions between those individuals. The equilibrium predicted by standard economics may never arise. The economy is an open, evolving system, not a mechanical clockwork system.

East Asian governments actively intervened in and governed their economies to promote growth.

Economic growth in East Asia was driven by government policies that promoted export-oriented manufacturing and technological upgrading. Governments in South Korea, Taiwan, Hong Kong, and Singapore, the so-called Asian Tiger economies, intervened in their economies in ways that seemed to support markets rather than interfere with them. They ensured macroeconomic stability, built infrastructure, improved education, and promoted targeted industries. Although their policies went beyond a minimal state role, the Tigers preserved private enterprise and competition.

Their governments were able to “get prices wrong” for a time by subsidizing and protecting new industries, but they also enforced performance criteria to ensure these “infant industries” became efficient. If governments had not maintained autonomy from private interests, their interventions might have led to stagnation rather than growth. The success of the Asian Tigers’ developmental states contrasted with failed attempts at such policies in Latin America and Africa, where governments were unable to discipline private firms.

China created its own variant of the developmental state after economic reforms began in 1978. China unleashed private economic activity and trade without establishing Western-style property rights and incentives. Its unique institutions, such as giving local managers responsibility for firms’ performance, helped promote dramatic growth, though China remains relatively poor. The rise of China has revived interest in the developmental state model.

In summary, the Asian Tigers achieved rapid development through a new kind of state that both led and followed markets. Their governments actively shaped the allocation of resources in line with market forces to build new competitive advantages and promote sustained growth. When implemented successfully, as in East Asia, such a developmental state could achieve rates of economic growth that far outpaced more market-friendly economies.

• Currency crises involve a sudden large drop in a currency’s value.

• They were more common after fixed exchange rates ended in 1971.

• Paul Krugman showed a crisis can happen when policies contradict a fixed exchange rate.

• In “first generation” models, speculation attacks a currency when its “shadow rate” falls below its fixed rate.

• These models seemed to fit Latin American crises in the 1980s but not the 1992-93 ERM crisis.

• “Second generation” models allowed for government choices and multiple outcomes. Crises could be “self-fulfilling.”

• The only way to avoid speculation is not to have a fixed exchange rate.

the tradition of Adam Smith and David Ricardo, was that free markets

Hyman Minsky (1919–96)

were inherently stable. This view prevailed until the 1930s Great Depres-

BEFORE

sion, when John Maynard Keynes revived the possibility that market economies could experience prolonged periods of joblessness and hardship.

1776 Adam Smith argues in

The Wealth of Nations that the “invisible hand” of the market

More recently, some economists have argued that financial markets

will produce stability.

can also be inherently unstable. One of the most prominent proponents

1936 Keynes’s General Theory

of this view was the US economist Hyman Minsky. Minsky believed that

argues that capitalism is not

stable economies contain the seeds of their own instability. During good

self-regulating and can result

times, optimism builds, interest rates fall, and credit flows freely. This leads

in prolonged unemployment.

borrowers and lenders to take on more and more risk, fueling speculative

AFTER

bubbles. When the bubble bursts, it is too late. The financial system seizes

2008 Following the global

up, lenders pull back, and major economic disruption results. Minsky argued

financial crisis, Minsky’s view

that government intervention is needed to constrain instability and pre-

that markets are not self-stabilizing

vent crises. His “financial instability hypothesis” has gained many adher-

gains greater credence.

ents, especially after the global financial crisis of 2008.

2014 French economist Thomas Piketty’s bestseller Capital in the Twenty-First Century argues that capitalism has a tendency toward instability, inequality, and crises.

Minsky laid out his view that stability contains instability in an influential

1986 book called Stabilizing an Unstable Economy. He argued that government institution of restricting regulation and that the growth of speculative finance and asset bubbles are natural consequences of stability itself. Policies are needed to contain instability and restrain speculation, but instability will always be an inherent tendency. His theory anticipated the dynamics behind the 2008 global financial crisis and has gained many followers as a result. The conflict between views of markets as self-stabilizing or prone

to instability and crisis continues to be debated and will likely shape economic policies for years to come.

weakened budgets. The ripple

effects spread around the globe. The summary is: 1) Hyman Minsky summarized that the assumption of mainstream economic theory up till then was that a capitalist economy will eventually attain a stable equilibrium. 2) However, based on the Great Depression of 1929, Minsky realized that a capitalist economy contains inherent instability.

• Finding certain goods or services, such as a used car or a job, typically involves search frictions. This means that buyers and sellers do not automatically find each other, unlike in the classical view of perfect markets.

• Search theory examines how people make choices in the face of imperfect information and costly search. Economists like George Stigler and Dale Mortensen studied how search frictions can lead to mismatch in markets.

• For example, there may be many unemployed workers at the same time as many unfilled job vacancies. This is because it takes time and effort for workers and firms to find good matches. The search process is like dating—people search within a limited range and accept less-than-perfect matches.

• The implication is that markets do not always clear quickly or reach a stable equilibrium. Search frictions help explain real-world phenomena like unemployment, unfilled jobs, and wage dispersion.

• Policymakers may need to provide job search assistance and labor market information to help overcome search frictions. But too much assistance can reduce the incentives for self-help. There is a trade-off between efficiency and equity.

The key points are:

free markets. Government policy

Apart from taxes, emissions

is needed to limit greenhouse gas

damages.

targets can also be achieved

• Burning fossil fuels releases carbon dioxide and other greenhouse gases, accelerating climate change.

by schemes such as emissions

trading

•

or

cap and trade,

The cost of tackling climate change will be high, but the cost of failing to act could be even higher. Economists

William Nordhaus and Nicholas Stern have calculated the potential economic impacts.

where governments set an overall

• The problem has unique economic features: It is long term, global, with uneven costs and benefits across countries.

cap on emissions but allow firms

• There are arguments for government intervention to curb emissions and provide public goods. Regulation, taxes,

to trade permits to emit within

and emissions trading are policy options.

that cap. Firms that pollute

• Developed economies are mainly responsible for historic emissions but developing countries will contribute more

less can sell extra permits for

in future. An equitable global solution is needed.

• There is no consensus on the best policies or the scale and speed of action required. Balancing economic costs and

a profit, giving them an incentive

environmental benefits is complex.

to cut emissions. Those needing

to emit more can buy extra

permits. The aim is to achieve the

emissions target in the most cost-

effective way overall. However,

such schemes require complex

regulation and monitoring. The key challenge is to find a

fair and equitable global solution,

as the impacts of climate change

and responsibilities for emissions

cuts will not fall evenly across

countries. Developed economies

have contributed most to historic

CONTEMPORARY ECONOMICS 309

cap-and-trade schemes aim to incentivize polluters to curb emissions, rewarding those who cut back the most. Critics argue they are complex to implement and open to abuse.

are most able to act but developing

in these decisions. The 2015

economies will dominate future

UN Paris Agreement marked

global emissions. According

a turning point, with 195

to the “polluter pays” principle,

countries pledging to curb

developed nations should take the

emissions to limit warming to

lead in cutting emissions. But this

under 2°C (3.6°F), and aim for

could hamper the economic growth

1.5°C (2.7°F). However, pledges

of developing countries, if they are

so far are not legally binding,

required to adopt expensive “green”

and there are doubts about the

technologies. There is no simple or

scale and speed of action that

universally accepted formula for

may actually result.

balancing responsibility, economic

The economics of climate

costs, and environmental benefits

policy is complex with many

in tackling this issue.

trade-offs to consider. There

International cooperation is vital to

are arguments on all sides, and

addressing climate change effectively,

reasonable disagreement on

but countries have different interests

the best course of action. ❯❯

310 ECONOMICS AND THE ENVIRONMENT

Economists… aim to devise policies that balance economic prosperity with environmental sustainability. The challenges are enormous but so are the costs of inaction.

Finding consensus at a global

scale is immensely challenging. Economists endeavor to evaluate the options objectively, aiming to devise policies that balance economic

prosperity with environmental sustainability. The challenges are enormous but so are the costs of inaction, if the scientific projections about future climate change prove correct. Urgent action is needed, but it must be economically sound and politically feasible to implement. There are no easy answers, but economics has a key role to play in defining the choices available and evaluating the likely outcomes of the policies we adopt. ■

• GDP measures the value of market transactions in an economy but ignores non-market activity like housework and child care.

• These non-market activities are disproportionately performed by women but are not counted in GDP. This results in a systematic underestimation of women’s economic contribution.

• The distinction between what is counted in GDP and what is not depends arbitrarily on whether a market transaction is involved, even if the underlying activity is the same. This arbitrarily disadvantages women’s work.

• GDP also fails to account for the depletion of natural resources and environmental damage. Although economic activity that consumes natural resources adds to GDP, the lost value of the resources themselves is ignored.

• The economist Marilyn Waring has been a prominent critic of the gender bias implicit in standard economic measures like GDP. She argues these measures systematically undervalue the economic contribution of women.

• Alternative measures of economic progress and development have been proposed to correct for the shortcomings of GDP, including measures that try to quantify the value of non-market activity and account for environmental sustainability.

So in summary, the key problems with GDP are that it ignores non-market activities disproportionately performed by women, systematically underestimating their economic contribution; it fails to account for environmental damage and natural resource depletion; and it relies on arbitrary distinctions that disadvantage women’s work. Alternative measures have been proposed to address these shortcomings.

Cold War or for commercial reasons.

• Poor countries racked up huge debts from 1970s onward. • By 1990s, debt had become unpayable for many and was hampering growth. • Campaigners argued debts were “odious” as many were made to corrupt regimes. • They said lenders were irresponsible and countries had no obligation to repay. • Others said canceling debts could kick-start growth by freeing up funds for investment. • G8 agreed to cancel some debts, but debt relief often came with damaging policy conditions. • The debt crisis has now shifted to Europe, with similar austerity measures but no debt cancellation.

• In the 1980s, economists Diamond and Dybvig developed a model explaining how bank runs can happen even to healthy banks.
• Their model assumes there are patient depositors who want to invest for a longer term and impatient depositors who want to withdraw money quickly.
• Banks invest most deposits for the long term but keep some in cash reserves. If many impatient depositors withdraw at once, the bank may run out of cash and have to sell investments at a loss.
• Pessimism or a shift in expectations can lead to a bank run as depositors rush to withdraw funds, fearing the bank may fail. This self-fulfilling prophecy can sink even a healthy bank.
• Diamond and Dybvig proposed deposit insurance and liquidity support from central banks as ways to prevent destructive bank runs.

Deposit insurance guarantees depositors’ funds up to a limit, reducing the incentive to join a run. Central bank support provides emergency cash to meet withdrawals.

• Ben Bernanke argued that large trade deficits in the US were funded by a “global savings glut” - excess savings in export-surplus countries like China.

• The US trade deficit rose sharply in the late 1990s and 2000s. Domestic investment was steady but domestic savings fell. The deficit was funded by foreign money, especially from China.

• China and other countries were saving excess money rather than investing or consuming. Bernanke cited reasons like rising oil prices and countries building up reserves.

• The excess global savings ended up in US financial markets, reducing interest rates and incentives for Americans to save. Lenders offered easy mortgage deals.

• To meet demand for investments, US banks created high-risk, high-return products like CDOs (collateralized debt obligations) that packaged risky mortgages with safer bonds. These were given AAA ratings.

• House prices rose and riskier “subprime” mortgages were offered. In 2008, subprime mortgage failures exposed how exposed major banks were to risks, triggering the global financial crisis.

• Bernanke argued Chinese cash fueled US risk-taking, though only a small amount went into risks. Critics argue global imbalances alone didn’t cause the crisis. Poor regulation and risk management were larger factors.

• The “savings glut” theory suggests an unhealthy dependence of the US on foreign money that can suddenly be withdrawn, but also implies China was to blame for the crisis. The reality is more complex.

So in summary, Bernanke pointed to high global savings and deficits as factors in the financial crisis, with money from surplus countries like China flowing into unsustainable US mortgages and fueling a credit bubble. However, the crisis really stemmed from failures of regulation and risk management. The “savings glut” theory is too simplistic.

• Alberto Alesina and Dani Rodrik examined how income distribution affects economic growth.

• They argued that economic growth depends on growth in capital (accumulated wealth).

• However, capital accumulation depends on tax rates, which are set by governments to please median voters.

• If wealth is evenly distributed, median voters will prefer lower taxes, enabling growth.

• If wealth is unequally distributed, median voters will prefer higher taxes, slowing growth.

• Therefore, more equal societies will have higher economic growth, according to Alesina and Rodrik.

• However, others argue that economic growth actually reduces inequality, not vice versa.

• Fast-growing economies have raised living standards and reduced poverty worldwide.

• Slower-growing economies often see little progress against inequality and poverty.

• Nordic countries combine high taxes, high living standards, and low inequality, contrary to the model.

• Alberto Alesina argued politics significantly influences economic outcomes.

with major economic expansions.

en rising house prices and GDP

• The housing market reflects

In the US, for example, house prices

growth. They argued that an

fluctuations in the wider economy.

growth and house price growth

increasing housing market boosts

During boom times, demand for

have moved closely together over

residential investment and

housing rises, fueling price increases

the last 50 years.

consumption. Using global data,

and residential investment.

they demonstrated that a 1.5

• House prices are often slow to adjust,

Housing and growth

percent increase in house prices

and so can remain high even when

A buoyant housing market can

is correlated with an increase of

sales fall. But stagnating prices and

actually fuel economic growth. In

around 0.35 percent in GDP. They

declining residential investment can

a 2014 paper, economists Christian

concluded that rising house prices

signal an impending recession.

Demurger, Louis-David Laredo,

were also correlated with higher

• Irresponsible mortgage lending and

consumption and investment in

unrealistic expectations of constantly

both residential and non-residential

rising house prices were major

stock. Declining house prices, on

contributors to the 2008 financial crisis.

the other hand, had a negative effect on both investment and consumption. ■

332

FREE TRADE

BENEFITS ALL

ECONOMIES

THE CASE FOR FREE TRADE

IN CONTEXT

FOCUS

International trade policy

KEY THINKER

David Ricardo (1772–1823)

BEFORE

The theory of free trade is based

of an economy to produce goods

on the idea that a free flow of goods

and services more efficiently due

between countries benefits all

to their availability of natural

economies. If countries specialize

resources and human skills.

in the areas that they are most

Key to this argument is the idea

efficient at producing, and then

of comparative advantage—that a

trade with other countries, more

country will specialize in goods

goods will be produced at a lower

that it can produce relatively more

cost. This increases the overall

cheaply, compared to other goods.

1776 Adam Smith argues in

welfare in all countries.

Even if a country is not as efficient

The Wealth of Nations that

as another in producing everything,

free trade leads to greater

it will still specialize in products

prosperity. Tariffs and

for which it has the lowest

trade barriers reduce

opportunity cost.

economic efficiency.

1817 David Ricardo outlines

the theory of comparative

advantage, showing how all

countries benefit from free

trade even if one country

has an absolute advantage

in all areas of production.

AFTER

1850 British economist

John Stuart Mill argues

that free trade leads to

peace between nations.

1944 Economists propose the

Bretton Woods system of

free trade and pegged exchange

rates to boost postwar

A container ship enters Singapore en route to ports in China, demonstrating

economic growth.

international free trade in action between many Southeast Asian countries.

2016 Economist Paul Krugman

argues that global trade may

have reached its peak due to

The theory of comparative

technological change and a

In his 1817 work On the Principles of

advantage states that each country

trend toward rising economic

Political Economy and Taxation,

should specialize in those products

nationalism in some countries.

British economist David Ricardo

that it can produce relatively cheaply.

developed a theory of international

This specialization and trading with

trade based on free markets and

other nations leads to lower costs,

specialization. He argued that free

increased efficiency, greater

trade benefits all trading partners,

production of wealth, and higher

even if one country is more efficient

overall world welfare.

at producing everything, because each country can focus on the area

CONTEMPORARY ECONOMICS 333

See also: Globalization 68–73 ■ Game theory 186–91 ■ Economics and international relations 266–71 ■ Economic

growth in developing countries 300–05

Comparative advantage in action To see how comparative advantage works, consider a simplified example of two

countries, Thailand and Brazil, and two

products, rice and coffee.

• Thailand can produce 10 units of rice or 5 units of coffee with the same resources. • Brazil can produce 15 units of rice or 20 units of coffee with the same resources.

Brazil has an absolute advantage in both products (it is more efficient at producing

everything). But Thailand has a comparative advantage in rice (it is relatively more

efficient at producing rice), and Brazil has a comparative advantage in coffee.

If each country specializes in their comparative advantage and trades, more of both

goods are produced overall:

• Thailand produces 10 units of rice. • Brazil produces 20 units of coffee.

• They trade, with Brazil exporting 10 units of coffee to Thailand in exchange for

5 units of rice from Thailand.

• Total world production increases to 10 units of rice and 20 units of coffee.

Without trade, world production would have been 10 units of rice and 15 units of

coffee (if both countries split their production). So both countries are better off

due to specialization and trade. Even though Brazil has an absolute advantage, it still

benefits from trade with Thailand.

The theory suggests that all countries can gain from free trade through increased

efficiency, lower costs, and greater total production. In practice, however, a move to

free trade may involve some short-term costs, such as job losses in declining sectors,

and the benefits are not always shared equally within countries. Also, the theory

assumes that markets are perfectly competitive, factors of production are highly

mobile between industries, and there are no externalities or public goods involved—

all unrealistic assumptions. But in general, free trade is seen as beneficial by most

mainstream economists.

Born in London, Richard Kahn shared

parties). His other major

John Maynard Keynes’ view that an

contribution was the Pigou

• Jean-Baptiste Colbert (1619–1683) reformed tax in France and boosted trade.

unregulated market system was

Welfare Fund, which applied

• Pierre de Boisguilbert (1646–1714) opposed Colbert’s taxes and favored free trade.

unstable and subject to periodic

utilitarian principles (seeking the

• Yamagata Banto (1748–1821) introduced Western ideas to reform feudal Japan.

slumps. While studying at King’s

greatest good for the greatest

• Friedrich List (1789–1846) proposed a German customs union and nationalist economics.

College, Cambridge, in the late

number) to the measurement of

• Joseph Bertrand (1822–1900) studied competition and proposed an alternative to Cournot’s model.

1920s, he proposed the idea of the

social welfare.

• Carl Menger (1840–1921) founded the Austrian School and proposed marginal utility theory.

“multiplier effect”—the way an

See also: External costs 134–35 •

• Eugen von Böhm-Bawerk (1857–1929) was also of the Austrian School; he studied interest and Marxism.

initial injection of investment could

Economics and sociology 136–41

• Thorstein Veblen (1851–1914) took an institutionalist approach and studied conspicuous consumption.

have a multiplied effect on aggregate

• Arthur Pigou (1877–1959) studied externalities and devised Pigouvian taxes and the concept of social welfare.

demand in an economy. Keynes

• Ragnar Frisch (1895–1973) founded econometrics and proposed a national macroeconomic model.

incorporated Kahn’s idea into his

RAGNAR FRISCH

• Richard Kahn (1905–1989) proposed the idea of the “multiplier effect,” incorporated into Keynes’s theory.

General Theory to argue for

1895–1973

the use of fiscal policy to stimulate demand. Kahn became director

A pioneer in the application of

of the economics department at

mathematical and statistical

Cambridge from 1959 to 1966.

methods to economics, Ragnar

See also: The Keynesian

Frisch was born in Norway. With

revolution 114–21

his collaborator Jan Tinbergen, he

Richard Kahn was a British economist known for developing the Keynesian multiplier. He studied at Cambridge University and worked as an advisor to the British government.

Paul Rosenstein-Rodan was an economist known for proposing the “Big Push” theory of development economics. He was born in Poland but fled to London during World War II. He worked for the World Bank and advised several developing countries.

Nikolai Kondratiev was a Russian economist known for proposing the existence of long economic cycles, now called Kondratiev waves. He studied at the University of St. Petersburg and worked for the Russian government before being executed in 1938.

Ragnar Nurkse was an Estonian economist known for his work in development and international economics. He studied in Estonia, Scotland, and Vienna before working for the League of Nations. He later taught in the US.

Ragnar Frisch was a Norwegian economist and the first winner of the Nobel Prize in Economics. He was known for applying mathematical and statistical techniques to economics.

Jan Tinbergen was a Dutch economist and the first winner of the Nobel Prize in Economics along with Ragnar Frisch. He studied mathematics and physics before applying scientific methods to economics. He proposed the “Big Push” theory of development along with Paul Rosenstein-Rodan.

Here is a summary of Michael Todaro:

• Michael Todaro is an American economist who specializes in development economics and urban economics.

• He studied economics at Princeton University and Harvard University, receiving his PhD from Harvard.

• He spent most of his career teaching at Harvard University and Stanford University.

• His research focused on migration, unemployment, economic growth, and economic development in poor countries.

• He is best known for proposing the Todaro migration model, which explains rural-urban migration in developing countries. The model argues that migration depends on the expected urban real wage and the probability of finding an urban job, not just the actual urban wage.

• Some of his major books include Economic Development in the Third World and Economic Development.

• He collaborated frequently with Stephen Smith, with whom he co-authored multiple editions of Economic Development.

• Todaro made significant contributions to development economics through his research, teaching, and advising of students. He helped shape many of the economic policies adopted by developing countries.

That covers the key highlights from Michael Todaro’s career and contributions as an economist. Let me know if you would like me to explain anything in the summary in more detail.

Here is a summary of the key economic terms:

Exchange rate The price of one currency in terms of another.

things today as it did 50 years ago).

Recession A period of economic

Utilitarianism claims that utility,

decline with a fall in production,

or total satisfaction, should be

income, employment, investment,

maximized across society.

and sales, persisting for at least

Utility The satisfaction gained

two quarters. Recessions are often

from consuming a good or service.

Oligopoly A market dominated by

caused by a drop in demand leading

a few large firms. There is a danger

to oversupply and a drop in prices.

344 GLOSSARY

Amount of goods: 1980: Higher due to post-WWII economic expansion 2000: Lower due to recession and financial crisis

Utility: A unit used to measure satisfaction from consuming goods and services.

Recession: A period when economic output decreases.

Oligopoly: An industry with a few large firms. They can influence the market but still face some competition.

It seems this is a list of names and concepts related to economics, especially history of economic thought and macroeconomics. The key names that appear repeatedly and seem most significant are:

• John Maynard Keynes: pioneer of macroeconomics and advocate of government intervention and spending during recessions.

• Adam Smith: founder of classical economics and advocate of free markets and division of labor. Proposed the “invisible hand” metaphor.

• Friedrich Hayek: leading proponent of free market economics and critic of government intervention and central planning.

• Milton Friedman: leader of the monetarist school of economics that focused on controlling the money supply. Critic of Keynesianism and advocate of free markets.

• Joseph Schumpeter: focused on entrepreneurship, innovation, and “creative destruction” of markets.

-Rational expectations theory: proposed by Robert Lucas and others. Argued that people rationally anticipate and respond to policy changes, limiting government’s ability to influence the economy.

The key concepts that are discussed include:

• Free markets vs. government intervention and regulation

• The “invisible hand” and self-interested behavior leading to economic benefit

• The quantity theory of money and monetarism

• Rational expectations and limitations of policy

• Creative destruction, innovation, and entrepreneurship

• Inequality and theories of economic growth in developing countries

• Microeconomics vs. macroeconomics

• General equilibrium theory and market failures

Does this help summarize the key ideas and themes in the list of names and concepts? Let me know if you would like me to clarify or expand on any part of this summary.

I apologize, but the publisher

Library of Munich: (Quad). 254 Getty

Mary F. Calvert (tl). 302 Getty Images:

has not provided picture credits for

Images: Eye Ubiquitous / Courtesy GlaxoSmithKline (tr); AFP / Daniel Mihailescu the images shown on pages 232 and

pages 208 to 210. 213 Corbis: Ed

of Senckenberg Museum (Shells).

(bl) 304 Corbis: Jeff Greenberg (bl).

Kashi (br). 215 Getty Images:

260 Getty Images: AFP / Rodrigo

305 Getty Images: Cris Bournocle/

Bloomberg / Graeme Hunter (br).

Arangua (tr). 261 Dorling Kindersley:

AFP / Stringer (cr). 307 Getty Images:

217 Globe Magazine (tc). 218

Philip Greenspun (bc). 263 Dreamstime. Digital Vision / Andrew Pinkerton

Dreamstime.com: Monkey Business

com: Peter Zelei Images (tr). Getty

The publisher has not provided picture

Images: Bloomberg / Scott Eells (bl).

credits for the images shown on

(tr). 221 Corbis: Ocean (bl). 222 Getty

264 Getty Images: Richard Cummins

pages 208 to 210.

Images: Alterphotos (br); Chris Graythen / Bloomberg (bl);

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Scott Eells / Bloomberg (tr). 223 Corbis: / Tony Burns (cr). 269 Getty Images:

A. Dagli Orti (bl). 272 Corbis: Bettmann

Reuters / Jason Lee (tl). Getty Images:

Bloomberg. 274 Dreamstime.com: Zsolt

The publisher apologizes for the

AFP / Sandy Huffaker (br). 225 Corbis: Balogh (tr). 276 Getty Images: Peter

missing information, but unfortunately

Custom / Andy Lyons (bl); NASA (tr).

Macdiarmid (bl). 278 Corbis: Viktor

we do not know the sources of those

227 Getty Images: AFP / Adek Berry

Bracic (tr). 280 Corbis: Robert Melanson

images.

(tc). 228 Bloomberg / Nelson Ching

(cr). 281 Corbis: John & Lisa Merrill

(Surface).

Final pass: Okay, I understand. My Assistant: I apologize, but I do not have access to the specific picture credits for those pages.

(bl); Getty Images: The Bridgeman Art

(tr). 283 Corbis: Gregory Bull / AP

Library (br); Rex Features / Startraks

(bl). 286 Corbis: Cho Young-ho

Photo (tr). 229 Corbis: Robert

Here is a summary of the contents:

• Property rights and markets

• The role of money and financial services

• Inflation and the quantity theory of money

• Protectionism and free trade

• Measuring economic growth and activity

• Public companies and the circular flow of income

• Public goods and services

• Theories of consumer and firm behavior (e.g. rational economic man)

• Supply and demand and utility

• Theories of value (e.g. paradox of value)

• Taxation, public finance and fiscal policy

• Division of labor and gains from trade

• Population growth and Malthusianism

• Cartels, collusion and market power

• Gluts, recessions, booms and busts

• Comparative advantage and gains from trade

• Monopolies and market power

• Speculation, bubbles and financial crises

• Labor theory of value and Marxist economics

• Elasticity of demand and competitive markets

• Efficiency, equity, opportunity cost and allocation

• Economies and diseconomies of scale

• Externalities, public goods and market failures

• Culture, institutions and religion

• Poverty, inequality and social justice

• Central planning versus free markets

• Unemployment, depressions and business cycles

• Risk, uncertainty and choice under uncertainty

• Fiscal and monetary policy (e.g. Keynesianism)

• Growth theories and emergence of modern economies

• Price discrimination and market segmentation

• International trade agreements and institutions

• Development economics and theories of growth

• Behavioral and decision theory

• Inflation-unemployment trade-off and Phillips Curve

• Consumption, saving and life-cycle hypothesis

• Role of institutions in economics

• Efficient markets hypothesis and market failures

• Social choice theory and voting

• Happiness, well-being and welfare economics

• Second-best theory and unintended consequences

• Social market economy and government intervention

• Globalization, market integration and interdependence

• Planned economies, socialism and shortages

• Game theory and strategic decision making

• Dependency theory and center-periphery

• Rational expectations and policy ineffectiveness

• Behavioral anomalies, heuristics and biases

• Exchange rates, currency and Optimum Currency Areas

• Entitlements, famines and food security

• Financial engineering, derivatives and risk management

• Behavioral economics and bounded rationality

• Laffer curve, taxation and supply-side economics

• Efficient market hypothesis and market unpredictability

• Cooperation, competition and prisoner’s dilemma

• Akerlof’s lemons problem and market signaling

• Central bank independence and credibility

• Complexity, chaos theory and unpredictability

• Social capital and trust

• Signaling, screening and education

• East Asian model of capitalism and state intervention

• Speculation, bubbles, crises and contagion

• Auctions, bidding and the winner’s curse

• Financial fragility, Minsky crisis and stability

• Principal-agent problem, incentives and efficiency wages

• Nominal and real wage rigidities

• Search, matching and unemployment

• Environmental economics and sustainability

• Gender, inequality and feminization of labor

• Geography, trade and natural endowments

• Technological change and creative destruction

• Debt relief, debt overhang and moral hazard

• Bank runs, panics and financial stability

• Global imbalances, twin deficits and reserve accumulation

• Inequality, equity and economic growth

• Special interests, lobby groups and status quo bias

• Definition and scope of economics as a discipline

• Economic liberalism, free markets and limited government

• Key summary and overview

• The housing market is closely linked to the overall economic cycle of boom and bust. During economic expansions and boom times, the housing market also tends to grow rapidly. Home prices rise, housing starts increase, and mortgage lending accelerates.

• When the economy slows down or enters a recession, the housing market also usually declines. Home prices stagnate or fall, housing starts decline, and mortgage lending slows. Large declines in the housing market can also exacerbate an economic downturn.

• There are several reasons for this connection between the housing market and the broader economy:

1. Housing is a major component of consumer spending. When home values rise during a boom, homeowners feel wealthier and spend more. When home values fall, spending slows down.

2. Residential construction is an important part of GDP and employment. When new home construction grows, it boosts economic growth and jobs. When construction declines, it can slow down the whole economy.

3. Mortgage financing closely follows the economic cycle. It is easy to get a mortgage during a boom but much harder during a recession. Greater mortgage availability fuels housing booms; less availability exacerbates housing busts.

4. Consumer confidence is tied to home values. When home prices are rising, consumers feel optimistic; when they are falling, confidence drops. This has ripple effects through the whole economy.

5. Government tax revenues are impacted by the housing market. Rising home values and sales boost property tax and other tax revenues, supporting government spending. Falling values and sales erode tax bases, forcing spending cuts.

So in summary, the housing market and the broader macroeconomy are deeply intertwined and interdependent. Booms and busts in one sector typically correspond to similar trends in the other sector. Economic policies often aim to stabilize housing in order to also support stabilization of the whole economy.