Economics: The Key Concepts

Donald Rutherford

• Publisher: Routledge
• Year: 2007
• Print ISBN: 9780415400565
• eBook ISBN: 9781134146192
• Topic: Business
• Subtopic: Business General
• Index: Business

An A-Z of contemporary economics in all its forms, Economics: the Key Concepts is an affordable, accessible reference for students, lecturers and economists at every level. The key topics explored include:

• competition and monopoly
• development economics
• game theory
• property rights
• taxation.

Fully cross-referenced with extensive guides to further reading, this is the essential comprehensive pocket reference to the ideas, issues and practice of economics in the twenty-first century.

ECONOMICS
The Key Concepts

ACCELERATOR

The relationship between an increase in net investment and changes in real income or output. This early twentieth-century theory is especially associated with Aftalion and JM Clark.

Although regarded chiefly as a theory based on a macroeconomic relationship between a change in aggregate income and aggregate net investment, it has microeconomic roots. When incomes increase, there is an increased demand for goods which will increase in price when the capital to make those goods is fully utilised. Manufacturers will increase the capital stock to meet the expected increase in demand. The accelerator can apply to a particular industry or to the economy as a whole. In the simplest expression for the accelerator it is the amount by which an increase in income is multiplied to predict the amount of net investment. It is also regarded as the desired capital-output ratio and will be more than one as the value of output from capital is much less than the value of the capital itself. The basic accelerator equation has been modified to deal with the problems of the time it takes to respond to an increase in income and the existence of excess capacity. Making net investment a function of previous income deals with slow responses; subtracting the value of the capital stock multiplied by the degree of excess capacity produces a better estimate of net investment.

An important application of the accelerator principle is in trade cycle theory. Hicks combined the accelerator with the multiplier, ceilings and floors to generate cycles. Increased income leads to increased investment through the accelerator, that extra investment creates more income through the multiplier, then the accelerator operates again. Only the full employment ceiling prevents infinite expansion of the economy; net investment independent of income will enable an economy to recover from the floor. In the first phase there is disinvestment as the extra demand is met from stocks, in the next there is induced investment and in the third oscillations as depreciated reserves are increased or run down as replacement takes place.

See also: cycles; investment

Further reading: Clark 1917; Hicks 1950

AID

Grants of money or of goods and services by national governments or private organisations and individuals to poor countries or regions.

There are different degrees of aid. Emergency help at a time of crisis such as an earthquake, medium-term assistance until a country establishes its own services, such as the loan of teachers and doctors, and long-term investment in infrastructure and business enterprises are the major categories. Multilateral aid consists of the distribution of donations from many sources through an international agency such as the World Bank to the recipient country. Bilateral aid flows directly between donor and recipient. Aid to foreign countries still amounts to a tiny fraction of the national income of developed countries.

There are many motives for aid. For strategic military reasons, superpowers help countries in return for military bases and to maintain internal political stability within them. From the nineteenth century large countries have tried to extend their power by creating spheres of influence: to be successful, such a policy needs continuous flows of help. This aid will be largely bilateral. For balance of payments reasons it is cheaper to offer goods and services in one’s own currency, but the value of that aid can be devalued by inferior and more expensive goods than available in world markets. But aid offered by supposedly impartial international agencies has its own problems. Lobbies in such organisations will achieve more for some countries than others. Also the potential amount of aid can be devalued by the large administrative costs of allocating it. Idealists genuinely hope that through aid there can be a movement to a greater equality of per capita incomes throughout the world, but the small volume of aid makes that unlikely.

Generous individuals through charities and religious organisations send monetary and other help to poorer countries. A sense of moral duty motivates such aid. Often it is untainted by the political motivation of official aid. But it can be only enough to launch new initiatives or supplement inter-governmental assistance.

Aid is an example of a transfer income. Boulding conceptualised aid through distinguishing a grants economy from an exchange economy. Grants are non-coercive, an expression of benevolence and a method of creating an international community: aid has these characteristics at its best.

Aid can be part of a plan, or the encouragement of the spontaneous mechanisms of an indigenous economy. Aid is either a means to making a country more dependent or a stimulus to sustainable development. Experience of managing aid programmes has modified them. Increasingly there are safeguards to avoid destroying local cultures and environment. The choice of technology is important as the recognition that large reserves of labour have to be considered, as has the expense of choosing capital intensive methods. The contribution of aid to encouraging trade is essential, otherwise one tranche of aid has to be succeeded by another. The method of distribution of aid is vital if those most in need are to be helped, and it is important that corruption is minimised by careful monitoring which keeps gifts out of the hands of the ruling elite and military. The greatest danger of aid is the creation of aid dependency, which means that a country loses its economic independence and is unable to plot its destiny. But it can be argued that few countries have any autonomy because of the growth of international corporations and the process of globalisation.

See also: development economics; equality; globalisation; poverty; trade theory

Further reading: Boulding 1973; Singer 1984

ALTRUISM

A philosophy of preferring the welfare of others to one’s own; unselfishness; the opposite of egoism.

Altruism can be practised within a family; perhaps the commonest examples are gifts, extended credit and the sharing of risk, within the wider population through private charity or government transfers, or even in the world as a whole through economic aid. This ideal has formed the basis of utopian communities.

It is agreed that it is the opposite of selfishness, which has often been confused with self-interest. This term was invented by the positivist Auguste Comte in 1851 and derived from the Italian word altro, other. The altruist forsakes personal gain and advancement in order to help the weak. Generally this attitude is derived from a moral stance, rather than the practicalities of economic life. The pursuit of profit under capitalism and the insistence on workers receiving the product of their labour under socialism are both hard to reconcile with altruism. It is possible to have short-term altruism in order to establish good industrial and international relations, and then to revert to usual market principles. Others would argue that the awareness of social cost in an environmentally conscious age necessitates the curbing of private interests for the others who constitute the wider community. Economic analysis of charities and religion has to consider altruism as a central motive for institutional behaviour. However, globalisation has had both the consequence of new opportunities for exploitation and also an awareness of greater and more distant needs, which inevitably will move the altruistic to action.

Altruism can take many forms. It can be intergenerational, where economic and social activities are restricted now for the sake of future generations’ enjoyment of the environment. It can be private or public. A wise government might select the amount of help requisite to others more capably than less informed individuals and charities, or not. Taxation can be used both to discourage bad action against others and to make individuals pay the social costs of their actions.

Embedding altruism as a principle in economic institutions and economic policy is always controversial. It is difficult to sum individual preferences to form any scheme of improvement. Also qualities of selfreliance, ambition and risk taking can be discouraged by recreating an economy according to a social model. The problem of altruism having destructive effects is recognised in the Samaritan’s Dilemma, in which helping others can lead to one’s own destruction. Buchanan recognised that there are predators within one’s own species in his account of the dilemma. It has many applications to welfare states.

Altruism is not always as genuine as it appears, as Collard pointed out. It can be enlightened self-interest, when what is ostensibly for others also benefits oneself. Gifts are prompted by many motives. They may be implicit exchange because we expect something back. They might be a form of personal security to appease potential enemies. The benevolent person in society has enhanced reputation and status so can benefit commercially.

There is a loose relationship between the stage of economic development and the incidence of altruism. In richer societies there might be few on low incomes and the government can afford through its fiscal policy to eliminate the needy.

Altruism requires imagination, empathy and a benevolent disposition. This can be practised directly, or by proxy, when voters require other people who are richer to help the poor. Altruism can be practised for the benefit of the present or future generations. What is crucial is the proportion of income consumed. By restraining consumption there can be more saving and investment for the future. Also the environment is improved by restraining the consumption of non-renewable resources.

See also: homo economicus; social choice theory

Further reading: Andreoni 1989; Buchanan 1975, 1977; Collard 1975; Fontaine 2000; Simon 1993

ARBITRAGE

Parallel simultaneous purchases and sales in different markets in order to gain from price differentials. Arbitrage is extensively practised in stock, bond, commodity and currency markets.

By this process efficient and consistent prices emerge despite places and times of sales and purchase being different. In pure arbitrage a riskless profit emerges as it costs nothing to hold contracts for different dates. The amount gained through arbitrage can be small but it has to be large to cover transaction costs, otherwise it is pointless. This form of arbitrage does not require the commitment of capital.

Under arbitrage pricing theory in a stock market selling a homogeneous stock, or share, the expensive will be sold and the cheap purchased in order to reach an equilibrium. A few risk factors will affect the price of an asset, including the rate of interest and the price of the asset relative to the price of a portfolio of assets. As financial markets have become more innovative, introducing a host of financial derivatives, so have the techniques for conducting arbitrage, including the use of stochastic differential equations.

Arbitrage can also be part of a merger and takeover strategy when an equity holding is acquired with a view to a company being taken over at a higher price. There can also be arbitrage over the current price of a company and its liquidation value.

See also: risk and uncertainty

Further reading: Ross 1976

AUCTION

A method of selling through a process of bidding which ultimately reaches an accepted price.

The simplest of these is the English auction, in which the auctioneer proposes a starting bid then conducts subsequent bidding until no one is willing to bid any higher. The successful bid must reach the seller’s reserve price. As ‘auction’ is derived from the Latin word augere meaning to augment or increase, there is the possibility that the English form of bidding has its origins in the Roman empire.

Other types of auction abound. The Dutch auction is conducted in reverse order to the English. The auctioneer deliberately starts with a price far higher than buyers are likely to accept then reduces the price until a buyer accepts by shouting ‘mine’. An automated version of this auction uses a ‘clock face’ with a hand moving from the highest to lower prices. Auctions are open, in the English or Dutch cases. The first-price auction uses the method of sealed bids being submitted and, when opened, the highest being accepted. This is used by the US Treasury for selling short-term securities. Similarly in second-price auctions there are sealed bids but the second highest is chosen. In hybrid auctions the bidders bid for quantities and the prices are negotiated subsequently. All these auctions have different outcomes. Auctions are assessed according to the revenue raised and passing the efficiency test of whether the person with the highest valuation succeeds.

The auction is important in understanding the working of markets, as it is the device for reaching equilibrium through the process of tatonnement, or groping, in general equilibrium theory. Under that Walrasian system the auctioneer announces a price and the buyers and sellers write down on pieces of paper whether the price is acceptable or not. The auctioneer can then collect the papers and determine whether at the suggested price there is excess demand or excess supply. The process will continue until demand and supply are balanced.

An auction is only one mode of selling. That they occur at all is to be questioned. They are public so can attract into a market more potential buyers. They can have lower information costs. Where there is uncertainty about the worth of an article an auction is superior to pricing by using customary formulae. The revenue equivalence theorem shows how risk-neutral traders will achieve the outcome of the sellers and buyers, achieving an equivalent exchange in terms of expected revenue to the seller and expected profits to the bidder. Bidders are ignorant of the private valuations of their rivals but sometimes can guess because a common source of information is used by all the auction participants.

Vickrey analysed auctions as games of incomplete information. He examined markets in a state of imperfect competition by considering counter-speculation as a means of achieving efficient resource allocation, and devised second highest price as a solution.

See also: price

Further reading: Krishna 2002; Vickrey 1961

AUSTRIAN ECONOMICS

A school of economics which began with Carl Menger in 1871.

This branch of economics was a reaction to the German historical school which had despised timeless universal economic laws, preferring the view that economies develop through stages. Both macroand microeconomic theories are propounded by the Austrians. The former has been concerned with the theory of economic cycles and the latter with prices, interest rates and investment.

The distinctive features of the school are its emphases on individualism, subjectivism, opportunity costs and the time preference in consumption and investment. Also they have made contributions to the study of entrepreneurship, money and inflation.

Carl Menger in his Principles of Economics (1871) demonstrated the usefulness of marginal concepts, but avoiding mathematics in the form of the differential calculus used by his contemporary WS Jevons. Implicitly using an idea of marginal utility, Menger showed how there would be a consumer equilibrium by equating marginal satisfactions from different goods consumed. He carefully considered a range of markets from an isolated exchange between two individuals to o...

Table of contents

• COVER PAGE
• TITLE PAGE
• COPYRIGHT PAGE
• LIST OF KEY CONCEPTS
• INTRODUCTION
• ECONOMICS THE KEY CONCEPTS