The Economist has an excellent A to Z of economics on their website. I have picked out a few of those concepts which really help to explain people’s economic behaviour:
When you do business with people you would be better off avoiding. This market failure is often associated with insurance. Adverse selection can be a problem when there is asymmetric information (see below) between the seller of insurance and the buyer; in particular, insurance will often not be profitable when buyers have better information about their risk of claiming than does the seller. Ideally, insurance premiums should be set according to the risk of a randomly selected person in the insured slice of the population (55-year-old male smokers, say). In practice, this means the average risk of that group. When there is adverse selection, people who know they have a higher risk of claiming than the average of the group will buy the insurance, whereas those who have a below-average risk may decide it is too expensive to be worth buying. In this case, premiums set according to the average risk will not be sufficient to cover the claims that eventually arise, because among the people who have bought the policy more will have above-average risk than below-average risk. Putting up the premium will not solve this problem, for as the premium rises the insurance policy will become unattractive to more of the people who know they have a lower risk of claiming. One way to reduce adverse selection is to make the purchase of insurance compulsory, so that those for whom insurance priced for average risk is unattractive are not able to opt out.
Buying an asset in one market and simultaneously selling an identical asset in another market at a higher price. Sometimes these will be identical assets in different markets, for instance, shares in a company listed on both the London Stock Exchange and New York Stock Exchange. Often the assets being arbitraged will be identical in a more complicated way, for example, they will be different sorts of financial securities that are each exposed to identical risks. Some kinds of arbitrage are completely risk-free—this is pure arbitrage. For instance, if Euros are available more cheaply in dollars in London than in New York, arbitrageurs (also known as arbs) can make a risk-free profit by buying euros in London and selling an identical amount of them in New York. Opportunities for pure arbitrage have become rare in recent years, partly because of the globalisation of financial markets. Today, a lot of so called arbitrage, much of it done by hedge funds, involves assets that have some similarities but are not identical. This is not pure arbitrage and can be far from risk free.
When somebody knows more than somebody else. Such asymmetric information can make it difficult for the two people to do business together, which is why economists, especially those practising game theory, are interested in it. Transactions involving asymmetric (or private) information are everywhere. A government selling broadcasting licences does not know what buyers are prepared to pay for them; a lender does not know how likely a borrower is to repay; a used-car seller knows more about the quality of the car being sold than do potential buyers. This kind of asymmetry can distort people’s incentives and result in significant inefficiencies.
Adam Smith’s shorthand for the ability of the free market to allocate factors of production, goods and services to their most valuable use. If everybody acts from self-interest, spurred on by the profit motive, then the economy will work more efficiently, and more productively, than it would do were economic activity directed instead by some sort of central planner. It is, wrote Smith, as if an “invisible hand” guides the actions of individuals to combine for the common good. Smith recognised that the invisible hand was not infallible, however, and that some government action might be needed, such as to impose antitrust laws, enforce property rights, and to provide policing and national defence.
LUMP OF LABOUR FALLACY
One of the best-known fallacies in economics is the notion that there is a fixed amount of work to be done – a lump of labour – which can be shared out in different ways to create fewer or more jobs. For instance, suppose that everybody worked 10% fewer hours. Firms would need to hire more workers. Hey presto, unemployment would shrink. In 1891, an economist, D.F. Schloss, described such thinking as the lump of labour fallacy because, in reality, the amount of work to be done is not fixed. government-imposed restrictions on the amount of work people may do can actually reduce the efficiency of the labour market, thereby increasing unemployment. Shorter hours will create more jobs only if weekly pay is also cut (which workers are likely to resist) otherwise costs per unit of output will rise. Not all labour costs vary with the number of hours worked. fixed costs, such as recruitment and training, can be substantial, so it will cost a firm more to hire two part-time workers than one full-timer. Thus a cut in the working week may raise average costs per unit of output and cause firms to buy fewer total hours of labour. A better way to reduce unemployment may be to stimulate demand and so increase output; another is to make the labour market more flexible, not less.
Moral hazard means that people with insurance may take greater risks than they would do without it because they know they are protected, so the insurer may get more claims than it bargained for.
PRINCIPAL- AGENT PROBLEM
These can arise when somebody (the principal) hires somebody else (the agent) to carry out a task and the interests of the agent conflict with the interests of the principal. An example of such principal-agent problems comes from the relationship between the shareholders who own a public company and the managers who run it. The owners would like managers to run the firm in ways that maximise the value of their shares, whereas the managers’ priority may be, say, to build a business empire through rapid expansion and mergers and acquisitions, which may not increase their firm’s share price. One way to reduce agency costs is for the principal to monitor what the agent does to make sure it is what he has been hired to do. But this can be costly, too. It may be impossible to define the agent’s job in a way that can be monitored effectively. For instance, it is hard to know whether a manager who has expanded a firm through an acquisition that reduced its share price was pursuing his own empire-building interests or, say, was trying to maximise shareholder value but was unlucky. Another way to lower agency costs, especially when monitoring is too expensive or too difficult, is to make the interests of the agent more like those of the principal. For instance, an increasingly common solution to the agency costs arising from the separation of ownership and management of public companies is to pay managers partly with shares and share options in the company. This gives the managers a powerful incentive to act in the interests of the owners by maximising shareholder value. But even this is not a perfect solution. Some managers with lots of share options have engaged in accounting fraud in order to increase the value of those options long enough for them to cash some of them in, but to the detriment of their firm and its other shareholders.
Impossible to predict the next step. Efficient market theory says that the prices of many financial assets, such as shares, follow a random walk. In other words, there is no way of knowing whether the next change in the price will be up or down, or by how much it will rise or fall. The reason is that in an efficient market, all the information that would allow an investor to predict the next price move is already reflected in the current price. This belief has led some economists to argue that investors cannot consistently outperform the market. But some economists argue that asset prices are predictable (they follow a non-random walk) and that markets are not efficient.
Gamekeeper turns poacher or, at least, helps poacher. The theory of regulatory capture was set out by Richard Posner, an economist and lawyer at the University of Chicago, who argued that “regulation is not about the public interest at all, but is a process, by which interest groups seek to promote their private interest … Over time, regulatory agencies come to be dominated by the industries regulated.” Most economists are less extreme, arguing that regulation often does good but is always at risk of being captured by the regulated firms.
Cutting yourself a bigger slice of the cake rather than making the cake bigger. Trying to make more money without producing more for customers. Classic examples of rent-seeking, a phrase coined by an economist, Gordon Tullock, include:
- a protection racket, in which the gang takes a cut from the shopkeeper’s profit;
- a cartel of firms agreeing to raise prices;
- a union demanding higher wages without offering any increase in productivity;
- lobbying the government for tax, spending or regulatory policies that benefit the lobbyists at the expense of taxpayers or consumers or some other rivals.
Whether legal or illegal, as they do not create any value, rent-seeking activities can impose large costs on an economy.
TRAGEDY OF THE COMMONS
A 19th-century amateur mathematician, William Forster Lloyd, modelled the fate of a common pasture shared among rational, utility-maximising herdsmen. He showed that as the population increased the pasture would inevitably be destroyed. This tragedy may be the fate of all sorts of common resources, because no individual, firm or group has meaningful property rights that would make them think twice about using so much of it that it is destroyed. Once a resource is being used at a rate near its sustainable capacity, any additional use will reduce its value to its current users. Thus they will increase their usage to maintain the value of the resource to them, resulting in a further deterioration in its value, and so on, until no value remains. Contemporary examples include overfishing and the polluting of the atmosphere.
When the gains made by winners in an economic transaction equal the losses suffered by the losers. It is identified as a special case in game theory. Most economic transactions are in some sense positive-sum games. But in popular discussion of economic issues, there are often examples of a mistaken zero-sum mentality, such as “profit comes at the expense of wages”, “higher productivity means fewer jobs”, and “imports mean fewer jobs here”