Nov 20

Industrial organization

Industrial Organization is the economic field that studies the strategic behaviour of firms, and their interaction to determine the structure of markets. Knowing their evolution helps to understand them. The traditional neoclassical theory made the relation between “industrial” and “manufacturing”, making the manufacturing market the main target of studies focusing in the technological result. It left aside aspects, such as organization, management and property. This perspective was criticized for using unrealistic assumptions and because it failed to explain a series of phenomena such as imperfect competition and asymmetric information amongst others.

During the 1930s, a new perspective started to take shape, especially from ideas coming from the Harvard school, and theory began to focus in the behaviour of agents in the industry and in the structure of both firms and industry. In his book “The Theory of Monopolistic Competition”, 1933, Edward H. Chamberlin wrote about imperfect competition and found that many markets were differentiated, thus turning markets into unique. There were many works and papers produced on how markets were arranged in terms of the concentration of suppliers, describing how some markets were dominated by a relatively small number of firms.

In his book “Industrial Organization”, 1959, Joe S. Bain Jr. provided the Structure, Conduct and Performance paradigm (SCP), which is used as an analytical framework, to make relations amongst market structure, market conduct and market performance. The market structure will determine its conduct and thereby its performance.

As implications of all this, regarding economic policies, Harvard School recognizes market power as being dangerous, and establishes a relation between, the concentration ratio, and the harmful effects on social welfare. The dynamic behaviour of buyers and sellers have an effect on the markets, making it harder to predict and establish fixed market structures. Difficulties arise when trying to explain the paradigm and this is due to data shortage, and the multiple definitions and extension of markets.

The Chicago school criticized the “empiricism without theory” of the SCP paradigm, and so returned to the Neoclassical pricing theory, having a more benign view of the market’s results, and having a theoretical (rather than empirical) approach. They start from the framework of perfect competition, and consider interventionism as being the source of monopolies. From Chicago’s point of view, the market’s efficiency guarantees the achievement of social welfare, and therefore firms are encouraged to seek efficiency in their production and distribution. As to the implications regarding economic policies, government intervention is considered undesirable, as the market’s forces should be left to act, and the cost of the intervention is believed to be higher than the social benefit, producing a deadweight loss.

The Austrian school also contributed to the development of the Industrial Organization theory, breaking with the Neoclassical approach. From the same school we can distinguish two main views: von Mises and his disciples’ view and Schumpeter‘s.

Mises describes the structure of the market as a dynamic process of exploration of new methods and opportunities to improve the use of resources, and thus competition is beneficial, as it encourages efficiency and innovations. Therefore, markets have to be free, and it dismays government intervention, although some regulation is praised when innovation is promoted.

From Schumpeter’s point of view, technical progress comes from a process of creative destruction, in which innovations make prior technology out-dated and originate from the innovative entrepreneur. Monopolies have a positive consideration, as they carry out the function of promoting innovation and investments, and government intervention should guarantee both of these.

Contestable markets came up as an alternative approach to the problems concerning market power. These ideas were first introduced by William J. Baumol in his “Contestable Markets: An Uprising in the Theory of Industry Structure”, 1982. In contestable markets there are no entry or exit barriers, no sunk costs and firms have access to the same level of technology. All this makes the number of firms irrelevant, as many will access it and then leave, following different strategies. This view has important limitations: for instance, its starting assumptions are quite restrictive; the definition of cost is not fully suitable; and that, in the real world, a market with such characteristics, is unconceivable.

Between the 1970s and 1980s, a series of theoretical models formulated using game theory in a framework of imperfect competition, made obsolete previous models, such as the SCP paradigm. As a result, there is more emphasis in imperfect information, in firms’ behaviour and, also, in mathematical tools used to calculate social or optimal equilibrium and market equilibrium. In general, there is a shift towards analysing the internal structure of firms, and different views of the firm arose.

Ronald H. Coase, described businesses as being a series of contracts amongst its workers, and explains that it is more beneficial to form firms, since there are a number of transaction costs that can be reduced or even eliminated.

When a business grows in size, there will normally be a distinction between managers and owners. Olivier E. Williamson took notice of the internal boundaries that firms have, and distinguished between decision-making, management and business ownership. The agency theory describes and explains the issues that arise between business managers and owners, as their respective objectives differ.

George Stigler’s contributions to industrial organization must also be mentioned, even though they were more focused on the economical aspect of the theory, rather than opening a debate on how firms interact with each other. Stigler stressed the importance of economies of scale, since it would make a big difference when concentration in the market and firms’ size increased. Furthermore, Stigler developed his “own” theory on cost analysis in his article “Production and Distribution in the Short Run”, 1939 (see Stigler’s cost analysis theory), which moved slightly away from neoclassical cost analysis. When considering the size of firms, economies of scope are also a possibility, as Baumol pointed out in his co-authored book “Contestable Markets: An Uprising in the Theory of Industry Structure”, 1982.

To conclude, it is necessary to clarify that, nowadays, the industrial organization theory accepts multiple perspectives. This theory has not only grown within its field, but also in others, such as applied microeconomics and business management, and, as we have seen during the last years, the boundaries of business and markets have become less clear, and many new definitions and shapes are appearing. This explains the flexibility and the relevance of the industrial organization theory.

Aug 28

Lope Gallego

New Keynesian Economics

The New Keynesian Economics seeks to provide Keynesianism with microeconomic foundation support. This contemporary economic doctrine comes as a response to the critiques that Keynesianism received from the New Classical Macroeconomics (NCM) advocates.

New Keynesian Economics can be traced back to late 70s when the first foundations were built by economists such as Stanley Fischer, Edmund Phelps and John Taylor. One of the best economists to characterize the New Keynesian Economics is Gregory Mankiw, as he has made many contributions to this doctrine.

The main issue of this economic doctrine is to explain why changes in the aggregate price level are “sticky”. While in NCM competitive price-taking firms make choices on how much output to produce, and not at what price, in New Keynesian Economics monopolistically competitive firms set their own individual prices and accept the level of sales as a constraint. From a New Keynesian Economics point of view, two main arguments try to answer why aggregate prices fail to imitate the nominal GNP evolution. One of them is used both by NKE and NCM approach to macroeconomics, this is the assumption that economic agents, households and firms have rational expectations. However New Keynesian Economics considers that rational expectations become distorted as market failure arises from asymmetric information and imperfect competition. As economic agents can’t have a full scope of the economic reality their information will be limited, and there will be no reasons to believe that other agents will change their prices, and therefore maintain their expectations unchanged. Expectations are a crucial part for price determination, as they remain unaltered, so will the price, what leads to price rigidity. For firms, price rigidity may also come from what’s known as menu costs, this is, costs that result from price changes.

As a result of this price stickiness, which implies a slow adjustment of the economy and can lead to undesired levels of unemployment, government intervention is justified to stabilize the economy, by using both fiscal and monetary policies. However, this intervention ought to be minimal, much lower than New Keynesian Economics’s predecessors, the Neoclassical Synthesis, would argue for.

Aug 27

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New Classical Macroeconomics

New Classical Macroeconomics (NCM) arise from the development of the neoclassical economics principles, such as market clearing and optimization behavior by economic agents, which relate this school to monetarism. Its rise as a doctrine can be traced to the work in the early 1970s of its lead economist Robert Lucas (Chicago School).

Indeed, Lucas developed in 1973 what is known as rational expectations, an improvement on the adaptive expectations hypothesis used by monetarists, which changed the way macroeconomic analysis (and econometric analysis) is undertaken. These rational expectations are still used nowadays in macroeconomics.

Regarding policymaking, the NCM believes that no government intervention concerning demand is beneficial for the economy, not even in the short run. They argue that government can promote growth and stabilize the economy only through supply-side policies.

Economists such as Thomas Sargent, Edward Prescott, Neil Wallace and Robert Barro are amongst the most renowned NCM economists, whose theories are usually opposed to those of the followers of New Keynesian Economics.

Aug 25

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Monetarism

Monetarism, a term first used by Brunner in 1968, can be understood in two ways. The first relates to the economic thought that sees in the quantity of money the major source of economic activity and its disruptions (especially inflation), as well as believing that targeting the growth of money supply is the best monetary policy. Secondly, it refers to a large group of economists adherent to these thoughts, lead by Milton Friedman and the Chicago School of economics.

This paradigm, which gained popularity in the 1960s, relates closely to neoclassical economics, believing that free flow of credit and interest rates, as well as a laissez faire attitude is the best way to go, since limited public intervention and a competitive economic system will grant better results than those resulting from Keynesian economics. However, since monetarists consider monetary policy more effective, government control over money supply is required. Also, since monetarists believed in the importance of the quantity of money, the equation of exchange regained popularity.

Monetarists view fiscal policy less effective than monetary policy because of the low interest elasticity of money demand. Therefore, when using the IS-LM model, monetarists consider the IS curve more elastic than the one used by Keynesians, and a LM curve more inelastic. This is the reason why, when using the monetarist’ IS-LM model, public investment created by fiscal policy creates a crowding out effect over private investment, reducing the effectiveness of public spending. However, even though monetary policy is more reliable, its effects may take a while to be noted in the economy, and therefore its implementation can be difficult.

Concerning the Phillips curve, monetarists criticise the money illusion implied in it, which is the basis for the relationship between inflation and unemployment. They believe that, given an unanticipated higher inflation and the subsequent decrease in unemployment, the trade-off shown in the Phillips curve will hold. However this will not be the case when monetary policies are anticipated, implying that the trade-off between inflation and unemployment does not apply in the long run. This is a clear example of the learning process introduced in the Adaptive Expectations hypothesis, firstly formulated (though not under its widely known name) by Irving Fisher in his article “The Purchasing Power of Money”, 1911, and popularized by Phillip Cagan in 1956 and by Friedman, in his paper “The Role of Monetary Policy”, 1968, where he also introduced the concept of natural rate of unemployment, which is the rate that the economy will reach after each movement along the Phillips curve. It must be highlighted that, contrary to New Classical Macroeconomics studies and its Rational expectations hypothesis, monetarists believe that the trade off can be systematically exploited in the short run, as long as each policy is unanticipated.

Given the low effectiveness of fiscal policy as well as the risks of high inflation caused by systematic monetary policies, monetarists defend a commitment by the monetary authorities to steady monetary growth, and reject discretionary and politically driven monetary policies, because of the uncertainty they create.

Aug 22

Lope Gallego

Neoclassical synthesis

Neoclassical synthesis (NCS) refers to an economic doctrine that appeared in the U.S. in the early 1940s, and would remain the dominant paradigm until the late 1960s, when monetarism took over. It was Paul Samuelson, in his book “Economics”, 1955, who gave this doctrine its sense of synthesis, since it can be described as Keynesian in the short run and neoclassical in the long run. This is, policy makers will be able to adjust the economy (especially using fiscal policies, seen by NCS’ economists as far more effective than monetary policy) in the short run, but considering also that equilibrium will be reached in the long run without the need for public intervention. Theoretical and empirical studies by NCS’ economists are mainly based on the IS-LM model and the Phillips curve.

The IS-LM model was first developed by John Hicks in 1937 and Hansen expanded and popularized it in 1949. It is built on the premises put forward by J. M. Keynes in his “General theory”, 1936, and gives fiscal policy a higher degree of efectiveness (IS-LM policies effects, NCS view).

The Phillips curve, derived from an empirical study, gave a relationship between unemployment and inflation, which was not explicit in Keynes’ analysis. The validity of this relationship has been highly criticized by different schools of economic thought, such as monetarism, the New Classical Macroeconomics and the New Keynesian Economics.

Other renowned NCS’ economists are Modigliani, for his analysis of consumption under an intertemporal utility maximization frame, known as the life-cycle hypothesis; Jorgenson, for his work on the investment function; and Tobin and Baumol, for their studies on the demand and supply of money.

The NCS as a macroeconomic mainstream started struggling in the late 1960s, following a high inflation episode in the U.S., which could not be explained using the theoretical framework of this doctrine. Not long after, in the mid-1970s, stagflation in the U.S. meant the rise of monetarism and the subsequent fall of the NCS.

Mar 29

Lope Gallego

Keynesianism

This school of economic thought, which focuses on macroeconomics, is mainly based on interpretations of John Maynard Keynes’ most important book, the “General Theory of Employment, Interest and Money”, 1936.

Keynes’ main thesis was that unemployment during the Great Depressionwas the result of a decreasing demand, and that the solution was to revive the economic system through public investment. A Keynesian policy would be one that promotes, for example, public works such as building dams or highways.

Supporters of Keynesianism, or Keynesian economics, believe that although businesses and private sector entities working on a liberal environment function in an efficient way, sometimes market failures may appear. For this, they support a certain degree of implication by the public sector in order to prevent these failures and restore the economy if they appear, through fiscal and monetary policies. However, they will give more credit to the former, the latter being more supported by Monetarists.

Keynesianism was the main economic doctrine from 1936 until the advent of Monetarism, with which it coexisted until the stagflation of the seventies.

Joan Robinson, Nicholas Kaldor and John R. Hicks, are just some of the great disciples of Keynes, and therefore Keynesian economists, mainly from the Cambridge School in its not neoclassical meaning, to name a few.

Mar 29

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Chicago school

From the University of Chicago, and opposing Keynesianism, a number of contributions and doctrinal attitudes of authors can be identified, which turn back to neoclassical economics, are in favour of laissez faire and monetarism. Created around the 1940s, its main precursor is Milton Friedman, along with Frank H. Knight and Friedrich A. von Hayek, the latter acting as a liaison with the Austrian School.

The common view of the Chicago School focuses on the idea that governmental interventions should be at its minimum required, being deregulation the most desirable path. Another characteristic theory of the Chicago School is that the reduction or eradication of all types of regulation on business activities is beneficial for the economy as a whole. They support monetary policies when required by the economic environment, as they assume these to be more reliable and effective than fiscal policies.

The Chicago School based their assumptions on the concept of rational expectations. Milton Friedman defended that the price levels in a certain economy are always determined by the amount of money moving in circulation. According to the Chicago School, by acting and allocating resources in a rational way, people drive economic growth, while at the same time controlling price levels.

Mar 29

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Neoclassical school of economics

This school of thought, which appeared around 1870 in what is known as the marginal revolution, can be considered a development of the classical school of economics’ main ideas. Supporting the concept of marginalism, and being more scientific in its work than its predecessors, the neoclassical school left aside classical economics’ matters such as wealth distribution and value theory, to study thoroughly the mechanisms that allow the allocation of scarce resources in different markets. This is, understanding how agents, such as consumers and producers, will try to maximize its objective function, utility and production, considering some given constraints, such as budget and input constraints. Indeed, it was the neoclassical school that initiated the study of optimisation problems including utility maximisation and, its dual problem, cost minimisation.

Although the boundaries of this school are quite diffuse, a number of common characteristics can be found in its adherents’ work. They will work supporting methodological individualism, and extensively using mathematics in order to support their conclusions. There will usually appear analysis studying the relations between both supply and demand, instead of studying them separately. They will use throughout their studies the Latin phrase ceteris paribus, as well as the term homo economicus. Finally, it was in the work of neoclassical economists that a distinction between positive economics and normative economics started to shape.

As the neoclassical school includes many renowned doctrines and schools, a mention to some of these schools is in order. The Austrian school included one of the most important marginalist economist, Carl Menger, as well as other renowned neoclassical economists such as Eugen von Böhm-Bawerk, Ludwig H. E. von Mises and Friedrich A. von Hayek. The Lausanne school included economists such as Léon Walras and Vilfredo Pareto. Finally, the Cambridge school included Alfred Marshall, considered the “father of modern economics”, as well as Arthur C. Pigou and Francis Ysidro Edgeworth.

Mar 22

Lope Gallego

Cambridge school

Name given to British economist Alfred Marshall and his followers, who were also part of the neoclassical school of economics, such as Arthur C. Pigou and Francis Y. Edgeworth, which fully assimilated the concepts and methods of marginalism.

They are also considered to be part of the Cambridge school, although in other terms not relating to neoclassical economics, the group of economists which in one way or another collaborated with J. M. Keynes in the thirties and forties, partly in connection with the problems of war. These include Post-Keynesian economists Joan Robinson and Nicholas Kaldor, extending the group to the Neo-Keynesians John R. Hicks, Paul A. Samuelson and James Tobin.

Mar 22

Lope Gallego

Bullionism

Bullionism is the name given to the essential features of economic thought in the first mercantilist era, during the XVI century. According to this economic doctrine, the State acted directly, through laws and regulations on precious metals in order to make them enter the country and prevent them from leaving. The volume of gold and silver stock was considered at the time as an expression of the wealth of a country.