Jan 6

Prospect theory

Prospect theory belongs to behavioural economics and outstands as an alternative model to expected utility theory, as the neoclassical assumption of the rational agent is put into question. This theory was developed by Nobel laureate Daniel Kahneman and his collaborator Amos Tversky in their “Prospect Theory: An Analysis of Decision under Risk”, 1979. They used results they gathered both from their own empirical observations and from various experiments.

Individuals establish preferences depending on a certain situation and specific circumstances, rather than in absolute terms. This means that depending on their initial situation, agents will act one way or another. One of the outcomes of this reasoning leads to behavioural asymmetries between situations of potential loss or gain. Individuals, for example, are generally more adverse to losses than they are attracted to gains. An endowment effect has also been distinguished, as the compensation required by someone to give away a good, is larger than he would be willing to pay in order to acquire it.

Prospect theory postulates the existence of a value function V (Δw) that depends on the deviation from a reference point (determined in terms of wealth), and a function ∏ (p_i) that turns the weighted probabilities applied in decision-making. In this context A is preferred to B if: ∑∏(p_A) V (Δw_A) > ∑∏(q_B) V (Δw_B)

Function ∏ (p) is defined on the interval [0, 1] transforms the probabilities into decision making weighted probabilities. It is a function characterized by being monotonically increasing that intersects the 45 degrees line near the origin, so that the weights in decision-making are smaller than the probabilities, except for the very low probabilities.

The value function V (Δw), which is shown in the adjacent diagram, is dependent on changes in wealth relative to a reference situation, having a sigmoid-shape: being concave for gains (risk aversion) and convex for losses (risk seeking). It presents a discontinuity at the origin with a steeper slope for losses than for gains.

This theory helps understand why the same individual can be, at different situations, risk-avoiding or risk-seeking. It explains behaviours observed in the economy such as the disposition effector why the same person may buy both a lottery ticket and an insurance policy.

Dec 28

Lope Gallego

Daniel Kahneman

Daniel Kahneman, born in 1934, is an Israeli-American psychologist and currently teaches at Princeton University. Even though Kahneman is a psychologist and he’s never attended an economic course, in 2002 he was awarded the Nobel Prize in Economic Sciences jointly with Vernon Smith. He was granted this prize for his work on integrating phycology into economic science, especially regarding decision making under uncertainty and his collaboration in the development of behavioural economics.

Kahneman along with his close associate, Amos Tversky, who was mentioned at the Nobel award, demonstrated that people are unable to fully analyse complex situations which consequences are uncertain and so breaking with the rational agent assumption derived from neoclassic economics. They uncovered this issue and developed what is known as the prospect theory in their “Prospect Theory: An Analysis of Decision under Risk”, 1979. It’s important to mention Maurice Allais who served as inspiration for Kahneman´s work.

Dec 27

Lope Gallego

Joseph Schumpeter

Joseph Alois Schumpeter, 1883-1950, was an Austrian-American economist and political scientist. While studying at the University of Vienna, Schumpeter was disciple of the Austrian economists von Wieser and Böhm-Bawerk. Later he became Professor at the University of Czernowitz , the University of Graz, the University of Bonn and Harvard University and during some time he held the position of Austrian Minister of Finance.

Schumpeter took special interest in analysing the economic business cycles. Related to this topic he wrote “Business Cycles”, 1939. His theory of economic development is focused in the idea of spontaneous and disruptive changes in the economic cycle coming from the supply side. Booms were a result of new combinations of production and innovation appearance, and recessions a result of diminishing profits as competition imitated and adopted these changes. Schumpeter believes that the key in capitalism lies in the entrepreneur that applies new combinations of factors of production.

Furthermore, Schumpeter also stands out for his contribution to the history of economic thought and his “History of Economic Analysis”, 1954, is considered his masterpiece in this subject.

However it is also worth pointing out Schumpeter’s view and analysis of society. In his “Capitalism, Socialism and Democracy”, 1942, Schumpeter made an analogy between the function of democracy in the public sector and the role of the market mechanism in the private one, as he regarded both as types of horizontal coordination. In the political process, voters were considered consumers and politicians and public servants were suppliers.

Dec 22

Lope Gallego

Hermann Gossen

Hermann Heinrich Gossen, 1810 -1858, was a Prussian economist who also served as a public servant in the Prussian administration. Although he only wrote one book, that was also practically ignored until first Jevons and after Walras came across it, he became one of the biggest contributors to the value and distribution theory of the 19^th century. Gossen is considered as a precursor of marginalism and mathematical economics.

In his “The Development of the Laws of Human Intercourse and the Consequent Rules of Human Action”, 1854, he uses mathematics to give a value to the utility concept of Bentham. Gossen develops the idea of marginal utility and reflects his ideas in what is known as Gossen’s Laws.

Gossen’s Laws:

The first law states: “The magnitude of a given pleasure decreases continuously if we continue to satisfy this pleasure without interruption until satiety is ultimately reached”, thus implying diminishing marginal utility.

The second law states: “The magnitude of each single pleasure at a moment when it’s enjoyable is broken off shall be the same for all pressure” which means that maximum satisfaction will be achieved when goods and needs are allocated and they provide the maximum utility.

Dec 22

Lope Gallego

Jeremy Bentham

Jeremy Bentham, 1748-1832, was a British jurist, philosopher and economist and he is also considered as a spiritual founder of the University College London. Bentham was tutor to John Stuart Mill as a personal favour to his father, economist John Mill, who was Bentham’s friend. He had a great influence on the economic theory of the 19^th century and also on early marginalism. Bentham however, was more successful in France than in England, thanks to the work of his disciple Ettiene Dumont, who did most of his editing in French.

Bentham´s work is based on the main idea of promoting those laws that will ensure the greatest happiness. In his first published work, “A Fragment on Government”, 1776, he states that the fundamental axiom is “the greatest good for the greatest number” an idea that was not completely original but that was named after him and ever since is known as the utility principle. His idea on this principle, was further developed in many of his works, “Introduction to the Principles of Morals and Legislation” 1780, stands out and become father to this principle.

Dec 22

Lope Gallego

Alban William Housego Phillips

Alban William Housego Phillips, 1914-1975 was a New Zealander economist and Professor at the London School of Economics. Phillips was a follower of Keynesianism and published several articles in which he used mathematically based models to analyse the relations between the Keynesian multiplier and the accelerator effect. However, Phillips is best known worldwide for his famous Phillips curve.

In 1958 he published his article “The Relation between Unemployment and the Rate of Change of Money Wages Rates in the United Kingdom, 1861-1957” in Economica. In this article he provides evidence of the relationship between unemployment and the rate of change of money wages and the basis of what is known as the Phillips Curve.

Dec 16

Lope Gallego

Economies of learning

Economies of learning derive from the know-howpicked up through experience. The main difference between this and economies of scale or economies of scope is the fact that it is not correlated to production levels in the same way: it does not depend on producing more quantity or a wider portfolio, but from becoming a true specialist in a certain field, by producing a greater cumulative amount of the same product. However, this differs from economies of scale because economies of learning do not stop at a certain level, they keep on improving efficiency.

A classic example of this which is often cited is Japan’s market leadership from the 1980s in technology intensive goods such as TVs and audio equipment. The know how from economies of learning often spreads from a company with employees, leading to clusters of knowledge-rich companies often situated in a relatively small area.

There are many ways in which this learning helps drive down cost: by boosting efficiency and reducing waste in production, by R&D synergies and productivity, by better management which helps coordinate and balance the different functions and by speeding up the productive process. When learning reflects only in labour productivity, it’s analysed with a learning curve. When learning applies to the whole firm, all its processes, it’s analysed with an experience curve.

The concept of economy of learning is actually morphing into that of a ‘learning economy’, one in which efficiency and growth is driven by training and specialisation resulting in profitable, high added value goods and services.

Dec 13

Lope Gallego

Experience curve

The experience curve (not to be confused with learning curve) is a graphical representation of the phenomenon explained in the mid-1960s by Bruce D. Henderson, founder of the Boston Consulting Group. It refers to the effect that firms learn from doing, which means that the higher the cumulative volume of production (X), the lower the direct cost per new unit produced (C). Therefore, the experience curve will be convex and have a downward slope, as shown in the adjacent diagram.

There is a simple rationalisation behind all this: there is a reduction in the average cost of production of a particular product, as a consequence of an increase in the firm’s experience. The time and cost of producing a unit of output will be reduced, as learning economies, economies of scale, economies of scope, etc. appear due to the cumulative output increase and other process related growth. The difference between learning curves and experience curves is that learning curves only consider time of production (only in terms of labour costs), while experience curve is a broader phenomenon related to the total output of any function such as manufacturing, marketing, or distribution. The experience curve is defined by the following function:

C_n = C₁X^-a

where:

C₁ = direct cost of first unit of production
C_n = direct cost of n^th unit of production
X = cumulative volume of production
a = experience rate (%)

The experience rate corresponds to the elasticity of cost with regard to output. In other words, the rate at which direct costs decrease (in percentage points) when output increases (also in percentage points).

Some important implications arise from this curve. If direct costs decrease as the cumulative output increases, this will mean that firms that have been producing more and for a longer period, will have lower direct costs per unit and thus dominate the market.

We must consider what happens when two firms compete with the same product and the same experience curve (blue curve, EC). In the diagram on the left, we have a starting situation where two firms compete. Firm B has been in that market for a longer time (or has produced more volume during the same period of time), therefore its direct costs are lower than A’s. If price equals the direct costs of A, firm B will have profits while firm A will just survive. It must be noted that B could decrease its price, which will force firm A to lower its price, thus incurring in losses. Firm A will ultimately leave this market.

However, if A and B maintain a price level at which firm A can endure, direct costs for A will decrease at a higher rate than B, because of the steeper slope for lower cumulative volumes of production. Therefore, the longer A stays in the market, the lower the profits for B, as it is drawn in the diagram on the right, where the difference between direct costs (from C’_A to C’_B) is smaller. Game theory and the analysis of oligopolies tell us that, since B is able to anticipate all these scenarios, firm B will try to banish firm A from the market.

As mentioned before, experience curves is a wider phenomenon than learning curves because they consider not only labour productivity, but also technology, distribution, etc. This difference allows for different experience curves to coexist. Let’s consider two more scenarios, considering open economies.

In the first scenario shown in the adjacent diagram, firm A enters firm B’s market with a different, steeper experience curve. This may happen when firm A is able to learn and get more experience out of the same increase in volume. A few examples include firm A’s workforce being able to learn quicker because it’s highly qualified, or because firm A’s factory allows for quicker modifications. Under these circumstances, even if firm A enters the market with higher direct costs than B (C_A > C_B), it will ultimately catch up with firm B. Actually, after a certain volume, firm A would get more experience and will have lower direct costs than firm B (C’_A < C’_B), even with lower cumulative volume.

In the second scenario, shown in the next diagram, firm C enters firm B’s market with an exclusive technology, which translates into a lower experience curve (let’s assume for the sake of simplicity that this innovative technology cannot be copied or transferred). Then, because of its lower experience curve, firm C will be able to get the same level of direct costs than B with lower cumulative volume. Initially, firm C will have higher direct costs than firm B (C_C > C_B). However, after a while, C will have reached a volume at which it has the same level of direct costs as B. After this point of inflection, firm C will produce each unit with lower direct costs than firm B (C’_C < C’_B).

These two scenarios are usually considered as good examples of the infant industry argument, since trade protectionismin these situations is welcomed. The rationale behind this is quite obvious: if we consider that all these firms (A, B and C) compete in an infant industry, which in these scenarios would be that existing in the home country of B, it is reasonable to limit the extent at which firms such as A and C can act in B’s country. If firm B isn’t kept alone for the time required to gain some experience, national industry in B’s country would not exist, and it would all be controlled by foreign and more powerful firms (A and C). This is usually the case in third world countries, in which infant industries must be protected, in order to help their economic growth.
Even though the term experience curve is usually merged in economics and business management literature with the term learning curve, there are a few differences between the two. These differences are summarized in the following grid:

	Learning curve	Experience curve
Conception:	microeconomics	macroeconomics
Origins:	Theodore P. Wright, 1936	Bruce D. Henderson, mid-1960s
Variable considered:	average time (labour cost) per unit	direct costs: production, labour, distribution, etc.(includes learning curve effects)
Measures:	labour productivity	total efficiency

Dec 12

Lope Gallego

Learning curve

The learning curve (not to be confused with experience curve) is a graphical representation of the phenomenon explained by Theodore P. Wright in his “Factors Affecting the Cost of Airplanes”, 1936. It refers to the effect that learning had on labour productivity in the aircraft industry, which translates into a relation between the cumulative number of units produced (X) and the average time (or labour cost) per unit (Y), which resulted in a convex downward slope, as seen in the adjacent diagram.

There is a simple rationalisation behind all this: the more units produced by a given worker, the less time this same worker will need to produce the following units, because he will learn how to do it faster and better. Therefore, when a firm has higher cumulative volume of production, its time (or labour cost) per unit will be lower. Wright’s learning curve model is defined by the following function:

Y = aX^b

where: Y = average time (or labour cost) per unit

a = time (or labour cost) per unit

X = cumulative volume of production

b = learning rate (%)

Some important implications arise from this curve. If the time (or labour cost) per unit decreases as the cumulative output increases, this will mean that firms that have been producing more and for a longer period, will have lower average time per unit and thus dominate the market.

We must consider what happens when two firms compete with the same product. Since the learning curve considers only time per unit, and we consider that they spend the same amount of time per unit for a given unit when each firm’s cumulative volume of production is at the same level, both firms will have the same learning curve (green curve, LC). In the diagram on the left, we have a starting situation where two firms compete. Firm B has been in that market for a longer time (or has produced more volume during the same period of time), therefore its average time (or labour cost) per unit is lower than A’s. If price equals the average cost of A, firm B will have profits while firm A will just survive. It must be noted that B could decrease its price, which will force firm A to lower its price, thus incurring in losses. Firm A will ultimately leave this market.

However, if A and B maintain a price level at which firm A can endure, time per unit for A will decrease at a higher rate than B, because of the steeper slope for lower cumulative volumes of production. Therefore, the longer A stays in the market, the lower the profits for B, as it is drawn in the diagram on the right, where the difference between average times (from Y’_A to Y’_B) is smaller. Game theory and the analysis of oligopolies tell us that, since B is able to anticipate all these scenarios, firm B will try to banish firm A from the market.

The obvious critique to all this is that, if learning curves were so obvious and could be anticipated as easily, we would live in a world consumed by monopolies. Older firms would keep banishing potential competitors from markets until entry barriers became so great that no other firm would try to enter this market.

Even though the term learning curve is usually merged in economics and business management literature with the term experience curve, there are a few differences between the two. These differences are summarized in the following grid:

	Learning curve	Experience curve
Conception:	microeconomics	macroeconomics
Origins:	Theodore P. Wright, 1936	Bruce D. Henderson, mid-1960s
Variable considered:	average time (labour cost) per unit	direct costs: production, labour, distribution, etc.(includes learning curve effects)
Measures:	labour productivity	total efficiency

Dec 11

Lope Gallego

Inflation

Inflation is the economic term that refers to a continuous general rise in the level of prices over a period of time. This will consequently be translated into a fall in the value of money and a loss in purchasing power. The main measures to calculate inflation are Consumer Price Indexesand the Gross National Product deflator. Oil prices can be an alternative inflation indicator as this product is used throughout the world for many different purposes and it virtually affects all of the elements of an economy’s price formation. It is important to understand that when inflation rates remain constant in a positive figure, e.g. 1%, over a period of time e.g. 10 years, and even if inflation didn´t change, purchasing power would ultimately be lost.

As an economic phenomenon, inflation can be the result of a different set of causes. The conventional distinctions made between these causes are:

Demand-pull inflation

Demand-pull inflation occurs as a result of an increase in aggregate demand and the inability of an economy to produce enough to meet the demand increase. Aggregate demand is formed by consumer spending, government spending, investment and net exports, and any increase in one of these components without its correlative effective response will create inflation. Demand-pull inflation is more likely to occur when employment of resources is closer to its full usage and the short run aggregate supply is most inelastic. Therefore, inflation is mainly caused by the inability of the economy of attending an increase in demand. Increases in aggregate demand might be caused by:

-Expansive monetary policies: when monetary authorities conduct an expansion of money supply, there is more money available, consumption is incentivized and thus there is an increase in aggregate demand that creates inflation. If economic growth is below money growth there will be inflation. Monetarists defend monetary policies as a way to efficiently control inflation rates counteracting economic growth.

-Expansionary fiscal policies: this kind of policies could indirectly increase aggregate demand by increasing consumers’ disposable income or directly through government intervention.

-Increase in exports: exports may rise for two main reasons. The first one is the result of a country’s currency depreciation; there will be an increase in exports, as these products will seem cheaper to foreign countries, thus increasing aggregate demand. The second one is caused by an increase of wealth in the foreign countries, which will allow them to import more of other countries products. Both of these will result in an increase in the aggregate demand and consequently cause inflation.

-Consumers’ confidence increase: whenever consumers feel confident on the economic situation they will tend to decrease their level of savings and consume more and hence increase aggregate demand.

Cost-push inflation

Cost-push inflation occurs as a response of agents raising prices to maintain their profit margins if there are higher production costs. Production costs may increase because of:

-Rising labour costs: new government measures can imply an increase in the costs of hiring (adjustment costs, see Cahuc’s adjustment costs model) or increases in the payroll taxes. Trade unions can also force firms to increase workers’ wages by using negotiation powers, as explained by the Layard-Nichell NAIRU model.

-Rising raw materials costs: raw material costs rise can result from different causes. Depreciation of their own currency can affect firms which depend on imported raw material for their productive process, as buying the same materials will cost them more of their domestic currency. Government regulations once more play an important part as subsides, policies and taxes can affect both raw material prices and the overall prices. Raw materials costs can also increase as a result of natural catastrophes. It is also important to remember the part that the price of oil plays in price formation, as the current world economy is highly dependent on it.

Built-in inflation

Built-in inflation, sometimes referred as wage price spiral or expectations-induced inflation (explained by the expectations-augmented Phillips curve), is the consequence of agents previous years’ experience and their ability to build rational expectations. In an inflationary price rates tendency, agents will try to anticipate the following price increase. On one side, workers will demand higher wages as a measure to avoid losing purchasing power. On the other side, firms will increase prices in order to maintain their profit margins. This is sometimes referred to as the wage price spiral as one will lead to the other, resulting in inflation inertia.

It’s important to see that inflation plays a key role in the economy. As seen in the Phillips curve, governments face a trade-off between different levels of unemployment and inflation. In pre-elections time, governments may be tempted to decrease unemployment levels at the cost of a higher inflation, in order to make it appear as if the economy is better than it is, and so gain votes. This is why monetary policies should be held by an independent authority, which in most countries translates into a central bank.