Oct 25

Supply-side policies

The purpose of supply-side economic policies is to increase the amount of supply and therefore the productive potential that the economy is able to produce. This kind of policies shift rightward the long-run aggregate supply curve and outward the production possibility frontier. They can be divided in policies that act over the production function, and those that act over the cost of labour.

On the one hand, the former are targeted at increasing production levels and examples of this kind of policies include incentives to technological improvement and capital stock increase. On the other hand, the latter are targeted directly on decreasing the cost of labour and this way more workers can be hired. Examples of these policies include reduction of social security contributions, increase of subsidies for firms, reduction of indirect taxes etc.

Supply-side policies have been praised by many economists including Nobel laureate Robert Mundell. There have been many studies regarding their effectiveness, and although it is true that they take effect in the long run, they are the only ones that can lead to perdurable economic growth. Furthermore, critics coming from monetarists and Keynesians have questioned the effectiveness of other policies, such as fiscal and monetary, respectively, pointing out how they are only useful in the short run, but are useless or even harmful for the economy in the long run. In fact, the last two great economic doctrines, New Classical Macroeconomics and New Keynesian Economics, have proven the ineffectiveness of fiscal and monetary policies, leaving supply-side policies as the only ones that are useful.

Oct 25

Lope Gallego

Economic policies

Reducing unemployment and stimulating the economy has been one of the biggest, if not the only, concerns of governments since the dawn of economic science. Economic policies have been very much theorized, and by many doctrines. As a result, a rich and plentiful literature has been developed on this topic. We will discuss the main economic policies:

1. Policies in order to reduce labour supply:

By reducing labour supply the government is reducing the number of people that are legally suitable to work, what is known as the labour force, and by doing so it indirectly reduces unemployment. This kind of policy is mostly effective when targeted over a group that has a higher unemployment rate than the average. If a country suffers from high unemployment amongst the young population, by increasing the minimum age of employment, governments will decrease unemployment levels. It will also be useful even if the targeted group has a low level of unemployment, as there will be new vacancies that unemployed can fill. Other examples of this policy include retirement age reduction and the increase of military service duration. However, as it can be easily seen, these policies are what Frenchmen would call “trompe-l’oeil”, that is, they reduce or eliminate the symptom (unemployment), but without treating the disease (the economy malfunction).

2. Policies to stimulate labour demand:

There are different policies depending if they affect demand of labour by using demand-side policies or supply-side policies.

-Demand-side policies stimulate the economy by increasing the demand for goods and services, thus incentivising firms to produce more, which will result in firms hiring more workers. Expansive fiscal and monetary policies are the tools that governments can use. This kind of policies is considered by their different advocates (Keynesian economists would implement fiscal policies whilst monetarists would implement monetary policies) to be most effective at reducing cyclical unemployment during economic depression.

-Supply-side policies focus on firms and their production of goods and services, in order to increase the supply (output) of the economy. These policies aim at the costs of labour and the production function. If the cost decreases there will be more money available to increase the workforce. This kind of policies is nowadays regarded by the latest economic doctrines as the only real possibility to ensure a perdurable economic growth. However, they are less attractive than demand policies since they need time to be implemented and to generate actual effects on unemployment and growth.

3. Structural reforms:

These policies aim at reducing real wages. With lower wages, the firms will be able to hire more workers. Examples of this policy are: minimum wage reduction, unemployment benefit reduction and removing differences between insiders and outsiders.

4. Income policies:

A pact between the firm and its workers allow for reduction of real wages, this way firms can hire more labour force, which reduces unemployment levels.

5. Labour distribution policies:

Employees will work fewer hours, they will earn less, and so a greater amount of employees will be able to be hired. Marginal productivity is also increased by these policies. However, these policies are not really popular.

It is important to notice that not all policies are effective in the same time frame nor their effects remain over the same period. While supply-side policies and structural reforms have an effect in the long term, the rest have an effect in a shorter time, being this the reason why they were thoroughly studied by Keynesians and monetarists. However, contemporary economic doctrines, such as New Classical Macroeconomics and New Keynesian Economics have proven their inefficiency, thus turning back to supply-side policies as the only plausible solution.

Oct 23

Lope Gallego

Michael Spence

Andrew Michael Spence

Andrew Michael Spence, born in 1943, is an American economist and has been Professor at Harvard University and Stanford University, amongst others. He is currently a lecturer at New York University. His researches and contributions have been mainly in the field of economics of information, and together with economists George A. Akerlof and Joseph E. Stiglitz, Spence was awarded the Nobel Prize in Economic Sciences in 2001 for his work regarding asymmetric information.

Spence paid special attention to the study of those situations in which if certain market participants have more information than the rest, they will take care of disseminating this information to everybody. For instance, it shows how companies use their dividend policy to signal their profitability to market analysts.

In his book “Job Market Signaling”, 1973, he develops Akerlof’s previous studies and applies them to the labour market: when hiring a new employee, and as the firm does not know the labour value that this potential employee will add, they will offer an average salary level that will not match what the best candidates deserve. It is therefore important to inform others about the features that are not readily observable, what Spence called signalling. Academic degrees are a way of signalling inside the labour market as they are used to show above average labour value.

Oct 21

Lope Gallego

Period analysis

Period analysis show the inter-temporal dimension of production theory. It was developed by Alfred Marshall in his “Principles of Economics”, 1890, and has remained practically unaltered since. It tries to explain how equilibrium is achieved and explains the adjustment processes to reach it, going from the short-run equilibrium to the long-run equilibrium. His method is able to classify forces with references to the length of time needed for the production process; and then confine in ceteris paribus those forces that are of less importance with regards to the specific time we are considering. Four periods can be distinguished: very short-run, short-run, long-run and very long-run.

The very short-run period is normally not studied as it is considered irrelevant. It is a period characterized by having all its production factors or inputs, fixed; thus implying there can be no change in their quantities. Costs are therefore considered to be fixed and logically there is inexistence of technological progress in this period.

The short-run period is a period in which some factors remain fixed while others may vary in their quantity. Capital elements, such as equipment, are considered fixed factors while labour is considered to be a variable factor. During this period, cost analysis has a large dependence on marginal cost and average total costs. But, since not all factors can be increased, this will result in diminishing returns, which will imply that marginal costs will increase. A firm should stop production until marginal costs reach average total costs in order to maximize profits. In this period technological progress is still non-existing.

The long-run period is formed by the succession of several short-run periods and it is considered to be like an envelope of many of these. As inputs can be increased, economies of scale can be achieved, so the cost of producing an extra unit of output will decrease, and thus reduce the average costs. Inputs and outputs should be increased until the point where the optimum size of the firm is achieved and from whereon an increase in size will only mean diseconomies of scale. All inputs may be varied but the basic technology of production still cannot be changed.

Finally, it is in the very long-run period when new production processes and new products come as a result of the existence of technological changes within this period, which allow for new ways of producing and different input requirements.

Oct 20

Lope Gallego

Christopher Pissarides

Christopher Pissarides
Christopher Antoniou Pissarides, born in 1943, is a Cypriot economist and a School Professor at the London School of Economics. His research has mainly been focussed in the field of macroeconomics, specially in job search frictions explaining unemployment. Pissarides, along with Peter A. Diamond and Dale T. Mortensen were the joint winners of the Nobel Prize in Economic Sciences in the year 2010, for their analysis of markets with search frictions.

Pissarides’ studies have been of great contribution to the search and matching theory. He has observed the relations and interactions between the labour market and the macro economy. He is one of the developers of the matching function, a concept that tries to explain the flows from unemployment to employment, at a given moment, using empirical work to support it.

Pissarides and Mortensen wrote their famous “Job Creation and Job Destruction in the Theory of Unemployment” first published in 1994 in the Review of Economic Studies. This paper was a summation of the authors’ researches and conclusions. The Mortensen-Pissarides modelthat was forged in this work has been key in modern macroeconomics. It has a matching function that describes how workers are matched to vacancies based on a Nash’s bargaining analysis.

Oct 19

Lope Gallego

Production in the very long run

Production in the very long run differs from long run production in that there may be changes in technology. There are three main types of technological advances:

New technology allows for completely new products
New technology allows us to produce equal quantities with less inputs, displacing our isoquants
New technology allows us to produce greater quantities with equal inputs, displacing our production function

These technological advances may displace our ratio of capital to labour one way or the other. Let’s see it graphically first:

-the first technological change shown in the adjacent figure is called Hicks-neutral, which translates into an unchanged ratio of capital’s marginal product to labour’s marginal product. John Hicks devised it in his book “The Theory of Wages”, 1932. Analytically: Y = AF(K,L)

-the second technological change is called Harrod-neutral or labour-augmenting increases efficiency of labour. Roy Harrodformulated it in his book “Towards a Dynamic Economics”, 1948. Analytically: Y = F(K,AL)

-the third and last technological change shown is called Solow-neutral or capital-augmenting , which increases the efficiency of capital. It was devised by Robert Solow in his article “Technical Change and the Aggregate Production Function”, 1957. Analytically: Y = F(AK,L)

Finally, we must also take into account the possibility of endogenous growth derived from endogenous technical changes. This can be easily plotted by using a Cobb-Douglas function, such as:

Oct 18

Lope Gallego

Production in the long run

When dealing with long run production, the main change from short run production is that we can vary the levels of fixed inputs we use (capital, K), as well as variable inputs (labour, L). Our levels of production will be determined by our returns to scale. It’s worth introducing here the concept homogenous functions. A function is considered homogenous if, when we have a multiplier, λ:

That is, we can reduce a production function to its common multiples multiplied by the original function. This is important to returns to scale because it will determine by how much variations in the levels of the input factors we use will affect the total level of production. Also, an homothetic production function is a function whose marginal rate of technical substitution is homogeneous of degree zero.

All this becomes very important to get the balance right between levels of capital, levels of labour, and total production. We can measure the elasticity of these returns to scale in the following way:

That is, the sum of the partial derivatives of production with regards to each factors multiplied by the proportion each input makes up of the whole. Graphically:

If µ is greater than one, we say that we have positive returns to scale (green). The more we produce, the less our costs will be per unit. If it is between one and zero, we have constant returns to scale (blue), and if it is negative, we will have negative returns to scale (red). When dealing with Cobb-Douglas functions, we can also determine which returns of scale are present, since α+β=µ.

All this will determine the average size of a business in the sector. Positive returns to scale, the most common scenario, will naturally attract a concentration of very large businesses, as is often the case in industrial, capital intensive sectors. Getting it right is crucial for another reason: in the long term, market equilibrium will determine that the total production of a certain good will be such to eliminate economic profits.

Oct 17

Lope Gallego

Production in the short run

The short run is considered the period of time where fixed costs are still fixed, which basically means that, if you have a factory, you have to make do with it because you can neither sell it, nor make it bigger, nor rent half of it: you are stuck with it for the time being. Capital is also considered fixed, meaning that, in the short run, all you can play around with are your variable costs, being labour the most commonly used variable cost.

If we look at the adjacent graphs, we can see how marginal productivity (cyan, second graph) drops with each added unit of labour, under the law of diminishing returns. The two diagrams allow us to see three clear phases, characterised by the point of inflection that marks the law of diminishing returns. In the first diagram, we see how production increases exponentially with each added unit of labour, up to a point where added units begin to offer less and less return. In the second diagram, we introduce average productivity too; to define even further at what level we should produce.

In phase I, average and marginal productivity increase with each added unit, corresponding with the first diagram up to the point of inflection. Phase I ends in the extensive margin (or technical optimum), being this the line that splits phases I and II. Phase II is where we should ideally be. Average productivity drops with each added unit, but marginal productivity is still positive. The line that separates phases II and III is called the intensive margin (or technical maximum), from which there will be too much variable input for each level of fixed input. When marginal productivity becomes negative, we enter phase III, and we should consider reducing labour. We can also see that, at optimum level, marginal and average productivity coincide.

This all relates to the productive elasticity of our product, which is the difference in quantity that occurs as the result of a change in the level of productive inputs. Obviously, in phase I, a change of one unit in labour input will produce a much larger return in production levels than itself: ε_L>1. In phase two, 1> ε_L>0, and in phase III, 0> ε_L.

Algebraically, the elasticity of production can be defined as:

It must be noted that the elasticity of production for a given input (here labour, L) is the first half of the elasticity of scale, which in turn gives us the returns to scale.

Oct 15

Lope Gallego

Oliver Williamson

Oliver Williamson Oliver Eaton Williamson, born in 1932, is an American Economist and has been a Professor at the University of Pennsylvania, Yale University and the University of California, Berkeley. In year 2009 he was awarded the Nobel Prize in Economics Sciences along Elinor Ostrom, for their analysis of economic governance.

Williamson’s contributions have been of great interest in the field of industrial organization theory. He has argued that hierarchical and market organizations, such as firms, can also realize the function of governance’s structures in the resolution of market conflicts. However, problems can also arise from this intervention, as firms with enough size can disturb the order and abuse their market powers. Williamson’s analyses about hierarchy and market power are at the core of some of his articles, such as “Economies as an Antitrust Defense: The Welfare Tradeoffs”, 1968, and “Market and Hierarchies: Some Elementary Considerations”, 1973.

As a disciple of Ronald Coase he took special interest on transaction costs, and made a distinction between two different kinds: repeated case-by-case and relationship-specific contracts. The latter comes from the repetition of the first one, and comes from an on-going relation that ends with an entrenchment amongst parties. In fact, Williamson is considered to be the economist that produced the most articles about transaction costs, from which must be highlighted the following: “Transaction-Cost Economics: The Governance of Contractual Relations”, 1979, and “The Economics of Organization: The Transaction Cost Approach”, 1981.

Oct 13

Lope Gallego

Joseph Stiglitz

Joseph Eugene Stiglitz, born in 1943, is an American economist and could be consider as a supporter New Keynesian Economics. In 2001, jointly with George A. Akerlof and Michael Spence, he was awarded the Noble Prize in Economic Sciences for his work regarding analysis in markets with asymmetric information. In 2003 he became a Professor at Columbia University.

Stiglitz paid special attention and studied those situations in which the market agents that are worst informed, manage to extract market information through the use of sampling technics. This was an extension and completion of Spence´s work on signalling, but from the consumer’s point of view. Through different papers and works, such as “Credit Rationing in Markets with Imperfect Information”, published in 1981 and co-authored by Andrew Weiss, Stiglitz has analysed and explained that some market phenomena, such as unemployment and credit rationing, are better understood by the existence of asymmetric information.

As a result of the research that Stiglitz carried out involving efficiency wages, he and Carl Shapirodeveloped the Shapiro-Stiglitz model in their article “Unemployment as a Worker Discipline Device”, 1984. This model helps explain why unemployment exists, even in equilibrium, and why also, even without minimum wages, wages do not decrease fast enough for everyone to be hired.

Stiglitz was part of the Clinton administration from 1993 to 1997. He also served as senior vice-president and chief economist at the World Bankfrom 1997 to 2000.