Oct 16

Ernst Engel

Ernst Engel, 1821-1896, was a Prussian statistician, founder of the International Statistical Institute and from 1860 to 1882 he was director of the Prussian statistical bureau in Berlin. However, he is best known for the formulation of his Engel’s law, deriving on what is known as the Engel curve.

Engel developed his famous curve in his book “Die Productions- und Consumtionsverhältnisse des Königreichs Sachsens” 1857, from observing and collecting data of the consumption patterns of Belgian working-class families, and he related their level of income with their expenditure in food and other goods. He observed that households with higher incomes tended to allocate a lower share of their income to food than poorer households. The Engel curve captures this inverse relation. His law is a reflection of this phenomenon and states this same relation. As Engel himself expressed, the implication of this law is very interesting in the macroeconomic sense as it implies that the higher the economic development of a country, the lower the share of agriculture will be in aggregate production.

Oct 13

Lope Gallego

Macroeconomics

Macroeconomics is the study of the economy as a whole, by means of aggregate variables, this is, the part of economic theory that studies the behaviour of economic agents in large aggregates of demand and supply, monetary aggregates, gross domestic product, etc. Macroeconomics therefore relate to the concepts of the national economy that are measured through national accounting, input-output models, etc. During the 30s, J.M. Keynes, promoted the study of this matters with his concepts of aggregate demand, full employment and so on.

In contrast to microeconomics, macroeconomics seeks the “large picture”, showing the operations of the economy as a whole, rather than its internal diversity. In fact, it regards the economy as producing a single and unique good. Its purpose is to obtain the least complex vision of the economy’s functioning, but in such a way that it also, allows the analysis of the level of economic activity.

We can use Engel’s Law to show the close relations between micro and macro concepts and how one can have profound implications in the other. Ernst Engel analysed Belgian working class families’ consumption patterns and related their levels of income with their expenditure on food and other goods. He discovered that the higher the income of the family, the lower the share of food in comparison to other expenses. This analysis would become the central statement of his law. As Engel already realized, this had huge consequences in the economic development. Agriculture production, which relies heavily on food consumption, as this is its main product, will see a decline regarding its share of the aggregate total production, as the share for food decreases in aggregate terms as the economy grows. From this concept, we can extract that growth of all sectors at the same rate is impossible, and we also find the close relation between micro and macro concepts.

There are a many topics covered in the field of macroeconomics: aggregate demand and supply, business cycles, unemployment, government role, inflation, etc.

Oct 9

Lope Gallego

Microeconomics

Microeconomics is a branch of economic theory that is centred in modelling the interactions amongst market agents, specially between consumers, which are trying to maximise their utility, and firms, which try to maximise their profits. It analyses the underlying logic of the individual behaviour of economic agents such as the employer, the consumer, etc., and the notions that derive from them, such as, profit, utility, market structures, etc. In its purest form it answers the philosophical question regarding the resources allocation process.

The line that separates microeconomics from macroeconomics has become increasingly narrow throughout time. Nevertheless, it has always existed, and most probably will always exist, as some barriers are insurmountable. The goal of macroeconomics is to understand and predict the behaviour of economic variables in its aggregate terms. Therefore we make the distinction of microeconomics as relating to individual, micro, terms (consumers, firms, etc.), while macroeconomics relate to aggregate, macro, variables (consumption, unemployment, investment, etc.). A way to view both terms is from a disaggregated vs. aggregated perspective.

The methods and tools used in microeconomics are mainly the construction of models that simplify the reality so that the interdependence between variables can be analysed and represented. Many techniques may be used for the construction of these models; however, the great majority of them fall into the categories of optimisation analysis and equilibrium analysis. Furthermore, models of optimising behaviour represent nearly all of the models of individual behaviour in microeconomics.

Oct 2

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Frank P. Ramsey

Frank Plumpton Ramsey, 1903-1930, was an English mathematician who applied his knowledge and interest to the disciplines of philosophy and economics, resulting in remarkable contributions. Regarding his works on Economics, he produced three master pieces which were, however, disregarded for many years.

His first economic paper “Truth and Probability”, 1926, covers subjective probability and utility. Ramsey argues Keynes’ point of view on the importance of subjective probabilities. Keynes believed in the relation between knowledge and probability, being knowledge common and available for all individuals and thus implying that everybody would have the same probability distribution. Ramsey argued that each individual would have its own knowledge resulting in different probability distributions. For him there was a difference between the notions of probability in physics and logic.

In his second paper “A Contribution to the Theory of Taxation”, 1927, Ramsey centred in optimal taxation so that revenue and utility are maximised and produced the concept of Ramsey pricing used to calculate the price a monopolistic firm should set in order to maximise social welfare subject to profit constraint.

Finally, in his third paper “A Mathematical Theory of Savings”, 1928, Ramsey tries to determine the optimal amount of savings for an economy in order to maximise its future utility. This would result in the infinite horizon growth model. His mathematical background is strongly noticed due to the use of calculus of variations and he laid the bases for the development of optimal accumulation theory or theory of optimal path of accumulation. His model was later adapted by Tjalling C. Koopmans and David Cass to maximise household’s utility function.

Sep 27

Lope Gallego

Transaction costs

Transaction costs are the associated costs that derive from the formalisation of complex relationships that necessarily exist for the production of goods and services. As an example, transactions cost can occur during the processes of negotiation, search, determination of prices, etc.

Ronald H. Coase developed a theory regarding industrial organisation, and specifically business formation, in which transaction costs play a main role. In his book “The Nature of the Firm”, 1937, he explained why productive individuals find it beneficial to form coordinating agencies (firms) as a reaction to transactions costs. Instead of individuals operating independently, and repeatedly incurring in numerous transaction costs, they could work in a global framework, and at the same time they could benefit, amongst other things, from learning and experience curves and from economies of scale.

Sep 25

Lope Gallego

Market failure

Market failures appear whenever a market is unable to work “successfully”, meaning it cannot achieve equilibrium with an efficient allocation of resources, which is known as Pareto efficiency. This imperfection in the price assignment system prevents an efficient resource allocation, and thus, government intervention is considered necessary and justified. Although the concept has been around since Adam Smith, it is unclear who coined the term, even though F. Bator was probably the first economist to use it, in his paper “The Anatomy of Market Failures”, 1958. The most common ways in which market failure appears are externalities, public goods and information asymmetry:

-Externalities are caused when the production or consumption of a good or service has a spill-over effect which is not fully reflected in its price and so no appropriate compensation is paid for it. If the price does not include the true cost of the good or service it will be incurring in market failure. It is important to point out that externalities can be either positive or negative. To prevent negative externalities, governments may add specific taxes to the goods or services to cover its social cost.

– Public goods are defined as non-excludable and non-rival goods, which are the main reasons why the private sector may find it impossible, or at least very difficult, to make an economic profit from producing the goods. Consumers can become as what is known as free riders as they can enjoy the good without paying for it. Due to the poor incentives of the private sector to produce these kinds of goods, it relies in the public sector to provide them.

-Information asymmetry is understood as the difference of information levels between different parties. If one of the parties has more information than the other, it can use it to its advantage and so causing the transactions to be unfair. This kind of information asymmetry may lead to adverse selection and moral hazard, which will lead to market failures. The government can use several measures in order to reduce this kind of market failure, such as, collection and provisions of information, product standards, warrants, etc.

Sep 22

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Ceteris paribus

Ceteris paribus is a Latin phrase that translates as “other things the same” and is a frequently used expression in economics. It refers to a phenomenon in which two or more variables intervene and for which it is assumed that, with the exception of the variable that is under study, the rest remain constant and stable, e.g. if the price of rice decreases, ceteris paribus, the demand for it will increase.

It is widely used in marginalism and macroeconomics, its use becoming popular thanks to the English economist Alfred Marshall.

Jun 3

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Exit barrier

Exit barriers (or barriers to exit) are obstacles that stop or prevent the exit of a firm from a specific market. It is associated with firms that are incurring in some form of losses, but cannot exit the market as a result of exit barriers that would further increase their level of loss. In Michael Porter’s model of competitive analysis, barriers are a fundamental element to gauge the level of competition in a sector, and defines the market structure in that industry. He identified the following exit barriers:

Non-transferable assets: when a firm invests on specialised assets, which cannot be used in other industries, exiting the market implies losing those assets.

Fixed exit costs: such as indemnities paid to employees, cancelation costs in contracts with suppliers, etc.;

Synergies: when producing one good allows for lower costs in the production of other goods, exiting an industry may imply higher costs when producing that good.

Although barriers may have negative consequences for some firms, for others they will be positive. Where some firms loose other win, it can be regarded as a zero-sum game. For abnormal profits to occur in a market, barriers have to exist. Using Joe Bain’s definition, “barriers give firms the power to maintain in the long-term prices higher than average cost”.

Jun 3

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Entry barrier

Entry barriers (or barriers to entry) are obstacles that stop or prevent the entrance of a firm in a specific market. It is associated with the situation in which a firm wants to enter a market due to high profits or increasing demand but cannot do so because of these barriers. In Michael Porter’s model of competitive analysis, barriers are a fundamental element to gauge the level of competition in a sector, and relates to the market structure. Here are some of these entry barriers:

Economies of scale, economies of scope: any of these could be necessary to enter an industry, since fewer costs can mean the possibility to remain in that industry;

Product differentiation: if incumbent firms in the industry have from customers a certain degree of loyalty towards their products, differentiation may be its origin;

Minimum capital requirements: in some industries, high investments may be needed in order to be able to produce;

Complicated change of supplier: if our potential customers find it hard to change suppliers, they might not be willing to change;

Access to distribution channels: of special interest when considering consumer goods, it means that getting the distribution channels to distribute your product may prove hard;

Costa advantages other than economies of scale: such as technology, know-howor simply because of the learning curve;

Government regulation: requirement of permits or licenses such as construction permits or taxi licenses;

Expected reaction from incumbents: if price wars or predatory pricing is expected, this could act as a barrier to entry.

The figure below shows the relation between entry barriers and market structure:

May 30

Lope Gallego

Contestable market

Contestable markets are those in which the short-term threats from potential competitors exert such a degree of pressure over the incumbents, that their behaviour is conditioned. Contestable markets are therefore in a competitive equilibrium even though the market can be considered to have a relatively small number of firms, meaning these could as well behave as in imperfect competition. In any case, the amount supplied by the industry and the prices of the goods are held at perfect competition levels and therefore maintain a desirable welfare outcome.

This threat of new entrants is real, these should be able to enter the market without any complications and have the same advantages as the incumbent firms, once inside the market. This theory pays special attention not only to barriers of entry but also to exit barriers. Firms that want to enter should know they can enter and exit the market without inquiring into high costs, which would otherwise restrain their incentives to enter.

For a market to be considered a contestable market a series of requisites must be met:

-potential entrants should have access to the same technology as incumbents. If this is not the case entrants would be in a disadvantage position compared to incumbents.

– sunk costsshould not exist. Firms that enter the market must be able to recover their investments.

-the reaction time to changes for an incumbent firm should be longer than the time for a new firm to enter the market. This gives entrants the possibility to enter markets and perform hit-and-run strategies.

The theory was proposed by William J. Baumol in his “Contestable Markets and the Theory of Industrial Structure” 1982. As he argued, perfectly contestable markets would always result in a competitive equilibrium independently of the number of firms in the market, as the threat of potential rivals would guarantee it. Nevertheless these conditions are subject to important limitations. Demand should be significantly sensitive to price, for the threat of entrants charging lower prices and attracting consumers to be real one. Technology should have constant returns so incumbents do not have an advantageous position over entrants. Due to all these restrictive assumptions perfectly contestable markets are of a rare nature.