Jan 6

Stagflation

Stagflation is a term that refers to the economic situation where there is a simultaneous combination of high unemployment levels and declining productivity growth, also known as stagnation, and high levels of inflation over long periods of time. This term was coined by the British politician Ian McLeod during a speech at the British Parliament in 1965.

Although some economists like Milton Friedman recognized the possibility of stagflation and consequently neglecting the Phillips curve, it was only after the events during the 1970s when this situation became well known. From 1969 to 1982, inflation averaged 7.5% annually while unemployment 6.4%.

Jan 6

Lope Gallego

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 24

Lope Gallego

For the last seven weeks we’ve been learning about the basics of microeconomics. We started with consumer theory, where we learned how agents make decisions about consumption. Then we moved onto production, and saw how firms decide how much and when to produce. Finally, we learned how cost analysis define the way firms behave in the market.

In January we’ll be back with new Learning Paths. We’ll start with game theory, where we’ll learn about what different kinds of games there are and how to solve them. We hope you’ll enjoy them!

In the mean time, you can read again other LPs, so you know the basics by the time we start launching new LPs. You can access them here.

We also want to wish you Happy Holidays, and a Happy New Year!

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

Cost III: X-inefficiency

X-inefficiency is known as the result of inputs not producing their maximum output as a consequence of an “X” factor. This translates into both cost minimisation and production maximisation failure and, hence, implies a loss of efficiency. This term was first introduced by Harvey Leibenstein in his “Allocative efficiency vs “X-efficiency”, 1966, since concepts such as organisation inefficiency or motivational inefficiency were not yet available. Therefore X-inefficiency makes reference to all non-allocative inefficiencies.

There are four main identified reasons that try to answer for X-inefficiencies:

Relaxing maximisation behaviour: as the psychological Yerkes-Dodson Law postulates, individuals who are exposed to low pressure will not put much effort in their actions. As pressure builds up, maximising behaviours are reached until a point where too much pressure will again result in inefficiency. Other non-maximising decision making processes include habits, conventions, moral imperatives, etc.
Incomplete contracts: employment contracts define workers economic compensation but other concerns such as the effort, the work load or specific tasks may remain undefined, which creates an incompleteness in contracts.
Inertia: forces that are external to the company may exert pressure to make the firm become more competitive. Only with this external force efforts will increase.
Discretion: it is assumed that workers will not show their “full potential” or maximize their efforts, and at the same time, that employers will not pay the maximum wages they could offer.

However empirical tests and models about X-inefficiency relevance have mixed results so no final transcendence can be assured. However, is interesting to realise the debate it has created, specially regarding incomplete contracts and managerial inefficiency, both also studied in the field of business management.

Dec 16

Lope Gallego

Cost III: Stigler’s cost analysis theory

As a contribution to industrial organization, George Stigler developed his “own” theory on cost analysis in his article “Production and Distribution in the Short Run”, 1939, which moved slightly away from neoclassical cost analysis.

This theory arises as many economist started to criticize the traditional U-shaped representation of a firm’s average costs. George Stigler used empirical data to question the traditional theory. His cost theory can be divided into the analysis of both the short-term and long-term average costs:

Average Costs in the short-term

According to classical economics, each plant ensured only a specific level of output could be produced in the short-run because of production inflexibility. However, Stigler introduced the notion that firms could adapt to changes in demand and be flexible even in the short-run. His main argument in favour of this idea is that whenever a firms built a plant they would have what is known as a reserve capacity.

The existence of this reserve capacity is justified by economic and technical reasons. From the former we include possible changes in the good’s demand due to cyclical reasons, favourable changes in consumers’ tastes or as a preventive method to avoid a production stop in case there is a breakdown or a repair. The latter can arise as there are some basic installations that are indivisible or as managers and workers are hired in excess to allow future expansions.

-before X₁ : marginal costs < decreasing average costs (increasing returns to scale)

-X₁ to X₂: marginal costs = average costs (constant returns to scale, maximum efficiency)

-after X₂: marginal costs > average costs (both increase, therefore decreasing returns to scale)

It must be noted that this theory allows for maximum efficiency to exist for a while, which completely differs from the neoclassical view, which viewed maximum efficiency as a point of inflection, rather than a straight line.

Average Cost in the long-term

Taking into account production costs and managerial costs, Stigler argued that in the long-run average costs will decrease until a point where they cannot longer do so and from which they will become constant.

Production costs will decrease due to economies of scale until the optimum size is reached and then remain constant. Further average production cost reduction could come along with technological or skills increase. As for managerial cost, he considers, they will start to increase after a certain size is reached. However, managerial diseconomies of scale would be compensated by technical economies of scale, with a zero sum net effect and therefore would remain constant as a result.