THE PENGUIN

DICTIONARY OF

SEVENTH EDITION

GRA
TER AND
IS
PENGUIN REFERENCE

The Penguin Dictionary of Economics

Graham Bannock is a graduate of the London School of Economics

and author of several books on finance and business. He has worked
in market research for Ford and Rover, and in economic research at
the OECD and the Economist Intelligence Unit, of which he was
managing director. He founded Bannock Consulting Ltd, an economic
research company in London. He is co-author of The Penguin Inter¬
national Dictionary of Finance and The New Penguin Dictionary of Business
and two of his other books, The Juggernauts: the Age of the Giant Corpor¬
ations and How to Survive the Slump, are also published by Penguin. He
is a director of Central Banking Publications.
Ron Baxter graduated from the London School of Economics with a
degree in economics. He has held posts in the International Nickel
Company, Hoover Ltd and the Electricity Council in London. He was
Director of Economics and Statistics at the National Ports Council. He
jointly founded Baxter Eadie Ltd, specializing in the appraisal of port
investment projects worldwide. He has acted as consultant for a wide
range of private corporations and international institutions. He is
co-author of Readings in Economics and author of Ports and Island
Waterways.
Evan Davis is the Economics Editor of the BBC. He was previously
Economic Correspondent at the BBC's Newsnight Programme. He has
also worked at the Institute for Fiscal Studies and the London Business
School. He studied at St John's College, Oxford and at the Kennedy
School of Government at Harvard University. He is the author of Public
Spending and co-author of The New Penguin Dictionary of Business.
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The Penguin Dictionary of

Econom
Graham Bannock
R. E. Baxter
Evan Davis

SEVENTH EDITION

PENGUIN BOOKS
 PENGUIN BOOKS

Published by the Penguin Group

Penguin Books Ltd, 80 Strand, London WC2R orl, England
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Penguin Books Ltd, Registered Offices: 80 Strand, London WC2R orl, England

www.penguin.com

First published 1972

Second edition 1978
Third edition 1984
Fourth edition T987
Fifth edition 1992
Sixth edition T998
Seventy edition 2003
1

Copyright © Graham Bannock, R. E. Baxter and R. Rees, 1972,1978,1984

Copyright © Graham Bannock, R. E. Baxter and Evan Davis, 1987,1992,1998 2003
All rights reserved

The moral rights of the authors have been asserted

Set in 7.5/9.75 pt ITC Stone

Typeset by Rowland Phototypesetting Ltd, Bury St Edmunds, Suffolk
Printed in England by Clays Ltd, St Ives pic

Except in the United States of America, this book is sold subject

to the condition that it shall not, by way of trade or otherwise, be lent,
re-sold, hired out, or otherwise circulated without the publisher's
prior consent in any form of binding or cover other than that in
which it is published and without a similar condition including this
condition being imposed on the subsequent purchaser
 Foreword

Foreword to the Fifth Edition

. no dictionary of a living tongue can ever be perfect, since while it is

hastening to publication, some words are budding, and some falling away'
Samuel Johnson, The Dictionary of English {1755)

'In the case of economics there are no important propositions that cannot,
in fact, be stated in plain language'
J. K. Galbraith, Annals of an Abiding Liberal (1979)

Our labours in regularly improving and updating this book have been rewarded, to
date, by total sales, worldwide, in excess of 500,000 copies. For this fifth edition we
have continued the process of revision. Some seventy entries have been deleted and
many others abbreviated to make space for over 150 new entries taking account of
new developments in economic theory and practical affairs.
Both the intended readership and the scope and method of the book are unaltered.
The dictionary is planned as a companion to two kinds of users of economics. First,
for the general reader who wants to follow economic discussion in the press or
elsewhere and for the increasing number of people who need some knowledge of
economics in their daily work, in teaching, business, the civil service, representative
bodies and the professions. Secondly, it is aimed at students - especially those up to
the second-year university courses in the subject - but also others, e.g. those at
business schools for whom economics is part of the curriculum.
Our distinctive approach remains unique. This approach consists of a micro-
encyclopaedic treatment with extensive cross-referencing, up-to-date institutional
material and a level of exposition that attempts to combine a reasonable degree of
academic rigour with brevity and practical relevance.
Our subject is large and growing continuously and we have had to be highly
selective. Words in common usage are not normally included unless they have
a specialized meaning in economics. Economic theory, including international,
monetary and welfare economics, has been treated fairly comprehensively. We have
also given considerable emphasis to the history of economics in keeping with our
view of the subject as a developing one. Individual economists are included only
where they have made an important and definable contribution to the body of
economic thought as it exists today. We have been particularly sparing in our
inclusion of contemporary economists (other than Nobel Prize-winners), so that
many distinguished living members of the profession are left out. We have tried to
 Foreword

include all the key terms used by econometricians and statisticians that are in
general use. Our treatment of financial and business economics, public finance,
international trade and development and payments has been more selective still
but, institutions apart, we hope that nothing important has been omitted.
We have been helped and encouraged by the response we have received from our
readers. We hope that they will continue to point out to us any errors or omissions.

G.B.
R. E. B.
E. D.
May iggi

Single and double arrows {> >►) in the text indicate, respectively see and see also,
where a point is either amplified or complemented in another entry.

Foreword to the Seventh Edition

This new edition has again been substantially revised and updated and we have
included a number of additional diagrams. We continue to emphasize the inter¬
national, rather than the purely UK, aspects of our subject and to incorporate
institutional detail and statistics where relevant.
Although the content has been greatly revised and expanded, the basic plan of
the work remains unchanged since it first appeared over 30 years ago. Readers are
referred to the Foreword to the Fifth Edition for an explanation of the scope of the
book and the system of cross-referencing.
We are greatly indebted to the help and support we have received from Dee Baxter
and Franfoise Bannock, and from Alex Allan in getting the work to the press. Finally
we wish to acknowledge the work of our copy-editor, Anthony John.
We hope that our many readers who have contacted us with valuable suggestions
will continue to do so. Readers may write to us care of Penguin Books, or use the
website www.penguin.co.uk/economics.

G.B.
R. E. B.
E.D.
London,
September 2002
 A

'A' shares >-share.

above the line »-below the line.

absolute cost advantage ^barriers to entry.

absorption Total expenditure on final goods and services. Domestic absorption

in an economy is equal to Consumption plus ^investment plus ^-government
expenditure (or C + I + G), and is equivalent to >national income minus net exports.

absorption costing ^management accounting.

abstinence theory of interest >interest, abstinence theory of.

acceleration principle The hypothesis that the level of ^investment in an

economy varies directly with the rate of change of output. Given technological
conditions and the relative prices of Capital and > labour, a certain size of capital
stock will be chosen to produce a particular level of output. If this level of output
changes, then, other things being equal, the desired size of capital stock will also
change. Net investment is, by definition, the amount by which the capital stock
changes, so it follows that the amount of investment depends on the size of the
change in output. At its simplest, the hypothesis asserts that investment will be
proportional to the rate of change of output, at all levels of output. However, under
more realistic assumptions the relationship may cease to be a simple, proportional,
one. There may, for example, be spare capacity over some range of increasing output,
so that the capital stock does not have to be increased until full capacity is reached;
or the capital intensity (>-capital-intensive) of production may vary as the level of
output varies. In addition, the relation will be influenced by ^expectations, time
lags, etc. As well as being very important in explaining the determination of invest¬
ment expenditure in the economy, the acceleration principle also plays an important
part in theories of the ebusiness cycle, e.g. the >accelerator-multiplier model, and
the theory of >-economic growth, e.g. in the >Harrod-Domar model, ^accelerator
coefficient; Clark, J. M.

accelerator coefficient The factor that determines how much ^-investment is

induced by a change in output (^acceleration principle). Its value is influenced by
the availability of spare capacity, the productivity of capital, the rate of »-interest
and the price of labour. >capital-output ratio; productivity.

accelerator-multiplier model A model of economic growth, incorporating the

effects of the > acceleration principle and the >multiplier. An increase in govern-
 accelerator theory of investment

ment expenditure, for example, raises consumers' incomes which, through the
multiplier, leads to an increase in output which in turn, through the accelerator,
raises investment. The increase in expenditure in investment, itself raises in¬
comes and the process is repeated. The model reveals that the multiplier and the
accelerator interrelate in a way that can produce a cyclical pattern to economic
growth. >^ Harrod-Domar model; Samuelson, P. A.

accelerator theory of investment ►acceleration principle; business cycle.

acceptance The act of accepting, i.e. agreeing to honour a ►promissory note such
as a ►bill of exchange. By extension, the document itself.

accepting house An institution specializing in accepting or guaranteeing ►bills

of exchange. All accepting houses have taken on other functions as the use of bills
of exchange has declined, returning to their original, wider, function of merchant
banking (>merchant banks). The Accepting Houses Committee represents the
accepting houses in the City of London and ensures policy co-ordination between
them, the ^Treasury and the ►Bank of England. Members of this committee are
eligible for finer >discounts on bills bought by the Bank of England, though this
privilege has recently been extended to other banks, including foreign banks, and
the term 'accepting house' is now an indication of status rather than function.

account 1 A record of financial transactions in the form of >stocks or flows

(►►balance of payments; balance sheet; current account; social accounting). 2 An
arrangement between a seller and a buyer under which a period of ►credit is allowed
before payment, e.g. the period in which ►stock exchange transactions take
place and after the end of which settlement must be made. Up to the end of an
account, transactions are made without payment and account dates are thus of vital
importance to speculators.

account day The day on which all transactions made during the previous >account
at the >stock exchange must be settled (hence, settlement day). On the London Stock
Exchange, as in the USA, the markets use rolling accounts which are settled a fixed
number of days after the transaction: at present 5 days, or T+ 5', (eventually T+ 3).

accounting equation, basic ►balance sheet.

accruals ►accrued expenses.

accrued expenses The cost of services utilized in advance of payment and written
into a company's accounts as ►liabilities.

Africa, the Caribbean and the Pacific. ►Cotonou Agreement.

acquisition ►take-over.

ACT Advance corporation tax ►corporation tax.

active labour-market policies Measures taken to increase the employment

prospects of the unemployed (►long-term unemployment) without creating upward
pressure on wage levels. Such policies include, for example, job counselling (job
broking), training, direct job creation in the public sector, and employment subsidies
o firms. They differ from the passive measure of paying out State benefits to the
unemployed. The distinguishing characteristic of active labour-market measures is
U advanced countries

that they do not rely on general macroeconomic growth to generate employment

(►Keynesian unemployment), nor do they include measures designed to price the
unemployed into existing jobs (>classical unemployment). Active measures have
been most extensively pursued in Sweden where, after 300 days, benefits for the
unemployed are replaced by options for work or training. There is some debate as to
whether these policies were responsible for the relatively low unemployment rate
in Sweden up to the 1990s. The UK has emulated some of these ideas in the New Deal
for 18-24 year olds through a comprehensive welfare to work package for those
unemployed for over 6 months. This embodies a 'carrot-and-stick' approach, com¬
bining the threat of loss of benefit, with the opportunity of a place on a training
scheme, community work, or a temporary job subsidy. Similar schemes have been
adopted in the USA through, for example, the Personal Responsibility and Work
Opportunity Act 1996. Success of such schemes would result in a downward shift of
the > Beveridge curve, ,^-workfare.

activity analysis >linear programming.

activity-based costing ►management accounting.

activity rate >labour force.

actuary Someone trained in the calculation of >risk and >-premiums for ►assur¬
ance purposes.

ad valorem tax >tax, ad valorem.

adaptive expectations The formulation of beliefs about the future value of

variables based on their past value and direction of movement. If economic agents
used adaptive expectations to predict inflation next year, they would take this year's
rate and adjust it. The adjustment would depend on how wrong they had been
last year when predicting inflation this year - if they had underestimated inflation,
they would upwardly revise their prediction for next year. Adaptive expectations
are perhaps naive, in that they will, respectively, always under- or overestimate a
variable which is consistently rising or falling. The assumption that people hold
them is crucial in allowing certain economic policies to have an effect (>policy
ineffectiveness theorem) and has been criticized as ad hoc. ^expectations; rational
expectations.

ADB Asian Development Bank.

administered prices Strictly, prices that are set by management decision rather
than by negotiation between buyer and seller. Tme ►market prices are to be found
only in the ►stock exchange and other places where prices change constantly. Most
retail and industrial prices are set by management, though they will be altered in
response to competition. The term administered prices is often used to refer to
price-fixing by a ►monopoly firm, a ► cartel or a government body. »»mean costs.

ADR ► American depository receipt.

advance corporation tax (ACT) ►corporation tax.

advanced countries States with the highest levels of ►national income per head,
e.g. the member countries of the ►Organization for Economic Cooperation and
advances

Development, ^developing countries; least-developed countries; transition,

economies in.

advances Loans (>bank loan).

adverse selection The problem that, in certain markets, the inability of one trader
to assess the quality of the other makes it likely that poor-quality traders will
predominate. Noted by >Akerlof in 1970, adverse selection is sometimes referred to
as the lemon problem. A popular example of the phenomenon is in the secondhand
car market, where sellers know whether or not their car is a lemon (i.e. performs
badly), but where buyers cannot make that judgement without running the car.
Given that buyers can't tell the quality of the car they are buying, all cars of the
same model will end up selling at the same price, regardless of whether they are
lemons or not. But the risk of purchasing a lemon will lower the price buyers are
prepared to pay for any car and, because secondhand prices are low, people with
non-lemon cars will be little inclined to put them on the market.
There are three ingredients in this problem: (a) a random variation in product
quality in the market; (b) ^asymmetric information about product quality between
traders in the market, and (c) a greater willingness for poor-quality traders to trade
at low prices than for high-quality ones to do so. (Lemon car owners will still put
their cars on the market when the prices drop; other car owners will not.) There are
many important markets where adverse selection is held to be significant, notably
insurance and the market for credit, ^market failure.

advertising Paid announcements to persuade or inform members of the public.

Outside the theoretical world of ^perfect competition, advertising of goods and
services is necessary to ensure that potential buyers are informed and helps to make
markets function efficiently. However, advertising can create or increase >barriers
to entry into an industry and enhance product differentiation (^differentiation,
product) and, it has been argued, promote ^concentration. Proponents of heavy
advertising expenditure argue that it provides a ^-signalling mechanism whereby
high-quality producers publicly demonstrate their commitment to their product -
something they would do only if they genuinely believed that it had a long-term
future - while others point out that consumers may have little choice in a concen¬
trated industry but to bear the cost of unnecessary advertising which serves only
to keep out new entrants. 'Own brand' products in supermarkets (which are not
advertised) have not replaced advertised brands, and this could be explained by the
power of advertisers to manipulate consumer psychology.

AfDB African Development Bank.

African Development Bank (AfDB) A regional international bank (>banking)

founded in 1964 for assisting in the economic growth of the independent African
states. In 1972* affiliated organization, the African Development Fund, was set up
with a membership open, unlike that of the bank, to non-African states. It is through
this fund that loans are made to African member states at low or nil »-rates of interest
(>^soft loan). Affiliation to the fund has enabled the bank to broaden its sources of
funds for investment. In 1982, the African members of the bank agreed to open its
membership to non-African states. In r998, members agreed to increase the capital
of the bank by about $8 billion, to about $30 billion. The bank has fifty-three African
s Akerlof, George A.

member states and twenty-four other member states, with the latter having a share
of capital of 40 per cent. J^Asian Development Bank; Caribbean Development
Bank; Colombo Plan; foreign aid; Inter-American Development Bank.

African Development Fund ► African Development Bank.

agency costs The inefficiencies associated with employing a representative to

perform a task for you, rather than carrying it out yourself. In any situation in which
people are employed to perform a task, those employees - or agents - may well have
their own interests, quite separate from those of the employer (often referred to as
the 'principal'). Agency costs refer to the loss of efficiency in the conduct of a task
from the fact that agents may let their own interests temper their behaviour. For
example, a travel agent may sell a more expensive ticket than necessary to obtain a
bigger commission. Agency costs - in practice very common in all sorts of economic
relationships - only prevail where the behaviour of the agent is hard to monitor
directly. >principal-agent problem.

aggregate concentration >concentration.

aggregate demand The sum of all expenditure within an economy, making up

►gross domestic product. The main categories are: (a) consumers' expenditure on
goods and services; (b) government spending (>-public expenditure); (c) >-invest-
ment in capital goods and stocks (►inventories), and (d) >-exports of goods and
services, less expenditure on ^imports of goods and services. Since >Keynes, eco¬
nomists have debated how far the level of aggregate demand affects the total level of
output and >economic growth, ^-national income; policy ineffectiveness theorem.

aggregate supply The total of all goods and services produced in an economy.
Prior to XKeynes, it was believed that > national income was determined by aggre¬
gate supply (>Say). Keynes shifted the emphasis on to >aggregate demand, with
supply meeting whatever demand existed up to a point. More recently, supply
factors have received more consideration in the determination of total output,
►►supply-side economics.

aggregated rebate >deferred rebate.

aggregation problem >Cambridge School.

aid ^foreign aid.

AIM ^unlisted securities market(s).

Akerlof, George A. (b. 1940) Economist from the University of California at

Berkeley and joint winner of the Nobel Prize in 20or for his work on the effect of
► asymmetric information and ^adverse selection on the functioning of markets.
His most famous paper by far, 'The Market for Lemons: quality uncertainty and the
market mechanism' Quarterly Journal of Economics (1970), was written in his first year
as an assistant professor at Berkeley, and describes the impact of adverse selection
on the secondhand car market.
Professor Akerlof was educated at Yale and the Massachusetts Institute of Techno¬
logy, and, apart from when at Berkeley, spent time at the London School of Econ¬
omics between 1978 and T980. He also spent a year at the Indian Statistical Institute
in New Delhi in t968. This convinced him that standard economics was not rich
Allais, Maurice
Lf
enough to explain all the market behaviour we observe. Akerlof's economics has been
characterized by a preoccupation with the conventions of behaviour, institutions or
inertias that might impede the frictionless functioning of markets. He contributed
to >efficiency wage theory, with an account of workers whose productivity was low
on account of them holding a sense of injustice at their low wages. He was also a
proponent of >-new Keynesianism, trying to explain why wages and prices might
be sticky, as companies would quite rationally use simplistic rules-of-thumb to set
prices. In aggregate, these might have a serious effect for the economy as a whole,
and indeed, provide an argument for why monetary policy may be more effective at
stimulating the economy than >new classical economics has acknowledged.

Allais, Maurice (b. 1911) Educated at the Ecole Polytechnique and the Ecole
Nationale Superieure des Mines in Paris, Allais became director of the Centre d'Ana-
lyse Economique at the Ecole Nationale Superieure in 1944, where he taught notable
economists like Malinvaud and >Debreu. He became the first French citizen to win
the >Nobel Prize in Economics in 1988. His main work is his book A la recherche
d'une discipline economique (1943), a report on >general equilibrium and ^economic
efficiency without any assumption of >-convexity. His name is best known for the
Allais paradox, an attempt to show the impact of psychological factors on consumer
decision-making in conditions of >risk. The paradox is as follows. If you offer people
either a certain £500 or a lottery ticket that gives them a 10 per cent chance of
winning £2500, an 89 per cent chance of winning £500 and a 1 per cent chance of
winning nothing, they often take the certain £500. But if you offer them a choice
between two lottery tickets, one which gives them an n per cent chance of winning
£500 and an 89 per cent chance of winning nothing, or another one that offers them
a 10 per cent chance of winning £2500 and a 90 per cent chance of winning nothing,
they often take the second one. Interestingly, however, the effective choice being
made is the same in both cases, and consistent consumers should pick either the
first option both times or the second option both times, ^behavioural economics.

Allais paradox >Allais, M.

allocative efficiency >-economic efficiency.

allotment letter A letter addressed to a subscriber to an issue of X-shares informing

him of the number of shares that he has been allotted and, where payment was not
made with the application, the amount due.

Alternative Investment Market >unlisted securities market(s).

American Depository Receipt (ADR) A document issued by a US bank against

►shares deposited with it or a bank overseas. The ADR circulates as a bearer docu¬
ment, (>bearer bonds), in effect giving title to the underlying shares.

amortization Provision for the repayment of >debt by means of accumulating a

'sinking fund' through regular payments which, with accumulated ^interest, may
be used to settle the debt in instalments over time, or in a lump sum. The term is
also used as a synonym for >depreciation.

Amsterdam Treaty >European Union.

Andean Pact A >customs union agreed at Cartagena in 1969 between Chile,

Peru, Colombia, Bolivia and Ecuador. Venezuela joined the pact in r973, but Chile
lJ anti-trust

terminated her agreement in 1976. Free trade was established between the member
states, although it was not until T994 that a Common External Tariff regime was
agreed. In 1996, the Act of Trujillo committed the member states to the setting up of
an Economic Community (>-European Union). In r999, a Framework Agreement was
concluded for the establishment of a ►Free Trade Area with >Mercosur. ^Central
American Common Market; Latin American Integration Association.

annually managed expenditure (AME) The portion of public spending in

the UK that is managed on a year-by-year basis, rather than on a rolling 3-year
budget. The biggest components are: (a) social security spending; (b) debt interest;
(c) local authority self-financed spending, and (d) contributions to the European
Union. Annually managed expenditure is sometimes seen as spending that is
demand-led, i.e. spending over which government has little short-term control, but
simply has to cover as the bills come in. It contrasts with departmental spending
(►departmental expenditure limits) that can be more easily allocated in advance,
►public expenditure.

annual percentage rate (APR) A legally standardized form for presenting the
►rate of interest and all the associated costs of a loan in the UK. The idea behind
the APR, which was introduced under the ►Consumer Credit Act of 1974, was to
prevent lenders quoting low interest rates while, in effect, making the loan expensive
by charging arrangement fees and demanding frequent payments. The APR is the
►compound interest you would pay if all costs associated with the loan were
collected as interest. It is calculated subject to a complex formula issued by the Office
of Fair Trading (►Fair Trading Act).

annuity 1 A constant annual payment. 2 A guaranteed series of payments in the

future purchased for a lump sum. Annuities are described as 'certain' where payment
is specified for a fixed number of years. A 'life' annuity payment continues until the
death of the person for whom it was purchased. Annuities may be 'immediate',
where payment commences on purchase, or 'deferred', where payment starts at a
future specified date. Some annuities, at higher cost, offer protection against the
erosion of the real value of income through ► inflation, e.g. by a guaranteed increase
of 5 per cent each year. Other variations include ►indexation and with-profits
annuities where income is tied to the profits of a life fund. The UK government sold
annuities until T962, but they are now available only from ► insurance companies
(►personal pension). The price of an annuity is based on the >present value of the
stream of income payments it provides, and it varies with ►rates of interest and, in
the case of life annuities, the age and sex of the person who will draw the annuity.

anti-trust (US) Legislation to control ►monopoly and restrictive practices in

favour of ►competition. It applies not only to amalgamations of firms (►trust) but
also to single companies. The Sherman Act (r89o) made monopoly or the restraint of
trade illegal. The Clayton Act (r9H) clarified earlier legislation and prohibited specific
activities, notably >price discrimination, ►exclusive dealing, and >interlocking
directorates and shareholdings among competitors. The Celler-Kefauver Act (r9so)
amended the Clayton Act by prohibiting mergers which might lessen competition.
The Robinson-Patman Act (r936) strengthened the provisions in the Clayton Act
against price discrimination and made it illegal to sell goods to retailers or wholesalers
at different prices unless justified by differences in the cost of supply. Anti-trust
APACS

policy is overseen by the Federal Trade Commission, a federal government agency

created in 1914 that co-operates with, but is independent of, the Anti-Trust Division
of the Department of Justice. United States anti-trust law is intended to be non¬
discretionary, in contrast to the UK approach that is more pragmatic. Section 4 of
the Clayton Act created a private right to recover triple damages inflicted by violation
of the Act. Private actions against monopolies have been far more numerous than
government actions. ►►Chicago School; competition policy; Monopolies and
Mergers Commission; Restrictive Trade Practices Acts.

APACS Association for Payment Clearing Services, ^clearing house.

APC ^average propensity to consume.

appreciation Increase in the value of an >asset; the antonym of ^depreciation.

Appreciation may occur through rising >prices as a result of ^inflation, increased
scarcity or increases in earning power. >► currency appreciation.

appropriation account A business account showing how net >profit is distri¬

buted between >dividends, reserves, ^pension funds, etc.

appropriation accounts ►public expenditure.

APR >annual percentage rate.

APS ►average propensity to save.

arbitrage The exploitation of differences between the prices of financial bassets

or »-currency or a ► commodity within or between markets by buying where prices
are low and selling where they are higher. If wheat is cheaper in Chicago than in
London after allowing for transport and dealing costs, it will pay to buy in Chicago
and sell in London. If interest rates are higher on a euro deposit in London than in
Frankfurt, a higher return will be obtained by switching funds from one centre to
the other. It will also pay to switch funds from a euro deposit in Frankfurt to a
sterling deposit in London if the interest rate differential is greater than the cost of
covering against the risk of a fall in the exchange rate of the pound against the euro
(►forward exchange market). Unlike ^speculation, arbitrage does not normally
involve significant risks, since the buying and selling operations are carried out more
or less simultaneously and the profit made does not depend upon taking a view on
future price changes. By eliminating price differentials, arbitrage contributes to the
achievement of ►equilibrium. S-Price discrimination between markets is difficult
or impossible where possibilities for arbitrage exist, ►►efficient markets hypothesis.

arbitration The process in which parties to a dispute allow a third party, who has
no other direct involvement, to suggest or impose a solution. Each party will be
more inclined to go to arbitration if it thinks it has both a good chance of winning,
and that the cost of resolving the dispute will be lower than by other means. The
logic behind arbitration is that disputants find it easier to agree with a third party
than to resolve their argument themselves. Arbitration can be: (a) binding, in which
case each party agrees in advance that it will do whatever the arbiter decides, or (b)
non-binding, in which case the parties are free to reject the arbiter's advice. Pendular
arbitration is that in which the arbiter can only accept the point of view of one side
or the other, but is not allowed to advocate a compromise solution. The idea behind
 Asia-Pacific Economic Cooperation

this is to encourage the disputants to make reasonable offers to each other before
the arbiter makes a decision, ^bargaining theory of wages; game theory.

arithmetic progression A sequence of numbers in which the differences between

all adjacent numbers in the sequence are the same, e.g. 2, 4, 6, 8, ro ... S^-geometric
progression.

Arrow-Debreu general equilibrium model A mathematical model of a market

economy that consists of consumers with demand functions for commodities, and
firms with production functions to produce those commodities. It was a break¬
through in ^general equilibrium theory. The model was developed in the early
1950s, and succeeded in showing, that in principle, it was possible to posit the
existence of a logically consistent set of prices across the economy that would ensure
demand and supply were in equilibrium in the markets for commodities themselves,
and for the inputs for production that were needed to make the commodities.
>*►Arrow, K. J.; Debreu, G.; Walras, M.E.L.

Arrow, Kenneth Joseph (b. 1921) After graduation at Columbia University and a
period at the Cowles Commission, Professor Arrow went to Stanford University in
1949, where he became a professor in r953. In r968, he accepted a Chair at Harvard
University, but returned to Stanford University in r979. He was awarded the >Nobel
Prize for Economics in 1972 (with >Hicks). His publications include Social Choice and
Individual Values (r95i), Existence of an Equilibrium for a Competitive Economy (with
SeDebreu, r954), Studies in Mathematical Theory of Inventory and Production (1958),
Public Investment, the Rate of Return and Optimal Fiscal Policy (1970), Essays in the Theory
of Risk-Bearing (1971) and General Competitive Analysis (r97r).
Professor Arrow showed that it was logically impossible to devise a constitution
for a community that would always ensure that outcomes would be ranked in a way
that appeared desirable (^impossibility theorem). He made important contri¬
butions to >-general equilibrium analysis that placed the theory on a firmer basis
after the work of > Walras. Professor Arrow has also made contributions to the
theory of decision-making under uncertainty (>risk) and to >growth theory.

articles of association ^Memorandum of Association.

ASEAN > Association of South East Asian Nations.

Asia-Pacific Economic Cooperation (APEC) A forum of, originally, fifteen

Pacific Rim countries, formed in 1989 on the initiative of Australia. In 1992, a sec¬
retariat was opened in Singapore and in r994 agreement was reached for the establish¬
ment of a Mree-trade area. The ^advanced countries in the group should achieve
the objective by 2oro and the >developing countries by 2020. At a meeting in Osaka
in r995, the member countries agreed to reduce import tariffs (> tariffs, import) and
liberalize services, public procurement contracts and ^foreign investment. It was
accepted that flexibility should be allowed in the implementation of measures by
the S*developing countries in the group and in relation to particularly sensitive
areas, e.g. agriculture. In 20or, there were twenty-one members: Australia, Brunei,
Canada, Chile, China, Hong Kong, Indonesia, Japan, Malaysia, Mexico, New Zea¬
land, Papua New Guinea, Peru, the Philippines, Russia, Singapore, South Korea,
Taiwan, Thailand, the USA and Vietnam. ^Association of South East Asian Nations;
North American Free Trade Agreement.
 Asian Development Bank
Lf
Asian Development Bank (AD B) The Asian Development Bank, based in Manila,
was established in 1966, following the recommendations of the United Nations
Economic and Social Commission for Asia and the Pacific. It was formed 'to foster
economic growth and cooperation in the region of Asia and the Pacific and to
contribute to the acceleration of economic development of the ^developing coun¬
tries of the region'. It encourages economic and financial co-operation among the
regional members. Membership carries the right to contract for projects supported
by bank loans. About 60 per cent of the total subscribed ^capital of $i.r billion
was contributed by nineteen countries within the UN Commission region, which
included the three developed countries of Japan, Australia and New Zealand. The
remaining non-regional members included the USA, which subscribed $200 million
(as did Japan), West Germany, Canada, the UK and Switzerland. The bank operates
as a viable ^-banking institution, charging realistic >rates of interest and encourages
a flow of capital to the region from outside sources. The bank's affiliate - the Asian
Development Fund - gives »-soft loans to the poorest nations in the region. By 2000,
the bank had a membership of fifty-nine countries, of which forty-three were in Asia
and the Pacific region and sixteen outside the region. The bank has switched its
emphasis from major projects to the alleviation of ^poverty and aims to reduce by
50 per cent the number of people in the region subsisting on incomes of less than
$1 per day by the year 2015. The authorized capital, in 2002, was about $49 billion
and loans were running at about $6 billion per annum. ^African Development
Bank; Caribbean Development Bank; Colombo Plan; foreign aid; Inter-American
Development Bank.

assessable profits The taxable > profit of a business, normally after the deduction
of ^capital allowances, interest and other business expenses. It differs, however,
from accounting profit not only because of different treatment of ► depreciation,
but because some business expenses (e.g. some forms of entertaining) are not allow¬
able in computing taxable profit.

asset specificity The feature of durable or fixed ^assets which have no, or limited,
alternative uses (e.g. a nuclear power station), and which, once built, therefore
generate >sunk costs.

assets 1 A business accounting term. On the ^balance sheet of a company,

everything the company owns and which has a money value is classified as an asset,
total assets being equal to total liabilities. Assets fall into the following categories,
roughly in order of the extent to which realizing their money value would disrupt
the company's business: (a) current assets: >cash, bank deposits and other items that
can readily be turned into cash, e.g. bills receivable, instock and work in progress,
and marketable > securities; (b) trade investments: > investment in subsidiary or
associated companies; (c) fixed assets: >land, buildings, plant and machinery,
vehicles and furniture, usually at cost less >depreciation written off, and (d) intan¬
gible assets: goodwill, patents, etc. The assets of an individual are those possessions
or the liabilities of others to him, which have a positive money value. 2 Financial
assets are titles to cash, e.g. a bank ^deposit or income and/or ^capital gains.
Financial assets may be classified according to their ^-liquidity, the protection they
offer against ^inflation (>indexation) or changes in >-exchange rates and the risk
of default. Some financial assets are income-certain (e.g. >gilt-edged securities),
HJ asymmetric information

while some are not, e.g. ►ordinary shares. Some assets are capital-certain (e.g. a
fixed-interest security that is redeemable at par (►par value; redeemable securities),
but ordinary shares are subject to a price risk. 3 Real assets are tangible assets such as
land, buildings or equipment.

assisted areas Regions in Great Britain that attract government assistance because
of their persistent high levels of unemployment relative to the rest of the country.
(Northern Ireland has its own forms of financial aid.) First introduced in the T930S,
they were substantially extended following the recommendations of the Hunt Com¬
mittee in 1969. Legislation was revised and consolidated in the Industrial Develop¬
ment Act r982. Under the r982 Act the government is empowered to give grants and
loans for investment which expand capacity and generate employment in assisted
areas (►investment incentives). Since the accession of the UK to the ►European
Union (EU), the assisted areas are defined according to EU guidelines: (a) 'Tier T
areas have a ►gross domestic product of less than 75 per cent of the EU average; (b)
'Tier 2' areas have clearly significant labour market deficiencies, as measured by
specified statistical criteria, and (c) an overall maximum population of r6.88 million.
In addition, a 'Tier 3', Enterprise Grant Areas, has been introduced in England for
assistance to small firms with fewer than 250 employees. The latest agreed map of
assisted areas is for the period 2000-06. ^enterprise zones; free-trade zone; Regional
Development Agencies.

Association of South East Asian Nations (ASEAN) An association set up in

r967 by five countries in South East Asia: Indonesia, Malaysia, the Philippines,
Singapore and Thailand. In r976, the ASEAN agreed to a list of industrial projects
covering petrochemicals, fertilizers, steel, soda ash, newsprint and rubber, on which
the group would co-operate in the construction of major plants. The ASEAN also
agreed to set up a permanent secretariat. Brunei joined the ASEAN in 1984, Vietnam
in 1995, Myanmar and Laos in 1997 and Cambodia in T999. As a move towards the
setting-up of a ►free-trade area, members have agreed that import tariffs (>tariffs,
import) on intra-ASEAN trade should be reduced to a maximum of 5 per cent by
2004, subject to the right to exclude some sensitive traded goods or services. Similarly,
it is planned to liberalize intra-ASEAN direct investment by 2oro and foreign direct
investment by 2020.^-Asia-Pacific Economic Cooperation; foreign investment.

assurance That branch of >-insurance under which a company is made to pay a

►capital sum on a specified date or on the death of the person assured. The former
contract or policy is called term or endowment assurance, and the latter whole-of-life.
Both types of policy may be with or without >profits. By paying a higher ►premium,
the policyholder can receive a share of the profits earned by the life fund. Policies
may also be linked in some way to ►equities so that the final payment is determined
by the stock market prices current at the time (>unit trust). Life assurance is an
important form of private ►savings.

asymmetric information Information concerning a transaction that is unequally

shared between the two parties to the transaction. The most famous application of
the problems that asymmetric information can create has been ►Akerlof's discussion
of the secondhand car market (>adverse selection). Other important applications
relate to the ►principal-agent problem and ►moral hazard. Much of economics in
the 1970s and 1980s was devoted to the discussion of mechanisms for coping with
these types of problems, ^information, economics of; screening; signalling.

ATM Automatic teller machines (►credit card).

auction A type of transaction in which the buyer of an item and the price paid for
it are chosen after a number of different potential buyers has each made some
declaration of their willingness to pay for the item. Auctions can be held in a variety
of forms: (a) the English auction, in which the bidders sequentially offer higher
prices, with the last remaining bidder paying his/her last offered price; (b) the Dutch
auction, in which a list of sequentially lower prices are offered by the seller, until a
potential buyer accepts one of these prices and then pays that price for the product;
(c) the sealed-bid auction, in which each bidder is given one chance to make an
offer, in ignorance of the offers of other bidders, and in which the highest offer is
accepted, and (d) the second-price (or ►Vickrey) auction, which is exactly like a
sealed-bid auction, except that the highest bidder has to pay only the price offered
by the second-highest bidder. Economists have used ►game theory to study how
auctions should be conducted, and what strategy should be adopted in each case by
the bidders.

Austrian school A tradition of economic thought originating in the work of

►Menger (r840-r92r), who was Professor of Economics at Vienna until r903. Men-
ger's principal achievement was the constmction of a marginal utility theory of
value (►value, theories of). He was succeeded in the Chair by von >Wieser (i8sr-
r926) who developed his work, and in addition, clearly formulated the important
concept of >opportunity cost. >Bohm-Bawerk (r85r-r9i4), who followed, made his
main contributions in the fields of ►capital and interest-rate theory (►rate of
interest). The Austrian tradition was followed in the work of von >Mises and von
►Hayek, and, later, in work by >Hicks. >^Jevons, W. S.; Longfield, S. M.

autarky National economic self-sufficiency (i.e. exclusion from international trade)

pursued as a policy by means of ►tariffs, ►exchange controls and other devices of
the ►planned economy as in Fascist Germany and Italy in the T930S (^closed
economy).

authorized capital The amount of share >capital fixed in the ►memorandum

of association and the articles of association of a company as required by the
Companies Acts (►company law). Also known as nominal capital or registered capital.

auto-correlation A >correlation, not between two different variables, but

between successive values of one variable. It is used most frequently to refer to a
potential problem in ► least-squares regression, when the residual of the regression
is auto-correlated, i.e. appears to have a systematic pattern, and therefore deviates
from the assumption of randomness usually made. Auto-correlation, or serial corre¬
lation, requires other analytical methods to be adopted.

automatic stabilizers >built-in stabilizers.

autonomous investment Investment expenditure which is not induced by

changes in output (► acceleration principle). Examples of such investment are: (a)
government expenditure on infrastructure, and (b) firms' expenditure on new plant
to exploit an invention.
13 average cost

average A single number calculated to summarize and represent the values of

items in a set (^frequency distribution). The most common such measure is the
arithmetic mean. This is calculated by adding together the values of the items in
the set and dividing the total by the number of items. For example, suppose that the
wages of five employees were £400, £420, £480, £500 and £550 per week respectively.
The arithmetic mean is (£400 + £420 + £480 + £500 + £550) divided by 5 = £470. There
is an implied assumption in the arithmetic mean that the values from which the
mean is calculated are more or less of the same order of magnitude. For example, if
another employee were included who earned £970 per week, the arithmetic mean
would show an average wage of the six employees to be £553 per week, which would
be misleading as all but one earned less than this, ^standard deviation.
The median avoids this problem of extremes by taking that value for which there
is an equal number of items with values below it as above it. For example, in the
above example of five employees, the median is £480, as there are two employees
with wages above and two with wages below this. If we include the sixth employee,
the median is the arithmetic mean of the two middle values (as there is an even
number of items), i.e. (£480 + £500) divided by 2 = £490. The median, therefore, is
less affected by extreme values and will be less than the arithmetic mean where the
items include an extreme high value and will be higher than the arithmetic mean
where there is an extreme low value.
The third important measure of average is the mode. This is simply the 'most
popular' value in a set of numbers. For example, suppose, out of a total of fifty
employees, five earned £400, ten earned £420, twenty-five earned £480, five earned
£500 and five earned £550 per week, respectively. The mode would be £480 per week,
because more employees earned that wage than any other of the wages specified. It
is to be noted that, unlike the other two measures, the mode is totally uninfluenced
by other items in the set.
A fourth measure of average is the geometric mean. This is calculated by multiplying
the items in the set and taking the nth root, where n is the number of items in the
set. For instance, the geometric mean of 3 and 12 is the square root of (3 x 12 = 36) =
6. In general, the formula can be written as log (geometric mean) = log x, + log xz +
log x3 ... + log xn divided by n. In the above example of five employees' wages, the
geometric mean works out at £467, compared with the arithmetic mean of £470. If
the additional employee earning £970 is added, the arithmetic mean rises to £553,
an increase of r8 per cent, but the geometric mean rises only to £527, an increase of
13 per cent. This is a general characteristic of the geometric mean. It tends to
constrict the effects of large-value items and enhance the effect of low-value items,
►harmonized index of consumer prices; ^weighted average.

average cost Total production costs per unit of output. It is calculated by adding
total >fixed costs to total Invariable costs and dividing by the number of units
produced. The effect of indivisibilities (>economies of scale) is that average costs
fall as output expands, spreading the fixed cost over more units. After a time,
however, average variable costs may increase as, for example, workers are paid
overtime to operate machinery nearer to its full capacity and more has to be spent
on maintenance. This is said to give short-run average-cost curves a characteristic
U-shape. In the ►long run, all costs are variable because more fixed ► assets can
be acquired or surplus capacity scrapped. The shape and slope of the long-run
average-cost pricing

average-cost curve, when all costs are variable, will be determined by the extent of
long-run economies of scale (if any).

average-cost pricing The pricing of goods or services so as just to cover the

^average cost of production. The firm engaging in this will neither make a profit
nor loss. >>► marginal-cost pricing.

average propensity to consume The proportion of income, whether of

individuals, households or countries, spent on goods and services, other than
for ^investment, ^consumption function; marginal propensity to consume;
savings ratio.

average propensity to save The proportion of income, whether of individuals,

households or countries, which is not spent on consumption (> average propensity
to consume; ^savings ratio).

average revenue Total sales value divided by the number of units sold and equal,
therefore, to average >price.

Averch-Johnson effect The tendency of companies, the Vrate of return of which

is regulated, to engage in excessive accumulation of capital in order to expand the
volume of their profits. If companies are told that they are not allowed to earn more
than a rs per cent return on capital, there is a strong incentive for them to over-invest
in order to earn that 15 per cent on as large a capital base as possible, even if it
would be more efficient for them to have less capital and higher ^variable costs.
> rate-of-return regulation; price regulation; regulation; yardstick competition.
avoidable costs >prime costs.
 B

B2B ^electronic commerce.

B2C electronic commerce.

backwardation 1 In a ►commodity market, the amount by which the spot

► price (including the cost of stocking over time) exceeds the forward price, ^for¬
ward exchange market; spot market. 2 On the > stock exchange, a sum of >money
paid by a >bear to a >bull for the right to delay delivery of >-securities sold forward
at a fixed price. A bear will have sold securities to a bull for delivery on a certain date
in the expectation that, by that date, the market price will have fallen. If it does not,
in fact, fall, he may consider it worth while to pay a backwardation so as to defer
delivery of the shares until the next account period. 3 A temporary situation in
which one S-market maker has a lower offer price than another's bid price.

BACS Bankers' Automated Clearing Service (^clearing house).

'bad money drives out good' The idea that an injection of a low-quality coinage
into a monetary system will dissuade holders of high-quality coins from parting
with cash. Before paper »-money (> banknote) became universally accepted as a
means for settling >debts, precious metals were the most common forms of money.
Gold and silver coins were struck bearing a S-face value equivalent to the value of
their metal content. Debasement of the coinage occurred when the face value was
kept above the value of the metal content of the coinage. The holders of the correctly
valued coinage became unwilling to exchange for the debased coinage because they
would obtain less metal in exchange than if they bought direct. The result was
that the 'good', undebased, coinage did not circulate. The process is referred to as
► Gresham's law, and is an early application of the idea of >adverse selection.

Bagehot, Walter (1826-77) Bagehot graduated in mathematics at University

College, London, and qualified as a lawyer in r852. After a spell as a banker in his
father’s business he succeeded his father-in-law as editor of the Economist newspaper
in r86o, a post he held until 1877. He was an influential commentator on current
economic affairs and a prolific writer who is often quoted today. His publications
include Universal Money (1869), Physics and Politics (1872), Lombard Street: a description
of the money market (1873) and Postulates of English Political Economy (1876).

balanced budget A situation in which the government's planned expenditure

equals its expected income. In public finance it refers to a situation where current
income from > taxation and other receipts of central government are sufficient to
meet payments for goods and services, ► transfer payments and debt interest. The
 balanced budget multiplier
L_!!
UK budget is often in deficit (does not balance) on both >current account and
►capital account and these deficits are financed by net borrowing and changes in
the >money supply (>public-sector borrowing requirement). The importance of
the budget balance and how it is financed is that it may affect levels of demand and
prices in the economy (>65031 policy; Keynes). »public-sector financial deficit.

balanced budget multiplier The effect upon the >national income of equal
changes in government expenditure and revenues. If government expenditure is
increased by £1000 million and income-tax rates are increased to raise an additional
£1000 million in revenue, >aggregate demand may not, as might be expected, remain
the same, since a proportion of personal >disposable income would have been saved.
Whereas all the increase in government expenditure results in increased demand,
some of the reduction in personal incomes leads to a fall in savings rather than expen¬
diture. If the >savings ratio were 10 per cent, then the additional demand would be
£100 million, which would have a ^multiplier effect upon the national income.

balanced growth The state of an economy in which there is a constant relation¬

ship between the components of aggregate > national income. Consumption expen¬
diture, ^investment and employment grow at the same rate as national income.
The model is applied to the study of equilibrium conditions in >growth theory.
» steady-state growth.

balance of payments A tabulation of the credit and debit transactions of a country

with foreign countries and international institutions during a specific period. The
data are collated on the principle of >■ double-entry bookkeeping, although, by
convention, the figures are published in a single column with positive (credit) and
negative (debit) signs. The entries in the account should, therefore, add up to zero
but because of measurement problems they fail to do so in practice and recourse has
to be made to a ^balancing item. Transactions are divided into two broad groups:
(a) ^current account, and (b) capital account. The current account is made up of trade
in goods (so-called visible trade) and in services and the profits and interest earned
from overseas >assets, net of those paid abroad (invisible trade). It is the current
account that is generally referred to in discussion of the state of the balance of
payments. The capital account is made up of such items as the inward and outward
flow of money for ^investment and international grants and loans.
The tables opposite show the composition of the balance of payments of the UK
and the USA in 2000.
The UK normally has a deficit on trade in goods (visible trade) and a surplus on
trade in services (► invisible trade). It has had an overall deficit on its current balance
of payments in every year since 1983. Exports of goods account for about 2r per cent
of >gross domestic product (GDP) and imports of goods about 25 per cent. Similarly,
the USA runs a deficit on trade in goods and a surplus on trade in invisibles. It has
had an overall deficit on its current balance of payments every year since ^75.
However, exports of goods account for only about 8 per cent of GDP and imports of
goods about ro per cent.
The overall deficits or surpluses in the balance of payments are brought into
balance by movements in the >gold and foreign exchange reserves or liabilities to
non-residents. The transactions between foreigners and residents are carried out, in
the UK, through the ^exchange equalization account. The balance of payments
UK Balance of Payments, 2001

Current account (£ billion)

Exports of goods + 191.8
Imports of goods - 225.3

Visible balance -33-5

Trade in services (net balance)

Government -0.4
Transport -3-6
Travel -13-7
Financial and other services + 28.2

Total services +10.5

Other transactions (net balance)

Government - 2.6
Other + 4-5

Current balance - 21.1

Capital and financial account

Direct investment abroad -237
Direct investment in the UK + 43-8
Other capital and financial transactions -4-5

Balancing item + 5-5

Source: UK Balance of Payments, 2002, Office for

National Statistics, London.

USA Balance of Payments, 2001

Current account ($ billion)

Exports of goods + 7r8.8
Imports of goods - H45-9

Visible balance - 427-1

Trade in services (net balance) + 68.9

Other transactions (net balance)

Government -94-5
Other + 59-3

Current balance - 393-4

Capital and financial account

US investment overseas - 371-0
Foreign investment in the USA + 752-8
Other + 0.8

Balancing item + 10.7

Source: US Department of Commerce: 2003.

 balance of trade
Li!
reflects many factors but specifically: (a) the state of Eggregate demand at home
and the state of demand abroad, and (b) the Exchange rate and the relative costs
of domestic production. Governments can only really influence the balance by
changing demand, or by changing the exchange rate.
A current account surplus can be seen as an accumulation of foreign bassets, and
is thus equivalent to a form of national saving. It is certainly true that the balance
of payments of different countries has tended to reflect savings levels. A deficit in
the balance of payments is not necessarily a bad thing, any more than a surplus
need be a good thing. It is a form of borrowing which could be used to enhance
domestic investment to the benefit of future growth. On the other hand, if a deficit
is caused by an unsustainable period of excess demand, perhaps occasioned by
an excessive Eudget deficit, it will persist until the home market has reached
Equilibrium brought about by, say, a reduction in the offsetting surplus on capital
account or a significant drop in the Exchange rate.
Although, in principle, there are many measures that can be taken in a direct
attempt to correct a ^-disequilibrium in the balance of payments, many, such as
import >tariffs, import >-quotas, Emport deposits and >-export incentives are now
constrained by the rules of the >World Trade Organization or the ^European
Union, and are generally reckoned to be ineffective in the long term, ^competitive¬
ness; J-curve.

balance of trade The difference between a nation's imports of goods and services
and its exports of them. It is the most important element of the Ealance of
payments.

balance sheet A statement of the >wealth of a business, other organization or

individual on a given date, usually the last day of the > financial year; not to be
confused with the profit-and-loss account (>double-entry bookkeeping), which
records changes in the company's wealth over one year. A balance sheet is in two
parts: (a) on the left-hand side or at the top, Essets, and (b) on the right-hand
side or at the bottom (^liabilities). The assets of the company - >debtors, cash,
investments and property - are set out against the claims or liabilities of the persons
or organizations owning them - the ^creditors, lenders and shareholders - so that
the two parts of the balance sheet are equal. This is the principle of double-entry
bookkeeping. The fact that the assets and liabilities are equal does not mean that
the Equity shareholders owe as much as they own; they are included among
the claimants.
According to the basic accounting equation, assets = liabilities + equity; therefore,
assets - liabilities = equity. Equity, shareholders’ interest or net worth (which are
all the same thing) calculated from the balance sheet in this way may not reflect its
true market value, since assets are normally written into the balance sheet at his¬
torical cost (Eook value) without any adjustment for ^-appreciation (^inflation
accounting).
Until the r98r Companies Act the law did not, in the UK, lay out requirements for
financial reporting of companies in detail or to any particular format, so that the
layout and content of balance sheets varied considerably. The Companies Acts
now require accounts to be set out in conformity with the European Economic
Community (EEC) (>European Union) Fourth Directive (Eompany law). Notes to
the accounts provide breakdowns of some of the elements of the balance sheet (e.g.
 bank deposits

tangible assets), as well as other information required by statute e.g. details of

directors' and employees' remuneration.

balancing allowance >capital allowances.

balancing item Data for the ^balance of payments accounts are collated on the
principle of >double-entry bookkeeping. For example, the value of a shipment of
the export from the UK of a motor vehicle to the USA will be recorded as a credit
item. The payment for the motor vehicle by the US importer by, for example,
depositing a sum to the account of the UK exporter in a bank in New York will be
recorded as a debit item to the same amount. In principle, for every credit item,
there is a corresponding debit item and for every debit item a corresponding credit
item, although, by convention, the figures are published in a single column with
positive (credit) and negative (debit) signs. The entries in the account should,
therefore, add up to zero. In practice, this is difficult to achieve for a number of
reasons, e.g. the difficulty of collecting accurate information, a difference in the
timing between the two sides of the balance, or a change in exchange rates. Because
of such measurement problems, recourse has to be made to the >balancing item
which simply adjusts the difference between the sums of the credit and the sums of
the debit entries in the balance of payments accounts so that they add to zero.

bancor The term >Keynes applied to the >-currency which he proposed a new
central international bank should create and put into circulation for the payment
of >-debts between countries (>► Keynes Plan). His proposal was rejected at the 1944
>-Bretton Woods conference that established the ^^International Monetary Fund
(IMF). However, the beginning of 1970 saw the introduction of a similar international
currency in the allocation of ^special drawing rights through the IMF.

bank, commercial ^commercial banks.

bank, industrial > industrial banks.

bank, joint-stock >-commercial banks.

bank, overseas >overseas banks.

bank, secondary ^secondary bank.

bank advances »-bank loan.

bank bill >bill of exchange.

bank clearings ^clearing house.

bank credit ^credit.

bank deposits The amount of money standing to the »*credit of a customer of a

bank. Bank deposits are >assets of its customers and > liabilities of the bank. Deposits
may arise from the payments of >-cash or a ^cheque to a bank for credit to a
customer, or by transfer into an account from another account, including a >loan
from a bank to its customer. Bank deposits are simply IOUs written in the books of
the bank. They do not necessarily reflect actual holdings of cash by the bank. Since
bank deposits are used in the settlement of debts, they are > money in the economic
Bank for International Settlements

sense, so that by creating deposits, banks create money (>banking). A deposit may
be on >-current account or ^deposit account. These two types of account are known
as ^demand deposits and >time deposits in the USA. Bankers' deposits are deposits
by a Commercial bank at the Central bank.

Bank for International Settlements (BIS) An institution, with head offices in

Basle, set up on the basis of a proposal by the Young Committee in r93o. The original
purpose was to enable the various national > central banks to co-ordinate through
their own central bank the receipts and payments arising mainly from German war
reparations. It was hoped, however, that it would develop beyond this, but many of
the functions that it might have performed were taken over by the ^International
Monetary Fund (IMF) after the Second World War. It has, however, in recent years
played a more active part in attempting to mitigate the effects of international
financial ^speculation and acts as a trustee for international government loans. In
addition, the bank has carried out financial transactions for the >■ Organization for
Economic Cooperation and Development and the IMF. From T973 until 1995, the
bank acted as agent for the European Monetary Cooperation Fund (^European
Monetary System). Although major functions of a central bank for central banks are
performed by the IMF, the meetings of the central board have been an important
means of central bank co-operation, especially in the field of offsetting short-term
monetary movements of a speculative kind. In 2002, fifty financial institutions
(> central banks or monetary authorities), including the > European Central Bank,
had the right to vote and attend the annual general meetings of the BIS. ^capital
adequacy.

bank loan A sum borrowed from a bank, normally for a fixed period of 2-3 years
or more for a specific purpose, usually by a commercial concern. The term is also
loosely used to include ^overdrafts and ^personal loans. In this broader sense,
bank loans are more commonly known as bank advances, while total bank lending
includes commercial paper (>promissory note) and Acceptances. In the UK, over
70 per cent of bank lending to UK residents by value is for business purposes,
although the ^commercial banks now make ^mortgage loans for house purchase
on a large scale. Bank loans are normally secured ^collateral security), repaid in
regular instalments and with interest charged at rates which vary with the bank's
>base rate. British banks have been compared unfavourably with those in other
countries in the extent to which they provide long-term loans to industry. It is
true that until about 25 years ago the bulk of bank advances was in the form of over¬
drafts, that are repayable on demand. This was partly because the banks in the
UK have not in general been able to attract long-term deposits, and it is regarded
as bad banking practice 'to borrow short and lend long'. Flowever, commercial
customers of the banks in the UK have also preferred overdraft finance, which is
cheaper and more flexible than other types of borrowing, provided the banks were
willing to renew overdraft facilities and allow, as they have done, much overdraft
borrowing to become 'hard core'. In recent years, the British banks have greatly
increased contractual medium-term lending (>term loan), and this type of advance
now accounts for over half the bank advances to non-personal customers. Most
medium-term lending is for periods of 5-7 years, and lending for longer periods
than this is still less common in the UK than in some European countries. ^s**business
finance.
 Bank of Japan

Bank of England The ►central bank of the UK. Founded in 1694 by a group of
private bankers, chiefly to raise money for the Crown, it was chartered first to operate
as a commercial joint-stock bank (►commercial banks). In succeeding centuries its
royal charter favoured the circulation of its notes, and it became a leading banker to
other banks. The Bank Charter Act 1844 recognized it as the central note-issuing
authority and the blender of last resort. By T870, it was recognized as responsible for
the general level of interest rates, which it regulated through the >bank rate, and
thus for the general state of >credit in the country. By the early twentieth century
the bank was recognized as the central organ for the execution of national financial
and monetary policy, under the overall direction of the government. In r946, the
bank was nationalized, thus completing its identification with the State.
The > Banking Act r979 provided formal definitions under which the bank exer¬
cised its supervision of commercial banking practices. The bank acts as a banker for
the commercial banks, transactions between which (outside the >clearing-house
system) are settled between accounts held at the bank. The bank also supplies funds
(by buying ^securities) to the commercial banks to enable them to balance their
books at the end of the day. By setting the >rate of interest for these operations, the
bank can influence the whole pattern of interest rates.
The Bank of England Act r998 conferred sole responsibility to the bank for
determining UK interest rates, a function until then exercised by the ^Treasury
(►Monetary Policy Committee). Since 1997, the bank has had statutory responsibility
for the effectiveness and stability of the financial system as a whole (►systemic risk),
while the Financial Services Authority (^Financial Services and Markets Act) now
supervises the individual banks and ►building societies for prudential risk (>capital
adequacy).
The bank no longer manages the government debt issue (>-national debt) but
engages in > gilt repos as part of daily market operations (►►gilt stripping). Securities
eligible for use by the bank's counterparties (^counterparty risk) as >collateral
security for lending include >gilt-edged securities, sterling ^treasury bills, eligible
bank bills (>bills of exchange) and euro-denominated securities (► European Monet¬
ary Union) issued by the European Economic Area (>-European Free Trade Associ¬
ation), central governments and major international institutions where eligible for
use in >-European Central Bank operations. Since June r998, the bank has been
organized in three operational areas: (a) monetary analysis and statistics; (b) financial
market operations, and (c) financial stability and central services.

Bank of France The ^central bank of France, established in r8oo and the oldest
in the world after the Bank of Sweden and the >Bank of England. In January 1994,
the French authorities appointed a nine-member council of the bank which, with
other measures, is intended to give it a high degree of autonomy in the formulation
of monetary policy in conformity with the ^Maastricht Treaty under which the
Bank of France is now part of the European system of central banks (>European
Central Bank).

Bank of Japan (BOj) Japan's > central bank, which acts as Mender of last resort,
manages ^monetary policy and issues ►currency. It does not regulate the banking
system, which is the role of the Financial Services Agency. The autonomy of the BOJ
was enhanced in the T998 Bank of Japan Act and the bank takes the final decision on
monetary policy.
bank overdraft

bank overdraft ►overdraft.

bank rate A now obsolete term for the ►rate of interest at which the ►central
bank lends to the banking system. In the UK in October r97r, the penal rate for
assistance to the ►discount market became the minimum lending rate and the term
has not been used since.

banker's draft A ►cheque drawn by a bank as opposed to a bank's customer.

Banker's drafts are drawn at the request of a customer, and that customer's account
is debited when it is drawn. They are regarded as ►cash, since they cannot be
returned unpaid and are used when a creditor is not willing to accept a personal
cheque in payment.

banking The business of accepting »-deposits and lending >-money. Banking

defined in this way, however, is carried out by some other ►financial intermediaries
that perform the functions of safeguarding deposits and making >Toans. >-Building
societies and >finance houses, for example, are not normally referred to as banks
and are not regarded as being part of the banking system in the narrow, traditional
sense. The banking system is still normally understood to include the >-commercial
banks (joint-stock banks), the secondary banks, the ►central bank, the ►merchant
banks or > accepting houses and the > discount houses (which no longer exist
as such), but to exclude the ^savings banks and investment banks and other
intermediaries. The deposits of some types of bank (e.g. the UK National Savings
Bank) cannot be used in the settlement of debts until they are withdrawn, but a
deposit in a commercial bank can be used to settle debts by the use of ►cheques or
> credit transfer. When the manager of a branch of one of the > clearing banks
opens an ►overdraft account for a customer, the loan creates a deposit, i.e. a book
debt has been incurred to the customer in return for a promise to repay it. Whether
or not the overdraft is secured by ►collateral security (e.g. an insurance policy, or
some other ►asset) when the customer draws upon the loan the bank has added to
the total >money supply. In ►balance-sheet terms, the deposit is a claim on the
bank (i.e. a ►liability) while the customer's promise to repay it (or the collateral
security) is an asset to the bank. In the absence of government control on lending,
the limitation on the bank's ability to create deposits is its obligation, if it is to
remain in business, to pay out ^current account deposits in cash on demand.
Since customers meet most of their needs for money by writing cheques on their
deposits, the cash holdings the banks need form only a small fraction of their total
deposits. (The settlement of debts between the clearing banks is made by electronic
transfer (►clearing house).) This ratio between their deposit liabilities and their cash
holdings is called the >cash ratio (sometimes called the primary ratio). Banks also
hold other ►liquid assets (►bills of exchange, loans at call and other loans to the
money market) (►liquidity ratio (secondary ratio)). The object of the banker is, of
course, to keep reserves as near as possible to the minimum, since there is only a
relatively low return in the money market and no return at all on holdings of cash.
The banking system is based on confidence in the system’s ability to meet its
obligations. In the short run, no bank is able to meet all its obligations in cash and,
if demands upon it exhausted its cash reserves, the bank would be obliged to close
its doors.
The prevention of bank failure and the protection of bank customers against fraud
 banking and currency schools

and loss is one objective of the control and regulation of the banking system which
is the responsibility, in the UK, of the Financial Services Authority (>Financial
Services and Markets Act). That regulation now relies on prudential ratios (>-capital
adequacy) to minimize failure and instability in the banking system. There is also
increasing emphasis on assessing the adequacy of the bank's own risk management
systems as an instrument of bank supervision. Until 1997, in the UK, under the
Banking Acts 1979 and 1987, virtually all deposit-takers had to be licensed by the
>Bank of England, which monitored their activities through regular statistical
returns and attempts to control their exposure to risk by indicative controls on
capital ratios and uncovered foreign-currency positions (^capital adequacy).
The Bank of England remains responsible, in the UK, for ensuring the financial
system generally is secure. Since the money supply is a basic tool of economic policy,
the government also wishes to exert control over the creation of credit by the banking
system through its finance ministry. In the UK, this function is also performed by
the Bank of England (>• central bank). Direct controls on bank lending in the interests
of controlling the >money supply were removed in 1971 in an attempt to introduce
more competition into the banking system. There are now no longer any significant
reserve ratios as such (>reserve requirement). The Bank of England now relies on
interest rates to influence inflation (^Monetary Policy Committee).
Recent years have seen substantial growth and change in the banking system. The
main features have been an increase in the importance of >-overseas banks operating
in the UK and other non-clearing banks, the increasing use of new parallel markets
as sources of funds for the banks and a decline in the number of merchant banks. At
the same time, traditional distinctions between the various types of bank are break¬
ing down as most >financial intermediaries diversify their activities. Building soci¬
eties and investment banks are offering high-interest cheque accounts, non-banks
such as multiple retailers are entering the banking market, and some building
societies are incorporating as banks (>incorporation). The clearing banks have
become major providers of ^-mortgage lending for house purchase and are increas¬
ingly providing non-banking financial services such as insurance broking, >equity
purchases, traveller's cheques and, of course, ^-credit cards, ^-banknote (for the
origin of banking); Financial Services and Markets Act.

banking, retail ^commercial banks.

banking, wholesale >wholesale banking.

banking and currency schools The representatives of the two sides of opinion
in a controversy which centred on Sir Robert Peel's Bank Charter Act r844. This Act
effectively limited the creation of >banknotes to the >Bank of England and regu¬
lated their issue. The banking school argued that, given that banknotes were convert¬
ible into gold, there was no need to regulate the note issue because the fact of
convertibility would constrain any serious overissue. Moreover, it was pointless to
try to regulate the issue of banknotes because the demand for currency would be
met by an expansion of >bank deposits, which would have the same effect as an
expansion of the note issue. The currency school, on the other hand, argued that
the check offered by convertibility would not operate in time to prevent serious
commercial disruption. Banknotes should be regarded as though they were the gold
specie they in fact represented, and consequently the quantity at issue should
banknote

fluctuate in sympathy with the >balance of payments, ^banking; fiduciary issue;

gold standard; money supply.

banknote A note issued by a bank undertaking to pay the bearer the >-face value
of the note on demand. Banknotes in England had their origin in the receipts issued
by London goldsmiths in the seventeenth century for gold deposited with them for
safe-keeping. The practice of >banking had its origin in the activities of these
goldsmiths, who began lending money and whose deposit receipts came to be
used as money. Later, the goldsmiths issued banknotes, and so did the banks that
developed later still. Today, only the >Bank of England and the Scottish and Irish
banks in the UK are allowed to issue banknotes. Since 1931, when banknotes became
inconvertible to gold, the promise on a banknote to 'pay the bearer on demand' has
simply been an undertaking that the note is legal tender. Thus, the Currency and
Bank Notes Act 1954, which regulates the issue of banknotes in the UK, refers to the
>fiduciary issue. Only four denominations of notes are now issued to the general
public, the largest being the £50 note. Most other developed countries issue notes
of much larger denominations than this, probably because the use of >-cheques is
less developed elsewhere than in the UK. (The ros. note was replaced by the sop
coin in 1969 and a £1 coin was introduced in 1983, entirely replacing the £1 note in
1986.) ^banking and currency schools.

bankruptcy A declaration by a court of law that an individual or company is

insolvent, i.e. cannot meet >debts on the due dates (^insolvency). A bankruptcy
petition may be filed either by the debtor or by his creditors requesting a receiving
order. An inquiry into the debtor's affairs is then conducted by, in the UK, the
Official Receiver - an official of the Department of Trade and Industry - who retains
temporary control of the debtor's financial affairs. If he thinks fit, the receiver may
call a meeting of the debtor's creditors and, if they wish it, declare the debtor
bankrupt. The debtor's assets are then realized and distributed among his creditors
either by the receiver or by a trustee appointed by the creditors and approved by the
Department of Trade and Industry. In the case of a company, it goes into >liquid-
ation. Until he is discharged (i.e. has paid off his debts and been declared a discharged
bankrupt in law) a bankrupt may not incur »-credit in excess of £ro without making
it known that he is an undischarged bankrupt, nor may he serve as a director in a
limited company without permission from the court.
The Insolvency Acts 1985 and 1986 codified existing law and made the handling of
the affairs of insolvent debtors the responsibility of a registered insolvency prac¬
titioner. Companies may be placed under administration rather than into liquida¬
tion. The Act introduced a wider range of sanctions against directors who have acted
negligently, as did the Company Directors Disqualification Act 1986.

bargaining The interaction between participants to a transaction by which they

decide on an allocation of the surplus they create by entering the transaction. If a
car is worth £10,000 to a potential buyer and £9000 to the owner, there is a potential
welfare gain of £1000 to be made by a sale. The buyer would be willing to buy it at
£9999, and the seller would sell it at £9001. Somehow, a price has to be fixed
between these two reservation prices. In this case, once they have decided to enter
the transaction, the negotiation between them can be likened to a > zero-sum game,
or to a problem of >bilateral monopoly. Economists have used >game theory to look
2±J barter

at the best bargaining strategies, and the potential outcomes of more complicated
bargaining situations, e.g. one in which the surplus to be divided shrinks the longer
the parties negotiate, ^-arbitration.

bargaining theory of wages A theory of wage determination based on negoti¬

ations between employers and unions. The theory has been set within a number of
different assumptions, e.g. as a >game-theory problem in which both sides wish to
divide the firm's profits but also to maximize them: an exercise in >-cost-benefit
analysis where each is aware of the costs of a strike and the risks of participating in
one. These theories are complementary to those based on >supply and >demand
analysis (>price theory) in the sense that the bargaining is seen to be carried out
within the framework of the conditions existing at the time in the >Tabour market
(>wage-fund theory), ^arbitration; bargaining.

barriers to entry Economic or technical factors that prevent, or make it difficult,

for firms to enter a market and compete with existing suppliers. An established firm
may enjoy an absolute cost advantage which might arise from the possession of patent
rights to certain production processes or a long-term contract for the supply of
energy or the ownership of sources of raw materials. In the same way, existence of
> economies of scale might mean that a new entrant would have to invest large
sums and produce on a large scale in order to compete on price. If the market were
small in relation to the ^optimum scale of production, new entrants might calculate
that the risk of entry would be unacceptably high because any new supplier would
reduce the output of all suppliers below the optimum, so that either the new or an
existing supplier would fail. Product differentiation (>differentiation, product) can
also raise the cost of entry by necessitating heavy expenditure on advertising and
the support of dealer outlets to overcome significant buyer preferences. > Collusion
on pricing and restrictive practices, such as > full-line forcing and >-exclusive deal¬
ing, may exclude newcomers, as may legislation, e.g. a requirement for licensing.
Potential exporters may suffer long delays waiting product approval under food
safety regulations. Barriers to entry may allow established firms to charge prices
above the level that would obtain in the absence of these barriers, ^competition
policy; contestability; monopoly; protection; sunk costs; World Trade Organization.

barriers to exit Restrictions on the ability of a company to withdraw from an

activity, or to redeploy its resources to an alternative activity. Such restrictions may
be imposed by government and designed to protect communities by discouraging
the closure of plant by the imposition of high social charges on exit. In this case,
they may also act as deterrents to new entry into a sector (which becomes more risky
if exit is expensive), and as an impediment to economic transformation. However,
the economics of ^-industrial organization has used >game theory as a device for
analysing business behaviour, and this can demonstrate the paradoxical logic that
companies may want to restrict their own ability to withdraw from an industry. Such
a strategy might be rational, as a means of persuading a potential competitor not to
enter the industry, on the ground that the incumbent is committed to remaining.

barter Acquiring goods or services by means of exchange for other goods or

services, rather than for >money. A form of barter has grown in recent years into a
serious business activity. Corporations specializing in barter deals offer to buy surplus
base period

products in exchange for credits that the company disposing of the goods can use
to buy other goods and services (e.g. TV advertising time) specified by the barter
corporation. These corporations have sufficient financial weight to be able to obtain
large discounts for the goods and services they offer for trade. >-counter trade.

base period The reference date from which an >index number of a >time series
is calculated. For example, the price index of commodities produced in the UK has
a base period of r995. The base year may be changed to reflect any changes over time
in the composition of items making up the index. »-Laspeyres index; weighted
average.

base rate The »-rate of interest which forms the basis for the charges for >*bank
loans and >overdrafts or deposit rates of the ^commercial banks. Since t97i, the
banks have fixed their base rates independently of one another, though obviously
they cannot differ very much for long periods. Prior to r97i, the banks agreed on
their deposit and overdraft rates, but this > cartel arrangement has been abandoned.
Very large first-class risk companies may borrow at i per cent above base rate or even
less, but small firms and individuals will have to pay several percentage points more
than this. Base rates will be generally close to short-term >money market rates but
change less frequently, so when, as sometimes happens, rates on the ^interbank
market rise much above base rate, large companies have taken advantage of the
interest-rate differential, borrowing on overdraft and lending in that market.

Basle II ^capital adequacy.

Basle Agreements >-capital adequacy.

battle of the sexes A situation - popularly characterized in the economics of

>game theory - in which people or institutions have a strong interest in co¬
ordinating their behaviour, but disagree over quite how to behave. An example
would be in the setting of an industry standard for, say, a pipe fitting. Everybody
may agree that it is overwhelmingly important that some standard fitting is agreed,
but each firm may take its own view as to what that standard should be. The
characterization of such situations as a 'battle of the sexes' derives from a simple
analogy used in game theory to caricature them: a husband and wife want to spend
the evening together, but what should they do? His first choice is to go to the ballet
with her; while she wants to go and watch some boxing with him. Assuming these
are the only possible activities, the ranking of different ways of spending the evening
in order of preference are:

Go to ballet with her

Go to boxing with her
Go to ballet alone
Go to boxing alone

Her preferences are to:

Go to boxing with him

Go to ballet with him
Go to boxing alone
Go to ballet alone
 Bayes' theorem

It should, of course, be possible to agree on an evening together, but the crucial

feature of these situations is the possibility that a struggle by husband and wife to
get their first-best option may result in them each getting the third-best option. For
example, if he insists on going to the ballet, and she insists on going to the boxing,
they may end up going their own way, even though both would prefer to be together.
It is generally recognized that if the situation is commonly repeated, it is easier
to reach agreement than if it occurs once only (>-repeated games), ^prisoner's
dilemma.

Bauer, Peter T. (1915-2002) > economic development.

Baumol effect The idea that services become relatively more expensive as econo¬
mies develop, and that manufactured goods become relatively less expensive. It was
outlined by Baumol in 1967 who argued that increases in > productivity led to lower
prices and productivity improved through investment in new technology, and
there was more scope for such investment in capital rather than labour-intensive
industries. As manufacturing industries tend to be more capital-intensive than
services, they would enjoy relatively falling prices.
It is true that in less-developed countries the prices of manufactured goods tend
to be very high compared to the prices of services, whereas in rich countries services
tend to be very expensive. But the Baumol effect should not be overstated: many
non-manufacturing sectors (such as telecommunications) have enjoyed spectacular
increases in productivity based on new technology. Moreover, it is argued that it is
hard to measure productivity in service industries, where outputs are often hard to
define precisely. (It is difficult to tell just how the productivity of a lawyer or teacher
should be defined.)
The Baumol effect is partly used to explain the growth of government spending,
as government primarily provides services rather than goods to the public. public
expenditure.

Bayes' theorem A formula in ^probability theory for calculating the chance that
an unknown prior event occurred, given that a known subsequent event occurred,
based on the work of Bayes (1702-61). We might use Bayes' theorem, for example, to
gauge whether a doctor prescribed the right drugs to a patient, by seeing whether
the patient recovered from a sickness or not. When we see whether the patient
recovers, we can make an assessment that the right drugs were given, but not a
perfect one: after all, the patient might get better without the right medicine, and
may not get better even with the right medicine. But clearly, if the patient gets
better, that makes it more likely the right drugs were given. Bayes' law puts a precise
probability on that event. More specifically, suppose that before the event we believe
that there is a fifty-fifty chance the doctor gives the right prescription. Suppose,
too, that one in ten patients who are wrongly prescribed recovers, and one in two
patients who are correctly prescribed recovers. Then, the observation that a patient
did recover makes it 5 times more likely that they were rightly prescribed than
wrongly prescribed.
More generally, the theorem says that the probability of a prior event E having
occurred, given that, a subsequent event S occurred, is equal to the prior probability
of E times the probability of S occurring given E occurred, all divided by the prob¬
ability of S occurring one way or the other. In the above example, this is:
 Probability that the wrong medicine
was prescribed given that
0.5 x 0.1
the patient got better 16.6 per cent
0.05 + 0.25

Probability that the right medicine

was prescribed given that
0.5 x 0.5
the patient got better = 83.3 per cent
0.05 + 0.25

The theorem has led to considerable controversy among statisticians, who argue
about the validity of ascribing a probability to a past event.

bear A X-stock exchange speculator who sells >stocks or X-shares that he/she may
or may not possess because a fall in prices is expected and, therefore, can be bought
(back) later at a >profit; the antonym of >bull. A bear who sells X-securities that he/
she does not possess is described as having 'sold short'. If possessing the securities
solds, he/she is described as a 'covered' or ‘protected’ bear. A 'bear market' is one in
which prices are falling.

bearer bonds >Bonds, the legal ownership of which is vested in the holder, no
^transfer deed being required since there is no central register of ownership. An
endorsed >cheque, or a cheque made payable to a bearer, or a >banknote, are
similar in nature to bearer >securities. Bearer bonds normally have dated interest
> coupons attached to them that can be presented to the issuer of the security for
payment.

bearer securities >bearer bonds.

Becker, Cary Stanley (b. 1930) An idiosyncratic and controversial economist and
winner of the > Nobel Prize for Economics in T992. Becker was educated at Princeton
University and lectured at Chicago University until r957; he went then to Columbia
University where he stayed until 1970, when he returned to Chicago. He has been
Professor of Economics and Society at Chicago University since 1983. Becker has
been more prominent than any other member of the profession in using economic
reasoning in the analysis of social behaviour. His publications include: The Economics
of Discrimination (1957), A n Economic Analysis of Fertility (i960), A Theory of the Alloca¬
tion of Time (1965), Crime and Punishment: an economic approach (1968), A Treatise on
the Family (1981) and, with his wife Guity Nashat Becker, The Economics of Life (1996).
His style has been to explain all sorts of normal human behaviour in the language
of economics and rational choice. Nowhere is this more obvious than in his analysis
of the family. He discusses the allocation of work within the household, and the
impact of changing household technology on, for example, female participation in
the labour market, and on the level of divorce. He is also responsible for path¬
breaking work in formulating and formalizing the microeconomic foundations of
our understanding of investments in training and education in the creation of
human capital. > sow's ear effect.

'beggar-my-neighbour' policy The enactment of an economic policy for the

benefit of a country's economy which has an adverse affect on the economies of
other countries. Such policies may be aimed directly at restricting imports, such as
applying high import tariffs (X-tariffs, imports) or >quotas which curtail the >ex-
 behavioural theory of the firm

ports of trading partners or a > devaluation of the currency to expand the country's
own exports.

behavioural assumption The pattern of human motivation built into any eco¬
nomic theory. For example, the theory of the firm (>firm, theory of the) assumes
that entrepreneurs are profit-maximizers; the cobweb theory (>cobweb model)
assumes that market suppliers are motivated by price in the period preceding that
in which they sell their supply. S^model.

behavioural economics Branch of economics that is concerned with understand¬

ing human decision-making more realistically than simply as a rational process. It
draws heavily upon psychology as a discipline, and at its crudest can be seen as a
means of cataloguing ways in which people appear systematically to make what
seem like mistakes in their judgements in traditional economic terms. An early
example of this type of study is the ►Allais paradox. Many examples can be drawn
from people's decisions under uncertainty. People put a disproportionate weight on
vivid but unlikely outcomes (e.g. winning the lottery) compared to pedestrian but
likely outcomes, e.g. not winning the lottery. Another important observation is that
people appear to hate losing money more than they enjoy gaining it - that we
are loss-averse (and that we are more loss-averse than traditional economics of
► diminishing marginal utility would predict). It is also observed that there is a bias
to the status quo in much of our decision-making. Thus, for example, employees
automatically enrolled in a pension are far more likely to stay in the pension than
those who are not automatically enrolled, even if employees are able to override the
automatic choices made for them.
While some postwar economists, notably Simon (>Simon, Herbert), did look
at decision-making as a special subject in its own right (Abounded rationality),
behavioural economics took off with the contributions of Tversky and >Kahneman.
They produced a model of behaviour that viewed most human decisions as being
made not as maximizing some absolute goal, but as a two-stage procedure in which
people first set some reference value of the goal and then, secondly, strive to perform
relative to the reference. The status quo might be a reference point. This might
explain why people appear less keen to sell a share that is falling in price, even if
they would not go out of their way to buy the same share if they didn't already own
it. Behavioural economics is a branch of the subject with numerous applications,
►endogenous preferences.

behavioural theory of the firm An approach to the study of firms that analyses
how decisions are reached within them, rather than, as is more traditional, assuming
that their behaviours conform to the pursuit of some single goal. It was primarily
developed by Cyert, March and ►Simon. The main tenets of the behavioural theory
are: (a) that firms attempt to ►satisfice, rather than adopt, maximizing behaviour,
and (b) that the firm is a set of individuals and groups, each of which has its own
aspirations, these groups, sometimes in coalitions, continuously bargaining over the
decisions the firm makes, leading to the pursuit of many complex goals. The theory
has not displaced the traditional approach, for a number of reasons - most notably
that it fails to generate any specific predictions about what firms would actually
do in any particular circumstances. Its primary influence has been in reminding
economists of the facts that, in practice, maximizing profits may be expensive for a
below the line Li!
firm (acquiring full and unbiased information from all departments is no easy task)
and institutional factors may impede the single-minded pursuit of any one goal,
infirm, theory of the; X-efficiency.

below the line Items in an account that are underneath the line at which a total
is made. If above the line, an item is included in the total.
In reported results for quoted companies (> quotation), extraordinary items that
arise from transactions that are outside the ordinary activities of a business (e.g. the
sale of an office building) may be taken below the line for the purposes of calculating
learnings per share, whereas exceptional items that do derive from the ordinary
activities may be taken above the line for that purpose.

benefit-cost analysis ► cost-benefit analysis.

Benelux The ►customs union between Belgium and Luxembourg on the one hand
and The Netherlands on the other, set up in 1948. The union abolished internal
►tariffs, reduced import >quotas between the three countries and adopted a
common external tariff. The aim of the union was the eventual merging of the
fiscal and monetary systems of the member countries. There was free movement of
►labour and »-capital within the union and a common policy with other countries.
In T958, Benelux joined the then European Economic Community. ► European
Union.

Bentham, Jeremy (1748-1832) The leading philosopher of ►utilitarianism. Self-

interest was deemed the sole stimulus to human endeavour, and the pursuit of
happiness an individual's prime concern. The purpose of government should be to
maximize the sum of the happiness of the greatest number of individuals.

Bernoulli, Daniel (1700-82) >-Bernoulli's hypothesis.

Bernoulli's hypothesis A proposition by Daniel Bernoulli ^700-82) that a

decision as to whether or not to accept a ►risk depended not just on money but also
on futility. For example, a bet would appear to be worth accepting if, at the toss of
a coin, you won £ro for every head and lost only £5 for every tail. Given the coin is
unbiased, there is an equal chance of a head or a tail turning up. However, if £5 was
all you had in the world, the bet would not seem so attractive. The £5 would have a
high utility attached to it and Bernoulli suggested that this is what counted in such
decisions, ^ marginal utility of money; risk aversion.

Bertrand competition A model of price competition between >firms in which

each charges the price that would be charged under ►perfect competition (►margi¬
nal-cost pricing). The model arrives at a result by assuming that each firm sets its
prices on the (incorrect) expectation that other firms will not move their prices in
response. This inevitably leads to a downward spiral in prices until marginal cost is
arrived at. As a model, it contrasts with that of ►Cournot, who found that price
and output in a duopoly situation would be somewhere between the extremes of
► monopoly and perfect competition. The Bertrand result can be seen as a >Nash
equilibrium outcome, ►►oligopoly.

BES ►Enterprise Investment Scheme.

beta 1 In finance theory, the degree to which the returns on a particular financial
asset track those of the rest of the market. A beta of r indicates that an asset, on
 Big Bang

average, moves with the rest of the market. A higher beta indicates that it moves in
the same direction as the market but with more extremity. A negative beta indicates
that the return on an asset grows when returns elsewhere in the market are falling,
and vice versa. Assets with a low beta are held to be attractive, as they perform well
when the market generally is doing badly. Under the ^capital asset pricing model,
it is believed that they are highly priced for this reason. 2 The Greek letter p,
commonly used in econometrics to represent the relationship between the >de-
pendent variable and the >independent variable. If >regression analysis produces
an estimate of a high beta, relative to the scale of the units involved, it means the
relationship is strong. »*null hypothesis.

Beveridge, William Henry (Lord Beveridge) (1879-1963) Director of the

London School of Economics from 1919 to r937, Lord Beveridge's work in economics
arose from a continuous interest through his life in the problem of >unemployment.
His major contribution to the subject was published in Unemployment (r93r). He was
a major influence in the setting-up of labour exchanges, and his 1942 report, Social
Insurance and Allied Services that became known as the Beveridge Report, led to the
extension of the welfare services. His definition of full employment, which he gave
in Full Employment in a Free Society (1944) as being reached at a level of 3 per
cent unemployed, became a reference point for subsequent government policy.
^►Sismondi, J. C. L. S. de.

Beveridge curve A graphical depiction of the relationship between the level of

>unemployment in an economy, and the level of vacancies. It is drawn with
vacancies on the vertical axis, and slopes downwards as a higher rate of unem¬
ployment tends to occur with a lower rate of vacancies. If it is observed that
the curve moves outwards over time, a given level of vacancies would be associated
with higher and higher levels of unemployment, and that would imply a less and
less efficiently operating labour market, with an increasing mismatch between
the unemployed, and the jobs available, ^structural unemployment; long-term
unemployment; active-labour-market policies.

Big Bang Term used to encapsulate the changes occurring on the London »-stock
exchange before and after 27 October 1986 when the strict segregation between
jobbers (>market maker) and >brokers and fixed commissions on securities, pur¬
chases and sales were abolished. In July ^83, the government agreed to exempt the
stock exchange from the provisions of the >• Restrictive Trade Practices Acts 1956 and
r976 in return for lifting a number of restrictions on competition, including fixed
commissions. In 1982, the Stock Exchange Council had raised the limit on any one
outside shareholder in a stock exchange member firm from 10 to 29.9 per cent and,
on r March r986, this limitation on outside shareholdings was removed completely.
Average commission rates fell by about 40 per cent to 0.26 per cent immediately
following Big Bang, but many bargains (transactions) are now carried out at net
prices, i.e. the market maker quotes a price direct to the purchaser (who may be a
large >institutional investor) that includes his profit margin. Commission rates for
small transactions have risen with the introduction of higher minimum charges.
Many banks and other financial institutions, both domestic and foreign, have
acquired interests in, or control of, stock exchange companies since March 1986,
while increased competition has led to mergers, a few failures and the withdrawal
bilateral agencies Le
of some firms from certain activities, e.g. dealing in >gilt-edged securities. Other
changes associated with the Big Bang have been the closure of the trading floor
in March ^87, a major extension in off-the-floor electronic dealing and a major
expansion in dealings in international ►equities.

bilateral agencies Organizations of one country, as distinct from ► multilateral

agencies. The term is used mainly to refer to national aid (>-foreign aid) agencies as,
for example, USAID in the USA and the Department for International Development
in the UK.

bilateral monopoly A market in which a single seller (a ►monopoly) is confronted

with a single buyer (a ►monopsony). Under these circumstances, the theoretical
determination of output and price will be uncertain and will be affected by the
interdependence of the two parties, ^-bargaining.

bilateralism The agreement between two countries to extend to each other specific
privileges in their ►international trade that are not extended to others. These
privileges may, for example, take the form of generous import ► quotas or favourable
import duties (>► tariffs, import). In so far as such agreements tend to proliferate,
and in that they impose artificial restraints on the free movements of goods between
countries, in the long run they could have an unfavourable effect on international
trade compared with ►multilateralism, under which there is no discrimination by
origin or destination. Bilateralism became widespread in the 1930s as countries tried
to protect themselves from the fall in international trade during the Depression.
After 1945, there was a fear that a restrictionist policy would be followed by the
Commonwealth and Western European countries in order to protect themselves
from the influence of the USA, which had emerged from the war in a relatively
strong position. However, the > General Agreement on Tariffs and Trade (GATT) was
established in 1947 on multilateral principles. The GATT and its successor organi¬
zation, the EWorld Trade Organization, have since pursued a policy designed to
eliminate bilateralism and other restrictions on international trade. The success of
this policy has been constrained somewhat by the setting up of a number of >com-
mon market and ►free-trade areas (»-counter-trade).

bill A document giving evidence of indebtedness of one party to another. A bill

may simply be a written order for goods which can be used as security for a loan to
the supplier from a bank, or it may be a security such as a > treasury bill or ►bill of
exchange.

bill broker A firm or individual dealing in ►treasury bills and ►bills of exchange
on the London ►money market. Traditionally, a bill broker was a >discount house.
>»-broker.

bill of exchange An IOU used in ►international trade by which the drawer

undertakes unconditionally to pay to the drawee a sum of >money at a given date,
usually 3 months ahead. In principle, a bill of exchange is similar to a post-dated
► cheque and, like a cheque, it can be endorsed for payment to the bearer or any
named person other than the drawee. A bill of exchange has to be 'accepted'
(endorsed) by the drawee before it becomes negotiable. This function is normally
performed by an ►accepting house, but bills may also be accepted by a bank (it is
then known as a bank bill) or by a trader (trade bill). Once accepted, the drawee does
 blue book

not have to wait for the bill to mature before getting his money; he can sell it on the
>money market for a small discount (^discount house). Bills of exchange, also
referred to as commercial bills, were first developed in inland trade by merchants who
wished to resell goods before making payment for them. They later became of great
importance in international trade, but their use declined with the development of
other means of >-credit.

bill of sale A document that gives evidence of transfer of ownership, but not of
possession, of goods. It is not often used nowadays, but was once a common method
of raising a Moan on the security of personal possessions, the borrower retaining
possession of goods until the >debt is repaid, ^mortgage.

BIMBO Buy-In Management Buy-Out. ^management buy-out.

birth rate The crude birth rate is the average number of live births occurring in a
year for every 1000 population. The crude birth rate of the UK fell steadily from
about 35 per rooo population in the 1870s to about 20 in the 1920s. It fell dramatically
to about r6 in the r930s and rose equally dramatically in 1947 to nearly 21. After
falling back from this exceptionally high figure, it was on an upward trend from the
early 1950s until the mid r96os. From 1964, it fell every year until it reached a low of
11.8 in 1977. Since increasing to a peak of 13.9 in 1990, it has fallen steadily, reaching
11.2 in 2001, the lowest ever recorded. Other statistical measurements computed for
the study of population trends include: (a) the general fertility rate, which measures
the average number of live births per 1000 for all women between the ages of 15 and
54 (a statistic which has, in fact, exhibited trends in the UK similar to the crude birth
rate (it reached its lowest level of 55.1 in 2001)); (b) the rate specific for age of mother
in which the number of live births per 1000 is given for different age groups of
mother, and (c) total period fertility rate which is the average number of children who
would be born to a woman if she gave birth at the rate specific through her childbear¬
ing years (which reached a low of 1.6 in 2001 in the UK, compared with a rate of 1.4
for the >European Union and 1.9 for the USA). Fertility rates have been falling
throughout the world but remain significantly higher in ^developing countries
than in >advanced countries. The average fertility rate in the former countries is
about three children per woman - having fallen from six in 1969 - whereas in the
advanced countries it has fallen to about 1.5. In consequence, the United Nations
forecasts that by 2050 the population of today's developing countries will increase to
about 85 per cent of the world total from a current level of 80 per cent, ^population.

BIS >Bank for International Settlements.

black economy >informal economy.

black market The trading in illicit or illegally acquired goods. Not to be confused
with >black economy.

Black-Scholes formula A formula used to establish a fair price for >options in

financial markets. The formula, which is used to solve what had previously been
considered a difficult problem, was published in 1973. It was based on looking at the
price of a basket of financial assets which carried the same risk and return as an
option. >Merton, R.; Scholes, M.

blue book An annual digest published by the UK Office of National Statistics

blue chip

containing the national income and expenditure statistics of the UK (> national
income; social accounting).

blue chip A first-class ►equity share, the purchase of which (the hope is) entails
little >risk, even of sharp declines in ►earnings, in economic recessions (►depres¬
sion). The term is, of course, applied as a matter of subjective judgement. In the UK,
Marks & Spencer, Unilever and Shell equities, for example, are commonly regarded
as blue chip.

Bohm-Bawerk, Eugen von (1851-1914) A member of the ►Austrian School who

took over the Chair of Economics at Vienna from von ►Wieser. His analyses of the
rate of ^interest and ►capital have had an important influence on the development
of these aspects of economic theory. His major publications include Capital and
Interest (1884) and the Positive Theory of Capital (1889). The nature of the rate of
interest could be found, he argued, in the three propositions: (a) that people expect
to be better off in the future; (b) that people put a lower valuation on future
goods than on present goods ('jam today is better than jam tomorrow' - the two
'psychological' factors (a) and (b) making people willing to pay to borrow against
their future income to spend on consumer goods now (►►time preference)), and (c)
the proposition that goods in existence today are technically superior to those
coming into existence at some future date because today's goods could be capable
of producing more goods during the interval (►►Fisher, I.; interest, productivity
theories of). Capital is associated with roundabout methods of production. In order
to reap a harvest you could send workers into the fields to pluck the ears of corn. A
more efficient method is to spend capital on making scythes and then use these
to cut the corn. An even more efficient method is to spend even more capital
manufacturing reaping machinery and use this to harvest your corn. Progress is
achieved through the use of >labour in more roundabout methods of production.
There is, therefore, a widening of the gap between initial ►inputs and final outputs
(►►input-output analysis). Capital supplies the necessary subsistence to labour
during the 'waiting time' before new consumer goods are produced (►►wage-fund
theory). This waiting time is extended to yield increased >productivity until, in
equilibrium, productivity is equated with the >rate of interest. This theory was later
developed into a theory of the ►business cycle by members of the Austrian School
(^►Hayek, F. A. von; Hicks, J. R.; Mises, L. von; Wicksell, K.).

bond 1 A form of fixed-interest ►security issued by central or local governments,

companies, banks or other institutions. Bonds are usually a form of long-term
security but do not always carry fixed interest, may be irredeemable, and may be
secured or unsecured. Economists frequently make use of the term in theoretical
analysis, e.g. of choices between holding cash and other financial assets, in which a
bond is a proxy for a whole range of securities. Eurobonds have been defined by
Morgan Guaranty, the investment bankers, as a 'bond underwritten by an inter¬
national syndicate and sold in countries other than the country of the currency in
which the issue is denominated'. There is no specific >stock exchange for these
bonds (►►bearer bonds; eurocurrency). The term has also been given to types of
non-fixed-interest security, e.g. property bonds, that provide the holder with a yield
on funds invested in property, or 'managed bonds', in which the funds are placed
in a variety of investments. Nowadays, and almost always in the USA, the term
 British Trade International

includes >• debentures, >xdeep discounted bond. 2 A term used to describe goods
in a warehouse on which customs duty (>tariffs, import) has not yet been paid.

bonus issue, or scrip issue, capitalization issue (US stock dividend, stock
split) Virtually synonymous terms describing Xshares given without charge to
existing shareholders in proportion to the shares already owned. A scrip issue does
not add to the >-capital employed by the firm, but is made where the capital
employed has been increased by withholding profits, and is therefore, out of line
with the Mssued capital. Consequently, it is a purely bookkeeping transaction.
►Dividends, for example, will, after a scrip issue, be divided among a larger number
of shares, so that the dividend per share will fall in proportion to the number of
bonus shares issued. *Xnew-issue market; rights issue.

book value The value of Xassets in the >balance sheet of a firm. This is often the
purchase price, and may be less than the market value. >► inflation accounting.

bounded rationality The idea that economic agents may not have the cognitive
power to make decisions about their optimum behaviour very precisely. They thus
may intend to be rational, but in practice, make choices on the basis of rules of
thumb. In particular, it may be that agents don't act to maximize some goal, but
merely to reach a satisfactory outcome in it. The phrase was coined by XSimon,
who applied the concept to the study of organizational behaviour. satisficing;
transaction costs.

branch banking A >banking system, most highly developed in the UK, in which
the small number of ^commercial banks have a large number of branches (some
9000). Many other ^advanced countries have a much larger number of banks with
fewer branches, e.g. Germany has some 246 commercial banks with 6500 branches,
less than half of which are operated by the six large universal banks. A banking
system in which each bank is a separate enterprise without affiliations with other
banks or branches is called unit banking.
In the USA, it was believed that branch banking led to > concentration of the
banking system and lack of competition. Now, prohibitions on branch banking
have been relaxed and, although branch banking is growing, 11,000 of the 15,000
commercial banks are purely local, with five or fewer branches. Branch networks
have been diminishing in importance in recent years, as automated teller machines
have, to some extent, obviated the need for personal contact with bankers, and
telephone services have supplanted the face-to-face visit.

Bretton Woods An international conference held at Bretton Woods, New Hamp¬

shire, USA, in July r944 to discuss alternative proposals relating to postwar inter¬
national payments problems put forward by the USA, Canadian and UK
governments. The agreement resulting from this conference led to the establishment
of the >International Monetary Fund and the ^International Bank for Reconstruc¬
tion and Development. >► Keynes plan; Smithsonian Agreement.

British funds Xstock exchange.

British Trade International (BTI) Export promotion agency of the UK Depart¬

ment of Trade and Industry and the Foreign and Commonwealth Office. The BTI
unites various services previously managed separately, including Invest UK which
broker

is responsible for inward investment. Trade Partners, within BTI, provides trade
support services via the Small Business Service and Business Link. BTI was set up in
May r999 as a successor to the British Overseas Trade Board.

broker An intermediary between a buyer and a seller in a highly organized market,

a >stockbroker, for example, or commodity broker or a market operator working on
his own account, e.g. a pawnbroker (>bill broker). On the >-stock exchange, a broker
is the intermediary between a >market maker and the public.

brokerage Commission or fee charged by a >broker. It is characteristic of the

broking profession that they operate only in highly organized markets where
margins are relatively small.

BTI ^-British Trade International.

Buchanan, James McGill (b. 1919) Professor Buchanan studied at the University
of Tennessee prior to obtaining his Ph.D at the University of Chicago in r948. He
became Professor of Economics at the University of Virginia in T956 and was
appointed, in r969, Director of the Center for Study of Public Choice, and is currently
Professor at George Mason University, Virginia. Professor Buchanan was awarded
the > Nobel Prize in Economics in r986. His published work includes: The Calculus
of Consent: logical foundations of constitutional democracy {1962), Public Finance in a
Democratic Process (1966), The Demand and Supply of Public Goods (T968), Cost and
Choice: an enquiry in economic theory {1969), Theory of Public Choice: political appli¬
cations of economics (r972), The Limits of Liberty: between anarchy and the leviathan
(1975), Freedom in Constitutional Contracts: perspectives of a political economist (1977),
Democracy in Deficit: the political consequences of Lord Keynes (1977) and The Power of
Tax (4980).
Professor Buchanan established, and inspired study in, > public-choice theory. As
'economic man' acted in his own self-interest, so government officials behaved, also.
Government actions, therefore, will be pursued according to the self-interest of
public officials rather than necessarily for the public good. For example, unpopular,
but inevitably required, corrective action may be delayed by governments to force
others into the responsibility, and political costs, of taking action. Given that this is
the case, the rules of the game by which the politicians serve the public are important
in determining how far public desires are served. Professor Buchanan thus takes
seriously the issue of constitutions and the constraints they apply on the State. An
example might be whether countries should have ^hypothecated taxes or whether
a >balanced budget provides a welcome discipline on the political process in
determining the level of government spending. W^public choice theory.

budget An estimate of >income and expenditure for a future period as opposed

to an account which records financial transactions. Budgets are an essential element
in the planning and control of the financial affairs of a nation or business, and are
made necessary essentially because income and expenditure do not occur simul¬
taneously.
In modern large-scale business, the annual budget, which is normally broken
down into monthly and weekly periods, is a complex document that may take
several months to prepare. The starting-point will be an estimate of sales and income
for the period, balanced by budgets for purchasing, administration, production,
 building society

distribution and research costs. There will also be detailed budgets of >cash flow
and >-capital expenditure. These are often also made for periods of further than i
year ahead, so that borrowing requirements and capacity requirements can be
assessed (»-capital budgeting). A flexible budget is one based on different assumed
levels of plant activity.
The UK's national budget sets out estimates of central government expenditure
and revenue for the financial year, and is normally presented by the Chancellor
of the ^Exchequer to Parliament late in the previous financial year. The Labour
government, which came to power in r997, decided to pre-release a Green Paper
outlining the background to the budget, and certain options. The budget is formally
concerned with >consolidated fund revenue and not with >National Insurance or
local government finance although, in practice, all spending and revenue decisions
are discussed. In his statement, the Chancellor reviews economic conditions and
government expenditure for the past year, makes forecasts for the coming year
and announces proposed changes in >taxation. These changes normally become
effective immediately, but are subject to parliamentary debate and approval in the
Finance Bill and Act. With the increasing importance of government expenditure
in the economy, the annual budget is an important instrument in government
economic policy. Fiscal changes may have more to do with decisions to modify the
budget surplus or deficit in the interest of demand management (>balanced budget)
than with planned expenditure which, in any case, is essentially discussed and
presented earlier in the year. >supply services; medium-term financial strategy;
>► public expenditure.

budget deficit >balanced budget; crowding-out; public-sector borrowing require¬

ment; >► Ricardian equivalence.

budget line A set of combinations of different commodities that, given a con¬

sumer's income, can just be afforded. If there were only two commodities (e.g. books
and CDs) the budget line could be drawn on a graph which had books on one axis
and CDs on the other (>indifference curve). Given the price of each and the
consumer's income, it would be a straight downward-sloping line cutting each axis
at the quantity of that commodity which could be purchased if all income were
devoted to it. The budget line represents the constraint facing the consumer when
consumption decisions are made and is used in >indifference-curve analysis.

budgetary control A system of control which checks actual > income and expen¬
diture against a f-budget so that progress towards set objectives may be measured
and remedial action taken if necessary. Budget-control statements comparing
actual and estimated expenditure are issued weekly or monthly. These statements
will be issued in considerable detail to department heads, and in less detail to
higher management. Budget control statements must, if any necessary remedial
action is to be taken in time, be issued as soon as possible after the close of the period
to which they relate, and for this reason need not be of the same accuracy as
accounting statements and may be based on estimated data. The development
of computerized accounting procedures has greatly facilitated budgetary control.
>$► resource accounting.

building society An institution that accepts >deposits, upon which it pays

>interest and makes Moans for house purchase secured by ^mortgages, and that
built-in stabilizers
Li!
is not owned by shareholders but by its members, comprising its customers. Building
societies are unique to the UK, though elsewhere similar functions are performed
by ^savings banks, e.g. Saving and Loan Associations in the USA. Building societies
grew out of the Friendly Society movement in the late seventeenth century and
are non- )*>profit-making. Their activities were regulated initially by the Building
Societies Act, r874, which set up a Registrar of Building Societies. Subsequent Acts
have tightened controls over the societies' financial management and the Building
Societies Act 1986 (see below) initiated fundamental changes to the whole movement.
The societies accept deposits which can be withdrawn on demand up to a limited
amount or at 1 month notice, or 'shares' which may be subject to a longer notice of
withdrawal. Traditionally, the societies' deposits are fed by regular small savings and
the average holdings are about £6000, though they also raise funds on the >money
market, i.e. on a wholesale as well as a retail basis. Loans are made to persons wishing
to purchase their homes, or more rarely to builders, and administrative costs are
financed by the difference between the borrowing and lending rates. The loans are
usually repaid on regular monthly instalments of > capital and interest over a period
of years, usually on a >reducing-balance basis. Sometimes loans can be repaid with
an )► assurance policy and remain outstanding until the policy matures; in these
instances only interest (and the premiums on the policy) are paid during the period
of the loans. Building societies’ > rates of interest must bear a close relationship to
rates charged or obtained elsewhere, since they compete with other institutions for
funds. Investors in building societies may put their money into shares or into
deposit. The former confer some rights of ownership but are not >equity shares;
they are simply a form of deposit for which slightly more restrictive withdrawal
terms are rewarded by a higher interest rate. Special interest-rate incentives are
provided for regular savers. Originally highly localized in their operations, the
building societies became increasingly to operate on a national scale. However, their
numbers in Great Britain have fallen from over 500 in the late r96os to 68 in 1995,
mainly as a result of >*mergers and the recent process of conversion into banks. The
biggest remaining building society is the Nationwide. The 1986 Act allowed the
societies to widen their services from their traditional property-mortgage business,
to include loans to individuals for other purposes, money transmission and foreign-
exchange services, personal financial planning services (acquisition and disposal of
shares, insurance, pension schemes), estate agency, valuation and conveyancing
services. The Act also provided for a regulatory agency, the Building Societies Com¬
mission, and an Investor Protection Scheme. The Building Societies Act 1997 gave
further freedom to societies to compete and inter alia introduced measures to
enhance the accountability of building society boards to their members, ^financial
intermediaries.

built-in stabilizers Institutional features of the economy that, without explicit

government intervention, automatically act to dampen down fluctuations in
employment and ► national income. Examples of these are: (a) aggregate unemploy¬
ment benefits and welfare payments, which automatically increase when unemploy¬
ment increases and fall when unemployment falls, so that this part of government
expenditure adjusts automatically in the desired directions to offset in part changes
in other components of ^aggregate demand, and (b) government taxation, which
falls in total as national income falls and rises as national income rises, both because
 business cycle

the burden of ►income taxes changes and because, with changes in ►consumption
expenditures, sales tax revenues change. Since an increase in taxation tends to
restrain expenditure and a fall in taxation to stimulate it, taxation 'automatically'
counteracts inflationary and deflationary pressures in the economy (►deflation;
inflation). These built-in stabilizers rarely have sufficient force to render positive
corrective policies unnecessary. cyclically adjusted budget; fiscal drag.

bull A ► stock exchange speculator who purchases ►stocks and >shares in the
belief that prices will rise and that he will be able to sell them again later at a profit
(►speculation); the opposite of >bear. The market is said to be bullish when it is
generally anticipated that prices will rise.

bullion Gold, silver or other precious metal in bulk, i.e. in the form of ingots or
bars rather than in coin. Gold bullion is used in international monetary transactions
between ►central banks and forms partial backing for many ►currencies (>gold
standard). A bullion market is a gold market.

Bundesbank The ►central bank of Germany, based in Frankfurt. It was formally

established in 1957, although its origins can be traced to 1875. Its constitution
demands that it maintains the internal and external value of the currency. To help
it resist short-term political pressures, the bank is shielded from governmental
interference in the conduct of monetary policy, although the powerful Bundesbank
president is effectively appointed by the government. During the life of the ►Euro¬
pean Monetary System, the Bundesbank was dominant in establishing monetary
policy for the entire European Union, with other member states gradually converg¬
ing on Germany's low Mnflation rate. The Bundesbank is now one of the twelve
central banks participating in ► European Monetary Union.

business angels ►risk capital.

business cycle Fluctuations in the level of ►national income. The business cycle
is a well-observed economic phenomenon, though it often occurs on a generally
upward growth path and has a variable time span, typically of the order of 5 years.
It has been a matter of government policy in Western economies to dampen the
amplitude (i.e. the height of the peaks and depths of the troughs) of the cycle so
that the trend path of output is followed without much fluctuation (^stabilization
policy).
Several suggestions have been put forward as to the cause of cycles. ►Samuelson,
► Hicks, Goodwin, ►Phillips and Kalecki in the 1940s and 1950s developed theories
that combine the ►multiplier with the ►accelerator theory of investment (►acceler¬
ator-multiplier model). In certain cases, investment can be related positively to
output one period back, and negatively related to output two periods back. This can
cause an oscillating path for income. This account quite plausibly requires that
investment is based upon companies' expectations of future growth, but rather less
plausibly relies upon these expectations being drawn from a naive extrapolation of
what happened in the last period. ► Friedman, in his analysis of US monetary
history, notes the correlation between money supply and economic activity and
suggests that the business cycle is a monetary phenomenon. Several theories of the
cycle embrace the notion of ►rational expectations, or the idea that expectations are
more forward looking. >New Keynesianism suggests that fluctuations in ^aggregate
Business Expansion Scheme |_40

demand account for the cycle. PNew classical economics explains it in terms of
unanticipated fluctuations in demand. More recently, attention has been paid to the
effects of shocks to the economy from technology and taste changes. These 'real'
phenomena can, it is suggested, account for many economic fluctuations (Preal
business cycle theory). There has been much debate on the effectiveness of
policymakers' attempts to dampen the cycle (P policy ineffectiveness theorem) and
there is a broad consensus that governments should make strenuous efforts to avoid
inflamingit. PFrisch, R. A. K.;Jevons, W. S.;Juglarcycle; Kondratieff cycle; Kuznets,
S. S.; Schumpeter, J. A.; stabilization policy; stop-go.

Business Expansion Scheme (BES) Enterprise Investment Scheme.

business finance The provision of Pmoney for commercial use. The Pcapital
requirements of business may be divided into short and medium term, or long term.
Short-term capital consists of the current Pliabilities of a business plus medium-term
capital. The main sources of short- and medium-term capital (for a company) can
be further subdivided into internal, and external, as follows:
Internal: P retained earnings, including Paccrued expenses and tax reserves.
>Pcash flow; corporation tax; self-financing.
External: Temporary Ploans from sister companies, directors and others; Pbills of
exchange; P factoring; trade creditors and expense creditors, and short-term Ptrade
investments. Short-term capital should, in theory, only be used for investment in
relatively liquid assets (»Pliquid) so that it is readily available to discharge the
liability if necessary. Thus, these sources of short-term capital may be used for
finished goods in stock and work in progress, trade debtors, prepaid expenses, cash
in hand and at the bank.
Correspondingly, the main sources of long-term liabilities or capital can be subdiv¬
ided in the same way as follows:
Internal: Reserves, retained earnings and Pdepreciation provisions.
External: Share capital, i.e. Pordinary shares, Ppreference shares, long-term loans
including Pmortgages, Pleaseback arrangements and Pdebentures.
Long-term capital may be used for long-term investment in fixed assets (e.g. land,
buildings, plant, equipment and machinery, etc.), in goodwill, patents and trade
marks and long-term trade investments.
There are important differences in the sources of capital open to large and small
firms. The latter do not have access to the Pstock exchange and rely more heavily
upon family and friends for equity capital, as well as upon the Pcommercial banks.
The main institutional sources of business finance are the commercial banks,
Pmerchant banks, Pfinance houses, Pdiscount houses, factoring companies and
the institutions concerned with new issues (Pnew-issue market). PInsurance com¬
panies and Ppension funds hold a large proportion of all quoted securities (Pquota-
tion). A number of other institutions specialize in providing Pterm loans and Prisk
capital, especially for innovation and smaller businesses.

business saving That part of the net revenue of a firm that is not paid out as
interest, Pdividends or Ptaxation, but rather is kept in the business as reserves
and Pdepreciation allowances or to finance new Pinvestment. Sometimes called
retentions. >Pself-financing.

business taxation Pcorporation tax.

—_i by-product

buyer's market A ^market in which prices are falling, owing, for example, to an
excess of ^supply of the goods or services traded compared with >demand. >*»-price
system.

by-product The output from a process designed for the production of some other
product. It is a necessary outcome of the production process and cannot be avoided.
Its ^-opportunity cost is zero, ^economies of scope.
c
cabotage The transportation of goods or passengers wholly within one country
by vehicles, ships or aircraft which are foreign-owned. Many countries prohibit or
place restrictions on such operations. For instance, under the Jones Act (the Mer¬
chant Marine Act) T920, US ships are given preference in the carriage of US domestic
cargo, and the Merchant Marine Act t936 enables the US government to impose
penalties on foreign vessels that have been built cheaply by means of subsidy if they
operate in US domestic trade. Similar restrictions apply to passenger traffic. A number
of European countries also prohibit or restrict cabotage. Restrictions imposed on
cabotage road transport throughout the > European Union were lifted for operations
owned by enterprises of member states in 1998. Similarly, such restrictions were
removed on shipping cabotage in r999, except for Greece, which continues to be
restricted until 2004. >#*free trade.
calculus of variations A branch of mathematics that is concerned with tracing
the optimal path of variables over time. It is to ^dynamics what the »-Lagrange
multiplier is to static analysis. An example of the use of the calculus of variations
would be to work out the path of economic growth in terms of the capital stock and
investment (»-optimal-growth theory).
call An unpaid portion of the price of a >share. This may appear when an applicant
for a new share issue pays only part of the price of the share on application and the
remainder on allotment, or when the issued shares of a company are not fully paid
up (>paid-up capital).

call option A contract giving a right to buy >shares from the dealer making the
contract at the price ruling at the time within a specified future period, usually 3
months. Call options carry a ^commission to the dealer on the price of the shares
traded. The opposite of put option (>option).

Cambridge School A system of economic thought influenced by economists at

the University of Cambridge, England. ^Marshall (1842-1924) held the Chair of
Political Economy until r9o8, as did >Pigou (1877-1959) until 1944, and during this
period the School was characterized by the theory of late ^-classical economics. After
the end of the Second World War, the School attempted to refute what became
known as >neo-classical economics and developed ideas based on those of > Keynes
(1883-^946), although linked also with the early Classical period. The leading
figures in the postwar debate were > Robinson (1903-83) and >Kaldor (r9o8-86). The
Cambridge School emphasized a > macroeconomic approach compared with the
>microeconomic approach of the Neo-classical School. The Cambridge School
 capital adequacy

denied that there was a direct functional relationship between the rate of ^-profit
and the capital intensity of an economy. They have demonstrated the possibility of
^capital re-switching (S-Wicksell effect, price) and have criticized the Neo-classical
School for leaping to conclusions about the aggregates derived from microanalysis.
For example, they argue that the aggregate ^production function of the >Cobb-
Douglas type is not compatible in practice with the microfunctions from which it is
derived. The neo-classical theory of ^distribution which relates relative factor prices
(>factors of production) to relative ^marginal revenue productivities is deficient in
throwing light on aggregate factor distributed shares of product (>Euler, L.). Per
contra, they themselves are criticized for neglecting >microeconomic theory.

Cantillon, Richard (1680-1734) An Irish international banker who wrote Essai sur
la nature du commerce en general, which was not published until 1755 but had circulated
from about 1730. This work was one of the first synoptic descriptions and analyses
of the economic process. His views on the importance of agriculture, based on its
receipt of pure >rent, and his analysis of the circulation of wealth, foreshadowed
the ^Physiocrats and the >Tableau economique, respectively.

CAP >-Common Agricultural Policy.

capacity utilization rate The output of a plant, firm or a whole economy divided
by its output at full capacity, ^excess capacity; output gap.

capital 1 Assets that are capable of generating income and that have themselves
been produced. Capital is one of the four ^factors of production, and consists of
the machines, plant and buildings that make production possible, but excludes raw
materials, >land and Mabour. All capital is itself, however, the product of labour
and raw materials, and can be seen as holding the stored value of them. If a Stone
Age man spent r day producing a tool (a capital good) he gained no utility from
doing so at the time. He did, however, save labour by using the tool thereafter. By
building the tool he had, in effect, put some labour away for use at a later date. The
essence of capital, therefore, is that it represents deferred consumption. 2 In more
general usage, any asset or stock of assets - financial or physical - capable of generat¬
ing income, w*-wealth.

capital adequacy A measure of the value of capital owned by the shareholders of

a financial institution relative to the amount the institution has lent out. Various
regulatory bodies set minimum >capital requirements for financial institutions such
as >unit trusts and banks (>banking). These requirements take the form of reserve
asset ratios, a minimum proportion of liquid assets. For banks, these requirements
were mainly used to control monetary aggregates (>money supply) but now increas¬
ingly they are aimed at preventing failure and instability in the financial system
(prudential regulation).
In the USA, the member banks in the >Federal Reserve System are subject to a
legal reserve requirement that they are required to maintain at their Federal Reserve
Bank. The reserves are related to ^deposits and the reserve ratios vary according to
the type of deposit. By raising or lowering reserve requirements the Federal Reserve
can tighten or loosen bank credit. In the UK, the VBank of England does not any
longer impose significant reserve requirements on banks but the Financial Services
capital, authorized |_44

Authority (> Financial Services and Markets Act) does, under national capital
adequacy standards derived from various >Directives of the European Union.
The increasing globalization of the world financial system has stimulated inter¬
national agreement on capital adequacy standards. Beginning in 1975, a series of
international agreements under the auspices of the >-Bank for International Settle¬
ments (BIS) have laid down, in the Basle Agreements, standards for bank supervision
and capital adequacy. In December 1987, eleven countries and the then European
Economic Community (^European Union) signed an international agreement for
capital adequacy for ^commercial banks. The agreement provided for common
prudential ratios (capital adequacy ratios) and a common definition of risk-adjusted
assets. Banks operating in signatory countries now need to have capital (>equity
and long-term >debt) equal to 8 per cent of risk adjusted assets (^liquidity ratio).
The percentage adequacy requirement can vary with an individual bank's exposure
to Moreign exchange risks and ^derivatives. Experience of the application of the
agreement and changes in capital markets have led the BIS to propose a new Basle
II Agreement for introduction by 2005. The changes, which have aroused controversy,
include the addition of a minimum capital requirement, more categories of defined
risk, regulatory supervision and more disclosure.

capital, authorized Authorized capital.

capital, cost of 1 The >rate of interest paid on the Aapital employed in a

business. Since capital will be usually drawn from a variety of sources, it will be an
average cost derived from weighting the cost of each source, including >-equity
capital, by its proportion of the total. There has been extensive debate about whether
the cost of capital is too high in the UK, or whether indeed company executives
merely think it is higher than it is. A high cost of capital is considered detrimental
to ^investment. 2 The cost of raising additional capital, i.e. the marginal cost. The
marginal cost of capital on a ^discounted cash flow basis may be used as the
minimum level of return in assessing investment projects, ^capital asset pricing
model; Modigliani-Miller theorem.

capital, issued >issued capital.

capital, marginal efficiency of > internal rate of return.

capital, marginal productivity of ^internal rate of return.

capital, nominal Authorized capital.

capital, registered Authorized capital.

capital, sources of >business finance.

capital, working ^-working capital.

capital account ^balance of payments.

capital allowances Reductions in tax (^taxation) liability that are related to a

firm's Aapital expenditure. In most countries, expenditure on new capital assets is
encouraged by various kinds of allowances, and annual > depreciation is recognized
as an expense of the business in calculating tax liability. The taxation authorities'
methods of depreciating an Asset are not necessarily the same as those used by the
company in the published Accounts. Where a company may claim depreciation
45j capital formation

for tax purposes at will (e.g. to write off the whole of the cost of an asset against tax
in a single year, or to spread it over 20 years as it chooses) this is known as free
depreciation or depreciation at choice.

capital asset pricing model A model of the market for different financial assets
that suggests that asset prices will adjust to ensure that the return an asset makes
precisely compensates investors for the risk of that asset when held with a perfectly
diversified portfolio. The model has dominated economists' understanding of the
financial sector. Under simplifying assumptions, the following propositions hold:
(a) everybody will hold a portfolio of assets which is as diversified as possible
(^diversification); (b) this means the particular risks of each individual asset will
be unimportant because the ups and downs of assets' performances will tend to
cancel out (isp portfolio theory); (c) there will, nevertheless, be some remaining
market risk - the risk of factors that affect all the assets together; (d) this risk depends
on how closely the assets' performances coincide; (e) the risk any particular asset
adds to a portfolio will thus depend only on how closely its performance tracks that
of the rest of the portfolio; (f) the price of assets that closely track other assets will
be low because they are unattractive - when other assets do well, they do well and
vice versa (Pbeta), and (g) the price of assets that hardly move at all with the market
will be high, because they pay out good returns when they are needed most.
The capital asset pricing model is a development of this chain of reasoning. It can
be used to calculate an expected return on any particular asset, as a function of the
rate of return on riskless assets, plus a risk premium based on the degree to which
the asset tracks the market. It thus provides one basis for assessing a cost of capital
(Pcapital, cost of) for a company. Pefficient markets hypothesis; Markowitz, H.;
Sharpe, W.

capital budgeting The adoption of financial plans for managing and monitoring
expenditure on non-recurrent expenditure. Capital is generally hard to plan for
within Pcash flow accounts as, in any one period, the relationship between cost
incurred and value derived is very small, ^resource accounting.

capital charges Charges in the ^accounts of a company or individual for interest

paid on Pcapital, ^depreciation or repayment of Moans.

capital consumption Pcapital stock.

capital deepening Pcapital widening.

capital employed The Pcapital in use in a business. There is no universally agreed

definition of the term. It is sometimes taken to mean Pnet assets (i.e. fixed plus
current assets minus current Pliabilities), but more usually >bank loans and Pover-
drafts are included and other adjustments made for purposes of calculating the
return on net capital employed (Prate of return), e.g. the exclusion of intangible assets
and the revaluation of P trade investments at market prices. PPinvestment appraisal.

capital expenditure The purchase of fixed Passets (e.g. plant and equipment),
expenditure on Ptrade investments or acquisitions of other businesses and expend¬
iture on current assets (e.g. stocks); to be distinguished from Pcapital formation.

capital formation Pnet investment in fixed Passets, i.e. additions to the stock
capital gains |_46

of real »-capital. Gross fixed capital formation includes >depreciation; net capital
formation excludes it.

capital gains A realized increase in the value of a capital >-asset, as when a share
is sold for more than the price at which it was purchased. Strictly speaking, the term
refers to capital appreciation outside the normal course of business. In the UK,
capital gains are subject to capital gains tax. The tax does not cover gains arising
from the sale of personal belongings, including cars or principal dwelling houses,
but it does cover gains from the sale of >-stock exchange securities (with special
treatment for >■ gilt-edged securities). The tax for individuals is now based on a
taper arrangement, with special provisions for business assets, while incorporated
businesses pay Corporation tax on capital gains. >-Capital losses may be set against
tax liability and the first £7700 is exempt from income tax (2002/03). Capital gains
arise from changes in the supply and demand for capital assets, but also from
>inflation, and for assets disposed of after the beginning of the r982 tax year the
original cost may be increased by ^indexation, i.e. the expenditure scaled up in
proportion to the increase in the retail price index between, in most cases, a year
after the acquisition and the date of sale. Capital gains are taxed in some countries
at lower rates for short-term gains, and a few countries do not tax them at all.

capital gearing >gearing.

capital goods Capital.

capital-intensive The production of a commodity in which a higher proportion

of Capital is used in the mix of inputs compared with other factor inputs, such as
labour. .»*• factors of production.

capital loss A reduction in the >money value of an Csset; opposite of Capital

gain.

capital market The market for long-term loanable funds as distinct from the
>*money market, which deals in short-term funds. There is no clear-cut distinction
between the two ^markets although, in principle, capital-market Coans are used
by industry and commerce mainly for fixed > investment. The capital market is an
increasingly international one and in any country is not one institution but all those
institutions that match the ^supply and >demand for long-term capital and claims
on capital, e.g. the ► stock exchange, banks and Cnsurance companies. The capital
market, of course, is not concerned solely with the issue of new claims on capital
(the primary or >new-issue market), but also with dealings in existing claims (the
^secondary market). The marketability of ^securities is an important element in
the efficient working of the capital market, since investors would be much more
reluctant to make loans to industry if their claims could not be disposed of easily.
All advanced countries have highly developed capital markets, but in ^developing
countries the absence of a capital market is often as much of an obstacle to the
growth of investment as a shortage of savings, and governments and industrialists
in these countries are obliged to raise capital in the international capital market, i.e.
that composed of the national capital markets in the advanced countries. Ebusiness
finance; public finance.

capital movements >-foreign investment.

47j capital structure

capital-output ratio The ratio derived by dividing the level of output into the
stock of >capital required to produce it. The incremental capital-output ratio is a
change in output divided into a change in capital stock, i.e. ^investment. The
relationship between incremental capital (investment) and output is described by
the >-acceleration principle and the incremental capital-output ratio is the >acceler-
ator coefficient. The interdependence of capital and output plays an important role
in >growth theory, in which various assumptions about the ratio are explored. For
example: (a) the ratio may be assumed to be a fixed constant as the economy grows
or, as in Marxian economics (>Marx, K.) it may be assumed to increase, implying
that the rate of profit earned on investment falls (>profit, falling rate of); (b) labour
and capital may be substitutable depending on wages and the rate of interest, and
(c) capital-embodied technical progress may occur, meaning that new investment is
more efficient than old, so that the ratio falls as old capital is replaced (>• technology),
^►capital theory.

capital reserves >company reserves.

capital re-switching A phenomenon that played an important part in the contro¬

versy over »-capital theory between a group of economists led by > Robinson at
Cambridge, England, and a group at Cambridge, Massachusetts, USA, led by
>Samuelson and >Solow. Specifically, it can be shown that the proposition that
S-investment increases as the required >rate of return (^internal rate of return) falls
may not be valid. We could imagine that, as the required rate of return falls, firms
would switch from fewer to more >capital-intensive methods of production, thus
increasing the rate of investment. However, it is possible to show that under quite
plausible circumstances the rate of return could reach a level at which firms would
switch back (i.e. re-switch) from more to less capital-intensive production methods,
thus causing investment to fall as the required rate of return falls. This possibility
then undermines the >-neo-classical economics on which the Cambridge, Massachu¬
setts, argument was based (>Wicksell effect, price).

capital stock The total amount of physical ^capital in the economy or, less
commonly, in a firm or industry. In theory, the most important valuation of the
stock is the S-present value of the >income stream it will generate in the future, and
changes in the capital stock should provide a guide to changes in the productive
potential of the economy. Since the different parts of the capital stock, roads,
machinery and buildings cannot be added together, in practice they have to be
valued to produce an estimate of the capital stock at the prices of a given year. In
the 1995 >blue book, the UK gross capital stock (at 1990 replacement values) was
£2695 billion, equivalent to about 4 years of >gross domestic product. Capital
consumption is the replacement value of capital used up in the process of production,
an identical concept to the ^-depreciation provisions in company accounts, though
not necessarily measured in the same way.

capital structure The sources of long-term >-capital of a company. A company's

capital structure is determined by the numbers and types of >shares it issues and its
reliance on fixed-interest debt (>gearing). A company's choice between different
sources of finance will be determined by their cost, the type of business it is, its past
and expected future earnings, >-taxation and other considerations. Ebusiness
finance; capital, cost of.
capital theory L48

capital theory That part of economic theory concerned with analysis of the
consequences of the fact that production generally involves >inputs that have
themselves been produced. The existence of these 'produced means of production',
or > capital, has profound implications for the nature of the economic system. A
central element is the role of time and inter-temporal planning. The production of
capital requires the sacrifice of current consumption in exchange for future, possibly
uncertain, consumption, and the mechanisms by which this process is organized
influence the growth and stability of the economy in important ways. The existence
of capital is also central to the analysis of the >income distribution. A major and
controversial question has been: What determines the income derived by the owners
of capital relative to that of the suppliers of labour, and can their share be justified
in terms of their contribution to the production of output? An understanding of
the nature and implications of capital is fundamental to an understanding of our
economic system and, indeed, as one leading contributor to the subject has
remarked, the problem in attempting to define capital theory is to do it in such a
way 'as to embrace something less than the whole of economics' (Bliss, in Capital
Theory and the Distribution of Income, 1975). >**Bohm-Bawerk, E. von.

capital transfer tax ^inheritance tax.

capital widening Increasing the quantity of capital without altering the pro¬
portions of the other ^factors of production. This will occur where the ^capital
stock and employment are both increasing. Where the capital stock is increased and
the numbers employed remain constant or fall, then production has become more
capital-intensive and capital deepening has occurred.

capitalism A social and economic system in which individuals are free to own the
means of production and maximize > profits, and in which resource allocation is
determined by the >price system. S-Marx argued that capitalism would be over¬
thrown because it inevitably led to the exploitation of labour.

capitalization 1 The amount and structure of the >capital of a company. 2 The

conversion of accumulated ^profits and reserves into >issued capital. 3 Market
capitalization is the market value of a company's issued >share capital, i.e. the
quoted price of its shares multiplied by the number of shares outstanding.

capitalization issue >bonus issue.

capitalized ratios Ratios which describe the ^capital structure of a company, by

indicating the proportion of each type of ^security issued.

capitalized value The > capital sum at current > rates of interest required to yield
the current earnings of an >asset. For example, if the earnings of an asset were £5
per annum and the appropriate rate of interest were 5 per cent, its capitalized value
would be £100, as an asset worth £roo yields an annual return of £5. The general
formula for capitalizing the value of an asset is to divide the annual income by the
annual rate of interest (all multiplied by 100). ^annuity.

captives »-risk capital.

carbon tax >-pollutor-pays principle.

Caribbean Basin Initiative (CBI) The Caribbean Basin Economic Recovery Act,
49 I cash flow

passed by the US Congress in 1983, granted preferential and ► tariff-free access to the
US market for a range of goods exported from twenty-three countries in the Carib¬
bean and Central America. These privileges excluded some commodity groups, e.g.
textiles and clothing, sugar and oil. The agreement was originally scheduled to end
in 1995, but Congress passed an Act in r99o that made the provisions of the ^83 Act
permanent. ^Caribbean Community and Common Market.

Caribbean Community and Common Market (CARICOM) Formed in 1973,

the Caribbean Community has fourteen member states: Belize, Guyana and Surinam
on the Central American mainland and Antigua, Barbados, Dominica, Grenada,
Jamaica, Montserrat, St Kitts/Nevis/Anguilla, St Lucia, St Vincent and the Grenadines
and Trinidad/Tobago in the Caribbean. The Bahamas is also a member of the
Community, although not of the Common Market. The Community has a secretariat
in Georgetown, Guyana. The British Virgin Islands, the Turks and Caicos Islands
and Anguilla are associate members. Haiti became a provisional member in 1992. A
Common External Tariff has been set up and restrictions on foreign exchange and
the free movement of skilled workers have been eased. The aim is the eventual
establishment of a >common market with monetary union. ►Central American
Common Market; >free trade; ^Caribbean Development Bank; Cotonou Agree¬
ment; customs union.

Caribbean Development Bank (C D B) A regional development bank, established

in r970, that channels >soft loans and grants for the financing of agricultural and
industrial projects in the Caribbean. It has twenty regional members and five others
(Canada, China, Germany, Italy and the UK). >African Development Bank; Asian
Development Bank; Inter-American Development Bank; International Bank for
Reconstruction and Development.

CARICOM ^Caribbean Community and Common Market.

carry-over Postponement of settlement of >account on the ►stock exchange

until the following period involving payment of a >rate of interest on the account.
Also called contango (^backwardation).

Cartagena Agreement ►Andean Pact.

cartel An association of producers to regulate >prices by restricting output and

competition. Cartels are illegal in the USA but have been promoted by governments
to achieve 'rationalization', as in Germany in the 1930s. They tend to be unstable
because a single member can profit by undercutting the others, while price-fixing
stimulates the development of substitutes. The most prominent example of an
international cartel is the > Organization of Petroleum Exporting Countries. »► olig¬
opoly; prisoner's dilemma.

cascade tax > turnover tax.

cash 1 Coins and ►banknotes. 2 ►legal tender in the settlement of ►debt.

cash flow The flow of >money payments to or from a firm. Expenditure is

sometimes referred to as a 'negative' cash flow. The gross cash flow of a business is
the gross >profit (after payment of a fixed >rate of interest) plus >depreciation
provisions in any trading period, i.e. that sum of money which is available
for >investment, >dividends or payment of taxes. The net cash flow is retained
cash-flow accounting
Lj?
►earnings and depreciation provisions before or after tax (^taxation). Net cash
flows of a particular project are usually defined as those arising after taxes have
been paid, expenditure on repairs and maintenance carried out, any necessary
adjustments made to ► working capital, and account taken of any residual value of
► assets at the end of the life of a project or other miscellaneous income accruing to
the project or business. This term is important in Mnvestment appraisal. 'Cash-flow
statement' is often used synonymously with 'statement of Vsources and uses',
^►budget.

cash-flow accounting >inflation accounting.

cash ratio 1 The ratio of a bank's >cash holdings to its total deposit >-liabilities
(^banking; liquidity ratio). 2 For an individual firm, the proportion of its current
liabilities that are accounted for by cash in hand, including >bank deposits, and
sometimes payments due from customers.

Cassel, Custav (1866-1945) >purchasing-power parity theory.

CBI ^Caribbean Basin Initiative; Confederation of British Industry.

CCA Current-cost accounting (Mnflation accounting).

CD ^certificate of deposit.

CDB >-Caribbean Development Bank.

Celler-Kefauver Act >anti-trust (US).

census A statistical survey covering every member of a ^population; population,

census of; ^sample.

Central American Common Market (CAC M) A common market of four Central

American states - Guatemala, El Salvador, Honduras and Nicaragua - agreed at
Managua, Nicaragua, in the General Treaty of Central American Economic Inte¬
gration signed in December i960. This treaty came into operation in June 1961, and
a headquarters was established in San Salvador. Costa Rica joined in 1963 and Panama
in 1991. >Free trade between the member countries was expected to be established
by June 1966. An agreement on the Equalization of Import Duties and Charges was
made in September r959, and subsequent agreements have established a common
external >tariff. In i96r, the Central American Bank for Economic Integration was
formed to finance industrial projects, housing and hotels in the region. In 1964, the
five >-central banks agreed to establish, in the long term, a common ^currency. The
Common Market suffered a setback by the imposition of import duties on a number
of commodities by Costa Rica in 1971 and Nicaragua in 1978. Little progress has been
made since for the setting-up of the market structures. However, at a meeting in
1990, the members reaffirmed their determination to establish the Market as agreed
at Managua and to reduce the Common External Tariff to a maximum of 20 per
cent. Discussions have been held, in 1996, on a plan for the establishment of a >free
trade area with >CARICOM and, in 2002, for a free trade area with the USA.
Andean Pact; customs union; Inter-American Development Bank; Latin American
Economic Integration; Mercosur; Prebisch, R.

central bank A bankers' bank and Mender of last resort (>Bank of England). All
developed and most > developing countries have a central bank that is responsible
!Ll certificate of deposit

for exercising control of the >credit system, sometimes under instruction from
government and, increasingly often, under its own authority. Central banks typically
execute policy through their lead role in setting short-term interest rates (Mate of
interest) which they control by establishing the rate at which loans of last resort will
be made. Some central banks also use other devices to control i*»money supply (e.g.
such as special deposits) though this is now out of fashion (>capital adequacy).
With an increasing consensus that ^monetary policy plays an important part in
determining ^aggregate demand, the stability of the >business cycle and the rate
of ^inflation, central banks have found themselves in a central role in economic
management. The success of those that operated at arm's length from political
authority - notably in the USA and Germany (>Bundesbank) - has led other nations
to follow in granting independence. The premisses are that the temptation to engage
in >overheating will be diminished if monetary authorities do not have to face an
election every few years, and that ^credibility of policy will be greater if a bank is
in charge. Some independent central banks have more power than others. In the
UK, New Zealand and Canada, the central bank essentially decides on the level of
interest rates, but does so to aim at an ^inflation target set by the government. In
Germany, until recently, and indeed in the constitution of the ^European Central
Bank governing >• European Monetary Union, the bank set its own target. The power
of central banks led one commentator in r996 to assert the Western world was in the
grip of central bankism in reference to the orthodox values most represent. Apart
from their function of making broad economic judgements, central banks (e.g. the
>-Bank of France, the Federal Reserve Bank and the Bank of Canada), control the
note issue (^banknote), act as the government's bank, accept ^deposits from, and
make Moans to, the ^commercial banks and the >-money market, and conduct
transfers of J^money and ^bullion with central banks in other countries. In many
countries the central bank supervises and regulates the commercial banks and other
financial intermediaries but there is a trend now to separate this function from
prudential regulation (>capital adequacy) concerned with the stability of the finan¬
cial system as a whole, as in the UK recently (>Financial Services and Markets Act).
S^Bank for International Settlements; Bank of Japan; Federal Reserve System.

central bank of central banks >Bank for International Settlements; Inter¬

national Monetary Fund; Keynes Plan.

central government ^public sector.

central government borrowing requirement ^public-sector borrowing

requirement.

certificate of deposit (CD) A negotiable claim issued by a bank in return for a

term ^deposit. Certificates of deposit are > securities that are purchased for less than
their face value, which is the bank's promise to repay the deposit and thus offer a
>yield to maturity. The ^secondary market in CDs is made up by the Miscount
houses and the banks in the > interbank market. Where a depositor knows that it is
possible, if necessary, to sell his/her CD, he/she will be willing to place funds with a
bank for long periods. Certificates of deposit were first issued in New York in the
1960s and thus denominated in dollars. Sterling CDs followed in r968. ^parallel
money markets.
certificate of incorporation
Li!
certificate of incorporation A document issued by the Registrar of Companies
certifying the legal existence of a company after certain legal requirements for
registration have been met. ^company law.

certificate of origin A certificate that specifies the country of origin of an export

or import. Such a certificate would be required by a customs authority for such
purposes as determining whether an import should benefit from a preferential
► tariff which may have been agreed with specific countries (e.g. those in a ►free-
trade area or >customs union) or whether, for example, a product is liable to an
anti- >dumping tax. Somewhat different rules may be applied depending on the
purpose for which the country of origin is required to be specified. The ►European
Union, for instance, generally determines origin by the location at which the last
major manufacturing activity took place but applies a somewhat less stringent
definition to some imports from ►developing countries benefiting from the ►gener¬
alized system of preferences. >Customs Cooperation Council.

CCT Capital gains tax (►capital gains).

Chamberlin, Edward Hastings (1899-1967) After a period at the University of

Michigan, Professor Chamberlin joined Harvard as a tutor in 1922 and became a
Professor of Economics there in 1937. His publications include Theory of Monopolistic
Competition (1933), Towards a More General Theory of Value (1957) and The Economic
Analysis of Labour Union Power (1958). In Theory of Monopolistic Competition he pro¬
posed a new emphasis for economic theory which broke away from the old concepts
of pure or ^perfect competition or pure >monopoly. These two cases he saw as
special limiting ones. In between was 'monopolistic competition', which was the
condition under which most industries, in fact, operated. Each firm pursued a policy
of product ►differentiation by special packaging or advertising so that it created a
'penumbra' of monopoly around its product. He also analysed the problem of selling
costs, e.g. advertising, ^monopolistic (imperfect) competition; Robinson, J. V.

chaos theory A branch of mathematics that is concerned with the time path of
►dependent variables in systems of non-linear equations. The odd feature of these
systems is that, even though the observed variable is not random in that it is
governed by a perfectly simple equation, it behaves in a way that looks very chaotic
and unpredictable. This is because, in these systems, very small changes in initial
conditions lead to large changes in the outcomes that result. It makes accurate
long-term forecasting of the variable impossible. The weather is taken as an arche¬
typal chaotic system, and economists have questioned whether certain variables
(e.g. as stock market prices) might not best be understood in the same way.

CHAPS Clearing House Automated Payment System (►clearing house).

charge account (US) ►credit account.

chartist A stock market analyst who predicts share price movements solely from a
study of graphs on which individual ►share prices, price indices and sometimes
trading volumes are plotted. This technique is called technical analysis. Unlike funda¬
mental analysis - which requires the study of financial accounts of companies -
technical analysis is based upon the belief that all the necessary information is in
the share price. In contrast to both chartists and fundamentalists, the adherents of
53 circular flow of income

the ^efficient markets hypothesis believe that stock market prices adjust rapidly
and fully to all information as soon as it becomes available, and that neither existing
nor past price levels are of any help in predicting the future.

cheque An order written by the drawer to a ^commercial bank or >-central bank

to pay on demand a specified sum to a bearer, a named person or corporation.
Although still very important, the use of cheques (in the UK, for example, it peaked
in 3990) is gradually giving way to other forms of >credit transfer, >-credit cards and
electronic payments systems.

Chicago School The free market and monetarist (^monetarism) economic think¬
ing that has been associated with the Economics Department at Chicago University,
and with > Friedman in particular. The Chicago School is most closely associated
with the complementary ideas that: (a) in >• microeconomics, markets allocate
resources most efficiently, and that government intervention should be very limited,
and (b) in » macroeconomics, with the > monetarist thesis that, as monetary growth
causes inflation, discretionary policies to manage >-aggregate demand should be
avoided, and that government should stick to rules aiming at a steady, low rate of
growth of money supply. Common to both beliefs is the idea that the unregulated
actions of private individuals are usually socially benign. For that reason, the school
has tended to argue for a Tight touch' in >competition policy, and has suggested
that most problems of ^monopoly are created by government regulation, rather
than solved by it. The school has also suggested that > vertical restraints are typically
harmless. >►laissez-faire.

CHIPS Clearing House Interbanks Payments System (^-clearing house).

c.i.f. Cost, insurance and freight, or charged in full. The seller of the goods must
pay the costs of carriage to the port of destination specified in the contract of sale
and must, also, insure the goods against loss or damage during transit. The UK
Overseas Trade Accounts record >imports in terms of their value c.i.f. (charged in
full) and exports S-f.o.b. (free on board) or >f.a.s. (free alongside ship). In order to
determine the goods or ^visible trade balance for the >balance of payments
accounts, the import figures are adjusted to an f.o.b. basis. The insurance and freight
element, which accounts for about ro per cent of the total import bill, is included in
the balance of payments as >services (^invisibles).

circular flow of income A simple model of the workings of an economy depicting

the movement of resources between producers and consumers. A number of flows
comprise the circular flow of income: (a) the wages and salaries paid by firms
to > households, and (b) the money spent by households and received by firms.
Corresponding to each of (a) and (b) is a flow of some resource in return - labour is
provided by households to firms; goods and services are provided by firms for
households. There is then a total of four flows in this highly stylized account of how
economies function, and complete symmetry between the two sectors (a) and (b).
Each provides the other with some real resource and each receives cash in return,
and each spends that cash on the supplies of the other. The same cash is spent by
one sector and then the other continuously.
^National income can be measured by either of the two cash flows: total wages
and salaries comprise the income measure, while total household spending comprises
claimant count
I_—
the expenditure measure. These two are different sides of the same coin and, in an
economy where all income is spent domestically, will necessarily be equal to each
other. In reality, there are leakages from the circular flow: >-savings (when money
is received by households but not spent); > imports (where money flows to foreign
firms), and > taxation (when money flows to the government). Each of these 'with¬
drawals', however, gives rise to a corresponding 'injection': >investment, >exports
and government spending (>public expenditure) and, if all markets are in equilib¬
rium, each pair will balance exactly. (Other complications include transactions on
the ^invisible account such as dividend income received from abroad.)
> Macroeconomics can be seen as the study of and extension to the circular-
flow model, removing the unrealistic assumptions underlying it and allowing for
deviations from the equilibrium. >multiplier; Tableau economique.

claimant count A measure of ^-unemployment based on the number of people

out of work and successfully claiming unemployment benefits. Claimant count
measures are useful in that they are quick and cheap to calculate, accurate (without
sample error) and can be used to obtain reliable measures of unemployment at a
very local level. They are, however, inconsistent over time, in so far as they are
affected by changes in benefit entitlement rules. They do not count many people
who would like to work but who, for one reason or another, are not entitled to
benefits. Relative to what some economists consider the real level of unemployment,
they include many people who are not actively seeking work, but who are still on
benefits. »TLO unemployment; Labour Force Survey.

Clark, John Bates (1847-1938) Educated at Amherst College, and Heidelberg

and Zurich Universities, Clark taught at Amherst until, in 1895, he was appointed
Professor of Economics at Columbia University. He held this post until his retirement
in 1923. His major publications include Philosophy of Wealth (1885), Distribution of
Wealth (1899), Essentials of Economic Theory (1907), The Control of Trusts (1901) and
The Problem of Monopoly (1904). He is regarded as the founder of the marginal
productivity theory of distribution in the USA (^distribution, theory of).

Clark, John Maurice (1884-1963) The son of >J. B. Clark. He succeeded his father
to the Chair of Economics at Columbia University in 1926. His publications include
Economics of Overhead Costs (1923) and Essays in Preface to Social Economics (1963).
In an article, 'Business Acceleration and the Law of Demand', Journal of Political
Economy (1917), he formulated the > acceleration principle, one of the basic theories
upon which has been constructed modern dynamic macroeconomic theory
(> macroeconomics).

classical economics The dominant body of economic thinking in the period from
>Smith's Wealth of Nations, which was published in ^76, to >Mill’s Principles of
Political Economy (1848). It was dominated by the work of >Ricardo. The French
> Physiocrats had laid stress on the position of agriculture in the economy, claiming
that this sector was the source of all economic wealth. Smith rejected this view and
drew attention to the development of manufacturing and the importance of labour
^productivity. Ultimately, > labour was the true measure of >value. Ricardo took
up this idea and propounded a theory of relative prices based on costs of production
in which labour cost played the dominant role, although he accepted that >capital
costs were an additional element. Capital was important, not only by improving
 classical unemployment
ffj
labour productivity, but also by enabling labour to be sustained over the period of
waiting before work bore fruit in consumable output. This was the idea of the wages
fund (»-wage-fund theory). Wages were dependent on two forces: (a) the demand
for labour, derived from the availability of capital, or savings, to finance the wage
bill, and (b) the supply of labour, which was fixed in the short run, but in the long
run was dependent on the standard of living. The latter was related to the level of
subsistence. This was not regarded as merely the basic necessities required to keep
the workers alive and to reproduce themselves. It was determined by custom, and
accepted to be increasing as real living standards improved. ^Malthus, in his theory
of population, pointed to the need for restraint because of the presumption that
there was a natural tendency for the growth of population to outstrip agricultural
output. Ricardo analysed the implications of the productivity of land at the margin
of cultivation. The Physiocrats and Smith had attributed agricultural >rent to the
natural fertility of the soil, but Ricardo refuted this. Rent existed because of the
poor fertility of the final increment of land taken under cultivation. Because of
competition, > profits and labour costs must be the same everywhere and, therefore,
a surplus must accrue to all land that was more fertile than that on the margin. This
surplus was rent. The presumption of competition was the foundation of classical
thought. The classical economists believed that, although individuals were each
motivated by self-interest and personal ambition, free competition ensured that the
community as a whole benefited. As Smith put it, 'It is not from the benevolence of
the butcher that we expect our dinner, but from [his] regard to [his] own interest.'
As a consequence, they concluded that government interference should be kept
to a minimum. The classical economists gave little attention to macroeconomic
problems (^macroeconomics), such as the ^business cycle. Most of the classicists
accepted >Say's Taw of markets', the gist of which purported to maintain the
impossibility of any severe economic recession (^depression) arising from an overall
deficiency in ► aggregate demand. (Malthus disputed this. He argued that increased
savings would not only lower consumption but would also increase output, through
increased investment. However, his view was not accepted.) The classical econom¬
ists, including Malthus, held a theory in which savings were equated with investment
through changes in the >rate of interest (>Turgot, A. R. J.). Mill's Principles of
Political Economy (1848) was used as a school text until the end of the nineteenth
century. ^Marshall in his Principles of Economics (1890) assimilated the old classical
economics with the new marginalism of »-Jevons, >Menger and >Walras. The great
controversy that raged in the years of the Depression of the r930s between the late
classical economists and the advocates of deficit spending on public works was
resolved at the time when the classical macroeconomic theory gave way to the
new economic revolution set in train by >Keynes. Classical economics continues
to influence economists, however. (>neo-classical economics; new classical
economics; ^economic doctrines.)

Classical School The tradition of economic thought that originated in >Smith

and developed through the work of >-Ricardo, >Malthus and >Mill down to
^Marshall and >Pigou (>classical economics; neo-classical economics).

classical unemployment A situation in which the number of people able and

willing to work at prevailing wages exceeds the number of jobs available. In short,
the real wage (the price of labour) is higher than that at which the market clears.
clearing banks
I_—
Classical unemployment is explained by any operations of the labour market that
prevent the unemployed bidding down wages until it is profitable for firms to
find jobs for everyone. It contrasts with ►structural unemployment or ►frictional
unemployment that occurs when the prevailing wage is too low to attract some
people into employment. Classical unemployment also contrasts with >-Keynesian
unemployment, although both represent different regimes of ►quantity rationing.
Under classical unemployment, firms are not rationed at all - they can get all the
labour they want and can sell all the goods they produce. Households, however, can
neither sell all the labour they wish nor obtain all the goods they could afford to
buy. »► insider-outsider theory.

clearing banks ^-commercial banks.

clearing house Any institution that settles mutual indebtedness between a

number of organizations, e.g. the ►commercial banks, ►building societies and large
corporate customers of the banks. The UK banks, through the Association of Payment
Clearing Services, have: (a) Bankers Automated Clearing System, which provides bulk
electronic bank clearing; (b) Clearing House Automated Payments System, which now
provides instant clearing for electronic transfers through the ►Real Time Gross
Settlement System, and (c) electronic funds transfer at point of sale (>-credit card).
There are similar institutions in other countries, e.g. the Clearing House Interbank
Payment System in New York. There is also a global system for settling payments that
flow through the foreign exchange markets - CLS Services, set up by the large
banks. There are similar arrangements on the ►commodity exchanges, the ► stock
exchanges OCREST), the > futures ►markets, and for payments in the euromarkets
(►eurocurrency). The clearing house is normally financed by membership subscrip¬
tions and other dues of the market.

cliometrics The 'new' ►economic history in which quantitative techniques

including ►econometrics are used to make interpretations and reconstructions of
the past. Pioneered by Fogel and ►North.

closed economy An economic system with little or no external trade, as opposed

to an open economy, in which a high proportion of output is absorbed by exports and
similarly domestic expenditure by imports, ^international trade.

closed-end fund An ►investment trust or other investment company with a fixed

►capitalization.

closing prices Price of a ►commodity (e.g. ►securities on the ► stock exchange)

at the end of a day's trading in a ►market.

Coase, Ronald (b. 1910) Coase, the winner of the Nobel Prize in Economics in r99r,
is an economist who was born and educated in the UK, but who made his home in
Chicago. He graduated from the London School of Economics, then taught at
Dundee ^932-4), Liverpool (1935—6) and the London School of Economics from r935
to r95i. His great contribution to economics during his life in the UK was an article,
'The Nature of the Firm', Economica {1937), that had been drafted as an undergraduate
essay several years before. It struggled to explain why individuals group together in
firms rather than making contracts with each other for the delivery of specified
 Cobb-Douglas function
!LJ
pieces of work. He couched his explanation in terms of ^transaction costs, the
difficulty that individuals would face in writing contracts and agreeing prices with
each other. His ideas opened up a seam of literature as rich today as ever, and now
commonly associated with Williamson. In the r95os, he emigrated to the USA,
taking up posts at universities in Buffalo (r95r-8) and Virginia ^958-64) before
settling at Chicago Law School until r982. It was in the USA that he made his
second great contribution, loosely labelled the >Coase theorem, which relates to
the efficiency of property rights as a means of allocating resources 'The Federal
Communications Commission', Journal of Law and Economics (a journal he later
edited) in r959, but which is more commonly associated with 'The Problem of Social
Costs' that appeared in the same journal the next year.
Coase's other preoccupations were monopoly and pricing, and it was these that
laid the foundation of his work on property rights. He wrote British Broadcasting: a
study in monopoly (r95o) and The British Post Office and the Messenger Companies (1961).
His output is best measured in terms of quality rather than quantity. His contribution
is to have explained the underpinnings of >market forces more successfully than
anyone of his generation.

Coase theorem A theorem stating that >economic efficiency will be achieved as

long as property rights are fully allocated and that completely free trade of all
property rights is possible. The importance of the theorem is in demonstrating that
it does not matter who owns what initially, but only that everything should be
owned by someone. Trade will place resources in their highest-value occupation
eventually.
The theorem is used to show that a solution to the problem of > externalities is
the allocation of property rights. For example, suppose someone wishes to play loud
music that disturbs a neighbour. It is unfair to allow the music to be played loudly
as this ignores the neighbour's interests; equally, it is unfair to prohibit it altogether
as this ignores his/her interest. Social efficiency requires that the music can be
allowed only if the pleasure given exceeds the displeasure caused to the neighbour.
This efficient outcome can be achieved by giving the right to play the music, but
allowing a neighbour to bribe him/her not to play, an option that will be exercised
if the necessary bribe is large enough. Alternatively, the neighbour could have the
right to enjoy silence, but allow the music to be played for a fee. It does not matter
who has the initial prerogative - both arrangements will lead to music being played
only when the neighbour's displeasure is sufficiently small. The theorem stands as
a classic of modern economics, but has been shown to rely on a number of strong
assumptions that render it of limited practical value, ^^compensation principle,
environmental economics; welfare economics.

Cobb-Douglas function A ^production function or futility function with

special characteristics, proposed by > Wicksell and tested against statistical evidence
by Cobb and Douglas in 1928. For production, the function is Y = A.La.C^, where Y =
output, L = labour input, and C = capital input. A, a and p are constants determined
by technology. If a and p = 1, the production function has constant returns to scale
(^►economies of scale), i.e. if L and C are increased by ro per cent, Y increases by ro
per cent. If a + f is less than r, returns to scale are decreasing; if greater than r,
increasing. Assuming perfect competition in markets, a and f can be shown to be
labour's and capital's share, respectively, of the value of output. Cobb and Douglas
 cobweb model

were influenced by statistical evidence at the time that appeared to show that labour
and capital shares of total output (i.e. >national income) were constant over time
in ^developed countries. They sought explanations for this by statistical fitting
(>least-squares regression) of their production function. There is doubt now
whether, in fact, such constancy of shares is true. The Cobb-Douglas form can also
be applied to futility. Consumer satisfaction or utility is represented by U = AXa1X^2)
where and X2 are quantities of commodities or services consumed (>Euler, L.).

cobweb model This is a simple dynamic >model of cyclical >-demand and

>*supply in which there is a time lag between the responses of producers to a change
in price. Farming, because of the gap between seed time and harvest, is illustrative
of such a model. Consider the diagram (below). >Equilibrium is represented at the
point of intersection of the demand and supply curves at which Q satisfies demand
and supply at price P. Suppose in the following period (1), there is a very poor harvest

0 Pi p3 p price

and supply falls to Qj. At Q,, prices will rise to P2 corresponding to (2) on the demand
curve. Producers then initiate a new production phase influenced by this high price
and in the next period supply Qj (point (3) on the supply curve). But prices must
now fall to P3 (point @ on the demand curve) for all the output to be sold. The
process then repeats itself. (Point (5) on the supply curve, point © on the demand
curve.) It can be seen in the diagram that the path converges to the equilibrium
point Qo, so that the system is stable. However, if the demand and supply curves
were drawn such that the latter was steeper than the former (to the P axis), the
fluctuations in price and quantity would get wider and wider. If the slopes were
equal, the cycle would oscillate around the equilibrium point (^ elasticity; rational
expectations).

coefficient of determination ^multiple correlation coefficient.

—_1 commercial paper

coefficient of variation (CV) A statistical measure that can be used to compare

the volatility of the prices of bassets that have different rates of return in terms of
risk per unit of return. The CV is calculated by dividing the >standard deviation of
the asset prices by the average or expected return on the asset. »*beta.

collateral security A second >security (in addition to the personal surety of the
borrower) for a Moan. >Bank loans, other than ^personal loans, are normally
made against the security of >stocks and >shares, property or ►insurance policies.

collinearity ►correlation between two variables. >► multicollinearity.

collusion Co-operation between independent firms so as to modify competition.

Collusion may be tacit or explicit and may involve fixing prices. In collusive oligopoly
(►oligopoly), where two or more firms produce identical or near-identical products,
levels of price and output may be similar to those obtaining under > monopoly,
^►cartel; prisoner's dilemma.

Colombo Plan for Cooperative Economic and Social Development in Asia

and the Pacific A plan for economic assistance for the >developing countries of
Asia and the Pacific agreed in 1950, originally with special concern for the re¬
establishment of economic activity in the aftermath of the Second World War. The
plan was put on a permanent basis in 1980. There are twenty-six member countries,
all from the Asia and Pacific Region. The Consultative Committee publishes an
annual report describing the economic progress and aims of the developing countries
in the plan and the nature and level of assistance received. The secretariat is in
Colombo, Sri Lanka. »► Asian Development Bank.

commercial banks Privately owned banks operating cheque >current accounts,

receiving ►deposits, taking in and paying out notes and coin, and making Moans,
in the UK through a large number of branches (>banking; bank loan; branch
banking). Sometimes referred to as retail (►wholesale banking) banks or clearing
banks (»-clearing house). In the USA, these banks are sometimes referred to as
member banks (►Federal Reserve System) and in Western Europe as credit banks to
distinguish them from Mnvestment banks. In most countries the commercial banks
are concerned mainly with making and receiving payments, receiving deposits and
making short-term loans to private individuals, companies and other organizations.
The banks increasingly provide a number of other services to their customers: trustee
and executor facilities, the supply of foreign currency, the purchase and sale of
>securities, ►insurance, ►credit transfer, ►personal loan and ►credit card facilities.
The banks have also over the years diversified into other financial services in compe¬
tition with the ►finance houses and the ►merchant banks, e.g. venture or ►risk
capital and the management of ►unit trusts (►universal banks). In the UK, compe¬
tition among the retail banks has intensified as technology has rendered the large
branch network far less important in the delivery of services, and as the division
between different types of financial service has broken down. In r997, to reflect that,
it was announced that a new unified regulatory structure for all types of financial
institution would be created. ►Financial Services Act 1986.

commercial bills >bill of exchange.

commercial paper >promissory note.

commission |_60

commission A percentage of the > value of a transaction taken by an intermediary

as payment for services, e.g. ^broker's commission, or estate agency's commission.

commodity 1 In economic theory, a commodity is a tangible good or service

resulting from the process of production. Differences between commodities, real or
imagined, will determine whether or not they are close > substitutes for one another.
2 In general usage, a primary product, e.g. coffee, copper, cotton, wool, mbber and
tin. ^commodity exchange; international commodity agreements.

commodity agreements ^international commodity agreements.

commodity control schemes ^international commodity agreements.

commodity exchange A >market in which ^commodities are bought and sold.

It is not necessary for the commodities to be physically exchanged - only rights to
ownership need be. The old practice of auctioning commodities from warehouses
in which samples could be inspected beforehand has become less important. An
efficient system of grading and modern systems of communication have enabled
the practice of >'c.i.f. trading' to develop. A buyer can buy a commodity in the
country of origin for delivery c.i.f. to a specified port at which it can be offloaded for
direct delivery to his/her own premises. This method saves warehousing costs and
auction charges. The market not only enables commodities to be sold 'spot' or for
delivery at some specified time and place (>spot market), but it also includes a
market in >'futures'. This latter enables merchants to avoid the effect of price
fluctuations by buying for forward delivery at an agreed price, which will not be
affected by intervening changes in the 'spot' rate (^clearing house). Commodity
exchanges are now being developed which bring together all the relevant business
interests from producer to user into virtual market-places on-line for >business-to-
business >electronic commerce transactions.

commodity stabilization agreements ^international commodity agreements.

commodity tax A levy on the price of a good or service. >direct taxation.

Common Agricultural Policy (CAP) The system of agricultural support adopted

by the >► European Union (EU). The CAP covers about 90 per cent of EU farm output.
The central feature of the policy is that it raises the income of farmers by keeping
agricultural prices to the consumer at an agreed level. 'Target' prices are fixed by the
EU Commission for specified commodities. Import prices are kept above the target
prices by the imposition of levies. 'Intervention' prices for domestic supplies are set
somewhat below the 'target' prices. If sales can only be made on the market below
the 'Intervention' price, the Commission buys into store in order to drive the price
up. The 'Intervention' price may vary from place to place in the EU in order to
induce 'surplus' areas to transport to 'deficit' areas and the Commission may also
subsidize exports in order to keep prices above the Intervention level. For some
commodities there is no intervention system and the EU relies on high import
> tariffs to keep prices high. The accumulation of large surpluses in some commodi¬
ties has led to the use of direct payments to farmers.
Criticism has been made of the high cost of the CAP. In the early 1980s, about 70
per cent of the EU budget was absorbed by agriculture. However, some reforms were
introduced in 1992 including a programme for a reduction in support prices for beef,
 company law

cereals and dairy products coupled with the setting aside to fallow of 15 per cent of
arable land. The agricultural budget is now about 50 per cent of the total EU budget.
These reforms were encouraged by the negotiations leading to the Agricultural
Agreement of the >Uruguay round of trade negotiations in 1993. Further reforms
were agreed in r999 by which support prices for cereals were reduced by rs per cent,
offset by increased compensation payments to farmers. However, with the expected
expansion of the EU by a further ten countries, further reform was proposed by the
Commission in 2002. The central features of these reforms were: (a) the abolition of
subsidies that directly encourage production; (b) the redirection of subsidies to
encourage rural diversification and development, and (c) cuts in direct payments to
farmers and an overall cap on the amount of subsidy received by individual farms.
The total budget would remain the same at about €/n billion.

Common Fund for Commodities >United Nations Conference on Trade and

Development.

common market >Andean Pact; Benelux; Caribbean Common Market; Central

American Common Market; Common Market for Eastern and Southern Africa;
customs union; European Union; Mercosur.

Common Market for Eastern and Southern Africa (Comesa) Countries of

eastern and southern Africa originally signed a treaty which inaugurated a Preferen¬
tial Free Trade Area (PTA) in r982. This treaty envisaged developments leading to the
setting-up of a customs and >monetary union. Consistent with the terms of that
treaty, the PTA was replaced by Comesa in r993, with a secretariat in Lusaka, Zambia.
The aim is to remove all > import tariffs and quotas on trade between members and
to set up a common external tariff, with the ultimate aim of progressing toward the
eventual establishment in 2025 of monetary union. Institutions (e.g. the PTA Trade
and Development Bank and the Comesa Court of Justice) have been set up. Twenty
countries in eastern and southern Africa are members. In 2000, nine member coun¬
tries - Djibouti, Egypt, Kenya, Madagascar, Malawi, Mauritius, Sudan, Zambia, and
Zimbabwe - agreed to the freeing of trade between themselves and the implementa¬
tion of a common external tariff by 2004 with the expectation that other members
of Comesa will join as their economies permit.

community charge >local taxation.

Company Directors Disqualification Act 1986 ^company law.

company law The law governing the establishment and conduct of incorporated
business enterprise. It developed, in the UK, from the ►partnership, and has its
origins in common law and, from the eighteenth century onwards, in a series of
company and other Acts. The first companies were created by royal charter, and the
whole basis of company law is that certain benefits are conferred (in many of these
first instances, that of a ►monopoly) in return for certain obligations. The r720 Act
created the statutory company with ►limited liability, making possible, for example,
the establishment of the early British railway companies. By r825, the expansion of
business had made the creation of companies by separate Acts of Parliament too
cumbersome, and in that year a new Act made it possible to form joint stock companies
by registration with a Registrar of Companies. It was not until r862, however,
 company law
L_2
that limited liability was extended to certain private as well as public companies.
Company law has continued to evolve under successive Acts as the needs of business
have developed and altered. The 1907 Act introduced the distinction between the
►private company and the ►public company. Other laws such as the Prevention of
Fraud Act 1958 also apply to companies (►bankruptcy). Under present law (deriving
principally from the 1948, ^67, r976, 1980 and i98r Companies Acts which were
repealed and consolidated in the Companies Act 1985 and the Companies Act 1989)
there are three classes of company: (a) limited private companies; (b) unlimited
private companies, and (c) public limited companies (pic). Compared with the
two other forms of business unit - the ►sole proprietor and the partnership -
> incorporation confers advantages for financing and, in certain circumstances,
►taxation, in addition to limited liability where appropriate. (An unlimited private
company does not have limited liability, i.e. its owners are responsible for company
debt to the full extent of their fortune.) However, companies, unlike individuals or
partnerships, are obliged to make public certain information about their business.
Both private and public limited companies are obliged to file certain information
for public inspection and to circulate accounts to their shareholders. Until 1967,
certain private companies - 'exempt private companies’ - were not obliged to comply
with all of the accounting and disclosure requirements and under present legislation
there are exemptions for small- and medium-sized companies which are not public
companies. Small- and medium-sized companies are defined in terms of turnover,
assets and employment (small having 50 or fewer employees, and medium, 250 or
fewer employees). From May 2000 the threshold for the statutory audit requirement
for small companies was raised to £1 million.
The amount of information larger companies are required to publish has increased
in successive Companies Acts, and the directors' report must now cover, for example,
employment, exports, employee aggregate remuneration and donations to political
causes or charities. Regulations came into force in 1997 requiring public limited
companies to state, in their annual reports, their payment practice and a figure
representing the average time taken to pay debts. The Companies Act 1976 contained
provisions to speed up the publication of accounts and covered the appointment and
removal of auditors and other matters. The Companies Act 1981 allowed companies to
acquire their own shares under certain circumstances and required them to publish
details of such transactions. That Act also, in a major departure, laid down detailed
schedules for the form and content of the ^balance sheet and profit-and-loss account
(►double-entry bookkeeping) to give effect to the European Community (►Euro¬
pean Union) Fourth Directive harmonizing company law in the EU. All these pro¬
visions remained essentially the same in the 1985 Act. Among other provisions, the
1989 Act requires companies to disclose a holding of more than 3 per cent in another
company. A public company may have an unlimited number of shareholders and
may offer ►shares for public subscription. The nominal value of the allocated share
capital may not be less than £50,000.
Quoted companies are public limited companies whose shares are listed on a
recognized ►stock exchange. Private companies may place certain restrictions on
the transfer of shares, but not offer shares to the public. Company law sets out other
provisions dealing with the powers, appointment, terms and disqualification of
directors (Company Directors Disqualification Act T986), the protection of investors,
including minorities, ownership and control, the regulation of shares, the disclosure
63 compensation principle

of interest in shares, the group accounts prepared by a holding company, winding

up and other matters.

company reserves >Profits retained in the business and set aside for specified
purposes. The various Companies Acts have drawn distinctions between capital and
revenue reserves and undistributable and distributable reserves. Capital reserves are
created when new shares are issued at a > premium over par or when the book value
of existing assets is revalued to bring it into line with replacement costs or when
^►capital gains are made. These capital reserves may later be transformed into issued
capital {>capitalization). Revenue, or distributable reserves, are created by transfers
of undistributed profits into special accounts, out of which a dividend may be paid
in a later year in which the company makes a loss. Reserves of either type may be
converted into capital by a >bonus issue. Provisions are not the same as reserves but
arise out of ^depreciation or allowances made for >liabilities, e.g. provisions for
doubtful debts.

company taxation ^corporation tax.

comparative advantage The idea that economic agents are most efficiently
employed in activities in which their relative efficiencies are superior to others. The
importance of comparative advantage is that it suggests that, even if someone is
very bad at some activity, perhaps even worse than anyone else at it, it could still be
profitably efficient for him/her to pursue it, if he/she is even more inept at other
activities. The idea has been seen as particularly important in explaining >inter-
national trade. Countries should specialize in areas in which they have a comparative
advantage (^division of labour; Ricardo, D.).

comparative cost >international trade; Ricardo, D.

comparative static equilibrium analysis The analysis of markets or economies

in terms of their different ^equilibrium positions, without reference to the process
by which adjustment between equilibria is achieved. Most non-mathematical eco¬
nomics is static in this sense. It consists of comparing diagrams which represent
snapshots of the state of a market at a single moment, and it aims to assess the
characteristics of the equilibrium state and discover the position of a new equilibrium
when some variable is changed. Most >-demand and >supply analysis, for example,
is of this sort. An equilibrium is noted, then the effect of a shift in demand or supply
is analysed, its impact on price and quantity sold determined, and the effect of
demand or supply curves with different slopes can be assessed.
Such analysis omits any trace of the path or speed of adjustment between different
equilibria. In ^perfect competition, for example, firms are assumed to have no
influence on price and be unable to deviate from the going market rate at all, yet by
what process can the market price change? As there is no auctioneer telling every¬
body what price to set, the price-takers themselves must also be the price-setters,
even though this contradicts the basic assumption of the model (**>tatonnement
process). Comparative statics simply ignores problems such as these, ^dynamics.

comparative statics ^comparative static equilibrium analysis.

compensation principle The principle that total economic welfare increases

from a change in the economy, if those who gain from the change could compensate
those who lose from it to their mutual satisfaction. It is not necessary for money
compensatory finance

transfers actually to take place. However, the principle has been criticized in this
respect because, without actual transfers, interpersonal comparisons of >utility of
money are implied. Actual transfers are required if individuals are to reveal the total
worth they place on their gains and losses (»»-economic efficiency). >► Pareto,
V. F. D.; social-welfare function; welfare economics.

compensatory finance >-United Nations Conference on Trade and Development,

competition ^perfect competition.

Competition Act 1980 Competition policy.

competition policy Government measures aimed at stimulating competition and

protecting consumers against ^monopoly. Policy seeks to achieve these aims by:
(a) targeting anti-competitive behaviour such as price-fixing (>-cartel), >-predatory
pricing, >resale price maintenance and > full-line forcing; (b) regulating ^mergers,
and (c) regulating 'natural' monopolies such as gas and water utilities. Another
element in competition policy is, or should be, the promotion of Contestability by
removing Carriers to entry.
There are different views on how competition policy should be handled. On one
side are those who believe in an activist competition policy of the type exemplified
by the US Department of Justice case against Microsoft in the late r99os. This view
is supported by the followers of the structure-conduct-performance (SCP) theory that
the performance of an industry follows from its conduct, which in turn is caused by
its structure (Concentration). On the other side is the more >laissez-faire school
(associated with economists at the University of Chicago (Chicago School)) which
believes that unfettered markets tend to have benign effects, and that even if mon¬
opolies emerge, they will tend to do so where they offer real consumer benefits and
will usually be transient. Recently a synthesis of the different attitudes seems to
have emerged in the main jurisdictions: (a) tough penalties for anti-competitive
behaviour; (b) a discretionary case-by-case approach to the sanctioning of mergers
where consumer benefits can be identified, and (c) a midpoint between intervention
and non-intervention in the case of >vertical restraints.
In the UK, competition policy is upheld by two main bodies: the Office of Fair
Trading (OFT) and the Competition Commission. The OFT is headed by the Director-
General of Fair Trading. The Fair Trading Act 1973 replaced the Monopolies and
Restrictive Practices (Inquiry and Control) Act r9q8 and the Monopolies and Mergers
Act of r965, but generally consolidated this previous legislation, and is supplemented
by various other Acts enforced by the OFT such as the Consumer Credit Act. Under
the subsequent Competition Act r98o, the Director-General could, subject to the
approval of the Secretary of State for Trade and Industry, undertake preliminary in¬
vestigations into anti-competitive practices in any commercial firm and certain
public-sector bodies. On completion of the investigation, the OFT could obtain
undertakings from firms to cease any anti-competitive practices (including mergers)
so identified or, with the approval of the Secretary of State, make a reference to the
Monopolies and Mergers Commission (MMC). Under the Competition Act r998, the
MMC became the Competition Commission (CC). The role of the CC remains to
investigate and report on matters referred to it by the Secretary of State or the Director-
General of Fair Trading or, in the case of the Cegulated utilities, by the appropriate
regulators.
65 competitiveness

Under earlier legislation (>Restrictive Trade Practices Acts), all potentially restric¬
tive agreements between firms had to be registered with the OFT (which could then
refer them to a Restrictive Practices Court to ascertain whether they were in the
public interest). This was a burden to some firms whose agreements were entirely
benign. The new approach is not to register all agreements but to punish heavily
those caught out as being anti-competitive.
The Enterprise Bill published in March 2002 introduces criminal penalties for
individuals who engage in cartels, grants new detection powers to the OFT, and
replaces the mergers code in the Fair Trading Act r973. Ministerial involvement will
end and competition, not the public interest, will be the test applied in investi¬
gations. The CC will itself prohibit mergers which fail the competition test or will
impose some other remedy, in both cases taking account of consumer benefits. The
system of two-tier investigations (by the OFT and CC) continues. The office of the
Director-General of Fair Trading will be abolished and the OFT will operate as a
board of at least four members and a chairman. There will be a new independent
Competition Appeals Tribunal (CAT).
Other countries have various institutions for upholding competition policy. In
the USA, this policy is overseen by the Federal Trade Commission (>anti-trust); in
Germany by the Federal Cartel Office (Bundeskartellamt) and there is a Monopoly
Commission (Monopolkommission) which has an advisory role, and in Italy by
the Competition Authority (Autorita Garante della Concorrenza e del Mercato).
National laws in the > European Union (EU) incorporate Community law but have
yet to be fully harmonized.
At the level of the EU, the European Commission is responsible for competition
policy and reserves to itself the power to investigate larger mergers and other compe¬
tition situations with a 'Community dimension'. The Commission's powers are
principally derived from Articles 85 and 86 of the Treaty of Rome (now renumbered
8r and 82), supplemented by subsequent regulation (such as the merger control
regulation 4064/89) and interpretation. Article 8r forbids cartel arrangements and
Article 82 outlaws the abuse of dominant positions.
The important development of the last decade has been the increasingly inter¬
national character of competition policy. European Union and USA authorities have
dominated, even to the extent of investigating mergers between companies of other
jurisdictions (the EU investigated the merger of the American giants TimeWarner
and AOL in 2000, for example). 3^-complex monopoly; Smith, A.

competitiveness A loose term, popularly used to reflect the ability of a nation to

grow successfully, and to maintain its share of world trade. While there have been
several government White Papers on the subject in the UK, a wide-ranging debate
about it in Europe and the USA and, while league tables of national competitiveness
are regularly produced by reputable business authorities, the term has never
impressed academic economists. It is used as though it refers to the state of the
productive base of the economy, yet attempts to apply a precise definition have
foundered. It either reduces to a measure of how rich a country is, measured by its
>gross domestic product per head of population, or to a measure of the price of
tradable goods expressed in foreign currency (primarily a reflection of the ^exchange
rate). Yet, those who use the term appear to believe they are talking of a broader
concept than either of these. Those who have criticized the growth in usage of the
 complementary goods I 66

term, argue that basic economic theory of ^international trade and ^comparative
advantage makes clear that we should not view the world as a group of nations
competing in a '.►zero-sum game.

complementary goods Pairs of goods for which consumption is interdependent

(e.g. cars and petrol or cups and saucers), are known as complements or complement¬
ary goods, and changes in the demand for one will have a complementary effect
upon the demand for the other. Complements have a negative >-cross-price elasticity
of demand: if the price of one rises the demand for both may fall. Complementary
demand creates difficulties in the application of the theory of > marginal utility,
since it cannot be said that the level of utility yielded by a complementary good is
yielded directly by that good and in isolation, ^substitutes.

complex monopoly A notion of ^monopoly used by the UK >Competition

Commission to characterize an industry even where a market is not dominated by
one firm. Under Section z(i)(c) of the Fair Trading Act 1973, a complex monopoly
situation arises if at least one-quarter of services is supplied by members of a group
of persons who, whether voluntarily or not and whether by agreement or not, so
conduct their respective affairs as in any way to prevent, restrict or distort compe¬
tition in connection with the supply of those services. Complex monopolies have
been found to exist in the brewing and banking industries, ^oligopoly.

compliance cost Expenditure of time or money in conforming with government

requirements. The compliance costs of >income tax will include the cost of record¬
keeping, payments to an accountant, etc. Compliance costs are additional to the
costs of collection, which are borne by the government and may be lesser or greater
than compliance costs. The compliance costs of ^regulation also include the pay¬
ment of licence fees for permission to trade and, for example, the cost of fireproof
doors installed to comply with fire regulations. Paperwork costs from red tape (so
named from the red ribbons formerly used by government departments to tie files
together) have been estimated to be the equivalent of 3-4 per cent or more of the
^gross domestic product in the ^advanced countries.

compound interest The calculation of total interest due by applying the *rate
of interest to the sum of the capital invested plus the interest previously earned and
reinvested. In contrast, simple interest is calculated only on the capital invested.

concealed discount > trade discount.

concentration The extent to which a small number of firms account for a high
proportion of sales or another dimension of economic importance in an industry.
In the USA, the four largest companies accounted, in the early T990S, for over 80 per
cent of output in domestic refrigerators, motor vehicles, electric lightbulbs and
cigarettes (the four-firm ^concentration ratio). In the UK, concentration is high in
multiple food retailing, brewing, banking and other sectors. Industry concentration
is a key determinant in ^competition policy. The two extremes are: (a) ^perfect
competition, in which products are homogeneous and firms small in relation to the
size of the total market (>small business) so that they cannot individually influence
price, and (b) ^monopoly, in which there is a single seller (concentration is abso¬
lute). Most markets in the ^advanced countries have high (^oligopoly) to inter¬
mediate levels of concentration and operate under conditions of ^monopolistic
 confidence interval

competition in which prices, in theory, tend to exceed marginal cost, and where,
even if there is no ^collusion, ^barriers to entry may keep concentration high.
Industry concentration, measured by the Concentration ratio generally increased
in the post-Second World War period, at least until the r970s, though there are a
number of practical and conceptual difficulties in measuring concentration and in
generalizing about trends over time. Some studies have indicated that ^mergers
have accounted for about half of increases in concentration.
Attitudes to concentration among economists vary according to their assessment
of the relative importance of competition, > contestability and economies of scale.
Where the ^optimum scale of output is high relative to the size of the total market,
more competitors might lead to higher costs through lower-scale economies. In
general, however, ^enterprise concentration in a given market is much higher than
>establishment (or plant) concentration, indicating that leading firms have a larger
share of markets than would be necessary for them to operate at optimum scales of
output (though there may be economies in distribution or other aspects of multi¬
plant operation (>-economies of scope)). Larger firms also operate in more than one
product market (^diversification) and this can result in high levels of aggregate
concentration in which a small number of firms have a significant share in economic
output as a whole. Since the r970S, there seems to have been some decline in
aggregate concentration as increased international competition (> globalization)
and other factors have encouraged large firms to focus on core activities and subcon¬
tract more to smaller firms. In the UK, the share of the hundred largest manufactur¬
ing enterprises in total manufacturing net output rose from r6 per cent in r909 to a
peak of 41 per cent in r970 and then declined from the early r98os to 30-35 per cent
in the r990s. There is some controversy about how important national concentration
is, at least in manufacturing, given the extent of actual and potential competition
from imports. Porter has argued that the presence of a number of strong local
rivals, however, is a more important factor in promoting >innovation and dynamic
efficiency than rivalry from firms abroad. Nations with leading world positions,
even in small countries such as Switzerland, often have a number of domestic rivals,
even in sectors with substantial economies of scale. ^-Chicago School.
concentration ratio A ratio calculated to show the degree to which an industry
is dominated by a small number of large firms or made up of many small firms.
There are many ratios that may be calculated, based on turnover, capital employed,
employment, etc., e.g. the ratio of the total capital employed of the top five firms as
a percentage of the industries' capital employed. However, a comprehensive ratio is
the Herfindahl index. This index is given by the sum of the squares of the market
shares of each firm in the industry: H=L„ f2„, where f„ = the market share of firm n,
i.e. the sales of firm n divided by industry sales. A pure > monopoly would take the
value of 1. At the other extreme, if all the firms in the industry had equal market
shares the value would be i/n. concentration.
confidence interval A measure of the likely statistical error in the estimation of
a >parameter. It is a term frequently used in >-econometrics, where a ^sample of
data is used to make a generalization of the relationship between different variables,
e.g. between the level of consumption and the level of income. A sample may imply,
for example, that consumption is equal to 0.8 times the level of income in the
economy. But the sample may naturally deviate from the exact relationship across
confirming house

the whole economy. The more variable the relationship in the sample, the less
certain one can be about the true relationship. A confidence interval expresses the
range of estimates within which it is likely the real relationship lies, e.g. it may be
0.8 ± o.r.
To estimate the confidence interval, one typically assumes the sample is represent¬
ative of the whole population, bar some random deviation. Given the variation
within the sample, one can calculate how many times such random samples would
generate estimates of the parameter outside the confidence interval. Usually, the
confidence interval is expressed as the range within which only 5 per cent of samples
would generate estimates lying outside the range (a 95 per cent confidence interval).
For more precision, one might describe a wider confidence interval, that suggests
the range outside of which only 1 per cent of random samples would generate
estimates. Clearly, the bigger the sample, the more certain one can be of the estimate,
and the smaller the confidence interval. For an estimate of a parameter in any very
large sample, the 95 per cent confidence interval can be calculated as the estimate
±r.96 times the ^standard deviation of the estimate, ^normal distribution.

confirming house An agency in the UK that purchases and arranges the export
of goods on behalf of overseas buyers.

conglomerate (US) A business organization generally consisting of a ^holding

company and a group of subsidiary companies engaged in dissimilar activities.
>► downsizing.

Consolidated Fund Sums standing to a particular account of the >Exchequer (for

which it is often used synonymously) into which the proceeds of ^taxation are
paid and from which government expenditures (^budget) are made. Prior to 1787,
different funds were maintained for various purposes and taxation receipts divided
among them, but after that date the various funds were consolidated, leaving, of
major significance, only the National Insurance Fund, which receives ^National
Insurance contributions and a grant from the Consolidated Fund to meet social
security payments. Consolidated Fund standing services is an item in the UK budget
which includes expenditure authorized by specific legislation. This expenditure (e.g.
the salaries of judges and payments to the ^National Loans Fund for service of the
»-national debt) is paid out of the Consolidated Fund but, unlike ^supply services,
does not have to be voted annually in Parliament.

consolidated stock >consols.

consols Abbreviation for consolidated stock: unredeemable government stock first

issued in the eighteenth century as a consolidation of the ^national debt. Consols
bear an interest of 2V2 per cent and have a total nominal value of £267 million.

conspicuous consumption A term used by Thorstein Veblen (1857-1929) in his

book The Theory of the Leisure Class (1899) to identify that ostentatious personal
expenditure which satisfies no physical need but rather a psychological need for the
esteem of others. Goods may be purchased not for their practical use but as 'status
symbols' and to 'keep up with the Joneses' (»»*-giffen good).

constant prices >real terms.

 consumer surplus

constant returns to scale Meturns to scale.

consumer behaviour >demand, theory of; indifference curve; indifference-curve

analysis; marginal utility; Marshall, A.

consumer credit Short-term Moans to the public for the purchase of specific
goods. Consumer credit takes the form of >credit by shopkeepers and other sup¬
pliers, >credit accounts, ^personal loans and WMire purchase. ^Overdrafts,
moneylenders and other private sources of borrowing are not referred to as consumer
credit, either because they are not tied to the purchase of specific goods or because
they are long-term loans facilities, e.g. ^-mortgages. »banking; finance; finance
house.

Consumer Credit Act A UK Act, passed in 1974, following the recommendations

of the Crowther Committee. The Act tidied up and consolidated legislation in the
field of ^consumer credit, some of which had existed on the statute books since
Victorian times. The Act introduced a licensing system which applied not only to
credit and hire firms such as > financing houses and banks, but to all agencies
connected with consumer credit such as credit brokers and debt collectors. Licences
are issued by the Office of Fair Trading if it is satisfied that the applicant has in no
way infringed any of the consumer protection laws. Group licensing may be granted
to cover the individual members of a professional body that has the authority and
standing to discipline its members; such a licence has, for example, been issued to
solicitors. Regulations may be made under the Act with respect to the content and
style of advertising material or other documents relating to consumer credit, and
also to the way the effective annual Mate of interest is calculated and explained to
the consumer (>annual percentage rate), ^-competition policy.

consumer durables ^durable goods.

consumer good An ^-economic good or >commodity purchased by >-households

for final consumption. Consumer goods include, for example, chocolate or draught
beer consumed immediately as well as >-durable goods which yield a flow of services
over a period of time, e.g. a washing-machine. It is the use to which it is put
that determines whether a good is a consumer good (sometimes referred to as a
consumption good or final good), not the characteristics of the good itself. Electricity,
or a computer bought for the home, are consumer goods, but the same thing bought
for a factory is a »-producer good.

consumer price index Metail prices index.

consumer surplus The amount by which consumers value a product over and
above what they pay for it. Before the phrase was coined by ^-Marshall, the idea of
a surplus of futility over the price paid for a good or service was explored by
>Dupuit in his study of the benefits arising from the construction of public facilities
such as roads and bridges. Marshall explained consumer surplus:

The price which a person pays for a thing can never exceed and seldom comes up to that
which he would be willing to pay rather than go without it: so that the satisfaction which
he gets from its purchase generally exceeds that which he gives up in paying away its price:
and he thus derives from the purchase a surplus of satisfaction. The excess of the price
consumers' expenditure

which he would be willing to pay rather than go without the thing, over that which he
actually does pay, is the economic measure of this surplus satisfaction.

Marshall's surplus is illustrated in the diagram of a >demand curve shown above.

The consumer buys on the market quantity Q,, at a price Pn. However, following
his demand schedule, if only Q, were available, he would be willing to pay P„ if Q,
to pay P2, and so on. If the supplier had a ^monopoly and could practise >-price
discrimination, he could extract as revenue the whole of the area under the demand
curve, i.e. AYOQ,,. However, there is a market price P„, so that the supplier only
obtains P„YOQ„ and leaves the difference XP„Y as a benefit to the consumer. A
difficulty is that as the price falls along Marshall's demand curve, the real income of
the consumer increases. To get a more accurate measure of the benefit of the surplus,
therefore, an adjustment must be made to offset the effect of the difference in real
income at the higher price (P,) and the lower price (Pn) (^Hicksian demand func¬
tion; income effect). Consumer surplus plays an important role in ^welfare econo¬
mics. ^producer's surplus.

consumers' expenditure Consumers' expenditure amounts to about 60 per cent

of the UK’s >gross domestic product. It comprises expenditure by >-households
(including certain non-profit-making organizations). It excludes house purchase
(including charges for services on the transfer of ownership) and major house
improvements, which are regarded as capital expenditure. It includes, however, an
imputed rent for owner-occupied houses and expenditure on durables, e.g. motor
vehicles.

consumers' preference Attitudes which determine consumer choice between

 contestability

alternative ^commodities or groups of commodities. When good X is preferred to

good Y it will have greater futility to the buyer, so that the allocation of expenditure
between these alternatives will, in a > free-market economy, be determined by
consumer preference and their relative >prices. These preferences will, in conjunc¬
tion with the >production function and the prices of the ^factors of production,
therefore, determine the allocation of scarce resources to the production of various
goods. Consumer preferences may change independently with, say, fashion or may
be influenced by ^advertising and other forms of sales promotion as well as by
the availability of new goods arising from technological progress (^technology).
Although preferences are something the economist takes as given, and makes no
►value judgement about, they are assumed to be consistent and rational in certain
ways. >indifference-curve analysis; revealed preference; transivity; von Neuman
Morgenstern utility function; endogenous preferences.

consumers' sovereignty >Resource allocation determined by s-consumers' pref¬

erence rather than by >State planning. In a ► free-market economy consumers vote
with their purses for the pattern of production and consumption they want; the
outcome, however, will be affected by the >income distribution.

consumption The use of resources to satisfy current needs and wants. It may be
measured statistically by the sum of consumers' and government's current expendi¬
ture (including defence expenditure), the remainder of ►national income being
made up by >-investment. However, such statistics may be inadequate in some
cases. For example, expenditure on ►durable goods such as washing machines may
exaggerate consumption, because they have a life of, say, 7 years and therefore are
not entirely consumed in the current period as implied by simply counting the
amount spent on their purchase (>consumption function).

consumption function The relationship between consumption and income. As

income increases, other things being equal, consumption will increase, though not
at the same rate as income in the short term. As income rises, consumers tend to
save proportionately more and spend proportionately less. The exact relationship
between income and consumption only holds constant given a number of assump¬
tions. For example, (a) purchases of >durable goods are related to income in the
stated way, e.g. they are replaced at a rate related to income and not to other factors;
(b) there are no expectations of price changes which might delay or bring forward
consumption; (c) no change takes place in the availability or the cost of credit, and
(d) there is a constant level of >-savings in real terms at any level of income.
(►Inflation could decrease the real value of savings such that consumers react by
increasing their contributions to their savings stock from current income until their
real value has been restored; they then revert back to the previous rate of saving.)
The consumption function was introduced by > Keynes and applied to his analysis
of income determination, ^average propensity to consume; marginal propensity
to consume; multiplier; permanent-income hypothesis.

consumption good ^consumer good.

contango Synonym for >carry-over.

contestability The degree of ease with which firms can enter or leave an industry.
A perfectly contestable industry is one in which, as in ► perfect competition, there are
contingency reserve

no barriers to entry at all. Unlike perfect competition, however, perfect contestability

implies nothing about how many firms currently exist in the industry - it is possible
for an efficient monopolist to exist while no barrier to entry prevents other firms
from competing. Contestability theory was stimulated by Baumol in the early t98os.
He showed that the attractive features of perfect competition could be achieved
merely by the threat to incumbent firms that entry would occur should large profits
be made.
The threat of entry should induce >marginal-cost pricing and efficient pro¬
duction. In practice, entry barriers do exist and, because incumbent firms can often
scare potential entrants away from entering, the discipline that potential compe¬
tition provides is considered less effective than that of actual competitors, ^barriers
to entry; competition policy; sunk costs.

contingency reserve >public expenditure.

contingent protection The use of anti- >-dumping and ^countervailing duties

as insidious devices to protect domestic industry from foreign competition. Under
the various international treaties since the end of the Second World War (W>-General
Agreement on Tariffs and Trade; World Trade Organization) (WTO), considerable
progress has been made in the freeing of >international trade from protectionist
measures (^protection). The application of ^tariffs against products sold by foreign
suppliers below their normal prices or against foreign exports that have received
government subsidy are generally allowed, the purpose of these tariffs being seen as
correcting price distortions in the market without affecting the integrity of free-
market principles. However, there has been a considerable growth in the number of
applications filed, reaching a peak in 2001, and this has led to the suspicion that
tariffs are being used in restraint of trade. Ambiguities can be exploited in the
meaning of 'normal' price and in the difficulties of obtaining convincing data.
Moreover, the need to defend a case is in itself a cost to the accused exporter. An
exporter could be induced to adjust his price simply to avoid a hearing. In 2000, the
WTO found that the US Anti Dumping Act 1916 was contrary to the WTO trade
agreements in that the Act allowed civil and criminal penalties to be imposed in the
US courts on a trader found guilty of dumping whereas WTO rules limit protection
only to the imposition of countervailing tariffs. In 200T, the WTO found that the
>European Union (EU) contravened WTO regulations in the methods it applied in
determining the amount by which products were being sold in the EU below the
prices in the exporter's own market.

continuation Synonymous with >carry-over.

contract A statement of the rights and obligations of each party to a transaction

or transactions. A contract, as familiarly envisaged, is a formal written statement of
the terms of a transaction or relationship, e.g. a house purchase or a pop star's deal
with a record company. But most transactions and relationships are conducted
without a formal contract: the contractual terms that exist when you buy a news¬
paper are simple enough to obviate the need for written terms and conditions,
and many business relationships are based on implicit contractual terms that are
supported not by law but by the mutual interest of the involved parties. An example
might be the obligation of a ^building society to charge a reasonable rate of interest
ilJ convergence

on a variable rate mortgage. While the formal contract that someone may have with
an institution to lend him/her money may not preclude the institution raising its
interest rate to above market levels, there is an implicit contract that it would not
do so. It is in the interest of the building society not to abuse the implicit contract, for
to do so would damage its long-term reputation, ^incomplete contract; tit-for-tat.

contract curve The curve of exchange between two parties along which their
►marginal rates of substitution are the same in relation to the commodities traded.
Any bargain concluded at a rate of exchange other than one on the contract curve
could be improved (i.e. by making at least one party better off without making the
other worse off) by moving to the contract curve. A term introduced by ► Edgeworth.
►Pareto, V. F. D.; >► economic efficiency.

contracting out 1 The practice by governments or firms of employing an outside

agent to perform some specific task rather than perform it themselves. The practice
is defended on the ground that it stimulates competition between companies for
contracts to provide services which might otherwise be run less efficiently in-house.
The Local Government Act rp88 requires authorities either to contract out or to
expose to competition a number of services, including refuse collection, vehicle
maintenance and general catering (^vertical integration). But it is proposed that
this should be replaced by an obligation simply to ensure 'best value' is obtained.
In the public sector contracts are normally awarded after a competitive tender in
which bidders state the price and conditions under which they are prepared to
supply. 2 An employee or employer may contract out of the State Earnings-Related
Pension Scheme (►National Insurance) where alternative pension arrangements
have been made.

control ►separation of ownership from control.

convergence The notion that countries become, or will continue to get closer in
terms of >per capita income (productivity) over time. In principle, one might expect
convergence to occur if poorer countries with lower pay rates attract investment and
thus raise their productivity. In practice, evidence for convergence is mixed. In the
eighteenth and nineteenth centuries Great Britain, followed by the USA and some
other European states, widened the gap between their productivity and that of the
rest of the world. Between the latter part of the nineteenth century and the mid
1930s, there was some convergence in the range and variation of output per capita
in these countries, although none caught up with the USA. After the Second World
War, convergence was resumed, while new members joined the convergence 'club'
with some reduction in the US lead. Since 1970, performance has been variable and
more new members of the club have emerged, including some ►newly industrialized
countries. The convergence hypothesis is controversial and debate has been con¬
fused by differences in the period and number of countries covered, as well as by
differences in what is meant by convergence. The term can be interpreted to mean
a narrowing in the variation between productivity in a group of countries or the
catching up of countries on the leader or leaders. If all countries - including the
poorest >developing countries, rather than ►Organization for Economic Co¬
operation and Development members - are included in the analysis, there has, in
fact, been negative convergence in the recent past (►►least developed countries;
sow's ear effect). The convergence hypothesis is resisted by those economists who
convergence criteria

emphasize the role of internal or ►endogenous factors, and thus the potential role
of government in economic growth, rather than external or exogenous influences
(►institutional economics; endogenous growth theory), ^economic development.

convergence criteria The conditions laid out in the »-Maastricht Treaty, that
were to act as a guide to the suitability of different ►European Union nations to
enter ►European Monetary Union. The criteria held that: (a) the government deficit
should be below 3 per cent of »-gross domestic product (GDP), unless any excess
over that level should be exceptional, temporary and small; (b) that government
debt (►national debt) should not exceed 60 per cent of GDP, or it should be
approaching that level; (c) ^inflation should not exceed the performance of the
three best-performing countries by more than 1.5 percentage points; (d) long-term
interest rates should not exceed those of the three best-performing countries, in
terms of inflation performance, by more than 2 percentage points, and (e) that
the >exchange rate shall have respected the normal fluctuation margins of the
►European Exchange Rate Mechanism for 2 years, without severe tension.

conversion Issue of a new >stock to replace another. This may arise where a
►debenture or ►warrant is convertible into ► equity shares or where holders of
►government stock at or near redemption are offered a new stock in exchange for
existing stock.

convertibility A ► currency is said to be convertible when it may be exchanged

freely for another currency or gold. All foreign >exchange controls were completely
removed by the U K in 1979. The convertibility of US dollars into gold was abandoned
in i97r. ^exchange control; foreign exchange market; gold standard.

convertible debenture stock >debentures.

convexity A characteristic of tastes or technology that a combination of commodi¬
ties is preferable to any one on its own. If someone prefers a slice of bread and half
a gram of butter to either a whole slice of bread or a whole gram of butter, they have
convex preferences. If it is easier to make one car using ten men and ten machines
than to make it using twenty men and no machines or using twenty machines and
no men, the production technology is convex. Convexity implies that combinations
of products are more desirable than extremes. It is itself usually implied by ►dimin¬
ishing marginal utility. It takes its name from the shape of the ►indifference curves
or ►isoquants that convexity generates.
corporate income tax (US) ►corporation tax.

corporate planning A business function concerned with the formulation of

long-term objectives and the development of plans to achieve them. Corporate
planning has become more and more formalized as business units have grown larger
and more diversified. ►Galbraith argued in The New Industrial State (1967) that the
enormously large >capital requirements of modern technology require that the
consumer and the ►market become subservient to the planning needs of the large
corporations which have come increasingly to characterize the modern economy.

corporate venture capital (CVC) Investment in the ►risk capital of smaller

firms by larger firms. Companies' CVC activity usually takes the form of minority
stakes in >equity ►capital for strategic, financial or social responsibility reasons.
 corporation tax

The motivation of these investments is usually primarily strategic: opening windows

on new technologies or markets that might affect the investor's core business. The
main force behind CVC has been technological change but, as in information
and communications (>new economy), the activity is not limited to high-tech
industries. Investors may invest directly or via venture capital funds. CVC is one of
several types of intercorporate relationships that include trade investments, alliances
and >joint ventures.

corporation tax A tax (^taxation) levied on the assessable ^profits of companies

and unincorporated associations after the first £10,000 at the rate of 30 per cent in
the UK in 2002/03. It is calculated after ^interest and all Inland Revenue allowances
(^capital allowances; stock appreciation), but before >-dividend distribution. In
2002/03 the corporation tax rate for companies with taxable profits of more than
£50,000 and less than £300,000 was 19 per cent, with tapering relief up to the full
tax rate of 30 per cent for companies with profits in excess of £r.5 million. In the
USA, companies are liable for corporate income tax, which also has a progressive
element.
Corporation taxes generally can be modelled on one of a variety of forms: (a) the
comprehensive business income tax applies tax to all profits, allowing no deduction for
interest costs - no major country has adopted this form, although US tax authorities
have shown an interest in it; (b) the classical system (used in the USA, Switzerland
and The Netherlands, for example) allows a deduction for interest payments, but
charges tax on all other profits, whether distributed as dividends or not - share¬
holders receiving dividends do then end up paying income tax on profits already
taxed, and (c) there is the so-called imputation system in which some relief is offered
to shareholders to ensure that dividends are not subject to both income tax and
corporation tax. The imputation system was introduced in the UK in April r973, 6
years after corporation tax as such had itself been introduced, but it was in effect
abolished in ^97/98, reverting to a modified classical system. Under the old system,
companies made a payment of advance corporation tax (ACT) of 20 per cent on their
dividend payments. This piece of corporation tax was recognized as a payment of
income tax on dividends by the shareholders who received them. It thus limited the
degree to which profits distributed as dividends suffered both corporation tax and
income tax. Now, however, ACT has been abolished. Companies pay mainstream
corporation tax on all profits, and shareholders also have to pay income tax on any
dividends they receive. Pension funds can no longer reclaim the tax credit.
The rationale for corporation tax is not entirely clear, and ^compliance costs are
high. It was originally introduced in classical form to encourage the retention of
earnings by companies in the hope that this would stimulate ^investment. The
reversion to something closer to the classical system was justified on the same
grounds. Some economists argue that the allocation of capital ^resources is best
determined by the >capital market, and would prefer to see a higher proportion of
dividends distributed and then rechannelled back to investment via the capital
market. Moreover, the possibility of >tax avoidance by individual investors liable
to high rates of tax in close companies has in the past led to the application of special
rules to enforce distributions by these companies, so-called shortfall assessments.
Companies are also liable to corporation tax on ^capital gains in many countries.
Stock relief was available in the UK to companies or individuals between ^74/75 and
correlation ^6

1983/84 to offset the effects of inflationary increases in the value of stocks upon
assessable profits for tax purposes.
Individuals in business on their own (operating on own account) and members
of > partnerships pay income tax on their individual share of total profits (broadly
defined in the same way as for companies). In the USA, certain companies can opt
to be taxed as unincorporated businesses under sub-chapter S.

correlation A statistical measure of the closeness of the variations in the values of

one > variable to the variations in the values of another. The 'correlation coefficient'
is calculated by the following formula:

S(*i - x) (y, - y)
V[Xi(x,- - x)z] VPiCy,- - y)2]
in which x,- and y, are the values of the two variables, X and y are their means
(.^-average); r can take any value between +1 and -r, at which extremes there is
perfect correspondence between the variations of the variables. At the value 0, there
is no correspondence. It should be noted that a value of r close to unity does not
imply a causative connection between the two variables, ^-multiple correlation
coefficient; partial correlation; regression analysis; Slutsky, E.

cost ^opportunity cost.

cost, avoidable >prime costs,

cost, overhead >fixed costs.

cost accounting, costing and cost control Procedures by which the expendi¬
ture of a firm is related to units of output. Cost accounts, while they can be related
directly to financial accounts, are concerned with the detailed elements of >oppor-
tunity costs in identifiable output for purposes of pricing, departmental budgeting
and the control of manufacturing methods, and material and Mabour usage for
these products rather than the overall financial results of the firm's operations.

cost-benefit analysis The appraisal of an investment project that includes all

social and financial costs and benefits accruing to the project. The techniques
adopted in order to evaluate and decide whether a proposed project should proceed
- whether, that is, its benefits would exceed its costs - are the same as applied
in >investment appraisal (>discounted cash flow; present value). However, the
valuation in money terms of the social or welfare costs and benefits (^welfare
economics) presents special problems, e.g. the costing of the loss of an area of
outstanding natural beauty or the valuation of the benefits arising from the reduction
in road accidents due to the construction of a motorway. In other cases, the market
prices prevailing may not be appropriate. For example, the real cost of labour may
be much lower than the going wage rate, because of very high unemployment. The
^opportunity cost (which is the cost that matters in cost-benefit appraisals) is lower
and, therefore, a >shadow price is used to represent this low opportunity cost in
place of the wage rate. Similarly, the rate of interest at which the future time streams
of costs and benefits are discounted has to be chosen with care. >interest, time
preference theory of; quality-adjusted life years; risk assessment.

cost centre ^management accounting.

nJ_ cost schedule

cost control ►management accounting.

cost curves The graphical representation of cost schedules, ^average costs or

►marginal costs, dependent on various levels of output or production.

cost of capital ^capital, cost of.

cost-of-living index »-retail prices index.

cost-plus A method of setting a price in which the contractor charges the actual
cost of the goods he supplies or for the work he carries out, plus either a percentage
or an agreed absolute amount for his services. Used for some government contracts,
the cost-plus formula provides no incentive for the contractor to keep his costs to
the minimum and, where a percentage service charge is applied, he actually has an
incentive to inflate them. The justification for the cost-plus system is that for certain
kinds of work (e.g. development contracts in large technical projects) it is not
possible to estimate costs in advance.
Cost-plus is also often used in business as a method for calculating prices (e.g. in
retailing) by adding a > gross margin or mark-up to the bought-in cost of goods,
where there may be no simple alternative. This is in contrast to the pricing described
by traditional economic theory, which asserts competitive forces should lead ►mar¬
ginal cost to be equal to ►marginal revenue. But because, if one retailer charges
more than another he may lose custom and be obliged to reduce his margins or go
out of business, >price theory (M>-firm, theory of the) is not invalidated by the
widespread use of the cost-plus method.

cost-push inflation >Inflation induced by a rise in the costs of production of

goods and services. Such cost increases may arise abroad and be transmitted through
higher prices of imported raw materials and then be fed by higher wage costs as
workers try to prevent inflation eroding the real value of pay. The rapid escalation in
oil prices in the r97os (> Organization of Petroleum Exporting Countries) accelerated
price inflation in the period, although the rate of inflation had begun to rise before
this. Cost increases may also arise within the domestic economy from firms
attempting to increase profits and/or employees to increase their earnings. Success
in achieving increases depends on their degree of market dominance (►monopoly)
and, therefore, bargaining power. Any money gains greater than >productivity will
tend to result in price increases. Economists assert that money wage increases
exceeding 4.5 per cent annually, on average, are inconsistent with an > inflation
target of 2.5 per cent. The cost-push argument for inflation is traditionally held to
contrast with ►demand-pull inflation and has been associated with the different
policy prescriptions (►►prices and incomes policy). However, cost push cannot lead
to sustained inflation, in the long run, without monetary growth being sufficient to
support it. ►►monetarism.

cost schedule A table showing the total costs of production at different levels of
output and from which ►marginal costs and ► average costs can be calculated and
cost curves drawn. A price schedule, in a similar way, would give information about
prices at different levels of sales or output. Cost and price schedules are basic tools
in economic theory, though in practice they are not easily constructed, especially
over wide ranges of output where the ^production function may not be linear.
costing Lz!
costing >cost accounting,

costs, fixed »-fixed costs.

costs, historical or historic Actual costs at the time incurred. An >asset in the
^►balance sheet at historical cost is shown at the price actually paid for it, even
though it might be worth more or cost more to replace, ^-depreciation.

costs, prime >prime costs.

costs, selling The expenses incurred in creating or maintaining the >market for
a product. Distribution costs are normally excluded, but ^advertising sales staff,
sales campaign costs and sales office expenses are included.

costs, supplementary ^supplementary costs.

Cotonou Agreement An agreement, signed in Cotonou, Benin, in 2000, between

the >European Union (EU) and the African, Caribbean and Pacific (ACP) group of
countries, which superseded the >Lome Convention which expired in that year.
The signatories comprised the fifteen countries of the EU and seventy-seven ACP
countries, of which forty were designated as >least-developed countries (LDCs).
The ACP countries cover forty-eight countries in Africa with a population of 609
million, fifteen countries in the Caribbean with a population of 23 million, and
fourteen countries in the Pacific with a population of 7 million which, with the
fifteen countries of the EU add to a total population of about 1 billion. The agreement
is for a period of 20 years with an opportunity for adjustment every 5 years. The
signatories were committed to the reduction of poverty within a framework of good
governance, democracy and co-operation. The implementation of the agreement
was made the responsibility of a Council of Ministers, supported by a Committee of
Ambassadors and a Joint Parliamentary Assembly. Economic Partnership Agree¬
ments (>free trade) for the abolition of tariff barriers between the EU and ACP states
and groups on a reciprocal basis are to be negotiated from 2002 with the intention
that they come into operation in 2008, with transitional periods of up to 12 years. A
review of progress will be undertaken in 2006. Meanwhile, the non-reciprocal trade
preferences granted to ACP countries by the EU under the Lome Agreement will be
maintained. The EU will provide €r3.5 billion through the European Development
Fund plus a residual balance of €9.9 billion underspend from the Lome Agreement
for the support of private-sector activity and the provision of capital for long-term
development. Special consideration will be given to the forty LDCs. In particular,
the EU agreed to liberalize all trade with the LDCs, though with special arrangements
for some agricultural products.

Council for Mutual Economic Aid (Comecon) A council set up in r949 consisting
of six East European countries - Bulgaria, Czechoslovakia, Hungary, Poland,
Romania and the USSR - followed later by the German Democratic Republic (1950),
Mongolia (1962), Cuba (r972) and Vietnam ^978). Its aim was, by means of central
planning (>planned economy) to develop the member countries' economies on a
complementary basis for the purpose of achieving self-sufficiency. In r99o, agree¬
ment was reached for a fundamental change in the economic policy pursued by
Comecon. Multilateral co-operation between member states based on 5-year plans
and inconvertible roubles (^convertibility) was to be abandoned in favour of a
nJ Cournot, Antoine Augustin

>free market, bilateral trade and convertible currencies. In 1991, Comecon was
replaced by the Organization for International Economic Cooperation, which would
continue to encourage international trade between the member countries on a
bilateral basis and offer advice and information on regional economic problems.

council tax A tax designed to finance a proportion of UK local government

spending. It was introduced as a replacement to the community charge or poll tax
in t993. It is a tax on the occupation of property (in contrast to the old rates, which
typically taxed the ownership of property), with the amount to be paid loosely
determined by the market price of the occupied property. All dwellings are put into
eight bands based on their values, and all homes in each group within a council
jurisdiction are charged the same amount. The banding system obviates the need
for periodic revaluation of properties. Homes occupied by only one person receive
a discount. Council tax is normally paid in ten monthly instalments. Business
occupiers of property continue to pay rates (>i*Tocal taxation).

counterparty risk The risk in securities trading that the other party (counterparty)
to a purchase or sale may fail to discharge his obligation.

counter trade A form of >-barter in ^international trade in which the buyer

requires the seller to accept goods (of the buyer's choosing) in lieu of currency. The
seller has the task of marketing the goods. Another form of counter trade is the
agreement by a seller of plant and machinery to 'buy back' the products produced
by the plant and machinery in settlement of the debt.
Counter trade developed rapidly as a favoured trading method by Communist
states and by ^developing countries with non-convertible currencies (^convert-
ability) and a shortage of foreign exchange. Counter trade may take the form of the
exchange of one commodity for another or the exchange of a mixed selection of
commodities. Multinational firms and banks have specialist divisions to advise on
counter trade and firms have been established specializing in the giving of advice
on conducting counter trade.

countervailing duty An additional import duty (^tariffs, import) imposed on a

> commodity to offset a reduction of its price as a result of an export subsidy in the
country of origin, ^contingent protection; dumping; export incentives.

countervailing power The balancing of the market power of one economic group
by another. The concept was advanced by ^Galbraith in the first of his books -
American Capitalism (1952) - on the domination of the modern economic system
by large firms along with ^economies of scale and technological development
(>-technology) and the need for planning, to meet the criticism that this system of
^monopolistic competition is inferior to ►perfect competition. The power of large
manufacturers was, he suggested, balanced by that of large retailing groups, the
power of large employers by that of the trade unions.

coupon A piece of paper entitling the owner to ►money payment (as in ►bearer
bonds), cut-price or free goods (gift coupons) or rations.

Cournot, Antoine Augustin (1801-77) Cournot was made Professor of Analysis

and Mechanics at Lyons in 1834, Rector of Grenoble University in 1835 and of Dijon
University in 1854. His main economic work, Recherches sur les principes mathematiques
cover |_80

de la theorie des richesses, was published in 1838. Other economic works were Principes
de la theorie des richesses (r863) and Revue sommaire des doctrines economiques (1877). In
Recherches, Cournot set out in mathematical form the basic apparatus of the theory
of the firm (>firm, theory of the) that, after being refined by >Marshall, appears in
elementary economic textbooks today. He was the first to set out: (a) the >variables
and functions facing a firm; (b) >demand as a diminishing function of >-price, and
(c) >cost curves and revenue curves. By the use of calculus he demonstrated that a
monopolist will maximize profit at the output at which > marginal cost is equal
to >marginal revenue. Cournot traced a direct logical line from the single seller
(►monopoly) through two (>-duopoly) or many (>oligopoly) sellers to 'unlimited
competition'. He showed how, in the last case, 'the marginal cost equals the marginal
revenue relationship of the monopolist' becomes 'the price equals the marginal cost
relationship of the firm in ►perfect competition'. In doing so, he analysed the
situation of duopoly and showed that, given that each seller assumed the other's
output was unaffected by his own, they would each adjust prices and output until a
position of ►equilibrium was reached, somewhere between that reflected by the
equations for monopoly and that for unrestricted competition (►Bertrand compe¬
tition). In spite of the undoubted significance of his work, he had no influence on
the mainstream of economic thought until his ideas were developed by Marshall.

cover The ratio of total to distributed >-profit of a limited company. A ►dividend

is said to be twice covered if it represents half the earnings of the company.

covered bear xbear.

CPP Current purchasing power (> inflation accounting),

crawling peg ^exchange rate.

credibility A measure of the expectation of the population that the government,

or monetary authorities, will adhere to policies delivering low ^inflation. It is an
important article of faith among macroeconomists that where people - particularly
those negotiating wage deals - expect inflation to be low, it is much easier to keep
inflation low. But if the monetary authorities have little credibility, and inflation is
anticipated, then people will factor inflation into their behaviour and will, for
example, demand higher pay rises. Those pay rises will be inflationary, or at least
make it costly for the authorities to keep inflation low. By sticking to rules on how
much money is in the economy (►medium-term financial strategy), or by delegating
authority over ►money supply to an independent Xcentral bank with no incentive
to print money, credibility can to some extent be enhanced. The usual measure of
credibility among economists is taken as the market ^interest rate on long-term
loans: if that rate is high, then it can be assumed the market anticipates inflation
will occur in the future, and hence extra compensation is required for those who are
lending, ^inflation target; monetary policy.

credit The use or possession of goods and services without immediate payment.
There are three types of credit: (a) consumer credit: credit extended formally and
informally by shopkeepers, ►finance houses and others to the ordinary public for
the purchase of consumer goods (^consumer credit); (b) trade credit: credit
extended, for example, by material suppliers to manufacturers, or by manufacturers
to wholesalers or retailers (>► trade credit) - virtually all exchange in manufacturing
 credit guarantee

industry, services and commerce is conducted on credit, and firms may provide
small discounts on accounts settled within, say, r month - and (c) bank credit: credit
consisting of Moans and ^overdrafts to a bank's customers (^banking).

I Credit enables a producer to bridge the gap between the production and sale of
goods, and a consumer to purchase goods out of future Mncome. Bank and other
kinds of credit form part of the > money supply and have considerable economic
importance.

credit account 1 An account against which purchases may be made and paid
monthly (US = charge account). 2 A form of revolving >instalment credit offered
by some retail stores in which the consumer makes fixed regular monthly payments

I into an account and receives in return credit to purchase goods up to the limit of a
certain multiple of the monthly payments, normally 8 or r2. A service charge, which
is, in effect, an > interest charge, is normally made as a percentage of the value of
each purchase. 3 Bank and agency >credit cards in which the consumer pays his
account monthly are also a form of credit account.

credit banks ^-commercial banks.

credit card A plastic, personal magnetized card with the name and account

I number of the holder and the expiry date embossed. Purchases up to a prescribed
limit may be credited on signature of a voucher franked by the card. The vendor
recovers the cash from the issuer of the card (less > commission) and the purchaser
pays the issuer on receipt of a monthly statement. For most cards, the purchaser has
the option of paying a minimum amount and settling the account in instalments,
plus interest. The use of credit cards has increased rapidly and in the UK the number
of transactions now exceeds those of ^cheques by about 40 per cent. Credit card
lending accounted for over 30 per cent of UK consumer credit outstanding in 20or.
A debit card works in the same way as a credit card, but the holder's bank account is
debited immediately through Electronic Funds Transfer at a Point of Sale. Credit
cards, popularly referred to as plastic money, are issued by banks, >building societies
and other organizations, including retailers (charge cards). Cards issued by financial
institutions often serve also as cheque cards and may be used to withdraw cash from
an automatic teller machine. A cheque card guarantees cheques, up to a specified
limit, drawn on a customer's account. The recipient of the cheque notes the cheque
card number on the back of the cheque, payment of which is then guaranteed by
the bank. Smart cards contain information about the holder in a microchip in the
card and can, for example, validate the holder's personal identification number,
improving security compared with an ordinary credit card.

credit guarantee A type of insurance against default provided by a credit guaran¬

tee association or other institution to a lending institution. Credit guarantees enable
otherwise 'sound' borrowers who lack ^collateral security, or are unable to obtain
loans for other reasons, to obtain the credit they require through banks in the
normal way. A government loan guarantee scheme insuring loans to small firms by
the ^commercial banks was introduced in the UK in 1980. Finder this scheme the
government guarantees repayment to the bank of 70 per cent of the loan in return
for an annual premium of r.5 per cent on the guaranteed portion for variable rate
loans. Loans are for a period of 2-7 years. All ^European Union member states
credit sale

(except Denmark), the USA, Japan and other countries have similar schemes. ^Ex¬
port Credits Guarantee Department.

credit sale Consumer credit.

credit transfer, or giro A system in which a bank or post office will transfer
>money from one account to another on receipt of written instructions. Several
accounts (e.g. >households or trade bills) may be included in a list which must state
the location or account numbers of the payee. Standing orders for giro transfer of
regular payments may be made. Credit transfers - which have been used by post
offices in continental Europe for many years - were first introduced into the UK by
the Commercial banks in r96r and the Post Office in r968. Benefits to the customer
include the saving on stamp duty payable on Cheques (since abolished in the UK)
and economies in accounting procedures, though banks may make a charge for each
item transferred.

credit union 1 A non-profit organization accepting deposits and making loans,

operated as a co-operative often run by volunteers aimed at the poorer sections of
the community without >bank or ^building society support. Credit unions in the
UK are regulated by the Credit Union Act 1979 and their activities have remained
restricted there with less than 1 per cent of the population being members. They are
much more active in other countries, e.g. the Republic of Ireland, the USA and
Australia. 2 A mutual Cavings bank (>mutual company).

creditor One to whom an amount of money is due. A firm's creditors are other
firms, individuals and perhaps the government to which it owes money in return
for goods supplied, services rendered and taxes for which it is liable, respectively.
Antonym of >debtor.

creditor nation A country with a >balance of payments surplus. The >Keynes

Plan recognized that ^disequilibrium in international payments was as much the
responsibility of creditor as of debtor nations. Under that plan, the International
Clearing Union or international Central bank would have given >overdrafts to
debtor countries and, by so doing, would have created deposits for the creditor
countries in terms of its special Currency called Cancor, in a similar way to
normal Canking operations. However, ^interest would be charged not only on
the debtors' overdrafts, but also on the creditors' deposits. Although the Keynes Plan
was not accepted at the >Bretton Woods conference, the principle that a surplus
country had 'obligations' was accepted and a scarce-currency clause written into the
^International Monetary Fund agreement, ^international liquidity.

CREST Electronic share settlement system introduced to the London >stock

exchange in 1996. By recording title to shares electronically it reduces the cost of the
traditional system of Chare certificates sent through the post. Title is recorded
through nominee companies set up by ^stockbrokers and others. However, share¬
holders may continue to hold paper certificates if they wish.

critical-path analysis A method of structuring the sequence of work on a project

to minimize the duration of work on the whole project. Between the start of a project
and its finish there are a number of separate tasks which have to be done in particular
sequence: in the construction of a house, for example, the foundations are laid
 currency

before the walls. The foundations are on the critical path because every extra day
spent on them means an extra day on the whole building project. Other tasks may
be carried out simultaneously, such as the fitting of window frames as the roof is
being tiled. Critical-path analysis attempts to order all tasks, minimizing the time
that resources are spent idly waiting for other tasks to be completed. The critical
path is the sequence of tasks - mostly those that have to be finished in a particular
order - that affect the overall length of the whole project. The window frames, for
example, may not be on the critical path, as fitters can install them while other work
goes on, and there is probably some flexibility in when the windows can be fitted.
Management is better devoted to focusing on keeping the foundations part of the
project working smoothly, rather than the window frames.

cross-price elasticity of demand The proportionate change in the quantity

demanded of one good divided by the proportionate change in the price of another
good. If the two goods are Substitutes (e.g. butter and margarine), this elasticity is
positive. For example, if the price of margarine increases, the demand for butter will
increase. If the goods are complementary (^complementary goods) (e.g. pot plants
and flower pots), this elasticity is negative. If the price of pot plants rises, the demand
for flower pots will fall, ^elasticity of substitution.

cross-section analysis Statistical analysis of the members of a >population at

one moment. It contrasts with >time-series analysis, in which the population
is drawn from a number of time periods (generally months, quarters or years),
^econometrics.

cross-subsidy Financing a loss-making line of business with profits made else¬

where. This may be motivated by private business concerns (to help establish new
lines of business, for example), or those of public policy (the provision of rural bus
routes at the expense of urban ones). It can be an important object of public policy
to prevent it where it provides the means by which ^predatory pricing can occur,
^►subsidy.

crowding-out The process by which an increase in government borrowing dis¬

places private spending. If an increase in government borrowing has a large effect
on interest rates, private spending will fall as investors slim down their plans.
Therefore, overall, spending will not increase much. If the government borrowing
has no effect on interest rates, however, then there will be no reduction in private
spending and aggregate demand will rise by the full amount of the increase
in government spending. ^►IS—LM model; Keynes, J. M.; monetarism; Ricardian
equivalence.

cum dividend With >-dividend; the purchaser of a security quoted 'cum dividend'
is entitled to receive the next dividend when due. The term cum, meaning 'with', is
also used in a similar sense in relation to >bonus issues, >• rights issue, or ^interest
attached to ^securities, etc.

cumulative preference shares ^preference shares.

currency Notes and coin that are the 'current' medium of exchange in a country
(>money supply). Gold and national currencies that act as >reserve currencies (e.g.
the dollar) are referred to as international currency because they are regarded as
currency appreciation
Lfi
acceptable for the settlement of international X-debts. ►►banknote; exchange con¬
trol; exchange rate; soft currency.

currency appreciation The increase in the ^exchange rate of one ^currency in

terms of other currencies. The term is usually applied to a currency with a floating
rate of exchange; upward changes in fixed rates of exchange are called revaluations.
For example, sterling appreciated from US$1.70 in 1977 to 2.40 in r98o, from r.r6 in
t984 to 1.89 at the end of T987, and from r.48 in r993 to r.65 in T997. As can be
seen, these short-run appreciations were against the background of a long-term
depreciation of sterling against the dollar, -•►currency depreciation; devaluation;
exchange rate.

currency board A national body charged with maintaining a fixed ^exchange

rate by expanding or contracting the issue of domestic currency in line with holdings
of foreign currency and other liquid assets. Unlike a >-central bank, a currency board
cannot simply issue new domestic currency without one-to-one backing, or act as a
blender of last resort. Currency boards link their domestic currency to a foreign
currency as, for example, the exchange-rate peg to the US dollar maintained by the
Hong Kong Currency Board.

currency depreciation The fall in the >exchange rate of one ►currency in terms
of other currencies. Usually applied to floating exchange rates. Downward changes
in fixed rates of exchange are called ^devaluations. A depreciation makes imports
more expensive in terms of domestic currency, and exports cheaper. However, in so
far as a currency depreciation simply reflects a relatively high level of domestic
inflation (e.g. if a ro per cent rise in prices leads to a ro per cent fall in the currency), the
real exchange rate has not changed. Indeed, if inflation occurs without a depreciation of
the currency, in real terms the currency has appreciated because the price of imported
goods will be relatively lower than domestic goods than before the inflation, and
the price of exported goods will have risen compared to foreign ones. ^currency
appreciation; J-curve.

currency school ►banking and currency schools,

currency snake ►European currency snake,

currency, trading >trading currency.

current account 1 The most common type of bank account, on which >deposits
do not necessarily earn >interest, but can be withdrawn by >cheque at any time
(US = demand deposit). The bank charges according to the number of cheques cleared
through the account and the credit balance. If the average balance is high, the
customer may pay no bank charges. 2 That part of the ►balance of payments
accounts recording current (i.e. non-capital) transactions.

current assets >assets.

current balance The net position on the current account of the ►balance of
payments.

current budget In the UK, a measure of government borrowing that compares

total revenues to total spending minus investment spending. If the current budget
is in deficit, it means the government is borrowing more than it is investing, which
85j customs union

implies that it is borrowing simply to sustain consumption spending. Under the

►golden rule of government finances - that government should only borrow to
invest - the current budget should be in surplus or in balance.

current-cost accounting ^inflation accounting.

current expenditure Expenditure on recurrent (i.e. non- >capital) items in

business or private accounts.

current liabilities ^liabilities.

current prices ►Prices unadjusted for changes in the purchasing power of money.
Whether prices are in current or constant terms in historical series of economic
statistics is of great importance at times of >inflation or ►deflation. >*real terms.

current purchasing-power accounting ►inflation accounting.

current ratio The ratio of the current ^-liabilities to the current >assets of a
business. Current assets normally exceed current liabilities. The difference between
the two is >working capital, which is normally financed from long-term sources.
The amount of working capital required varies with the type of business and its
commercial practices (e.g. on the proportions of its output sold for cash and on 3
months' ►credit) so that the current ratio is not a universally useful guide to the
solvency of a business, ^capital; liquidity.

current yield ►yield.

Customs Cooperation Council An international council established in r9so with

a secretariat in Brussels, for the development of agreed rules for the application of
customs procedures and the provision of advice and assistance. The council has
established a classification of commodities for the application of customs ^tariffs
to international trade.

customs drawback The repayment of customs duties (>tariffs, import) paid on

imported goods which have been re-exported or used in the manufacture of exported
goods.

customs duties ►tariffs, import.

customs union A union established within two or more countries if all barriers
(e.g. > tariffs or ►quotas) to the free exchange of each other's goods and services are
removed and, at the same time, a common external tariff is established against
non-members. This contrasts with a ►free-trade area in which each member country
retains its own tariffs vis-a-vis non-members. At one time, it was generally accepted
that customs unions unambiguously yielded economic benefits. Without the distor¬
tions imposed by tariffs, trade was directed in favour of the producer with advantage¬
ous costs (►Ricardo, D.). It was believed that as ►free trade was itself beneficial in
that it led to the optimal allocation of world resources, so a customs union, which
was a step in that direction, must also be beneficial. However, Viner, in The Customs
Union Issue (r95o), pointed out that in the creation of a customs union there could
be two effects: (a) a trade-creating effect, and (b) a trade-diversion effect. Although
(a) might be a gain, greater losses might be incurred by (b). Take the example of two
countries A and B and the rest of the world C producing a particular commodity for
£50, £40 and £30 respectively. If the home market of A is protected by a £25 tariff on
cycle, trade |_86

the item, then no one in A will find it economic to import from B or C. Production
in A will occur, at £50. If A then forms a customs union with B, trade will be created
because it is cheaper for A to obtain the commodity from B than to produce it itself.
There is a gain in so far as A is £ro better off. On the other hand, if A's original import
duty had been £15, trade would then have taken place with the rest of the world C,
despite the tariff, as this would be the least-cost source to A. In this example, if A
forms a customs union with B it will now switch its trade because it can obtain the
commodity for £40 from B compared with £30 + £15 = £45 from C. This trade diversion
represents a move away from the optimum of >-resource allocation, because B
is a higher real-cost source than C (^second best, theory of). Whether, therefore, a
customs union will yield overall gains from shifts in the location of production will
depend on the superiority of trade creation to trade diversion. However, this type of
analysis covers only a part of the problem; many other factors must be taken into
account in assessing whether a customs union is beneficial. In particular, the removal
of tariff barriers between countries will change the >-terms of trade and therefore
the relative volumes of the different commodities demanded, because of the price
changes. It will shift the commodity pattern of trade as well as the geographical
origins of the commodities traded. Whether a community will finish up better off
therefore depends on the price and income elasticities of demand for the commodi¬
ties traded (>elasticity). An added benefit may accrue because the increase in the
size of markets may enable >economies of scale to be made. Finally, a protective
tariff is initially imposed because home costs are high, but home costs may remain
high because a protective tariff is imposed. Removal of the tariff may induce more
efficient operation and lower costs. ^-Association of South East Asian Nations;
Benelux; Caribbean Common Market; Central American Common Market; Euro¬
pean Free Trade Association; European Union; Latin American Integration
Association.

cycle, trade ^business cycle.

cyclically adjusted budget deficit A measure of government borrowing at any

period, that attempts to strip out any effect of a strong or weak economy on the
government's financial position. If the actual deficit is, for example, 3 per cent of
national income, but the economy is in a serious recession, the 3 per cent may not
be regarded as seriously imprudent. The cyclically adjusted budget deficit, also
referred to as the structural budget deficit, is a measure of what government borrowing
would be in the absence of any > output gap, or in the absence of any ^built-in
stabilizers.

cyclical unemployment Temporary >unemployment resulting from lack of

^aggregate demand in a downswing in the ^business cycle.
 D

data-mining The practice of searching for ^-correlations in data with the purpose
of generating theoretical hypotheses. The normal pattern of scientific research is for
hypotheses to be produced by abstract models and then validated by ^empirical
testing. Data-mining reverses the procedure. It is not held to be a respectable
mode of inquiry because, while any theories it produces will be empirically valid, it
is hard to tell whether they are the result of coincidence or not. All data are bound
to wrap up some coincidences, and the data-miner is likely to have unearthed
these. For example, a data-miner might unearth a theory that people whose names
start with the letter H tend to be richer than average. But this would not be remarkable
if discovered in data, as at least one letter group must have higher than average
income. The theory would only be convincing if there was some prior reason for
believing it that was subsequently substantiated by data analysis. »mull hypothesis;
regression analysis.

dated securities >-bonds, >bills of exchange or other ^securities that have a

stated date for redemption (repayment) of their nominal value. Short-dated securities
are those for which the ^redemption datejs near; long-dated securities are those for
which it is a long time ahead.

DCE ^domestic credit expansion.

d.c.f. Discounted cash flow (^present value).

deadweight debt A >debt incurred to meet >current expenditure, or which for

any other reason is not covered by a real >asset. Most of the ^national debt is
deadweight debt since it was incurred to finance war and other current »-public
expenditure.

deadweight loss 1 A particular loss in Asocial welfare deriving from a policy

or action that has no corresponding gain. Deadweight losses represent economic
inefficiency (^economic efficiency) and usually result when there is some flaw in
the price-setting mechanism. For example, congestion on roads imposes costs on
road users, and these costs are deadweight losses, because the inconvenience of
congestion to one driver is not matched by a reduction in inconvenience to another.
If on the other hand, road space were allocated by setting high prices for road
access, the costs borne by drivers that pay those charges would benefit government
revenues, and would thus not be deadweight costs at all. Society often finds it worth
bearing certain deadweight losses in order to promote social objectives. 2 The part
of the cost of a particular policy that has to be incurred, but that does not further
death rate | 88

the objective of the policy. For example, the cost of subsidizing those in > long-term
unemployment back to work includes some element of subsidy to people who would
have returned to work regardless of the subsidy.

death rate The number of deaths occurring in any year for every rooo of the
population (the crude death rate). It may be quoted for each sex and each age group.
The rapid growth in UK population in the early nineteenth century is attributed
more to the decline in the death rate than to an increase in >birth rate. A similar
effect is to be observed in the highly populated >developing countries. The UK
death rate of male children under 5 years of age was 57 in rpoo, compared to 1.4 at
the present time. The expectation of life at birth in the UK has risen from about 50
years for babies born in T900 to 75 years for males and 80 years for females born in
2000. An alternative measure is >quality adjusted life years that estimates the number
of years a new-born baby may expect to have a healthy life, i.e. a life in which there
is no illness severe enough to limit physical mobility or mental acuity. In the UK,
the current expectation of such a healthy life is about 67 years for males and 69 years
for females. demographic time bomb; dependency ratio; human development
index; poverty.

debentures, debenture stock Fixed-interest ^-securities, now more commonly

called >bonds, issued by limited companies in return for long-term >loans. The
former term is sometimes also used to refer to any title on a secured interest-bearing
loan. Debentures are dated for redemption (i.e. repayment of their nominal value
by the borrower to the holder) between ro and 40 years ahead (^redemption date)
but occasionally may be irredeemable. Debentures are usually secured. There are
two main types of secured debenture: (a) mortgage debenture, that is secured by a
^mortgage on specific ^assets of the company, and (b) floating-charge debenture,
where its assets are not suitable for a fixed charge (>-floating debentures). Debenture
interest must be paid whether the company makes a >profit or not. In the event of
non-payment, debenture holders can force ^-liquidation and rank ahead of all
shareholders in their claims on the company's assets. The interest which debentures
bear depends partly on long-term >rates of interest prevailing at the time and partly
on the type of debenture, but will in any case, because of the lower risk involved, be
less than that borne by > preference shares. Debenture shares are most appropriate
for financing companies whose profits are stable and which have substantial fixed
assets, e.g. property companies.
Convertible debentures carry an option at a fixed future date to convert the stock
into ordinary Xshares at a fixed price. This option is compensated for by a lower
rate of interest than an ordinary debenture, but convertible debentures are attractive
since they offer the investor, without sacrificing his security, the prospect of purchas¬
ing >-equity shares cheaply in the future. For this reason, convertible debentures are
issued at times when it is difficult to raise > capital either by equity or fixed-interest
securities. >*-new-issue market.

Debreu, Gerard (b. 1921) A graduate in mathematics at the University of Paris,

Debreu joined the Cowles Commission in r95o. In r96o, he was appointed to the
Chair of Economics and Mathematics at the University of California. His published
works include Existence of an Equilibrium fora Competitive Economy ^954) with > Arrow
and Theory of Value, an Axiomatic Analysis of Economic Equilibrium ^959). Professor
89_| deferred shares

Debreu, who was awarded the >Nobel Prize in Economics in 1983, is recognized,
with Arrow, as having proved the theoretical consistency of a market economy in
which prices can lead to > equilibrium between supply and demand in many differ¬
ent markets simultaneously. Furthermore, by extending the notion of what we mean
by a 'good' to something at a particular place, at a particular time under particular
conditions, Debreu's work naturally extends itself to the study of location, capital
and uncertainty, ^general equilibrium; Walras, M. E. L.

debt A sum of >-money or other property owed by one person or organization to

another. Debt comes into being through the granting of >credit or through raising
►loan capital. Debt servicing consists of paying interest on a debt. Debt is an essential
part of all modern, capitalist economies (>capitalism), ►►national debt.

debt conversion >conversion.

debt management The process of administering debt (e.g. the >national debt)
by providing for the payment of ►interest and arranging the refinancing of maturing
►bonds.

debt neutrality The idea that financing spending by borrowing money will have
exactly the same effects as financing it through other means. It has been applied in
various forms, notably to government spending (> Ricardian equivalence) and to
corporate investment (►Modigliani-Miller theorem).

debt ratio >gearing.

debtor One who owes money to another. A firm's debtors, for example, are those
to whom invoices have been sent for goods or services supplied and which remain
unpaid. Antonym of >creditor.

decentralized decision-taking ►free-market economy,

decile >percentile.

decreasing returns >diseconomies of scale; returns to scale.

deemed disposal The assumed realization of an >asset in the calculation of

liability for >capital gains taxation or >inheritance tax. Shares in a company, for
example, might be valued and tax charged on the difference between that value and
the price originally paid for them, even where the shares did not change hands.

deep discounted bonds ►Bonds that are issued at a price much lower than that
at which they can be redeemed (>redeemable securities) at the specified date. The
intention is to provide large ►capital gains for the holders and to pay a correspond¬
ingly low interest rate. In some countries and especially for higher-rate taxpayers,
less tax may be payable on a gain than upon interest income; however, the 'capital
gain' on deep discounted bonds is liable to be treated as income by the tax authorities.

deferred rebate A rebate or discount on a purchase which is accumulated for a

specified period to encourage customers to remain with a particular supplier. Also
called aggregated rebate. ►►Monopolies and Mergers Commission.

deferred shares A ►share issued where ► ordinary shares have a fixed ►dividend
and which entitle the holders to all ►profits after prior charges have been met. Now
virtually unknown.
deficit

deficit An excess of an expenditure flow over an income flow, e.g. >-budget deficit,
imbalance of payments deficit, or an excess of Pliabilities over Passets.

deficit financing The use of borrowing to finance an excess of expenditure over

Pincome. Most often, it refers to governments, who often spend more than they
can raise in taxation. The term is normally used in economics to refer to a planned
budget deficit (Pbalanced budget) incurred in the interests of expanding Paggregate
demand by relaxing Pfiscal policy and thus injecting purchasing power into the
economy, a policy advocated by Keynes to increase employment in the t930s.
>Pcrowding-out; fiscal policy; public-sector borrowing requirement.

defined-benefit pension Ppension funds.

defined-contribution pension A pension policy, such as a personal pension, in

which the individual's entitlement to pension receipt is specifically tied to the
individual's own contributions to the fund. These have grown in popularity with
legislative changes in the 1980s, and the increasing job turnover of employees who
required more portability of pension entitlements between different employers.
Defined-contribution schemes carry no Pcross-subsidy between different categories
of investor, and simply act as personal savings accounts. Ppension funds.

deflation 1 A sustained reduction in the general level of prices. Deflation is often,

though not inevitably, accompanied by declines in output and employment and is
distinct from 'disinflation' which refers to a reduction in the rate of inflation.
Deflation can be brought about by either internal or external forces in an Popen
economy. Although uncommon in the second half of the twentieth century, it has
recently re-emerged on to the world stage with a vengeance, most notably in Japan.
The most obvious policy response to a deflation is to stimulate spending, to get
demand up, so that prices stop falling and the economy stabilizes. Unfortunately,
one of the biggest problems of a deflation is that the normal tool of monetary policy
to increase spending and borrowing - lower interest rates - may be ineffective. If
there is a deflation of 3 per cent, and if interest rates fall to zero, the real interest rate
is still 3 per cent. This may not be low enough to promote spending and borrowing.
Or, to put it another way, consumers will be inclined to postpone spending as long
as they think prices will be lower in future than they are now. Further, they will not
be inclined to borrow if they think that the debt they take out will be growing in
Preal terms over time. 2 A deliberate policy of reducing Paggregate demand and
output so as to reduce the rate of Pinflation and the quantity of imports and lower
the Pexchange rate, thus improving export performance and the Pbalance of
payments. Aggregate demand may be reduced by Pfiscal policy (increasing taxes or
reducing government expenditure) or Pmonetary policy (increases in the Prate of
interest and slower growth or contraction in the Pmoney supply). 3 In economic
statistics, the adjustment of index numbers or economic aggregates to eliminate the
effects of price changes, as in dividing an index of the Pgross domestic product
(GDP) at Pcurrent prices by a price index (Pindex number) to give an index of GDP
in Preal terms. In estimating changes in net output in real terms, there are two
alternative methods: (a) to deflate the series of the value of net output at Pcurrent
prices by a single index of output prices, and (b) to deflate separately each particular
input by its own appropriate price index, and to subtract the sum of these adjust¬
ments from the value of gross output deflated in the same way by indices of output
 demand curve
!LJ
prices. Method (b) is called double deflation, which has the advantage of capturing
changes in the ratio of net to gross outputs in real terms. This may be important
where, for example, profit margins are being squeezed by faster increases in input
than in output prices. To deflate net output directly by output prices in these
circumstances would lead to an overstatement of the real rise in net output.

deflationary gap A state of the economy in which there are unemployed resources
and there is no inflationary pressure. It is a state first highlighted by >Keynes, and
in more modern literature identified as >Keynesian unemployment, characterized
by a chronic shortage of »-aggregate demand. More recently, the concept has been
revived in mainstream economic policymaking, as the existence of a gap between
actual »-gross domestic product (GDP), and the economy's potential GDP (>-output
gap), inflationary gap; Keynesian economics.

deflator >GDP deflator.

de-industrialization A decline in the share of manufacturing in ^-national

income. In the UK, the contribution of manufacturing to the >gross domestic
product fell from 28 per cent in 1979 to 22 per cent in 1991, with a slower change since
then to 18 per cent in 2001. Although a decline in the manufacturing ratio is common
to most of the ^advanced countries and reflects the growth of ^-services, fears have
been expressed that, since manufactures constitute the bulk of exports, the process
of decline could continue to the point where a large imbalance on >-visible trade
could not be offset by the growth of ^-invisible exports without a decline in >real
income. However, it has been argued that the exceptional weakness in British
manufacturing exports in the 1980s reflected the strength of sterling buoyed up by
the effects of North Sea oil, and that now that oil production has peaked, the growth
of manufacturing output can be expected to continue. Moreover, the decline of
manufacturing is to some extent a statistical illusion, reflecting the growth of >prod-
uctivity in manufacturing compared with slower growth in output per person in the
rest of the economy (>Baumol effect).

demand The desire for a particular good or ^service supported by the possession
of the necessary means of exchange to effect ownership. demand curve; demand,
theory of; Marshall, A.; money.

demand, theory of The area of economics concerned with the allocation of

limited resources to different commodities in the purchasing decisions of rational
consumers. Together with the theory of the >firm (which is really a theory of
supply), it forms the basis of > microeconomics.
There are several different approaches to consumer behaviour: (a) the cardinal
futility approach associated with ^Marshall and other economists of the nine¬
teenth century; this was superseded by (b), »-indifference-curve analysis (^ordinal
utility), which dispensed with the need for an absolute measure of utility; a third
approach, (c), >revealed preference, is largely a re-expression of indifference-curve
analysis, in which no explicit notion of utility is used at all. All these approaches
give rise to the same qualitative analysis of consumer behaviour and support the laws
of demand and supply, such as that price rises lead to cuts in demand, ^demand
function.
demand curve The graphical representation of a schedule listing the quantities of
demand deposit
Lff
a commodity a consumer would be willing to buy at various prices. The schedule is
drawn up on the assumption that other economic factors remain the same between
the consideration of one price and another. Such factors are: (a) income; (b) prices

of > substitutes or Complementary goods, and (c) consumer preferences or expec¬

tations. In most cases, the curve would slope downwards from left to right, reflecting
the fact that the higher the price of a commodity the lower the demand for it. In the
diagram, the quantity q would be demanded at the price p for a commodity with the
demand curve shown. However, the slope and shape of the demand curve (see
diagram) will depend on the response of demand to a change in price (^elasticity)
in specific cases, ^demand, theory of; endogenous preferences; excess demand;
income effect; indifference-curve analysis; substitution effect; supply curve.
demand deposit (U S) Money on ^current account, i.e. a >bank deposit that can
be withdrawn without notice.
demand for labour iabour, demand for.
demand function A mathematical expression of the relationship between the
quantity of a good or service that is demanded, and changes in a number of economic
factors, e.g. its price, the prices of ^substitutes and ^complementary goods, income,
credit terms, etc. The quantity demanded is the ^dependent variable and the other
factors are independent variables. The effect of each independent variable on
the dependent variable may be estimated statistically by iime-series analysis or
>cross-section analysis of >household expenditure data. Also known as the Mar¬
shallian demand function. Wfr-demand curve; demand, theory of; elasticity; Hicksian
demand function.
demand management >fiscal policy.
demand-pull inflation inflation induced by a persistence of an excess of
^aggregate demand in the economy over ^aggregate supply. The balance of aggre-
93 dependency ratio

gate supply and demand does not reach ^equilibrium because supply reaches a
capacity limit at the >full-employment level (^output gap). The excess demand
probably persists because there is a growth in the quantity of >*-money either through
the creation of money by government to finance the budgetary gap between its
expenditure and income or because the quantity of money is allowed to expand to
accommodate the rise in prices, ^cost-push inflation; Friedman, M.; inflationary
gap; Keynes, J. M.; quantity theory of money.

demand schedule A list showing the quantities of a good or service a consumer

would be willing to buy at various prices, ^demand curve.

demographic time bomb A reference to the possibility that many countries

could face a crisis in the next few decades, caused by the ageing of their populations
(>population). Increased life expectancy, a declining »birth rate, both sometimes
allied with a trend towards earlier retirement, have meant that the proportion of the
population of retirement age (> dependency ratio) is rising. The trend is evident in
many advanced countries, e.g. the European Union and Japan. The problem has
given rise to the suggestion that pensions should be provided on a funded basis
rather than on a pay-as-you-go basis (>pension funds).
Governments may look more closely at private pensions to take the burden off
public finance. Such measures do not mean that the workers of tomorrow avoid
supporting the elderly; it simply means they support them from returns to savings
rather than from extra tax revenue. Those who are not working in a society will
always be dependent for their income on those who are working.

demography > population.

Denison, Edward F. (born 1915) ►growth accounting.

departmental expenditure limits (DEL) The portion of public spending in the

UK that is allocated to the main government departments in rolling 3-year budgets.
► public expenditure.

dependency culture The phenomenon by which the granting of some kind of

help or aid to those in adverse circumstances increases the likelihood of the recipients
being in adverse circumstances. The phenomenon became a fashionable diagnosis
of the increase in recipients of benefits subject to a > means test in the UK (from
under r million in t948 to c. 6 million in 2003). As such benefits are withdrawn from
those whose incomes rise, they penalize those who make an effort to earn their way
out of them, and are thus blamed for fostering a reliance on benefits. This analysis
has been responsible for the introduction of more > active labour-market policies,
but the analysis does not simply have to apply to the impact of the benefit system -
it can be used as a description of any perverse response by private agents to a
well-intentioned government intervention aimed at helping them. Dependency
culture can be seen as the application of the ►Lucas critique to an area of ►micro¬
economics in that it suggests that the existence of a policy towards a problem affects
the relationship between the problem and its causes. ►poverty trap.

dependency ratio The dependency ratio is defined as the ratio of the total number
of children (0-14 years of age) and pensioners to the working population, i.e. the
number of people of non-working age in an economy, relative to those who are of
dependent variable |_94

working age. The term is used flexibly, sometimes referring to dependants of old age
only, and sometimes to those either too old or too young to work. It is calculated by
taking the ratio of non-working to working-age groups, and multiplying by roo to
give a percentage. The inverse is the support ratio. The UK dependency ratio is
forecast to increase from 73 in 2000 to 80 in 2026. ^population; ^-demographic
time bomb.

dependent variable A >variable whose value is conditional on the value of

another variable. For example, if the quantity of butter a person buys falls or rises as
the price of butter rises or falls, the quantity of butter is a variable depending on
the movements in the (independent) variable price, ^econometrics; endogenous
variable.

deposit Money placed in an account at a bank and constituting a claim on the

bank. The term 'bank deposit' includes deposits on all types of account, including
»-current accounts, ^banking.

deposit account An account with a bank, >-building society or other financial

institution in which ^deposits earn >interest, and withdrawals from which may
require notice. Until i97r, interest was paid by the bank at a rate fixed by agreement
between the clearing banks and normally 2 per cent below >bank rate. Since that
date, banks have been obliged to fix their rates individually and now offer a range
of deposit accounts to compete with the remaining > building societies and other
>financial intermediaries. Deposit accounts are called time deposits in the USA and
savings accounts in France and other continental European countries, ^banking.

depreciation 1 The reduction in lvalue of an >-asset through wear and tear. An

allowance for the depreciation on a company's assets is always made before the
calculation of >profit, on the grounds that the consumption of ^capital assets is
one of the costs of earning the revenues of the business and is allowed as such,
according to special rules, by the tax authorities. Since depreciation can be measured
accurately only at the end of the life of an asset (i.e. > ex post), depreciation provisions
in company accounts require an estimate of both the total amount of depreciation
and the asset life. Annual depreciation provisions are normally calculated according
to two methods: (a) the straight-line method, where the estimated residual (e.g. scrap)
value of an asset is deducted from its original cost and the balance divided by the
number of years of estimated life to arrive at an annual depreciation expense to set
against revenue, and (b) the reducing-balance method, in which the actual depreciation
expense is set at a constant proportion of the depreciated value of the asset, i.e.
a diminishing annual absolute amount. There are other methods of calculating
depreciation and also of dealing with the fact that, in periods of rising prices, the
replacement cost of an asset may be very much greater than its original cost. This
latter problem is dealt with by revaluing assets at intervals, or even annually, using
special capital-cost indices and adjusting depreciation charges accordingly. This is
called replacement-cost depreciation as opposed to historic-cost depreciation (>costs,
historical or historic; inflation accounting) when the original cost of purchase is
retained throughout the period.
It should be noted that > obsolescence is distinct from depreciation in that the
former is an unforeseen change in the value of an asset for technological or economic
reasons. If an asset becomes obsolescent, its undepreciated value is usually written-off
9SJ deregulation

(depreciated) completely in the year of replacement. In some cases, the life of an

asset may be very difficult to determine because it is specific to the production of a
product, the demand for which is subject to rapid changes in taste or fashion, i.e.
there is a high risk of product obsolescence. In these cases, the life of the asset is
written-off over a very short period. The purpose of depreciation provisions in
accounting is to ensure that the cost of the flow of services provided by capital assets
is met in the price of the company's products - it is not for the purpose of building
up funds for the replacement of these assets to be available at a certain date. In
practice, depreciation provisions are treated as part of the net ►cash flow of a
business and are used to repay >loans, to purchase other fixed assets, or to invest in
other businesses, i.e. they are put to the use that will give the highest possible
return. Much confusion is caused on this point, since what happens to depreciation
provisions - which are, in effect, transfers of funds from fixed assets to current
assets and sometimes back again - is not often clear from the ►balance sheet,
^►amortization; sources and uses of funds.
Depreciation is accepted for tax purposes as a charge against profits, but this
depreciation has to be calculated according to certain rules and does not necessarily
bear any relation to the depreciation actually charged by the business in its accounts.
>► capital allowances.
2 A reduction in the value of a ► currency in terms of gold or other currencies under
►free-market conditions and coming about through a decline in the >demand for
that currency in relation to the supply, ^currency depreciation.

depreciation at choice ►capital allowances.

depression A downturn in the ►business cycle in which there is a sustained high

level of ►unemployment. The 3 or 4 years following 1929 was the period of the last
major depression in the world economy, ^-recession; Juglar cycle.

deprived areas ►assisted areas.

deregulation The process of invigorating activity in a sector of the economy by

reducing the burden of government controls, particularly those that have the effect
of creating ►barriers to entry. The goal of deregulation initiatives - which have been
particularly important in the last decade - is generally to promote competition in
areas previously considered to be ►natural monopolies, or in areas in which regu¬
lation appeared to have long outlived its original rationale. Deregulation in any of
a variety of forms has affected a substantial area of economic life in much of the
developed world, from financial services to those manufacturing sectors subject to
international competition (in Europe, in particular as a result of the ►Single Euro¬
pean Act, but globally with the promotion of world trade), to sectors primarily under
government ownership. Apparent success in sectors such as telecommunications
worldwide, and intercity coach travel in the UK, has not been matched in every
area. British local bus services have proved a more controversial area, and even
though, in the case of the deregulated US airline sector, prices are low and activity
high, the impact has been marred by a constant flow of bankruptcies and some
safety concerns. More recently, there has been a concern that global deregulation
has led producers to operate under such tight competitive constraints, that normal
social obligations are being neglected, and that jobs are insecure as obsolescent
workers are made redundant as soon as they are no longer useful (► downsizing).
derivatives

Nevertheless, many economists believe that, although deregulation was seen as a

policy complementary to ^privatization, it was the more important of the pair.
> regulation.

derivatives A generic term for >-futures, >options and >swaps, i.e. instruments
derived from conventional direct dealings in securities, currencies and commodities.
Trade in derivatives increased substantially in the 1990s, given their usefulness to
company treasurers and fund managers as a >hedge against security price changes
and currency fluctuations, particularly in the disturbed currency markets of the
period. In the ro years to 1993, eighteen derivatives exchanges were created in
Europe, trading ninety-eight different contracts. The market - which had come to
be dominated by trade in swaps and to be handled chiefly by a relatively small
number of banks - was estimated to have reached a total value of some $4 billion by
r992. This figure was questioned by some commentators, who held that the true
measure was not the total value of the instruments traded but the level of risk
involved, a figure around one-tenth of the total value. Moreover, many, including
the Group of 30 in a report published in July 1993, pointed out that the derivatives
market was small in comparison with total bond, equity or foreign exchange
transactions ($900 billion at the time).

derived demand The demand for a >factor of production in which the demand
for the factor is derived indirectly from the demand for the finished product to
which the factor has contributed in production. >► labour, demand for.

destination principle ^value-added tax.

devaluation The reduction of the fixed official rate at which one >currency is
exchanged for another (> currency depreciation) in a fixed ^exchange rate regime.
Currencies were in such regimes for much of the second half of the twentieth century,
particularly under the arrangements agreed at the >Bretton Woods conference and
in Europe under the > European Monetary System. Apart from such general schemes,
individual countries may opt to fix their currency's exchange rate. For example,
Argentina, in r99i, based its monetary policy on a ^currency board and a fixed rate
of exchange of r peso to i$US. This regime lasted until 2002, when the peso was first
devalued and then left to float (^exchange rate).
There are three basic situations which lead to devaluation: (a) persistent ^balance
of payments deficits; (b) a period of high ^inflation, and (c) diversion between the
economic activity of the country and the other members of the fixed rate region. In
(a) and (b) the devaluation helps the exporting sector of the economy at the expense
of the non-tradable sector. For example, it works to reduce a deficit, because devalu¬
ation makes prices (in foreign currencies) of exports cheaper and the domestic
price of imports more expensive. (The immediate effect, however, is similar to
an unfavourable change in the > terms of trade (>J-curve).) Similarly, with high
inflation, prices (in foreign currencies) of exports rise and demand of the country's
exports falls, unless the exchange rate falls to make the prices competitive again. If
a country is a member of a fixed exchange-rate area, economic policy differences
lead to devaluation. For example, if one country is >overheating, while another is
deflating (^deflation), then a looser ^-monetary policy is required in the former.
Under fixed exchange rates, it is not possible for monetary authorities to fix both
the >rate of interest and the >exchange rate independently - fixing one implies
97J differentiation, product

some rate of the other. The country requiring a looser policy needs to devalue until
policies converge. In effect, all three causes of devaluation are the same: a need to
restore domestic balance (neither overheating, nor deflation) while also maintaining
a reasonable balance between the exporting and non-exporting sector.

developing country A country that has not yet reached the stage of ^economic
development characterized by the growth of industrialization, nor (as was once
thought) a level of ^national income sufficient to yield the domestic > savings
required to finance the ^investment necessary for further growth (>Rostow, W. W.).
The notion of a vicious circle of underdevelopment, however, has been criticized
heavily (>economic development). Also referred to as Third World countries and
less-developed countries. The attempt by developing countries to obtain significant
increases in their >real incomes has been frustrated by the deterioration in their
>terms of trade and the rapid expansion of their populations. According to the
United Nations (>United Nations Conference on Trade and Development),
developing countries succeeded in increasing their share of world trade in the 30
years up to 2000 through an expansion in exports of manufactures to the point that
they accounted for about 70 per cent of their total exports by 2000. However,
this expansion was not reflected in export incomes, their share of world income
remaining constant. This is because developing countries' manufactures are still
based on unskilled labour and natural resources which do not earn the added
value enjoyed by more technology-based trade. In spite of the increase in their
exports, imports into the developing countries grew faster leading to deteriorating
^•balance of payments. As a result, many developing countries have accumulated
large foreign debts.
The > World Bank estimates that 23 per cent of the world's population are in
extreme S-poverty (living on less than $r a day). Life expectancy at birth in these
low-income countries is only 59 years on average compared with 78 years in the
^advanced countries. Over 25 per cent of those in extreme poverty live in Sub-
Saharan Africa.
Many ideas have been put forward to assist these countries bridge the gap between
themselves and the developed countries (^United Nations Conference on Trade
and Development). Some developing countries, particularly in Asia, have embarked
successfully on economic development and attracted a substantial growth in private
capital investment in the T990S that has more than offset static or declining official
>foreign aid (>emerging markets; newly industrialized country). >► Asian Develop¬
ment Bank; Association of South East Asian Nations; Colombo Plan for Cooperative
Economic and Social Development in Asia and the Pacific; convergence; General
Agreement on Tariffs and Trade; International Bank for Reconstruction and Develop¬
ment; international commodity agreements; least-developed country; transition,
economies in.

development areas ^assisted areas.

development economics ^economic development.

differentiation, product Distinguishing essentially the same products from one

another by real or illusory means, as in petrol, washing powder, cigarettes. The
significance of product differentiation in economic theory is that by relaxing the
assumption of product homogeneity under > perfect competition, each supplier
diminishing marginal product | 98

may create an opportunity to depart from the market price, charge a premium for
his product and make greater > profits. Under perfect competition, this supplier
would sell nothing if he raised the price above market levels (he faces a horizontal
>-demand curve); with product differentiation he may be able to build up some
loyalty from his customers (and introduce a downward slope to the demand curve,
which is a characteristic of ^monopolistic competition). The means by which
suppliers differentiate their products may involve improved product performance
and ^innovation (e.g. radial-ply tyres which, though more expensive initially than
conventional tyres, have a longer life) or they may be restricted to > advertising and
packaging. In business economics, differentiation is seen as one of two important
strategic directions, the other being leadership through volume sales and low cost.

diminishing marginal product ^diminishing returns, law of.

diminishing marginal utility The psychological law that, as extra units of a

commodity are consumed by an individual, the satisfaction gained from each unit
will fall. For example, although for every extra Mars bar someone eats they derive
extra pleasure, the more Mars that are eaten, the less the pleasure gained from each
incremental one. Eventually, as sickness strikes, subsequently consumed Mars bars
will yield disutility.
The approach to consumer theory that uses the notion of diminishing marginal
utility is flawed, as there is no single unit or scale by which the utility derived from
a wide range of items can be measured (^ordinal utility). Nevertheless, the concept
remains relevant to many issues, especially when applied to consumption in general.
For example, it provides a case against a poll tax (Mocal taxation) which, it shows,
cuts the utility of the poor (who treasure their every possession) more than the rich
(who hardly notice small losses). It also explains why people may like to avoid risk:
the utility lost from a £roo cut in income is greater than the utility gained by a £roo
increase in income and, consequently, most consumers would reject a fair bet in
which they were faced with a 50 per cent chance of either, despite the fact that on
average they would lose nothing in cash terms. >• behavioural economics; >► endog¬
enous preferences; marginal utility; risk aversion.

diminishing returns, law of A law that states that, as extra units of one ^factor
of production are employed, with all others held constant, the output generated by
each additional unit will eventually fall. In effect, that the ^marginal product of
factors declines when they are employed in increasing quantities. For example, a
farm owner with one field might find that one man could produce 2 tons of grain;
two men 5 tons of grain - more than twice as much; but three men only 7 tons of
grain. The extra production gained from adding a worker started at 2, rose to 3, then
fell back to 2.
Diminishing returns should not be confused with negative returns. Successively
adding workers to a factory can increase its total output but at a falling rate; only
when the factory becomes very overcrowded would the presence of an extra worker
actually cause production to fall. diseconomies of scale; returns to scale; short-run
cost curves; Turgot, A. R. J.

direct costs invariable costs.

direct investment Moreign direct investment.

99_| discount market

direct taxation ►Taxation on the income and resources of individuals or organiz¬

ations. In general, direct taxation (► income tax, corporation tax, inheritance tax,
local taxation, National Insurance contributions) is levied on ►wealth or ►income
and is in contrast to indirect taxation (►value-added tax, >excise duties, betting
duties, vehicle-licence duties, ►stamp duty) which is levied on expenditure. Direct
taxation accounts for over two-thirds of UK general government tax receipts. It was
argued that a shift in favour of indirect taxation would improve incentives for
higher earnings and capital accumulation; however, that process, which occurred
substantially in the UK in the r98os and r990S, can make the tax system more
regressive (>regressive tax) and may also distort ► resource allocation. The categoriz¬
ation of direct and indirect taxation is not as precise as it may appear because it tells us
nothing about the incidence of taxation (Maxation, incidence of), ^expenditure
tax; fiscal neutrality; marginal tax rate.

Directives of the European Union Legislation of the ^European Union (EU).

Directives can be aimed at one or more members of the EU and are not effective
until they are passed into the national law of the member state to which they are
addressed. Directives, therefore, differ from regulations that are imposed directly on
to all member states and do not require further legislation. ^-Banking Acts; com¬
pany law; Investment Services Directive.

dirty float >managed currency.

Disabled Persons Tax Credit ►income tax.

disclosure requirements ►private company.

discount Generally meaning a deduction from Mace value, i.e. the opposite
of >premium. Discount has a number of specific applications in economics and
commerce: (a) a discount for cash is a percentage deductible from an invoice as an
incentive for the debtor to pay within a defined period; (b) a deduction from the
retail price of a good allowed to a wholesaler, retailer or other agent; (c) a charge
made for cashing a >bill of exchange or other promissory note before its maturity
date (► discount house; factor), and (d) the difference, where negative, between the
present price of a >security and its issue price. >► discounting; present value.

discount house 1 An institution, no longer existing, in the London ►discount

market, that purchased ►promissory notes and resold them or held them until
maturity. Essentially a ►bill broker. The discount houses financed their purchases
of securities mainly by borrowing at short term from banks and other financial
institutions. These borrowings were secured against their holdings of securities.
From March r997, on a phased basis, the term discount house ceased to be used and
the institutions bearing that name became banks or other >financial intermediaries.
These changes resulted from a new policy of the >Bank of England to influence
interest rates via >gilt repos. (Mender of last resort.) 2 A 'cut-price' retail store
selling goods at a ►discount.

discount market The market dealing in ►treasury bills, ►bills of exchange and
short-dated ►bonds and consisting of the ^banking system, the ► accepting houses
and the ►discount houses. Although the existence of discount houses as such has
ceased in the City of London, a ►money market of some kind is a feature of all
discount rate | 100

financial centres. The discount houses originally dealt mainly in bills of exchange
accepted by the ^merchant banks, and later in government (including local govern¬
ment) securities and negotiable ^certificates of deposit, ^discount.

discount rate >bank rate; discounting.

discounted cash flow (d.c.f.) >-present value.
discounting 1 The application of a discount or Mate of interest to a >-capital sum
or title to such a sum. Calculations of >present value or the price of a bill before
maturity are made by discounting at the current appropriate rate of interest. 2 The
future effects of an anticipated decline or increase in >profits or some other event
on >security prices, commodity prices, or >-exchange rates. These are said to be
discounted if buying or selling leads to an adjustment of present prices in line with
expected future changes in these prices. 3 (US) The pledging of accounts receivable
(i.e. sums owed by debtors), as >collateral security against a Moan, ^discount.

discriminating duty An import duty (Mariffs, import) imposed at a level different

from other comparable import duties such as to favour (or discourage) the importa¬
tion of a particular commodity or imports from a country of origin. ^customs
union; most-favoured nation clause; World Trade Organization.

discriminating monopoly A company with some degree of >market power,

and able to charge different prices for its output in the different markets. W^price
discrimination.

diseconomies of scale Increase in long-run ^average costs which may set in as

the scale of production increases. Although the unit cost of production may fall as
plant size increases (>economies of scale), there are several reasons why this process
is eventually reversed:

(r) The different processes within a plant will probably not have the same >optimum
scale. For example, a car-body press might be at its most efficient at r50,ooo units
a year, while an engine transfer machining line may be optimal at roo,ooo units
a year. When 150,000 cars are produced, it will be necessary either to have a
suboptimal engine line with a capacity of 50,000 in addition, or to run a second
line at 50 per cent capacity.
(2) As firm size increases, problems of administration and co-ordination increase and
there is a growth of bureaucracy.
(3) If output for a national or international market is concentrated at one large plant
in a single location, transport costs of raw materials and finished goods to and
from distant markets may offset scale economies of production at the large plant.

I hese are internal diseconomies. External diseconomies are said to arise as a geographic
region sees larger-scale production - these might include traffic congestion or pol¬
lution, for example (>externalities). Diseconomies of scale are not to be confused
with diminishing returns (^diminishing returns, law of). returns to scale.

disequilibrium A state in which the forces influencing a system are not in balance
and there is a tendency for one or more >-variables in the system to change. The
operation of some mechanism or process is central to the concept of disequilibrium,
as it is this that drives the system variables to move. The direction of movement
caused by a process in most applications is towards a state of equilibrium, but this
101 | distribution, theory of

need not be the case. The ► cobweb model provides an example of a mechanism
that can take either form, ^dynamics; equilibrium; stability analysis.

disguised unemployment A situation in which more people are available for

work than is shown in the ► unemployment statistics. Married women, some stu¬
dents or prematurely retired persons may decide to register for work only if they
believe opportunities are available to them. Also referred to as concealed unemploy¬
ment and the 'discouraged worker effect'. Disguised unemployment will be revealed
in an unusually low ►participation rate. The term has become less relevant with the
wider use of surveys. ►claimant count; ILO unemployment; Labour Force Survey.

dishoarding The reduction of stocks of goods or money previously accumulated

by ►hoarding.

disinflation The reduction or elimination of ► inflation. ^deflation.

disintermediation Flows of funds between borrowers and lenders avoiding the
direct use of >financial intermediaries. Companies, for example, may lend surplus
funds to each other without the use of the banking system or may issue bills
guaranteed (accepted) by the banks but sold to non-banks. Disintermediation may
make it more difficult to measure and control the > money supply since the authori¬
ties' measures to do so are focused upon financial intermediaries who can avoid
controls based upon deposits by lending through >parallel money markets (Especial
deposits). The use of financial intermediaries for lending and borrowing activities
previously carried out outside them (i.e. the opposite of disintermediation) is called
re-intermediation, ^securitization.

disinvestment Negative investment which occurs where part of the capital stock
is destroyed or where gross ► investment is less than ► capital consumption,
i.e. capital equipment is not replaced as it wears out. Antonym for investment,
^divestment.

disposable income Total >income of households less > income tax and employee
►National Insurance contributions.

dissaving Negative ►saving, i.e. ►consumption in excess of ►income. Dissaving

is financed either by the running down of ►assets or by borrowing, and results in a
reduction in net worth, ►balance sheet; s^public-sector financial deficit.

distribution, theory of Explanation of the determination of the >incomes of

the ► factors of production. The theory of distribution is actually part of the more
comprehensive theory of production and distribution (►production, theory of),
since in their determination output and factor prices are interdependent. It is one
of the oldest branches of economic theory (►Marx, K.; Ricardo, D.) but today is still
dominated by the basic theoretical structure of >neo-classical economics. In the
first part of this theory, the incomes of ►land, ►labour and >capital are determined
by the >supply and ►demand for them, which in turn is a >derived demand for
► commodities. In the market for the factors of production, the owners of the factors
will seek to maximize their incomes and the purchasers (firms) will seek to maximize
their >profit from the use of the factors in the production process. Firms will adjust
their output and their employment of each factor to the point where the >marginal
cost and ► marginal revenue of each additional unit of the factor are equal. This
 diversification

equilibrium quantity and equilibrium price will be determined by supply and

demand. For example, shortages of computer programmers will tend to push up
their incomes. On the other hand, if there are more programmers than jobs, their
incomes will fall. The theory does not state, it should be noted, that a computer
programmer will receive his/her marginal product (the amount he/she personally
adds to the employer's revenue), but the increase in output that would arise from
the employment of one additional programmer if inputs of all other factors of
production were held constant. Profit maximization and competition between them
should, in theory, ensure that factor incomes equate to their marginal products,
►marginal productivity theory of wages. This is how the first part of the theory
explains the reward to the factors of production.
The second part of the theory describes the share of total output accruing to different
groups, e.g. the amount going to workers equals the wage rate multiplied by the
number of workers employed. When the number of workers increases, the >marginal
product of labour is assumed to fall and the wage level will fall, but as the total number
of workers has risen, the share of output going to labour may not fall.
The third part of the theory holds that with total output divided up in this way
between the different groups, there will be nothing short and nothing over. This is,
in fact, true in conditions of perfect competition with constant returns to scale or
zero profits (>Euler, L.).
For these reasons, alternative theories to replace each part of the traditional
account have been developed. On the first part, wage bargaining is viewed as occur¬
ring outside perfectly competitive markets with collective bargaining by trade
unions. On the second part, shares of national income have been explained in terms
of the distribution necessary to maintain ►balanced growth in a macroeconomic
approach associated with >Kaldor. On the third part, the existence of monopoly
profits suggests that some portion of total output does not accrue to workers,
investors or property owners, but to those fortunate enough to be in monopoly
industries, ^bargaining theory of wages; S»Cobb-Douglas function.

diversification 1 Extending the range of goods and services in a firm or geographic

region. The motives for diversification will include declining profitability or growth
in traditional markets, surplus capital or management resources and a desire to
spread risks and reduce dependence upon cyclical activities. Diversification has
accounted for a significant proportion of the growth of ►multinational corpora¬
tions, though more recently competitive pressures have encouraged large corpora¬
tions to return to core businesses and dispose of unwanted subsidiaries. This process
has been called »-downsizing (US) or ^divestment. The means of diversification are
either internal growth or ► merger. By definition, a ►conglomerate is a diversified
firm. 2 The holding of shares in a range of firms in a ►portfolio in order to spread
the risk, ^capital asset pricing model; portfolio theory; risk.

divestment The liquidation or sale of parts of a firm. Divestment is, in effect, the
opposite of acquisition or ► merger.

dividend The amount of a company's ►profits that the board of directors decides
to distribute to ordinary shareholders. It is usually expressed either as a percentage
of the ^nominal value of the ► ordinary share capital, or as an absolute amount per
►share. For example, if a company has an issued ►capital of £100,000 in 400,000
 Doha Round of Trade Negotiations

25P ordinary shares and the directors decide to distribute £10,000, then they would
declare a dividend of ro per cent or 2'Ap per share. A dividend is only the same as a
►yield if the shares stand at their nominal value. Some shareholders may not have
bought their shares at >-par value and might have paid, say, sop each for them, in
which case the yield would not be 10 but 5 per cent.
Dividends are declared at general meetings of the shareholders. Interim dividends
are part payments of the annual dividend made during the year. Dividends are paid
out of profits for the current year or, if profits are inadequate but the directors
consider that a dividend is justified, out of reserves from profits of previous years.
The profits after tax from which dividends are paid are those after payments to
holders of ^-preference shares and > debentures have been allowed for, the balance
being split between dividends and reserves.
There has been much discussion of whether the rate of > investment could be
raised if companies paid out fewer dividends, as that would leave more cash to
invest.

dividend cover The number of times the net >profits available for distribution
exceed the ^dividend actually paid or declared. For example, if a company's net
profits are £100,000 and the dividend was £5000, the dividend cover would be 20. It
is the inverse of the payout ratio.

dividend warrant The Cheque by which companies pay ^-dividends to share¬

holders.

dividend yield >yield.

divisia money > money supply.
division of labour The allocation of labour such that each worker specializes in
one or a few functions in the production process. >Smith illustrated the principle
in the different stages of pin-making: drawing the wire, cutting, head-fitting, sharp¬
ening. The division improved labour productivity: (a) by the more efficient acquiring
of specialist skills, and (b) through the saving of time because workers did not have
to move from one operation to another. Through the division of labour > economies
of scale could be achieved. The exchange economy was essential to its operation.
Each worker could so specialize as long as he was assured that he could exchange his
output for others to satisfy his needs. The principle applies to firms and countries
also: similar benefits may be achieved by the specialization in those activities in
which the firm or country has a Comparative advantage. >► Ricardo, D.

Doha Round of Trade Negotiations Agreement was reached at Doha, Qatar in

2oor to launch a further round of international trade negotiations, and the first
meeting of the >World Trade Organization's Trade Negotiations Committee was
held in January 2002. These negotiations are expected to be concluded by January
2005. Although many aspects will be a carry-over of the work of the ►Uruguay
round of trade negotiations, special consideration is to be given to the needs of the
►developing countries. In the first stage, improvements in market access will be
sought in agriculture, services and industry, through, for example, a reduction in
agricultural subsidies and industrial tariffs. Environmental issues, particularly as
they may impinge on the trade of developing countries, will also be considered at
this stage. Later, there will be other areas to be covered, e.g. investment, competition
 dollar certificate of deposit | 104

and transparency in government procurement. >-Common Agricultural Policy; farm

subsidies; protection; >► trade promotion authority.

dollar certificate of deposit ^Eurocurrency.

domestic credit expansion (DCE) A measure of monetary growth that allows
for changes in the ^balance of payments. It is equal to the >public-sector borrowing
requirement minus public-sector borrowing from the domestic non-bank private
sector plus the increase in bank lending to the private sector in domestic currency
at home and overseas. The significance of the DCE, a measure favoured by the
^International Monetary Fund, is that it nets out changes in the >-money supply
created by overseas capital flows on capital and the current account of the balance
of payments. ^monetary policy.

dominant strategy A course of action that is best pursued whatever it is that

other agents choose to do. It is a concept of »-game theory, applied to situations in
which players choose from a selection of strategies, taking into account the response
and behaviour of fellow players. The best-known dominant strategy is to 'confess'
in the ^prisoner's dilemma game. The strategy to 'not confess' is dominated. In most
situations, there are no dominant or dominated strategies; the best strategy will
depend on what the other side chooses to do. W^tit-for-tat.

dominated strategy A course of action that would not make sense whatever
other agents chose to do. ^dominant strategy.

double deflation ^deflation.

double-entry bookkeeping The accounting system in which every business
transaction, whether a receipt or a payment of s^money, sale or purchase of goods
or >services, gives rise to two entries - a debit and a corresponding credit - tradition¬
ally on opposite pages of a ledger. The credit entries record the sources of finance
(e.g. shareholders' >capital, funds acquired from third parties or generated through
current operations) the debit entries record the use to which that finance is put, e.g.
acquisition of fixed bassets, >stocks, financing of debtors and current operating
expenses, etc. Since every debit entry has an equal and corresponding credit entry,
it follows that if the debit and credit entries are added up they will (or should) come
to the same figure, i.e. balance (>balance sheet). Confusion is caused by identifying
credits and debits with gains or losses. While this is basically true in the very long
run, the profit or loss over a short period of time is measured by selecting from
ledger balances items of income and expenditure that are then used to produce
a profit-and-loss account (US = income and earned surplus statement), imbalance of
payments; business finance.

double option >option.

double taxation The situation in which the same >tax base is taxed more than
once. Double-taxation agreements between two countries are designed to avoid, for
example, ^incomes of non-residents being taxed both in the country they are living
in and in their country of origin. Many proponents of an ^expenditure tax argue
that its main advantage is to avoid double taxation of savings.

Dow-jones industrial average A daily index (Mndex number) of prices on the

principal >stock exchange in New York. It is an >average of the prices of thirty
 dumping

industrial stocks accounting for about 25 per cent of the market >capitilization of
the shares quoted on the New York Stock Exchange and is calculated and published
every day the exchange is open. In its present form the index dates from r928.

downsizing Large-scale shedding of employees by major corporations, sometimes

also used to refer to the disposal of subsidiaries and other unwanted activities.
Downsizing is generally a response to pressures from competition, or investors, to
reduce costs and may in some cases reflect long-delayed reaction to technological
change which allows output to be maintained with fewer employees. In a dynamic
and changing economy some firms will be reducing and others gaining employment,
but redundancies by large firms attract more attention than widespread employment
gains among smaller firms. Downsizing in the USA (e.g. an announcement by AT & T
in r996 that it would reduce its employment by 40,000 persons over a period of time)
has created concern and a sense of insecurity on the part of many employees. Over
the past decade, however, US employment has risen substantially and studies suggest
that the average length of job tenure has changed little. Critics point out that the
quality of jobs lost in large corporations, in terms of salaries, pensions and other
benefits, is superior to that in employment gained in smaller firms, but this might
suggest the existence of ^economic rent.

drawback »-customs drawback.

duality An area of mathematics, sometimes used in economics, in which essentially

the same optimization problem can be framed in two different ways. For example,
the problem of maximizing futility given prices and income can also be seen as a
problem of minimizing the cost of obtaining the level of utility that would be
achieved. This can be useful for the economist trying to observe consumer behaviour
if the cost-minimizing problem is easier to frame than the utility-maximizing one.
^envelope theorem.

dummy variable A variable in ^regression analysis that takes a value of r or o,

depending on whether some particular characteristic applies to the observation. For
example, in a regression that measured the relationship between weight and height,
there might be a sex dummy which takes a value of 1 for men, and o for women.
This would take account of the possible fact that, on average, a man of the same
height as a woman may weigh more.

dumping Strictly, the sale of a >commodity on a foreign >market at a >price

below > marginal cost. An exporting country may support the short-run losses of
this policy in order to eliminate competition and thereby gain a ^monopoly in the
foreign market. Alternatively, it may dump in order to dispose of temporary surpluses
in order to avoid a reduction in home prices and therefore producers' > incomes.
The international trade regulations developed under the > General Agreement on
Tariffs and Trade (GATT) and its successor, the eWorld Trade Organization(WTO)
approves the imposition of special import duties (>tariffs, import) to counteract
such a policy if it can be established that dumping is taking place and is harming a
domestic industry. Under WTO regulations, if products are sold in a foreign market
below the price at which they are sold on the home market, dumping is deemed to
take place. The practice of dumping is prohibited under the terms of the >European
Union (EU) Treaty of Rome. Rules to be followed by governments were agreed as
duopoly | 106

part of the GATT Kennedy round of trade negotiations concluded in 1967 by the EU,
North America and the ►European Free Trade Association. The review of the rules
for determining anti-dumping measures was also part of the negotiations of the
► Uruguay round of trade negotiations. In the USA, the government must obtain the
approval of the ►International Trade Commission before imposing anti-dumping
duties on an import and decisions may be overruled by the US Court of International
Trade. >contingent protection; >^free trade; protection; reciprocity.

duopoly Two sellers only of a good or service in a market. A decision by one seller,
such as the raising or lowering of his price, will be likely to stimulate a response from
the other which, in turn, will affect the market response to the first seller's initial
decision. Depending on assumptions made about the market and each seller's
responses, price >equilibrium may exist at any point between that of a ►monopolist
and that of ►perfect competition (>Bertrand competition; Cournot, A. A.). >^-game
theory; oligopoly.

duopsony Two buyers only of a good or service in a market.

Dupuit, Arsene Jules Etienne Juvenal (1804-66) A French civil engineer, whose
main works relating to economics were De la mesure de I'utilite des travaux publics
(T844) and De I'influence des peages sur I'utilite des voies de communication (1849). His
studies of the pricing policy for public services such as roads and bridges led him to
the concepts of >consumer surplus and >producer surplus. These terms were, in
fact, invented by >Marshall, but the ideas were clearly brought out by Dupuit. He
realized that the prices were not the maximum users would be willing to pay for
services, except those users at the very margin who found it just worth while to pay.
Consumers, therefore, benefited by the difference. Similarly, the producer selling
the service obtains a surplus in so far as his fixed charge is related to his cost at the
margin (>marginal cost) and this is greater than his ►average cost.

durable goods Consumer goods like washing-machines, motor cars and TV sets,
which yield ►services or ►utility over time rather than being completely used up
at the moment of ►consumption. Most consumer goods are in fact, durable to some
degree, and the term is often used in a more restricted sense to denote relatively
expensive, technologically sophisticated goods - 'consumer durables' - such as the
examples given above. The significance of the durability of these goods is that the
conventional apparatus of demand analysis must be supplemented by the modes of
analysis developed in ►capital theory (►demand, theory of).

dynamic peg ^exchange rate.

dynamics Analysis that aims to trace and study the behaviour of variables through
time, and determine whether these variables tend to move towards >equilibrium.
Although the word 'dynamic' is used rather loosely, it safely describes any analysis
which gives an account of the process by which equilibrium is achieved, or disequi¬
librium sustained. An example of dynamic analysis is ►optimal-growth theory,
which traces the path an economy should follow to maximize the ►present value
of consumption over time. In contrast to ►comparative static equilibrium analysis,
dynamics does not just specify the conditions that prevail when the economy is in
equilibrium, or whether it is in a satisfactory equilibrium or unsatisfactory one. It
traces the optimal path towards an equilibrium.
 E

earnings 1 The return for human effort, as in the earnings of >labour and the
earnings of management. In labour economics, wage earnings are distinguished
from wage rates; the former include overtime, the latter relate only to earnings per
hour or standard working week. Earnings may be quoted as pre- or post-tax (gross
or net) and other deductions and in >real terms or money terms. 2 The > income
of a business, part of which may be retained in the business and part distributed to
the shareholders (^-retained earnings). Earnings per >share (post-tax), which is a
measure of the total return earned by a company on its ^ordinary share capital,
are calculated by taking gross income after ^depreciation, > interest, > preference
shares and minority interests, deducting tax and dividing the resulting figure by the
number of ordinary shares. Note that earnings per share are normally higher than
the ^dividend per share. For example, a firm may earn rop per share but may only
pay a 5p or 20 per cent dividend on its 25P ordinary shares.

earnings yield >yield.

EASDAQ >European Association of Securities Dealers Automated Quotation

System.

East African Community The original East African Community failed in T977 but
was revived by a treaty signed in r999 and the new Community of Tanzania, Uganda
and Kenya came into operation in 20or. The treaty envisages the elimination of
import tariffs (^tariffs, imports) and import barriers (Emport restrictions) between
member states and the setting up of a common external tariff by 2004. By 2002,
internal tariffs had been reduced by between 80 and 90 per cent. The long-term goal
is the formation of ^monetary union. ^Common Market for Eastern and Southern
Africa; Cotonou Agreement.

ECCD Export Credits Guarantee Department.

e-commerce Electronic commerce.

econometric models The representation of a relationship between economic

variables as an equation or set of equations in which statistical precision can be
attributed to the > parameters linking the variables. »► econometrics; model.

econometrics The setting-up of mathematical >models describing economic

relationships (e.g. that the quantity demanded of a good is dependent positively on
income and negatively on price), testing the validity of such hypotheses (> statistical
economic activity rate | 108

inference) and estimating the >-parameters in order to obtain a measure of the

strengths of the influences of the different independent ►variables. Econometricians
most commonly use the techniques of ►regression analysis (^least-squares
regression), in which the relationship between a »-dependent variable and an inde¬
pendent variable is analysed, based on the ►correlation in the variation of the two.
The more they move together, the more likely it is there is a relationship between
them. If the variation analysed is variation over time, then it is referred to as
►time-series analysis; if the variation is across a sample of different subjects, it is
known as > cross-section analysis. Sets of such models are used to make ►macro-
economic forecasts, e.g. by the UK ►Treasury. Although econometrics has domi¬
nated all >empirical testing in economics, it has nevertheless had its critics, who
point to problems in interpreting causation between variables that are correlated,
and in separating out statistical fluke from underlying cause (►data-mining; confi¬
dence interval). >► Frisch, R. A. K.

economic activity rate ►labour force.

Economic Community of West African States (ECOWAS) The member states

of ECOWAS agreed, by the Treaty of Lagos in T975, to develop a ►customs union,
and in 1981, at Freetown, Sierra Leone, concluded a plan for the elimination of trade
restrictions. The treaty was revised in r993. The aim is for the gradual elimination of
all barriers to trade in goods and services, the free movement of people between the
fifteen member states, the improvement in inter-regional transport and telecom¬
munications and the eventual establishment of a ►monetary union. A Fund for
Cooperation, Compensation and Development has been established to finance
projects and to compensate for losses derived from the implementation of the treaty.
In 2001, the West African Monetary Institute - the precursor to the West African
Central Bank - the Court of Justice and the West African Parliament began oper¬
ations. A Secretariat operates from Abuja, Nigeria. Sfc-Cotonou Agreement.

economic development The growth of ► national income per capita. Development

economics is concerned with the reasons why ►developing countries remain behind
the >advanced countries, and what can be done about them. Mainstream thinking
of development economists, and with it the policies of ►bilateral and ►multilateral
agencies, has changed considerably over the past 50 years. In the early post-Second
World War period, there was emphasis on the roles of >investment in ►infrastruc¬
ture and industrial or agricultural projects and the ►planned economy. The view
then was that poor countries lacked the savings and investment necessary for growth,
which created a vicious circle of poverty. The policy response therefore was for aid
agencies to provide loans and grants for large investments in physical capital. Later,
in the face of the intractability of the problem and the influence of >growth
accounting studies which found that quantities of inputs of ► capital and other
factors of production in the advanced countries could not alone explain develop¬
ment, attention turned to the role of >human capital (►sow's ear effect). More
emphasis was accordingly placed on programmes for improvements in health and
education that would not only be of immediate benefit to the poor but which would
make growth possible. In the r98os, there was another shift in emphasis towards
freeing-up markets and allowing the market to channel resources to growth activi¬
ties. Attention therefore turned to ►macroeconomics, and the ► Bretton Woods
 economic development

institutions made structural adjustment programmes to reduce government budget

deficits, remove price controls, free exchange rates and privatize (>privatization)
State assets. Once again emphasis on a single set of policies, in this case macroecon¬
omic, proved insufficient, even in the early 1990s in the economies in transition
(^transition, economies in) in which education and infrastmcture standards were
much higher than in developing countries. Meanwhile, > newly industrialized coun¬
tries, particuarly in South and East Asia and China, have experienced rapid growth
rates without massive foreign aid. Models of development in these demerging
markets have varied, and there is controversy about why their experience has been
so different from that of most developing countries.
From the late 1990s onwards, policies were again shifting, this time to emphasize
a more broadly based and comprehensive strategy towards ^poverty alleviation
that recognized not only the overriding role of private sector development but also
the importance of institutions and the rules and regulations that affect economic
activities (^institutional economics).
There has always been much dissent in development economics. As long ago as
the r95os, Bauer argued that all countries were once poor and that if there were a
vicious circle of underdevelopment the advanced countries would still be in the
Stone Age. He also believed that foreign aid was corrupting and ineffective. More
recently >Stiglitz has criticized the Bretton Woods institutions and the >Intern-
ational Monetary Fund in particular for placing too much faith in the workings of
free markets, ^growth theory.
A large proportion of the > labour force in ^developing countries - as much as 70
per cent or more in some cases - is in the ^-informal sector. In the informal sector,
most people are engaged in agricultural subsistence or in small trading and craft
activities. > Direct taxation and most Regulation is not enforced and because land,
particularly in Africa, is held under communal arrangements, formal property rights
do not exist. De Soto has argued that lack of property rights prevents the use of
Ravings embodied in buildings as ^collateral for borrowings, thus neutralizing
these savings and preventing the development of ^capital markets. It has also been

US dollars Per cent of Per cent of GDP in 1999 Per cent of

urban real GDP
population per capita
growth
1998/99

Agriculture Industry Services

Low incomes 3i 26 30 44 2.1

<$755
Middle 50 IO 36 54 1-9
incomes
$756-9265
High incomes 77 2(a) 27(a) 7fia) 1 -7
>$9266

(a) Europe EMU only

Source: World Development Indicators 2001, World Bank.
economic doctrines

argued that the high > compliance cost of regulation in the formal sector acts as a
barrier to the integration of the informal economy into the modern formal sector.
The importance of the informal sector, where much output may be unreported and
is not exchanged in the market economy, means that statistics for developing
countries are subject to qualifications.
It can be seen from the above table that development is associated with an increase in
the proportion of the population living in urban areas, a decline in the proportion of
>gross domestic product (GDP) generated in agriculture, and an increase in that gener¬
ated in services. Industrialization first becomes more important as development pro¬
ceeds, and then declines again as countries reach the advanced stage. Rates of GDP per
capita growth per annum also tend to decline as countries develop.

economic doctrines Sets of beliefs about how economies function and their
corresponding policy implications. The most interesting modern means of truly
defining different mainstream doctrines is in their view of the importance of
>aggregate demand in determining output and employment in the economy, and
in whether policy to influence demand has any effect (►policy ineffectiveness
theorem).

(1) ^Classical economics was not much concerned with macroeconomics, but gener¬
ally held >Say's law (i.e. that anything supplied would create a demand) as the
earnings paid to the supplier would be spent, equating overall demand and
supply. Investment and saving would be equated through the interest rate. Almost
by assumption, therefore, the economy was in ►equilibrium.
(2) Keynesian disequilibrium economics (^ Keynesian economics; quantity ration¬
ing) holds that the economy can get stuck in >disequilibrium as the overall level
of saving may not be absorbed by the level of investment, and, hence, not all
output will necessarily be bought by anyone; hence government can influence
the economy by increasing demand, most effectively by borrowing (^fiscal
policy).
(3) Neo-Keynesian/>neo-classical economics holds that the Keynesian view is
broadly right in the short term, but that over long periods of time the economy
did have a natural tendency to find an equilibrium. Policy could be effective in
the medium term.
(4) Monetarist economics (►►monetarism; quantity theory of money) holds that it
is money, rather than aggregate demand, that matters, and that policies to
increase demand using money supply growth would only be effective in the short
term, and then at the cost of increasing rates of inflation.
(5) >New classical economics holds that policy won't even work in the short run if
private agents anticipate its effect. A policy to increase money supply will simply
increase prices immediately if agents spot it coming, and have ►rational expec¬
tations. >New Keynesians revert to the idea that anticipated policy can have
short- to medium-term effects, on the ground that prices are sticky, and therefore
that equilibrium is not immediately restored after a shock, by a change in prices.

The doctrines also fall into categories dependent on how far they use the analysis of
► microeconomics. Classical economists almost only used microeconomic analysis;
the Keynesians, and indeed the monetarists, almost only use ► macroeconomics
in their analyses. Neo-classicists blend the two, while the new classical and new
 economic growth

Keynesian economists have attempted microeconomic rationales for all their mac¬
roeconomic findings.

economic efficiency The state of an economy in which no one can be made

better off without someone being made worse off. For this to be the case, three types
of efficiency must hold: (a) productive efficiency, in which the output of the economy
is being produced at the lowest cost; (b) allocative efficiency, in which resources are
being allocated to the production of the goods and services the society most values,
and (c) distributional efficiency, in which output is distributed in such a way that
consumers would not wish, given their >• disposable income and market > prices, to
spend these incomes in any different way.
In a two-person, two-product economy with two factors of production, the follow¬
ing three types of efficiency are achieved when three conditions hold:

(1) Productive efficiency demands that the >*rate of technical substitution for the
two products must be equal, to ensure a unit of one factor of production is worth
the same amount in terms of the other factor whichever product it is used in.
Otherwise, factors could be swapped between products and extra output gained.
(2) The > marginal rate of substitution must be equal for both consumers; otherwise,
the consumers could swap commodities to their mutual benefit.
(3) Allocative efficiency requires that the marginal rate of transformation must equal
the marginal rate of substitution: if consumers feel one banana is worth two
apples, and producers can make one extra banana at the sacrifice of only one
apple, it will pay society for them to produce one apple less and one extra banana,
and to go on making that switch, until eventually consumers tire of bananas and
value apples more highly than they did; and land suitable for banana production
will be so marginal that for every bit of land removed from apples, hardly any
bananas will be produced. At this stage, the two rates of substitution will be equal.

Economic efficiency on these criteria will exist in an economy in which perfect

competition characterizes every sector, ^compensation principle; marginal-cost
pricing; Pareto, V. F. D.; perfect competition; price system; Ricardo, D.; welfare
economics.

economic good Any physical object, natural or manmade, or service rendered,

that could command a price in a market.

economic growth The increase in a country's >■ national income, or sometimes,

its per capita national income. Growth is taken as the basis of advancing human
welfare, although in fact there are problems in the measurement of national income
(some activities - such as do-it-yourself car maintenance rather than buying the
services of a garage mechanic, or transactions in the >informal economy - may not
take place in a >market, or not in a market for which statistics are collected).
Moreover, growth in national income should not be equated necessarily with growth
in welfare (^environmental accounting; welfare economics). The processes of
growth (e.g. industrialization, the expansion of the motorway network, the construc¬
tion of airports) yield disbenefits, e.g. pollution, noise and the destruction of country¬
side amenity, all of which are costs that are not subtracted from the statistical
measures of the national income. Nevertheless, explaining the factors behind econ¬
omic growth, in order that more of it can be generated, is an important area of
economic growth, stages of

economics (>-growth theory). Most important is not the growth associated with the
►business cycle - which tends to vary to some extent with >aggregate demand -
but instead > trend growth, or the growth in the long-term productive potential of
the economy. The dominant interest in growth theory post-Second World War has
been the degree to which the accumulation of >capital through ►investment
explains economic performance. Clearly, more capital, like more of any >-input,
should lead to more output (eventually). But does it lead to enough output to justify
the sacrifice of saving for it? And how much extra output does it yield? Capital
accumulation alone has never been able fully to account for growth - there has
always been a residual determinant, typically caught under the heading 'technol¬
ogy'. More recently, growth theory has moved into trying to explain how much
capital is accumulated, and how successfully technology translates capital into
growth, ^endogenous growth theory; ►‘•economic development; economic
growth, stages of.

economic growth, stages of The five stages of economic growth through

which all economies are considered to pass in their development from fairly poor
agricultural societies to highly industrialized mass-consumption economies. These
five stages were defined and analysed by >Rostow in his book The Stages of Economic
Growth (i960), i.e.:

(1) The traditional society, in which adherence to long-lived economic and social
systems and customs means that output per head is low and tends not to rise.
(2) The stage of the establishment of the pre-conditions for 'take-off' (see (3) below).
This stage is a period of transition, in which the traditional systems are overcome,
and the economy is made capable of exploiting the fruits of modern science and
technology.
(3) The take-off stage. 'Take-off' represents the point at which the 'old blocks and
the resistances to steady growth are finally overcome', and growth becomes the
normal condition of the economy. The economy begins to generate its own
►investment and technological improvement at sufficiently high rates so as to
make growth virtually self-sustaining.
(4) The 'drive to maturity', which is the stage of increasing sophistication of the
economy. Against the background of steady growth, new industries are
developed, there is less reliance on >imports and more exporting activity, and
the economy 'demonstrates' its capacity to move beyond the original industries
which powered its take-off, and to absorb and to apply efficiently the most
advanced fruits of modern technology.
(5) Stage (4) ends in the attainment of this stage, which is the age of high mass
consumption, where there is an affluent population and durable and sophisti¬
cated consumer goods (► economic good) and >services are the leading sectors
of production.

As a broad and imaginative description of the process of economic growth, this

characterization of the stages of growth is interesting and possibly useful, having
much the same flavour as ► Marx's famous theory of the evolution of society from
feudalism to bourgeois »-capitalism and finally to communism. It also leads directly
to a policy conclusion that was already favoured by many: aid should be given to
the economies at the pre-take-off stages, in an attempt to get them to the take-off
 economic sanction

stage. Once this is achieved, these economies will have their own dynamic and
momentum, and hence aid becomes much less necessary. The theory has had only
limited impact among professional economists concerned with the problem of
► economic development. Partly this is because Rostow's analysis of exactly what
factors were responsible for take-off and subsequent self-generating growth tended
to be vague, ambiguous and incomplete. Also, the theory is framed in such general
terms that it can be made consistent with virtually any past growth situation. Partly
also perhaps, the broad sweep of the historian's vision, with the implication of the
inexorability of the historical processes, is not of very much help in trying to solve
the particular development problems of particular economies, ^economic growth;
foreign aid.

economic history The study of the subject matter of economics in a historical

context. Economic history was originally part of political economy, the antecedent
of modern ^economics, and taught in faculties of history and moral philosophy.
In the late nineteenth century economic history began to separate off from history
and economics and is now a more or less distinct discipline. The first chair in
economic history was established at Harvard in 1892 and occupied by Ashley, an
Englishman. A Chair at Manchester University in the UK followed in 1910, the first
incumbent being Unwin. >cliometrics.

economic imperialism The exploitation of ^developing countries by ^advanced

countries. >Marx held that the capitalist classes were inexorably driven to overseas
economic expansion by falling profit opportunities at home. The export of high
►value-added goods and the import of raw materials developed with exported
capital buttressed by ^tariffs and other restrictions on imports of cheap manufac¬
tured goods (e.g. textiles) are the continuing essential features of economic imperial¬
ism even after the granting of political independence, according to critics of
advanced countries.

economic rent The difference between the return made by a factor of production
and the return necessary to keep the factor in its current occupation. For example:
(a) for a brain surgeon earning £100,000 whose only other possible occupation is
nursing on £20,000, the economic rent is £80,000 (the surgeon would remain in his
current job even if it paid only £20,100), and (b) a firm making excess profits
(►profits) is earning economic rent.
In >perfect competition, no rents are made by any factor, because changes in
supply bid prices of inputs and labour down to the level just necessary to keep them
employed. In general, economic rents accrue where changes in supply of this sort
are not possible, e.g. to a brain surgeon with rare skills, that are difficult to emulate,
or to a >monopoly protected by >barriers to entry. True economic rents are among
the few returns that can be taxed (>-taxation) without distorting production
decisions. SH^quasi-rent.

economic sanction A measure, taken in respect of some economic activity, that

has the intention of damaging another country's economy, e.g. a complete embargo
on trade between countries, or refusal to permit >-bank deposits held in a country
imposing the sanction to be drawn upon by the government and residents of another
country.
economics

economics The study of the production, distribution and consumption of wealth

in human society. Economists have never been wholly satisfied with any definition
of their subject. This one is as good as any. It should not be interpreted as restricting
the subject matter of economics to the positive aspects of material welfare alone.
>Robbins criticized this limitation by pointing out, for example, that the economy
of war, which may destroy material welfare, is an aspect of choice in the use of
resources and therefore a proper subject for economic inquiry. His definition was:
'Economics is the science which studies human behaviour as a relationship between
ends and scarce means which have alternative uses.' In fact, no short definition can
convey to the beginner the scope and flavour of the whole subject as it has evolved.
The reader will gain a good notion of the scope of economics by examining the
coverage of this Dictionary, but the borderlines between such other disciplines as
psychology, sociology, accounting and geography are not easily defined and it is,
perhaps, not particularly productive to attempt to do so. Political economy, an early
title for the subject, now sounds old-fashioned but usefully emphasizes the impor¬
tance of choice between alternatives in economics which remains, despite continu¬
ing scientific progress, as much an art as a science, ^economic history.

economies in transition ^transition, economies in.

economies of scale Factors that cause the average cost of producing a commodity
to fall as output of the commodity rises. For example, a firm or industry that would
less than double its costs, if it doubled its output, enjoys economies of scale.
There are two types of such economies:

(r) Internal economics, that accrue to the individual firm regardless of the size of
its industry. They generally result from technological factors which ensure the
optimal size of production is large: (a) with high fixed costs in plant and machin¬
ery, the larger its production, the lower the cost per unit of the fixed inputs, e.g.
producing steel without a blast furnace is possible but very expensive - once a
blast furnace is built it is inefficient only to make small quantities of steel with it
and, hence, steel companies tend to be large; (b) large firms can also arrange for
the specialization of labour and machines as, for example, in the techniques of
the production line which can increase productivity (>-Smith, A.), and (c) only
large firms can afford the high costs of > research and development - non-
technological factors are important, too, however, e.g. by buying inputs in bulk,
large firms can get discounts from their suppliers (who grant them because of
economies of scale in distributing the supplies); there are also economies of scale
in ^business finance.
(2) External economies, that arise because the development of an industry can lead
to the development of ancillary services of benefit to all firms, i.e. a labour force
skilled in the crafts of the industry, a components industry equipped to supply
precisely the right parts, or a trade magazine in which all firms can advertise
cheaply; these can at least partly explain the much observed tendency for firms
to cluster geographically more often than would be predicted from random
location decisions. >industrial districts.

The existence of economies of scale in most industries is used to explain the predomi¬
nance of large firms in the world economy, but recently there has been some
reassessment of the relative importance of technological economies of scale as
 efficient markets hypothesis

such, ^diseconomies of scale; economies of scope; minimum efficient scale; returns

to scale.

economies of scope Factors that make it cheaper to produce a range of related

products than to produce each of the individual products on their own. Economies
of scope can provide a base for corporate ^diversification, ^economies of scale.

Economistes, les >Physiocrats.

ECOWAS ► Economic Community of West African States.

ECSC ^European Coal and Steel Community.

ECU ^European Currency Unit.

EDF European Development Fund (>Lome Convention).

Edgeworth, Francis Ysidro (1845-1926) Professor Edgeworth held the Chair of

Political Economy at Oxford University from 1891 to 1922 and edited the Economic
Journal from i89t to 1926. His published work includes Mathematical Physics (1881),
Theory of Monopoly (1897), Theory of Distribution (1904) and Papers Relating to Political
Economy (1925). The last includes the two reports of 1887 and 1889 of the committee
on the study of > index numbers set up by the British Association for the Advance¬
ment of Science, for which Edgeworth acted as secretary. Apart from economics, he
made valuable contributions to statistics and statistical method. In showing the
inadequacy of the lvalue theory of >Jevons, Edgeworth invented the analytical
tools of >indifference curves and >-contract curves. Pareto, V. F. D.

effective exchange rate The >exchange rate of a country's currency measured

by reference to a >-weighted average of the exchange rates of the currencies of the
country's trading partners. The weights are chosen to correspond to the relative
importance of each trading partner in the country's domestic, as well as overseas,
markets. The >International Monetary Fund calculates effective exchange rate indi¬
ces (>index number) for a number of countries. The >Bank of England publishes
indices for sterling with weights based on the currencies of the >-European Union,
the US dollar and the Japanese yen. The weights are recalculated from time to time
to take into account relative changes in international trade. Weal exchange rate.

efficiency-wage hypothesis The hypothesis that it may benefit employers to

pay their workers wages that are higher than their >marginal revenue product
(>marginal productivity theory of wages). The idea behind the theory is that the
value of a worker may depend on how much he/she is paid. This may be because
richer workers are healthier and more productive, or better motivated, or keener to
avoid unemployment. The theory can be used to explain why it is that the >price
system may not work in the >labour market, and that wages do not get bid down
until there is no unemployment. >Akerlof, G.; Stiglitz, J.; >► tournament theory.

efficient markets hypothesis The idea that the prices prevailing in a market
make it impossible to earn abnormally large economic profits by trading in that
market on some specified amount of information. The hypothesis is invariably
applied to financial markets. Here, it says that if on commonly held information,
the price of an asset is expected to rise tomorrow, traders, anticipating this, will buy
EFTA

the asset today. This will drive the price of the asset up immediately until tomorrow's
price rise has already occurred, and no further rise is expected. Thus no quick capital
gain could be made by buying the share. The idea is encapsulated in the slogan that
there are no $roo bills on the sidewalk, because if there were, people would have
already picked them up. If the market were not efficient, the possibility of making
>arbitrage profits would exist, and a clever trader could make quick speculative
gains. »►capital-asset pricing model; chartist; random walk; rational expectations.

EFT A > European Free Trade Association.

EFTPOS Electronic funds transfer at a point of sale ►credit card.

EIB ► European Investment Bank.

EIS >Enterprise Investment Scheme.

elasticity The proportionate change in a ►dependent variable of a ►function,

divided by the proportionate change in an ►independent variable at a given value
of the independent variable. It is a measure of the sensitivity of one thing (e.g.
demand for a commodity), to another, e.g. the price of it. In practice, you can have
elasticities of anything, with respect to anything else (►cross-price elasticity of
demand; elasticity of substitution; income elasticity of demand) and not just in the
area of consumer demand theory. Government, for example, estimates the elasticity
of its tax revenues with respect to economic growth.
Elasticity, being the product of ratios, is independent of the units in which the
variables are measured. The formula is:

% change in y
% change in x

In the case of price elasticity, y would be the quantity demanded, and x would be
price. One might have observed market behaviour in order to calculate an elasticity;
alternatively, it can be derived from an ►econometric model expressing demand as
a >function of price in equation form. If an elasticity has an absolute magnitude
numerically smaller than unity, the quantity demanded is price-inelastic, i.e. that if
the price is increased (marginally) the quantity demanded will not fall proportion¬
ately as much and, therefore, the total expenditure on the good will increase. If the
good is price-elastic (i.e. elasticity is numerically greater than unity) demand will be
reduced more than price, and therefore less will be spent on the good than before
the price was increased. The term 'elasticity' was invented by ►Marshall.

elasticity of substitution The proportionate change in the relative use of a

commodity compared with another over the proportionate change in its relative
price. It is used to measure the degree to which two commodities can substitute for
each other in consumer demand (►demand, theory of) or in production. For
example, if labour and capital are two inputs in production (> factors of production),
they would have a high elasticity of substitution if a small increase in the relative
price of labour leads firms to switch in large measure to the use of capital. If the
elasticity is zero, the two commodities are used in fixed proportions no matter how
expensive one of them becomes. If the elasticity is infinity, the two are perfect
12ZJ empirical testing

substitutes. The formula for the elasticity of substitution between two inputs, x and
y, with prices pl and p2 respectively, is:
% change in x/y
% change in p2lpi
>E technical substitution, rate of.

electronic commerce (e-commerce) Trading activities carried out wholly or

partly using new information and communication technologies (> new economy)
and principally the Internet. It is increasingly possible for consumers (business to
consumer, or B2C) or businesses (business to business or B2B) to search for and
compare goods and services and order them on line. Some items (e.g. computer
software) can also be delivered on line, but in most cases physical delivery by post
or van is necessary. Because of this, and because consumers seem loath to give
up the shopping experience involving seeing and handling branded goods and
discussing them with a salesperson, the penetration of e-commerce, though wide¬
spread, has so far been limited. Initially, it was thought that new companies would
capture most of the business, but what has happened is that old-economy companies
with well-known brands have partially adapted their marketing to embrace the new
technologies, a phenomenon known as 'clicks and mortar'. E-commerce should
increase customer proximity (and thus favours international trade), price transpar¬
ency and »-contestability and therefore competition (Eperfect competition).

emerging markets 1 Markets in ^securities in Enewly industrialized countries

and in countries in central and eastern Europe and elsewhere in transition from
Eplanned, to Efree-market, economies ^transition, economies in) and in >devel¬
oping countries with Ecapital markets at an early stage of development, e.g. the
Estock exchanges in Mexico, Thailand and Malaysia. 2 Although originally used to
refer to securities markets, the term now commonly refers to the countries them¬
selves. The economies of these countries have been growing rapidly at rates several
times greater than those of members of the >Organization for Economic
Cooperation and Development. How this has been achieved and, in particular, what
the role of national governments has been in the process, is controversial. However,
common factors have included high rates of savings, the devotion of considerable
resources to education (Esow's ear effect), high levels of >exports and shifts in the
labour force from agriculture to industry and services, Eeconomic development.

emigration Emigration.

empirical testing Checking theories against facts. In contrast to the physical

sciences, it is rarely possible to conduct controlled experiments in economics, e.g.
to see what would happen to exports if the ^exchange rate were reduced and all
other variables in the international economy remained unchanged. It is possible,
however, to test hypothesis with facts, e.g. to verify historically the extent to
which changes in the exchange rate have been associated with changes in exports
(^econometrics). In fact, experiments can be, and are, carried out in economics (e.g.
laboratory simulations of market behaviour) and there is a growing interest in
experimental economics as an adjunct to historical empiricism and theoretical work.
XEstylized fact.
Employee Share Ownership Plan

Employee Share Ownership Plan (UK) US = Employee Stock Ownership Plan

►employee share-ownership schemes.

employee share-ownership schemes Schemes to allow employees to acquire

►shares in the company in which they work. These and ►profit-sharing are pro¬
moted in some countries by various forms of tax relief, e.g. the Employee Share
Ownership Plan in the UK and Employees Stock Ownership Plan in the USA. The
effectiveness of these schemes in improving business performance is controversial.

employment, full A situation in which everyone in the >labour force who is

willing to work at the market rate for his type of labour has a job, except for those
who are switching from one job to another, i.e. it excludes ►frictional unemploy¬
ment. Under full employment there is neither ►structural unemployment nor any
unemployment arising from a deficiency in ► aggregate demand. It does not imply
anything about the rate of >inflation (^labour force; unemployment; unemploy¬
ment, natural rate of) but the term does normally apply to a situation in which the
►capital stock and the labour force are in balance, i.e. the full employment level of
►gross domestic product is one in which capacity is fully utilized. ►Beveridge, W. H.

EMS >European Monetary System.

e-money Money can now be transferred electronically from account to account

and stored in smart cards (►credit cards) and other pre-paid devices such as phone
cards. Strictly speaking, e-money is a store of value in electronic form that can be
transferred between individuals and organizations without necessarily involving
bank accounts.

endogenous growth theory A set of economic models and ideas that attempt
to explain the rate of >economic growth without recourse to the assumption that
technological progress is simply given, and cannot be accounted for. Traditional
growth models did tend to assume that technology - which they interpreted very
widely to include everything from new machines to a better understanding of
efficient production methods or improved marketing techniques - is exogenous
(►exogenous variable), that for all intents and purposes it is predetermined. Models
of endogenous growth attempt to explain that technology. The earlier models simply
outlined a more important role for > investment - in physical and human capital -
than had until then been common. In particular, they questioned the assumption
of diminishing returns to investment (►diminishing returns, law of). As much
investment has appeared to be subject to diminishing returns, these models have
been superseded by others that have tended to focus far more narrowly on 'know¬
ledge-based' investment in education and in research in particular. They have
stressed the need for institutions that nurture innovation, and provide incentives
for individuals to be inventive. Indeed, > competition policy, industrial relations
and the trade regime in place could all be said to be important. In general, these
models have supported the conclusion that it may be sensible to subsidize education
and research and development. They have also demonstrated that a far wider set of
factors can affect growth than was traditionally supposed. But beyond that, they have
not yielded a precision sufficient to offer useful prescriptions for policy. >► sow's ear
effect; supply-side economics.

endogenous preferences Consumer tastes that are not fixed as a matter of

 entrepreneur

personal character but which are to some extent dependent upon the experiences
of the consumer. The most clear example of endogenous preferences follows from
addiction - an individual’s taste for cigarettes is very much affected by whether the
individual happens to have smoked many cigarettes or not. Acquired tastes, habits,
the desire to justify to oneself one's past consumption, all provide examples of ways
in which yesterday's purchase affects our preferences today. The notion is destructive
of much traditional economics, because once the assumption of exogenous (►exo¬
genous variable) preferences is removed, life is far more complicated than normal
demand theory (>demand, theory of) would imply. A cut in the price of a product
may lead to a shift of the demand curve. The notion of >diminishing marginal
utility may be turned upside down. Unfortunately, it is hard to provide a very
constructive and precise theory of endogenous preferences, although study of the
subject has fruitfully introduced an element of psychology into economics, ►behavi¬
oural economics.

endogenous variable A ^variable whose value is determined by other variables

within a system. The quantity of a good demanded is endogenous within the normal
framework of demand theory (►demand, theory of) because it is affected by price,
while consumer tastes are not usually seen as endogenous. However, in the real
world, it can be argued that almost everything is endogenous eventually. Even the
weather - always taken as the prime example of a non-endogenous variable - is said
to be affected, through climate change, by economic behaviour. Several recent
developments in economics have attempted to explain factors that were considered
fixed. ► endogenous growth theory; endogenous preferences; ^-dependent vari¬
able; exogenous variable; parameter.

Engel, Ernst (1821-96) >Engel's law.

Engel's law A law of economics stating that, with given tastes or preferences, the
proportion of income spent on food diminishes as incomes increase. The law was
formulated by Engel, the director of the Bureau of Statistics in Prussia, in a paper
published by him in 1857.

enterprise One or more firms under common ownership or control, ►establ¬

ishment.

Enterprise Bill ^competition policy.

Enterprise Investment Scheme (ElS) A scheme that provides income-tax relief

to individuals investing in »-small business. Qualifying individuals may be a director
but not an employee or control more than 30 per cent of the capital of the firm, and
many types of non-manufacturing companies are excluded. EIS was introduced on
r January 1994 to replace the Business Expansion Scheme (BES) and tax relief is given
only at 20 per cent rather than at the investor's marginal rate, as under the BES.

entrepot A centre at which goods are received for subsequent distribution. An

entrepot port has facilities for the transhipment of imported goods or their storage
prior to their re-export, without the need to pass through customs control. >*»-free-
port; free trade zone.

entrepreneur An economic agent who perceives market opportunities and

assembles the > factors of production to exploit them in a firm. As the prime mover
in economic activity the entrepreneur has received attention from the beginnings
of economics (e.g. by >Cantillon and »-Say) but, as Casson has recently pointed
out, has never been fully integrated into modern economic theory. In the static
> neo-classical economics of >-perfect competition there is no place for the entrepre¬
neur, since it is assumed that there is perfect information and perfect freedom of
entry. After »-Knight the pure function of the entrepreneur is to deal with uncer¬
tainty in the dynamic, imperfect, real world in which ^-profit is a return to uncer¬
tainty and entrepreneurship is inseparable from control of his/her firm. The essence
of the entrepreneur, therefore, is that he/she should be alert to gaps in the market
which others do not see and is able to raise the finance and other resources required
by a firm to exploit the market that he initiates. If successful he will make a super¬
normal >profit that will later reduce to a normal profit as new competitors are
attracted into the market. In this conception, the pure function of the entrepreneur
is as a fourth factor of production. Other functions than risk-taking have been
attributed by economists to the entrepreneur: invention, the provision of >risk
capital and management, for example. Though not part of the pure entrepreneurial
function which is remunerated by profit, all these functions may be embodied in
the owner-manager of a >small business. His/her remuneration may compromise
>rent as an owner of >land, ^interest as a return on >capital, a wage or salary for
management function and therefore a return for his/her > labour, and profit, a
return for entrepreneurship. In the large firm, the entrepreneur is a theoretical
abstraction whose functions are divided between the management (the board of
directors and senior executives) and the shareholders. Many economists have argued
that the ^separation of ownership from control has important implications for the
behaviour of managers and market performance.

entry ^barriers to entry; freedom of entry.

envelope theorem A proposition with numerous applications in the economics

and mathematics of futility and of production (>production, theory of) that uses
the assumption of optimizing behaviour to simplify the mathematical relationship
between different variables. It is best explained by example. Imagine a firm produces
widgets, using only skilled labour and unskilled labour, and that to some extent it
can ^substitute one type of labour for the other. Now imagine the firm wants to
know how the total cost of producing ioo widgets changes, if the cost of skilled
labour rises by £i an hour. The answer is that there is a direct effect and an indirect
effect. The direct effect is that the cost rises by £i for every hour of skilled labour
employed. The indirect effect emerges because the firm will, in light of the change
in relative prices, choose to alter the mix of skilled and unskilled labour it employs.
(It will want to replace skilled workers with unskilled ones as far as is possible.) The
envelope theorem says that if the firm is optimizing the mix of skilled and unskilled
labour, then for small changes in costs, the indirect effect is effectively zero. Thus,
the theorem dramatically simplifies the calculation needed. It does so because the
firm could only be optimizing when it mixes inputs such that small changes in how
much of each is used have no effect on profit. (After all, if changing the product mix
could increase profits, then the firm could not have been optimizing in the first
place.) If the effect of changes in the quantity of the different types of labour can be
ignored, so can the indirect effects of the cost change. Thus, the change in total cost
resulting in a unit change to the price of an input, is simply the amount of the input
 equation of international demand

employed. Of course, if the firm were not optimizing, it would not be possible to
make the assumption that small changes in the input mix were irrelevant. The
theorem is central to ^duality theory - the relationship between the >* production
function and the related function describing the firm's costs, given an optimal
input mix. It asserts that the ^demand function for inputs is effectively deriv¬
able from the firm's cost function. Similarly, in demand theory (>demand, theory
of), it can be used as a means of obtaining the demand function, from observation
of the consumers' expenditure at different prices. The theorem is also known as
Shephard's lemma.

environmental accounting The attempt to apply numerical magnitudes to

uncosted environmental factors, and to include these in conventional accounts. The
goal is to improve those conventional accounts as a measure of overall well-being. For
example, at the national level, an environmental disaster (e.g. an oil-spill) has the
perverse effect of enhancing national income, spawning as it does extensive, fully
costed, clear-up activity. Obviously, though, the economy is no richer as a result of
an oil spill. Environmental accounting can reflect this. It can also introduce rational
treatment of depletable resources, deducting their consumption as a cost, rather
than adding it as a benefit. Changing the national accounts on this basis would
make little difference to international rankings of economic success. Those who
propound it do so in the hope that a greater emphasis on environment in the
headline measures of success would lead to changes in policy. Attempts have been
made to produce accounts reflecting this argument. Daly and Cobb's index of
sustainable economic welfare, devised in 1989, appears to have grown at 0.9 per cent
a year, in contrast to conventional gross domestic product (GDP) growth of about 2
per cent a year. Tobin (>-Tobin, J.) and Nordhaus, constructed a measure of economic
welfare with more limited environmental accounting, (but still with a large number
of welfare effects included (e.g. the negative cost of time spent travelling to work))
and found an annual per capita growth rate of about x.i per cent over a long time
period in which GDP had grown at about 1.7 per cent. >#»-cost-benefit analysis;
depletion theory; environmental economics; social accounting.

environmental economics The area of economics concerned with issues relating

to man's use and abuse of »-natural resources. Environmental problems are fre¬
quently characterized by the existence of »-externalities and ^public goods. In these
areas, it is hard for the >price system to operate in such a way as to allocate
scarce resources (e.g. clean air and the ozone layer) in an efficient way (^economic
efficiency). Many of the problems that are faced in this area derive from the lack of
clearly defined property rights over natural resources, which makes environmental
abuse likely in the absence of governmental control (J^Coase theorem). Much of
environmental economics has concerned the relative merits of different policy
responses to the various flaws of the market mechanism in these areas. For example,
should emissions be stopped by regulation, or should they be taxed (^polluter pays
principle)? There are also problems that derive from the depletable nature of some
resources (^-depletion theory).

equation of international demand The law of comparative cost (>-Ricardo, D.)

sets out the limits of the >terms of trade within which one country will exchange
commodities with another. >Mill realized that the point at which exchange actually
equilibrium

took place within these limits set by costs would depend on the reciprocal ►demand
of each country for the other's commodities. The ratio at which one country's
commodities exchange for another country's commodities (the ►terms of trade)
will be in equilibrium when the quantity the importer will accept at this ratio equals
the quantity the exporter will be willing to deliver. It will depend, inter alia, on
the ► elasticities of demand and ►supply of the goods traded. W^Marshall-Lemer
criterion.

equilibrium A situation in which the forces that determine the behaviour of some
variable are in balance and thus exert no pressure on that variable to change. It is a
situation in which the actions of all economic agents are mutually consistent. It is a
concept meaningfully applied to any variable whose level is determined by the
outcome of the operation of at least one mechanism or process acting on counter¬
vailing forces. For example, equilibrium price is affected by a process that drives
suppliers to increase prices when demand is in excess and to undercut each other
when supply is in excess - the mechanism thus regulates the forces of supply and
demand.
It is possible for a short-run equilibrium to exist when some quickly adjusting
processes are in balance while other, longer-term, forces are still causing change to
occur. For example, in >perfect competition, in the short run firms' profit-
maximizing behaviour can lead to a market equilibrium with price equal to marginal
cost, yet if abnormal ►profits exist at that price new firms might enter the industry
- a process quite separate from the price-setting behaviour of those already in it -
that will change the long-term equilibrium price.
A distinction can be drawn between a static equilibrium - when the value of the
relevant variable is unchanging - and a dynamic equilibrium - when the value of
the variable is changing, but in a regular way. Equilibrium growth, for example,
might manifest itself in a steady 2.25 per cent rise in gross domestic product.
The concept of an equilibrium has developed in recent decades with the advance
of >game theory. An equilibrium in a game is, loosely, a set of mutually compatible
strategies such that given the strategies of other players, each player will be content
with own strategy.
Finally, equilibrium should not be confused with efficiency. Although the efficient
level of a variable is sometimes likely to be an equilibrium, there is no guarantee that
equilibria are efficient. >► disequilibrium; Nash equilibrium; tatonnement process.

equities ►shares in companies.

equity The residual ►value of a company's ►assets after all outside ►liabilities
(other than to shareholders) have been allowed for. In a ►mortgage, or >hire
purchase contract, equity is the amount left for the borrower if the asset concerned
is sold and the lender repaid. The equity in a company under ►liquidation is the
property of holders of ► ordinary shares, hence these shares are popularly called
equities. Equity yields and prices, although fluctuating, have historically delivered
returns about 8 per cent higher than risk-free ►stocks (>capital asset pricing model).

equity/efficiency trade-off The conflict that is traditionally held to arise

between maximizing average consumption and making that consumption equal
across the population. Under certain conditions, a >free-market economy is gener¬
ally recognized as exhibiting >economic efficiency, but would have no tendency to
 Euler, Leonhard

result in equality of earnings. To achieve an alternative income distribution, a

>progressive tax system is required. However, it is possible that high taxes have a
negative effect on work incentives, or create other distortions, and thus depress
output. In so far as there is a trade-off, however, a >social welfare function must be
defined to derive the optimal combination, ^welfare economics.

equity gearing >gearing.

equity-linked assurance > assurance.

ERDF European Regional Development Fund (>European Union).

ERM >European Exchange Rate Mechanism.

escalator The policy of the UK government to raise the specific duties (>tax,
specific) on petrol and tobacco by more than the rate of inflation each year. In 1997,
the escalators were set at 6 per cent and 5 per cent, respectively.

ESOP Employee Share Ownership Plan; Employee Stock Ownership Plan (>em-
ployee share-ownership schemes).

establishment An operating unit of a business, to be distinguished from a firm or

►enterprise, which are controlling units.

ethical investing The attempt by lenders or shareholders to influence company

behaviour by investing only in companies that observe certain standards of
behaviour. The goal - apart from satisfying the conscience of the investors concerned
- is to increase the cost of capital (>capital, cost of) to firms whose ethical standards
are low, and in doing so make capital less available. Where a capital market is
dominated by non-ethical investors, however, it is not clear that any small cluster
of individuals has the power to affect any company's cost of capital. In so far as they
do, the less ethical can pick up investment bargains. Ethical investment funds - and
those doing research on their behalf - have influenced corporate behaviour through
the publicity they bring to company actions.

Euler, Leonhard (1707-83) Economists have found that certain propositions in

pure mathematics developed by Euler, a Swiss mathematician, can be usefully
applied to problems in economic theory. The most notable application concerns a
theory of distribution based on > marginal productivity. This theory states that
►factors of production (i.e. >-land, >labour and ►capital) will each earn an ►in¬
come corresponding to the >value of >output produced by the last unit of the
factor employed. For example, if a firm employs nineteen workers at an average
wage of £400 per week, it will be willing to employ an additional worker as long as
his/her output is worth more than £400. Moreover, if the twentieth worker yields,
say, £410 per week it will be worthwhile to pay him/her more than £400 to attract
him/her. The firm cannot, however, pay its workers different wages if they have the
same skill, and therefore must pay all of them more than £400 per week. The earnings
of each worker are therefore made equal to that at which it is just worthwhile to the
firm to employ one more worker. A similar argument is applied to other factors of
production and for the total national output as well as for a single firm. However,
total output must, by definition, equal total income (►national income). National
output is distributed among the three basic factors of production: land, labour and
capital. No arithmetical reasons, however, can be given for the different factor
Euler's theorem

incomes, derived from marginal productivities, necessarily adding up to the same

figure as total output. Euler's theorem resolved the problem by showing what
assumptions about the nature of the ^production function (which describes how
the factors of production are combined to produce outputs) had to be made in order
for the equality between the sum of incomes and the sum of outputs to be achieved.
»► Cambridge School; distribution, theory of; neo-classical economics.

Euler's theorem >Euler, L.

euro >-European Monetary Union.

eurobond >bond; eurocurrency.

eurocurrency ^Currency held by individuals and institutions outside the country

of issue. The >Bank for International Settlements has described eurodollars as the
dollars acquired 'by banks located outside the United States, mostly through the
taking of > deposits, but also to some extent through swapping other currencies into
dollars, and the relending of these dollars, often after redepositing with other banks,
to non-bank borrowers anywhere in the world'. It should be noted, therefore, that
the market for eurocurrencies is not confined to Europe. In terms of a simple example,
the following happens. A London bank, as a result of a commercial transaction of
one of its customers, has, for example, a >credit balance with a US bank in New
York. A Tokyo businessman asks his bank for dollars to finance imports from the
USA. In order to meet this request, the Tokyo bank accepts the dollar deposit
transferred by the London bank from its account in New York. The essential point
about this operation is that it creates credit. The London bank still has a claim on
Tokyo instead of New York, whereas the Tokyo bank now has a claim on New York
that its customer can use to finance his trade. The questions are naturally raised as
to why London should be willing to transfer its deposit and why Tokyo should
finance its requirements in this way. The US ^balance of payments deficits and
dollar certificates of deposit issued by overseas branches of US banks generate a supply
of eurodollars, and interest-rate >arbitrage (New York versus Tokyo) enables a
>profit to be made. Relative >rates of interest are a factor in these transactions but,
in addition, the existence of national ^exchange controls and credit controls may
encourage the practice. Of course, there can be many relending transactions between
banks in response to differentials in interest rates and in many different currencies.

eurodollars >eurocurrency.

European Association of Securities Dealers Automated Quotation System

(EASDAQ) A pan-European market for trading >shares in growth companies and
modelled on NASDAQ (>over-the-countermarket) in the USA. The EASDAQ,
which opened in 1986, is a for-profit company based in Brussels. Its shareholders
include venture capital companies (>risk capital), > investment banks and
NASDAQ.

European Bank for Reconstruction and Development An international bank

set up in T99T to 'promote private and entrepreneurial initiative in the central and
eastern European countries committed to, and applying the principles of, multi¬
party democracy, pluralism and market economics'. It was established to help the
previously ^planned economies of Central and Eastern Europe to develop free
125 European Exchange Rate Mechanism

markets that would have a minimum of government intervention and whose govern¬
ments would be freely elected on a multi-party basis. Sixty countries and institutions
are members of the bank, including the >European Union and the »-European
Investment Bank, and of these shareholders, twenty-seven countries in central and
eastern Europe and central Asia are recipients of the bank's investment and lending.
It may lend at market rates of > interest or invest in > equities. Total new investment
in 2002 reached €3.9 billion and the shareholders agreed to double the bank's total
capital to €40 billion. The Bank is located in London. ^-International Bank for
Reconstruction and Development.

European Central Bank (ECB) The organization responsible for conducting

^-monetary policy in the eurozone at the supra-national level (>European Monetary
Union (EMU)). It was established in Frankfurt in r998 and became fully operational
on 1 January 1999, when it became responsible for monetary policy in the euro
area. The ECB is independent of national governments; it works with the national
^central banks of the member states that have adopted the euro. The governing
council of the ECB consists of a six-member, full-time executive board and the
governors of the central banks participating in EMU. The ECB has the sole right to
authorize the issue of euro banknotes. The objectives of the ECB are laid down in
the >Maastricht Treaty and are: (a) to maintain price stability (less than 2 per cent
annual increase in the ^harmonized index of consumer prices) and, (b) subject to
price stability, to 'support the general economic policies in the Community'.

European Coal and Steel Community (ECSC) The conception of the Schuman
Plan (named after the then French foreign minister) for the establishment of a
common European market in coal and steel. It was embodied in the Treaty of Paris
of 195T, ratified by the member countries (i.e. Germany, France, Italy and ^Benelux)
in 1952. All import duties and >quota restrictions on coal, iron ore, steel and scrap
were eliminated on intracommunity trade. The treaty also provided for the control
of restrictive practices and >mergers considered contrary to the maintenance of free
competition. The ECSC merged with the then European Economic Community and
Euratom in T967 to form the European Community (^European Union), and ceased
to exist with the termination of the treaty in 2002. >customs union.

European Community >-European Union.

European Currency Unit (ECU) Notional currency introduced as a unit of account

(>money) of the then European Community (>European Union (EU)) on the
formation of the >European Monetary System in 1970. The ECU was a >weighted
average of the currencies of the member countries of the EU and used solely for
bookkeeping purposes. The ECU was replaced at the rate of r for 1 by the euro on
the formation of the >European Monetary Union.

European Development Fund >Lome Convention.

European Economic Area ^European Free Trade Association.

European Economic Community ^European Union.

European Exchange Rate Mechanism (ERM) The fixed >exchange rate regime
established by the then European Community (^European Union) in 1979. The
system was designed to keep the member countries' exchange rates within specified
European Free Trade Association

bands in relation to each other. Each currency in the system was allowed initially to
fluctuate between ±2.25 per cent against any other currency, later widened to up to
±15 per cent. The ERM came to be seen as a precursor to >European Monetary
Union, with membership implicitly representing a condition of entry to EMU
according to the ►Maastricht Treaty.

European Free Trade Association (EFTA) The Stockholm Agreement of r959

established a >free-trade area between the UK, Norway, Sweden, Denmark, Austria,
Portugal and Switzerland. The association was later joined by Finland, Iceland
and Liechtenstein. Currently, there are four member states, Iceland, Liechtenstein,
Norway and Switzerland, the other countries having left on becoming members of
the >EU. In r994, the European Economic Area (EEA) came into force which linked
EFTA, excluding Switzerland, with the EU into a wider free trade area. This estab¬
lished a single market for the free movement of goods, services, people and capital.
The agreement does not extend to the European Common Agricultural Policy nor
the Common Fisheries Policy and the group remains a free trade area rather than a
►customs union. Meanwhile, Switzerland had concluded a number of bilateral
agreements with the EU and it was decided to subsume the EEA and these Swiss/EU
agreements into a revised EFTA Convention in 20or. The members of EFTA have
the right to consultation in the EU legislative process and the EEA convention is
continuously updated to keep it in line with relevant EU legislation. The EFTA has
continued a policy of setting up free trade agreements with other countries and
these have covered countries in Central and Eastern Europe, the Mediterranean and
Mexico. »-General Agreement on Tariffs and Trade; North American Free Trade
Agreement.

European Investment Bank (EIB) A bank established in t958 by the then Euro¬
pean Community (^European Union (EU)) whose board of governors comprises
the ministers of finance of the EU. It is a non-profitmaking institution whose
function is to make loans and give guarantees with respect to: (a) projects in the
underdeveloped areas of the EU and in support of EU >foreign aid (>-Lome Conven¬
tion); (b) projects of modernization, conversion or development that are regarded
as necessary for the development of the EU, and (c) projects in which member
countries of the EU have a common interest. Under the EIB's charter, loans and
outstanding guarantees cannot exceed two-and-a-half times its subscribed capital of
€r5o billion in 2002.

European Monetary Cooperation Fund >European Monetary System.

European Monetary System (EMS) The European Monetary System was the
name given to the common international financial structures adopted by the
member countries of the > European Union (EU) in advance of > European Monet¬
ary Union. The major elements in this structure were the ^European Exchange Rate
Mechanism, the > European Currency Unit and the European Monetary
Cooperation Fund. The last was the >clearing house for the ►central banks in the
EMS although, in practice, the day-to-day running of the system was carried out by
the >-Bank for International Settlements.

European Monetary Union (EM U) A programme for the establishment of monet¬

ary union was agreed under the terms of the ►Maastricht Treaty, to establish a single
 European Union

European currency (the euro). Member states of the European Union (EU) judged to
have 'converged' sufficiently with other members of the EU, by reference to a
number of conditions are entitled to join (>convergance criteria). EMU came into
full operation with the replacement of national currencies with euronotes and coins
on i January 2002. Twelve members of the EU joined the EMU, i.e. Austria, Belgium,
Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, The Netherlands,
Portugal and Spain. Three members (i.e. Denmark, Sweden and the UK) did not join.
Countries inside are subject to rules on government borrowing (S-stability and
growth pact).
Member nations are not able to exert an independent monetary policy. A level of
interest rate is set for all members. If each member tends to follow the others, and
absorb similar shocks to demand and supply, this need not be a problem. However,
if member states endure divergent patterns of economic performance, the burden
of adjustment will have to fall on domestic prices and employment, rather than
interest rates or exchange rates. For example, if Germany is >overheating, and
Austria is in the grip of >• deflation, Austria would have to endure the high interest
rates suited to calm down the German economy. To boost >aggregate demand in
Austria, the government would be constrained in its borrowing by the stability and
growth pact. It would have to rely on recession to cause domestic prices to fall in
order to lead to extra demand for Austrian products and, subsequently, higher
output and employment.
It is worth nothing that on the basis of >Keynesian economics - that regards
control of aggregate demand to be central to good economic management - monet¬
ary union looks risky. On the basis of »-new classical economics, which believes in
the > neutrality of money, the single currency should not make much difference to
the behaviour of European economies (>Mundell, R. A.).

European Regional Development Fund (ERDF) >• European Union.

European Social Fund >European Union.

European Union Six countries of Western Europe (i.e. France, West Germany,
Italy, Belgium, The Netherlands and Luxembourg) signed the Treaty of Rome in 1957
for the creation between them of a ^customs union or common market. By this
treaty the European Economic Community (EEC) came into force on 1 January 1958.
The EEC merged with the ^European Coal and Steel Community and Euratom in
1967 to form the European Community, subsequently referred to as the European
Union (EU). All internal import duties were abolished and a common external tariff
established by 1 July r968. For agricultural products, the ^Common Agricultural
Policy became effective in 1968. As from r January r973 the Republic of Ireland and
two members of the >■ European Free Trade Association (i.e. the UK and Denmark)
became full members of the EU. The elimination of tariffs between the original six
and the new members and the adoption by them of the common external tariff was
completed on r January 1977. Greece became a member in 1981, Portugal and Spain
in r986, Austria, Finland and Sweden in 1995. The German Democratic Republic (East
Germany) became a member in 1990 following its merger with the Federal Republic
of Germany (West Germany).
The EU was not a complete single ^market because there existed restrictions that
prevented free trade, e.g. national differences in technical standards within the
ex ante

Community and differential qualification requirements for the professions (> barri¬
ers to entry). A programme was initiated and embodied in the Single European Act
1986 for the abolition of such restrictions. The programme involved the abolition of
exchange controls, the recognition of qualifications, the abolition of restrictions on
internal transport (>cabotage), liberalization of the market in air services, public
procurement tendering, life insurance and banking services, and the abolition of
frontier controls (>Schengen Treaty). The Act also widened the application of
qualified majority decision-making in the EU. The Treaty of Rome was subsequently
amended by the Treaties of >-Maastricht in 1992, Amsterdam in t997 and Nice in
2000. The executive management of the EU is vested in a Commission, the members
of which are appointed for periods of 4 years. Problems of policy are the concern of
the Council of Ministers, to which the Commission's proposals are submitted. Each
member country is represented by one minister in the Council. Decisions can be
taken by unanimity (each country has a veto) or by qualified majority voting in which
each nation has votes partially weighted by its size; a majority of about 70 per cent
of total votes is needed to carry a provision. In preparation for the expansion of the
EU to twenty-seven member countries, voting rules were revised at Nice in 2000.
Majority voting was widened, and the qualified majority threshold raised to about
75 per cent. A unanimous vote was retained for decisions relating to taxation and
social security. Considerable legislative influence, but less ultimate power, also
resides in the European Parliament. The European Court of Justice has ultimate
authority to interpret the treaty, and acts as a kind of supreme court. It is supported
by a Court of Auditors, and a Court of First Instance. Decisions of the EU are
transmitted either through the member countries' governments by means of Direc¬
tives (^Directives of the European Union) or directly through Regulations. Consulta¬
tive institutions include an economic and social committee and a monetary
committee. The >European Investment Bank has been formed and a European
Regional Development Fund established with powers to lend and grant money for
the development of backward regions of the EU and for >foreign aid. In addition,
a European Social Fund has been set up to assist the redeployment of workers thrown
out of work, particularly if caused by the creation of the EU. A European Environment
Agency was set up in 1990. The Commission monitors competition to ensure that
no enterprise acts in such a way as to restrict the free movement of goods and
services in the EU or to exploit a dominant market position (^competition policy).
There is expectation that ten states in Central and Eastern Europe, the Baltic and in
the Mediterranean will join the EU in 2004, their applications having been approved.
A further three countries have applied to join. In 2002, a Convention on the Future
of Europe was opened to which representatives from prospective new member states
were invited. The Convention is to make recommendations regarding the future
governance of the EU, particularly in relation to its extended membership. The
recommendations of the Convention are scheduled for consideration in 2004. >-Eur¬
opean Monetary Union; migration.

ex ante Expected or intended before the event, as distinct from ex post, which is
the result after the event. Since the future is largely unpredictable, expectations and
outcomes will often be different. The concepts of ex ante and ex post are particularly
useful in economics because the nature of expectations may help either to realize or
to falsify expectations in the process of moving towards ^equilibrium. For example,
 exchange control

if investors expect security prices to rise today ex ante, this will increase demand for
them and their price now, so that ex post and ex ante prices may be similar. If intended
aggregate > savings (ex ante) are larger than intended > investment, this will set in
train forces, via lower incomes, to reduce savings so that ex post savings and invest¬
ment will be equal (Encorne determination, theory of). W^Myrdal, G. K.

ex post >ex ante.

exceptional items Eelow the line.

excess capacity 1 The difference between the amount produced by a firm or group
of firms and the higher amount that could most efficiently be produced. If a firm
produces 1000 cars at a cost of £5000 each, but the lowest cost output would be T300
cars at £4000 each, there is said to be excess capacity of 300 cars. It will exist at any
point on an ► average-cost curve to the left of the lowest point. Sustained excess
capacity is a feature of firms in ^monopolistic competition. In >perfect compe¬
tition, it will exist only in the short term. 2 The difference between actual output
and maximum possible output in a firm, industry or economy. Excess capacity
exists when there are unemployed resources; for a national economy it implies the
existence of a ^deflationary gap. Eutput gap.

excess demand The state of a market for a commodity in which consumers would
choose to buy more of the commodity than is available at the prevailing price.
Excess demand will be equal to zero at the Equilibrium price; it will be negative
(i.e. Excess supply will exist) when the price is higher and will be positive when
the price is lower. If price does not ration the available supply, something else must;
usually it will be State-organized rationing or a queuing system coupled with a
first-come first-served distribution. The situation can result from price control in
which suppliers are legally prevented from raising their prices in response to high
consumer demand, ^repressed inflation.

excess profit >profit.

excess supply The state of the market for a commodity in which more of the
commodity is available for purchase than consumers choose to buy at the prevailing
price. Usually, such a situation leads to a price fall and excess supply disappears. In
a market in which minimum price control is applied it can, however, persist; if, for
example, trade unions prevent wages from falling enough, some argue that there
can be an excess supply of labour (or unemployment) at the prevailing wage.
^Excess demand; Keynesian unemployment.

exchange control The control by the State through the >banking system of
dealings in gold and foreign ^currencies. Exchange control is concerned with
controlling the purchase and sale of currencies by residents alone, since governments
do not have complete powers to control the activities of non-residents. This must
be done through the >market and is a matter of exchange management (Exchange
equalization account). Exchange control is required only where a country wishes to
influence the international value of its currency. It is not willing to leave the value
of its currency in terms of other currencies or gold to be determined in the Mree
market, as it would be under a system of floating Exchange rates, or to allow the
fixed external value of its currency to be the determinant of the domestic price level.
exchange economy

In its most extreme form, a country facing a balance-of-payments deficit may use
exchange control to restrict imports to the amount earned in >foreign exchange by
its nationals. All forms of exchange control are discouraged by the ^Organization
for Economic Cooperation and Development and other international organizations
concerned with encouraging > international trade. It should be noted that a currency
is not fully convertible (^convertibility) when exchange control is operated. ^Eur¬
opean Monetary Union; counter trade; mobility of capital.

exchange economy An economy which has progressed beyond the point at

which each household produces goods solely for its own consumption. Exchange,
whether by >barter or by the use of >money, enables the benefits of the specializ¬
ation (>division of labour) and the >economies of scale to be realized, ^economic
growth.

exchange equalization account (UK) An account controlled by the ^Treasury

and managed by the >*Bank of England through which sterling is bought and sold
for gold and foreign >currencies with the potential object of offsetting major
fluctuations in the exchange value of the pound and keeping the >-spot market price
for the pound around some required rate. The Vassets of the account include the
►gold and foreign exchange reserves and sterling, provided by the »-Exchequer,
invested in >treasury bills. Similar funds or stabilization accounts are operated by
other countries, ^exchange rate; International Monetary Fund.

exchange equation m-Fisher, I.

exchange of shares A means of business combination which can take two forms:
(a) the companies retain their separate identities, but exchange a quantity of >-shares
so that each company holds shares in the other and normally some directors will sit
on both boards (>interlocking directorates), and (b) two companies will merge,
shares of one company being exchanged with or without a cash adjustment for the
whole of the issued share >capital of the other. X^merger; reverse take-over.

exchange rate The price (rate) at which one ^currency is exchanged for another.
Transactions in foreign exchange occur spot or forward (»-spot market and forward
market) in the > foreign-exchange markets. The actual rate at any one time is
determined by >-supply and >demand conditions for the relevant currencies in the
market. An economy has an internationally traded sector and a domestic sector.
The prices obtained by the former are determined by the prevailing prices on the
international market and the exchange rate, whereas prices in the latter are not
determined so directly.
A fall in the exchange rate will increase demand and make the internationally
traded sector relatively more attractive compared with the domestic sector and
therefore there will tend to be a redirection of resources in its favour. The reverse
would happen with an increase in the exchange rate. Often when the economy
receives a 'shock', the relative size and profitability of the two sectors needs to adjust,
and the exchange rate is one means by which the relative price changes needed to
induce the adjustment can be transmitted to the two sectors. For example, a shock
might include a big rise in domestic savings, without a rise in domestic investment.
In this event, as domestic demand falls, exports may be expanded to offset this loss
of demand by a fall in the exchange rate. The exchange rate is simply a component
 excise duties

of the >price mechanism, albeit an important one, responding to the pressures set
by preferences for domestic and foreign goods and services, and the flows of savings
and investment funds across currencies. It follows that the value of the currency is
also determined by domestic >monetary policy - more inflation tends to mean a
lower exchange rate as, without a depreciation, inflation hits the tradable sector
more harshly than the non-tradable sector because it has to accept the world prices
for its products. Given the importance of such an economic variable, governments
have often sought to control exchange rates.
In the absence of government controls, there would be an entirely free or floating
exchange rate in operation. With a freely floating system, no >gold and foreign
exchange reserves would be required as the exchange rate would adjust itself until
the supply and demand for the currencies were brought into balance. Fluctuations
in the rate may be inconvenient for trading, and these fluctuations could be volatile
if left to move freely. Moreover, because of the pressure of short-term ^capital
movements or ^speculation, the exchange rate could move in a direction different
from that justified by conditions in the domestic economy (>exchange-rate over¬
shooting). The alternative is some form of fixed system, ranging from 'hard' to 'soft',
the ultimate 'hard' being a >currency union and the ultimate 'soft' being a freely
floating rate with no government intervention. A middle course has been proposed
in the 'moving parity', 'sliding parity', 'dynamic' or 'crawling peg' idea. In the moving
parity, the par rate is automatically adjusted according to a moving average of past
rates taken over a number of months. Under the sliding parity, instead of the whole
amount of a revaluation or devaluation taking place at once, it is spread in small
percentages over a number of months. Under the crawling peg, the gradual adjust¬
ments in the exchange rate are linked to the level of a country's reserves rather than
past exchange rates. A disadvantage of 'pegged' currencies is that an imbalance
between monetary policy and the exchange rate regime may remain concealed until
there is a forced devaluation leading to serious financial losses. Since the 1990s, there
has been a drop in the number of countries following pegged currency policies.
>-currency board; European Monetary Union; Mundell, R.; ^currency appreci¬
ation; effective exchange rate; European Monetary System; real exchange rate.

exchange-rate overshooting The idea, promulgated by Dornbusch, that when

governments make a domestic monetary policy shift, for a short time the exchange
rate will adjust further than the changed monetary stance merits. For instance, under
plausible assumptions about the >mobility of capital, if the >rate of interest in the
UK is to be higher than that of the USA, investors must expect the pound to devalue
against the dollar: this depreciation would reduce the value of their sterling assets,
offsetting the higher interest rate. If they did not believe that the pound was to
devalue, they would put all their money in pounds, earning a higher rate of return.
As a result, if a government orchestrates a rise in interest rates, money will flow into
its currency from other lower-interest-rate jurisdictions. This will lead the currency
to appreciate in value, and it will go on appreciating until it has gone up so far that
it is now expected to fall again, ^exchange rate; law of one price.

Exchequer The account of the central government kept at the >-Bank of England.
>*• Consolidated Fund.

excise duties Indirect taxes levied upon goods (e.g. beer) produced for home
exclusive dealing

consumption as distinct from customs duties (> tariffs, import), which are levied on
goods entering or leaving the country (^taxation). Both excise duties and tariffs in
the UK are administered by HM Customs and Excise.

exclusive dealing A 'tie' under which a retailer or wholesaler contracts to purchase

from a supplier on the understanding that no other distributor will be appointed or
receive supplies in a given area, e.g. tied petrol-filling stations and public houses.
Exclusive dealing may be a ►barrier to entry, but it can be defended on grounds of
benefits to the consumer, such as after-sales service. »*-Chicago School; competition
policy; vertical restraints.

ex-dividend Without ►dividend. The purchaser of a >security quoted ex-dividend

does not have the right to the next dividend when due. The term 'ex-', meaning
'excluding', is also used in a similar sense in relation to ►rights issue, capitalization
issue (►bonus issue), etc.

exempt company ►private company.

exogenous variable A ►variable whose value is not determined within the set
of equations, or ►models, established to make predictions or test a hypothesis.
W'-endogenous variable; parameter.

expectation of life >death rate.

expectations The views held by economic agents as to the future behaviour of

relevant economic variables. Although expectations have some role in the theory of
►microeconomics (in particular, the ►cobweb model and in pricing behaviour in
►oligopoly) their primary importance is in >macroeconomics. In almost all models
of the economy, in-built assumptions are made as to what views individuals hold
about the future. For example, when future rates of return in asset markets are
uncertain, the expectations of investors will determine the prevailing rate of interest
more than the actual return made on any asset; when wage bargainers target a >real
wage, they must have a view of expected inflation to know what money wage to
seek, and under the >acceleration principle of investment, it is the expectations of
firms about future demand that determines their investment behaviour. In any
model where uncertainty is prevalent, the expectation-forming process of indi¬
viduals will be important.
There are various different assumptions that can be made about expectations: (a)
they could be an > exogenous variable - in this case they are not influenced by
any events in the model, but are just imposed from outside; (b) they could be
backward-looking, made by economic agents on the basis of past values of the variables
in question (>adaptive expectations), and (c) they can be so-called >rational expec¬
tations, in which case agents are assumed not to make systematic errors in their
forecasting of variables. In certain economic models, by assuming rational expec¬
tations, very strong conclusions can be reached about how the economy should be
controlled. »► Lucas critique; policy ineffectiveness theorem.

expected utility A measure of the welfare accruing to a consumer from an asset

which yields an uncertain flow of benefits. Suppose, for example, a consumer takes
part in a lottery, in which there is a 50 per cent chance of winning £10 and a 50 per
cent chance of winning nothing. The consumer's expected >utility will be 50 per
 Export Credits Guarantee Department

cent of the utility of winning £10 and 50 per cent of the utility of winning nothing.
An important distinction should be made between the expected utility of a lottery
and the utility of the expected outcome. In the example above, the expected utility
of £5 may not be the same as the average of the utility of £10 and the utility of zero
pounds. >von Neumann-Morgenstern utility function,’^diminishing marginal
utility; risk; risk aversion.

expenditure tax A form of >direct taxation on spending. Advocated by >Kaldor

and > Meade and others on the ground that it would eliminate the necessity to
define >income, which is a source of complexity and, many would argue, inequity
in the common form of >income tax. In practice, an expenditure tax would be just
like income tax, either with full tax deductibility of all income that is saved, or with
a zero rate of tax on all income from savings. Each of the two systems involves
removing >double taxation from income that is invested. With so many forms of
savings now subject to generous tax treatment, we already have a rather complex
hybrid income/expenditure tax mix. Among the advantages claimed for a full expen¬
diture tax are that it: (a) would encourage saving and not discriminate between
alternative savings media (eliminating one set of distortions in ^capital markets),
and (b) would reduce > compliance costs, and close loopholes in the present system
that allow the avoidance of income tax by converting income into >capital. It
should be understood that indirect taxes such as > value-added tax, although taxes
on expenditure, are quite different from the proposed expenditure tax both in
the method of collection and in their inability to take the individual financial
circumstances of the spender into account.

experimental economics >empirical testing.

export credit insurance The granting of >insurance to cover the commercial

and political risks of selling in overseas markets. Concern about the use of govern¬
ment export credit agencies to subsidize export markets led to the Export Credit
Arrangement, agreed between a number of member states of the >Organization for
Economic Cooperation and Development (OECD). This arrangement established
minimum Crates of interest and maximum repayment periods for specified cate¬
gories of borrower. These guidelines were revised in 1991 following concern about
the growth of the use of a mix of credits with direct aid tied to a requirement that
the recipient country must buy the goods and services of the donor country. The
terms are regularly updated by the OECD. >► Export Credits Guarantee Department;
Export-Import Bank; Multilateral Investment Guarantee Agency.

Export Credits Guarantee Department (ECGD)AUK government department

(set up in 1930 as an independent department, although it had operated in another
form from 1919) responsible to the Secretary of State for Trade and Industry, that has
the authority, under ^Treasury control, to issue ^insurance policies to cover risks
met by exporters. Its powers were revised by the Export and Investment Guarantees
Act (1991) and its short-term credit insurance operations were privatized (> privatiz¬
ation) in 1991. The ECGD can give insurance cover to firms selling overseas and to
their banks in the UK for credit extending for 2 years or more. It can also insure
against political risk in overseas markets. Most major exporting countries have
similar organizations, e.g. Compagnie francaise d'assurance pour le commerce
Export-Import Bank

exterieur (COFACE) in France and the >Export-Import Bank (US), ^export credit
insurance; Multilateral Investment Guarantee Agency.

Export-Import Bank A US government agency, established in r934, and re¬

established in r945, for the purpose of encouraging US trade by supplying >credit
at subsidized rates of interest and financial guarantees to customers of US exporters.
It also gives US exporters reinsurance cover Vexport credit insurance. »Export
Credits Guarantee Department; Multilateral Investment Guarantee Agency.

export incentives Preferential treatment for firms that sell their products abroad,
compared with firms that sell to the home market. They may take the form of direct
^subsidies, special ^credit facilities, grants, concessions in the field of >direct
taxation, benefits arising from the administration of indirect taxation, and >>export
credit insurance on exceptionally favourable terms. Various international associ¬
ations discourage the practice of artificially stimulating exports by any of these
methods. The EWorld Trade Organization lays down special provisions relating to
export subsidies, direct or indirect, in an attempt to limit them. In the field of 'tied
aid’ (>foreign aid) the rules of the > Organization for Economic Cooperation and
Development determine that a minimum proportion of the finance must be grant
aid where the finance is not conditional on the donor country receiving the contract
for the project being financed.

export multiplier The ratio of the total increase in a country's > national income
to the increment in export revenue generating the increase. The size of the multiplier
depends on the propensities to save (>average propensity to save; marginal propen¬
sity to save) of the recipients of the increases in incomes derived from the increase
in export revenue and the country's ^propensity to import. The export multiplier
can be regarded as a special case of the general ^-multiplier.

export processing zone Mree trade zone.

export rebates ^customs drawback; export incentives.

export surplus >-balance of payments.

exports The goods and »-services produced by one country that are sold to another
for gold, or ^foreign exchange or in settlement of >debt, in exchange for the second
country's own goods and services. Countries tend to specialize in the production of
those goods and services in which they can be relatively most efficient, because of
their indigenous factor endowments (»► factors of production). Countries devote
home resources to exports because they can obtain more goods and services by
international exchange than they would from the same resources devoted to home
production directly. The USA's exports of goods and services amount to about ir per
cent of its >-gross national income, compared with about 28 per cent in the UK.
^balance of payments; international trade; mercantilism; Ricardo, D.

external deficit A synonym for ^balance of payments deficit.

external diseconomies ^diseconomies of scale.

external effects ^externalities.

externalities Consequences for welfare of >opportunity costs not fully accounted

for in the >price and > market system. External diseconomies of production include
 extraordinary items

traffic congestion and pollution created by a manufacturing plant. These cause

reductions in the welfare of people living near the factory and perhaps increased
costs to adjacent factories that might need to purify water taken from a river
bordering both plants. Because the third parties receive no compensation (do not
charge) for these external diseconomies, there are costs of production not accounted
for in the price system. External diseconomies also arise in >consumption, e.g.
where people eating ice-cream leave paper on the pavement or cigarette smokers
pollute the air in a public building. Both production and consumption externalities
can occur simultaneously where, for example, a restaurant creates noise, congestion
and smell.
External economies of production may arise where the existence of several factories
stimulates the availability of skilled labour, shopping facilities or component sup¬
plies. External economies of consumption include a garden at the front of a house
that gives pleasure to passers-by as well as to the occupants and increases the
value of adjoining property. Defence or other public expenditure on research and
development is sometimes justified on the additional ground that it stimulates the
development of new >technology that may become freely available to all. This is
usually called a spillover effect, an alternative term for externality.
Externalities are important in determining the efficient allocation of resources. In
a >free-market economy, individuals typically only attempt to maximize their own
private utility or profit, and external costs and benefits will not be reflected in the
prices of things. A firm may make perfumes very cheaply but, nevertheless, be
polluting the atmosphere in the process, to the detriment of non-perfume buyers.
Unless the cost of this pollution is reflected in the price of the perfume, people will
buy more of it than they would choose to if they had to pay for the entire cost to
society of its production. In short it is full social costs that are important in determin¬
ing an efficient resource allocation, and private costs that determine prices.
There are two means of dealing with externalities: (a) a structure of taxes and
subsidies can be designed to internalize the externalities and ensure that the full costs
or benefits of production are reflected in the prices charged; in this case, even if a
factory causes pollution, it can carry on producing as long as it properly compensates
society for the damage caused, and (b) to put restrictions on certain unsocial activities
and make other beneficial activities compulsory. This will, however, usually not be
as efficient as the optimal taxes or subsidies could be, because you may restrict
activity that, despite its negative external effects, still benefits the performer more
than its restriction helps society. > social welfare; >*^Coase theorem; environmental
economics; polluter pays principle.

extraordinary items »-below the line.

F

face value Nominal as distinct from >-market value. The face value of a >security
is the price at which it will be redeemed: (a) of an ^ordinary share its >par value or
issued price, and (b) of a coin the amount stamped on it which might, for a silver or
gold coin, be less than its market value.

factor 1 >factors of production. 2 >factoring. 3 An agent who buys and sells

goods on behalf of others for a >commission called 'factorage'.

factor cost A term used in the national accounts (Asocial accounting) to describe
the valuation of output at market prices less taxes on expenditure plus subsidies.

factor endowment The relative availability of the different ^factors of pro¬

duction in a country. An important determinant of the pattern of international
trade. >Heckscher-Ohlin principle; ^comparative advantage.

factor markets The Mabour market, the >-capital market and other ^markets in
which the Mactors of production are bought and sold. The theory of distribution
(^distribution, theory of) attempts to explain how the >prices of factors are deter¬
mined and how they are allocated between alternative uses.

factor payments Payments made to the owners of the > factors of production in
return for their use in the production process.

factor price equalization theorem >Samuelson, P. A.

factoring The business activity in which a company takes over the responsibility
for the collecting of the >debts of another. It is a service primarily intended to meet
the needs of small and medium-size firms. Typically, the client debits all his sales to
the factor and receives immediate payment from him less a charge of about 2-3 per
cent and interest for the period of > trade credit given to the customer, thus improv¬
ing the client’s cash flow considerably. There are a number of different types of
factoring; the simplest is known as 'invoice discounting'. In its most elaborate form
the factor maintains the company's sales ledger and other accounting functions,
and does not seek recourse to its client if unable to obtain payment from that client's
customers (non-recourse factoring). The customer need not know that a factor is
being used. The factor generally has some control over sales either by imposing a
maximum >credit limit that he is willing to meet or by vetting specific prospective
clients. Through international factoring companies, the factor can offer a service
to exporters by protecting his customers from bad debts overseas and by giving,
 Federal Reserve System

for example, expert advice on Moreign exchange transactions (»-Export Credits

Guarantee Department).

factors of production The inputs or resources used in the process of production.

►Land, ^labour and ►capital are the three primary groups used in analysis of
factors, with entrepreneurship (^entrepreneur) often counted as a fourth. factor
endowment; natural resources; Say, J.-B.

Fair Trading Act ► competition policy.

FAO ►Food and Agriculture Organization.

farm subsidies Financial assistance granted by governments to support and

protect their agriculture. Protection may take the form of import ►tariffs, import
► quotas and export subsidies (► export incentives) to insulate the industry from
foreign competition, guaranteed commodity prices or direct payments to farmers.
Arguments for farm subsidies are: (a) the perceived need to have a secure domestic
food supply; (b) to limit the effect of wide fluctuations in farm prices (>► cobweb
model), and (c) to maintain the rural environment. The practice is widespread
throughout the world though with a wide range in degree. The value of subsidies
supporting farm production as a proportion of farm revenues in 200T ranged, accord¬
ing to the >Organization for Economic Cooperation and Development, from a low
of r per cent in New Zealand to 60 per cent in Japan, with 2r per cent in the US and
35 per cent in the ►European Union. Such subsidies distort international trade and
are detrimental to the economies of the > developing countries, and agreement was
reached through the ►Uruguay Round of Trade Negotiations that ^developed
countries should reduce their import tariffs and export subsidies between 1995 and
2000 by 36 per cent and their domestic financial support for agriculture by 20
per cent compared with the levels of r986/8. Improvements in market access for
agricultural products of the developing countries are to be considered in the ►Doha
Round of Trade Negotiations. ►Common Agricultural Policy; General Agreement
on Tariffs and Trade; protection.

f.a.s. Free alongside ship. The term in a contract by which the seller is required to
deliver the goods to a quay or to lighters alongside the vessel at the seaport of
shipment specified in the contract of sale. The seller is not obliged to obtain ►insur¬
ance cover, ►►c.i.f.; f.o.b.

fast track authority Trade promotion authority granted in 2002 to the US

President by Congress by which ►free trade agreements concluded by the President
may only be vetoed in their entirety by Congress and cannot be simply amended.
»*Doha Round of Trade Negotiations.

Fed ► Federal Reserve System.

federal reserve banks >Federal Reserve System.

Federal Reserve Board >Federal Reserve System.

Federal Reserve System (Fed) The ►central banking system of the USA, estab¬
lished by the Federal Reserve Act t9r3 and organized on a regional basis, given the
large area involved and the multiplicity of small- and medium-sized banks. The
system is composed of twelve regional Reserve banks, twenty-five branches and
Federal Trade Commission

eleven offices under the control of a board of governors located in Washington, DC

(the Federal Reserve Board). The board of governors consists of seven governors
appointed by Congress on the nomination of the President, each serving for 14 years,
with one reappointment falling due every 2 years. The chairman of the board of
governors is the head of the Federal Reserve System, appointed for a term of 4 years.
The board approves the discount and other Vrates of interest of the system,
supervises foreign business and generally regulates the operation of the Vbanking
system, including the review of applications for > mergers. It has proved a formidable
force in controlling inflation through tight ^monetary policy, and its independence
in decision-making has been much admired - indeed, partly copied in the reform of
the VBank of England announced in 1997.
The regional Reserve banks are controlled by boards of nine directors, of whom
three are commercial bankers, three represent local labour and commerce, and three
are appointed by the board of governors; the president and vice-president of each
Reserve bank are drawn from the last three.
The regional Reserve banks supervise banking practice and management, act as
►lenders of last resort, provide common services in cheque clearing, statistics and
research, and apply monetary policy at the instance of the board of governors.
Monetary control is exercised chiefly through open market operations and is deter¬
mined by the board of governors' Federal Open Market Committee, day-to-day
transactions in pursuance of this being handled by the Reserve Bank of New York.
The board of governors' constitutional independence is guaranteed by the long-term
appointment of the governors and by the fact that the system generates a surplus
(mostly paid as a dividend to the Treasury) relieving it of financial dependence on
Congress. The chairman, members and staff of the board frequently explain Federal
Reserve policy to congressional committees and maintain close contact with the US
administration, but retain final responsibility for their policy.
Since the Monetary Control Act r98o, all US banks are members of the Federal
Reserve System. The system was modified by the Banking Act 1935. VFederal Deposit
Insurance Corporation.

Federal Trade Commission ►anti-trust.

fertility rate vbirth rate.

fiat money Currency that is legally decreed a valid means of financing transactions.
It is, in short, legal tender, in contrast to other forms of paper (e.g. cheques) that
carry credibility but no legal support, ^fiduciary issue; monetary base.

fiduciary issue Paper Vmoney (►banknote) not backed by gold or silver. The
term has its origins in the Bank Charter Act 1844 in the UK, that fixed the fiduciary
issue limit at £14 million. Any notes issued in excess of this amount had to be fully
backed by gold. The fiduciary limit has been successively raised and the monetary
authorities are now free to alter the note issue as they wish; effectively the note issue
is now entirely fiduciary, ^banking and currency schools.

final consumption Vfinal goods.

final expenditure vfinal goods.

final goods Goods that are produced for ^consumption rather than as an Vinter-
 financial intermediaries

mediate product used in the process of production. Final consumption (i.e. consump¬
tion of final goods alone) is included in the totals of national output in >social
accounting. (If intermediate goods were also included there would be double count¬
ing of output.) Only government final consumption (that excludes > transfer pay¬
ments), consumers' expenditure (all of which, by definition, is final) and investment
goods enter into final expenditure and thus into the >gross domestic product.

finance 1 he provision of >-money when and where required. Finance may be short
term (usually up to r year), medium-term (usually over i year and up to 5-7 years)
and long-term. Finance may be required for ^consumption or for ^investment. For
the latter, when provided, it becomes >capital. Ebusiness finance; consumer credit;
public finance.

finance company An imprecise term covering a wide range of »-financial inter¬

mediaries, most commonly a synonym for > finance house.

finance house A financial institution engaged in the provision of >hire purchase

and other forms of instalment credit. Also called finance companies, hire-purchase
finance companies and >• industrial banks. There are several hundred finance houses
in the UK that, together with >credit card companies, account for the bulk of
>instalment credit debt, the remainder being owed to retailers. Some of the hire-
purchase debt of retailers is purchased by the finance houses under what are known
as 'block discounts'. The funds of the finance houses come from interest-bearing
deposits, not only from the general public but from industrial and commercial
companies and other financial institutions, including the ^commercial banks (the
interest paid is generally higher than that offered by the commercial banks); other
sources of funds are capital reserves, »-bills discounted and bank overdrafts. The
largest source of finance house funds is the commercial banks, and most of the larger
finance houses are subsidiaries of the banks. Similarly, several finance houses are
subsidiaries of manufacturing companies and advance instalment credit only for
their parent company's products, e.g. Ford Motor Credit Co. Although advances for
cars and other consumer durables represent a major proportion of their business, a
huge proportion of the outstanding balances of the finance houses is for business
purposes. Hire purchase is not the sole, although it is the main, activity of the
finance houses; they also make loans for other purposes, including bridging finance,
leasing and > factoring, stocking loans for motor dealers and second mortgages.

financial assets >assets.

financial intermediaries Institutions that hold >money balances of, or borrow

from, individuals and other institutions in order to make loans or other >in-
vestments. Hence, they serve the purpose of channelling funds from lenders to
borrowers. In standing between lenders and borrowers, intermediaries provide ser¬
vices to each, often at little or no cost compared with direct investment. By virtue
of their size and expertise, financial intermediaries are able to reduce risks for lenders
by enabling them to spread their investments widely, e.g. through >assurance or
^investment trusts. They also provide maturity transformation. > Building societies,
for example, allow depositors to withdraw their money on demand but provide
long-term funds for > mortgage lending. It is usual to distinguish between banks in
the banking sector and so-called non-bank financial intermediaries. The importance
financial ratios

of this distinction arises from the fact that the liabilities of banks are part of the
Pmoney supply, and this may not be true of the non-bank financial intermediaries
(Pbanking). The most important of the non-bank financial intermediaries are the
building societies, P hire-purchase companies, ^insurance companies, >-savings
banks, Ppension funds and investment trusts.

financial ratios 1 Specifically, measures of creditworthiness. The principal

measures are: (a) the Pcurrent ratio; (b) the Pdebt or net worth ratio (long-term debt
to net worth); (c) P dividend cover; (d) > interest cover and, (e) the net tangible
Passets ratio (total tangible assets less current Pliabilities and minority interests to
long-term debt). All these ratios are measures of the asset or income cover available
to the suppliers of Pcapital to the business. 2 Generally calculations based on
company accounts and other sources (e.g. P stock exchange share prices) designed
to indicate the profitability or other financial aspects of a business, e.g. return on
net assets, Pprice-earnings ratio and stock sales ratio (Pinventories). >Prate
of return.

Financial Services Act 1986 (FSA) (UK) Legislation enacted in November 1986
but coming into force on 29 April T988 to regulate the investment business in the
UK. The Act followed a report on investor protection commissioned in 1981 from
Professor Gower and completed in 1984. The Gower Report recommended that the
new regulatory system should cover life assurance, Punit trusts and other forms of
investment in business in addition to Pstock exchange investments. The Act set up
a Securities and Investments Board (SIB) to oversee financial regulation, paid for by
investment professionals, but with statutory powers and reporting to the Depart¬
ment of Trade and Industry (DTI). Investment businesses were registered with the
SIB directly or with one of four self-regulating organizations (SROs). The original
SROs were: (a) the Financial Intermediaries', Managers' and Brokers' Regulatory
Association (FIMBRA), that covered independent intermediaries (e.g. Pbrokers deal¬
ing in Pinsurance); (b) The Securities Association (TSA), for Psecurities dealing (e.g.
by Pmarket makers); (c) the Association of Futures Brokers and Dealers, for dealings
in P futures and Poptions (these last two bodies were merged to form the Securities
and Futures Authority Ltd in 1991); (d) the Investment Managers' Regulatory Organiz¬
ation for investment management (e.g. pension funds), and (e) the Life Assurance
and Unit Trust Regulatory Organization (LAUTRO). The FIMBRA and LAUTRO
were replaced by the Personal Investment Authority in 1994. Certain investment
markets were also approved by the SIB or via the appropriate SRO; these markets
are recognized investment exchanges, e.g. the International Stock Exchange (Pstock
exchange) and the Baltic Exchange. Lawyers and accountants, for whom the pro¬
vision of investment advice is only a minor part of their business, are self-regulated
by their own professional bodies. Recognized professional bodies were approved by the
SIB, including the Institute of Chartered Accountants of England and Wales.
By the mid T990S, the regulatory system was deemed to be failing - burdening
firms with a large compliance requirement but not protecting consumers very
adequately. In 1997, it was announced by the new Labour government that a new
unified regulator would take over all the functions of the SIB and the SROs, and
indeed, some functions of the DTI and PBank of England, including bank super¬
vision. PFinancial Services and Markets Act 2000.
 Financial Times share indices

Financial Services and Markets Act (UK) Adopted in June 2000 and coming
into force in November 200T, the Act superseded the > Financial Services Act 1986
and substantially replaced its provision. A new, single, statutory body, the Financial
Services Authority (FSA), was substituted for the Securities and Investments Board
(SIB) and the Self-Regulating Organizations (SROs): the Investment Management
Regulatory Organization, the Securities and Futures Authority and the Personal
Investment Authority. The rulebooks of the SIB and SROs were replaced by a
comprehensive rulebook compiled by the FSA. Part of the rulebook comprised a
Code of Market Conduct which, inter alia, contained a definition and prescribed
penalties for the new offence of market abuse, i.e. >* insider dealing and other practices
designed to distort the market.
The operational scope of the FSA was considerably widened. In addition to that
prescribed for the institutions under the Financial Services Act 1986, the new FSA
supervised and regulated the banking industry, >building societies, and >general
insurance (as distinct from life assurance - already covered). Thus, the Building
Societies Commission disappeared, and the >Bank of England and the ^Treasury
surrendered their authority over the banking system and insurance respectively.
Listing authority was passed over from the London Stock Exchange, which otherwise
retained its status, as did other 'designated investment exchanges' and 'recognized
professional bodies' (>■ Financial Services Act). The FSA is expected to assume powers
to regulate >-mortgages and funeral plans and long-term care plans.
The effect of the Financial Services and Markets Act was thus to place in the hands
of the FSA virtually the entire financial sector of the UK economy.

Financial Times share indices The standard measures of general stock market
performance in London. The FTO (Financial Times (Industrial) Ordinary) or FT 30
Share Index, an unweighted (^weighted average) geometric >average of 30 leading
>blue chips quoted on the London >stock exchange, was introduced in r935 and
calculated hourly. The FT 30 has been superseded by the FT/SE 100 'Footsie 100'
Index, a >market capitalization weighted average calculated minute by minute (real
time). The base period for the FT 100 is 3 January 1984 = 1000, and its constituents
are the 100 largest quoted industrial and commercial companies by capitalization,
reviewed quarterly (^investment trusts are excluded). The FT/SE \Iid250 Index, also
calculated minute by minute, covers the next 250 companies, ranked by market
value, and the FT/SE/Actuaries 350 Index includes all the constituents of the roo and
250 indices. The 350 Index covers about 92 per cent of total market value and the 100
Index about 72 per cent. The FT/Actuaries All-Share Index has been published daily
since ro April T962; it now covers some 800 shares and fixed-interest >stocks, covers
some 98 per cent of total market value and has indices for industry baskets and
subsections. The FT/SE Small Cap Index, introduced in 1993 and calculated daily,
covers those shares within the FT/A All-Share Index but not within the 350. In ^87,
the FT/Actuaries World Share Index was introduced, based on a weighted sample of
2400 share prices, initially from twenty-four countries. There is also a FTSE Eurotop
300 Index. The FT/Actuaries Fixed Interest Indices measure the prices and ^-yields of
UK gilts (>gilt-edged securities), index-linked (^indexation), ^debentures and
Moans. Total return figures are calculated for all the UK indices and published daily.
These figures, which are gross of tax, take account of both price performance and
income received from ^-dividends. >Mndex number.
 | 142
financial trusts

financial trusts >-trust.

financial year The period of account used for financial purposes. These often do
not coincide with calendar years, and are hence referred to as financial years. A
financial year 2002/3, for example, might run from 31 August 2002 to 1 September
2003. The UK government fiscal or tax year runs from 6 April of one year to 5 April
in the following year. In the USA the fiscal year runs from 1 July to 30 June.

firm, theory of the The study of the behaviour of firms with respect to: (a) the
inputs they buy; (b) the production techniques they adopt; (c) the quantity they
produce, and (d) the price at which they sell their output. Two basic approaches to
the theory can be identified:

(r) The traditional approach assumes that producers aim to maximize profits;
whether they are monopolists or perfect competitors, they produce at a point
where ^marginal cost equals >marginal revenue and employ inputs to a point
at which their ^marginal revenue product is equal to the cost of employing them
(>labour, demand for; perfect competition).
(2) Other theories attempt to represent the complications of the large institutions
which characterize society today, especially the Reparation of ownership from
control of firms which, it is suggested, may lead to objectives other than profit
maximization. These alternative theories postulate the aim as being the maximiz¬
ation of sales, growth, or management utility - with profit merely held to some
minimum level (>satisficing). The ^behavioural theory of the firm postulates
the existence of a multiplicity of conflicting objectives. It is not clear whether
the alternative theories actually contradict the claim of the traditional approach
that firms maximize profits because in the long run the maximization of, for
example, sales growth might merely amount to the maximization of profit.
Moreover, as a single goal, profit maximization perhaps better and more simply
approximates to the behaviour of firms than any other single objective. It is thus
usually accepted that the insights of traditional theory are useful despite their
dependence on apparently unrealistic assumptions.

More recently, >game theory has been influential in analysis of firms, with concepts
like the principal-agent problem increasingly deployed to explain behaviour.
Cournot, A. A.; Galbraith, J. K.; Simon, H. A.

first-mover advantage The notion that countries or firms that create new
industries or products first may establish a competitive advantage that makes it hard
or impossible for other countries to follow in the same area. The advantage is most
likely to prevail in sectors with large ^economies of scale, and especially in cases
where the most efficient scale represents a high proportion of the global market. It
would certainly be difficult for, say, China or Japan to enter wide-bodied aircraft
manufacture in competition with Boeing and Airbus. The frequency with which
airframe manufacture is quoted as an example of potential first-mover advantage
suggests it may be one of very few special cases requiring a large supplier chain and
technological depth. It is not difficult to think of examples of other first movers (e.g.
motor cycles in the UK) that have failed to sustain an early advantage. The argument
is not new; it is a variant of the >infant-industry argument for protection against
imports. It re-emerged in the late 1980s under the guise of strategic trade theory
 fiscal neutrality

associated with Krugman. He suggested the traditional arguments for nations to

allow Mree trade were undermined. In practice, however, he has argued that so few
industries meet the right conditions to justify strategic trade policy, and the gains
are so small, that a presumption in favour of free trade is justified.

fiscal drag The effect of inflation upon effective tax rates, or the effect of growth
in >nominal gross domestic product on tax revenues. Under progressive ^income
tax systems, increases in earnings may push taxpayers into higher tax brackets. In a
tax system that is not indexed for inflation (^indexation), this has the result that
increasing earnings to keep pace with inflation will generate higher tax revenues.
With the decline in inflation rates since the r98os, the term 'fiscal drag' has loosely
been used to refer to the fact that, even in an indexed tax system, if earnings grow
more quickly than prices (and indeed, they typically do), then the government again
ends up with extra revenues without having to raise tax rates in explicit policy
changes. Fiscal drag could result in an unintended shift in ^fiscal policy, with a
depressing effect upon the growth of demand and output. A similar process can
work in reverse and under conditions of >-deflation, e.g. if prices fall, tax rates will
also fall even though real incomes have increased. Fiscal drag, therefore, can have
the effect of a >-built-in stabilizer; >► fiscal illusion.

fiscal federalism The system of sharing tax revenues and public expenditure
between central and regional government (>-public sector). Revenue may be raised
by the upper level of government and grants given to lower levels on the basis of
population or other criteria, or revenues from specific national taxes may be shared
in agreed proportions, e.g. a small proportion of national ► value-added tax revenues
in the >European Union go to help finance community institutions. Another
possibility is that certain >-tax bases (e.g. property in the UK) may be reserved for
local government, with or without freedom on the part of local authorities to
determine their own tax rates. For the division of expenditure between central and
regional government, the main principle is that local governments should confine
their expenditure to uses which have limited spillovers outside their areas, e.g. roads
and schools. >externalities; ^subsidiarity.

fiscal illusion The lack of transparency in taxation that allows governments to

raise extra revenue without the population fully understanding the extent of the tax
burden. Fiscal illusion is often a consequence of ^-fiscal drag. Some economists in
the area of 2^public-choice theory have worried that governments have found it too
easy to grow as a result of public ignorance, and have advocated constitutional limits
on the size of Western governments' spending. However, the need has diminished
with popular resistance to unlimited growth in tax revenues. >^Buchanan, J. M.;
hypothecation; tax tolerance.

fiscal neutrality The idea that the tax system should be designed so that as few
distortions are caused to economic behaviour as possible. It is not fiscally neutral,
for example, to apply >-value-added tax to some items but not others, for this causes
consumers to switch spending from taxed items to untaxed ones. This distortion of
behaviour is economically inefficient. Despite the ^economic efficiency of applying
the principle of fiscal neutrality, it is often argued that distributional or other
objectives are served by manipulating different taxes. For this reason, >lump-sum
taxes, which are the most neutral, are rarely applied in practice and fiscal neutrality
fiscal policy

is seen as only one of a number of desirable features of a tax system, ^deadweight

loss; double taxation.

fiscal policy The budgetary stance of central government. Decisions to lower

taxation or increase ^public expenditure in the interests of stimulating ^aggregate
demand are referred to as 'loosening fiscal policy'. Higher tax rates or reductions in
public expenditure will tighten fiscal policy. There is considerable controversy about
the appropriate weight of fiscal policy in economic management, relative to > mone¬
tary policy. It is generally left to monetary policy to regulate economic activity in
the short term, and the recent goal of fiscal policy has been directed at maintaining
a prudent level of borrowing ^structural deficit), preferably according to certain
rules (>golden rule; stability and growth pact). This is because tax changes can take
too long to be effective in fine-tuning the ups and downs of the economy, and
changing tax rates can distort the timing of economic decisions. However, the
economic cycle does bring about changes in government borrowing, as tax revenues
follow economic activity up and down, and government borrowing thus tends to
swing counter-cyclically. This is automatically stabilizing of the economy, ^bal¬
anced budget; Keynesian economics; medium-term financial strategy; policy ineffec¬
tiveness theorem; quantity theory of money; reflation.

fiscal year >-financial year.

Fisher, Irving (1867-1947) A mathematician by professional training, Fisher was

Professor of Political Economy at Yale University from T898 to 1935. His main works
on economics are Mathematical Investigations in the Theory of Value and Prices (1892),
Nature of Capital and Income (1906), Rate of Interest (1907), Purchasing Power of Money
(r9rr), The Making of Index Numbers (1922) and Theory of Interest (r93o). Rate of Interest,
which was substantially revised in 1930, developed the theory of ^interest from
.^Bohm-Bawerk towards the modern theory of >investment appraisal. The >rate
of interest is governed by the interaction of two forces: (a) the 'willingness or
impatience' of individuals with respect to the giving up of > income now compared
with income in the future (Fisher invented the term >time preference), and (b) the
'investment opportunity principle', the technological ability to convert income now
into income in the future. He called the latter the 'rate of return over cost', which
> Keynes said was the same as his 'marginal efficiency of capital' (^internal rate of
return). He defined this 'rate of return over cost' as that discount rate (^discounting)
that equalized the >-present value of the possible alternative investment choices
open. He showed how the ranking of investment choices depended on the rate of
interest used. He clarified economists' ideas on the nature of ^capital, distinguishing
between a stock and a flow of >-wealth. A house is capital stock, but its use is a flow
of income. Fie was the author of the 'quantity of money' (exchange) equation MV =
PT, in which M = the stock of money, V = the ^velocity of circulation, P = the S-price
level and T = the output of goods and >services (>quantity theory of money).
Fisher developed the theory of S-index numbers and established a set of conditions
which an ideal index should satisfy.

Fisher equation >Fisher, I.; quantity theory of money.

fixed asset ^assets.

fixed capital >business finance; capital.

 floating charge

fixed charge ^floating charge.

fixed costs VCosts that do not vary with output, e.g. the >rent on a factory
>-lease. Also called overhead, although in accounting terminology all costs except
direct labour and materials are usually regarded as overheads and some of these
overhead costs (e.g. electricity and postage) may vary with output. In the Mong run
all costs are variable, and the >-short run is defined as the period of time in which
all the >factors of production cannot be varied. average costs; sunk costs.

fixed debenture >floating debentures.

fixed exchange rate ^exchange rate,

fixed interest Securities.

fixed-point theorem A theorem stating that for certain types of functions, y =

f(x), there is at least one value of x such that y = x. That is, that x maps on to itself,
or x is a fixed point. These theorems are used in ^equilibrium analysis to help prove
the existence of a ^general equilibrium. If a simple economy can be modelled as a
system of functions that conform to the types described in a fixed-point theorem,
the fact that a fixed point must exist can be turned into proof that a market
equilibrium exists.

fixed trust ^flexible trust.

flags of convenience An expression relating to the practice of shipowners of

registering their vessels with countries other than those of their own home ports in
order to avoid taxes, or stringent safety or crewing regulations. The extent of the
movement can be seen from the growth of the merchant fleets of such small countries
as Panama and Liberia.

flat yield A ► yield on a fixed-interest > security calculated by expressing the

annual >interest payable as a proportion of the purchase price of the security. It
omits any allowance for the difference between purchase price and redemption
price, ^redeemable securities.

flexible exchange rate ^exchange rate.

flexible trust The most common form of >-unit trust, in which the ^-portfolio of
^►securities purchased by the trust can be varied at the discretion of the managers.
Also called a 'managed' trust. Flexible trusts were developed in the 1930s to overcome
the problems raised by the inflexibility of fixed trusts, in which the investment
^portfolio is fixed in the trust deed.

floating asset ^floating capital.

floating capital ^Capital that is not invested in fixed Vassets, (e.g. machinery)
but in work in progress, wages paid, etc. Synonymous with >-working capital.
>► current ratio.

floating charge An assignment of the total >assets of a company or individual

as ^collateral security for a >debt, as opposed to particular assets, when such an
assignment is called a fixed charge.
floating debentures

floating debentures A type of debenture (►bond) in which the Moan is secured

by a charge on the assets of a firm generally. Where specific assets secure a debenture
Moan, it is known as a fixed debenture.

floating debt 1 Generally, any short-term ►debt as opposed to ►funded debt.

2 Specifically, that part of the UK > national debt that consists of short-term
borrowing, i.e. ► treasury bills. Treasury bills form an important part of the Miquid
assets of the money market, so that the size of the floating debt has considerable
influence over the total ►money supply.

floating exchange rate ►exchange rate.

flotation Raising new ►capital by public subscription. A private company issuing

►shares to the public for the first time is said to be 'going public' or making an Initial
Public Offering. »Mtock exchange; unlisted securities market.

f.o.b. Free on board. The term in a contract in which the seller is required to deliver
and load the goods on board a ship in the seaport of shipment specified in the
contract of sale. The seller is not obliged to obtain Mnsurance cover. UK imports
are entered by HM Customs in the overseas trade accounts as c.i.f., and exports as
f.o.b. For the >balance of payments accounts, the Mmport figures are adjusted to
an f.o.b. basis to make them comparable with exports, the revenues or costs rep¬
resented by the difference between c.i.f. and f.o.b. being included in Mnvisibles.
»*c.i.f.; f.a.s.

Fogel, Robert William (b. 1926) A joint winner of the ►Nobel Prize for Economics
in 1993, an economic historian and director of the Center for Population Economics
at the University of Chicago, Fogel has been a pioneer in the area of 'new economic
history'. This attempts to analyse the past on the basis of new, or reconstructed
databases. Fogel has applied this approach in controversial ways, e.g. to argue that
slavery was an economically efficient social order that ultimately collapsed on
account of political decisions. He has also reassessed the role of the railways in
American economic development, in Railroads and American Economic Growth (1964),
arguing that the sum of many changes, rather than a few great innovations, deter¬
mines economic advance, ►cliometrics; North, D.

Food and Agricultural Organization (FAO) An organization set up in 1945,

with headquarters in Rome, within the framework of the United Nations. It conducts
research and offers technical assistance with the aim of improving the standards of
living of agricultural areas. It is concerned with the improvement of ►productivity
and distribution networks for the agricultural, forestry and fishing industries. It
conducts surveys, issues statistics, produces forecasts of the world food situation and
sets minimum nutritional standards.

forced saving A situation in which expenditure falls short of >disposable income

because goods are not available for ►consumption, rather than because consumers
have voluntarily decided to accumulate ► saving. Under these circumstances,
►prices of goods would rise and supply would increase in a ►free-market economy
so that forced saving would be a temporary symptom or ► disequilibrium. If for any
reason there were ► long-run constraints on the increase in output, the increase in
prices would reduce demand and stimulate the development of ►substitutes. Forced
 foreign-exchange market

saving does occur in > planned economies and, at a > macroeconomic level, demo¬
cratic governments can enforce saving by increasing >taxation while holding
>public expenditure constant, ^quantity rationing; repressed inflation.

foreign aid The administered transfer of resources from the ^advanced countries
for the purpose of encouraging economic growth in the developing countries
(>economic growth, stages of). Funds transferred to the developing countries from
governments and international institutions (^International Bank for Reconstruc¬
tion and Development) in the form of official aid account for about one-third of the
total transfer of funds to the developing countries (the rest is accounted for by loans
through the ^commercial banks and ^foreign investment). Official aid from the
advanced countries represented in the >-Organization for Economic Cooperation
and Development's Development Assistance Committee amounted to $sr.4 billion
in 20or, 0.22 per cent of their total >*►gross national income (GNI), significantly
lower than in the r990s. Within the total, the USA accounted for $10.9 billion (o.rr
per cent of GNI), Japan $9.7 billion (0.23 per cent) and the >European Union (EU)
$26 billion (0.33 per cent). Aid is expected to increase by 2006 to 0.24 per cent of
GNI, the USA at 0.15 and the EU at 0.39 per cent. >► Export credit insurance; export
incentives; foreign direct investment; generalized system of preferences.

foreign balance ^-balance of payments.

foreign bill of exchange >foreign-exchange market.

foreign direct investment (FDI) Investment in a foreign country through the

acquisition of a local company or the establishment there of an operation on a new
('greenfield') site. Direct investment implies control and managerial, and perhaps
technical, input. According to statistics collected by the ^United Nations Confer¬
ence on Trade and Development, the total world inflow of foreign direct investment
has grown from about US$33r billion in 1995 to a peak of US$1,270 billion in 2000.
In 2000, the largest recipients of FDI were the USA (US$281 billion), Germany
(US$176 billion) and the UK (US$r3o billion) and the largest source countries were
the UK (US$250 billion), France (US$173 billion) and the USA (US$T39 billion).
Foreign direct investment has been a major source of finance for the >developing
countries; rising from US$H3 billion in r995 to US$240 billion in 2000. >► foreign
aid; foreign investment; globalization; multinational corporation.

foreign exchange Claims on another country held in the form of the currency
of that country or interest-bearing Vbonds. ^exchange control; foreign-exchange
market; gold and foreign-exchange reserves.

foreign-exchange market The >market in which transactions are conducted

to effect the transfer of the ^-currency of one country into that of another. The need
to settle accounts with foreigners gave rise to the foreign bill of exchange, which
was accepted by banks or other institutions of international standing (^accepting
house). These bills were traded at discount, and in this way the foreign-exchange
market was established, the bills reflecting actual international trade flows. However,
the market has developed in modern times and is now dominated by financial
institutions that buy and sell foreign currencies, making their >profit from the
divergences between the ^exchange rates and >rates of interest in the various
financial centres. In April 20or, the >Bank for International Settlements estimated
foreign investment 148

that average daily world turnover in foreign-exchange dealing was US$1,200 billion
compared with a turnover of US$1,490 billion recorded in its previous survey for
April 1998. Within the total, dollar-euro transactions accounted for 30 per cent,
dollar/yen 20 per cent and dollar/sterling ir per cent. > forward-exchange market;
>► convertibility; Tobin tax.

foreign investment The acquisition by governments, institutions or individuals

in one country of »-assets in another. Foreign investment covers both >foreign
direct investment and >portfolio investment, and includes public authorities, pri¬
vate firms and individuals. For a country in which >savings are insufficient relative
to the potential demand for ^investment, foreign capital can be a fruitful means of
stimulating rapid growth. In addition, foreign investment may be a means of finan¬
cing a >balance of payments deficit.

forward-exchange market A >market in which contracts are made to supply

>currencies at fixed dates in the future at fixed ^prices. Currencies may be bought
and sold in the >foreign-exchange market either 'spot' or 'forward' (>-forward
market; spot market). In the former case, the transaction takes place immediately,
and it is in this market that > exchange rates are kept at their managed levels by
government intervention. In the forward-exchange market, currencies are bought
and sold for transacting at some future date, i.e. in 3 months or 6 months time. The
difference between the 'spot' rate of exchange and the 'forward' rate is determined
by the >rate of interest and the exchange risk, i.e. the possibility of ^appreciation
or > depreciation of the currencies transacted. Therefore, the size of the >premium
or ^discount of, for example, forward dollars compared with spot dollars indicates
the strength of the market's expectation of an appreciation or depreciation of the
dollar and its extent, ^exchange rate overshooting.

forward market Any >market in >-futures, i.e. a market in which promises to

buy or to sell >-securities or ^commodities at some future date at fixed >prices are
bought and sold. An example of a forward market is the >■ forward-exchange market.

franchising A contractual arrangement under which an independent franchisee

produces or sells a product or service under the brand name of the franchiser and to
his/her specifications and with marketing and other support. The franchisee pays a
royalty to the franchiser and may purchase supplies from him/her. The franchisee
provides his/her own ^capital and is legally an independent >-enterprise that is none
the less highly dependent upon the franchiser though, as Curran and Stanworth have
pointed out, many >small businesses (e.g. with a high proportion of sales to a single
customer) may enjoy no greater degree of independence than many franchised
enterprises. Franchising is growing rapidly in the UK but is less important than in
the USA.

franked investment income Mncome, normally of a company, on which

>taxation has already been paid at source, i.e. income received as a ^dividend by
one company from another (^corporation tax).

free depreciation ^capital allowances.

free-enterprise economy Mree-market economy,

free exchange rate ^exchange rate.

 free trade

free goods ► Commodities that have no ►price because they are not scarce and
do not require the use of scarce >factors of production to create them, e.g. fresh air
and sunshine (in certain parts of the world). Things that are given away without
charge (e.g. book matches or government services) are not free goods because they
have >opportunity costs.

free market A ►market in which ►supply and ►demand are not subject to
► regulation other than normal >competition policy, but in which property rights
are allocated and upheld so that trade can occur. The definition of a free market
becomes blurred in cases where free trade and competition are incompatible. Most
economists would be loath to describe the world diamond market as completely
free, given its dominance by an international cartel arrangement. ^ Chicago School;
Coase theorem.

free-market economy Strictly, an economic system in which the allocation of

►resources is determined solely by >supply and ►demand in >free markets, though
in practice there are some limitations on market freedoms in all countries. Moreover,
in some countries governments intervene in free markets to promote competition
that might otherwise disappear. Usually used as synonymous with ►capitalism.

free reserves ►company reserves.

free-rider problem The problem, arising in many situations, that no individual

is willing to contribute toward the cost of something when he/she hopes that
someone else will bear the cost instead. The problem arises whenever there is a
►public good, e.g. everybody in a block of flats may want a faulty light repaired, but
no one wants to bear the cost of organizing the repair themselves - they would each
rather free-ride on the effort of someone else. Examples of the problem abound. For
example, shareholders take little interest in the management of their companies,
hoping someone else will monitor what the executives are doing (► separation of
ownership from control); rude taxi drivers free-ride on the reputation of the pro¬
fession as a whole; nations who contribute nothing to disaster relief efforts are said
to free-ride on the efforts of others. Obtaining satisfactory levels of managerial
monitoring, politeness or disaster relief in these situations is difficult in the absence
of compulsory enforcement measures, ►stability and growth pact.

free trade The condition in which the free flow of goods (>economic good) and
►services in international exchange is neither restricted nor encouraged by direct
government intervention. In practice, all governments are involved in regulating
overseas trade in some way. The most common means of affecting the distribution
and levels of international trade are import ►tariffs, import ►quotas and export
subsidies (►export incentives). It has been broadly accepted among economists that
an international free-trade policy is desirable to optimize world output and ►income
levels in the long run. The >Organization for European Cooperation and Develop¬
ment and the United Nations (► World Trade Organization) are committed to freeing
world trade, but most economists would agree that under present conditions com¬
plete freedom of trade would not be desirable. In any case, it is clear that individual
countries could gain from protectionism (►customs union; first-mover advantage;
infant industry argument; protection). Towards the end of the eighteenth century
there was a reaction against ► mercantilism, which had advocated government
free trade area

intervention to obtain surpluses on >visible trade. This reaction was consolidated

in a new economic liberalism and the doctrine of > laissez-faire. The ^classical
economists' support of a free-trade policy was not so much based on specific econ¬
omic analyses of international trade as simply part of their general belief in what
►Adam Smith called the 'hidden hand': the greatest good is achieved if each indi¬
vidual is left to seek his own > profit. The free-trade era lasted in England for almost
a century. After the First World War, economic nationalism reached its peak and
free trade was abandoned for protectionism. However, since the end of the Second
World War, there has been a general acceptance internationally of the dangers of
protectionism and some reduction in ^international trade barriers, especially for
manufactured goods. Progress has been slow, and has paradoxically been associated
with the growth of regional »-customs unions and >free trade areas. Some econom¬
ists have advocated unilateral free trade (countries can help themselves by freeing-up
imports, regardless of other countries' behaviour). Other economists have seen the
problem as that of the ^prisoner's dilemma - with gains for nations individually if
they restrict trade but a collective net benefit if all nations should pursue it. In
practice, the latter view is reflected in the several international negotiations pursued
through the ^-General Agreement on Tariffs and Trade,, culminating in the setting
up of the World Trade Organization and continuing in the >Doha Round of Inter¬
national Trade Negotiations. European Free Trade Association; European Union.

free trade area An association of a number of countries between which all import
►tariffs and >quotas and export subsidies and other similar government measures
to influence trade (> export incentives) have been removed. Each country, however,
continues to retain its own international trade measures vis-a-vis countries outside
the association. There has been an increase in recent years in the number of trading
areas being formed worldwide. For example, in 20or, agreement was reached at
Quebec City, Canada, between representatives from thirty-four countries in North,
Central, South America and the Caribbean with a view to setting up a free trade area
for the Americas by 2005. >► Andean Pact; Asia-Pacific Economic Cooperation;
Customs Union; Economic Community of West African States; international trade;
Latin American Integration Association; Mercosur; North American Free Trade
Agreement.

Free Trade Area for the Americas >free trade area.

free trade zone A customs-defined area in which goods or services may be

processed or transacted without attracting taxes or duties or being subjected to
certain government regulations. A special case is the Mreeport, into which goods
are imported free of customs > tariffs or taxes. According to the > International
Labour Organization, there are about 850 free trade zones throughout the world
employing about 30 million people, almost all of them women.

freedom of entry Absence of ►barriers to entry preventing new suppliers entering

a > market. One of the assumptions of »-perfect competition, ^contestability.

freeport A seaport or airport that is able to accept cargo without the imposition of
any import > tariff or some specified »-taxes. In addition, freeports may be granted
special dispensation regarding legislation affecting businesses in the domestic
market outside the port, e.g. employment conditions, health and safety regulations
151 Friedman, Milton

and development planning. There are several hundred such ports throughout the
world. >#»free trade zone.

frequency distribution A tabulation showing a (statistical) ^population allo¬

cated numerically into subcategories of a specified classification (»>• income, distri¬
bution of). For example, the following frequency distribution shows how the total
population of the UK was divided into different age-groups in 2000.

Age-group Number (thousands)

0-14 years 11,324

15-64 years 39,n6
65 and over 9,3i6

59,756

Source: UK Digest of Statistics, Office of

National Statistics, 2002

frictional unemployment The .^unemployment that results from the process of

jobseeking. It will exist under conditions of so-called full-employment conditions
(^employment, full), but it is not precisely clear what proportion of total unemploy¬
ment can be called 'frictional'. Frictional unemployment arises in the functioning
of >labour markets because of inevitable time lags in a >free-market economy -
there are search delays involved, for example, in moving from one job to another.
Frictional unemployment is conceptually distinct from ^structural unemployment,
which results in heavy local concentrations of unemployment, and from unemploy¬
ment arising from a deficiency of demand, ^classical unemployment; labour,
mobility of.

Friedman, Milton (b. 1912) Professor of Economics at the University of Chicago

and leading member of the Chicago School. After a short period with the Natural
Resources Commission in Washington, Professor Friedman joined the research staff
of the National Bureau of Economic Research in 1937 and, apart from a short period,
has maintained a close association with this important research organization. During
the Second World War, he served in the Tax Research Division of the US Treasury.
In 1946, he was appointed Associate Professor of Economics and Statistics at the
University of Chicago, becoming Professor of Economics there from r948 until he
retired in 1979. In 1976, he was awarded the >-Nobel Prize in Economics. His main
published works in economics include Taxing to Prevent Inflation U943), Essays in
Positive Economics (1953), A Theory of the Consumption Function (1957), A Program for
Monetary Stability (i960), Price Theory (r962), A Monetary History of the United States
1867-1960 (1963), Inflation: causes and consequences ^963), The Great Contraction (1965),
The Optimum Quantity of Money (1969), A Theoretical Framework for Monetary Analysis
(1971), An Economist's Protest: columns in political economy (1975)/ Free to Choose. A
Personal Statement (1980) and Monetary Trends in the United States and the United
Kingdom (1982).
Friedman has made contributions to the > theory of distribution, arguing for an
approach in which high incomes are regarded as a reward for taking risks. He has
also been a leading defender of the Marshallian tradition in >microeconomics
(>Marshall, A.) and made a methodological defence of classical economics that
friendly society

stimulated controversy for a decade. His ► permanent income hypothesis was also
an important contribution to the theory of the Consumption function. His main
work, however, has been on the development of the ►quantity theory of money
and its empirical testing. He has extended the Fisher equation (►Fisher, I.) to include
other ►variables such as ►wealth and Cates of interest, and has made statistical
tests to attempt to measure the factors determining the demand for money to
hold. Friedman has advocated strict control of the ►money supply - preferably in
accordance with a simple rule as to how much growth will be allowed year by year
- as a means for controlling ►inflation. His view that it is not desirable to fine-tune
the economy using > stabilization policy (an early adherent to the ►policy ineffec¬
tiveness theorem) has, to a large extent, been accepted, but in the world of economic
theory Friedman's findings have been overshadowed by the more elegant route to
similar conclusions based on ► rational expectations, and associated with ► new
classical economics. ►►Chicago School; economic doctrines; liquidity preference;
unemployment, natural rate of.

friendly society A mutual organization, often an ►insurance association (►mut¬

ual company). There are several thousand friendly societies in the UK, including
working-men’s clubs, set up voluntarily to provide benefits and assistance during
sickness, unemployment, retirement or death. The tax advantages enjoyed by the
friendly societies have been reduced in recent years, and are limited in respect of life
or endowment business to premiums of not exceeding £270 a year.

fringe benefits Non-wage or salary rewards provided for employees, e.g. pensions
and company cars. Some fringe benefits, within certain limits (e.g. pension arrange¬
ments, private use of company e-mail, or subsidized canteens) are not assessed for
► income tax, while others (e.g. cars and low-interest loans), are. Holidays (in excess
of any legal minimum requirement), private health insurance and discounts on
goods purchased through the employer are other examples of fringe benefits. In
England, a series of laws from r749 onwards culminating in the Truck Acts in the
nineteenth century made it illegal to pay workers wholly in kind, because of abuse
by employers of rights given, for example, in 'company stores'.

Frisch, Ragnar A. K. (1895-1973) Born in Norway, Professor Frisch graduated in

economics at the University of Oslo. He was appointed to the Chair of Economics
at that university in r93r, a post he held until he retired in ^65. His published works
include Statistical Confluence Analysis by Means of Complete Regression Systems (1943),
Planning for India (1960), Theory of Production (1965), Maxima and Minima (1966) and
Economic Planning Studies: a collection of essays (r976). He won the ►Nobel Prize in
Economics (jointly with Tinbergen) in 1969. Professor Frisch pioneered work in the
application of mathematics and statistics in the testing of hypotheses in economics.
He invented the word ►'econometrics' and founded the Econometric Society. He
contributed to the analysis of the dynamics of ►trade cycles and the application of
econometrics to economic planning.

FTC Federal Trade Commission (►anti-trust).

FT/SE 100 Share Index (Footsie) ►Financial Times share indices,

full employment ►employment, full.

 futures

full-line forcing The exercise of market power to oblige a buyer to take a whole
range of products rather than only one of them. Also known as Cie-in sales, that
more strictly means that sale of a product carries with it a condition that some other
item will be purchased at the same time, ^competition policy; vertical restraints.

function A description of the relationship which governs the behaviour of two or

more related ^variables. Functions can be expressed in different ways. If consump¬
tion C is 0.9 x income Y, we can represent this information as either: an equation
(C = 0.9Y), a graph (C on one axis, Y on the other), or a tabulation (with certain
values of C in one column and the corresponding values of Y in the other). The
function is an important feature of many different areas of economics. For example,
the futility function maps the quantities of different goods consumed against corre¬
sponding levels of consumer utility. A >demand function maps different price levels
against the corresponding quantities demanded, ^production function.

fundamental analysis Chartist.

funded ^pension funds.

funded debt Generally, short-term Cebt that has been converted into long-term
debt (>-funding). Specifically, the funded debt was originally that consisting of
Consols, the Vinterest on which was paid out of the >Consolidated Fund. Then
it came to mean all government perpetual > loans where there is no obligation on
the part of the government to repay (e.g. consols 2V2 per cent war loan) but it
is sometimes taken to include all government ^securities quoted on the Ctock
exchange.

funding The process of converting short-term to long-term >debt by the sale of

long-term ^securities and using the funds raised to pay off short-term debt. Funding
may be carried out by a company because its Capital structure is inappropriate, i.e.
to take advantage of the fact that long-term Capital is normally cheaper and less
likely to be withdrawn than short-term capital. Companies or governments may
also take advantage of a period of low Cates of interest to repay long-term >stocks
at the earliest possible date and replace them with new stocks at lower rates of
interest. Funding has also been used as an instrument of ^monetary policy by
the government as well as for > national debt management. By selling long-dated
securities and purchasing ^treasury bills (which are treated as part of the >-cash
reserves of the Commercial banks), the ^liquidity of the ^banking system is
reduced. Overfunding occurs when the government is selling more debt to the non¬
bank sector than is necessary to meet the >public-sector borrowing requirement,
^►pension funds.

funding operations The conversion of short-term fixed-interest >debt (>floating

debt) to long-term fixed-interest debt (>funded debt). It is normally used in relation
to the work of the ^national debt commissioners, but the >Bank of England's
operations in ^treasury bills and government >bonds approaching maturity are also
covered by the term. Private companies with bank >-overdrafts or other short-term
sources of Capital may also decide to convert them to long-term debt by funding
operations, ^funding.

futures Contracts made in a 'future ^market' for the purchase or sale of Commodi-
futures

ties or financial >-assets, on a specified future date. Futures are negotiable instruments,
i.e. they may be bought and sold. Many commodity exchanges (e.g. wool, cotton
and wheat) have established futures markets that permit manufacturers and traders
to (►hedge against changes in >price of the raw materials they use or deal in.
^forward exchange market; London International Financial Futures Exchange;
options; speculation.
 G

G7 Originally a forum of the world’s largest five industrial economies: the US,
Japan, Germany, France and the UK; the group became seven in r986 when Italy and
Canada joined. In r997, Russia also joined the group, although not as a full member.
The G7 finance ministers meet several times a year, and on some notable occasions
(e.g. the Plaza Agreement in September ^85 that talked the dollar down, the Louvre
Agreement in February ^87 that set out a sophisticated package of exchange rate
co-ordination, and, to a lesser extent, the Washington meeting in April r995 that set
out the beliefs of the G7 that the dollar was too low) the ministers have successfully
managed to engineer changes in the direction of the > foreign-exchange market. In
2002, in Halifax, Canada, the G7 confirmed action plans for the control of potential
international financial crises and for international co-operation in the policing
of the financing of terrorism. The G7 reiterated their support for the policy that
^developing countries with strong institutions and appropriate economic policies
should be given priority in the granting of »-foreign aid.

G8 >G7.

Galbraith, John Kenneth (b. 1908) A leading American political economist. He

was born in Canada and, after graduating at Toronto in agriculture, took a Ph.D at
the University of California. In 1949, he became Professor of Economics at Harvard
University and was, from r96r to T963, US ambassador to India. His major books
include A Theory of Price Control ^952), American Capitalism (r952), The Great Crash
1929 (4955), The Affluent Society (1958), The Economic Discipline (1967), The New Indus¬
trial State (1967), Economics, Peace and Laughter (1971), Economics and the Public Purpose
(1974) and The Nature of Mass Poverty (1979). He has been a sharp critic of current
economic theory because of its preoccupation with growth (>growth theory). He
has accused advanced societies of producing waste simply to satisfy the need for
growth for its own sake. He has argued that in modern advanced economies the
problems of the distribution of the total product to the different sectors of society
should be given more attention. At the same time, he believes that academic theoreti¬
cal economics is too bound by its old tradition of the efficacy of competition to the
extent of losing touch with the real world. In American Capitalism (t952) he showed
how modern society breeds monopolistic power systems. ^Monopoly in industry
induces a countervailing monopoly or >monopsony in distribution, in >labour
and even in government purchasing agencies.
In The New Industrial State (1967) he argued that the 'technostructure' (managers)
of the largest corporations in modern industrial society is motivated primarily by a
desire to remain secure and to expand its corporation rather than to maximize
Galiani, Ferdinando

►profits. The highly capitalized nature of the industrial system has required a
considerable extension of planning and control, notably of the ►capital supply
through > self-financing, and of demand through advertising and distribution tech¬
niques. Under these conditions the assumption of ►consumers' sovereignty that
underlies modern microeconomic theory (►microeconomics) is invalid and the
theory no longer relevant to much of the economic system. Galbraith's views have
been challenged by many economists as an overstatement of monopolistic power
but are none the less sometimes accepted as an accurate statement of tendency in
the modern economy. He has been critical of the advocates of the strict control
of the supply of ►money as a means of reducing ►inflation, ^consumption;
countervailing power; firm, theory of the; Friedman, M; Keynes, J. M.; Mill, J. S.;
oligopoly; quantity theory of money.

Galiani, Ferdinando (1728-87) A Neapolitan priest who wrote a number of treatises

on economic subjects, in particular Della moneta (1751) on ►money and exchange,
and Dialogues sur le commerce des bles (1770) on ►free trade in cereals. He resolved
the so-called a ►paradox of value (e.g. water is useful but cheap, whereas diamonds
are useless but expensive), by analysing the ►price of a ►commodity in terms of its
►scarcity on the one hand and its ►utility on the other - utility being not only a
reflection of a commodity's usefulness, but also its pleasure-giving potential. He
explained how price both influences, and is influenced by, ►demand. Much of his
work in >value theory was original, though part of a long tradition of ecclesiastical
thought. However, he was not familiar to English economists of the early nineteenth
century, and much of the ground covered by Galiani was revisited by them, ►►margi¬
nal utility.

galloping inflation ►hyperinflation.

game theory The branch of economics concerned with representing economic

interactions in a highly stylized form, with players, pay-offs and strategies. Much of
economic theory is concerned with the processes and conditions under which
individuals or firms maximize their own benefits or minimize their own costs
in markets in which their individual actions do not materially influence others
(►►perfect competition). There are, however, many cases in which economic
decisions are made - often in situations of conflict - where one party's action induces
a material reaction from others, e.g. wage bargaining between employers and unions.
A more simple case is that of > duopoly, in which the price set by one seller will be
based on his/her view of that set by the other in reply. The mathematical theory of
games has been applied to economics to help elucidate problems of this kind. The
theory of games is concerned with the study of the optimal strategies to maximize
pay-offs, given the risks involved in judging the responses of adversaries and also
the conditions under which there is a unique solution, i.e. that the optimum strategy
for X and that of Y are both possible and not inconsistent. Games may be classified
into ►zero-sum games, in which one player's gain is another player's loss; non-zero-
sum games, in which one player's decision may benefit (or hurt) all players; co¬
operative games, in which collusion between players is possible, and non-co-operative
games, when it is not. The application of the theory of games to economics was first
introduced by von Neumann and Morgenstern in Theory of Games and Economic
Behaviour (1944). It has since risen to become perhaps the most important source of
 General Agreement on Tariffs and Trade

new ideas in > microeconomics, and the mindset of game theory now dominates
almost any analysis of interactions between economic agents. Game theory was at
the heart of the design of the rules applied in the W^auction of telecommunications
licences in the UK in 2000. ^-bargaining; mixed strategy; Nash equilibrium;
prisoner's dilemma; repeated game; tit-for-tat.

GATT »-General Agreement on Tariffs and Trade.

GDP >gross domestic product.

GDP deflator An index of prices (Mndex number) that can be applied to the
value estimates of the >gross domestic product (GDP) over a time period in order
to remove the effects of changes in the general level of prices. The resultant revised
estimates give a more accurate picture of movements during the period in the
physical or real output of goods and services. In practice, the components of GDP
are deflated (>deflation) separately to constant prices and then added together to
give an estimate for a given year in Meal terms. The advantage of the GDP deflator
as a measure of domestic ^inflation, is that it strips out the effect on prices of a
change in the price of ^imports, on account of, say, a change in the ^exchange
rate. It is argued that it represents the best measure of ^underlying inflation. It is
not used as the basis for the ^inflation target, as publication of the deflator is less
frequent than the > retail prices index, and often subject to late revision.

gearing The relative importance of Moans in the ^capital structure of a firm. Also
called the debt ratio and, in the USA, leverage. There are several ways of measuring
gearing. The usual way is the ratio of fixed-interest >debt to shareholder's interest
plus the debt (>net worth). Equity gearing is the ratio of borrowings to >equity or
risk capital. Capital gearing may be defined as bank borrowings and other debt as a
percentage of net tangible assets (>assets; financial ratios). A corporation may borrow
>-capital at fixed interest, and if it can earn more on that capital than it has to pay
for it in interest, then the additional earnings accrue to the >equity shareholders. A
firm with high gearing will be able to pay higher >-dividends per >share than a firm
with lower gearing earning exactly the same return on its total capital, provided that
return is higher than the rate it pays for Moan capital. However, the contrary is also
true, so that the higher the gearing, the greater the risk to the equity shareholder.
Roughly speaking, if a firm's initial capital consists of £7000 subscribed by ordinary
shareholders and £3000 borrowed at fixed interest (e.g. through ^debentures) it
would be said to have a gearing of 30 per cent. The tax system (>taxation) encourages
gearing, since interest is deductible for > corporation tax but dividends are not.
>*► Modigliani-Miller theorem.

General Agreement on Tariffs and Trade (GATT) An international organiz¬

ation that came into operation in r948. Its Articles of Agreement pledged its member
countries to: (a) the expansion of multilateral trade (>-multilateralism) with the
minimum of barriers to trade; (b) the reduction in import tariffs and >quotas,
and (c) the abolition of preferential trade agreements. There have been successive
negotiations between the contracting parties, aimed at reducing the levels of tariffs,
from the first meeting in Geneva in T947, up to the eighth, so-called ^-Uruguay
round of trade negotiations that began in 1986 and was concluded in T993. Members
were required to give details of any subsidies, and if these were liable to prejudice
General Agreement on Trade in Services

the interests of any other member they were required to discuss the possibility of
reduction or elimination. On export subsidies, in particular, member governments
'should seek to avoid' the use of subsidies on the export of primary products. For
exports of other products, subsidies, whether direct or indirect, should cease 'as soon
as practicable' if they resulted in export prices lower than the home prices of the
product. In r965, a revision came into force that laid emphasis on the special problems
of the ►developing nations and a committee on trade and development was given
the responsibility for progress on the elimination of barriers on the trade in products
of particular interest to the developing nations. This enabled the ►most-favoured
nation principle to be waived in relation to agreements entered into with developing
countries (>generalized system of preferences). There had been a growing tendency
for countries to become more protectionist (►protection) through the imposition
of non-tariff barriers, and for economic blocs to make preferential trade agreements
with other countries. >free trade area.
A ministerial meeting of GATT was held in r982 to reaffirm the ►free trade
principles upon which GATT was founded. The ministers affirmed that they would
'make determined efforts to resist protectionist measures and refrain from taking
or maintaining any measures inconsistent with GATT'. Studies were initiated to
examine farm export subsidies, financial support for domestic industries, a formula
by which a country may impose import restrictions to protect its domestic industry,
textiles, tropical products, and trade in ►services. Agreement was eventually
reached, at a meeting of delegates at Punta del Este, Uruguay in r986, on an agenda
for the Uruguay round of trade negotiations. This round considered aspects such as
agricultural export subsidies, restrictions on trade in services (e.g. banking,
insurance, transport, etc.) and restrictions on direct ►foreign investment. The
GATT was replaced by the >World Trade Organization from i January 1995. A
further round of trade negotiations was agreed at Doha in 2002. ►Doha round of
trade negotiations.

General Agreement on Trade in Services (GATS) Following from decisions

made at the >Uruguay round of trade negotiations, rules were established for the
liberalization of international trade in services, e.g. banking, insurance, transport,
telecommunications, health and education provision. The aims of the GATS were
confirmed at the ►Doha round of trade negotiations that were begun in 2001.

general arrangements to borrow ►International Monetary Fund.

general equilibrium The state of a set of interrelated markets when there is no

►excess demand or supply in any market. In a world of two commodities, increase
in demand for one must lead to a decrease in demand for the other if all consumers
spend what they have and no more. Given this interrelation, it is not as obvious
that equilibrium can prevail in all markets simultaneously as it is that it can prevail
in one market at a time. ► Arrow-Debreu general equilibrium model; general equilib¬
rium analysis; Walras, M. E. L.

general equilibrium analysis 1 The study of the behaviour of economic variables

taking full account of the interaction between those variables and the rest of the
economy. For example, a general equilibrium approach to the study of waiters'
wages would concentrate both on demand and supply in the market for waiters and
the effects of wages or unemployment in other markets more generally. In this it
 Gibrat's law

contrasts with ^partial equilibrium analysis. 2 The study of simultaneous equilibria

in a group of related markets. The prime focus is whether there is a set of prices that
would ensure that equilibrium exists in each market. If so, is such an equilibrium
stable - if disruptions occurred, would there be a tendency to return to equilibrium?
And is such an equilibrium unique, or are there any sets of prices at which all markets
clear? The analysis is attributable to >Walras, who limited his consideration to a
theoretical economic system in which all consumers were utility-maximizers and
firms perfectly competitive. A unique, stable equilibrium can exist in such an econ¬
omy. >Arrow-Debreu general equilibrium model; Leontief, W. W.; Walras, M.E.L.

general government Term used as an overall heading for the central and local
government sectors, but which excludes public corporations. General government
is thus a more restrictive notion of the state than that defined as the >public sector.

generalized system of preferences The elimination or reduction of import

^tariffs by the ^advanced countries on specified products exported by approved
>developing countries. The scheme was first introduced in r97i. The intention is to
encourage the development and diversification of developing countries' exports.
>Cotonou Agreement; Doha round of trade negotiations; World Trade Organiz¬
ation; >*-most favoured nation clause.

generational accounting A system for assessing the differential impact of

government tax and spending decisions on the welfare of different generations. It
starts by calculating the present value of all government spending and taxes on an
average person born in each year, over his/her whole lifetime. If governments did
not make pension promises that have differential impacts on the generations, and
if governments could not borrow money (which can transfer a burden from one
generation to the next) one would expect that each generation of citizens would
more or less finance the spending from which they benefit. As it happens, though,
governments can transfer burdens from one generation to the next. Studies for
the USA and Japan indicate that those over age 60 in 1995 were net recipients of
government policy, while the generation below them were likely to be net contribu¬
tors, i.e. to pay more tax over their lifetime than they would receive in spending.

geometric progression A sequence of numbers in which the ratio of each number

to the preceding one is a constant, e.g. 2, 4, 8, r6 ... . ^arithmetic progression.

German stock exchanges The numerous >stock exchanges in Germany are now
grouped under Deutsche Borse AG which itself floated (>flotation) in 2oor. Frankfurt
is by far the largest, accounting for over 75 per cent of volume. There is an >unlisted
securities market, the Neuer Markt (New Market).

GFCF Gross fixed capital formation (^capital formation).

Gibrat's law If each firm in a population of a fixed number of firms is subjected

to a growth rate randomly derived from a distribution of potential growth rates
with the same mean and standard deviation as applies to each other firm in the
population, the distribution of firms will be of a >log-normal distribution, the
skewness of which will increase with repeated applications of the rates of growth.
The law is derived from the work by Gibrat in Les inegalites economiques published
in 1931.
giffen good

giffen good A commodity for which demand increases at higher prices and
falls at lower prices. This odd feature of basic commodities in the budgets of the
nineteenth-century poor was observed by Giffen (1837-1910). As the price of bread
rose, the poor, who relied on it as their staple diet, could no longer afford to buy
other relatively more luxurious food items that they had to replace with increased
purchases of bread. Similarly, because bread constituted the bulk of their spending,
they enjoyed such an increase in their Weal income when its price fell that they
could afford to substitute other more palatable food than bread in their diet.
The 'giffen paradox' is explained within the normal framework of demand and
supply analysis. When the price of any good rises, it has two effects: (a) it changes
the relative attractiveness of other goods, increasing the desire of consumers to buy
more of the items with prices that have not risen - the ►substitution effect, and (b)
has an effect on the spending power of consumers, who can do less with their money
than they could before prices rose, as though their income had fallen and no prices
had changed - the ►income effect. Two features explain the characteristics of a
giffen good: (a) demand for it rises as the income of consumers falls (it is ►inferior),
and (b) what essentially accounts for its perverse behaviour is the fact that this
income effect on the demand for the giffen good outweighs the substitution effect
which causes consumers to switch purchases from items that have rising prices.
The giffen good should not be confused with items that enjoy 'snob value'. These,
too, can enjoy simultaneously rising prices and demand, accounted for by the fact
that some consumers delight in paying for the knowledge that certain of their
possessions are expensive. Such behaviour can be explained as a form of Signalling.
The usual way of viewing this 'snob effect' is to treat a change in price of an item to
which it applies as a change in the fundamental characteristics of the product sold,
making it wholly incomparable to the same physical object sold at a different price
and not, therefore, an item for which a single demand curve can be constructed,
►price theory.

gift tax (US) A levy on the lvalue of certain property given away to others and
paid by the donor. The gift tax is graduated and levied by the Federal government
and also by some states. In the UK prior to the introduction of capital transfer tax
(►inheritance tax), there was no tax on gifts as such, although they were added
back into the estate of the donor for duty purposes if made within 7 years of the
donor's death.

gilt-edged securities Fixed-interest British ►government securities traded on

the Wtock exchange. They are called gilt-edged because it is certain that ^interest
will be paid and that they will be redeemed (where appropriate) on the due date. For
individuals, no ►capital gains tax arises on disposal of gilts. Some gilt-edged securi¬
ties are >dated securities, some are ^undated securities and some are index-linked
(►indexation). Gilt-edged securities are not, of course, a risk-free investment,
because of fluctuations in their market value. Gilt-edged securities do not include
►treasury bills. >► yield.

gilt repos The market in agreed sales and repurchase of >gilt-edged securities
(►repo) introduced by the ►Bank of England in January r996. Within 2 months of
launch, the open gilt repo market was already much larger than the ►bill market
(►money market), the restricted size of which has recently hampered ►open-market
 GNP

operations. The gilt repo market was launched to increase the attractiveness of gilts
to foreign investors and to reduce the cost of funding the government X-deficit, but
may be used by the Bank of England for open-market operations as repos are used
by the > Bundesbank and the > Federal Reserve System.

gilt stripping The creation of two tradable financial securities out of a single
>gilt-edged security, with one security taking the Mnterest, and the other left with
the ^-principal. The facility for strippable gilts was introduced by the x-Bank of
England in r997 but has long been available in the USA for US Treasury and other
securities.

gini coefficient A coefficient, based on the >Lorenz curve, showing the degree of
inequality in a >frequency distribution, e.g. personal income. It is measured as:

„ area between Lorenz curve and 45° line

(j = '
area above the 45° line

If the frequency distribution is equal, the Lorenz curve coincides with the 45° line,
and G = 0. ^concentration ratio.

giro system >-credit transfer.

global corporation >multinational corporation.

globalization Geographical shifts in domestic economic activity around the world

and away from nation states. The >Organization for Economic Cooperation and
Development defines globalization as 'the geographic dispersion of industrial and
service activities (for example ^research and development, sourcing of inputs,
production and distribution) and the cross-border networking of companies (for
example through »-joint ventures and the sharing of assets)'. The most obvious
manifestations of this process are that the annual rate of growth in international
trade has been consistently higher than that of world production, while > multi¬
national corporations have continued to extend their operations. However, globaliz¬
ation no longer necessarily requires a physical presence in other countries, or even
►exports and ► imports, e.g. activity can be shifted abroad by licensing, which only
needs information and finance to cross borders. Although not new, the pace of
globalization has accelerated, facilitated by improvements in transport and com¬
munications, the promotion of > deregulation in different sectors, the removal of
trade restrictions and > exchange controls (^-convertibility; General Agreement on
Tariffs and Trade).
The motives for globalization include lower labour costs and other favourable
►factor endowments abroad and the circumvention of remaining > tariff and ► non¬
tariff barriers to trade. Concern has been expressed that economic activity and
employment in the ^advanced countries will drain away to the > developing coun¬
tries, but the theory of ^international trade and past experience suggest that all
nations in the globalization process will gain in the long run. That has not allayed
concerns that certain sections of the population in richer countries - notably rela¬
tively unskilled workers - will lose as an abundance of unskilled labour makes itself
available to the world's companies. »-weightlessness.

GNP >gross national product.

gold

gold This precious metal ceased to have a significant monetary role in r97i, when the
USA abandoned its commitment to buy or sell gold at a fixed price (►International
Monetary Fund). However, the non-monetary role of gold, especially in jewellery,
has expanded rapidly and gold also remains in demand as a store of value as well as
a means of adornment. In the long term, gold has retained its value in real terms.
Recent sales of gold depressed sentiment in favour of gold but there has been some
recovery in the gold price with the weakness in stock markets in the early part of the
millenium. >^gold standard.

gold and foreign exchange reserves The stock of gold and foreign >currencies
held by a country to finance any calls that may be made from its creditors for the
settlement of ►debt. Reserves used to be held primarily to finance the >balance of
payments. Pressure on the reserves, therefore, tended to reflect underlying trading
problems of the country in question, or sometimes the expectation of a fall in the
►exchange rate which led people to sell their holdings in the currency. Today,
however, currencies are more freely traded than they used to be (>convertibility)
and the national reserves are not relied upon to finance private transactions. As a
result, the reserves are primarily seen as a tool for influencing the ►exchange rate.
The authorities can use them to influence supply and demand on the ►foreign-
exchange market. Such intervention is bound to be of limited duration, but can
serve a role as a >signalling device, letting the markets know the intention of the
authorities. The official published figures of reserves, however, do not necessarily
reflect the total amount of gold and foreign currency that could be used to meet
obligations any more than does an individual's ►current account at the bank. The
reserves exclude, for example, the ►credit facilities available through the ►Intern¬
ational Monetary Fund and ►portfolio foreign investments, ►►foreign investment;
reserve currency.

gold exchange standard A special form of the >gold standard. In this system
the ►central bank will not exchange its ►currency for gold on demand (as is the
case under the gold standard), but will exchange it for a currency which is itself on
the gold standard. The central bank holds the parent country's currency in its
reserves along with gold itself. The Scandinavian countries adopted this system in
respect of sterling up until r93r, when the UK came off the gold standard.

gold points ►specie points.

gold standard A country is said to be on the gold standard when its ^central
bank is obliged to give gold in exchange for any of its ►currency presented to it.
When the UK was on the gold standard before 1914, anybody could go to the ►Bank
of England and demand gold in exchange for ►banknotes. The gold standard
was central to the ►classical economists' view of the equilibrating processes in
►international trade. The fact that each currency was freely convertible into gold
fixed the ►exchange rates between currencies (►specie points), and all international
debts were settled in gold. A ►balance of payments surplus caused an inflow of gold
into the central bank's reserves. This enabled the central bank to expand the ►money
supply without fear of having insufficient gold to meet its >liabilities. The increase
in the quantity of money raised prices, resulting in a fall in the demand for ►exports
and therefore a reduction in the balance of payments surplus. The reverse happened
in the event of a ►deficit. The UK came off the gold standard in r9i4, partly returned
 Cossen, Hermann Heinrich

to it in 1925, but was forced to abandon gold finally in 1931. The USA was on the gold
standard from T879 to r933, although gold was officially required in bank deposits to
support a percentage of the currency in circulation until 1968. For overseas monetary
authorities only, the dollar was convertible into gold until r97r. Switzerland, which
abandoned gold convertibility in T954, still required a percentage of its currency to
be supported by gold until 1999.

golden rule 1 The idea that government should borrow each year only to finance
^-investment, not to finance ^current expenditure. This implies that the >current
budget should be in balance. Meeting the golden rule across the economic cycle
became official UK government policy in 1997. At that time, net >- public-sector
investment spending represented a little under r per cent of gross domestic product
- the government's rule could be interpreted as saying there should be a structural
budget deficit no higher than that in any year. 2 The level of savings and investment
that an economy enjoying ^balanced growth would need to support, in order to
maximize the long-term value of consumption per head (»-optimal growth theory).
The rule holds, under a number of restrictive assumptions, that the growth rate of
population, output and capital stock should equal the real Sate of interest. This is
sometimes referred to as the biological interest-rate rule, as it stipulates projects should
be discounted (>- discounting) at the rate of population growth. It implies that share
of profits in the economy should equal the share of savings and investment. Note:
Definitions 1 and 2 above are clearly related. If the rule in definition 2 holds, it
will be the case that a government subscribing to the rule in definition 1 will
have interest payments on its debt equal to the value of its borrowing. So such a
government would be in a sustainable and balanced position. It will be borrowing
to invest, and the returns it makes on investment will just finance its debt. Conduct
of government in definition 1 is therefore consistent with the golden rule in
definition 2 .

good »-economic good.

Goodhart's law The phenomenon that when regulatory policy focuses on a

particular variable with which it is expected to have a close relationship (e.g. the
quantity of money in circulation (>-money supply) and bank deposits) the relation¬
ship will alter, thus frustrating the exercise of policy. The law, credited to Goodhart,
Professor of Banking and Finance at the London School of Economics, was originally
applied to the targeting of ^monetary policy but has since been accepted to have
wider applicability.

goodwill The value of a business to a purchaser over and above its >net asset
value. It is normal practice to show goodwill in the »-balance sheet but to write it
down for >-depreciation.

Gossen, Hermann Heinrich (1810-58) Born in Diiren, near Aachen, in Germany,

Gossen studied law and went into government service in deference to his father's
wishes. It was not until after his father's death in 1847 that he dedicated himself to
the study of economics. His major economic work is Entwicklung der Gesetze des
menschlichen Verkehrs und der daraus fliessenden Regeln fur menschliches Handeln (1854).
In this book, Gossen set out a theory of consumer behaviour based on theories that
were subsequently to be independently rediscovered and enshrined in the theory of
government expenditure

►marginal utility by ►Jevons, ►Menger and >-Walras. The first edition of his book
was completely ignored, and Gossen's recognition had to wait until after his death.
It was Jevons who, in the preface to his own Theory of Political Economy (1871), drew
attention to the significance of Gossen's achievement, admitting that Gossen had
'completely anticipated him as regards the general principles and methods of econ¬
omics'. Gossen's first law states that the pleasure obtained from each additional
amount consumed of the same >-commodity diminishes until satiety is reached.
Gossen's second law states that once a person had spent his entire ►income, he
would have maximized his total pleasure from it only if the satisfaction gained from
the last item of each commodity bought was the same for each commodity. Gossen's
third law, derived from the first two, states that a commodity has a subjective
►value, and the subjective value of each additional unit owned diminishes and
eventually reaches zero. ^Bernoulli's hypothesis.

government expenditure ►public expenditure.

government securities All government fixed-interest paper, including ►funded

debt and >treasury bills. The government does not, of course, issue ►equity capital.
»► gilt-edged securities.

government stocks Fixed-interest ►securities issued by the government, often

known as >'gilt-edged'. ►► funded debt.

Granger causality A means for determining whether a variable A can be said to

have a causal influence on a variable B. If we observe that money-supply increases
are followed by inflation, we cannot say that increases in money supply cause
inflation. It may be that both money-supply increases and inflation are caused by
something else. Under the Granger test of causation, a >time series of both money
supply and inflation is taken, and each is stripped of any independent long-term
trends they may exhibit. Then the values of money supply and inflation are regressed
against each other (►regression analysis). Money-supply changes can be said to
cause inflation if in such analysis: (a) values of inflation are explained by previous
values of money supply, and (b) values of money supply are explained by future
values of inflation.

Gresham's law The law states that if two coins are in circulation, the relative
►face values of which differ from their relative ►bullion content, the 'dearer' coin
will be extracted from circulation for melting down (►'bad money drives out good').
The law is named after Gresham (1519-79), a leading Elizabethan businessman and
financial adviser to Queen Elizabeth I.

grey imports ►parallel imports.

gross cash flow ►cash flow.

gross domestic product (GDP) A measure of the total flow of goods and ►serv¬
ices produced by the economy over a specified time period, normally a year or a
quarter. It is obtained by valuing outputs of goods and services at ►market prices,
and then aggregating. Note that all ►intermediate goods are excluded, and only
goods used for final ►consumption or investment goods (►capital) or changes in
►stocks are included. This is because the ► values of intermediate goods are impli¬
citly included in the ►prices of the final goods. The word 'gross' means that no
 Croup of Seven

deduction for the value of expenditure on capital goods for replacement purposes is
made. Because >income arising from ►investments and possessions owned abroad
is not included, only the value of the flow of goods and services produced in the
country is estimated; hence, the word 'domestic' to distinguish it from the gross
national product >gross national income. Since no adjustment is made for indirect
taxes (>direct taxation) and >-subsidies, the measure here defined is often referred
to as 'GDP at market prices'. >-gross value added at basic prices.

gross fixed capital formation (GFCF) ►capital formation.

gross investment investment expenditure inclusive of replacement of worn-out

and obsolescent equipment, i.e. inclusive of ►depreciation. >*-net investment.

gross margin In a retail business, the margin on a sale that is the difference
between the purchase >price of a good and the price paid by the retailer, i.e. it
makes no allowance for > fixed costs, >stock appreciation or >tax. The gross margin
is sometimes loosely referred to as gross profit, but this term has a different, strictly
defined, meaning in accounting (>-profit).

gross national expenditure ►national income.

gross national income (GNI) >Gross domestic product plus the ►income
accruing to domestic residents arising from ►investment abroad less income earned
in the domestic market accruing to foreigners abroad. >national income.

gross national income at market prices >Gross national income with all
flows valued at ►market prices. Since market prices include indirect taxes (►direct
taxation) and ► subsidies, and since taxes and subsidies are regarded simply as
> transfer payments, it is often preferable to measure national income and output
excluding these. This gives the measure of national income, net of ►taxation and
subsidies, known as >gross value added at basic prices. Valuations may be at prices
obtaining in the current year (current prices) or in a specified year, e.g. r995 prices.
► real terms.

gross profit ►profit.

gross trading profit Gross ►profit before allowing for ►depreciation, ►interest
and stock ►appreciation.

gross value added at basic prices The measure of ►gross domestic product
(GDP), that makes an adjustment for the impact of taxes and subsidies. In the
measure of 'GDP at market prices', the prices used to value outputs and aggregate
them include indirect taxes, i.e. lvalue added tax, and ^subsidies. As a result, the
►value of output will not equal the value of ►incomes paid out to ^factors of
production. This is because it is the revenue received by firms after indirect taxes
(►direct taxation) that is distributed as factor incomes. So, by subtracting the total
of indirect taxes (and, since subsidies have the opposite effect of taxes, by adding-in
subsidies) from the GDP we arrive at the estimate of the gross value added at basic
prices, which is consistent with the value of incomes paid to factors of production.
This is the measure of GDP from which growth rates are conventionally drawn,
►national income.

Croup of Seven >67.

Group of Ten

Group of Ten >International Monetary Fund.

growth accounting Quantitative analysis of economic growth rates that seeks to

disaggregate the sources of growth: (a) changes in inputs of the >•factors of pro¬
duction (^labour and ^capital); (b) changes in the quality of labour, and (c) total
factor productivity, a residual intended to capture the contribution of knowledge,
technological progress and other exogenous factors (>exogenous growth theory).
Growth accounting, which is a statistical imputation of the ^production function,
was pioneered by Denison (b. 1915) and developed by Maddison and others. Deni¬
son's first book on this subject appeared in 1962. In Accounting for United States
Economic Growth 1929-1969 (1974), he calculated that the annual growth of real
►national income of 3.3 per cent over the period was composed of growth of labour
input of r.31 per cent, capital of 0.50 per cent and a residual of r.52 per cent attributable
to advances in knowledge and other causes. Labour inputs were split down into
employment, average hours worked, education of workers and other. Since it is not
actually possible to separate-out the contributions of all the various factors to growth,
growth accounting is based on assumptions; e.g. Denison weighted the factors of
production according to their shares in the national accounts (Asocial accounting).

growth theory The area of economics concerned with the development of models
that explain the rate of > economic growth in an economy. The most important
questions in growth theory post-Second World War were about: (a) the optimal level
of growth (>► optimal-growth theory), and (b) whether the economic system has a
natural tendency to achieve ^balanced growth, a position in which all variables
grow at the same rate. If growth in the economy is balanced, it can be shown that
n = s/v where n is the rate of growth of the labour force, s the ^average propensity
to save and v the ratio of capital in the economy to output produced ^capital-
output ratio). For balanced growth to be sustained with ^investment equal to
savings and with constant full employment, some mechanism has to exist to cause
one of these three factors to change when one of the other two moves out of balance.
In the neo-classical (>neo-classical economics) approach to growth, it is the capital-
output ratio, v, that alters. If, for example, the labour force was growing too fast to
maintain full employment with the given level of savings and stock of capital, the
capital-output ratio would fall as entrepreneurs switched from employing capital
to labour in response to the lower wages that the excess supply of labour caused.
The fixed relationship between the three factors would thus still hold.
In the >Harrod-Domar model, none of the three variables is endogenous (►en¬
dogenous variable) and thus there is no tendency for balanced growth to occur at
all. The capital-output ratio is assumed to be fixed by technological factors or by
sticky interest rates (^liquidity trap). In models associated with the ^Cambridge
School, it is the propensity to save which is the endogenous variable; in particular, if
there is a difference between the inclination for profit-earners and wage-earners to
save, growth can lead to redistributions from one group to the other in such a way
as to alter the savings necessary to maintain a full-employment steady-state growth
path. In recent years, economics has become less concerned with steady-state
growth, and more with the factors that explain why some economies grow faster
than others, ^endogenous growth theory; inequality; optimal growth theory.
 H

Haavelmo, Trygve (1911-99) Norwegian economist and winner of the ►Nobel

Prize for Economics in T989, Haavelmo's contribution to the subject was made during
the Second World War in the USA. His most important paper, 'The Probability
Approach to Econometrics', in Econometrica (1944), was path-breaking in introducing
the ideas of Improbability theory into ►econometrics, explicitly accounting for
uncertainty in the estimation of variables. Haavelmo argued that economists' models
were necessarily simplistic, and thus could not hope to explain fully the factors
affecting a piece of economic data, representing the behaviour of many individual
agents. There would inevitably be a degree of randomness in the real world as
economists observed it, and he pioneered the use of statistical techniques to make
assumptions about the pattern of that randomness and draw inferences from the
data. He also had a huge effect on how econometric models are drawn up, where
systems of different variables interact upon each other. He argued that econo¬
metricians need to look at relationships between variables that are autonomous,
in the sense that the relationships are not affected by other parts of the system
being estimated.

hard currency A ► currency traded in a ► foreign-exchange market for which

►demand is persistently high relative to the >supply. >^>soft currency.

harmonized index of consumer prices A standardized measure of inflation

introduced in 1997 by the ►European Union (EU). The index is used by the ►Euro¬
pean Central Bank as its measure of ►inflation in determining >monetary policy
and for comparison of inflation rates between member countries of the EU. The
index is designed to be a measure consistent throughout the EU member countries
and does not, therefore, have the same structure of goods and services or weights
(►index number) as those in, for example, the UK ►retail prices index. It is calcu¬
lated using a geometric mean, as opposed to the arithmetic mean in use in the UK.
average.

Harnsanyi, John C. (1920-2000) Hungarian-born, Hamsanyi made a major contri¬

bution to >game theory in ^67-68 with his paper 'Games with Incomplete Infor¬
mation Played by Bayesian Players'. He was a joint winner of the ►Nobel Prize for
Economics in 1994. He extended an understanding of game theory to situations in
which players had incomplete and differing amounts of information. He showed
that for every game characterizing such a situation, there was an equivalent game
that could be defined with complete information. Those equivalent games could be
studied using conventional methods. ►►Nash, J. F.; Selten, R.
Harrod, Sir Roy Forbes

Harrod, Sir Roy Forbes (1900-78) Educated at New College, Oxford, Professor
Harrod began his career in 1922 as lecturer at Christ Church, Oxford, and continued
teaching there until r952. From 1940 until 1942, he served under Lord Cherwell and
in the prime minister's office and then held the post of Statistical Adviser to the
Admiralty until 1945. In 1952, he was appointed Nuffield Reader of International
Economics. His publications include The Trade Cycle (r936), Essay in Dynamic Theory
(i939)/ Towards a Dynamic Economics (1948), The Life of John Maynard Keynes (r95r),
Policy Against Inflation (1958), The British Economy (1963), Reforming the World's Money
(r965), Towards a New Economic Policy (1967), Dollar-Sterling Collaboration (1968),
Money (1969) and Economic Dynamics (1973).
His Essay in Dynamic Theory (1939) brought together in a mathematical framework
the accelerator and the ^multiplier (^accelerator-multiplier model). Professor
Harrod shifted economic theory away from its preoccupation with the conditions
of stationary Equilibrium toward the analysis of the problems of growth (>► growth
theory). He investigated the implications for growth of the interactions of the
^acceleration principle and the multiplier (>^Harrod-Domar model).

Harrod-Domar model A theory of economic growth (>growth theory) that

suggests there is no natural tendency for an economy to enjoy ^balanced growth.
In the model, developed by >-Harrod in 1939 and independently by Domar shortly
afterwards, there are three concepts of growth: (a) warranted growth: the rate of
output growth at which firms believe they have the right amount of capital and
don't feel it necessary to increase or decrease investment, given their expectations
of future demand (>capital-output ratio); (b) natural rate of growth, which corre¬
sponds to the increase in the labour force - if the labour force rises, growth must rise
to maintain full Employment, and (c) actual growth: the change in aggregate
output that finally materializes.
In the model, two problems are seen to arise in the growth pattern of an economy
- the relationship between actual and natural growth, and the relationship between
actual and warranted growth. The first problem is that the factors determining actual
growth are quite independent of the factors determining natural growth, and so
there is no reason that an economy will achieve a level of growth necessary to
maintain full employment. The natural rate of growth is determined by factors
such as attitudes to birth control and the tastes of the population with respect to
family size. Actual growth, however, is affected by the propensity to save (the more
^saving, the more >-investment, and the more growth) and the increase in output
caused by each pound's worth of investment. Neither the capital-output ratio
nor the propensity to save will adjust to meet the requirements of the labour
market, however.
The second problem is that, in the model - if entrepreneurs expect output to grow
- they will increase their investment to meet the anticipated demand. If the increase
in demand is forthcoming, the aspirations of firms will be met and warranted growth
will be equal to actual growth and no problem arises. If, however, actual growth
exceeds expectations, then entrepreneurs will discover they have not invested as
much as they would have wanted to if they had known what was coming. In
response, they will increase their investment to the level warranted by actual growth,
but this increase in investment will cause actual growth to rise even more. A reverse story
can be told when actual growth falls short of warranted growth: entrepreneurs, in
 Hayek, Friedrich August von

the model, set up a vicious circle, by which any discrepancy between their expected
growth and actual growth magnifies as they attempt to change the level of their
investment to the level warranted. The result is instability.
The conclusion of the Harrod-Domar model (i.e. that the economy does not
naturally find a full-employment, stable-growth rate) is analogous to the Keynesian
(3*#>-Keynes, J. M.) belief that it need not find a full-employment equilibrium level of
output. However, the model's results can be criticized because of the severity of the
assumptions built into it. The first problem suggested by the model - that there is
no reason for growth to equal the level necessary to maintain full employment -
is largely because it assumes that the relative price of labour and capital is fixed,
and that they are always employed in equal proportions. It is quite possible,
however, that increases in labour supply might drive down wages and lead to an
increase in the amount of labour used relative to capital. Secondly, the model
naively assumes that investors are influenced by only one thing: the level of
output. This is the ^acceleration principle. This explains the way in which discrep¬
ancies between warranted and actual growth may lead to spiralling increases or
decreases in growth, ^economic growth; optimal-growth theory; steady-state
growth; trend growth.

Hawtrey, Sir Ralph George (1879-1975) After a long career in the UK ^Treasury
that lasted from T904 to 1945, Hawtrey was appointed Professor at the Royal Institute
of International Affairs. He held his post until his retirement in 1952. Hawtrey's
publications include Currency and Credit (i9r9), The Gold Standard in Theory and
Practice (1927), The Art of Central Banking (1937), Capital and Employment (1937), A
Century of Bank Rate (r938), The Balance of Payments and the Standard of Living (1950),
Cross-Purposes in Wages Policy (1955), The Pound at Home and Abroad (1961) and Incomes
and Money (1967).
His theory of the ^-business cycle emphasizes monetary factors. The amount that
consumers and investors were willing to save or spend depended on the level of
>rates of interest. Fluctuations in economic activity arose through variations in
the quantity of money (>#*-money supply), especially bank >credit, because these
variations alter the level of the rate of interest (>Mises, L. E. von). He criticized
the Radcliffe Committee (>Radcliffe Report) because he felt that it had not given
sufficient attention to the possibility that the rate of interest had a significant
influence on a firm's willingness to hold stocks of commodities (>inventories).

Hayek, Friedrich August von (1899-1992) Born in Vienna, Hayek was director
of the Austrian Institute for Economic Research from r927 to T93r and lectured at
Vienna University. In r93r, he was appointed Tooke Professor of Economic Science
and Statistics at the London School of Economics, a post he held until 1950. From
t950 until 1962 he was Professor of Social and Moral Science at Chicago University.
He was Professor of Economics at the University of Freiburg until 1969, when he was
appointed Visiting Professor of Economics at the University of Salzburg. In 1974, he
received the Alfred Nobel Memorial Prize (>Nobel Prize) in Economics jointly with
> Myrdal. His published works include Monetary Theory and the Trade Cycle (1929),
Prices and Production (t93r), Profits, Interest, Investment (1939), The Pure Theory of Capital
(r94i), Road to Serfdom (1944), Individualism and Economic Order (r948), The Constitution
of Liberty (t96r), Studies in Philosophy, Politics and Economics (1967), Law, Legislation
and Liberty (3 volumes, 1973-79), Denationalisation of Money (1976), New Studies in
Heckman, James J.

Philosophy, Politics, Economics and the History of Ideas (1978) and The Fatal Conceit: the
errors of socialism (1988).
A member of the ►Austrian School, Hayek elaborated the ►business-cycle theory
of von ►Mises by integrating it with von ►Bohm-Bawerk's theory of ►capital. In a
boom, >real wages fall because of the rise in prices, and so firms switch to less
'roundabout' (►capital-intensive) methods of production. In consequence, ►invest¬
ment in total is reduced. In ►recession, the reverse situation induces 'roundabout'
production methods, and investment is stimulated. Professor Hayek believed that a
very severe restriction on the growth of the ►money supply was necessary in order
to control the growth of ►inflation, even if such a policy led to very high levels of
►unemployment. Hayek criticized socialist planning (►planned economy), advo¬
cating free markets which, he argued, were more accommodating to the propagation
and dissemination of the knowledge required for efficient economic systems. Open
markets gave proper opportunities to the expression of personal incentives and the
freedom to work and save, ►►acceleration principle; Keynes, J. M.; Ricardo effect.

Heckman, James J. (b. 1944) Economist from the University of Chicago and a
pioneer in the area of microeconometrics, the study of large sets of data on groups of
individuals, firms or households. Professor Heckman jointly won the Nobel Prize for
Economics in 2000 for his work on statistical techniques for coping with samples
that are not randomly selected. The problem is ubiquitous, not just because adminis¬
tratively data collation agencies may have their own impediments to random sam¬
pling, but because there are innate obstacles to unbiased samples. For example,
when looking at wages and labour supply, data can only include the wages of those
in work, and yet those out of work are, of course, an important component of
analysis that looks at the motivations for work participation. Another example is
work that assesses the effectiveness of government schemes to get the unemployed
into work. Entry into these schemes is non-random, and thus you can't just compare
people in the schemes to those outside them to see how successful the schemes are.
Professor Heckman's published works include 'Sample Selection Bias as a Specifi¬
cation Error', Econometrica (1979). But he has not just been a theoretician in econo¬
metrics - he has also practised empirical economics too, most notably in the study
of labour supply decisions and racial discrimination. His works include 'Shadow
Wages, Market Wages and Labour Supply', Econometrica (1974) and 'Determining the
Impact of Federal Antidiscrimination Policy on the Economic Status of Blacks: a
study of South Carolina', with Payner, American Economic Review (1989). Apart from
Chicago, his career has involved periods at Columbia and Yale Universities.

Heckscher-Ohlin principle The principle that a country will export those com¬
modities that are intensive (►capital-intensive; labour-intensive) in the factor (►fac¬
tors of production) in which it is most well endowed. The law of >comparative
advantage (►►Ricardo, D.) had been established by economists as an explanation
for the existence and pattern of international trade based on the relative ►opportun¬
ity-cost advantages between different countries producing different commodities.
The principle says nothing about why or how a comparative advantage exists. The
Heckscher-Ohlin principle states that advantage arises from the different relative
factor endowments of the countries trading. The principle was first put forward by
Eli F. Heckscher (1879-1952) in an article published in i9r9 and reprinted in Readings
in the Theory of International Trade (1949). It was refined by ►Ohlin in his Interregional
 Hicks, Sir John Richard

and International Trade (1933). The principle has been developed further by >Samuel-
son in his factor price equalization theorem.

hedge Action taken by a buyer or seller to protect his business or assets against a
change in >prices. A flour-miller who has a contract to supply flour at a fixed price
in 2 months can hedge against the possibility of a rise in the price of wheat in 2
months by buying the necessary wheat now and selling a 2 month > future in wheat
for the same quantity. If the price of wheat should fall, then the loss he will have
sustained by buying it now will be offset by the gain he can make by buying-in the
wheat at the future price and supplying the futures contract at higher than this
price, and vice versa. In practice, perfect hedging may not be possible because spot
(>spot markets) and future prices will not balance one another out after the event,
but a significant reduction in risk is normally possible. Hedging in this form is, in
effect, shifting risk on to specialized futures operators. The purchase of ^equities,
or other things for which prices are expected to move at least in line with the general
price level, is often referred to as a 'hedge' against > inflation.

hedonic price index An >index number for prices adjusted for changes in the
quality of the goods for which market prices are being measured, i.e. quality adjusted
price indices. The rationale for these adjustments is that products are not homogene¬
ous over time. For example, motor cars now frequently have radios or assisted
braking systems, or even air-conditioning, fitted as standard equipment, features
which at one time were optional extras. If car list prices have not changed, then
effectively there has been a price reduction. For personal computers, prices have
actually fallen considerably but at the same time processing power has increased so
that price for a given standard of product has fallen even faster. In a hedonic price
index the price-relatives (>■ index number) are adjusted downwards to allow for
product improvements. The use of hedonic indices has important implications
because >gross domestic product (GDP) in >real terms will be higher if the >GDP
deflator is quality adjusted than if it is not. Official statistics in the USA make
extensive use of hedonic indexes while those in, for example, Germany do not.
Hedonic price adjustments have been criticized for being confined to quality
improvements, whereas quality reduction resulting from overcrowding on transport
systems, for example, is not. While theoretically defensible, in practice quality
adjustments involve judgements by statisticians and may not necessarily reflect
market-determined prices.

Herfindahl index ^concentration ratio.

heteroscedasticity The problem encountered in ^regression analysis when the

>variance of the error term in a regression is not constant for every observation. It
may be in >time-series analysis, for example, that while the relationship between
the ^dependent variable and the ^independent variable remains constant on
average, it becomes more and more variable around that average as time pro¬
gresses. In this case, >least-squares regression will not be the most efficient method
of measuring that relationship; instead it is better to give more weight to those
observations that have the smallest expected error, ^econometrics.

Hicks, Sir John Richard (1904-89) Educated at Balliol College, Oxford, Hicks
lectured at the London School of Economics from T926 until 1935, when he became
Hicksian demand function

a Fellow of Gonville and Caius College, Cambridge. In 1938, he was appointed to the
Chair of Political Economy at the University of Manchester. In T946, he was made
Official Fellow of Nuffield College, Oxford, and in r952, Drummond Professor of
Political Economy at Oxford, a post he held until ^65. In r972, he was awarded the
»-Nobel Prize in Economics jointly with > Arrow. His major published works include
The Theory of Wages (1932), Value and Capital ^939), The Social Framework (1942), A
Contribution to the Theory of the Trade Cycle (1950), A Revision of Demand Theory
(1956), Capital and Growth (1965), Critical Essays in Monetary Theory (1967), A Theory of
Economic History {1969), The Crisis in Keynesian Economics (1974), Capital and Time: a
neo-Austrian theory (t976), Economic Perspectives: further essays on money and growth
(i977)- Causality in Economics (1979) and A Market Theory of Money ^989).
In an article in Economica in 1934, Hicks and Allen showed how the ► indifference
curve could be used to analyse consumer behaviour on the basis of >-ordinal utility.
Their exposition gave an important impetus to the development of this tool of
analysis in economic theory (►►Slutsky, E.). In his work on the ►business cycle,
Hicks demonstrated by means of mathematical ►models how the accelerator could
induce several types of fluctuation in total output. In an article in Econometrica in
1937, 'Mr Keynes and the Classics', he expounded the analytical tool of the MS-LM
model that he had invented in order to explore the assumptions relating to the
equilibrium between the supply and demand for ►money, ^savings and > invest¬
ment, the rate of Mnterest and >income. ►►Harrod, R. F.; Keynes, J. M.

Hicksian demand function The relationship between the consumer's demand

for a commodity and the price of that commodity, when the total level of consumer
►utility is held constant. Hicksian demand curves are also known as 'compensated
demand curves' as, when the price of a product changes, it is assumed that the
consumer is compensated so that he/she feels no less satisfied than before; they
contrast with Marshallian (>-Marshall, A.) demand functions (►demand function).
»► substitution effect.

hidden economy >informal economy.

hidden hand ►'invisible hand'; Smith, A.

hire purchase (H P) (U K) A form of ►consumer credit in which the purchaser pays

a deposit on an article and pays the balance of the purchase price plus > interest in
regular instalments over periods from 6 months to 2 years or more; hence, the US
name ►'instalment credit'. The credit is usually arranged by the vendor, at least for
consumer purchases such as motor cars. In a HP contract, unlike a credit sale,
ownership of the goods does not pass from the seller to the buyer until the final
payment is made, i.e. the goods are ►security for the Moan. Until that time, the
seller is entitled to repossess the goods under law. Abuse of this right, extortionate
►rates of interest and the practices of certain salesmen, who persuaded customers
to buy more than they could afford, led to a series of Hire Purchase Acts from r938
onwards to give protection to the buyer. Because interest charges are calculated on
the total loan and not the amount outstanding, HP is a more expensive form of
► credit than it often seems to be. Private purchases now account for less than
one-half of HP sales, and it is an important source of credit for certain types of
machinery and equipment (►finance house). Hire purchase originated with retailers
in the USA during the nineteenth century but is now supplemented for consumers
 Hotelling, Harold

by forms of non-vendor credit such as > personal loans, credit cards and store cards.
Please.

historical costs >costs, historical.

hoarding The accumulation of idle ►money balances, ►inactive money,

►►liquidity preference.

holding company A company that controls one or more other companies, nor¬
mally by holding a majority of the >-shares of these ^subsidiaries. A holding
company is concerned with control and not with > investment, and may be econ¬
omically justifiable where one holding company can perform financial, managerial
or marketing functions for a number of subsidiaries; most large companies in the
UK are holding companies exercising a greater or lesser degree of control over
their subsidiaries. The holding-company form of organization also has a number of
practical advantages, e.g. it is a simpler and less expensive way of acquiring control
of another company than by purchasing its >assets, and the original company can
retain its name and goodwill. It is possible for a holding company to control a large
number of companies with a combined >capital very much greater than its own,
since it needs to hold only half or even less of the shares of its subsidiaries. Abuse of
this possibility of 'pyramiding', as it is sometimes called, is now limited by company
legislation (>company law). Diversified holding companies, or >conglomerates,
are tending to become less important than they once were, ^downsizing.

homogeneous in degree n The characteristic of a function that, when all the

►independent variables are multiplied by A, the independent variable rises by A
to the power n. It is commonly referred to in describing the characteristics of a
►production function, e.g. y = f(x,z) where y is output and x and z are inputs to
production. This function, for example, would be homogeneous of degree 2 (A = 2)
if 4y = f(2X,2z) (►►Cobb-Douglas function).

homogeneous products Goods and services purchased by consumers that the

latter consider to be perfect substitutes (►perfect competition). It is mostly in
►commodity markets that homogeneity can be assumed and, indeed, the charac¬
terization of something as a commodity frequently simply means different producers
are selling more or less homogeneous outputs. In some markets, the differentiation
of their products by producers (►product differentiation) is criticized as wasteful.
On the other hand, the tendency for markets to generate uniform products may be
a form of market weakness (►Hotelling's law).

horizontal integration ►merger.

hot money Funds that flow into a country to take advantage of favourable > rates
of interest in that country, influencing the ►balance of payments and strengthening
the ►exchange rate of the recipient country. These funds are highly volatile and
will be shifted to another ►foreign-exchange market when relative interest rates
favour the move, ►►arbitrage; Bank for International Settlements.

Hotelling, Harold (1895-1973) Associate Professor of Mathematics at Stanford

University from 1927, Hotelling became Professor of Economics at Columbia Univer¬
sity in 193T. He held this post until 1946, when he was appointed Professor of
Mathematical Statistics of the University of North Carolina. In 'Stability in Compe-
Hotelling's law

tition’, Economic Journal (1929), he showed how profit maximization can lead retail
outlets or competing companies to locate close to each other (»-Hotelling's law). In
'The General Welfare in Relation to Problems of Taxation and of Railway and Utility
Rates', Econometrica (1938), he put forward the case for > marginal-cost pricing by
public utilities, arguing that, even if by so doing such industries ran at a loss that
had to be financed by lump-sum payments by the State, total economic welfare
would be increased by such a pricing policy (^welfare economics).

Hotelling's law The observation by Hotelling that in many markets it is rational

for all the producers to make their products as similar as possible. Suppose, for
example, there are two newsagents in a street, each of which wanted to maximize
its share of local business by locating its shop so that it is the nearest newsagent for
as much of the trade visiting the street as possible. In this situation, both newsagents
will position themselves in the middle of the street guaranteeing themselves half
the market. It would be socially more desirable for them to separate themselves, and
sit a third of the way along the street from different ends. Unfortunately, if one
newsagent did this, the other could position himself so as to capture more than half
the total market. Too little variety results from the process. Hotelling's law manifests
itself in numerous markets, e.g. competing bus operators scheduling their buses to
run at the same times. s#»-Nash equilibrium.

household An economic unit defined for the purpose of a >-census of population

as a single person living alone or a family or group voluntarily living together, having
meals together and benefiting from housekeeping shared in common. Because of
the fact of shared use - which is a household's characteristic - it is an important
economic statistic when considering the > market potential for certain consumer
products. The percentage of households owning certain consumer durables (e.g.
computers, washing-machines, television sets, refrigerators and video recorders) is
critical to the growth of the future sales of these products. In the initial introductory
period, sales grow quickly as households buy for the first time, but then slow down
rapidly when a high proportion of householders own the product (^logistic curve).
Thereafter, sales can only be for replacement. The number of households in the USA
in 2000 was 106 million and in the UK, 25 million.

HP >hire purchase.

human capital The skills and knowledge embodied in the >-labour force. A
metallurgist can expect to earn more than a laboratory assistant because he/she has
invested more in education and training, and these higher earnings are a return on
the investment he/she (or his/her parents, or the State) have made in school fees
and forgone earnings. Investment in human ^capital should increase labour >prod-
uctivity in the same way as investment in machinery. W^Becker, G.; sow's ear effect.

human development index (HDI) An index published by the United Nations

(UN) Development Programme in its annual Human Development Report that lists
countries in order of human achievement. The measures included in calculating the
index are: (a) life expectancy at birth (»-death rate); (b) adult literacy rate and the
school attendance rate (»-sow's ear effect), and (c) >gross domestic product per
capita, measured in US dollars at ^purchasing power parity. The UN Development
!Z?J hysteresis

Programme also publishes a Gender Development Index based on the HDI but
adjusted for inequalities between men and women in the population.

Hume, David (1711-76) Scottish philosopher whose systematic treatment of econ¬

omics is contained in several chapters of his Political Discourses (1752). He exposed as
unwarranted the mercantilist fear (►mercantilism) of a chronic imbalance of trade
and loss of gold. He argued that the international movement in >bullion responded
to the rise and fall of prices and in so doing kept national price differences within
limits and prevented permanent ►balance of payments surpluses or deficits. He also
foresaw how this mechanism could be distorted by the growth of domestic > banking
and of paper money. He accepted a ^quantity theory of money but distinguished
between >short-run and >long-run effects. By tracing the course of the effects of a
rise in the quantity of ► money, he came to the conclusion that money was not
neutral (>-neutrality of money) but could affect employment, although only in the
short run. His belief that the level of the >rate of interest depended on the rate of
business profits became the basis of >Smith's interest-rate theory, ^interest, classi¬
cal theory of.

Hutcheson, Francis (1694-1746) The teacher of ►Smith at Glasgow University.

Smith succeeded him to the Chair of Moral Philosophy.

hyperinflation Very rapid growth in the rate of ^inflation in which >money

loses its value to the point where alternative mediums of exchange (e.g. >barter or
foreign currency) are commonly used.

hypothecation Earmarking of particular sources of finance to particular uses. The

idea of hypothecating tax to particular forms of spending has been much discussed
- although in the UK, the Treasury has tended to oppose the idea on the grounds
that it introduces an element of inflexibility into spending, and sometimes makes it
hard to cut programmes once they are underway. Nevertheless, the principle was
adopted with respect to the revenues of the National Lottery and, with decreasing
►tax tolerance, many believe it is a good way of ensuring revenue for popular
programmes and overcoming public mistrust of the way politicians use tax revenue.

hypothesis A theoretical explanation of the behaviour of phenomena that can be

tested against the facts. A hypothesis can be refuted, unlike a tautology - which is
true by logical form but may not be capable of proof that it is correct. An example
of a hypothesis is that ►saving is a function of >disposable income such that
when disposable income doubles, savings will also double (the >savings ratio is a
constant). The statement that saving equals income minus expenditure, however,
is a tautology. >► empirical testing.

hysteresis A term derived from more common use in the physical sciences, to
describe a lag between the behaviour of a variable and a change in the factors that
influence the variable. It is a characteristic of viscous liquids, for example, that when
inverted in an open jar they do not pour out immediately. In economics, hysteresis
has acquired a life of its own, to describe the idea that the history of a variable - the
path it has followed over time - can have an effect on where it settles. In its most
common manifestation, hysteresis is the idea that a high level of unemployment is
self-reinforcing because the unemployed become less and less suited to work as they
stay out of work longer. A burst of high unemployment tends to solidify into a
hysteresis

permanently high level of unemployment, notwithstanding the removal of the

original cause of the high unemployment. It enjoyed preponderance as a possible
explanation of the rising levels of unemployment in the r98os across Western Europe.
Hysteresis has also been taken as having broader implications for economic method.
It holds that the ^equilibrium of a variable is dependent on the path it follows, so
conventional analysis explaining the equilibrium entirely in terms of the factors
that normally influence things is impoverished. >flong-term unemployment;
unemployment natural rate of.
IADB >Inter-American Development Bank.

IBMBR Interbank market bid rate (>interbank market).

IBOR Interbank offered rate (►interbank market).

IBRD ►International Bank for Reconstruction and Development.

IDA >International Development Association,

idle money ►inactive money.

IEA ►International Energy Agency.

IFC ►International Finance Corporation.

illiquidity A situation in which >assets cannot easily and quickly be turned into
► money. Antonym of >liquidity.

ILO >Intemational Labour Organization.

ILO unemployment A standard definition of >unemployment agreed through

the ►International Labour Organization for the purpose of statistical measurement.
It covers people above a specified age who, at the time of survey, are without work,
available for work, actively taking steps to get work or waiting to start work that has
been offered, ►claimant count; Labour Force Survey.

IMF ►International Monetary Fund.

Immigration ►migration.

impact effect The first effect of a change in a variable before any secondary
responses can be made to the change. It amounts to the very short-run effect. For
example, when demand in a market increases, price rises because output is fixed in
the short period involved by more than it does once producers have had time to
respond to the increases in demand. ►►J-curve.

imperfect competition ►monopolistic competition.

imperfect market A market in which the forces that tend to ensure productive
and allocative efficiency are thwarted (►economic efficiency). In a perfect market,
three characteristics predominate: (a) price equals >marginal cost (or >marginal
revenue equals marginal cost); (b) there are no abnormal ►profits (i.e. ►average
cost equals ►average revenue), and (c) production takes place at the minimum cost,
i.e. at the bottom of the average-cost curve, where average cost equals marginal cost.
implicit contract

Although price acceptance by consumers and firms, and free entry and exit of firms,
are the important features to ensure these hold, underlying them are a number
of other conditions. These include rational consumers, profit-maximizing firms,
►homogeneous products made without ►economies of scale, a smooth pattern of
►demand without peaks, a smooth pattern of ► supply where the quantity of output
is easily adjusted, no collusion between producers, and the existence of complete
and costless market information. In the absence of any of these, imperfect markets
exist and the efficiency result no longer necessarily holds. The most important
developments in economics in recent years have concerned the role of inform¬
ation in explaining deviations from perfect markets (>-asymmetric information;
screening; signalling). >Pareto, V. F. D.; ^perfect competition.

implicit contract ►contract.

import deposits A system of ►import restriction under which importers are

required to deposit, with a government-nominated institution, a percentage of the
value of their >imports. This ►deposit is held for a period of time, after which it is
repaid to the importer. The system restricts imports because it reduces the ►liquidity
of importers and also imposes an extra charge on them, inasmuch as they are, in
effect, forced to give an interest-free loan to the government. However, the impact
of import deposits may be weakened if there is sufficient liquidity generally in the
economy to enable importers to obtain loans at favourable >rates of interest against
the ^collateral security of their import-deposit receipts. Again, foreign exporting
companies may be willing to finance the deposits themselves rather than lose their
market position, especially if it is expected that the scheme is only a temporary one.
►protection.

import duties ^tariffs, import.

import licence A document that gives the importer authority to import the
commodity to which the licence applies. It is a device to enable the government to
regulate and supervise the flow of ► imports, e.g. under its import ► quota regu¬
lations.

import quota ►quotas.

import restrictions Restrictions on the importation of products into a country

may be effected by means of ► tariffs, ►quotas or ► import deposits, and are generally
imposed to correct a ►balance of payments deficit. Their purpose, as with ►devalu¬
ation, is to divert expenditure away from foreign-produced goods in favour of goods
produced at home. The magnitude of this diversionary effect will depend on the
►elasticity of demand for the ►imports in question, i.e. the degree to which accept¬
able ►substitutes are available on the home market. In addition, import restrictions
could be used to increase a country's economic welfare (►welfare economics) at the
expense of foreign countries to the extent that it has power to exploit its foreign
suppliers, e.g. as a monopolist (►monopoly), without fear of retaliation. Finally,
import duties may be applied to protect the market of a domestic industry while it
is being established (►free trade; infant-industry argument; protection). Non-tariff
barriers to trade include revenue duties (e.g. value added tax) which, being imposed
as a percentage on landed (i.e. duty-paid) ►value, increase the cost of imported
goods more than locally produced goods and thus discriminate in favour of the
 inactive money

latter. Other examples are domestic taxes applied according to the technical charac¬
teristics of goods (e.g. on engine capacity) which may subtly discriminate against
imports. > General Agreement on Tariffs and Trade; World Trade Organization.

import surcharge A temporary increase in import tariffs (^tariffs, import)

designed to correct a short-term ^balance of payments deficit and to stabilize the
►exchange rate.

import tariffs >-tariffs, import.

imports The flow of goods and >services that enter for sale into one country and
that are the products of another country. About 30 per cent of >gross domestic
product in the UK was spent on imports in 2000 compared with, for example, the
USA, where the proportion was about 12 per cent, >► balance of payments; exports;
international trade; invisible; parallel imports.

impossibility theorem A proof that it is impossible to devise a constitution or

voting system, complying with certain reasonable conditions, that can guarantee to
produce a consistent set of preferences for a group from the preferences of the
individuals making up the group. Suppose, for example, that a society wants to vote
on whether to spend the proceeds of a national lottery on education, the arts or
sport. If resources are to reflect public tastes, it would be desirable that the public's
individual rankings of the three options could be combined by some voting system
to produce an overall ranking to determine which option was the choice of the
society as a whole. > Arrow showed in the impossibility theorem that no system
could be found that was both rational and egalitarian. For example, a simple majority
voting system, although giving equal weight to everybody's opinion, gives rise to
the >paradox of voting, allowing the possibility of an inconsistent ordering of
preferences. A system that may be consistent would be to allow one individual - a
dictator - always to determine what choice to make, but this lacks the feature of
equality. It has since been shown that a democratic system can at least meet a weaker
rationality condition, but only by abandoning a third desirable property of a voting
system - decisiveness. Such a system would allow every individual a personal veto
over any decision so that society would simply be unable to do anything unless
there was no one opposed to it. Asocial-welfare function.

imputation system ►corporation tax.

imputed cost The cost attributed to using an asset owned by the user. The
► opportunity cost of not putting an asset to its best alternative use. For example, a
shopkeeper who owns his/her own shop forgoes rent if the shop was not used for
his/her own business. This loss of income is an imputed cost, which the owner
would compare against the revenue from the business when considering whether it
were truly profitable. Similarly, an imputed income is the amount an owner would
pay not to put the asset to an alternative use. If the shopkeeper had to pay £10 a day
to rent an alternative to his own shop he would willingly forgo £10 to keep it, and
he thus enjoys an imputed income of £10 from his shop. Aincome.

imputed income >-imputed cost.

inactive money > Money that is not in circulation, i.e. not on ^deposit or invested
in other financial >assets or being used for transactions. Inactive money is also
inactivity rate

referred to as idle money or idle balances. According to ► Keynes' theory of ^liquidity

preference, the amount of idle balances will depend, among other things, upon the
>-rate of interest. »• velocity of circulation.

inactivity rate The percentage of the ^labour force that is neither employed nor
looking for work. >ILO unemployment.

incentive compatibility A system of behaviour in which each individual has a

personal incentive to act in accordance with some overall interest. A classic example
of an incentive-compatible system is that used by parents to divide a cake between
two hungry children, in which one is allowed to slice the cake in two and the other
allowed to choose which slice to take. The first child then has the incentive to split
the cake into two equal halves, which is the fairest division. Incentive compatibility
is important throughout economics, but has more recently risen as a preoccupation,
because it is an ingredient in the economics of ^screening and >-signalling, where
there are types of behaviour (e.g. the giving of an engagement ring) that are used to
distinguish certain types of individual from certain other types, e.g. people who are
serious about getting married from those who are not. These systems work only if
the types of individuals being distinguished do not have the incentive to behave
like the other type, e.g. it must not be the case that the benefits of pretending you
were going to marry someone were so large that you would be willing to buy them
an engagement ring even if you were not intending to wed. This condition is known
as the incentive-compatibility condition. The same notion is important in the
areas of >■ public-choice theory, where voting systems are designed to obtain true
indications of people's preferences, undistorted by tactical considerations. Another
example is the > Vickrey >auction, in which participants have the incentive to bid
their true valuation of an item. Amoral hazard.

incidence of taxation >taxation, incidence of.

income A flow of money, goods or services to any economic agent or unit. Such
flows can take a variety of forms. At the level of individuals, income is usually a
return to a > factor of production - Mabour yields wages, ^-capital yields ^interest,
land yields >rent and entrepreneurship yields >profit. Otherwise, income can be a
^•transfer payment in the form of a State benefit or receipt from a private-sector
source, e.g. alimony payments. At the level of the firm, income can be seen as either
total sales receipts (turnover) or receipts minus costs. For a country, ^national
income is taken as the sum of all incomes.
Economists do not view income in conventional ways. First, their concept of
income extends more widely than a cash receipt - the person who lives in his own
house effectively derives an income in the form of housing consumption worth the
rental values of his property. Secondly, great importance is attached to the concept
of 'permanent income' - the flow of resources that is sustainable in the long term.
For example, North Sea oil provides the UK with sale receipts but these will expire
when the oil runs out. The permanent income deriving from the oil is therefore the
money that would be earned from investing those receipts and making a return on
them that lasts for ever. This would be lower than the actual flow of receipts while
the oil is still being tapped but it would provide a flow of income after the oil has
gone. > income, distribution of; permanent-income hypothesis.
 income elasticity of demand

income and earned surplus statement (US) >-double-entry bookkeeping,

income, circular flow of >-circular flow of income.

income determination, theory of The body of theory that describes the factors
affecting > national income. The term is usually used to describe specifically
Keynesian models of the economy, in which ^aggregate demand is the primary
factor explaining output and employment. »-Keynesian economics.

income, distribution of A > frequency distribution showing numbers of persons,

taxpayers or households classified by levels of annual income. A feature of this
distribution is that it is skewed - a greater number appear in the low-income classifi¬
cations than in the high-income ones. >Gini coefficient; inequality; Kuznets curve;
Lorenz curve; Pareto, V. F. D.; poverty.

income effect The change in demand for a product caused by the impact of a
change in its price on the spending power of consumers. The change in price of a
product leads to a change in the Vreal income of individuals, who either can no
longer afford the ‘basket' of goods that they previously bought or who can afford
the old basket with cash over to spend on extra items. The income effect is the impact
of this change in spending power on the demand for the product with the price that
has changed. It is equivalent to some change in income with all prices remaining
constant. It can be added to the ^-substitution effect to derive the total effect of the
price change on the demand for the product.
The main factor in determining the size of the income effect of a product is the
proportion of total spending that item comprises. The effect on total spending of a
change in the price of matches, for example, is trivial, but it is large for a change in
the price of food. Unlike the substitution effect, the income effect can move in either
direction. If a product is demanded more as incomes fall (e.g. second-hand clothes)
it is called an >-inferior good. If, as is more usual, it is demanded more as income
rises, it is called nonnal. ^-income elasticity of demand; giffen good.

income elasticity of demand The proportionate change in the quantity of a

commodity demanded after a unit proportionate change in the income of consumers
with prices held constant. For example, a product that has an income ^elasticity of
2 will enjoy demand growth of 2 per cent for every r per cent growth in consumer
income. Commodities can be grouped by their income elasticities: (a) luxury
items that comprise a high proportion of the spending of the rich have income
elasticities in excess of 1 and enjoy growth in demand above that of average
incomes; (b) basic items (e.g. food) enjoy some increased demand when the
economy grows, but proportionately not as much as the growth in average incomes,
and (c) ^inferior goods have negative income elasticities - as soon as people can
afford to stop buying them they do, e.g. secondhand clothes and certain cheap but
unsavoury foods.
Income elasticities can be measured at the level of individual consumers or at that
of the economy as a whole, and can be assessed for individual commodities or groups
of commodities taken together. In the most general case, the income elasticity of all
spending in the long term must be equal to 1 (i.e. spending must rise in the same
proportion as income) otherwise savings would have to be unsustainably growing
or contracting. The income elasticity is of practical importance to business and
income tax

policymakers because any product that has an income elasticity below i in a growing
economy will have a falling share of total spending, and countries that export
commodities with low-income elasticities will suffer worsening >-terms of trade in
the long term if world economic growth occurs. The income elasticity of a com¬
modity is equal to the negative of the sum of the elasticity of demand of a commodity
with respect to its own price and all other prices.

income tax A >tax on >income. In the UK, individuals are taxed on the full
amount of their income from employment or >-investment in the > fiscal year
(including some > fringe benefits but not including gifts (^inheritance tax); >capi-
tal gains are taxed separately). Deductions (e.g. single and married personal allow¬
ances or dependant's allowance) are allowed by the Tax Acts in arriving at taxable
income. Income tax is progressive in its effect, and successive slices of assessable
income are taxed (2002/03) at 10 per cent (lower rate), 22 per cent (basic rate) and 40
per cent (higher rate). To complicate matters, dividends at the higher rate are taxed
at 32.5 per cent. There are special rates for capital gains and other savings income.
Married couples may opt for taxation as individuals. Persons in employment are
normally taxed under the >pay-as-you-earn system under the so-called Schedule E.
Working Families Tax Credits and Disabled Persons Tax Credits are administered by
the Inland Revenue and employers and are payable to persons on low incomes. The
self-employed, including those in ^partnerships, are taxed under the so-called
Schedule D, Cases I and II. Under this schedule, the assessment was formerly made
on the > profits of a continuing trade or profession for the year preceding the
year of assessment, but from 1996/97 this system was changed (>self-assessment).
(Other schedules deal with investment income (where tax is not deducted at
source), income from abroad and other sources of income.) Company income is
taxed under a different system ^corporation tax). There is some disagreement
among economists on the effects of income tax on incentives to work and save and
these effects are difficult to verify empirically. On equity grounds, a progressive
income tax places a higher burden on those with the means to bear it, but this may
discourage effort through the > substitution effect or encourage people to work
harder (and encourage sophisticated tax avoidance) to make up their income (>in-
come effect). The system of income-tax reliefs for particular types of saving
(e.g. pension contributions) distorts savings decisions and this is one of the reasons
why many economists advocate an ^expenditure tax in place of income tax.
>► supply-side economics.

income velocity of circulation ^-velocity of circulation,

incomes policy ^prices and incomes policy.

incomplete contract A formal or written > contract that fails to outline the rights
and duties of each party in all situations. The difficulty of framing complete contracts
- even in quite straightforward situations - is increasingly seen as an economic
problem in that it can inhibit individuals from trading with each other. A builder
may not wish to enter a contract to build a wall for someone at a given price in a
given time unless he knows exactly what will happen if the ground is found to be
hard to build on, or if the weather is bad. It is very costly to draw up a contract that
specifies every eventuality, and this may force the builder to charge a high price to
 index-number problem

cover the risks. Or it may be that certain features of the best contract would be
unenforceable. »► principal-agent problem; transaction costs.

incorporation The action of forming a company by carrying out the necessary

legal formalities, ^company law.

increasing returns ^economies of scale.

independent commodity ^complementary goods,

independent variable ^dependent variable.

indexation The introduction of automatic linkage between monetary obligations

and the price level. It can apply to wages, prices or government tax charges. In
practice, it should mean that the money value of a long-term loan would be increased
in line with the ^retail prices index so that the borrower would have to repay the
loan in >real terms. In the absence of indexation, unanticipated >inflation, by
eroding the real value of loans, shifts resources from lenders to borrowers and
therefore dismpts the credit mechanism and the >capital market. While indexation
reduces the costs of inflation, some economists believe it entrenches inflationary
expectations and makes it harder to get inflation down. General indexation has
been used in some countries (e.g. Brazil) to help cope with inflation in the past. The
UK government introduced an index-linked ► gilt-edged security in 1981 for financial
institutions and has subsequently issued others for private investors as well as
institutions, e.g. 2/2 per cent Index-linked Treasury Stock 2orr. Some ^National
Savings Certificates are also index-linked.

index-linked ^indexation.

index number A >weighted average of a number of statistical observations of

some economic attribute as a percentage of a similar weighted average calculated
for the attribute at an earlier, or base, period. Typical economic attributes for which
index numbers are calculated are prices and production, the most familiar being the
►retail prices index, or cost-of-living index. In principle, the method of indexation
is the same for all indices and, therefore, can be explained by reference to this price
index. The price of each commodity or service included in the index is recorded in
the current period (e.g. 2003) and divided by its price in the base period (e.g. 1993),
to obtain a price relative for each item. Each price relative is then multiplied by a
weight and all the items summed and averaged. The weights used may be either the
amount spent on each item in the current period (2003) - a current-weighted index or
►Paasche index or the amount spent on each item in the base period (1993) - a
base-weighted index, or >Laspeyres index. >harmonized indices of retail prices;
hedonic price index; index-number problem.

index-number problem This problem arises from the use of Mndex numbers,
that are summary single numbers encapsulating a range of values and used to
describe succinctly changes in values over time. The ^retail prices index, for
example, could equally rationally, for the above purpose, be calculated as a base-
weighted or a current-weighted index, but the two types of index do not necessarily
give the same answer. For example, consider a simple example of two goods X and
Y that have the following prices and quantities purchased in the base year 1 and the
current year 2:
indexed

Year i Year 2

Price Quantity Price Quantity

X iop 5 8p 6
Y 20p 5 25P I

The current-weighted index is given by:

Year 2 = [(710 x6) + fVzo) * 1] - 7 = 0.86 (Year 1 = 1.00)

The base-weighted index is given by:

Year 2 = [(7io) »5 + fVzo) *5] - 10 = 1.025 (Year 1 = 1.00)

According to the base-weighted index, the general level of prices rose in year 2
compared with year r (by 2.5 per cent), but according to the current-weighted index,
prices fell in year 2 (by 14 per cent). The problem of choice is that if base weights are
not updated, items will continue to be included that are no longer relevant in
household expenditure. On the other hand, changing weights in order to keep them
current could lead to the index being influenced by changes in quantities and
therefore not be properly representative of price movements only. Further, a con¬
sumer price index may fail to reflect in its weights technological changes enhancing
product quality. A new computer launched in 2003 could have benefits unknown to
its 5-year-old predecessor that are not reflected in its price, s^-hedonics; price index.

indexed ► indexation.

indifference curve A graphical representation of sets of different combinations

of commodities which each yield to the consumer the same level of satisfaction (see
diagram). Indifference curves can be plotted on graphs called 'indifference maps',
on each axis of which is represented the quantity of some commodity. To produce
such a curve, any point can be taken to start with, representing a basket of two goods
(though the analysis can be extended to more than two). One unit of the first
commodity (e.g. books), could be removed from the basket and units of the second
commodity (e.g. CDs) added until a point is found at which the consumer feels that
the new CDs exactly compensated for the loss of the book. This new basket, with
perhaps two more CDs in it but one less book, is the second point on the same
indifference curve as the first basket. The exercise can be repeated with steadily fewer
books and increasing numbers of CDs and then again with increasing numbers
of books and correspondingly falling numbers of CDs. A new indifference curve
altogether could be derived by taking a starting-point with both more CDs and
books than the previous basket and repeating the whole process again.
Indifference curves can never intersect. If a point X lies on two intersecting
indifference curves, then all the points on each curve must have the same utility as
point X, and the two curves must both represent bundles of goods of equal utility.
It is then logically impossible for them to be separate indifference curves. As a result
of this, every point on the indifference map lies on one and only one indifference
curve. Normally, various assumptions are made about consumers and their tastes,
with the result that indifference curves have the following properties:
 indifference curve

(1) They slope downward. As the consumer loses some of one commodity, he/she must
receive more of another if satisfaction is to be maintained. Similarly, a consumer
should always prefer a basket with more of both commodities than another.
(2) They are convex to (i.e. bulge towards) the origin (>convexity). This is because, as
units of the first commodity are removed from the basket, increasing amounts of
the second commodity will be required to compensate. A consumer may start off
valuing CDs and books equally, but after accumulating a basket of books with
only a tiny selection of CDs remaining, there will be a requirement for a large
number of extra books in return for one CD.

In the diagram, the line AB is the >-budget line. The consumer would buy a combi¬
nation of CDs and books given by the point at which the budget line is tangent to
the indifference curve. Any other combination would either be above the budget
line and therefore unaffordable, or on a lower indifference curve and therefore give
less satisfaction.
Various extreme forms of indifference curve can be drawn without the usual
properties described above. Perfect ^substitutes (two identical brands of washing
powder, for example) have indifference curves that are straight downward-
sloping lines. At no stage will the consumer change the rate at which one item is
swapped for the other. Perfect complements (^complementary goods) on the other
hand, have L-shaped indifference curves; increasing quantities of a left shoe will
derive for a consumer no extra utility at all unless extra right shoes are found to
match. If a consumer actively hates one commodity, his indifference curves will
slope upwards.
Indifference maps are used extensively in theoretical economics. By plotting
money against any commodity, the individual's demand curve for that commodity
can be derived. If leisure is compared to money on an indifference map, analysis of
indifference-curve analysis

the decision of individuals on how much to work (and earn) and how much to
relax can be analysed, »convexity; demand, theory of; indifference-curve analysis;
marginal rate of substitution; ordinal utility.

indifference-curve analysis The study of consumer demand in terms of ranked

combinations of commodities consumed subject to the constraints of price and
income. Under this approach, there is no need for an absolute measure of utility or
satisfaction; consumers merely need to be able to choose between different bundles
of goods (HN-ordinal utility). One can view the basic task of the consumer as ranking
all the combinations of items that can be bought with the income available and
choosing the bundle at the top of the resulting list. The tools for this analysis are
the indifference map (built of ^indifference curves), that expresses the consumers'
tastes, and the ^budget line, that shows the combinations of items that can be
bought for a given income and set of prices.
Indifference-curve analysis suggests that people should consume items such that
the rate at which they are prepared to swap them with complete indifference equals
the ratio of the prices of the two items. For example, if two glasses of milk cost the
same as one glass of wine and a consumer values one glass of each equally, he can
enhance his utility by reducing his wine consumption by a glass and increasing his
milk consumption by two glasses, without an extra cost. This process can go on until
the consumer has so much milk and so little wine that he would actually enjoy a
single glass of the one rather than two glasses of the other. On the indifference map,
this corresponds to the point at which the budget line is tangential to the indifference
curve. » marginal rate of substitution.

indirect taxation >direct taxation.

indirect utility function The relationship between the total futility of a con¬
sumer on the one hand, and the price of different commodities and the income of
the consumer on the other. In >demand theory, a direct utility function maps the
quantity of different commodities consumed to the utility of the consumer. To get the
indirect utility function, we have to make two steps from this: (a) for any level of
income and set of prices, rational consumers will select a particular quantity of each
commodity that maximizes their utility, and (b) we can see from this 'rational'
selection of goods, what overall level of utility is delivered. By combining these two
steps, we can get the direct function linking prices and income and total utility.
»ordinal utility.

individual savings account (ISA) A tax-free savings scheme announced in the

UK >budget of 1998 that came into operation in April 1999, and replaced >personal
equity plans. Savers are able to invest up to £7000 a year, with a maximum of £3000
in cash and a maximum of £rooo in life assurance, the remainder in ^equities.
Savings in these accounts are exempt from >-capital gains and ►income taxes.

induced investment That part of >investment that is determined by changes

in output, as opposed to autonomous investment, e.g. government expenditure on
infrastructure capital (^acceleration principle).

industrial bank Another name for a >603006 house.

industrial districts Geographical clusters of firms in the same and related activi¬
ties, e.g. Silicon Valley near San Francisco and Route r28 near Boston in the USA,
 infant-industry argument

and Cambridge in the UK. In these three instances the firms are predominantly in
new >technology-based industries that are >research and development intensive.
There are many other examples of industrial districts in traditional sectors, e.g.
ceramic goods in Sassuolo, Emilia Romagna, Italy. The existence of industrial districts
has long been noted by economists - indeed, they are sometimes referred to as
'Marshallian districts' after >Marshall, who first gave them extended analysis. Firms
in industrial districts benefit from > externalities in the availability of suppliers,
reserves of skilled labour, specialized distribution, training facilities and information
that seems to promote >innovation. It has been suggested that industrial clusters
allow >-small businesses to enjoy some of the >economies of scale (via market
co-ordination under conditions of low ^-transactions costs) available to large
firms within their own organizations. The origin of industrial districts cannot be
attributed to similar causes. In Cambridge and on Route r28, proximity to centres of
academic scientific research has played a major role. In some traditional industries,
the origin of clusters can be traced to putting-out systems, trade routes, markets and
other factors.

industrial organization Branch of applied >microeconomics dealing with the

performance of business enterprises and especially with the effects of > market
structures on market conduct (e.g. pricing policy, restrictive practices and innov¬
ation) and how firms are organized, owned and managed. »concentration; firm,
theory of the; game theory.

industrial zone >free trade zone.

industry concentration ^concentration.

inequality The degree to which the distribution of economic welfare generated in

an economy differs from that of equal shares among its inhabitants. In practice, the
measure most commonly adopted is that of the distribution of personal incomes
(^income, distribution of) or of income of >• households, but other measures also
employed include expenditure and wealth and may also be applied across countries
worldwide. Inequality in the distribution of the ^disposable income in the UK
increased significantly in the T980S but has since stabilized. In 2000, the top 10 per
cent of households earned about 4 times that of the bottom 10 per cent. According
to the United Nations Human Development Report (>Human Development Index),
inequality has grown worldwide with an increase in inequality within countries and
between countries - 20 per cent of the world ^population in the most advanced
countries were 30 times better off then the poorest 20 per cent in the >Teast developed
countries in r96o, and 75 times better off in the late T990S. > developing country;
poverty.

infant-industry argument An argument in support of the retention of a protec¬

tive import > tariff to promote the creation of a local industry. It is held to apply in
cases in which an industry cannot operate at an optimum least-cost output until it
has reached a sufficient size to obtain significant >economies of scale. A new
industry, therefore, in, for example, a ^developing country will always be in a
competitively vulnerable position vis-a-vis an established industry in an advanced
country. It follows that the stage of growth at which the industry (or country)
can 'take off' (>Rostow, W. W.) industrially will be postponed indefinitely. The
inferior good

argument concludes that >protection is necessary until the industry has reached its
optimum size (> first-mover advantage).

inferior good A good, the demand for which falls as income rises, i.e. its >-income
elasticity of demand is negative, e.g. the demand of married couples for small apart¬
ments. A good that is not inferior is called a normal good. W^giffen good; income effect.

inflation Persistent increases in the general level of prices. It can be seen as a

devaluing of the worth of money. Inflation is a recurring but only intermittent
historical phenomenon. Its most serious recent appearance occurred during the
1970s in the wake of the quadrupling of oil prices in 1973, when annual inflation
rates in the developed world rose as high as 25 per cent, but for the rest of the
post-Second World War period it has not been unusual for the inflation rate to be
exceeded by the real growth rate. A crucial feature of inflation is that price rises
are sustained. A once-only increase in the rate of »-value added tax (VAT) will
immediately put up prices, but this does not represent inflation, unless the indirect
effects of the VAT rise have repercussions on prices in periods after the direct effects.
Accounts of the causes of inflation are numerous. The most popular arguments
are that it is caused by S-excess demand in the economy (>demand-pull inflation),
that it is caused by high costs (>cost-push inflation) and that it results from excessive
increases in the money supply (^monetarism). These causes often amount to the
same thing. The mechanism by which the increase in money supply causes inflation
is by creating excess demand, making monetarism compatible with the demand-pull
argument. The demand-pull and cost-push theories are also linked. An excess of
demand causes producers to raise their prices, but this leads workers to demand
higher wages to maintain their living standard, causing higher demand, and the
process begins again. Similarly, if under the cost-push argument the cost increases
stimulating price rises are wage costs (which represents most of the total net costs
of the economy), firms can still only raise their prices if there is demand for their
goods - if not, high costs merely bankrupt them. All three of these causes amount
to an attempt by a nation to live beyond its means, or to enjoy a living standard
higher than that allowed by its output and borrowing. This implies that inflation
can rarely be cured by a measure that does not suppress attempts at maintaining
high living standards and explains why the reduction of inflation is associated with
austerity measures. When oil prices rose in the 1970s, countries without oil suffered
a loss of their >real income and should have accepted a cut in living standards;
unable to impose a cut, however, governments attempted to maintain higher levels
of income than were merited by the products to be bought by that income. Too much
money chasing too few goods inevitably caused inflation. Controlling inflation by
restricting demand (either through tight control of the money supply through high
>rates of interest or through cuts in government borrowing) has costs, however. If
wages are growing rapidly, and the government squeezes demand in the economy,
unemployment may result because employers will not be able to afford to pay their
staff if they cannot raise their sales prices because of low demand. In other words, if
wages are high, but aggregate demand is restricted, firms will have high costs but
will not be able to pass these on in higher prices because sales will be too low, and
many will go out of business or sack some of their employees. In the short term, it
appears that by allowing higher demand, inflation occurs, but unemployment can
be lower than otherwise.
 inflation target

That inverse relationship between money wages and unemployment was

described by the Phillips curve (^Phillips, A. W. H.). However, the Phillips relation¬
ship did not hold through the 1960s and the role of > expectations in pre-empting
rises in prices was stressed, mainly on account of the work of >Friedman. Inflation
could not act as a break on real wages, it was asserted, unless it outstripped the
expectations of wage bargainers. If, in the longer term, inflation rates could be
anticipated, inflation would have no effect on unemployment (^-unemployment,
natural rate of). The Friedman view that the inflation-unemployment trade-off
was only short term was superseded in theoretical economics by >new classical
economics, that held that there was no trade-off even in the short term (impolicy
ineffectiveness theorem). Now, policymakers tend to accept the idea that there is no
trade-off but, equally, they tend to believe policy can have a positive effect on
demand without necessarily provoking inflation. They act on the assumption that
if the economy is operating below its potential (>output gap), inflation will tend to
fall; if the economy is above its potential, inflation will tend to rise. The task is
simply to manage >aggregate demand to ensure demand is neither too high, nor
too low. In its effects, inflation probably disrupts investment, by causing interest
rates to rise, shortening pay-back periods, and affecting company cash flow. It
arbitrarily distributes wealth away from those whose incomes are fixed in money
terms or rise more slowly than inflation. It generates > menu costs. To allow inflation
to develop carries the risk of incurring rates high enough to disrupt economic life.
>► hyperinflation; indexation; prices and incomes policy; superneutrality of money.

inflation accounting Methods of keeping a record of financial transactions and

analysing them in a way that allows for changes in the purchasing power of money
over time. Until recently, solely historic-cost accounting methods have been used, i.e.
accounts were derived more or less directly from bookkeeping records of actual
expenditures and receipts. For example, ^assets (e.g. buildings) were recorded in
the balance sheet at their actual (depreciated) cost (^-depreciation). In a period of
rapidly rising prices, the replacement cost of these assets is likely to be much higher
than their recorded cost, and historic-cost accounting, therefore, may understate
depreciation and costs in >real terms and overstate profits. Over a period of time
this may lead to a situation where >-capitai is not being maintained in real terms at
all but distributed as 'illusory' money profit in dividends and tax payments.
Among the various ways of coping with inflation, is the practice of recording net
assets in accounts by reference to their value rather than their cost. Among the
different approaches to asset valuation (which include >present value), the Sandil-
ands Committee of Inquiry in 1975 adopted a form of replacement-cost accounting that
involves revaluing assets from historic costs to current costs. The main features of
the system that is called current-cost accounting are that money is retained as the unit
of measurement, that both 'assets and liabilities are shown in the balance sheet at a
valuation' and that >operating profit 'is struck after charging the "value to the
business" of assets consumed during the period thus excluding holding gains from
profit and showing them separately'.

inflation target The adoption of an explicit level of inflation to which ^-monetary

policy is geared towards steering the economy. Inflation targets rose to prominence
in the early t990S as national authorities grew disenchanted with the effectiveness
of targeting growth of > money supply. The UK's inflation target was introduced in
inflation tax

1992 as a range of 1-4 per cent, subsequently to fall to 'below two and a half per cent'.
In T997, the target was set at 2.5 per cent precisely for the >retail prices index
excluding mortgage interest (>-underlying inflation) with policy ex post (>ex ante)
considered satisfactory if it actually delivers inflation within one percentage point
either side. The recent 'point target' is a more useful guide to policy - if inflation is
heading above the target, policy should be tightened, and vice versa if it is below.
The range around the target is more useful for judging whether the authorities have
succeeded or failed reasonably to control inflation. In New Zealand, Canada and the
UK, inflation targets came to have an explicit role in setting the relationship between
national government and the ^central banks, who were given responsibility for
setting monetary policy. The objective of policy - the target - is then an explicit
political choice, while the operation of policy is delegated. The >European Central
Bank, which was established on the setting up of the >European Monetary Union,
has a similar inflation target based on the ^harmonized index of retail prices.
>Taylor rule; >*-monetary policy.

inflation tax A form of incomes policy (>prices and incomes policy) under which
firms granting pay rises above a set level are taxed on those pay rises.

inflationary gap A situation in which aggregate demand is at an equilibrium level

in excess of the full-employment level of output. If it exists, all resources in the
economy are fully utilized and prices have to rise to eliminate the excess demand.
Based on Keynesian (> Keynesian economics) models of the economy, the inflation¬
ary gap leads to a >demand-pull inflation that can be removed by ^deflation.
Because persistent inflation has been combined with high unemployment (some¬
thing that should not occur in the inflationary gap view of the world) the concept
faded from view. In recent years, however, it has been revived in all but name with
the growth in popularity of the ^output gap as a basis for analysing economic
policy. inflation; stagflation.

informal economy 'Underground', 'black' or 'popular' economic activity which

avoids government regulations. In >developing countries, such activity can make
a major contribution to employment, particularly in urban areas. It has been esti¬
mated that about 25 per cent of workers worldwide are employed in the informal
sector but in developing countries this could reach to as much as 80 per cent. In
these countries, the impetus to this activity is often simply the need to generate
income for survival in a situation in which the formal sector fails to generate
sufficient employment opportunity. It can, however, also be generated from incomes
earned overseas and repatriated in cash outside the banking system. The latter, for
example, is thought to be an important factor in inflating the informal economy of
the Philippines by up to about 20 per cent of >gross domestic product (GDP). In
^advanced countries, the motivation for such activities is more likely to be the
avoidance of government taxes. The European Commission (>European Union)
(EU) has estimated that the informal economy accounts for between 7 and r6 per
cent of the GDP of the EU on average and, possibly, as high as 30 per cent in some
member countries.

information and communication technologies (ICTs) >-new economy,

information, economics of The area of economics concerned with the impact

 innovation

of information, or lack of it, on the functioning of markets and economies. Until

the 1960s, economists were happy to assume that economic agents were more or less
perfectly informed. While this was obviously simplistic, it was not appreciated
that deviations from this assumption could make an enormous difference to the
functioning of markets. In particular, >asymmetric information, in which one party
has more knowledge than another, turns out to be crucial to market performance.
Many economic institutions can be explained by a need for gaps in information to
be filled, for example, by >signalling and >screening. In >macroeconomics, it is
possible to rewrite much of > Keynesian economics as a form of information
deficiency in the functioning of a modern economy. ^principal agent theory;
Stigler, G.; Stiglitz, J.; >► quantity rationing.

infrastructure Roads, airports, sewage and water systems, railways, telecommuni¬

cations and other public utilities. Also called social overhead capital, infrastructure is
basic to economic development and improvements in it can be used to help attract
industry to a disadvantaged area.

inheritance tax (UK) A tax on the transmission of wealth on death and on

gifts made in the 7 years before death. Cumulative transfers in excess of £250,000
(2002/03) are taxed at a flat rate of 40 per cent, with tapering relief on gifts made
between 3 and 7 years of death. All transfers to a spouse living in the UK are exempt.
Business property qualifies for relief of up to 50 per cent. This tax is not a true
inheritance tax because it is levied on the donor or his/her estate, not on the
recipient. The tax replaced capital transfer tax in T986, which in turn replaced estate
duty, first introduced in 1894.

initial allowances ^capital allowances.

initial public offering > flotation.

innovation Putting new products and services on to the market or new means for
producing them. Innovation is preceded by research that may lead to an invention
that is then developed for the market (^research and development) (R & D). Inno¬
vation is an important source of economic expansion and > productivity. It is central
to the new theories of economic growth (^endogenous growth theory) although it
has long been taken as important - >Schumpeter gave a central role to it in his
theory of economic growth. Long before, »-Smith drew attention to the way in
which specialization through the >division of labour stimulates technological
invention, and >Marx emphasized the embodiment of technological innovation in
^capital goods. Interest in innovation grew with the much later recognition that
the expansion of physical and human capital left a major proportion of growth to
be explained by other factors, including technological progress (^growth account¬
ing). For these reasons there is intense interest in how innovation comes about and
what can be done to promote it.
Whitehead announced in his book Science and the Modem World (1925) that 'the
greatest invention of the 19th century was the invention of the method of invention'.
Research, development and innovation became more strongly institutionalized in
the twentieth century and Schumpeter believed that ^-monopoly favoured inno¬
vative development because research and development (R & D) required large
resources and large markets. This view can no longer be fully sustained. Studies
input

show that >small businesses account for a disproportionate share of innovations

(disproportionate to their share in output or R & D expenditure, although the latter
may not be fully captured in the statistics). There is also some evidence that rivalry
stimulates innovation.
The determinants of innovation are now recognized as being very complicated
and operating through national innovation systems, increasingly on a global scale
(>globalization). The term 'innovation system' is perhaps misleading because its
operations are not planned or systematic and it has three main elements: govern¬
ment, higher educational and research establishments, and business. Early theories
of innovation saw it as a linear process driven either by 'technology push' from
research establishments or 'need pull' by the market, which transmitted consumer
needs to firms and technology needs to the research community. The role of govern¬
ment in these models was to invest in research. This was necessary because, since
technology and other forms of knowledge are not fully appropriable by the firm, the
social return on investment in R & D is much greater than the private return. Other
firms will benefit from knowledge of technology privately developed in a business
even where an adequate system for the protection of intellectual property is in place.
There are many innovations that cannot be patented. The idea of telephone banking,
for example, has been widely copied. That replication is an important development
for the benefit of consumers, but does it diminish the likelihood that such ideas will
flow in the future? The existence of a >first-mover advantage may be important,
however; allowing the innovator to capture profits from an early start can be an
important incentive, ^weightlessness.
The linear theories could not be supported empirically since there is not a clear
relationship between inter-country and inter-regional R & D investment and rates
of economic growth. It is now generally accepted that the absorptive capacity of the
innovation system - the ability of businesses to make use of scientific developments
- is an important factor in innovation. Moreover, technology is not perfectly mobile;
much knowledge is 'embedded' in people and groups in their tacit knowledge and
acquired skills. The linear models of innovation have therefore given way to circular
and dynamic models with multiple paths and feedbacks.
input ^factors of production.

input-output analysis The analysis of an economy in terms of the relationship

between all > inputs and outputs. The output of a good or service in an economy is
used either in the production of goods and services (including itself) or it goes
into final consumption, e.g. households, exports, government. Each output in an
economy can be represented by an equation, with output equal to its final consump¬
tion plus the sum of its inputs used in all production activity throughout the
economy. The amounts used in production will depend on the >production func¬
tions for each. Consider the simplified >model of two commodities, 7, and Y2:

Y\ - Cl + flll7l + 0,272
Y2 = C2 + a--. 7, + o22 72
7, and Y2 are total outputs, C, and C2 are the final consumptions for each and o„,
o,2, o2i and a22 are the input-output coefficients representing the amounts of 7, and
Y2 required to produce one unit of 7, and 72. These equations may be put in > matrix
form:
 institutional economics

Y=C + AYor V = (i -A)'1C

where Y is the >vector Y,YZ, C the vector C,C2 and A the matrix

an al2"I
,a21 flzzj

AY is the total of intermediate demands and A is the matrix of input-output coef¬

ficients or technology matrix. By structuring the production functions of an economy
in this way, it is possible to trace the effects of a change in final demand, or change
in output, of one good or service, throughout its inter-industry linked relationships,
so that the knock-on effects on other industries may be measured. PLeontief, W. W.;
>► non-substitution theorem.

input-output matrix > input-output analysis; Leontief, W. W.

insider-outsider theory The division of participants in a market - usually it is

the labour market - into a privileged core with a certain amount of market power,
and a less privileged periphery with almost no market power. For example, there
might be insiders who have good union jobs, with full employment rights, and
outsiders who find it difficult to get any job at all. The crucial feature of this kind of
segmentation is that the outsiders are not in a position to influence the market
conditions of the insiders, e.g. they cannot credibly offer themselves as alternative
employees at a lower wage. As a result, the mechanism normally assumed to bring
about increased employment - a falling wage reducing the cost of taking more
people on - simply doesn't work. The gap between the two types of worker, of course,
has to be explained to be meaningful. It may result from a difference in the perceived
employability or skills of the different types, or from powerful unions who can use
industrial muscle to prevent non-union labour from displacing union labour. The
idea has been seen both as a cause and an effect of >Tong-term unemployment.
>-hysteresis; unemployment.

insolvency The state of a firm when its Pliabilities, excluding Pequity capital,
exceed its total > assets (xPbankruptcy). A less stringent definition would be that a
firm is insolvent if it is unable to meet its obligations when due for payment.

Insolvency Act 1985 Pbankruptcy.

instalment credit (US) Term for Phire purchase, though sometimes used gener¬
ally to refer to a credit sale when payment is made in instalments (> consumer
credit).

institutional economics A school of economic thought that flourished in the

1920s in the USA. Economists holding institutional views criticize orthodox econom¬

ists for relying on theoretical and mathematical models that not only distort and
oversimplify even strictly economic phenomena but, more important, ignore their
non-economic, institutional environment. The political and social structure of a
country may block or distort the normal economic processes (Peconomic develop¬
ment). Institutionalists believe that there is a need for economists to recognize the
relevance of other disciplines (e.g. sociology, politics, law) to the solution of econ¬
omic problems. > Veblen, PMitchell and PMyrdal have been the leading econom¬
ists sympathetic to institutionalism. Institutional economics has been strengthened
institutional investor

and renewed by the work of a number of economists and economic historians.

PNorth, D. C.; Olson, M.

institutional investor An organization, as opposed to an individual, that invests

funds arising from its receipts from the sale of ^securities from »-deposits and other
sources, i.e. ^insurance companies, >-investment trusts, Punit trusts, Ppension
funds and trustees. Institutional investors own three-quarters of all quoted securities.

insurance A contract to pay a Ppremium in return for which the insurer will
pay compensation in certain eventualities, e.g. fire, theft and motor accident. The
premiums are so calculated that, on average in total, they are sufficient to pay
compensation for the policyholders who will make a claim together with a margin to
cover administration costs and profit (Pactuary; underwriting). In effect, insurance
spreads risk, so that loss by an individual is compensated for at the expense of all
those who insure against it, and as such it has an important economic function. The
traditional forms of insurance are general insurance (i.e. marine and other property
insurance against theft, fire and accident) and life insurance, the last-named strictly
being Passurance, because the cover is given against the occurrence of an event that
is inevitable. There are also many other kinds of insurance, including public or
professional liability, sickness and unemployment insurance, some of which, like
PNational Insurance and the BUPA insurance for private medical treatment, are
not carried out by the traditional insurance companies. Traditional insurance is
carried out in the UK by several hundred companies. The UK is an important centre
for the world insurance industry and about half of the premium income of British
insurance companies is derived from their overseas operations. The bulk of their
Passets consist of > investments made out of premium income against their Pliabili¬
ties to 'pay out' on life policies - only about 10 per cent of their assets are in respect
of general funds. Life insurance is a popular way of providing for old age and
purchasing a house or even Pequity shares, as well as protecting the financial
positions of dependants. SPadverse selection; Lloyd's; moral hazard; pension funds;
unit trust.

insurance premium tax An indirect tax (Pdirect taxation) on certain ^insurance

premiums (Ppremium) administered by HM Customs and Excise in the UK. The
tax applies to motor, health and household insurance, but not to long-term
insurance, e.g. life and pensions.

intangible assets Passets.

integration Pmerger; vertical integration.

intellectual property rights >patents.

Inter-American Development Bank (IADB) The bank was established in 1959

to give financial assistance for the encouragement of economic and social develop¬
ment to the Pdeveloping countries of Latin America and the Caribbean. The head
office is in Washington. Membership now covers twenty-six borrowing countries in
Latin America and the Caribbean and twenty non-borrowing countries covering
Canada, Europe, Israel, Japan and the USA. In 1994, the authorized capital of the
bank was increased to $roi billion, the bank was given authority for the first time to
lend to the private sector, and shares of the member countries readjusted. The main
 interest cover

effect was an increase to 5 per cent for Japan and reductions for the USA down to 30
per cent, and of the Latin American and Caribbean countries to 50 per cent. Bank
lending reached about $ro billion per year by 1998. >Asian Development Bank.

interbank market The >money market in which banks (►banking) borrow

or lend among themselves for fixed periods either to accommodate short-term
►liquidity problems or for lending on. The interest rate at which funds on loan are
offered to first-class banks is called the inter-bank offered rate or, in London, the
London inter-bank offered rate. The corresponding rate for deposits is known as the
inter-bank market bid rate.

inter-company loans market The ►money market in which large companies

borrow or lend money among themselves to accommodate short-term ^liquidity
problems or for the lending on of surplus funds, ^promissory note.

interest 1 A charge made for the use of borrowed money, levied as a percentage of
the amount of the >debt (►rate of interest; usury). 2 More generally, a right,
privilege or share in something, as in common grazing land or in shareholders'
interest (►balance sheet).

interest, abstinence theory of An explanation of >rates of interest in terms of

a reward for choosing to abstain from consumption, ^interest, classical theory of;
Senior, N. W.; time preference.

interest, classical theory of In the early tradition of classical theory (e.g. that of
►Smith and >Ricardo) interest was regarded as simply the >rate of return on
►capital invested. It was considered to be an ►income to capital rather like >rent
to land. With the subsequent development of the classical system, (>classical econ¬
omics), the nature and the determinants of the rate of interest came to be regarded
in terms of a more complex pattern. The rate was arrived at by the interaction of
two forces operating on the supply of, and the demand for, funds. On the one
hand, the strength of demand was related to businessmen's expectations regarding
► profits. This was connected with the marginal productivity of >investment. On
the other hand, the supply was dependent upon the willingness to save. This
willingness was in turn related to the marginal rate of ►time preference. People
judge how much a pound is worth to them today compared with a pound in the
future. They make their decision of whether or not to save by comparing this 'rate
of exchange' between now and the future with the current rate of interest. In the
classical system, therefore, it was the rate of interest that brought >savings into
balance with investment. ►Keynes attacked this assumption in his General
Theory of Employment, Interest and Money (1936). The balance was brought about, he
argued, by means of changes in income and output. The rate of interest was itself
more closely identified with monetary factors. ►•Hume, D.; liquidity preference;
loanable funds.

interest cover The number of times the fixed-interest payments made by a

company to service its ►loan capital are exceeded by ►earnings. This ratio shows
the decline in earnings that could take place before interest payments could not be
met out of current income and is therefore a useful guide for the prospective
fixed-interest investor.
interest, natural rate of

interest, natural rate of The >rate of interest at which economic activity is

neither driving prices higher nor lower. One of the conditions put forward by
>Wicksell for monetary ^equilibrium (i.e. a situation in which there are no forces
tending to make >-prices rise or fall) was that the money >rate of interest should be
equal to the 'natural rate'. The owner of a forest has a choice between two alternatives
in any one year. Either the trees can be cut down and the money obtained from
them lent out, or they can be allowed to grow for another year. The >*rate of return
obtained from lending is the 'money rate'; the return from letting the trees grow
heavier is the 'natural rate’. Wicksell thought of the natural rate, therefore, in terms
of a physical investment. However, >-Myrdal, in developing this theme, pointed out
that the natural rate should also take into account the price at which the timber was
expected to be sold. W^Fisher, I.; Keynes, J. M.

interest, productivity theories of Theories that place the emphasis of the

explanation for the existence of a >rate of interest on the >yield from ^investment.
>Bohm-Bawerk, in particular, developed this theory as one of his reasons for the
existence of a positive interest rate. It was built upon his theory of 'roundabout'
production methods. A direct method of obtaining drinking water, for example, is
to go to a stream and drink. A more roundabout method is to manufacture a bucket
and use it to fetch water. An even more roundabout method is to build a water-pipe,
pump and tap. Each stage involves more > capital, and also more time, but neverthe¬
less yields increased product. Goods available today, therefore, have more value
than goods available tomorrow, for two reasons: (a) goods today can be used in a
time-consuming roundabout process to yield benefits tomorrow that are greater
than could be obtained by the same goods applied to direct production tomorrow,
and (b) they also yield greater benefits over the same goods applied to roundabout
production tomorrow. This is because there are ^diminishing returns to the exten¬
sion of roundabout methods. Present goods are, therefore, always technically
superior to future goods, and it follows that there must exist a positive rate of interest
by which future goods are equated to present goods, ^interest, classical theory of;
interest, natural rate of; Keynes, J. M.

interest rate s^rate of interest.

interest, time preference theory of A psychological theory of the existence of

Crates of interest. An individual prefers consumption now to consumption in the
future for two reasons: (a) awareness of the possibility that death may occur before
the benefits from postponing consumption can be enjoyed, and (b) and less ration¬
ally, there exists a tendency for people to undervalue future benefits - a 'deficiency
of the telescopic faculty'. M»*B6hm-Bawerk, E. von; Fisher, I.; interest, classical theory
of; interest, natural rate of; interest, productivity theories of; time preference.

interim dividend »-dividend.

interlocking directorate The holding by an individual of directorships in two

or more separate companies.

intermediate goods, intermediate products Something that is used in the

production of other goods, e.g. sheet steel used in the production of car bodies. Also
called producer goods.
 internal rate of return

intermediate products >intermediate goods.

intermediate technology The use of simple, labour-intensive means of pro¬

duction, utilizing non-traditional techniques incorporating modern science and
technology. Intermediate technology was advocated notably by Ernst Friederich
Schumacher (1911-77) in a number of publications including the popular book of
essays ‘Small is Beautiful': a study of economics as if people mattered (1973). Schumacher
founded the Intermediate Technology Development Group, a non-governmental
organization that works in ^developing countries. His ideas were based on the belief
that modern large-scale >capital-intensive industry is not an appropriate vehicle
for economic development in backward societies that lack capital and skilled person¬
nel but have a surplus of labour. Intermediate technology is, moreover, less environ¬
mentally intrusive, is consistent with >sustainable development and minimizes
dependence on external assistance allowing citizens in developing countries more
control over their lives.

internal markets The adoption of market-like mechanisms as a reform strategy

in public services. Central to the principle of internal markets is the idea that there
should be a division between those who deliver services (e.g. hospitals) and those
who purchase them, e.g. general practitioners or health authorities. Reforms in the
National Health Service, and at the BBC did appear to deliver productive efficiency,
as cost-conscious purchasers applied pressure to the service providers to keep prices
low. But the reforms were criticized as generating a great deal of extra bureaucracy -
inevitable in a world in which all output is measured and accounted for. And they
were also criticized for failing to deliver the benefits of genuine market mechanisms
- providers have not been subject to the real budget constraints of private firms and
have been cushioned by long-term contracts ensuring comfortable levels of business.
>s*-private finance initiative; privatization; resource accounting.

internal rate of return That >rate of interest necessary in discounting the flow
over time of net revenue generated by an investment such that the > present value of
the net revenue flows is equal to the capital sum invested. The internal rate of return,
therefore, is the discount rate at which the net present value of a project is zero. It may
be used in ^investment appraisal to determine whether a prospective investment is
viable. For example, if the internal rate of return is higher than the rate of interest at
which a firm can borrow, the investment would be worth pursuing. However, the
internal rate of return has two disadvantages: (a) if the period (e.g. annual, quarterly)
costs and revenues of the project being considered change sign more than once (costs
exceeding revenues give negative flows and revenues exceeding costs give positive
flows) during the life of the project, a solution cannot be found giving a unique internal
rate of return, and (b) in ranking alternative investment proposals in priority order,
the internal rate of return procedure could give a different ranking from that of net
present value. For example, consider the following two investment projects:

(1) (■2)
Capital cost £100 £300
Net revenue per year £ 40 £ 40
Project life (years) 3 12
Net present value at 5 per cent £ 8.9 £ 54-5
Internal rate of return (per cent) 9-7 8
International Bank for Reconstruction and Development 198

According to the ranking by net present value, (2) is preferable to (1), whereas by
ranking according to the internal rates of return (1) is preferred to (2). The net present
value calculation always gives the correct answer because it shows the absolute
amount of profit to be made on the investment. The internal rate of return is also
the marginal efficiency of capital and investor's yield.

International Bank for Reconstruction and Development (IBRD) A part of

the World Bank Group (►International Development Association; International
Finance Corporation; Multilateral Investment Guarantee Agency). The establish¬
ment of the IBRD, like the ►International Monetary Fund, was agreed by the
representatives of forty-four countries at the United Nations Monetary and Financial
Conference at ►Bretton Woods in July 1944. It began operations in June 1946, and
has its head office in Washington, DC. The purpose of the bank is to encourage
►capital investment for the reconstruction and development of its member coun¬
tries, either by channelling the necessary private funds or by making ►loans from
its own resources. Originally, 20 per cent of each member's subscription was paid
into the bank's funds in >currency and gold, but this has been progressively reduced
to 4.4 per cent; the remainder is retained but available for call to meet any of the
bank's ►liabilities if required. The bank also raises money by selling >bonds on the
world market. Generally speaking, the bank makes loans either direct to govern¬
ments or with governments as the guarantor. Contributions of member countries
to its capital are made in proportion to that member's share of world trade. Members'
voting rights are allocated in the same way. In 200T, there were T84 member countries
and total lending reached $10.5 billion.

International Clearing Union >Keynes Plan.

international commodity agreements Several international commodity agree¬

ments have been signed in the past. They have included cocoa, coffee, olive oil,
rubber, sultanas, sugar, timber, wheat and tin. It has been a feature of the ►markets
in primary commodities that imbalance between >supply and >demand gives rise
to wide fluctuations in ►prices. Primary commodities often have long production
cycles that are difficult to bring into >equilibrium with relatively short-run fluctu¬
ations in demand. At the same time, the development of the economies of the
primary producing countries can depend heavily on the export earnings of these
commodities, with the result that, in response to a fall in demand, there can be a
tendency to increase supply to maintain total earnings in the face of intensified
competition, thereby forcing prices down even further. There are two features of
commodity agreements; they could be concluded for: (a) the stabilization of prices,
or (b) the raising or maintenance of prices. The first Coffee Agreement signed in
1962, covering the 5 years to 1968, was designed to halt the long decline in prices by
fixing export ►quotas for each producing country. Agreements have since been
regularly renewed. The last agreement in 2000 by the Association of Coffee Producing
Countries attempted to raise prices by stockpiling 20 per cent of each country's
output but failed to do so and was abandoned in 2001. The International Tin
Agreement was an example of a 'price stabilization' agreement. The first operated
for 5 years from July 1956. A 'buffer' stock of tin was created and a manager appointed
who had the responsibility of buying and selling tin such as to keep the price within
a 'ceiling' at which point he sold, and a 'floor' when he bought, tin. It was replaced
 International Finance Corporation

by the Association of Tin Producing Countries that operate an export quota system.
In t973, an International Cocoa Agreement was concluded that has been sub¬
sequently renewed and amended on several occasions, the last being in 2001 for
co-operation between producers and consumers to achieve long-term price stability,
but market intervention has now been discontinued. At the end of 1976, an agree¬
ment was concluded among producers for the stabilization of the prices of natural
rubber by means of a buffer stock and controls on production. The International
Rubber Agreement was renewed in 1995 with thirty-one member countries, both
producers and consumers of rubber. It was the last agreement that regulated price
by selling and buying from a buffer stock. The agreement was abandoned in 1999
when Thailand, Malaysia and Indonesia formed their own joint project for control¬
ling prices through restraints on production, ^developing country; multi-fibre
arrangement; Organization of Petroleum Exporting Countries; United Nations Con¬
ference on Trade and Development.

International Development Association (IDA) Part of the World Bank group

(international Bank for Reconstruction and Development; International Finance
Corporation; Multilateral Investment Guarantee Agency) established in r96o. It gives
long-term Moans to governments at little or no interest for projects in the poorer
of the >developing countries. It is intended for investments for which finance
cannot be obtained through other channels without bearing uneconomically high
interest charges and is mainly for items of infrastructure. The repayment period
for the loan may be up to 50 years with repayments being delayed by up to ro years.
In 2000/01, the IDA agreed loans totalling $6.8 billion. In 2002, agreement was
reached covering the period until 2005 under which $23 billion would be
made available.

International Energy Agency (IEA) An organization established in 1974 by the

>Organization for Economic Cooperation and Development. Its aims are to: (a)
reduce the member countries' dependence on oil supplies; (b) maintain an infor¬
mation system relating to the international oil markets; (c) develop a stable inter¬
national energy trade, and (d) through cooperative sharing, prepare and protect
member countries against a disruption of oil supplies. Member countries agree
to hold a particular level of oil stocks. ^Organization of Petroleum Exporting
Countries.

International Finance Corporation (IFC) A part of the World Bank group

(>International Bank for Reconstruction and Development (IBRD); International
Development Association; Multilateral Investment Guarantee Agency). In the early
1950s, it was recognized that the requirement that IBRD loans should have a govern¬
ment guarantee was a significant handicap to the attraction of private >investment
to ^developing countries. The IFC was created in r956 so that greater advantage
could be taken of private initiative in the launching of new >capital projects. Until
i96r, when its charter was amended, its activities were restricted because it had few
resources and could not participate itself in >equity holdings. Since that time its
activities have been able to develop rapidly. The IFC can invest directly and give
Moans and guarantees for private investors. It can hold equity interests in private
companies, although its interest in any one company is generally restricted to below
25 per cent. The IFC is empowered to borrow from the IBRD to re-lend to private
international investment

investors without government guarantee. It is financed by subscriptions from

the T75 countries that make up its membership. It has an authorized capital of
$2.5 billion.

international investment ^foreign investment.

International Labour Organization (ILO) An organization established in rs>r9

under the Treaty of Versailles that became affiliated to the United Nations in r946.
Its aims are the improvement of working conditions throughout the world, the
spread of social security and the maintenance of standards of social justice. It has
drawn up a labour code based on these aims. The ILO offers technical assistance to
►developing countries, especially in the field of training. Its budget is financed by
contributions from its r74 member countries. The organization was awarded the
Nobel Peace Prize in ^69. ► ILO unemployment.

international liquidity The amount of gold, ►reserve currencies and ►special

drawing rights available for the finance of international trade. Broadly, if sufficient
reserves were not available, a fall in prices and world trade could follow (►quantity
theory of money). Gold has lost some of its appeal as a reserve asset in a world of
comparatively low inflation. Preference is given to the holding of interest-bearing
assets denominated in stable reserve currencies such as the US dollar, the euro,
Japanese yen and sterling. ►►Creditor nation; eurocurrency; United Nations Confer¬
ence on Trade and Development.

International Monetary Fund (IMF) The organization set up by the ►Bretton

Woods conference of 1944 that came into operation in 1947. The IMF was established
to encourage international co-operation in the monetary field and the removal
of ►foreign exchange restrictions, to stabilize exchange rates and to facilitate a
multilateral (>multilaterism) payments system between member countries. Under
the IMF's articles of agreement, member countries were required to observe an
►exchange rate, fluctuations in which should be confined to r per cent around its
par value. This par value was quoted in terms of the US dollar, which was in turn
linked to gold. In 1969, the creation of an international unit of account was ratified.
The system proposed was that annual increases in international credit would be
distributed to IMF members by means of ►special drawing rights (SDRs). These
credits are distributed among member countries in proportion to their quotas and
may be included in their official reserves; the first, $3.5 billion, was distributed in
this way on 1 January 1970. An agreement in 1976 led to a major revision of the IMF's
articles. First, it was no longer required for member countries to subscribe 25 per cent
of their quotas in gold, and gold was no longer the unit of account of the SDR. The
IMF was authorized to sell its gold holding. Second, the commitment to fixed par
values contained in the original articles was abolished.
Member countries finance the IMF through subscriptions based on their quotas
that reflect their economic standing. In 2002, quotas totalled SDR 212.4 billion. This
fund is used to tide members over temporary ►balance of payments difficulties
and thus to help stabilize exchange rates. Borrowing ability and voting rights are
determined by this quota. A member in temporary balance of payments deficit
obtains foreign exchange from the IMF in exchange for its own currency, which it
is required to repurchase within 3-5 years. In 2002, the IMF had 184 members.
During the early r96os, it became evident that there was a strong case for increasing
 international trade

the size of the IMF, and in 1962 the General Arrangements to Borrow (GAB) was signed
by twelve countries, namely the USA, the UK, West Germany, France, Belgium, The
Netherlands, Italy, Sweden, Canada and Japan (called the 'Group of Ten' or the 'Paris
Club'), Switzerland and Saudi Arabia, under which SDR 6.7 billion credit was made
available to the IMF should it be required. This agreement has been regularly
renewed and in 1993 the credit limit was raised to SDR 18.5 billion. In 1998 the
New Arrangements to Borrow (NAB) was approved between the IMF and twenty-five
member countries and institutions to supplement the funds available for an initial
period of 5 years. The sum available under the GAB and the NAB together totals
SDR 34 billion. >s*gold standard.

International Settlements, Bank for (BIS) > Bank for International Settlements.

International Standard Industrial Classification (ISIC) ^Standard Industrial

Classification.

international trade The exchange of goods and services between one country
and another, which arises because of differences in relative costs of production
between countries, and because it increases the economic welfare of each country
by widening the range of goods and services available for >consumption. > Ricardo
showed with the law of comparative advantage that it was not necessary for one
country to have an absolute cost advantage in the production of a commodity for it
to find a partner willing to trade. Even if a country produced all commodities more
expensively than any other, trade to the benefit of all could take place provided only
that the relative costs of production of the different commodities were favourable.
Differences in costs of production exist because countries are differently endowed
with the resources required. Countries differ as to the type and quantity of raw
materials within their borders, the climate, the skill and size of the labour force,
the stock of physical >>capital and their institutions (^institutional economics).
Countries will tend to export (>exports) those commodities the production of
which requires relatively more than other commodities of those resources (^factors
of production) it has most (>Heckscher-Ohlin principle). By increasing the scope
for the specialization of labour (^division of labour) and for achieving ^economies
of scale by the enlargement of > markets, there is a presumption that international
trade should be free from restrictions (>*-free trade). The classical economists
(>classical economics) condemned >mercantilism for its advocacy of government
control over trade in order to achieve export surpluses, and from the nineteenth to
the early twentieth century there was a presumption in favour of free trade. This
philosophy gave place to economic protectionism (>protection) in the 1930s but it
was revived again in the ^General Agreement on Tariffs and Trade in r948. The latter
had some success in reducing tariffs on ^imports (>tariffs, import), culminating in
the creation of the > World Trade Organization. However, many trade restrictions
still remain (>protection). At the same time, there has been an increase in the
number of ^customs unions and >free trade areas. The >European Union, for
example, had, in 2002, free-trade agreements agreed or in discussion with thirty-
seven countries. While these agreements do establish free trade between member
countries, they discriminate against outsiders. World trade has expanded faster than
world output. Over the past 50 years, trade has grown on average at about 6 per cent
per annum, about 50 per cent more than world output.
International Trade Commission

International Trade Commission (ITC) A US government agency set up by

the Trade Act 1974; it replaced the US International Trade Organization that had
previously operated since 1916. The ITC has judicial powers to investigate cases in
which >imports are alleged to damage materially domestic industry and to make
recommendations to the President. Such damage need not be due to unfair trading
practices (e.g. >dumping), although the ITC does carry out studies to determine
whether dumping has taken place. It has the power to overturn anti-dumping duties
imposed by the US Department of Commerce if it finds that no injury is caused to
the USA from the imports under suspicion. The ITC also investigates cases in which
imports might be undermining US agriculture-support schemes. It collects and
disseminates information and statistics on US international trade and domestic
production (^international trade).

intervention Any form of government interference with > market forces to achieve
economic ends. Intervention may be in the area of ^macroeconomics (impolicy
ineffectiveness theorem), or may be applied to one sector or market. In the latter
case, it may take the form of ^regulation, ^taxation (e.g. a tax on environmentally
destructive behaviour, ►pollutor-pays principle) or ^subsidy. There are numerous
problems with interventions. They may have: (a) unforeseen costs (e.g. a regulation
designed to improve food hygiene in restaurants may result in the closure of many
local restaurants); (b) side-effects (e.g. the provision of subsidized child care may
undermine the provision of informal, unpaid child care); (c) revenge effects (in which
they achieve the opposite of the intended result, e.g. the building of a road to reduce
traffic congestion may create extra traffic and increase congestion); (d) > deadweight
costs (the intervention ends up affecting many more people than it needed to to
achieve its end, e.g. a job subsidy for those in Mong-term unemployment may go
to many people who would have found jobs anyway), and (e) they may create
perverse incentives (e.g. a job subsidy to help the long-term unemployed gives the
short-term unemployed an incentive to become long-term unemployed). cost-
benefit analysis; risk assessment.

invention The creation of ideas for new products and processes that lead to
► innovation that makes them available on the ►market. Inventions that may be
subject to >patents may be made by one individual or organization and developed
for the market by others, or the whole process may be carried out by one organization.
There may be a long gap between invention and innovation, e.g. between the
Wright brothers' flight in T903 and the development of scheduled intercity flights
30 years later.

inventories Term for ^stocks of raw materials, work in progress and finished
goods. Inventories represent ►capital tied up in unsold goods and require storage
space, insurance and other incurred costs, but are an inevitable part of the process
of production and distribution. This is because: (a) in most cases, customers are not
willing to wait while goods are produced, but expect delivery off the shelf; (b) it is
not possible to forecast sales accurately and sales might be lost if stocks were not
held, while it may be uneconomic to interrupt production to match short-term
fluctuations in sales because of loss of ^economies of scale; (c) while production
may be continuous, deliveries of components and raw materials arrive in batches,
and (d) transport arrangements may be such that finished goods also need to be
 investment, inward

dispatched in batches, e.g. by the lorry-load. Inventory investment may be intentional

(e.g. where stocks are built up to meet an anticipated seasonal peak in demand) or
unintentional, e.g. when demand falls sharply. Since increasing the level of stocks
is an ^investment, running them down is ^disinvestment. The management of
inventories, in particular the goal of minimizing the capital tied up in them, is seen
as an important task (>just-in-time). As the change in inventories each year varies
so much, and gross domestic product so little, inventories can affect > aggregate
demand significantly, ^inventory investment cycle.

inventory investment ^inventories.

inventory investment cycle Fluctuations in economic activity caused by changes

in ^inventories. Although firms may increase or run down stocks to maintain
a steady rate of production, there will be upper and lower limits to inventory
accumulation determined by the need to hold a minimum stock and the cost of
excessive stocks. For these reasons, many firms will try to keep stocks at so many
days of sales or output. Since production will increase faster than sales when inven¬
tories are increasing (and vice versa) changes in inventories tend to accelerate the
effect upon production of changes in sales, thus contributing to >business cycles,
►►acceleration principle.

inverse elasticity rule The rule that, if prices are to deviate from marginal cost
(►marginal-cost pricing), it is best for the mark-ups to be highest for those products
that have the most inelastic demand. By this argument, first articulated by Ramsey
and also known as Ramsey pricing, if we were to tax certain goods, the tax should be
highest on goods that people will continue to buy anyway and low on those items
that are very price-sensitive. Keeping to these rules will minimize the distorting
effect of the tax, because it means that consumers will behave very much as they
would have without the tax. The same principle can also be applied to allocating
fixed costs to different consumers when >marginal cost is below >average cost in a
particular industry. Although this idea has achieved wide currency, it does not stand
up to ►general equilibrium analysis. If all commodities are going to be taxed, for
example, the inverse elasticity rule will not apply.

investment 1 Real ►capital formation (e.g. the production or maintenance of

machinery or the construction of dwellings) that will produce a stream of goods
and services for future consumption. Investment involves the sacrifice of current
►consumption and the production of investment goods that are used to produce
► commodities (►producer goods) and includes the accumulation of ^inventories.
In the national accounts (Asocial accounting) investment is the sum of gross fixed
►capital formation and the physical change in inventories and work in progress.
Investment contributes to higher output. Investment may be stimulated by changes
in >demand or ►technology, by high ► profits or by low interest rates (since
much investment expenditure is financed by borrowing). The theory of >income
determination shows how ^savings and investment are brought into equilibrium,
(►►capital; depletion theory; gross investment; net investment.) 2 In common
usage, expenditure on the acquisition of financial or real >assets. To the economist,
this is not investment but simply a shift of savings from one form (cash) to another.

investment, inward ^-foreign investment.

investment allowances 204

investment allowances >capital allowances.

investment appraisal The evaluation of the prospective costs and revenues

generated by an investment in a capital project over its expected life. Such appraisal
includes the assessment of the risks of, and the sensitivity of the project's viability
to, forecasting errors. The appraisal enables a judgement to be made whether to
commit resources to the project, ^internal rate of return; present value.

investment bank (US) A financial intermediary that purchases new issues and
places them in smaller parcels among investors. In the UK, the alternative terms
>'merchant bank' or >'issuing house' are still occasionally used. Investment banks
are often subsidiaries of banks and other financial institutions; they provide advice
on >mergers and acquisitions and deal in ^-securities.

investment function ^acceleration principle.

investment goods ► investment.

investment incentives Government assistance designed to encourage firms to

invest in physical or other ^-assets in total, in particular industries or in particular
locations. The incentives may take the form of >capital allowances for tax relief,
e.g. temporary allowances of ioo per cent were given to small firms by the UK
government in the T997 budget. More recently, the UK has given special reliefs for
>research and development and for ^corporate venture capital. Or they may be in
the form of special regional incentives, ^enterprise zones; free trade zone; regional
policy.

Investment Services Directive (ISD) A ^European Union (EU) directive that

came into force in r996 and that provides for securities dealers and > investment
banks, including portfolio managers and underwriters, authorized in one member
state to operate directly or via branches in any other EU state without further
authorization. The Capital Adequacy Directive sets out minimum ^capital adequacy
requirements with which the ISD firms must comply. >► Directives of the European
Union.

investment trust A company, the sole object of which is to invest its > capital in
a wide range of other companies. An investment trust issues >shares and uses its
capital to buy shares in other companies. A >unit trust, on the other hand, issues
units that represent holdings of shares. Unit holders thus do not share in the Vprofits
of the company managing the trust. Although sharing the advantages of widespread
investment with unit trusts, investment trusts pay their management expenses out
of taxed ^income and not out of shareholders' incomes. The total funds managed
by investment trusts are twice as great as those of unit trusts. Investment trusts can
also raise part of their capital by fixed-interest > securities, and the >yield on
>ordinary shares can thus benefit from ^gearing. There are some 250 investment-
trust companies in the UK. Some investment trusts underwrite new issues (>new-
issue market; open-ended investment company).

investor's yield ^-internal rate of return.

invisible A term used to describe those items (e.g. financial services) included in
the current > balance of payments accounts, that are distinct from physically visible
 IS-LM model

^-imports and >-exports of goods. Invisibles include government grants to overseas

countries and subscriptions to international organizations, payments for shipping
services, travel, royalties, commissions for banking and other services, transfers to
or from overseas residents, > interest, > profits and »-dividends received by or from
overseas residents. Invisibles account for about 25 per cent of total >international
trade and are increasing at a faster rate than visible merchandise. Invisible trade is,
however, generally less free from >■ protectionism than visible trade. Examples of
protective policies are: (a) the exclusion of foreign ^insurance companies from
some domestic markets; (b) restrictions on foreign-owned banks (^banking) setting
up branches; (c) that some countries allow only a limited percentage of their visible
trade to be carried on foreign-flag ships, and (d) ^exchange controls. >-Doha round
of international trade negotiations; General Agreement on Trade in Services.

invisible balance >Invisibles; balance of payments.

'invisible hand' The idea, promoted by >Smith, that society is best served by
individuals being free to pursue their own self-interest. Smith said that each indi¬
vidual was Ted by an invisible hand to promote an end which was no part of his
intention'. >Mandeville, B. de; price system; resources.

involuntary saving >forced saving.

inward investment >foreign investment.

IRR ^internal rate of return.

irredeemable security A > security that does not bear a date at which the »-capital
sum will be paid off or redeemed, e.g. 2/2 per cent >consols or certain ^debentures.
Sometimes called 'undated securities'. Possession of an irredeemable security entitles
the owner to ^interest payments but not to repayment of face-value capital. This
affects the price at which the security is marketable. For example, 2/2 per cent
consols, which are irredeemable £roo stock bearing 2/2 per cent interest, might,
depending on prevailing interest rates, fetch only about £50, i.e. the price at which
they will give a 5 per cent yield. If this stock were redeemable in r year, its price
would obviously be very much higher.

ISA ^individual savings account.

ISD >Investment Services Directive.

ISIC International Standard Industrial Classification (>Standard Industrial Classi¬

fication).

IS-LM model A model developed by »*Hicks shortly after the publication of

> Keynes' General Theory of Employment, Interest and Money (1936), providing a frame¬
work for analysing the factors determining the level of demand in an economy. It
became the standard framework for studying >macroeconomics, primarily because
it appeared to be able to encompass widely differing views of how the economy
works. The strength of the model is that it combines events in the market for cash
with events in the market for goods and services to establish an equilibrium level of
overall demand. Two variables - aggregate expenditure and the ^interest rate -
isocost line

L-M

0 expenditure

determine whether: (a) equilibrium exists in the two markets; (b) the demand for
>investment goods matches the supply of >savings, and (c) the demand for cash
(or liquid assets) matches the supply. On a graph (see diagram) with the interest rate
on the vertical axis and the level of spending on the horizontal axis, two curves
can be plotted. The I-S (investment-savings) curve slopes down from left to right
depicting the set of combinations of interest rate and spending that ensure equilib¬
rium in the investment and savings market. For each level of the interest rate, there
is a unique level of spending, ensuring that planned investment equals planned
saving. The second curve, L-M (liquidity-money supply), plots combinations of
interest rates and income levels, ensuring that the demand for money (^liquidity
preference) is equal to the supply. A high interest rate suppresses the demand for
cash and thus may be combined with a high level of national income (stimulating
the demand for cash) if equilibrium is to be maintained. This curve usually thus
slopes upwards. Where the two curves intersect, there is an equilibrium level of both
> aggregate demand and the interest rate.
Much of the dispute between > Keynesian economics and ^monetarism can be
interpreted as arguments over the relative slopes of the I-S and L-M curves. However,
the IS-LM model says nothing of the factors determining the >aggregate supply of
goods and services, and in recent years more attention has been paid to this area of
analysis rather than the level of demand. >supply-side economics; ^economic
doctrines; transmission mechanism.

isocost line A graphical representation of combinations of inputs, each of which

may be purchased for a given cost. It may be that by spending £1000 per week a firm
could hire ten workers or ten robots or any combination in-between. In this case,
the isocost line could be plotted on a graph with a quantity of robots on one axis
and a quantity of workers on the other. It would be a straight, downward-sloping
 issued capital

line passing from the point of ten robots and no workers to ten workers and no
robots. Every point on such a graph would represent a combination of inputs costing
a certain level and each point would be on one, and only one, isocost line.
The isocost line, which is analogous to the >budget line in consumer theory,
is useful for analysing the optimal combination of inputs firms should employ,
isoquant.

isoproduct curve >isoquant.

isoquant A graphical representation of combinations of inputs, each of which

produces the same output (see diagram). A company might be able to produce a
given output of its product either with five workers and five machines, or with eight
workers and four machines. If so, an isoquant could be plotted on a graph, on one
axis of which was the number of machines and, on the other, the number of workers
employed. Each point on such a graph would represent a combination of inputs and
each would thus produce some level of output. Each would be on one, but only one,

isoquant. Normally, economists allow for two inputs - capital and labour - but the
analysis can be extended. Isoquants have the following properties: (a) they are
downward sloping because, as one factor is removed (and we move down one axis),
more of another factor must be added to maintain the old level of output (moving
up the other axis), and (b) they are convex to (i.e. bulge towards) the origin, because
increasing amounts of a second factor are required to compensate for unit decreases
in the first (^-diminishing returns, law of). The isoquant is analogous to the ►indiff¬
erence curve in the theory of consumer demand, ^ convexity; isocost line; rate of
technical substitution.

issued capital That part of a company's ^capital that has been subscribed to by
shareholders. It may or may not be paid up (>paid-up capital).
issuing broker 208

issuing broker A >-broker acting as an agent for a new issue of insecurities.

issuing house An ^investment bank, >-merchant bank or ^stockbroker, that

organizes the raising of ^-capital by new issues of ^securities on behalf of clients.
The issuing house will advise the client on the timing and form of the issue, and
investment banks, in return for a commission, will underwrite all or part of the
issue. The sponsorship of an issue by an established issuing house greatly affects the
confidence of the investor and success of the issue. Increasingly, and especially in
►unlisted securities markets, other securities dealers and firms of accountants are
sponsoring new issues while other financial institutions will underwrite issues,
^►new-issue market; underwriting.
(-curve The immediate effect of a depreciation or devaluation of the >exchange
rate is to raise import prices and reduce export prices. In the short run, therefore,
the >balance of payments could worsen. Eventually, the effects of the change in
the relative price of exports, as compared with imports, induce the expansion
of exports and a cut in imports that would improve the balance of payments.
The J-curve traces the initial worsening in the balance of payments followed by a
recovery, ^international trade; 'leads and lags'.

(evons, William Stanley (1835-82) Jevons studied natural science and worked as
an assayer to the Australian Mint from 1853 to 1859. He became Professor of Logic at
Owens College, Manchester in 1866, and in r8/6 at University College, London. His
main theoretical economic work is Theory of Political Economy (1871). Other aspects
of his work are collected together in Investigations in Currency and Finance (T884). He
was one of the three economists to put forward a ^-marginal utility theory in the
r870s. He argued that one > commodity will exchange for another such that the
ratio of the >prices of the two commodities traded equals the ratio of their marginal
utilities. > Edgeworth criticized the way Jevons developed these ideas, and in so
doing invented the >indifference curve. Jevons also made an important contri¬
bution to the theory of >• capital, many aspects of which were, in fact, taken up by
the > Austrian School. He superimposed on the »-classical economic theory the idea
that capital should be measured in terms of time as well as quantity. An increase in
the amount invested is the same as an increase in the time period in which it is
being employed. Output can be increased by extending the period in which the
investment is available by, for example, reinvesting the output instead of consuming
it at the end of the production period. With given levels of Mabour and capital,
output becomes a function of time only. He derived from this a definition of the
>rate of interest as the ratio of the output gained by an increase in the time capital
remains invested divided by the amount invested (>Bohm-Bawerk, E. von; internal
rate of return). Jevons was also one of the founders of ^econometrics - he invented
>moving averages. He also propounded a theory of the ^-business cycle based on
sunspots, but this is of little importance except for the stimulus it gave to the study
of statistics for economic empirical work. »**Gossen, H. H.; Menger, C.; Walras,
M. E. L.

jobber >market maker.

jobseekers' allowance The main Asocial security benefit in the UK for those out
of work but looking for a job. It replaced unemployment benefit (which was available
joint costs

to anyone who had paid sufficient »-National Insurance for 12 months), and income
support for the unemployed (which was available on a >means-test basis thereafter),
►^unemployment.

joint costs >Costs arising simultaneously in the production of two or more

Commodities that cannot be precisely allocated to each product. >#-economies
of scope.

joint demand ^-Demand for two or more Commodities or >• factors of production
that are used together so that a change in demand for one will sooner or later be
reflected in a change in demand for the other, e.g. cloth and thread. Another term
for complementary demand (Complementary goods).

joint products ►Commodities that are produced in such a way that a change in
the output of one of them necessarily involves a change in the output of the other.
For example, in refining crude oil into petrol, fuel oil and other heavier oils, limits
are set to the relative proportions of each product that can be achieved. Leather and
beef are joint products. Under conditions of joint production, the allocation of costs
between the products will be arbitrary, ^economies of scope.

joint supply > joint products.

joint venture A business arrangement in which two companies invest in a project

over which both have partial control. It is a common way for companies to collabor¬
ate - especially on risky high-technology ventures - without engaging in full-scale
>merger. The growth of international joint ventures has been striking and raises
many public policy issues analogous to those raised by acquisitions, for which joint
ventures may often be a strategic substitute.

Juglar cycle A ^business cycle identified by Juglar (^9-1905) of about 9 or ro

years in length. Juglar was one of the first analysts to use ►time-series data effectively
to elucidate an economic problem. His work was published in T862 in Les crises
commerciales et leur retourperiodique en France, en Angleterre et aux Etats Unis. Through
his work he came to the conclusion that 'The only cause of >depression is pros¬
perity.' >Kondratiev cycle; Kuznets, S. S.

just-in-time A form of production management, originating in Japan, in which

companies do not obtain stocks of components until they are actually needed.
Traditionally, companies kept large quantities of parts ready for use in production.
Just-in-time management can cause the production process to be held up if a certain
part is short but, as this exposes which parts of the production process are going
wrong most often, this is not seen as a disadvantage. It also lowers the costs of
maintaining stocks of parts. inventories.
 K

Kahneman, Daniel (b. 1934) Israeli-American psychologist from Princeton Uni¬

versity, who jointly won the Nobel Prize for Economics in 2002 for pioneering work
in combining the study of human economic behaviour with insights from cognitive
psychology. Kahneman is seen as one of a handful of pioneers in the fledgling
discipline of >behavioural economics. This attempts to analyse human decision¬
making and its deviations from the traditional economic assumption of 'rationality'.
Economists always understood that people were not fully rational, but hoped that
deviations were not very systematic in any particular direction. In practice, there are
systematic deviations. Kahneman and his late colleague Tversky have documented
different biases in behaviour. The two have written many influential papers, e.g.
'Subjective Probability: a judgment of representativeness', Cognitive Psychology (1972),
'On the Psychology of Prediction', Psychological Review (1973), 'Prospect Theory: an
analysis of decision under risk', Econometrica (1979), and edited Choices, Values and
Frames (2000).

Kaldor, Nicholas (1908-86) Born in Budapest, Kaldor graduated at the London

School of Economics in 1930 and lectured there until 1947. Between 1943 and 1945,
he was a research associate at the National Institute of Economic and Social Research,
and in 1947 was appointed Director of the Research and Planning Division of the
Economic Commission for Europe, a post he held for 2 years. He was a member of
the UK Royal Commission on Taxation of Profits and Incomes from T951 to 1955. In
1952, he moved to Cambridge University as Reader, and in 1966, was appointed
Professor of Economics. From 1964 to 1968 and from 1974 to 1976, he was special
adviser to the Chancellor of the >Exchequer on economic and social aspects of
►taxation policy. His published works include 'The Quantitative Aspects of the Full
Employment Problem in Britain', Appendix to Full Employment in a Free Society by
► Beveridge (1944), reprinted in Essays in Economic Policy (1964), An Expenditure Tax
(1955), Essays on Economic Stability and Growth (i960), Essays on Value and Distribution
(i960), Capital Accumulation and Economic Growth (1961), Causes of the Slow Rate of
Growth of the UK (1966), Conflicts in Policy Objectives (1971), Collected Economic Essays
(1978) and Economics Without Equilibrium: the Okun Memorial Lectures (1985). In his
capacity as government adviser, Professor Kaldor was an advocate of the long-term
► capital gains tax and the selective employment tax and he put forward the idea
of the > compensation principle in >welfare economics. ^Cambridge School;
distribution, theory of.

Kantorovich, Leonid (1912-86) An economist of the then USSR, and joint winner
of the >Nobel Prize for Economics in 1975. Based at the Academy of Sciences in
 Keynes, John Maynard | 212

Moscow, Kantorovich's subject was the optimal allocation of resources. His book,
The Best Use of Economic Resources, was published in 1965. He was keen to improve the
planning system adopted by his country, and developed mathematical techniques -
notably ►linear programming and the use of ►shadow prices - as a means to that
end. His work was concerned with the decentralization of planning, and the need
for a rational price system to make decentralization work.

Keynes, John Maynard (1883-1946) Educated at Eton, Keynes won prizes there
in mathematics as well as in English and Classics before going up to King's College,
Cambridge. At university he graduated with a first in mathematics. During his
stay at Cambridge he studied philosophy under Whitehead and economics under
► Marshall and ►Pigou. After a period in the Civil Service, he accepted a lectureship
in economics at King's College, Cambridge. In 1911, he became editor of the Economic
Journal. During the First World War he held a post in the UK >Treasury, but resigned
because he believed that the figure for German war reparations was set too high {The
Economic Consequences of the Peace (1919)). He was also a severe critic of the decision
of the government to return to the >gold standard at the prewar >-exchange rate
CThe Economic Consequences of Mr Churchill (1925)). In 1930, he published A Treatise
on Money, and in the same year was appointed a member of the ►Macmillan
Committee on Finance and Industry. His major work, The General Theory of Employ¬
ment, Interest and Money, appeared in 1936. He served a second spell in the Treasury
during the Second World War, and was responsible for negotiating with the USA
on Lend-Lease. He took a leading part in the discussions at ► Bretton Woods in 1944
that established the ►International Monetary Fund.
► Unemployment during the interwar period persisted in the UK at high levels,
never falling below 5 per cent, and at its worst reaching 20 per cent of the total
► labour force. The failure of the economy to recover from such a long depression
was unprecedented in the economic history of industrial society. Fluctuations in
activity were well known, and had received much attention from theorists on the
► business cycle in the past. The classical economists (►classical economics) held
that in the downturn of the business cycle both wage rates (►earnings) and the
►rate of interest fell. Eventually, they reached levels low enough for businessmen
to see a significant improvement in the profitability of new ►investments. The
investment so induced generated employment and new ►incomes and the economy
expanded again until rising prices in the boom brought the next phase in the cycle.
The classical economists therefore concluded that the failure of the economy to
expand was because wages were inflexible. Their policy recommendations were that
the unions should be persuaded to accept a wage cut. Keynes argued that, although
this policy might make sense for a particular industry, a general cut would lower
► consumption, income and ►aggregate demand, and this would offset the encour¬
agement to employment by the lowering of the ►'price' of labour relative to the
price of ►capital, e.g. plant and machinery. Pigou countered Keynes' argument by
pointing out that, by lowering wages, the general price level would be lowered,
therefore liquid balances that people owned would have a higher spending value
(►Pigou effect). The upturn, it was agreed, was stimulated by businessmen
responding to lower wages with increased investment expenditure. Why, said
Keynes, should not the government take over the businessman's function and
spend money on public works? Current opinion upheld the belief that government
mj Keynes Plan

budget-deficit financing would bring more hardship than already existed. The >-bal-
anced budget was regarded as a correct accounting practice for the government and
for a private household. Most economists of the period accepted that public-works
expenditure would reduce unemployment, even given the need to keep the budget
in balance. Pigou showed the mechanism by which this could be brought about.
However, the Treasury view was that public works would merely divert ^savings
and labour from the private sector and, as the former was less productive, the net
effect would be a worsening of the situation (^-crowding out). It was not until after
Keynes had written his General Theory and crystallized his arguments into a coherent
theoretical framework that his views were accepted.
Keynes did not deny the classical theory. He agreed that a reduction in wage rates
could be beneficial, but it would operate only through the ^liquidity preference
schedule. A fall in prices would increase the value of the stock of money in people's
hands in real terms. This would make available an increase in the amount that
people were willing to lend, with a consequent drop in the rate of interest to the
benefit of investment. However, if this is so, why not operate directly on the rate of
interest or the quantity of money in the economy? Moreover, Keynes argued that
there exists a level of interest rate below which further increases in >money supply
are simply added to idle balances (> inactive money) rather than being used to
finance investment. Wage cuts or not, the economy would stick at this point with
chronic unemployment. In the classical system, the national product (^national
income) was determined by the level of employment and the latter by the level of
>real wages. The quantity of money determined the level of prices. Savings and
investment were brought into balance by means of the rate of interest. In Keynes'
system, the equality of savings and investment was achieved by adjustments in the
level of national income or output working through the ^multiplier. The rate of
interest was determined by the quantity of money people desired to hold in relation
to the money supply. The level of output at which savings equals investment does
not necessarily correspond to full employment. The innovation in the Keynesian
system was that the rate of interest was determined by the quantity of money and
not the level of output, as in the classical system. In the Keynesian model, if you
increased the propensity to invest or consume, you did not simply raise the rate of
interest, you raised output and employment (^-consumption function). Keynes'
study of monetary aggregates of investment, savings, etc., led to the development
of national accounts. Keynes' General Theory is now criticized for its reliance on
special cases (wage rigidity, the insensitivity of investment to the rate of interest,
and the idea of a minimum rate of interest at which the demand for money became
infinitely elastic), its preoccupation with ^equilibrium and the fact that, despite its
presentation as a radical new departure, it nevertheless embodies many of the
analytical limitations of the >Classical School of economics. However, the transfor¬
mation which Keynes brought about, in both theory and policy, was considerable.
In effect, he laid the foundations for what is now > macroeconomics. >► Keynesian
economics; Keynesian unemployment; new Keynesian economics.

Keynes Plan Proposals by the UK > Treasury submitted for the establishment
of an International Clearing Union (ICU) for discussion at the >Bretton Woods
conference in r944. These proposals were primarily the work of >-Keynes, and became
known as the Keynes Plan. The ICU would have basically the same functions as a
Keynesian economics | 214

domestic >bank and ^clearing house. International >debts would be cleared on a

multilateral basis between its members. It would give >-overdraft facilities to a
member running a temporary imbalance of payments deficit and would create its
own unit of ^currency - called ^bancor - in which the overdraft facility would be
made available. Bancor would have a gold >exchange rate in the initial phases of
the scheme, though it was expected that it would eventually break its gold connec¬
tion and replace gold in international finance. Each member would have a quota
that determined the limits of its credit facilities with the ICU. There was a set of
suggested safeguards and penalties to encourage the elimination not only of deficits
but also of persistent surpluses. The plan did not win approval at Bretton Woods
and the less radical > International Monetary Fund was established, which was more
in line with the ideas put forward by the USA.

Keynesian economics The branch of economic theory, and the doctrines, associ¬
ated with >Keynes. In general, Keynesian economics tends to support the following
propositions: (a) ^-aggregate demand plays a decisive role in determining the level
of real output; (b) there is no automatic tendency for the level of >-savings and
^-investment to be equal, as the level of investment is not primarily determined by
the >rate of interest; (c) as a result, economies can settle at positions with high
unemployment and exhibit no natural tendency for unemployment to fall, and (d)
governments, primarily through fiscal policy, can influence aggregate demand to
cut unemployment.
It would be wrong, however, to consider Keynesian economists to be a single,
united body of theorists. Since t945, two predominant Keynesian schools have
emerged. First the Neo-Keynesians reached a consensus view with more classically
oriented economists. Under what is known as the neo-classical synthesis (>neo¬
classical economics), it was largely accepted that the practical conclusions of Keynes
were correct but that, at least in theory, the market did have a theoretical tendency
toward full employment (other than possibly in the very exceptional circumstances
of a ^liquidity trap). It was on account of price rigidities and institutional inflexi¬
bility that unemployment could persist. This Neo-Keynesian view used the >TS-LM
model to describe the determination of aggregate demand, and the > Phillips curve
acted as a description of the behaviour of ^aggregate supply. The synthesis domi¬
nated ^macroeconomics until it was challenged by >Friedman and ^monetarism.
At the same time, a second strand of Keynesian thought emerged. This held that
economists were mistaken in considering the behaviour of an economy only in
>equilibrium. It was possible that because of interactions between different sectors
of the economy, a state of disequilibrium could persist. When the economy left
an equilibrium state, no amount of price flexibility could guarantee its return to full
employment. This branch of disequilibrium economics is associated with Clower,
Leijonhufvud and Malinvaud (^Keynesian unemployment; quantity rationing).
More recently, another variant - >new Keynesian economics - has been concerned
to find foundations for Keynesian findings in >-microeconomics. It arrives at certain
Keynesian implications, using the assumption of ^rational expectations, .^inform¬
ation, economics of.

Keynesian unemployment A situation in which the number of people able and

willing to work at prevailing wages exceeds the number of jobs available and, at the
same time, firms are unable to sell all the goods they would like. s-Excess supply
 knowledge economy

thus exists in both the labour and goods markets. Keynesian unemployment is one
of four possible regimes in an economy in which ^-quantity rationing exists, i.e.
that markets are not in equilibrium. Its important distinguishing feature is in its
possible cures. For >classical unemployment, a cut in wages should make it profit¬
able for employers to take on new workers. In the Keynesian case, however, firms
are already unable to sell all their output. This induces them to cut their prices at
the same time that workers will be trying to price themselves into jobs by accepting
lower wages. When both prices and wages fall >-real wages remain constant, and it
is real wages that determine the level of employment. Thus, when both the labour
market and goods market are in excess supply, even if prices and wages are flexible,
there will be no natural tendency for the economy to lift itself out of recession. In
this case, the most obvious solution is for the government to inject some demand
through higher borrowing. ^Keynesian economics; unemployment.

Klein, Lawrence R. (b. 1920) Professor Klein studied at Berkeley, the University of
California, and obtained his Ph.D at the Massachusetts Institute of Technology.
After working for the Cowles Commission, he was at Michigan University from 1949
to r954 and at Oxford University until 1958. Professor Klein was then appointed
Professor of Economics and Finance at the Wharton School of Finance, University
of Pennsylvania. He was awarded the >Nobel Prize in Economics in r98o. His major
publications include The Keynesian Revolution (1947), Economic Fluctuations, 1921-
1941 (1950), Econometric Model of the United States, 1929-1952 (1955), An Essay in the
Theory of Economic Prediction (1971) and The Economics of Supply and Demand (1983).
Professor Klein pioneered the design, construction and application of large-scale
►econometric models for forecasting gross national product and its components in
the r950S and r96os, capitalizing on the emergent computer technology of the
time. His work has contributed to the development of applied > econometrics
and stimulated the development of statistical information about ► macroeconomic
fluctuations.

Knight, Frank Hyneman (1885-1973) Appointed Associate Professor of Economics

at the University of Iowa in r9r9 and Professor in 1922; after studying at Cornell and
Chicago Universities, Knight returned to Chicago as Professor of Economics in 1928.
His major published works include The Economic Organisation (1933), The Ethics of
Competition and Other Essays (1935), The Economic Order and Religion (1945), Freedom
and Reform (1947), Essays on the History and Method of Economics (1956) and Intelligence
and Democratic Action (i960). His most influential work has been Risk, Uncertainty and
Profit (1921). In this work, he made a clear distinction between insurable >risk and
uninsurable uncertainty. It was the latter that gave rise to >-profit. A businessperson
must guess future demand and selling prices and pay in advance the ►factors of
production amounts based on his/her guesses. The accuracy of the guesses is reflected
in the profit made. It follows that profits are related to uncertainty, the speed of
economic change and business ability.

knowledge economy A characterization of modern economies in which 'know¬

ledge-intensive' activities (i.e. those that involve the creation, processing and
interpretation of information) account for a substantial and growing proportion of
employment and output. Examples of these activities are education, professional
services, the media, communications and ►research and development. The term
Kondratiev cycle

first came into common use in the 1960s and had its roots in the observations
that services accounted for more employment than agriculture, manufacturing and
mining, and that rates of economic growth were considerably higher than could be
explained by the combined growth of inputs of >capital and >labour, a difference
that in part was attributed to advances in knowledge (>-growth accounting). The
preponderance of service activities and the role of knowledge has given rise to
another term - post-industrial economy - which can be a synonym for knowledge
economy. However, all production, whether in manufacturing, agriculture or ser¬
vices, requires knowledge and always has, and there is no novelty in the importance
of knowledge, ^innovation; new economy.

Kondratiev cycle A ^business cycle of very long duration - >Schumpeter applied

the term to a cycle of 56 years. Named after the Russian economist Kondratiev (1892-
1938), who made important contributions in the 1920s to the study of long-term
fluctuations. Kondratiev studied US, UK and French wholesale prices and interest
rates from the eighteenth century through the 1920s and found peaks and troughs
at regular intervals. Similar work has been carried out at Harvard, confirming a
54-year cycle in UK wheat prices since the thirteenth century. 5**-Juglar, C.; Kuznets,
S. S.; Schumpeter, J. A.

Koopmans, Tjalling C. (1910-86) Professor Koopmans was born in The Nether¬

lands and studied physics and mathematics at the Universities of Utrecht and Leiden.
After 4 years with the League of Nations in Geneva, he went to the USA in 1940 to
take up a post as statistician with the Allied Combined Shipping Adjustment Board.
He moved to the Cowles Commission at Chicago in 1944, where he was appointed
Director in 1961. He was a Professor of Economics at Yale University from 1955 until
his retirement in 1981. Professor Koopmans was awarded, in 1975, the >-Nobel Prize
in Economics (jointly with ^Kantorovich). His publications include Linear Regression
and Activity Analysis of Economic Time Series (1937), Statistical Inference in Dynamic
Economic Models (1950), Analysis of Production as an Efficient Combination of Activities
(1951), Three Essays on the State of Economic Science (1957) and The Scientific Papers
of Tjalling C. Koopmans (T970). Professor Koopmans introduced the mathematical
procedures of > linear programming (or activity analysis) to economics. He demon¬
strated the application of linear programming to the solution of transportation
problems, to general ^equilibrium analysis and to problems in ^investment
appraisal. He has made important contributions to the theory of >econometrics.

Kuznets, Simon S. (1901-85) Professor Kuznets, who was born in Russia, went to
the USA in 1922 where he studied economics at Columbia University, receiving his
Ph.D in 1926. After a number of years at the National Bureau of Economic Research, he
went in 1930 to the University of Pennsylvania where he was later to be appointed
Professor of Economics, a post he held until 1954. There followed a period as Professor
of Economics at Johns Hopkins University until 1960 when he accepted a Chair in
Economics at Harvard, where he remained until his retirement in 1971. Professor Kuz¬
nets was awarded the >Nobel Prize in Economics in 1971. His publications include
Secular Movements in Production and Prices (1930), National Income, 1929-1932 (1934),
National Income and its Composition, 1919-1938 (1941), National Product Since 1869
(1946), Six Lectures on Economic Growth (1959), Economic Growth and Structure (1965),
Modem Economic Growth: rate, structure and spread (1965), Economic Growth of Nations
 Kuznets curve

(1971) and Population, Capital ami Growth (1979). Professor Kuznets made important
contributions to the development of applied >econometrics through the compi¬
lation of macroeconomic statistics. His analysis and statistical identification of T5-
20-year fluctuations in time series of production and prices initiated a continuing
debate in the analysis of >trade cycles. He completed major studies in income
distribution exploring the relationship between growth in income per head and the
distribution of income (>-Kuznets curve). >juglar cycle; Kondratiev cycle.
Kuznets curve A proposition put forward by ► Kuznets in 'Economic Growth and
Income Inequality', American Economic Review (1955) which suggested that inequality
in ^income distribution increased during the early rapid phase of economic growth
and subsequently moved towards equality; thus tracing an inverted U-shape.
labour A >factor of production. The term not only includes the numbers of people
available for, or engaged in, the production of goods or services but also their
physical and intellectual skills and effort, ^employment, full; human capital;
labour force; sow's ear effect; unemployment.

labour, demand for The amount of labour that firms will employ at different
wage levels. In a simple model of the structure of the Mabour market, firms employ
labour as long as it is profitable for them to do so. It will be profitable as long as the
selling price of the output of the marginal worker is greater than the cost of that
worker. To maximize profits, therefore, firms employ additional workers until the
> marginal revenue product (i.e. the marginal revenue of the firm's output times the
number of extra units produced by taking on one more worker) is equal to the wage
costs. In this situation: (a) when the price of the firm's output rises, its demand for
labour rises; (b) when the physical output of workers rises (from more developed
skills or harder work), the demand for labour rises; (c) when the wage rate falls, the
demand for labour rises, and (d) when the amount of capital employed increases,
the demand for labour will either increase - as the capital enhances the productivity
of each worker - or it will fall - if the capital displaces workers.
This account, in which all workers are assumed to be identical, has been developed
in many directions: (a) complications can be added, e.g. the influence of trade
unions and industries in which there is only one employer (>■ monopoly); (b) alterna¬
tive models have been developed to account for the stickiness of wages and to
describe alternatives to fixed-wage contracts (>efficiency-wage hypothesis; profit-
sharing). Finally, the whole subject can be viewed in a >macroeconomic perspective,
in which the demand for labour is viewed as a function of >aggregate demand only.
In this case, high wages can be portrayed as stimulating employment through
their effect on maintaining high aggregate demand, ^-marginal productivity theory
of wages.

labour, division of >division of labour.

labour force The total number of people in a country who are either in work
or unemployed but looking for work. According to the > International Labour
Organization, the total labour force of the more developed countries (MDCs) of
North America, Europe, Japan and Australasia was 6or million in 2000, having grown
by 6.2 per cent in the previous decade compared with a labour force of 2.3 billion
and a growth of 21 per cent in the less developed countries (LDCs). Activity rate (or
participation rate) is defined as the proportion of the labour force of a specified group
 labour, mobility of

in the total population of that group. In 2000, the activity rate for women was
44 per cent in the MDCs compared with 39 per cent in the LDCs. The labour force
is significantly younger in the LDCs where over 50 per cent is in the age-
group between r,5 and 35, compared with less than 40 per cent in the MDCs.
developing country.

Labour Force Survey (LFS) A regular public survey designed to elicit accurate
information about the state of the labour market. It is used to derive a measure of
unemployment on the basis of the International Labour Organization definition
(>ILO unemployment) in contrast to the »-claimant count measure. It counts
everyone who wishes to work, and has looked for work in the previous 4 weeks,
as unemployed, whether or not he/she is eligible for benefits. It includes many
unemployed people who live with working partners and are thus excluded from
obtaining benefit. It excludes people who are on benefits but admit to not having
looked for work in the previous 4 weeks. The net effect is that the LFS measure of
unemployment has followed the same trend as the claimant count, but is higher,
^unemployment.

labour-intensive A production technology for which relatively more labour

value is required as input per unit of output than other ^factors of production,
^capital-intensive; production function; productivity.

labour market The >-market in which wages, salaries and conditions of employ¬
ment are determined in the context of the supply of labour (>labour force) and the
demand for > labour. Most economists believe that lack of labour market flexibility
is an important cause of ^unemployment and a drag on ^economic growth. Many
factors can reduce incentives for the unemployed to move to available jobs, e.g.
deficiencies in training and education, the availability of housing and transport and
generous unemployment benefits. The >regulation of labour markets, restrictions
on temporary workers, hiring and firing and, possibly, > minimum wages, if set at a
high level, can reduce labour market flexibility. There is little direct evidence that
employers are deterred from hiring the unemployed by these 'employment protec¬
tion' measures, but various measures of labour market flexibility have been found
to be negatively correlated (>-correlation) with unemployment rates across a wide
range of countries. >Neo-classical economic analysis certainly indicates that any¬
thing that raises the cost of employment will reduce the demand for labour and
encourage J-capital-intensive methods of production. Lack of labour market flexi¬
bility could help to explain (and many economists think it mainly explains) the loss
of the growth advantage that Europe had over the US before the early r970S. Superior
USA growth since then has been made possible not by a greater productivity increase
(which has been lower than in Europe) but by higher labour utilization rates, i.e.
lower unemployment. The USA seems to have been more able to employ its low-skill
workers and this can be explained by greater labour market flexibility. »► active
labour-market policies; labour, demand for; labour, mobility of.

labour, mobility of The degree to which workers are able and willing to move
between jobs in different occupations and areas. A lack of .^labour mobility may
manifest itself in high ^frictional unemployment or high ^structural unemploy¬
ment and it has been an object of policy to encourage workers to move to areas in
which jobs are available and to take on jobs in new occupations requiring skills
labour, specialization of

different from those in which they were first trained. Policies to this end could
include: (a) a faster rate of housebuilding, making it easier for people to find homes
in different areas; (b) the removal of taxes like >stamp duty on house transfer; (c)
the provision of full information on what jobs are available and where; (d) the
provision of training courses for the unemployed, and (e) the abolition of restrictions
on entry to different jobs. In practice, it has been found that, for a multitude of
social and economic reasons, labour may be geographically and occupationally
immobile. Moreover, it is recognized that social costs could be incurred by an
itinerant population, from regional overcrowding or depopulation. These factors
have been used to justify ^subsidies to jobs in regions of high unemployment. The
Treaty of Rome of the ^European Union (EU) guarantees the free movement of
labour throughout the Union. Such movements are, however, additionally con¬
strained in Europe by the lack of a common language and it has been found that
interstate mobility in the USA is 6 times higher than intercountry mobility in the
EU. »► active labour market policies.

labour, specialization of »-division of labour.

labour theory of value lvalue, theories of.

labour turnover The number of employees who leave a firm within a year as a
percentage of the firm's total employment.

Laffer curve A graphical illustration of the argument that there exists an optimum
rate of tax at which government tax revenue is maximized. If tax rates are low,
revenues will be increased if tax rates are increased; however, if rates are raised
beyond the optimum point, the loss of incentives caused by the resultant low net
incomes discourages production and tax revenues fall. The curve is named after the
American economist Professor Arthur Laffer, who argued that the economy could
be expanded without government budget deficits. Lower taxes lead to lower prices,
higher output and, therefore, higher government revenues. This argument has yet
to find full empirical justification. >► supply-side economics.

LAFTA Latin American Free Trade Association (>Latin American Integration

Association).

Lagrange multiplier A technique, devised by the French mathematician Joseph

Louis Lagrange (1736-1813), for calculating the optimal value of a variable subject to
some constraint, in order to maximize or minimize another variable. It is a technique
pervasive in economics, where so many problems relate to the best use of scarce
resources. In demand theory (>-demand, theory of), for example, the consumer is
assumed to maximize utility subject to prevailing prices and income by choosing
the right combination of goods to buy. Firms are assumed to maximize profits
subject to the constraints of technology and the >production function by setting
their output and price at the right levels. The Lagrangian technique allows the
method of maximizing a ^function without a constraint - using >calculus to set the
derivative of the function with respect to the variable that can be controlled equal
to zero - to be used in those cases where there is a constraint. It does this by
expanding the function to be maximized - the objective function - to include the
constraint, multiplying the constraint by a new parameter - the Lagrange multiplier
- and then setting the derivatives of the new function equal to zero. For example,
suppose we wish to set X and Z at a level that maximizes Y, where the objective
function is:

Y = XxZ

and is subject to the constraint that (X + Z) is equal to ro, or:

X + Z -10 = 0

We construct a new, artificial objective function of this form:

L = X x Z + X(X + Z - io)

This is, in fact, the same as the old one, but it has had the constraint added on. It
has been added on, however, in such a way that it equals zero, if it holds. We could
just as well have subtracted it. The constraint is also multiplied by A, called the
Lagrange multiplier.
Maximizing this new objective function is the same as maximizing the old one
subject to the constraint. So we then maximize L by controlling X, Z and X in the
normal way. We set the partial derivatives of these three equal to zero and solve
them as a system of simultaneous equations. The resulting values of X and Z are the
values we want. Note that the partial derivative of the equation with respect to X is
the constraint itself, thus ensuring that it will hold when the solution is found. We
can also interpret A as the value by which the objective can be advanced for a
one-unit relaxation of the constraint. It can thus be seen as the >shadow price of
the constrained variables. In this case, the values of X and Z will each be 5, and the
value of A will be -5. ^-calculus of variations; linear programming.

LAIA > Latin American Integration Association.

laissez-faire ‘Laissez-faire, laissez-passer1 was the term originally used by the >Physi-
ocrats. They believed that only agriculture yielded wealth. Consequently, they
condemned any interference with industry by government agencies as being inap¬
propriate and harmful, except in so far as it was necessary to break up private
►monopoly. The principle of the non-intervention of government in economic
affairs was given full support by the classical economists (> classical economics),
who inherited the theme from ►Smith (Wealth of Nations, Book IV, chapter 2):

The Statesman, who should attempt to direct private people in what manner they
ought to employ their capitals, would not only load himself with a most unnecessary
attention, but assume an authority which could safely be trusted, not only to no
single person, but to no council or senate whatever, and which would nowhere be
so dangerous as in the hands of a man who had folly and presumption enough to
fancy himself fit to exercise it.

More recently, laissez-faire economics has been associated with the > Chicago
School, who not only believe in ►free-market economics, but have also promoted
the idea that some privately imposed restrictions on trade are socially efficient.
^►Manchester School; Mandeville, B. de; Sismondi, J. C. L. S. de.

land Taken to include, in economics, all ►natural resources, including the sea and
outer space. One of the ►factors of production, land is distinguished from the others
in that its supply is more or less fixed. Since the productive power of land is
Laspeyres index
Lie
conceptually distinct from that of >-capital, land is a factor of production only in its
natural, unimproved state, ^depletion theory.

Laspeyres index An >-index number whose weights (>-weighted average) are

derived from values obtaining in a base year. For example, the UK producer price
index of output in 2000 was calculated on weights reflecting the pattern of sales of
the different industries making up the index in 1995. Because the weights are constant
from one year to another, indices can be constructed to give a consistent time series.
On the other hand, the weights do get significantly out of date eventually and have
to be revised. The above index was previously based on iggo weights. A base-weighted
index formula was first published in r864 by Laspeyres (r834-i9t3). >^index-number
problem; Paasche index.

latent variables A variable in ^regression analysis that is, in principle, unmeasur¬

able. Examples of variables that might be wanted for inclusion in a >model would
be intelligence or permanent income (^permanent-income hypothesis). These can¬
not be measured directly, and have to be replaced by proxy variables.

Latin American Free Trade Association (LAFTA) > Latin American Integration
Association.

Latin American Integration Association (LAI A) The Latin American Free Trade
Association (LAFTA), which had been set up in r96o, was replaced by the LAIA
through a new treaty agreed in r98o. Under this treaty the member countries Argen¬
tina, Bolivia, Brazil, Chile, Colombia, Ecuador, Mexico, Paraguay, Peru, Uruguay
and Venezuela agreed to continue the encouragement of economic integration
through regional tariffs and other measures. The intention of the LAIA is to reduce
tariffs between member countries but on a pragmatic industry-by-industry approach,
rather than by across-the-board tariff reductions following a fixed timetable, as
attempted by LAFTA. Cuba joined the Association in r999. >^Mercosur.

Lausanne School The Chair of Economics in the Faculty of Law at Lausanne

University was founded in r8;o with ^Walras as the first incumbent. He retired in
1892 and was succeeded by »-Pareto. The school was noted for the development of a
^-general equilibrium theory.

Law, John (1671-1729) A Scottish financier who put his monetary theories into
practice in France through such institutions as the Banque Royale and the Compag-
nie des Indes. His most significant publication appeared in ^05 under the title Money
and Trade Considered, with a Proposal for Supplying the Nation with Money. He was in
favour of the replacement of specie coin by paper money (>banknote). Not only
would this save expensive precious metals, but it would enable the State to manage
the currency more effectively by making it independent of the ^market for
precious metals. Moreover, it would facilitate increasing the quantity of money in
circulation and therefore the stimulation of economic activity. )»Hume, D.; quan¬
tity theory of money.

law of comparative advantage > Ricardo, D.

'law of demand' >-demand curve.

law of diminishing returns >diminishing returns, law of.

223 | least-squares regression

law of large numbers >probability.

law of one price The law, articulated by VJevons, stating that: 'In the same open
market, at any moment, there cannot be two prices for the same kind of article.' The
reason is that, if they did exist, >arbitrage should occur until the prices converge.
M» price system.

LDC Less developed country. >developing country.

'leads and lags' The differences in timing in the settlement of >debts in >intern-
ational trade. These differences could cause a deficit or surplus for a short period in
the >balance of payments, even though the underlying trade was in balance. The
effect may be particularly acute when there is an expectation of a change in the
>exchange rate. Importing countries will delay payment to their supplying country
if it is expected that the latter's rate of exchange will fall, ^devaluation; J-curve.

lease An agreement between the owner of property (lessor) to grant use of it to

another party (lessee) for a specified period at a specified >rent payable annually,
quarterly or monthly. The rental may be subject to review, e.g. every 5 years. It is
possible to lease cars, office equipment, machinery, etc., as well as buildings or
>land, and a recent development has been the rapid growth of leasing arrangements
for business requirements. In most cases these include servicing and maintenance.
In some cases the title of the property passes to the lessee at the end of the lease for
a nominal charge. In effect, this is a form of >-hire purchase without a down
payment, and is subject to differences in tax treatment that may be advantageous.

leaseback An agreement in which the owner of property sells that property to a

person or institution and then leases it back again for an agreed period and rental.
Leaseback is often used by companies that want to free for other uses the >-capital
tied up in buildings.

least-developed countries In 3973, the General Assembly of the >United Nations

Conference on Trade and Development drew up a list of twenty-five countries
that it defined as least-developed, each having »-gross domestic product (GNP) per
capita below a minimum, (in 2000 this was $900), a share of manufacturing of
ro per cent or less of GDP, and a literacy rate of 20 per cent or less. By 2000, forty-nine
countries were classified as least-developed, of which thirty-four were in Africa, nine
in Asia, five in the Pacific and one in the Caribbean, »► convergence; developing
country; poverty.

least-squares regression A statistical technique for estimating the relationship

between a ^dependent variable and independent variables. The method derives
estimates for the parameters and constants in the equation postulated as rep¬
resenting the nature of the relationship between the variables (>model). For
example, a > demand function may take the form D = a + bP, in which D is the
quantity demanded of a good and P its price. The observed values of D and P (i.e.
how much was actually demanded at each of a number of price levels) may be
plotted on a graph, with D on the x-axis (horizontal) and P on the y-axis (perpendicu¬
lar) (called a 'scatter' diagram). We would expect in this case that the points on the
graph would be grouped such as generally to slope downwards from left to right (the
lower the price, the higher the demand). The least-squares regression finds that line
legacy costs | 224

such that the difference between the actual observations and those traced by the
line along its length is at a minimum. The slope and position of the line yields the
estimates for b and a, respectively. >**-beta; dummy variable; heteroscedasticity;
latent variable.

legacy costs The Asocial costs inherited from past economic activity. An ►enterpr-
ise might incur such costs through legislation requiring it to clean up the site of an
abandoned chemical plant or through damages awarded to users of a product that
has had unintended consequences. These are examples applying mainly to large
firms but any firm may, if it goes into voluntary ►liquidation, be left with large
costs for compensating redundant employees. Some legacy costs will have to be met
by the public sector, but in the case of an otherwise still viable enterprise they may
be an obstacle to the acquisition of the firm and the redeployment of its ^assets,
►sunk costs.

legal tender That which must be accepted in legal settlement of a money >-debt.
In the UK > Bank of England notes and £r coins are legal tender up to any amount.
Cheques and postal orders are not legal tender. >*-fiat money.

lemon problem ►adverse selection.

lender of last resort The essential function of a >central bank, in its willingness
to lend to the >banking system at all times (►bank rate). Because it can do so on its
own terms, it is this function that permits the bank: (a) to influence the level of
►rates of interest and the >money supply, and (b) to provide a basis of confidence
for the banking system, since it stands ready to lend to solvent but illiquid banks.
In the UK the >Bank of England traditionally acted as a lender of last resort only to
the ► discount houses, and would not lend to the ►commercial banks, as part of its
exercise of monetary policy (the first function). Since March 1997, the bank uses
► gilt repos as a means of influencing the interest rate structure and deals directly
with counterparties which include commercial banks. One of the motives for these
changes was to prepare the way for >European Monetary Union and it has brought
the UK into line with other countries in which the central bank deals directly with
the commercial banks.

Leontief, Wassily W. (1906-99) Born in Leningrad, Leontief obtained a post at

the University of Kiel in Germany in ^27. In r93r, he moved to Harvard and was
appointed Professor of Economics there in 1946. In 1973, he was awarded the >Nobel
Prize in Economics. His publications include Studies in the Structure of the American
Economy (1953), Input-Output Economics: collected essays (1966) and The Future of the
World Economy (1977). The interdependence of the various sectors of a country's
economy has long been appreciated by economists. The theme can be traced from
► Cantillon and >Quesnay and the >Tableau economique through ►Marx and
►Walras. The sheer complexity of the interactions and interrelationships between
the different sectors of a modern economy was a Gordian knot that had to be cut
before the theoretical structure could be translated into a practical reflection of
an actual economy and serve as the basis for policy recommendations. Leontief's
achievement was to see the solution of this problem in ►matrix algebra, and modern
computers have made ►input-output analysis a practical proposition. His book The
Structure of the American Economy, 1919-1929 was first published in r94r, and a second
 liabilities

edition, 1919-1939, appeared in 1951. He attempted, with the limited statistical facts
available to him, to establish in these studies a tableau economique (^Physiocrats) of
the USA. The economy was described as an integrated system of flows or transfers
from each activity of production, Consumption or distribution to each other
activity. Each sector absorbs the outputs from other sectors and itself produces
Commodities or Cervices that are in turn used up by other sectors, either for
further processing or for final consumption. All these flows or transfers were set out
in a rectangular table - an input-output matrix. The way in which the outputs of
any industry spread out through the rest of the economy could be seen from the
elements making up the rows. Similarly, the origins of its >-inputs could be seen
directly from the elements of the appropriate column. Given such a structure, the
implications of a specific change in one part of the economy could be traced through
to all the elements in the system. >► social accounting.

Lerner, Abba Ptachya (1903-82) >Marshall-Lerner criterion.

less-developed countries (LDCs) >-developing country; least-developed coun¬

tries.

letter of credit A non-negotiable order from a bank to a bank abroad authorizing

payment to a person named in the letter of a particular sum of s^money or up to a
limit of a certain sum. Letters of Credit are often required by exporters who wish
to have proof that they will be paid before they ship goods, or who wish to minimize
delay in payment for the goods. Letters of credit, unlike >bills of exchange, are not
negotiable, but being cashable at a known bank, are immediately acceptable to the
seller in the exporting country. A confirmed letter of credit is one that has been
recognized by the paying bank. Letters of credit may be irredeemable or revocable,
depending on whether or not they can be cancelled at any time.

leverage s-gearing.

Lewis, Sir William Arthur (1915-91) Professor Lewis was born in St Lucia in the
Caribbean. He received his university education at the London School of Economics
and the University of Manchester. He was appointed to a Chair of Economics at
Manchester University in 1948 where he remained until he took up the post of
Principal of the University College of the West Indies in 1959. He was subsequently
appointed Professor of Public and International Affairs at Princeton University in
r963- Professor Lewis was awarded (jointly with >Schultz) the >Nobel Prize for
Economics in 1979. His published works include Overhead Costs (1949), Economic
Survey, 1918-1939 (1949), The Principles of Economic Planning (1950), The Theory of
Economic Growth (1955), Development Planning (1966), Some Aspects of Economic Develop¬
ment (1969), Tropical Development, 1880-1913 (1971), The Evolution of the International
Economic Order (1977) and Growth and Fluctuations, 1870-1913 (1978). Professor Lewis
made fundamental contributions to the theory and application of economics in
the context of the problems of the growth of developing countries. Developing
countries were characterized by dual economies of urban growth centres within
large areas of traditional agriculture in which the latter was the source of a supply of
labour that kept urban wages low. Wages remained low until urban industrialization
had absorbed the surplus labour from the agricultural sector.

liabilities Sums of >money for which account has to be made. The liabilities of a
life-cycle hypothesis | 226

company include its ►bank loans and ►overdraft, short-term >debts for goods
and ►services received (current liabilities) and its Moan capital and the ^capital
subscribed by shareholders, imbalance sheet.

life-cycle hypothesis A theory that suggests that consumers during their lifetime
will save when their income is high and spend more than they earn when their
income is low. In this way, they smooth their consumption flow, despite the fact
that income varies over a lifetime. The theory, attributable to ►Modigliani, comple¬
ments the ►permanent-income hypothesis, ^consumption function; product
life-cycle.

life expectancy ►death rate; human development index.

LIFFE >London International Financial Futures Exchange.

limited liability The restriction of an owner's loss in a business to the amount of

►capital that he has invested in it. If a limited public company is put into ►liquid¬
ation because it is unable to pay its >debts, for example, the individual shareholders
are liable only for the nominal >value of the ►shares they hold (unless they
have provided personal guarantees to the bank or other ►creditors). Before the
principle of limited liability was recognized, investors could be made liable for the
whole of their personal possessions in the event of ►insolvency. The extension of
limited liability to private as well as public companies that wished to register for it
in the second half of the nineteenth century greatly increased the flow of capital,
and today the limited liability company is the predominant form of business
organization. There are also limited liability >partnerships. ^company law.

linear expenditure system ► Stone, Sir J. R.

linear programming A mathematical technique for the solution of problems in

which a maximum or minimum of a function is to be determined, subject to a set
of constraints. Examples of such problems are:

(x) Stocks of a commodity are located at a number of ports and need to be shipped
to meet a demand for specific quantities at a number of other ports. The cost per
tonne for shipping differs between the various ports of loading and discharge.
The problem is to find the minimum cost of shipment, subject to the constraints
that no more than the stock available can be loaded at a port and the total amount
discharged at a port should equal the demand at that port.
(2) A firm able to produce a range of commodities, each of which would require a
different mix of inputs (►factors of production). Given the selling prices of the
commodities and the costs per unit of the various inputs, the firm chooses the
mix of output which maximizes profits, subject to the technical constraints of its
►production function and restrictions on the availability of the different inputs.

As its name implies, the technique is applicable only to problems in which all the
relationships are linear (►linear relationship). In problems of resource allocation of
the firm and the economy as a whole (►input-output analysis), linear programming
is also synonymous with activity analysis.

linear relationship A mathematical >function that traces a straight line on a

graph. The >independent variables, of which there may be one or more, are additive.
The simplest example is y = ax + b, in which x is the independent variable, a and b
227 | liquidity ratio

are constants. These functions are such that any given absolute increase in an
independent variable (e.g. x), will give an absolute increase in the ^dependent
variable (e.g. y), which will always be the same whatever the size of x on which it
is based. Many non-linear relationships can be transformed into linear ones by
converting the values of the variables into logarithmic form.

liquid In economics, the description of an >asset which can easily be converted

into > money. In practice, it applies to Pcash or anything that can be quickly
converted into cash at little loss. Assets are said to possess degrees of P liquidity that
are their nearness to cash. Highly liquid assets other than cash and bank deposits
are Post Office Psavings, P treasury bills, Pmoney at call ^liquidity preference.

liquidation The termination, dissolution or winding-up of a limited company

(Plimited liability). Liquidation of a company may be initiated by the shareholders,
the directors (voluntary liquidation) or by its creditors, or by a court order if the
company is insolvent (^insolvency). Where initiated by the creditors, a liquidator
is appointed to realize the company's bassets and to pay the creditors. In case of
insolvency, these functions are performed, initially at least, by the Official Receiver.
If the company is solvent, the ordinary shareholders will receive any surplus after
the company's liabilities have been met. ^bankruptcy.

liquidity 1 The degree to which an Passet can be quickly and cheaply turned into
Pmoney that, by definition, is completely liquid. A Pcurrent account bank deposit
is a liquid asset because it can be withdrawn immediately at little cost; an office
building, by contrast, will take a considerable time to dispose of and estate agent's
fees and other costs will be incurred. A company or individual is said to be liquid if
a high proportion of its or his/her assets are held in the form of cash or readily
marketable securities. 2 international liquidity consists of the total of Pgold and
foreign-exchange reserves and Pspecial drawing rights of all countries.

liquidity preference The desire to hold Pmoney rather than other forms of
Pwealth, e.g. Pstocks and Pbonds. It can be thought of as stemming from the
P transactions motive, »>-speculative motive and ^-precautionary motive for holding
money, and so will be influenced by the levels of income and wealth, >-rates of
interest, ^expectations and the institutional features of the economy. A high degree
of liquidity preference implies that a given supply of money flows relatively slowly
through the economy, resulting in a low ^velocity of circulation. >P Keynes, J. M.

liquidity ratio 1 The proportion of the total Passets of a bank which are held in
the form of Pcash and iiquid assets. These assets consist, in general, of money lent
out to the Pmoney market at call and short notice, short-term Pbonds issued by
the government and other borrowers and balances at the PBank of England. There
is no longer a mandatory liquidity ratio, although all larger banks are now required
to deposit 0.45 per cent of eligible liabilities with the Bank of England. This cash-ratio
deposit earns no interest and is effectively a tax to provide income for the bank - it
has no significance for credit control or »-monetary policy. The Bank of England
now monitors the adequacy of liquidity and its composition for each, but does not
make public what it regards as satisfactory liquidity ratios (^-capital adequacy).
2 The ratio of liquid assets to the current Pliabilities of a business. Also called the
Pcash ratio, it is a very crude test of solvency.
liquidity trap

liquidity trap A situation in which the >rate of interest is so low that no one
wants to hold interest-bearing assets (i.e. ►bonds) and people only want to hold
cash. The interest rate can fall far enough for everybody to expect it to rise. Bond
prices fall when interest rates rise and, because no one wants to hold an asset whose
price will fall, everyone will hold cash rather than bonds. In this situation, the
interest rate can fall no further - >-liquidity preference is absolute. If the government
expands the money supply, instead of the usual fall in interest rates occurring, there
is no effect at all. There is no need for the interest rate to drop to entice people to
hold the extra cash available. Although best described in terms of the simplifying
assumptions of the MS-LM model, the liquidity trap can also be applied to a world
in which wealth is stored in forms other than merely cash or bonds. It was first
described by > Keynes as an example of a case where, at least theoretically, changes in
the money supply did not affect ► aggregate demand. >► transmission mechanism.

listed company A company, the shares of which are listed on the main market of
the ► stock exchange.

listed security A ►security listed and tradable on the ►stock exchange,

^quotation.

Lloyd's An incorporated society of private insurers established by Act of Parliament

in i87t. Capital has traditionally been provided by a large number of individual
members or 'names', organized into syndicates, each led by a full-time underwriter
(►underwriting) who writes policies on behalf of the members, each of whom bears
unlimited liability. As a result of severe losses incurred in 1989-91 the number of
syndicates has fallen and most of Lloyd's insurance capacity is supported by corpor¬
ate capital. Clients are dealt with through >-brokers. The Lloyd's insurance market
deals with almost any kind of insurance but has traditionally specialized in the
marine market and provides a comprehensive system of shipping intelligence.

loan The borrowing of a sum of ► money by one person, company, government or

other organization from another. Loans may be secured or unsecured (►securities),
►interest-bearing or interest-free, long-term or short-term, redeemable or irredeem¬
able. Loans may be made by individuals and companies, banks, ► insurance and
► hire-purchase companies, >building societies and other ►financial intermedi¬
aries, >pawnbrokers, or by the issue of >securities. >^bank loan; finance; term
loans.

loan capital Fixed-interest borrowed funds. Alternative term for >debentures.

loan guarantee scheme ►credit guarantee,

loan stock Synonym for >debenture.

loanable funds Money available for lending in financial markets. It consists of

current ►saving, ►dishoarding and any increase in the ►money supply, e.g. credit
creation by the banks. The loanable funds theory holds that the rate of interest (like
any other ►price) is determined by the supply and demand for loanable funds in
the capital market. This theory has its origins in classical theory (►interest, classical
theory of) but was developed by ►Wicksell.

local taxation >Taxation levied by (or for) local rather than central government.
The design of local tax systems is not straightforward. ►Income tax is not easy to
229 location theory

administer, at least in small jurisdictions where people may work and live separately.
In any event, in the UK at least, governments have been reluctant to let local
authorities determine a variable as important as the basic rate of income tax. Corpor¬
ate taxes do not work well at all, given the extensive nature of most large companies.
>Sales taxes fail, in that varying rates of tax encourage cross-boundary shopping,
and distort trade. As a result, in the UK, local taxes have for the most part been
property taxes - with the advantage that at least property can't move between
jurisdictions. Until r9$>o, domestic rates were proportional to the estimated rentable
value of business and domestic properties (though not farms, which were exempt).
They were criticized as being unrelated to income, and there were many anomalies
in the valuations that had not, in any case, been re-estimated since r973. In 1990 (in
England, earlier in Scotland) rates were replaced by the community charge, a flat-rate
tax levied on all adults, with some exemptions and rebates for those with limited
means. This tax, the poll tax (>lump-sum tax) required costly compilation of new
registers of residents and massive changes to billing systems, since under rates
there was only one bill to each household while under the new system all eligible
individuals had to be billed separately. The new tax aroused such widespread hostil¬
ity that in 1992 the government reverted to property tax with the council tax. The
council tax is levied on occupants of dwellings valued in one of eight bands at rates
set by local councils. Non-domestic rates are based on estimated rentable value and
set by the government on a uniform basis. Local government finance still has
two major problems, however. The varying nature of property prices in different
authorities means that central government subsidy to poorer authorities is necessary
to equalize the effective tax base. At the same time, even in the rich authorities, as
government has been reluctant to see council taxes rise to very high levels, a
substantial proportion of local authority spending has to be financed nationally.
This undermines the relationship and accountability that should exist between
voters and their local politicians.
Internationally there are greater differences in the forms of local than national
taxation. In the USA the states levy a >► sales tax. In France, the principal local tax
on business is based on the rentable value of buildings and equipment but also
includes a ^payroll tax. In Germany, regional government levies local business
profits, assets and property taxes.

location theory The area of economics concerned with the factors that determine
where producers choose to locate and the effects of the location of a piece of land
on the use made of it. The starting-point of this area of theory was developed by
>Thiinen in T826. Thunen held that farmers near a market would tend to grow
things that would be relatively expensive to transport, while those further away
from towns would produce lighter items that were cheap to carry. Thus, the location
of land would have a significant effect on the >economic rent that could be derived
from it. A second important theory, of industrial location, attributable to Weber,
established that firms producing goods less bulky than the raw materials used in
their production would settle close to the raw-material source. Firms producing
heavier goods would settle near their market. The firm minimizes the weight it has
to transport and, thus, its transport costs. These two theories primarily treated
transport costs as the main factor in influencing location. However, many other
factors have been identified as having an important role:
logistic curve 2 BO

(1) Being able to capture monopoly power in the local market.

(2) The possibility of gaining external ^economies of scale, by settling in an area
where firms requiring similar inputs have settled.
(3) The influence of non-profit-maximizing behaviour - notably the ^behavioural
theory of the firm - suggests that location could be dependent on where a firm’s
management considers it pleasant to live.
(4) The possibility of attracting public assistance in the form of grants or subsidies
paid out as part of a country's regional policy.
(5) The influence of local taxation and provision of >public goods. An area that
has good roads, efficient refuse collection or low business taxation will be more
attractive than a high-tax or low-service area. Firms will choose the combination
of service provision and taxation that most suits their needs. Those producing a lot
of refuse will perhaps value refuse-collection services more highly than low taxes,
while the reverse might be true for a firm requiring no refuse collection at all.
(6) The location and cost of labour. Because workers are geographically quite immo¬
bile - especially across international borders on account of, for example, immi¬
gration controls - wages are not equal across countries. This makes it attractive
for some labour-intensive firms to settle in areas in which wages are low. This
has particularly manifested itself in the high investment that has occurred in
South-East Asia. >labour, mobility of.
(7) Other international influences. Political and social factors have a particularly
strong effect on the expectations multinational firms have as to the profits they
can make. Local tariff regimes can also induce firms to produce domestically
where otherwise they would be unable to sell in the local market at all. >globali-
zation; multinational corporation.

logistic curve A curve traced on a graph by the function, y = a/(i + be-**), in which
a, b and care constants (^parameters), x = >independent variable, e = approximately
2.7T828, which is a constant with many applications in the analysis of growth (e can

0 x
231 | long rate

be defined as follows: if £i were invested at ioo per cent per annum, its worth at
the end of the year would get closer and closer to £e, the more frequently interest
was added and compounded (Vcompound interest) for shorter and shorter
periods during the year). The logistic function takes the following values: if x = o,
y = a/(i + b); if x —> + °c, y a; and if x —» - °c, y o; as can be seen by substituting
these values in the above equation. The curve is illustrated above. It is often used to
describe the sales growth of a new product - an initial learning period when sales
are low, rising rapidly as sales spread through the population and then slowing
down as new demand for the product reaches Saturation point.

log-normal distribution A ►frequency distribution that is skewed towards the

higher values of the independent variable, as in an income distribution, which
is transformed into a ► normal distribution when the independent variable is con¬
verted into logarithms.

Lome Convention A convention signed in 3975 at Lome, the capital of Togo, by

the members of the then European Economic Community (EEC) (►European
Union) and forty-six ►developing countries in Africa, the Caribbean and the Pacific
(ACP) states. Under the Lome Convention, all ACP industrial exports, and most
agricultural exports, to the EEC were free of duty. Financial and technical aid was
also agreed upon, and the European Development Fund was set up by the EEC to
administer and channel aid funds to the Lome countries. In 3979, a second agreement
was signed, a third in 3984 and the fourth in 1990. The Lome IV agreement was for a
period of ro years and in 2000 was replaced by the ►Cotonou Agreement.

London inter-bank offered rate (LIBOR) >interbank market.

London International Financial Futures Exchange (LIFFE) A ►market to

trade in financial >futures and ►options. Set up on 30 September 1982. Futures
traded include an equity index contract based on the FT/SE100 Share Index (►Finan¬
cial Times stock indices). In 2003, LIFFE introduced futures in single stocks and made
an arrangement to Emerge with Euronext.

London Stock Exchange ►stock exchange.

long-dated securities ►dated securities.

long-end of the market That part of the market for >bonds that is concerned
with dealings in long-term issues.
Longfield, Samuel Mountifort (1802-84) An Irish lawyer who became the first
incumbent of the Chair of Political Economy at Trinity College, Dublin. His most
important work in economics was Lectures on Political Economy, which was published
in 3834. He argued convincingly against the labour theory of value (►value, theories
of) and developed a marginal revenue productivity theory (> marginal revenue
product) of ►labour and >capital. Some of his ideas on capital and ►interest
foreshadowed the work of the ►Austrian School.

long rate The Xrate of interest on long-term ►bonds. Because purchasers of bonds
take a risk that ►inflation may erode the value of their investment over a long time
period, the market rate that is observed is often held to be a good indicator of
inflationary expectations. Long rates tend to drop when the authorities gain
►credibility, and appear to be more committed to low inflation.
long run
Lff
long run A period of time in which all variables are able to settle at their equilibrium
or final disequilibrium levels and all economic processes have time to work in full.
Its most common application is in the theory of the firm (►firm, theory of the), in
which it is the period of time in which the quantities of all ► factors of production
employed are allowed to vary and all entry and exit that can occur into or from an
industry has occurred. The duration of the 'long term' will clearly vary with the
context in which the term is applied, depending on the speed with which the
variables spoken of change. >**-short run.

long-term capital > business finance.

long-term unemployment Joblessness for a period in excess of 6 months, a year

or 2 years. There has been increasing concern that long-term unemployment is a
different problem from that of unemployment generally. It has a self-reinforcing
character - the longer a period of unemployment, the harder it is to find work. This
may be explained by demotivation on the part of the unemployed, or by lack of
trust on the part of potential employers. The existence of long-term unemployment
may be associated with the protection afforded by the benefit system, particularly
the indefinite persistence of unconditional benefits. Policymakers have started to
give increasing attention to >active labour-market policies. These concentrate on
ensuring the unemployed are trained and motivated and may involve a temporary
employment subsidy. Long-term unemployment is usually a form of >structural
unemployment. >► hysteresis; insider-outsider theory.

Lorenz curve A graphical representation showing the degree of inequality of a

►frequency distribution in which the cumulative percentages of a population (e.g.
 lump-of-labour fallacy

taxpayers, firms) are plotted against the cumulative percentage of the variable under
study, e.g. incomes, employment. A straight line rising at an angle of 45° from the
start on the graph will indicate perfect equality, e.g. if 10 per cent of firms employ
ro per cent of the total labour force, 20 per cent of firms employ 20 per cent of the
total labour force and so on (►linear relationship). However, if there are a large
number of small firms that employ few people and a small number of large firms
employing many people, the distribution will be unequal. When such a distribution
is plotted, a curve will be traced below the 450 line (see diagram) and the degree of
curvature will be greater the greater the inequality (►►gini coefficient).

Lucas, Robert E. (b. 1937) An economist from the University of Chicago, Lucas
probably had more influence than anyone else in the 1970s on research in > macroe¬
conomics. He was the man who took »-rational expectations, first devised as an
assumption by Muth in 1961, and investigated their rich implications for economic
policy. He also did more to promote the rational expectations hypothesis than
anyone else. His name was put to the > Lucas critique, the argument that relation¬
ships that appeared to characterize the fundamental features of an economy could
not be relied upon to last, were policy to change. In particular, the Phillips curve
(►Phillips, A. W. H.) would break down as soon as one attempted to exploit that
apparent trade-off between inflation and unemployment. It is now virtually taken
for granted that in assessing a change in policy, the authorities must take into
account any change in expectations and behaviour consequent upon the policy
change. For these contributions, Lucas won the >Nobel Prize for Economics in 1995.
►policy ineffectiveness theorem; new classical economics.

Lucas critique An argument put forward by ►Lucas in the 1970s that economists
were mistakenly assuming that relationships they observed to hold would continue
to hold even when conditions changed. The critique was an important component of
the move towards accepting ^rational expectations as a significant development in
► macroeconomics. In essence, Lucas argued that, although economic agents may act
in a certain way, you should not assume that they would continue to act in that way if
you changed economic policy. For example, if consumers believed that inflation was to
be 5 per cent next year, they might only demand 5 per cent wage increases. But suppose
that a government, failing to understand the Lucas critique, expands the money supply,
causing inflation to be ro per cent in the hope that this would cut the ►real income of
consumers and make it cheaper for firms to employ new staff to make higher-priced
goods. This would increase output by effectively exploiting people's expectation that
inflation would be 5 per cent and cutting their real wage. Lucas claimed that such
policies may work once or twice, but that if a government tried to exploit via such
corporations, people would come to anticipate the ro per cent inflation and set their
wage demands accordingly. Thus, the expansionist policy would not work at all.
Exploiting the trade-off between unemployment and inflation is rather like employers
getting 2 minutes' of extra work out of employees by setting the clocks 2 minutes slow
and fooling them into staying a little longer than they wanted to stay. Observing that
the workers do work more when the clocks are slow would not imply at all that, by
setting the clocks 10 minutes, or an hour slow, you would get 10 minutes or an hour of
additional work from them. »^new classical economics.

lump-of-labour fallacy Advocates of a statutory maximum of hours that a worker

lump-sum tax

can work in order to reduce ^unemployment imply the belief that there is a limited,
fixed, amount of work available to spread among the >Tabour force. Similar is the
argument against the introduction of innovative production methods in that these
displace labour and therefore increase unemployment. It is a fallacy because there
is always work to be done, and increases in ^productivity through innovation
increase opportunities for workers through the generation of higher incomes.

lump-sum tax A tax that must be paid irrespective of the behaviour of an economic
agent, e.g. a tax of £roo on blue-eyed people that bore no relation to their income
or spending. While usually considered impractical on political grounds, economists
see lump-sum taxes as efficient in that they do not have any tendency to affect the
incentives of individuals to work, save, purchase goods or services, etc. These are all
things that other taxes will necessarily distort, ^fiscal neutrality; local taxation;
marginal tax rate.
 M

Maastricht Treaty Treaty signed in Maastricht, The Netherlands, in February

1992, more formally entitled Treaty on European Union. The Maastricht Treaty was
simply a large package of amendments to the Treaty of Rome, with the effect of
creating the >European Union (EU), out of the European Economic Community; it
plotted the path towards ►European Monetary Union, it enshrined for the first time
the principle of ►subsidiarity into the EU's affairs and contained the >Social
Charter. It also built the foundations of intergovernmental co-operation on foreign
policy, and on certain domestic policy matters.

Macmillan Committee The Committee on Finance and Industry, set up in 1929,

that published its report in i93r. It was under the chairmanship of Lord Macmillan,
and > Keynes was a member. The committee carried out its task against an economic
background in which the ►gross domestic product had reached, after 16 years, only
5 per cent above the prewar level. Unemployment was 10 per cent in 1929, and was
to rise to over 20 per cent by the time the committee published its report. The
committee took the evidence from many leading economists of the day on the
subject of ►unemployment policy (►Classical School). It decided in favour of the
so-called ^Treasury view that expenditure on public works was not the answer, in
spite of the signing of Addendum I by some of its leading members who advocated
a programme of public works and >-import restrictions. However, the committee
insisted that monetary policy should be concerned with 'the maintenance of the
parity of the foreign exchanges before the avoidance of the credit cycle and the
stability of the price level'. The maintenance of the »-exchange rate was agreed to
be the first priority by all, including the signatories of Addendum I. (Two months
after the report was published, the UK came off the ►gold standard and the exchange
rate depreciated immediately by 2 per cent and continued downwards for 12 months.)
The committee expressed concern that small companies found it difficult to raise
long-term capital (Ebusiness finance) by the usual means of placing issues through
the Mssuing houses; this has become known as the Macmillan Gap. It recommended
the setting up of an institution that would 'provide adequate machinery for raising
long-dated capital in amounts not sufficiently large for a public issue, i.e. amounts
ranging from small sums up to say £200,000 or more'. This recommendation was
eventually met in r945, when the > clearing banks and Scottish banks with the
support of the >Bank of England combined to finance the creation of the Industrial
and Commercial Finance Corporation. There remain concerns about the availability
of finance for small business, but improved sources of bank finance, >risk capital
Macmillan Cap

and the development of >-unlisted securities markets have largely closed the
Macmillan Gap. >^new issue market; Radcliffe Report.

Macmillan Cap ►Macmillan Committee.

macroeconomics The study of whole economic systems aggregating over the

functioning of individual economic units. It is primarily concerned with ►variables
that follow systematic and predictable paths of behaviour and can be analysed
independently of the decisions of the many agents who determine their level. More
specifically, it is a study of national economies and the determination of ►national
income. It focuses on sectors of the economy - not those that function as separate
units like the 'car-production sector' - but those that run across the entire economy:
the industrial, personal, financial, government and overseas sectors. In classical
macroeconomics (^-classical economics) lay a presumption of the efficiency and
effectiveness of free markets, and all macroeconomic variables were seen as the sum
of the variables as they applied to individual firms or consumers. Macroeconomic
mechanisms were largely embedded in the theory of ►microeconomics. Since
►Keynes, however, economists have allowed for ►disequilibrium in macroecon¬
omic variables as such, and therefore collective outcomes distinct from those implied
by individual behaviour (>► paradox of thrift).
The main topics covered by macroeconomics are: (a) the determination of national
income (^income determination, theory of), prices (^inflation) and ►employ-
ment; (b) the role of ►fiscal and ►monetary policy, analysed through different
> models, each containing its own assumptions and emphasis; (c) the determination
of >consumption and ► investment; (d) the ►balance of payments, and (e) ►econ¬
omic growth. In recent years, the tendency in academic economics has been for
macroeconomic models to be laid on >microeconomic foundations, ►►circular
flow of income; economic doctrines; information, economics of.

mainstream corporation tax >corporation tax.

Malthus, Thomas Robert (1766-1834) Educated at St John's College, Cambridge,

Malthus became a Fellow there after studying mathematics and philosophy. He was
ordained and became a country parson. He was subsequently Professor of History
and Political Economy at the East India Company's Haileybury College. His Essay
on the Principle ofPopulation as It Affects the Future Improvement of Society was published
in r798, with a revised edition in r8o3. His other works include An Inquiry into the
Nature and Progress of Rent H815), The Poor Law (1817), Principles of Political Economy
(r82o) and Definitions of Political Economy (1827).
Malthus is remembered for his essays on >population. Population had a natural
growth rate described by a ►geometric progression, whereas the natural resources
necessary to support the population grew at a rate similar to an ►arithmetic pro¬
gression. Without restraints, therefore, there would be a continued pressure on
living standards, both in terms of room and of output. He advocated moral restraint
on the size of families. Malthus also carried on a long argument with >Ricardo
against Say's law (>Say, J.-B.). Briefly, Say's law stated that there could be no general
overproduction or underproduction of ►commodities on the ground that whatever
was bought by somebody must have been sold by somebody else. (►Keynes found
some affinity between Malthus' conclusions and his own in his General Theory of
Employment, Interest and Money (r936).) Malthus, however, was arguing strictly within
 management accountancy

the basic assumption of the equality of planned >savings and ^investment in

^classical economics, and was a long way away from Keynes' revolutionary assump¬
tion that they are made equal only by movements in total > income. Saving to
Malthus was investment. His argument for under-consumption was simply that an
increase in savings necessarily diminished consumption on the one hand, and on
the other increased the output of consumer goods through increased investment.
At the same time, because the >labour supply was inelastic (^elasticity), wages rose
and, therefore, so did costs. >*-Sismondi, J. C. L. S. de.

Malynes, Gerald (1586-1641) An English merchant and government official and a

leading exponent of ^mercantilism. His publications include A Treatise of the Canker
of England's Commonwealth (r6or), Saint George for England, Allegorically Described
(r6or), England's View in the Unmasking of Two Paradoxes (1603), The Maintenance of
Free Trade (1622) and The Centre of the Circle of Commerce (1623). He showed how an
outflow of precious metals could lead to a fall in prices at home and a rise in prices
abroad. This was an important clarification of the economic thought of the time.
He suggested that higher import ^tariffs should be levied and >-exports of >-bullion
prohibited, because he believed that a country's growth was related to the accumula¬
tion of precious metals. He thought that »-exchange control should be used to
improve the UK >-terms of trade, supporting his policy on the belief that the UK's
exports were price inelastic (>elasticity), ^quantity theory of money.

managed bond >bond.

managed currency A ^currency is said to be managed if the >exchange rate is

not determined by >-free-market forces, i.e. if government influences the rate by
buying and selling its own >^money or by other means. Most currencies are managed
in some sense today, even when they are allowed to float, ^exchange control;
International Monetary Fund.

managed trade ^-protection.

management accountancy Business accounting practice concerned with the

provision of information to management for policymaking purposes, as opposed to
financial accounting. Management accountancy techniques have developed con¬
siderably since the nineteenth century, when firms had few locations and products.
Modern multinational enterprises may have hundreds of profit centres in which
managers have operational discretion and are evaluated on the basis of their financial
results. Not only are financial accounts produced for these centres, but also, for
example, return on investment (>rate of return), used for the purpose of allocating
capital between them. These large enterprises may have thousands of cost centres
that are established where output and related inputs can be measured. In cost
accounting for these centres, costs are related to outputs for the purposes of pricing,
departmental budgeting and the control of production methods, material and
labour usage.
Some costs vary with output (e.g. material or labour costs), while others (e.g.
overheads) do not. Overheads may be allocated to outputs using the measures of
standard costing or absorption costing, where unit overheads are costed at levels that
will cover total overhead costs at budgeted output by means of, for example, percent¬
ages of direct labour cost. In activity-based costing, more sophisticated methods are
management buy-in

used to allocate overheads in a way that reflects cost-drivers. For example, the cost
of the after-sales service overhead is allocated to products according to the number
of guarantee claims received or the number of sales-engineer-related visits in connec¬
tion with the product in question.
Management accountancy may be concerned simply with the production of
management accounts prepared on a more frequent basis (e.g. quarterly) than
financial accounts and show gross profits for profit centres, i.e. their contribution to
overheads and the overall financial result for the enterprise after overheads. Or
management accounts may be very similar to the audited financial results, with
adjustments for >depreciation, >work in progress, foreign exchange gains and
losses, etc. With modern information technology and full data capture throughout
the organization it should be possible to produce management accounts at shorter
intervals - indeed, one large IT company claims to produce them on a daily basis!

management buy-in ►management buy-out.

management buy-out (M BO) The acquisition of all or part of the >equity capital
of a company by its directors and senior executives, usually with the assistance of a
financial institution (>risk capital). Competitive pressures upon large companies in
the r98os led to the disposal of many weak or peripheral subsidiaries in this way. In
a management buy-in an outside team of managers acquires a company in the same
way. In a >BIMBO, some existing management is retained. Developing in the early
1970s in the USA, buy-outs were virtually unknown in the UK before 1980 but have
developed greatly since then.

Manchester School 'Manchesterism' was an epithet applied in Germany to those

who subscribed to a political-economic philosophy of >laissez-faire. It was applied,
in particular, to the movement in England from T820 to 1850 which was inspired by
the propaganda of the Anti-Corn Law League. This was headed by Cobden and
Bright, and supported by the economics of ►Ricardo. The 'school' believed in
► free trade and political and economic freedom with the minimum of government
restraint.

Mandeville, Bernard de (1670-1733) Born at Dort in Holland, Mandeville

obtained an MD at Leyden and established himself in London as a general prac¬
titioner. In 1705, he published a poem called The Grumbling Hive, which was reissued
in 1714 and 1729 under the title of The Fable of the Bees or Private Vices, Public Benefits.
In this pamphlet he showed how, although individuals indulge in unholy vices in
their private behaviour, nevertheless in the aggregate they contributed to the public
good and therefore could be excused. ►Smith was severely critical of the satirical
nature of the work (►'invisible hand').

marginal analysis The study of >variables in terms of the effects that would
occur if they were changed by a small amount. For example, rather than analyse
whether or not it is in the interest of an individual to spend money on food at all,
attention can sensibly be focused on whether or not welfare could be enhanced by
spending slightly more or less on food. Nothing better demonstrates the concept
than the paradox of value: although water is more necessary to man than diamonds,
it has a much lower price. This is because man usually has so much of it that extra
water is worthless. This is not true of diamonds ( W#-marginal utility). The marginal
 marginal efficiency of investment

value of a variable is equivalent to its rate of change or, mathematically, its first
derivative. For example, a firm's sales revenue rises as sales increase and this can be
plotted on a graph as total revenue. By taking the gradient of the total revenue curve,
>-marginal revenue can be derived, depicting how much extra revenue is gained,
from an extra sale, at each different level of total sales. If the marginal revenue is
plotted on a graph, total revenue can be derived by finding the area under the
marginal-revenue curve up to a given level of sales. The marginal value of a variable
lies below the average value of that variable if the average is falling. The marginal
value lies above it if the average is rising.
The margin is important in economics as it is the impact of small changes in
variables rather than their level per se that determines whether rational economic
agents change them. It is the average level of utility, costs or revenues that tends to
determine whether things are consumed or produced at all, but the marginal
utility, costs or revenues that determine how much is consumed or produced once
a decision to do so at all has been taken. »S»*-Gossen, H. H.; Jevons, W. S.; marginal
cost; marginal-cost pricing; marginal product; Menger, C.; Thunen, J. H. von;
Walras, M. E. L.

marginal cost The increase in the total costs of a firm caused by increasing its
output by one extra unit. If all costs are fixed, the marginal cost of the first unit of
output will be very high, but all subsequent units can be made for nothing. Econom¬
ists normally assume firms to be producing at a point at which marginal costs are
positive and rising. ►►firm, theory of the.

marginal-cost pricing The setting of the price of an item equal to the cost of
producing one extra unit of the item. >-Marginal cost represents the >opportunity
cost, or the total sacrifice to society from producing an item. The price represents
the cost to consumers of buying a unit of it, and they will ensure therefore that they
will buy it if and only if they value it at least as much as the money it sells for. If
price is below marginal cost consumers will be happy to buy an item even if they
perhaps value it less than the goods that could have been made if it had not been
produced. If, on the other hand, price is greater than marginal cost, some consumers
who value the item more than it costs to make will still be deterred from buying it.
For an efficient allocation of >resources (^economic efficiency), therefore, mar¬
ginal-cost pricing is considered essential.
There are, however, factors that undermine the case for marginal-cost pricing.
Primarily, any company enjoying >economies of scale will have average costs in
excess of marginal costs (^marginal analysis), and with marginal-cost pricing, aver¬
age costs will exceed price. A company in such a position will therefore make a loss.
Only if production is at a point at which marginal and average costs are equal,
will marginal-cost pricing be sustainable. Marginal-cost pricing provides a major
advantage of >perfect competition over ►monopoly or ►monopolistic compe¬
tition, and attempts to impose it on firms outside competitive markets - especially
►nationalized industries - have been made, with limited success. ►►Hotelling, H.;
peak pricing.

marginal efficiency of capital ► internal rate of return,

marginal efficiency of investment ►internal rate of return.

marginal product

marginal product The output created by the employment of one additional unit
of a ► factor of production. In general, it is believed that the marginal product of a
factor rises when the factor is employed in small quantities, but eventually falls as
the amount of the factor employed increases. Marginal product is measured in the
physical units of the output produced and it is thus sometimes called marginal
physical product, ^diminishing returns, law of.

marginal product of labour The output created by the employment of one extra
worker with all other >-factors of production held constant. It is a measure of the
physical increase in output that occurs in a firm or in the economy as a whole when
one extra person starts work. It is generally assumed that the marginal product of
>labour rises initially, and then diminishes. In a hypothetical factory manned by a
single worker, adding helpers would allow at first for specialization and the ^division
of labour. Eventually, however, all such gains would be realized and the gains from
employing additional staff would diminish, ^-diminishing returns, law of.

marginal productivity of capital The value of the output that would be created
by the employment of one extra unit of capital. As a major part of the cost of capital
is the interest that has to be paid to buy the capital, the marginal productivity of
capital can be measured by the >internal rate of return, the interest rate at which
the marginal productivity has a > present value of zero.

marginal productivity theory of wages The doctrine that the demand for
labour is determined by the value of the output created by the employment of an
extra worker. In this account of the determination of wages, firms employ workers
as long as the revenue generated by the output of the marginal worker exceeds the
cost of that worker, i.e. until the worker's ^marginal revenue product is equal to
the market wage rate. From this account of a firm's behaviour, a curve depicting
the demand for labour at different wage levels can be derived, and the wage rate
determined by the interaction of this curve with that of the supply of labour at
different wage levels. As more workers are employed at a given level of capital stock,
the ^marginal product of labour will decline and the wage of all workers will fall
^diminishing returns, law of). This fall in wages occurs because any new workers
entering the labour market cannot profitably be employed at the going wage rate as
the value of their output would be less than that of the workers already employed.
If they are keen for work, therefore, they will offer themselves to employers at lower
rates of pay than the current employees, and all wages will be bid down. At the new
lower wage level, all workers can profitably be employed.
The theory is part of the neo-classical theory of distribution (>distribution, theory
of) that attempted to explain the share of total output accruing to labour, investors
and landowners (^bargaining theory of wages; efficiency-wage hypothesis; neo¬
classical economics).

marginal propensity to consume (MPC) The proportion of a small increase

in income that would be spent rather than saved. The most important variable
determining expenditure on consumption is income (>► consumption function).
The ► average propensity to consume is the proportion of total income that is spent,
rather than saved. In principle, the MPC should really depend on whether the
income is assumed to be permanent or a temporary windfall. >permanent-income
hypothesis; >► Keynes, J. M.; multiplier.
241 | marginal tax rate

marginal propensity to save (MPS) The proportion of a small increase in

income that is saved. It is equal to i minus the ^marginal propensity to consume,
^•savings ratio.

marginal rate of substitution (MRS) The rate at which a consumer needs to

substitute one commodity for another in order to maintain constant total >utility
from the commodities taken together. If a consumer values two bags of apples
equally to one bag of pears, the marginal rate of substitution between them is 2,
because if one bag of pears were taken away from the consumer, two bags of apples
would have to be provided to compensate. The marginal rate of substitution between
commodity A and commodity B usually diminishes as consumption of commodity
A increases. If at consumption of twenty oranges and twenty bananas the consumer
is indifferent between one of either, at consumption of thirty oranges and ten
bananas the consumer is likely to start demanding more than a mere one orange
before giving up a scarce banana. Graphically, the MRS is the slope of an ^indiffer¬
ence curve and it is in JHndifference-curve analysis that the concept is important.
Mathematically, it is the ratio of the >marginal utilities of two items. As long as the
MRS declines with increased consumption of an item, the indifference curves are
convex (>convexity) to the origin of an indifference map. strafe of technical
substitution.

marginal revenue The increase in the total revenue received by a firm from the
sale of one extra unit of its output. For a small firm that cannot influence market
price (^perfect competition), the extra revenue gained is equal to the price of the
sale. For a firm with a large share of the total market (>monopoly), however, putting
an extra item on sale drives down the market price slightly, so that the revenue gain
equals the cash gained on the new sale minus the loss that occurs on all the sales
that would otherwise have been made at the previously higher price, ^market
power.

marginal revenue product The revenue gained by a firm when it sells the output
generated by the employment of one additional unit of a >factor of production. It
is influenced by three factors: (a) the physical output of the extra factor; (b) the sale
price of the product made, and (c) the rate at which that price falls when the extra
supply of the new factor is put on to the market. To calculate it, ^marginal product
must be multiplied by >marginal revenue (> marginal productivity theory of wages;
marginal value product).

marginal social product The effect on Asocial welfare of employing one

additional unit of a Mactor of production. When new workers are taken on, for
example, the physical output they produce has a private value to their employer,
measured as the >-marginal value product, or the price at which the output is sold.
However, to measure the value of their output to society, two other factors must be
taken into account: (a) >-consumer surplus: the amount by which consumers value
something in excess of what they pay for it, and (b) any > externality present: a benefit
(or cost) that accrues to other than the purchaser of the item.

marginal tax rate The rate of tax paid on extra units of income. An individual
may pay no tax on the first £rooo of income, and 50 per cent tax on all pounds earned
thereafter. Those individuals earning more than £rooo will thus face a marginal tax
marginal utility | 242

rate of 50 per cent even though their overall tax rate will be less than 50 per cent.
Someone earning £1001, for example, will only pay sop of tax - a tiny proportion of
his total income. The marginal tax rates facing economic agents are often considered
important in determining how far taxation impinges on incentives to work, save or
spend money. They are of only limited importance in determining whether a tax is
progressive or not (> progressive tax). The fact that poor people may lose 80 per cent
of any marginal earnings (^poverty trap) and the rich only 60 per cent is irrelevant
in assessing whether the tax system is borne more heavily by either group - an
assessment that depends not on the tax paid on incremental pounds of earnings but
on tax paid on all actual earnings. M^lump-sum taxes; taxation.

marginal utility The extra satisfaction gained by a consumer from a small

increment in the consumption of a commodity. More formally, it is the partial
derivative of the futility function with respect to the quantity of some commodity
that is consumed. It is a concept of central importance to demand theory (>demand,
theory of), one approach to which holds that marginal utility diminishes as con¬
sumption of an item increases (>marginal utility, diminishing). Rational consumers
will equalize the marginal utility gained from a unit of spending on all the different
things they consume, because not to do so would imply that costless extra utility
could be derived by switching spending from items yielding low marginal utility to
those for which it is higher. Such a theory can explain why a price rise causes
consumers to cut demand of an item. As consumers, however, do not possess an
objective scale of utility measurement (>ordinal utility), in more modern theory
(►indifference-curve analysis) no meaning is attached to the numerical magnitude
of the marginal utilities themselves, but only to their ratios and signs. >^-demand,
theory of.

marginal utility, diminishing >diminishing marginal utility.

marginal utility of money The pleasure or satisfaction gained by a consumer

from an extra unit of money. The rational consumer should ensure that the marginal
futility of money with respect to the different things consumed is the same: if
someone would get more utility from spending an extra pound on clothes than they
would get from spending it on books, by transferring some of their budget from
books to clothes they would costlessly increase their utility. They should go on
transferring until they have so many clothes that they no longer value them, pound
for pound, more than books. The marginal utility of money diminishes the greater
the quantity of money available to a consumer, ^demand, theory of; marginal
utility; Marshall, A.; ordinal utility.

marginal value product The market value of the output generated by the
employment of one additional unit of a Mactor of production. It is equal to the
►marginal product of a factor multiplied by the unit selling price of the extra output
produced. It is thus comparable to the >• marginal revenue product, which is marginal
product multiplied by >-marginal revenue; in >perfect competition, where price is
equal to marginal revenue, the two are identical.

market A collection of homogeneous transactions. A market is created whenever

potential sellers of a good or service are brought into contact with potential buyers
and a means of exchange is available. The medium of exchange may be »-money or
 market maker

> barter. Exchange agreements are reached through the operation of the laws of
►supply and ► demand. In traditional economics (►Marshall, A.) a market is charac¬
terized by a single prevailing price for commodities of uniform quality (Maw of one
price). This is not necessarily the same as the business view (the market is a collection
of selling opportunities) or the legal view (the market is a trading zone free of
artificial restrictions on transactions). >►price system; single market.

market capitalization ►capitalization.

market economy ►free-market economy.

market failure An outcome deriving from the self-interested behaviour of indi¬

viduals in the context of > free trade, in which ►economic efficiency does not result.
Market failures provide a ubiquitous argument for ►intervention of some form or
other. But they have two main sources:

(r) They derive from the fact that many transactions that would need to occur for
the sake of economic efficiency simply do not occur. This may be on account of
►transaction costs. Or there may be a deficiency of information to the parties
involved, or ►asymmetric information (with its corresponding problems of ►ad¬
verse selection, >moral hazard and ►agency costs). Or the necessary transaction
may be deterred by the fact that the efficient price is not set - on account of
►menu costs. Or there may be strategic behaviour by the individuals involved,
who fail to engage in a trade in the hope that they might extract a better deal
from their adversary if they 'play it tough'. A large number of 'missing trades' are
those involving the many resources over which no properly defined ►property
rights exist (such as clean air) and thus over which no trade can occur (S*#*-Coase
theorem).
(2) There are sometimes collective interests that are unable to be served by self-
interested, individual behaviour. There are goods or services that have to be
consumed collectively, e.g. ►public goods like defence. There can be ►free-rider
problems in which, for example, citizens hope to avoid paying for a service on
the ground that someone else will pay (why should I invest in ►innovation, if
someone else will do it for me?). There can be ►prisoner’s dilemma-type situ¬
ations, in which selfish behaviour leads to sub-optimal outcomes (particularly
apt in areas in which ►utility is a function of relative position, rather than
absolute position). There can be industries subject to ►increasing returns to scale,
in which ►monopoly is inevitable, that carries large efficiency costs unless there
is a collective effort to regulate.

The two sources of market failure - missing trades and collective interests - can be
used to describe certain market failures that are commonly discussed. For example,
►externalities are a combination of lack of allocation of property rights, and a lack
of trade in the externality itself. Or deviation of price from ►marginal cost tends to
occur as a result of increasing returns to scale.

market forces The application of self-interested, individual behaviour in a ►free-

market economy that, through ►supply and ►demand in different ►markets,
determines ►price and the allocation of resources.

market maker A ►broker-dealer who is prepared to quote buy and sell (bid- and
market power

offer) prices and to buy and sell specified ^securities at all times at these prices and
is thus 'making a market' in them. Prior to the >Big Bang this function was carried
out by the jobbers, who were not allowed to deal with the public. Since the Big Bang,
all members of the >stock exchange have been able to deal with the public as
broker-dealers, some of whom specialize as market makers and others as >stockbro-
kers. Market makers help to provide >-liquidity on the stock market, particularly for
less frequently traded >shares.

market power The degree to which a firm exercises influence over the price and
output in a particular market. Under >-perfect competition, all firms are assumed to
have zero market power: they have to take the going price, and cannot hope to alter
it on their own. Wherever firms represent a non-negligibie portion of the whole
market, however, instead of facing a flat >demand curve, they will face a downward-
sloping one. This means that, in contrast to the perfect competitor, they do not lose
all their sales if they raise their price. It also means, however, that if they wish to
increase their sales they have to lower their price. The stronger this relationship,
the greater the market power. Where market power exists, the producer has such
influence on the market that the amount he/she produces affects the market price,
and so price is not equivalent to 5»-marginal revenue. Market power is related to the
availability of substitute items. Those items that are highly differentiated from those
of competitors will give more market power to the producer than those that are
standard. monopoly.

market share Either: (a) the sales of the product or products of a firm as a
proportion of the sales of the product or products of the >market as a whole, e.g.
sales of Ford motor cars compared with total UK motor car sales, or (b) the sales of
a particular >commodity compared with the total sales for the class of commodity
of which the particular commodity is a member, e.g. sales of mobile telephones
compared with sales of all telephones. The presumption is that the firm's product
in (a) and the particular commodity in (b) are faced with competitive Substitutes
in their respective markets.
Market shares may also be calculated in terms of the proportion of the product in
the total existing stock of that class of products, as opposed to its share of the flow
of new sales, ^Saturation point.

market structure The organizational and other characteristics of a >market and

in particular those that affect the nature of competition and pricing. Traditionally,
the most important features of market structure are the numbers and size distri¬
butions of buyers and sellers, which reflect the extent of >monopoly or ^monop¬
sony; this, in turn, will be affected by the existence or absence of ^barriers to entry,
^►concentration.

marketable securities Securities dealt in on the Stock exchange.

marketing Broadly, the functions of sales, distribution, Advertising and sales

promotion, product planning and market research. That is, those functions in a
business that involve direct contact with the consumer and assessment of his/her
needs, and the translation of this information into outputs for sale consistent with
the firm's objectives.

Markowitz, Harry M. (b. 1927) Markowitz, from the City University of New York
 Marshall, Alfred

and a joint winner of the 1990 >Nobel Prize for Economics, is credited with the
pioneering contribution in the field of financial economics. His insight was to
recognize that the risk of an asset that was relevant to assessing its price was its risk
relative to the market generally. Other risks more specific to particular assets can be
diversified away in a moderately sized ^portfolio. With his contribution, the massive
problem of designing the optimal portfolio, with maximum expected return for
minimum risk, could be seen to be reduced to a two-dimensional problem of looking
at the mean and the variance of the portfolio returns. That laid the foundation to
the >capital-asset pricing model.

Marshall, Alfred (1842-1924) Educated at Merchant Taylors' School, Marshall

graduated in mathematics at St John's College, Cambridge. In 1868, he was appointed
to a lectureship in moral science at Cambridge, and it was during this period that he
began to study economics. In 1882, he moved to the Chair of Political Economy at
Bristol. In 1885, he returned to Cambridge as Professor of Political Economy, a post
he retained until his retirement in 1908. His most important works include The Pure
Theory of Foreign Trade (1879), The Principles of Economics (1890), Industry and Trade
(1919) and Money, Credit and Commerce (1923). Marshall was in the long tradition of
the English ^Classical School, which was founded by >Smith and >Ricardo, and
his influence on succeeding generations of economists has been very great. His
achievement was to refine and develop >microeconomic theory to such a degree
that much of what he wrote is still familiar to readers of the elementary economic
textbooks today. His theory of >-value brought together the diverse elements of
previous theories. On the one hand, he showed how the demand for a ►commodity
is dependent on a consumer's futility or welfare. The more of a commodity a
consumer has, the less extra utility or benefit accrues to him/her from an additional
purchase (>Gossen, H. H.j. Consumers will not go on buying a commodity until
this extra benefit falls to zero but rather, will stop buying extra when finding that
the >money to pay for it is worth more to them than the gain from having an extra
unit of the commodity. At this point of > equilibrium, a fall in the > price, therefore,
will mean that it becomes worthwhile to exchange his/her money for more of the
commodity. In general, therefore, a fall in price will increase the quantity of the
commodity demanded, and in theory a schedule could be drawn up which shows
how much would be demanded at each price. The resultant graph would show a
downward-sloping >demand curve. Marshall invented the expression ►'elasticity'
to describe his measure of the response of demand to small changes in price.
Similarly, on the supply side, higher prices are necessary to bring forward increased
outputs, and a supply schedule with its corresponding supply curve can be drawn
up. The price of the commodity is determined at the point at which the two curves
intersect. These work like a pair of scissors, neither blade of which cuts without the
presence of the other.
Marshall recognized that his consumer utility theory was in some ways an over¬
simplification. It does not take account of complementary or competitive goods
(►complementary goods), and assumes that the >marginal utility of money is
constant. However, he argued that his analysis applied to small price changes and
to goods upon which only an insignificant proportion of income was spent. It
was within this framework that Marshall discussed the idea of >consumer surplus
(►Dupuit, A. J. E. J.). For a given quantity of a commodity purchased on a competitive
Marshall Aid 246

market, the price will be the same for each unit of the commodity sold. However,
for any individual purchaser the price is equal to the utility of the last unit of the
total quantity purchased, the last but one being worth more, the last but two worth
more again, and so on. These utilities can be added up and the extra, over the
price and quantity paid out, is the consumer's surplus. Marshall was aware of the
shortcomings of the 'stationary state' of the typical classical analysis and emphasized
the importance of the production period. He recognized the element of time as the
chief difficulty of almost every economic problem, and considered: (a) a market
period in which supplies are all fixed; (b) a short period in which supplies can be
increased, but only to the extent possible by better use of current capacity, and (c) a
long period in which capacity itself can be increased. The classical economists had
shown how >rent is received by landowners as a surplus. As land was a >-factor of
production in fixed supply, it differed from other factors of production in that its
returns were not related to work done. Marshall extended the concept by pointing
out that, in the short run, manmade >capital was in fixed supply also, and during
the period it took to manufacture earned a > quasi-rent. W^Cournot, A. A.; Marshall-
Lerner criterion; Mill, J. S.

Marshall Aid At the end of the Second World War, only the USA had the necessary
productive capacity to make good the losses experienced by other countries. Euro¬
pean countries had heavy ^balance of payments deficits vis-a-vis the USA. In 1946,
in order to alleviate the resultant shortage of dollars, the USA and Canada made
substantial >loans, including £1 billion to the UK. It was expected that these loans
would be sufficient to cover requirements over the short period that was all that was
expected to be necessary for the world economies to recover. However, in r948 a
general >liquidity crisis was avoided only by further loans made under the ►Euro¬
pean Recovery Programme, through which the UK received loans amounting to
£1.5 billion between 1948 and 1950. This programme was called Marshall Aid, after
the then US Secretary of State, General Marshall. The loans were allocated under the
direction of the Organization for European Economic Cooperation (► Organization
for Economic Cooperation and Development) set up for this purpose. Marshall Aid
in total amounted to the equivalent of 1 or 2 years > gross domestic product of the
recipient European countries and it allowed imports, particularly of capital goods,
to continue despite payments deficits.

Marshall-Lerner criterion A rule stating the ^elasticity conditions under which

a change in a country's ►exchange rate would improve its ►balance of trade. Lerner
set out the appropriate formulae in his book Economics of Control (1994) on the basis
of the elasticity concepts developed by ^Marshall. In its simplest form, the rule
states that the price elasticities of demand for > imports and >exports must sum to
greater than unity for an improvement to be effected. The volume of exports
increases and the volume of imports decreases in response to a fall in the >price of
the former and rise in the price of the latter when a ► currency is devalued (assuming,
for the sake of the argument, that there are no other factors influencing the > market,
e.g. > supply restrictions). There would, therefore, be an improvement in the balance
of trade in volume terms, i.e. in terms of the prices ruling prior to devaluation.
However, what is important for the ► balance of payments is the impact of devalu¬
ation on the value of trade. If the price elasticity of exports plus the price elasticity
of imports is less than unity, it means that the increased cost of imports in terms of
247 | Marx, Karl

the domestic currency outweighs the value of the growth in exports. Putting it
another way, the improvement in the volume of the balance of trade is not sufficient
to offset the fall in the value of the balance of trade occasioned by the devaluation.
>►1-01 rve; terms of trade.

Marx, Karl (1818-83) Born in Trier, Marx studied philosophy at Bonn University
and at the Hegelian Centre at Berlin University, and took a doctorate at Jena. For a
time, he was editor of Rheinische Zeitung, but the paper was suppressed, and in 1843
he fled to Paris. There he began his friendship and close association with Engels,
who encouraged in him an interest in political economy. After a brief return to
Germany he was banished, and in 1849 he settled in London where he remained
until his death in 1883. The Communist Manifesto, written jointly by Marx and Engels,
was published in 1848. In 1859, the first fruits of his long, painstaking research at the
British Museum appeared: the Critique of Political Economy. The first volume of Das
Kapital appeared in 1867. The remaining volumes, edited by Engels, were published
posthumously in 1885 and 1894.
Marx's economics was essentially that of the ►Classical School, especially of
►Ricardo, to whom he owed a great debt. However, he shifted economics away from
its preoccupation with agriculture and stationary states. For Marx, ►capitalism was
a stage in the process of evolution, removed from the primitive agricultural economy
and moving toward the inevitable elimination of private property and the class
structure. Marx attempted a synoptic view of the development of the whole structure
of human society. His economics was only a part, though a fundamental part, of his
all-embracing sociological and political theories. Marx postulated that the class
structures of societies, their political systems and, indeed, their culture were deter¬
mined by the way in which societies produced their goods and >services. Moreover,
the whole structure was evolutionary. The class structure of a capitalist state was a
reflection of the split between owners and non-owners of ►capital, which division
characterized the manner in which production was carried out, and that already had
within it the necessary ingredients of change.
Marx developed from ►Smith and Ricardo their labour theory of value (>value,
theories of) which held the central place in his economic theory. For Ricardo,
the amount of ► labour used in the production of ►commodities was a rough
determinant of relative prices in the long run. For Marx, however, the quantity of
labour used up in the manufacture of a product determined value, and this value
was fundamental and immutable. He did not satisfactorily explain any connection
with relative prices. Labour consumption determined exchange value, which dif¬
fered from use value. The distinction between the two in the case of labour, regarded
in itself as a commodity, was a vital one in Marx's analysis. The capitalist pays wages
that are determined by the exchange value of workers. This exchange value is, in
turn, determined by the socially necessary labour time required to 'produce' the
worker, i.e. labour inputs required to rear, feed, clothe and educate him/her. How¬
ever, in return, the capitalist receives the labourer's use value. The value of the
labourer to the capitalist who uses him/her is greater than the value the capitalist
paid in exchange for his/her services. This difference Marx called 'surplus value' (s).
Only labour yields surplus value. Other ►factors of production (e.g. plant and
machinery and raw materials) reproduce only themselves in the productive process.
(These ideas have some affinity with the ►Physiocrats' ‘produit net, although in
matrix

their case it was inland that was the only factor which produced a surplus.) The
amount of capital required to pay wages Marx called variable (v) (>wage-fund
theory), and the remainder he called constant (c). >-Gross national product in the
Marxian system therefore is given by c + v + s. The ratio of constant capital in total
capital d{c + v) he called the organic composition of capital. The 'exploitation rate'
was s/v. The rate of profit was s/(c + v). The desire for further wealth, coupled with
competition and technical change, induced capitalists to invest from the surplus
(which they expropriated from the workers) and in labour-saving machinery. The
organic composition of capital, therefore, rose over time as more was spent on plant
and machinery (c) compared with wages (v), with the result that, as only variable
capital produced a surplus (and assuming that the exploitation rate remained con¬
stant), the rate of profit tended downwards (>profit, falling rate of). On the one
hand, diminishing profits and stronger competition would lead to >-monopoly and
the concentration of >wealth in a few hands, and on the other there would be an
increasing squeeze on the >real incomes of workers by the capitalists in their attempt
to maintain ^profits and the emergence of a large 'reserve army of unemployed'
arising from mechanization (>• Ricardo, D.). The class conflict would become increas¬
ingly acute until the environment was such that the change inherent in the econ¬
omic structure would be made manifest by the overthrow of capitalism.

matrix An array of numbers displayed in rows and columns. For instance:

'2 f
.7 3.

The numbers are called the elements of the matrix and are generally denoted by aif
in which i refers to the row and / to the column. In the example above, a21 = 7- The
order of a matrix is given by the product of the number of rows times the number
of columns. The above matrix is of order 4. An algebra exists for the manipulation
of matrices, with rules for addition, subtraction, multiplication and division. Matrix
algebra has found many useful applications in ^econometrics, and in particular in
Mnput-output analysis and > linear programming. ^Vector.

maturity The date upon which the principal of a redeemable security becomes
repayable, ^redeemable securities; securities.

maturity transformation ^financial intermediaries.

maximin strategy A decision rule in the theory of games (>game theory). The
rule states that a 'player' with a number of optional strategies to choose considers
first the minimum pay-offs that could be gained from each depending on the reaction
of his 'opponent'. The 'player' should then choose that strategy corresponding to
the maximum of all the possible minimum pay-offs. In other words, it is a selection
of the best possible worst-case scenario. For example, consider a decision-maker
faced with two optional strategies, each of which could have two pay-offs. They can
be summarized in a ^matrix:
(1) 1"2 5"
(2) 1.4 3.

Strategy (r) could have a pay-off of 2 or 5, strategy (2) a pay-off of 4 or 3. The minimum
pay-off of strategy (1) is 2 and that of strategy (2) is 3. The maximum minimum
 Meade, Sir James Edward

pay-off is therefore 3 and strategy (2) would be chosen under the rule. There is no
obvious rationale for choosing a maximin rule. Most of us would focus attention on
likely outcomes, not just worst-case outcomes. However, since >• Rawls, the rule has
almost developed into a political philosophy, with the argument that it justifies
increased attention to the poor in society (^prisoner's dilemma).

maximum-likelihood estimation Estimation of a ^parameter by choosing the

value which is statistically most likely, given observed data. In > regression analysis,
under certain assumptions, it can be shown that ^least-squares regression yields the
maximum-likelihood estimate of the >beta coefficient in an equation. Once the
simple assumptions are removed, maximum-likelihood approaches may diverge
from other statistically plausible methods.

MBO ^management buy-out.

MCA Monetary compensatory amounts (>green currency).

McFadden, Daniel L. (b. 1937) Economist from the University of California at

Berkeley and joint winner of the Nobel Prize for Economics in 2000 for his work in
microeconometrics, the analysis of large datasets of households, firms or individuals.
In particular, Professor McFadden was instrumental in improving the statistical
techniques that economists use to study decisions that are necessarily drawn from
limited choices, e.g. whether to buy a car, how many children to have, whether to
marry, what occupation to take. These contrast with such decisions as how much
food to buy, because the range of options is 'discrete'. You can't have 2.4 children.
McFadden edited, with Manski, and contributed to Structural Analysis Of Discrete
Data With Econometric Applications (1981), and has written a long list of papers on
transport, economic development and production. McFadden has also taken an
interest in the empirical implications of ^behavioural economics, studying, e.g.
how people answer survey questions. He has held academic appointments at Pitts¬
burgh, Yale, the Massachusetts Institute of Technology and the California Institute
of Technology as well as at Berkeley.

Meade, Sir James Edward (1907-95) Educated at both Oxford and Cambridge
Universities, Professor Meade was appointed Professor of Commerce at the London
School of Economics in T947. He was appointed to the Chair of Political Economy at
Cambridge University in r957, a post he held until 1969. Professor Meade was awarded
the >Nobel Prize in Economics (jointly with ►Ohlin) in 1977. His published works
include The Theory of International Economic Policy (1951), A Geometry of International
Trade (1953), The Theory of Customs Unions (1955), A Neo-Classical Theory of Economic
Growth (1961), Efficiency, Equality and the Ownership of Property (1964), Principles of
Political Economy (1965, r976), The Inheritance of Inequalities (1974), The Intelligent
Radical's Guide to Economic Policy (1975) and Stagflation (1981, 1983). Professor Meade
made important advances in the theory of international trade, in the study of
equilibrium conditions in domestic and external economies. In his work on the
welfare effects (^welfare economics) of tariffs and customs unions (^customs
union), he introduced the concepts of the theory of the >second best. Professor
Meade contributed much to the analysis of income distribution and in the field of
>growth theory, being an advocate of a >-prices and incomes policy, ^nominal
gross domestic product.
mean

mean ►average.

means test The assessment of wealth or income as, for example, when determining
the eligibility of a claimant for welfare benefits. Means tested benefits contrast with
universal benefits given to all families irrespective of income, e.g. State pensions,
^dependency culture; marginal tax rate; poverty trap.

measure of economic welfare (MEW) ^environmental accounting.

median ► average.

medium of exchange ►money.

medium-term financial strategy (MTFS) A statement of the ►monetary policy

and »-fiscal policy of the UK government set out in the ►budget each year during
the r98os. It traced the target path of >-money supply, ►gross domestic product
(GDP) and the ►public sector borrowing requirement for the following 3 or 4 years.
When introduced in r98o, it was believed it would add ►credibility to the govern¬
ment's anti-inflation strategy, and most attention focused on the targeting of growth
of >money supply. In r982, the MTFS started down a path of increasingly focusing on
targets of nominal GDP growth, and in 1984 another measure of money supply Mo
(►money supply), was added. After 1987, the MTFS existed in name only. Monetary
policy shifted, first into the targeting of the ►exchange rate, then into targeting of
► inflation directly (►inflation target). The MTFS was formally dropped in r997.

member banks (US) >commercial banks.

Memorandum of Association The document forming the basis of registration

of a company. As required by the Companies Acts, the Memorandum of Association
must list the subscribers to the ^capital of the company and the number of ►shares
they have agreed to take, the name and address of the company and, where appropri¬
ate, the powers and objects of the company, and that the ►liability of its members
is limited (>company law). The Articles of Association set out the rules by which the
company will be administered, e.g. the voting of directors, the calling of meetings.

Menger, Carl (1840-1921) Professor of Economics in the Faculty of Law at Vienna

University from 1873 to r903. His major work, in which he develops his marginal-
utility theory, Grundsatze der Volkswirtschaftslehre, was published in 1871. He was one
of the three economists in the r870S who independently put forward the theory of
►value based on ►marginal utility and whose work had a profound influence on
the subsequent evolution of economic thought (►Gossen, H. H.; Jevons, W. S.;
Walras, M. E. L.). Exchange takes place, he argued, because individuals have different
subjective valuations of the same >commodity. Menger saw commodities in terms
of their reverse order in the productive process, i.e. bread is prior to flour and flour
prior to wheat. The ►price of the first-order commodities, which is determined by
their exchange for ►consumption, is imputed back through to the higher-ordered
commodities. The theory of diminishing ►utility was the catalyst that eventually
unified the theories of production and consumption. Menger himself, however,
overemphasized consumption demand in the theory of value, just as the ►classical
economists had overemphasized production supply (►Marshall, A.).

menu costs The practical costs incurred by producers in having to change their
!2J merger

prices - costs of relabelling products, or re-entering prices into computer systems.

Menu costs are one factor in support of keeping ^inflation relatively low. They also
explain why prices may move in moderate-sized jumps, rather than in smooth,
small increments. The existence of menu costs can explain why money may not be
neutral (>neutrality of money). »^-new Keynesianism.

mercantilism The growth of ^international trade and the establishment of the

power of the merchant after the medieval era led to the emergence of a body of
thought, between the mid sixteenth and late seventeenth centuries, that was primar¬
ily concerned with the relationship between a nation’s wealth and its balance
of foreign trade. The mercantilists recognized the growing power of the national
economy and were in favour of the intervention of the State in economic activity to
maximize national > wealth. Partly because the monetary system was very primitive
in relation to the growing needs of economic expansion, mercantilist writing was
often overburdened with the identification of national wealth with precious metals.
Its leading writers, however, did make important progress in developing economic
thought and made significant contributions to the analysis of ^international trade
problems. J^Malynes, G.; Misselden, E.; Mun, T.; Serra, A.

merchant banks Institutions that carry out a variety of financial services, includ¬
ing the acceptance of Mulls of exchange, the issue and placing of Moans and
insecurities, ► portfolio and >unit trust management and some Manking services.
Several houses, often through subsidiaries, also provide >risk capital for small firms,
deal in gold Mullion, insurance banking and >hire purchase and are active in
the market for ►eurocurrency. Historically, the merchant bankers were merchants
dealing in overseas trade and who used their knowledge of traders to accept bills of
exchange and who developed other banking services connected with foreign trade,
e.g. dealing in gold and foreign ^currency and assisting foreign borrowers to raise
money in London. Their most prominent function has been that of advising the
government on ►privatization and the ^private finance initiative and firms on
► mergers and Make-overs and other financial matters. Many merchant banks
are well known, e.g. Rothschilds, Barclays de Zoete Wedd, Lazards and Schroders.
Merchant banks are also referred to as Missuing houses', Maccepting houses' or
►'investment trusts' in exercising particular functions. The merchant banks are
relatively small institutions that pride themselves on their personal, flexible manage¬
ment. There has been a recent trend, especially following the ►Big Bang, for mer¬
chant banks to join financial ►conglomerates so as to be able to offer a full range of
financial services, including retail services, and many of these banks in London are
foreign-owned. The term is now falling out of use in favour of ►investment banks.

Mercosur A ►customs union of Argentina, Brazil, Paraguay and Uruguay. By the

Treaty of Asuncion in 1991 and a final protocol signed in 1994, they agreed to establish
the Mercosur - or Southern Common Market - between their four countries from
January r995. In r996 Bolivia and Chile became associate members. Tariffs were
abolished on intra-Mercosur trade and a Common External Tariff (CET) established.
However, economic crises in Argentina and Brazil in 2000/1 led to the relaxation of
the CET. >► Andean Pact; free trade area; Latin American Integration Association.

merger The fusion of two or more separate companies into one. In current usage
merit goods
I*
merger is a special case of combination, where both the merging companies wish to
join together and do so on roughly equal terms, as distinct from a >take-over,
which occurs against the wishes of one company. However, 'merger', 'take-over',
'amalgamation', 'absorption' and 'fusion' are sometimes all used as synonyms.
Where two firms in the same business (i.e. competitors) merge, this is known as
‘horizontal integration'. Where two firms that are suppliers or customers of one
another merge, this is known as Vvertical integration'. Acquisitions and mergers -
which research suggests frequently do not benefit the shareholders of the acquiring
company - have been an important cause of increasing ^concentration, and some
economists have argued that major mergers should be controlled more closely by
the authorities, even when they do not threaten to reduce competition directly
(^competition policy; Take-Over Panel). This is because pressures to maintain high
short-term earnings and, hence, share prices to avoid the risk of a take-over bid, may
inhibit investment in research and development. Against this it is argued that
mergers are the only way of transferring assets to more capable hands when existing
management has proved deficient. The value of merger activity has fluctuated
roughly in line with stock-market prices. Not all acquisitions involve take-overs of
independent companies. In recent years between one-fifth and one-third of total
expenditure has been accounted for by sales of subsidiaries between company
groups. ^Management buy-outs have also been growing, ^conglomerate; holding
company; reverse take-over.

merit goods A >commodity, the consumption of which is regarded as socially

desirable irrespective of Consumers' preferences. Governments are readily prepared
to suspend ^consumers' sovereignty by subsidizing the provision of certain goods
and services, e.g. education.

Merton, Robert C. (b. 1944) Professor Merton is a finance specialist at Harvard

Business School, and joint winner of the T997 Nobel Prize for Economics, for his
work in deriving methods for the valuation of complex financial instruments, e.g.
^options. The work was also crystallized by Black and Scholes in one particular
and path-breaking equation (>Black-Scholes formula), but Professor Merton found
means of generalizing their formula and expressing it in a widely applicable form.
Their work led to the development of a significant new financial market that enables
traders to diversify risk and allocate it in far more flexible ways than had hitherto
been possible. In addition, insurance and guarantees comprise forms of option, and
thus these also can now be valued more accurately. Professor Merton's most famous
paper is 'Theory of Rational Option Pricing', Bell Journal of Economics and Management
Science (1973)- Merton's career has primarily centred around Cambridge, Massachu¬
setts, first at the Massachusetts Institute of Technology, then at Harvard.

MFA >Multi-Fibre Arrangement.

microeconometrics >McFadden, Daniel.

microeconomics The study of economics at the level of individual consumers,

groups of consumers or firms. No very sharp boundary can be drawn between
microeconomics and the other main area of the subject - >macroeconomics - but
its broad distinguishing feature is to focus on the choices facing, and the reasoning
of, individual economic decision-makers. It is a long-standing requirement of micro-
 Mill, John Stuart

economics that it can justify the behaviour it ascribes to individuals as being logical,
given their preferences or objectives. The general concern of microeconomics is
the efficient allocation of scarce resources between alternative uses (^resource
allocation) but more specifically it involves the determination of >-price through
the optimizing behaviour of economic agents, with consumers maximizing futility
and firms maximizing S-profit. It covers both the behaviour of individual sectors
and the way the sectors interact in ^equilibrium and disequilibrium in individual
markets. The main areas of microeconomics are: (a) demand theory (Vdemand,
theory of); (b) the theory of the firm (>firm, theory of the); (c) the demand for
labour (^labour, demand for), and other >factors of production; (d) >-welfare
economics, and (e) the study of the interactions between markets in ^general
equilibrium analysis.

migration The movement of people outwards (emigration) and inwards (immig-

ation) between one location and another either within a country or between coun¬
tries. There was an increase in immigration into the more developed countries in the
last decades of the twentieth century. According to the > Organization of European
Cooperation and Development (OECD), foreign-born people living in the OECD's
member countries increased by about r3 million in the decade to t998. Foreign-born
people accounted for about 5 per cent of the population in the > European Union
in 1998, and about ro per cent in the USA. Such immigration is beneficial in so far as
it eases the problems of a static, declining or ageing ^population that exist in many
advanced countries, and satisfies the demand for skilled and unskilled workers that
could not otherwise be met in the short run. However, the sources of this immi¬
gration are the ^developing countries from which people are attracted by the higher
incomes prevailing in the advanced economies. This outflow, through the loss
particularly of skilled workers, could inhibit the economic growth of the developing
countries, although emigrants do provide a useful source of income through remit¬
tances home. The OECD has estimated that such remittances were equivalent to
about 12 per cent of exports of goods and services in r998. Achievement in increasing
the real incomes of the developing countries to reduce the international ^-inequality
of incomes would diminish the incentive to migrate. >Samuelson (factor price
equalization theorem).

Mill, John Stuart (1806-73) Mill was subjected as a child to a regime of severe
educational discipline by his father, James Mill. He was acquainted with the major
works of economics of the day by the age of 12, and was correcting the proofs of his
father's book, Elements of Political Economy, when he was 13. He learnt Ricardian
economics and Benthamite >utilitarianism from his father. In 1823, he joined the
East India Company, where he remained for 35 years. For 3 years, before moving
to France to spend his retirement, he was a Member of Parliament. He was an
extraordinarily prolific writer, especially when it is remembered that he had a
full-time job. His reputation was made by his A System of Logic, Ratiocinative and
Inductive, Being a Connected View of the Principles of Evidence and the Methods of Scientific
Investigation, which was published in 1843. His essay On Liberty appeared in 1859, and
his Examination of Sir William Hamilton's Philosophy in 1865. His two most important
works on economics are Essays on Some Unsettled Questions of Political Economy (which
came out in 1844, though he actually wrote it in 1829 when he was only 23) and
Principles of Political Economy with Some of Their Applications to Social Philosophy (1848).
Miller, Merton H. | 254

The latter was intended to be a comprehensive review of the field of economic theory
at the time, and was, in fact, an up-to-date version of >-Smith's Wealth of Nations
(1776). It succeeded so well that it remained the basic textbook for students of
economics until the end of the century. The work is regarded as the apogee of the
»-Classical School of Smith, >Ricardo, >Malthus and >-Say. Mill himself said the
book had nothing in it that was original, and indeed it is basically an eclectic work,
intended simply to bring together the works of others. However, it is not true to say
that Mill lacked originality altogether. He analysed the forces that lead to increasing
>■ returns to scale, arguing that as a result there will be a tendency for industries to
become more and more concentrated in a few firms. The advantages this gave should
be set against the disadvantages that will accrue in the form of higher prices from
the loss of competition. Recognition of this tendency led him to support strike
action by trade unions. Trade unions were a necessary counterweight to the powerful
employer (VGalbraith, J. K.). In his exposition of the theory of >value, Mill showed
how >price is determined by the equality of > demand and >-supply, although he
did not demonstrate the relationship by means of graphs or schedules. Mill recog¬
nized as a distinct problem the case of ^commodities with >joint costs. He showed
also how reciprocal demand for each other's products affected countries' terms of
trade. Mill brought in the idea of ^elasticity of demand (though the actual
expression was invented later by >Marshall) to analyse various alternative trading
possibilities. His father had suggested that tent, being a surplus according to
Ricardian theory, was ideally suited to taxation. Mill took up this idea, and it
became quite popular. He proposed that all future increases in unearned rents should
be taxed.

Miller, Merton H. (1923-2000) An economist from the University of Chicago,

and joint >Nobel Prize winner in 1990. Miller's great contribution was in the theory
of finance, with ^Modigliani, F. (>Modigliani-Miller theorem). Even though the
pair's findings were based on a large number of simplifying assumptions, Miller had
been pre-eminent in analysing the effect of taxation and bankruptcy costs on optimal
company financial structure.

minimum efficient scale (m.e.s.) The scale of production at which further

increases in scale would not lead to lower unit costs (^average costs). > Economies
of scale are measured in terms of unit costs versus plant size or output. The resulting
long-run cost curve is generally thought to be L-shaped. The m.e.s. is the point on
this curve at which it flattens out. Where the m.e.s. is large and requires large
tapital expenditure, it may act as a ^-barrier to entry, especially where the m.e.s.
is large in relation to total market size. Often, however, many firms may operate
profitably below m.e.s. because: (a) the cost disadvantage of doing so is small;
(b) they expect to grow; (c) because of product differentiation (^differentiation,
product), or (d) other departures from the theoretical conditions of ^perfect compe¬
tition. It should also be remembered that technological economies of scale revealed
in plant size are only one of the forces determining the efficiency of firms, transac¬
tion costs; X-efficiency.

minimum wage Legislation prohibiting the paying of wages below some specified
level. The aim of such a prohibition is to boost the incomes of the low paid, or to
prevent employers exploiting the existence of government benefits for the low paid
 Mises, Ludwig Edler von

by cutting wages. As a means of helping the poor, minimum wages are of limited
efficiency - many poor households have no worker in them and are thus not affected.
Many reasonably well-off households have a second earner on low pay, and they
are affected. A minimum wage can price labour out of the workforce, and create
unemployment. It is at least very difficult to set a national minimum wage that is
high enough to help, say, someone supporting a family of three children, while also
giving employers sufficient incentive to employ single r8-year-olds. In defence of
such laws, it has been argued that the demand for labour is in practice very inelastic
(>elasticity) and that minimum-wage laws do not give rise to the problem of the
>poverty trap. Moreover, they encourage employers to nurture their staff more
carefully and make them more productive (>efficiency-wage theory). It has also
been argued that in some circumstances, because of the inflexibility of a labour
market, an employer could in effect behave as a > monopsonist and restrict demand
for labour to keep wages down. A minimum wage, therefore, rather than reducing
employment would increase it as the incentive to restrict labour take up would have
been removed. Minimum wage schemes have been agreed in one form or another
in most of the member countries of the >Organization of Economic Cooperation
and Development.

minorities, minority interest Elements shown in the consolidated accounts of

groups of companies in which one or more of the ^subsidiaries is not wholly owned
by the parent. Where a company owns 95 per cent of the ordinary >capital of a
subsidiary, for example, and its accounts are consolidated, then the whole of the
assets and income of the subsidiary will be included in the consolidated accounts.
In showing net assets attributable to shareholders of the parent company, 5 per cent
in this case belongs to the minority shareholders and must be deducted. Similarly,
in calculating >net income attributable to the same shareholders, earnings will be
shown after minority interest.

Mirlees, James A. (b. 1936) A Scottish-born economist, Mirlees has been a Professor
at both Oxford and Cambridge Universities (at the latter since 1995). He received the
joint >Nobel Prize in Economics in r996. His main area of study has been in the
economics of taxation. His achievement has been to analyse the trade-off between
equity and efficiency in a tax system, and to derive rules and conditions to govern
the imposition of efficient taxes. For example, he is credited with the finding that,
under certain assumptions, it is inefficient to impose any tax that affects business
production decisions. It is always better to levy taxes on final consumption and to
maintain efficient production. He also investigated the role of marginal tax rates,
and the idea that it is better to have higher marginal rates lower down the income
spectrum in order that the rich pay more tax on that middle slice of their income,
but themselves face a low marginal rate. He found that that particular advantage
was outweighed by the fact that more people were affected by marginal rates in the
middle-income spectrum than at that top. He also posited the problem of designing
an income tax in terms of > asymmetric information, in that the government does
not know how hard people could work in the absence of a tax, and hence initiated
a discussion of an old issue - the design of tax systems - in terms of a new area of
economic thinking - the economics of information.

Mises, Ludwig Edler von (1881-1973) Professor at Vienna University from 1913
Misselden, Edward

until he joined the Graduate Institute of International Studies at Geneva in 1934. In

T940, he left Europe for the USA and was appointed 5 years later to a professorial
Chair at New York University, where he stayed until 1969. His published works
include The Theory of Money and Credit (t9i2), The Free and Prosperous Commonwealth
(1927), Geldwertstabilisierung und Konjunkturpolitik (r928), Bureaucracy (1944), Omnipo¬
tent Government (1944), Human Action (r949), Theory and History: an interpretation of
social and economic evaluation (r957) and The Ultimate Foundation of Economic Science
(1962). Von Mises argued in favour of the >price system as the most efficient basis
of > resource allocation. A >planned economy must be wasteful, because it lacks a
price system and cannot institute such a system without destroying its political
principle. He applied the ^-marginal utility theory of the ^Austrian School to
develop a new theory of >money, and pointed out that futility could be measured
ordinally only and not cardinally (>Hicks, J. R.). He also outlined a >purchasing-
power parity theory comparable to that of »-Cassel. His ►business-cycle theory
explained fluctuations in terms of an expansion of bank credit in the upturn which
caused a fall in the >rate of interest and surplus ^investment with a consequent
reversal when the >money supply was reduced. »a&»Hawtrey, R. G.; Hayek, F. A. von.

Misselden, Edward (1608-54) A leading member of the merchant adventurers

and a member of the group of writers referred to as ^mercantilists. He argued that
international movements of specie and fluctuations in the ^exchange rate depended
on international trade flows and not the manipulations of bankers, which was the
popular view. He suggested that trading returns should be established for purposes
of statistical analysis, so that the State could regulate trade with a view to obtaining
►export surpluses.

Mitchell, Wesley Clair (1874-1948) ^institutional economics.

mixed economy A market economy in which both private and >public enterprise
participate in economic activity, though not necessarily in all sectors, some of
which may be reserved for public > monopoly. Mixed ownership of the means of
production is, in fact, characteristic of all contemporary economic systems, w^free-
market economy; planned economy.

mixed strategy A means of making one choice from a set of options by random
selection, on the basis of pre-assigned probabilities attached to each option. It is a
concept used in >game theory where, in certain situations and in order to prevent
an opponent guessing your behaviour, your best strategy is to behave unpredictably.
It is the opposite of a pure strategy, in which there is no random element. A mixed
strategy is beneficial when, given your opponent’s action, you are indifferent
between two pure strategies, and when your opponent can benefit from knowing
what your next move is. It is best to adopt a mixed strategy in the game tic-tac-toe
(sometimes referred to as paper-scissors-stone), for example. An important finding
in game theory is that anyone facing a mixed strategy will always find a pure strategy
to be among the best responses.

MNC ► multinational corporation.

mobility of capital The ability of investment funds to flow across international

borders. Impediments to capital mobility may take the form of restrictions on the
inflow of investment funds to a country (restrictions on the rights of foreigners to
 Modigliani-Miller theorem

buy property or companies, for example) or >-exchange control, limiting the ability
of domestic citizens to invest overseas. If capital is mobile, investors can lend money
to those borrowers who are willing to pay the highest rate of return (after taking
into account any expected changes in exchange rates). If they do this enough, and
if the > purchasing-power parity theory holds, real interest rates should converge
across countries. In practice, they deviate but not by very much. exchange-rate
overshooting.

mobility of labour >labour, mobility of.

mode >average.

model A representation of an economic system, relationship or state, that takes

any of a variety of forms. At its most informal, a model can be said to consist of a
verbal description or analogy of some real-world phenomenon. It may take the form
of a diagram (e.g. the graph of the >cobweb model), or a set of equations setting out
the relationship between > variables (e.g. ^consumption as a >function of income).
In applied economics, a model is likely to be expressed in a computer program or
spreadsheet in which data (the 'input') are processed and manipulated to produce
results (the 'output'). Model-building usually consists of two main stages: (a) inspired
by economic reasoning, the development of the structure of the model (setting out
what factors affect which variables) - this is often as far as construction goes, and
(b) estimation of the actual strength (^parameters) of the relationship postulated,
often by using ^econometrics.
Models have a variety of uses: (a) they can illuminate and describe systems clearly
by stripping them of all unnecessary complications; (b) computer models in particu¬
lar are useful for ^simulation - a variable (e.g. ^unemployment) is defined in terms
of the values of a set of other variables and, by simulating a change in these, the
effect of different policies on unemployment can be estimated; (c) forecasts of
the behaviour of variables can be made, based on past observations, and (d) the
specification of models is a prerequisite to the testing of different theories, ^empir¬
ical testing; hypothesis.

Modigliani, Franco (b. 1918) Born in Rome, Professor Modigliani studied at the
University of Rome. Moving to the USA, he obtained his Ph.D at the School of Social
Research in New York in 1944. He was appointed to a Chair of Economics at the
University of Illinois in r949 and in 1952 to the Chair of Industrial Administration at
the Carnegie Institute. Since 1962, he has held the post of Professor of Economics
and Finance at the Massachusetts Institute of Technology. Professor Modigliani was
awarded the >Nobel Prize for Economics in 1985. His many published articles in the
professional journals have been assembled in Collected Papers of Franco Modigliani
(r98o). He has put forward an explanation of the constancy of the aggregate > average
propensity to save: (a) in the face of rising incomes in the economy, and (b) in
terms of the balance between the high savings of the employed workforce and the
dissavings of the retired population (>life-cycle hypothesis). He has also contributed
to financial economics. >^Modigliani-Miller theorem.

Modigliani-Miller theorem The proposition that the market value of a firm is -

under certain assumptions - independent of the way it chooses to finance its invest¬
ment or distribute ^dividends. If a firm wants to expand, it can choose between
 monetarism [ 258

three methods of financing its investment: borrowing, issuing shares and spending
profits rather than giving them to shareholders in the form of dividends. ►Modigli-
ani and ►Miller showed that under a number of assumptions (e.g. an absence of
taxes) the method of financing a firm chooses in a perfectly functioning capital
market will ultimately not affect the cost of capital (^capital, cost of) or the value
of the firm. It is the risk and expected rate of return of the expanded firm that will
determine how attractive investors find it, not the way the firm raises the money.
Any attempt to attract low-cost capital will probably have the effect of raising the cost
of other capital in the company, ^investment appraisal; Ricardian equivalence.

monetarism The name applied to a theory of ► macroeconomics which holds

that increases in the ►money supply are a necessary and sufficient condition for
►inflation. Two strands of thought underlie this doctrine and distinguish it from
its main theoretical antagonist, >Keynesian economics (»-Keynes, J. M.):

(1) That changes in the money supply have a substantial effect on ►aggregate
demand. Two separate reasons are given for this: (a) that the demand for money
is stable and insensitive to the >rate of interest, and (b) that the demand for
goods in the economy, particularly ^-investment, is sensitive to the interest rate.
Together, these determine the monetarists' ►transmission mechanism - the way
in which increases in the money stock affect spending in the economy. Under
the monetarist account, if the authorities printed some crisp £10 notes and
dropped them over the country from a helicopter, people would find they had
more cash in this liquid form (►►liquidity; liquidity preference) than they
wanted. They would therefore spend much of the cash on goods and services,
increasing aggregate demand. The rest might be invested in interest-bearing
►securities; the increase in demand for these would drive the price up and the
interest rate down. Under the monetarist account, even the smallest cut in interest
rate would cause a large increase in investment, again boosting aggregate demand.
The contrary account holds that the helicopter money would not be spent at all,
but invested in financial assets. The interest rate would fall a great deal, but that
investment is insensitive to interest rates, so this would have no effect on the
demand for investment goods. In effect, all that happens from expanding the
money supply is that interest rates drop, and people hold more cash, without
spending it, implying that the speed with which cash circulates has slowed down
to offset the extra cash (► velocity of circulation).
(2) That any change in aggregate demand the government succeeds in bringing
about will manifest itself (in the long run at least) in higher prices and not higher
output. The economy will tend to an equilibrium position with all markets clear¬
ing: all that money can do is raise all prices equally, leaving all relative prices con¬
stant (►neutrality of money). Increases in the stock of money can, however, have a
short-term effect on the economy, but only as long as the inflation created outstrips
people s expectations of inflation. Once inflation is built into people's expec¬
tations, increases in the money supply only result in increases in the level of prices.

In terms of the ^quantity theory of money, of which monetarism can be seen as a

revival, the above propositions are equivalent to holding that the velocity of circu¬
lation of money and the level of output are ►exogenous, and fixed independently
of the money stock.
 monetary policy

Monetarists advocate >-supply-side economics, and deny a role for >stabilization

policy. Instead, greatest stability can be achieved by adhering to a rule for money-
supply growth in line with the growth of real output (>real terms). The emergence
of monetarism in the r96os and among policymakers in the r97os can mainly be
attributed to >Friedman (^economic doctrines). The doctrine has been somewhat
superseded by the theoretically more elegant theory deriving similar results, from
>new classical economics. >policy ineffectiveness theorem.

monetary base The stock of an economy's most liquid financial assets (^liquidity).
The monetary base is usually taken as the stock of notes and coins and the banks' own
deposits at the ^central bank. It has often been suggested that the > money supply as
a whole could be controlled by strict rationing of the monetary base. However, the
base is very small relative to the total money supply, so rather sensitive changes to the
base could lead to instability in the money supply as a whole.

monetary compensatory amounts >green currency.

monetary policy Central government policy with regard to the quantity of

money (^quantity theory of money) in the economy, the >rate of interest and the
^exchange rate. Monetary policy is now broadly accepted as having the predomi¬
nant role in the control of ^aggregate demand, and therefore of ^inflation. This
owes much to the rise of the doctrine of > monetarism and to the defeat of the
popular interpretation of ^Keynes, who was held to believe that >fiscal policy was
more important, and that monetary policy matters only in so far as it affects fiscal
variables, e.g. the level of government borrowing.
Monetary policy in most advanced economies is executed primarily by the authori¬
ties engaging in >open market operations to set a level of short-term interest rates
that encourage the banks to let their deposits grow at a level consistent with the
objectives of policy. This being said, there are still plenty of important decisions to
be made over what those objectives are:

(r) Is the ultimate objective simply to control inflation? Or are there other motives
for changing policy as well, e.g. preventing asset prices from changing too rapidly
even if there are no consequences for the general price level?
(2) Is there an intermediate objective of policy, e.g. constraining growth of >-money
supply (broad or narrow money) or stability of the ^exchange rate? It is not
possible to set up targets individually for the money supply and the exchange
rate rates because the two are often simultaneously determined. If the money
supply is increased, for example, the exchange rate tends to fall unless interest
rates are raised. Exchange-rate targets (e.g. those that existed for members of the
^European Exchange Rate Mechanism) encourage trade by reducing the risk of
exchange-rate fluctuations, while targeting money supply, it is argued, can have
an impact on incredibility and, hence (somewhat implausibly) on wage demands;
plus, money-supply targeting can better reflect domestic economic needs.
(3) Whether policy should be run on the basis of preset rules or on discretion.
(4) Who conducts policy in the absence of a rule? Should control be in the hands of
elected politicians, or an independent >-central bank?

While monetarists appear to have essentially won the battle over the importance
and objectives of monetary policy, they lost the battle over the conduct of policy.
monetary policy committee

They supported the use of simple money supply growth rules, yet the experiences
of the UK and USA in following such rules were unhappy. Even the >European
Central Bank, which explicitly includes money supply in deciding policy action, has
used a heavy dose of discretion in responding to changes in money supply growth.
>Taylor rule.

monetary policy committee The nine-person committee of the >Bank of

England, charged with setting interest rates in the UK. The committee consists of
the bank's governor, the two deputy-governors, two other officials of the bank, plus
four economists nominated by the government. It is accountable to the Court of
the Bank of England, and to Members of Parliament through the House of Commons
Treasury and Civil Service Select Committee. It meets monthly, and the minutes of
its proceedings are published. The committee is charged with setting interest rates
to meet the government's explicit ^inflation target, ^credibility; monetary policy.

monetary sector (UK) Defined by the >Bank of England to include its own
banking department, the Metail banks, >accepting houses, other UK and foreign
banks, and the >-discount houses. Other ^-financial intermediaries (e.g. the >build-
ing societies, insurance companies and »-pension funds) are not counted as part of
the monetary sector.

money Something that is widely accepted in payment for goods and services and
in settling >debts. In primitive economies, goods and services were exchanged
wholly through ^-barter. Exchanging goods for one another or using property
(e.g. cows, sheep) as money was cumbersome and inconvenient and inhibited the
> division of labour. Later, coins made of valuable metals came into use as intermedi¬
ate commodities, but in the modern economy Vbanknotes and coins have little or no
intrinsic value, while »*bank deposits are simply book entries (►banking): their use as
money depends upon confidence that they can be exchanged for things of value. In
addition to its use as a medium of exchange, money acts as a store of value making
►saving convenient, a measure of value (or unit of account), and as a standard of
deferred payments that facilitates the granting of ►credit, though all these functions
can be threatened by ► inflation. >S»money supply; transactions motive.

money, demand for ^liquidity preference.

money, inactive ► inactive money.

money, neutrality of >neutrality of money.

money, superneutrality of ►superneutrality of money.

money at call and short notice In the UK, ► money loaned to the ►money
market on a short-term basis by the ^commercial banks. These Moans are regarded
as part of the Miquid assets of the banks because they can be withdrawn immediately
or at periods of notice of up to 14 days. They also include overnight loans. The terms
of the loans vary, and in practice the money may not be called-in for long periods.
The commercial banks are willing to loan their liquid funds to the money market in
this way, because they know that the >Bank of England will act as a ►lender of
last resort. In most other countries the major commercial banks invest directly in
short-term paper and have direct access to the >central bank for loans, e.g. ►Federal
Reserve System, ^discount market.
 monopolistic (imperfect) competition

money illusion The confusion of changes in money values and changes in real
values. If someone's salary is increased by ro per cent over a period during which
consumer prices have risen by 20 per cent, that person is suffering from money
illusion if thinking he/she is better off in Meal terms.

money in circulation >Money in use to finance current transactions as distinct

from idle money (Mnactive money).

money market The financial institutions that deal in short-term Insecurities and
Moans, gold and Moreign exchange. >Money has a 'time value', and therefore the
use of it is bought and sold against payment of Mnterest. Short-term money is
bought and sold on the money market, and long-term money on the >-capitaI
market. Neither the money market nor the capital market exists in one physical
location. In the money market most transactions are made by telephone or elec¬
tronically. In the UK the money market sometimes refers only to the Commercial
banks dealing in Mreasury bills, >bills of exchange and >money at call, with the
>Bank of England acting as Mender of last resort (^discount market). In a wider
context, the money market also includes ^parallel money markets, the Moreign-
exchange market and the >bullion market.

money supply The stock of liquid assets in an economy that can freely be
exchanged for goods or services. Money supply is a phrase that can describe anything
from notes and coins alone (^monetary base) to the sum of all cash plus bank
deposits, because by writing cheques, individuals exchange bank deposits for goods
or services. There is a spectrum of assets of differing Miquidity in the economy, and
any degree of liquidity may be chosen to define an asset as money. A set of very
liquid assets is known as ‘narrow money'. A set includes also less liquid assets, known
as broad money. In general, the wider the definition, the harder it is for the authorities
to control the money supply, but the more direct the relationship between money
supply and other economic variables. For example, the quantity of notes and coins
in the economy - a narrow definition - is easy to control, but is of little importance
in influencing the spending of individuals.
In the UK, several definitions of money supply are used for monitoring the money
supply. 'Mo' is the stock of sterling notes and coins in circulation, plus the banks'
deposits at the »>Bank of England. 'M4' is a much broader definition, embracing
notes and coins, plus the value of all UK sterling bank (^banking) and building
society accounts held by private citizens and companies. Because some of these are
not really used to support transactions, they are more a form of savings. Since r993,
the Bank of England has also published an index of growth in divisia money. This
simply takes the elements of M4, and weights them by the degree to which they are
used for financing transactions. It is, in essence, a measure of M4, adjusted to give
more importance to the more liquid part. At times of rapid financial innovation or
change, particular definitions can exhibit rather erratic behaviour, compounding
the problems of control and interpretation of the money supply. »»credit control;
domestic credit expansion; monetary policy.

money terms Meal terms.

Monopolies and Mergers Commission ^competition policy,

monopolistic (imperfect) competition Competition in an industry in which

monopoly | 262

there are many firms each producing products that are close, but not perfect, >substi-
tutes. Three features characterize such an industry.

(1) The firms make products between which consumers slightly differentiate (they
may have different-coloured packets, for example) and consequently, the demand
for any individual firm's product is not perfectly elastic (>► elasticity). Some
consumers will prefer one product to those of its competitors sufficiently to
exhibit a limited amount of loyalty to that brand when its price rises. This means
that each firm has a small amount of »-market power (> monopoly) and is thus
not a price-taker in the market for its own product. In this regard it is similar to a
monopoly, but not a perfect competitor (>-perfect competition).
(2) Firms are able to enter the industry if the level of >-profits is attractive. This is a
feature shared with the perfectly competitive industry, but not the monopoly.
(3) Like both perfectly competitive and monopolistic firms, producers in monopol¬
istic competition are assumed to maximize profits.

In monopolistic competition, firms set output to equate ^marginal cost and ►margi-
nal revenue. Price at the specified output is determined by demand. Profits are zero
in the long term, on account of entry occurring whenever they are positive, driving
up > supply in the industry and cutting the >demand for each company's product.
While it shares this with perfect competition, its output will be rather lower than it
would be under perfect competition and its price above marginal cost and thus
rather higher. Moreover, production will not take place at the lowest cost point as it
does under perfect competition. Each firm operates with some >excess capacity.
The theory of such markets, which lie between monopoly and perfect competition,
was simultaneously developed by >Chamberlin in the USA and >Robinson in
the UK.

monopoly A market in which there is only one supplier. Three features characterize
a monopoly market: (a) the firm in it is motivated by ►profits; (b) it stands alone
and barriers prevent new firms from entering the industry (>barriers to entry), and
(c) the actions of the monopolist itself affect the market price of its output (Vmargi-
nal revenue) - it is not a price-taker. The output of the monopolist will be set at the
point at which marginal revenue is equated with >marginal cost. If marginal revenue
were any higher it would pay the monopolist to increase production because the
additional costs generated would be lower than the revenue and profits would rise.
The reverse would be true if marginal revenue were any lower than marginal cost
(S^-marginal-cost pricing). The price of the monopolist is determined by ^demand
as the firm cannot set both output and price. For its chosen output, the monopolist
can read price off a market > demand curve, which will lie above the marginal
revenue curve.
The monopoly will make profits in excess of those merely necessary to keep in
business, and no pressure exists for price to fall and reduce these. Theory suggests
that, under monopoly, prices are higher and output lower than they would be under
►perfect competition. The power of the monopolist derives from the fact that
demand for his/her product is not perfectly elastic (^elasticity) so that, when price
rises, sales largely hold up. This is not so for a perfect competitor, who will sell
nothing on raising price even a fraction above the going rate. The degree of monopoly
power a firm enjoys can be measured by how inelastic demand for its product is. The
 mortgage

more inelastic demand is, the more the monopoly can raise its prices without losing
sales.
Monopoly is held to be inefficient because, under it, price will be higher than
marginal cost so that, even if some consumers value an item more than it costs to
make, they may not choose to buy it (>► marginal-cost pricing). Moreover, there is
no tendency for costs to be at their lowest possible level in the long term, because
the pressure of more efficient, incoming competitors does not exist. It is not surpris¬
ing, given these results, that most nations choose to control monopolies, which are
usually defined as any firm dominant in a particular industry, e.g. with a market
share in excess of 25 per cent. However, in some industries, efficient production
requires a single dominant supplier (^economies of scale; natural monopoly; regu¬
lation). Moreover, a distinction has to be made between a monopoly that has earned
its dominance, and one that has not. It is possible that consumers benefit from
monopoly in the long run if the profits generated act as a spur to ►innovation
(►Schumpeter, J. A.). And in any event, defining monopoly is a more subtle process
than it looks - almost no company really has a monopoly. Even what appears to
be a monopoly gas company faces some competition from electricity suppliers,
^bilateral monopoly; complex monopoly; contestability; monopsony.

monopoly, discriminating A ►monopoly that charges different prices for the

same product to different consumers. ►►price discrimination.

monopsony A market in which there is only one buyer of the item sold. Unlike
individual consumers in most markets, a monopsonist will have an impact on the
market price. When he/she purchases an extra unit of the item, market demand
perceptibly increases and the market price rises. This means that to buy one extra
item costs the monopsonist not only the price of that item, but also the extra price
that has to be paid for all the items that were previously being bought at the lower
price. In some markets, therefore, it could pay a monopsonist to restrict his demand
► minimum wage. >#-bilateral monopoly; monopoly.

Monte Carlo method A technique for estimating ►probabilities. The method

involves the construction of a >model and the ►simulation of the outcome of an
activity a large number of times. Probabilities are then estimated from an analysis
of the range of outcomes from the model.

moral hazard The presence of incentives for individuals to act in ways that incur
costs that they do not have to bear. A typical example is that of insurance, because
in insuring property against burglary there is less incentive to be as careful than if
personally responsible for its protection. Another example would be the incentive
to find a job - perhaps a rather less than satisfying one - given the existence of State
benefits for the out of work (>job seeker's allowance). Moral hazard is one of those
important market distortions based upon imperfect information, as it is the inability
of, say, the insurer to distinguish the well-behaved claimant from the badly behaved
one that creates the problem, ►►dependency culture; incentive compatibility;
principal-agent problem.

mortgage A legal agreement conveying conditional ownership of bassets as

►security for a ►loan and becoming void when the >debt is repaid. ►Building
societies, banks (►banking) and ►insurance companies (mortgagees) loan a
mortgage debenture | 264

proportion of the purchase Xprice of houses to individuals or companies (mort¬

gagors), the property being mortgaged to the lender until the loan is repaid.

mortgage debenture xbond.

most-favoured nation clause The clause in an international trade treaty under

which the signatories promise to extend to each other any favourable trading terms
offered in agreements with third parties. ^General Agreement on Tariffs and Trade;
generalized system of preferences.

moving average A Mime series derived from another by the calculation of a

sequence of Xaverages. The averages are calculated in sequence from a consecutive
group in the series; for each average, the next value in the series is added and the
earliest value in the group dropped. The number of values in the group to be averaged
may be two or more, depending on the time series from which they are to be derived.
Moving averages are calculated to eliminate seasonal variations from a series and to
highlight the longer-term trends.

MPC >marginal propensity to consume.

IMPS ^marginal propensity to save.

MRS > marginal rate of substitution.

MTFS >medium-term financial strategy.

multicollinearity ^Correlation between the ^independent variables in a

regression (> regression analysis) equation. If such correlation exists, the application
of > least-squares regression for estimation of the parameters in an equation is
difficult, because it is hard to determine which of several correlated variables is truly
influential.

Multi-Fibre Arrangement (MFA) An international arrangement within which

individual importing and exporting countries agreed that specified textile and cloth¬
ing goods would be subject to Mmport quotas. The aim was to protect the textile
industries in high-wage countries from being overwhelmed by imports from low-
wage countries. The first MFA was put in place in 1974, and renewed in 1978, 1982
and 1986. The fourth expired in r99i. Under the terms of the xUruguay round of
trade negotiations initiated by the ^General Agreement on Tariffs and Trade, the
MFA is being phased out. Quotas should be abolished in stages by 2005. ^develop¬
ing country; international commodity agreements.

multilateral agencies International organizations for aid (Moreign aid) and

economic co-operation funded by several or many countries, as distinct from ^bilat¬
eral agencies. The ^^International Bank for Reconstruction and Development,
>Asian Development Bank, the X European Bank for Reconstruction and Develop¬
ment and the ► Inter-American Development Bank are multilateral agencies.

Multilateral Investment Guarantee Agency An agency of the World Bank

(XWorld Bank Group) which was established in T988 and is open to all members of
the World Bank. The agency gives guarantees and ^insurance cover for private
direct investment in ^developing countries (Moreign investment) against non¬
commercial risks (e.g. the imposition of Moreign exchange restrictions, war and the
expropriation of assets) and is financed from incomes received from insurance
 multiplier

premiums and financial contributions made available by member countries,

amounting to US$r billion. >export credit insurance.

multilateralism ^International trade and exchange between more than two

countries without discrimination between those involved. In contrast to »-bilateral-
ism. ^General Agreement on Tariffs and Trade; most-favoured nation clause.

multinational corporation, multinational enterprise (MNC, MNE) Acom-

pany, or more correctly an ^enterprise, operating in a number of countries and
having production or service facilities outside the country of its origin. A commonly
accepted definition of an MNE is an enterprise producing at least 25 per cent of its
world output outside its country of origin. There are, according to earlier United
Nations estimates, 35,000 corporations with direct investments outside their head¬
quarters country, with over 170,000 affiliates over which they have effective control,
but these numbers would be much greater now. The too largest MNEs account for
about 40 per cent of cross-border assets. The multinational corporation takes its
principal decisions in a global context and thus often outside the countries in which
it has particular operations. The rapid growth of these corporations since the Second
World War, and the possibility that conflicts might arise between their interests
and those of the individual countries in which they operate, has provoked much
discussion among economists. MNEs possibly account for over one-quarter of world
trade, but earlier fears that they would come to dominate the world economy now
seem misplaced. Bartlett and Ghoshal make distinctions between three types of
international company which are widely accepted as useful. They argue that neither
the decentralized types of business with strong local presence (multinational), nor
the more centralized types of business building cost advantages through centralized
production (global) or exploiting the parent company's ^research and development
and systems capability (international) are now sufficient to maximize competi¬
tiveness. The above authors claim that the transnational company that somehow
blends these approaches by differentiating contributions by national units to a none
the less highly integrated worldwide operation has the most successful approach.

multi-plant operations Firms that produce at more than one plant or location.
Most small firms operate from a single establishment. Large firms serving a national
market (e.g. in the brewing industry) may find that lower transport costs to the final
consumer from multiple plants outweigh the ^economies of scale in a single large
plant, ^enterprise.

multiple correlation coefficient A statistical measure of the accuracy by which

a known >'variable is estimated by an equation, or > model, containing two or more
^independent variables (^correlation). It can take values between o and r. At o,
there is no correspondence at all between the predicted and actual variable, and at
unity the coefficient indicates a perfect correspondence. Also called the coefficient of
determination and K-squared (>partial correlation; regression analysis).

multiplier An increase in »-national income divided by the increase in expenditure

generating that increase in income. In simple models, the size of the multiplier
depends on the ^-marginal propensity to consume. For example, if the government
increased its investment expenditure by £100, this sum would be paid out in wages,
salaries and profits of the suppliers. The households and firms receiving these
multi-product firm

incomes and profits will, in turn, save a proportion and spend the remainder. These
expenditures will in turn again generate further incomes and profits and so on. At
each round, therefore, a proportion of receipts will be paid and a proportion spent,
the latter being the marginal propensity to consume, denoted, for example, by c.
We have, therefore:

Expenditure Saving

Round 1 £100
2 £iooc £roo(i - c)
3 £100 c2 £100(1 - c)2

n flood1 £100(1 - c)n

and, therefore, the total increase in national income generated by the £roo is the
sum of the infinite number of expenditures:

£100 + £iooc + £iooc2 + £iooc3 + .. . £100c"

= £100(1 + c + c2 + c3 + . .. c")

This series is the sum of a ^geometric progression whose sum can be shown to be
equal to £roo[(r - c") / (r - c)]. The marginal propensity to consume is less than unity,
so that as n gets larger, <f becomes smaller. Therefore, the series converges to £roo/
(r - c) and the multiplier is, therefore, equal to 1/(1 - c) or i/s, where s is the ^marginal
propensity to save, ^-accelerator-multiplier model; Keynes, J. M.

multi-product firm A business producing two or more different ^commodities

or products. Most large firms produce more than one product and are often engaged
in more than one industry (^diversification), although for simplicity the basic
theory of the firm (>-firm, theory of the) is couched in terms of a single-product
firm.

Mun, Sir Thomas (1571-1641) An English mercantilist (^mercantilism) and a

director of the East India Company. His publications include Discourse of Trade from
England unto the East Indies (1621) and England’s Treasure ofForraign Trade (1664). He
attacked the idea that >exports of >bullion should be completely prohibited and
other restrictions put on trade, pointing out that restrictions on trade invited retali¬
ation in foreign >markets and raised domestic 5*-prices. He did emphasize, however,
that an export surplus should be sought in the ^balance of trade for the country as
a whole, although it was unnecessary to seek to achieve this with each trading
partner.

Mundell, Robert A. (b. 1932) A Canadian economist at Columbia University in

New York, Professor Mundell was awarded the J-Nobel Prize for Economics in 1999
for his work on fiscal and monetary policy in different ^exchange rate regimes, and
on optimum currency areas. His contribution was primarily generated in the 1960s
(for some of this period he was at the University of Chicago) where he more or less
transformed the study of international macroeconomics, and is perhaps primarily
 Myrdal, Cunnar Karl

associated with the Mundell-Fleming model (with the late Marcus Fleming) of an
open economy that demonstrates a paradox: in a fixed exchange rate regime > fiscal
policy is powerful and E monetary policy impotent, while the reverse is true in a
floating rate regime. The reason for the paradox is that with a floating exchange
rate, fiscal policy enacted through, for example, extra government borrowing either
pushes up the interest rate (thus reducing investment) or simply sucks in foreign
capital, which drives up the exchange rate (thus reducing exports). Either way, any
stimulatory effect is negated. Monetary policy can work through changing interest
rates by increasing the money supply and by affecting the exchange rate. In the
fixed-rate regime, monetary policy is powerless, as it has to accommodate any
exchange rate target. Fiscal policy can work, though, as no offsetting exchange rate
or interest rate effects can undermine it.
Professor Mundell was also prescient in analysing the nature of optimal currency
areas. He asked when countries should combine their currencies. He concluded that
there are benefits in terms of transaction costs in so doing, but that if asymmetric
shocks occurred to the different countries, policy would be difficult to manage unless
labour was mobile and could migrate from a high unemployment zone to a low
unemployment one. Emigration.
His two most prominent publications are probably 'Theory of Optimum Currency
Areas', American Economic Review (i96r) and 'Capital Mobility and Stabilization Policy
under Fixed and Flexible Exchange Rates', Canadian Journal of Economics (1963). He
has also written several books, including The International Monetary System: conflict
and reform (1965) and Building the New Europe (1992).
Mundell-Fleming Model EMundell, R. A.
mutual company A company without issued Ecapital stock owned by those
members doing business with it. The Eprofits of a mutual company, after deductions
for reserves, are shared out among members or used to reduce prices of services for
members. Some Esavings banks and Einsurance companies (e.g. Standard Life) are
mutual companies. In the USA, the term 'mutual' is also used to refer to open-ended
Etrusts or mutual funds, which correspond to Eunit trusts in the UK. EBuilding
societies in the UK are mutual organizations, but recently some have demutualized
and incorporated and sought Eflotation so as to facilitate Emergers and capital-
raising. Since mutual companies are owned by their members (e.g. depositors) in
these cases members have received Eshares in the newly floated enterprises.
mutual funds Emutual company.
Myrdal, Cunnar Karl (1898-1987) Born in Sweden, Professor Myrdal graduated in
law at Stockholm University in 1923. After a period in private practice, he obtained
a degree in economics in 1927 and took a post as lecturer in political economy
at Stockholm University, eventually succeeding ECassel to the Chair of Political
Economy and Financial Science in 1933. From 1936 to 1938, he was a Member of
Parliament as a Social Democrat. After a period as Economic Adviser to the Swedish
legation in the USA, he was appointed Minister of Commerce in the Swedish
government, a post he held from 1945 to 1947. He resigned from this post to become
Secretary-General of the UN Economic Commission for Europe at Geneva, where he
stayed until 1957. In 1957, he was appointed Professor at the Institute for International
Economic Studies of Stockholm University and in 1974 was awarded the ENobel
Myrdal, Cunnar Karl

Prize for Economics jointly with von >Hayek. His published work includes Price
Formation under Changeability (1927), Vetenskap och Politik i Nationalekonomin (1929),
Om Penningteoretisk jamvikt (i93r), An American Dilemma {1944), Economic Theory and
Underdeveloped Regions (1957), Value in Social Theory (1958), Beyond the Welfare State
(i960), Challenge to Affluence (1963), Asian Drama: an inquiry into the poverty of nations
(1968), Objectivity in Social Research (1969), The Challenge of World Poverty (1970) and
Against the Stream - Critical Essays in Economics (1973). Professor Myrdal invented the
terms, and formulated the distinction between, >ex ante and >ex post, in particular
in relation to the equality of aggregate savings and investment in equilibrium. He
emphasized the need to study the dynamics of ►macroeconomic processes. His
book, Monetary Equilibrium (1931), that developed the economics of ►Wicksell, fore¬
shadowed many aspects of ► Keynes' General Theory of Employment, Interest and Money
(1936). He argued that economists should accept the need to make explicit value
judgements, without which their theoretical structures were unrealistic. He became
an advocate of >institutional economics. Professor Myrdal believed that such a
framework was necessary in any economic studies of the ^developing countries.
 N

NACE ^-Standard Industrial Classification.

NAIRU Non-accelerating inflation rate of unemployment (^unemployment, natu¬

ral rate of).

NASDAQ National Association of Securities Dealers Automated Quotations system

(>over-the-counter market).

Nash, John F. (b. 1928) A mathematician from Princeton University in New Jersey
and the Massachusetts Institute of Technology, John Nash gave his name to the
most important concept of ^equilibrium as applied to >game theory. For that, he
won the >Nobel Prize for Economics in r994 (jointly with > Harsanyi and >Selten,
who refined his work). Nash drew the important distinction between co-operative
games and non-co-operative games, where players have incompatible interests and are
unable to make binding agreements to maximize joint welfare. He outlined the
equilibrium position for non-co-operative games, in which all players' expectations
are fulfilled and all players' strategies are optimal. While this remains the foundation
of most discussion in game theory, it is not sufficiently limiting to be universally
interesting as a tool of analysis. Moreover, it relies on each player having complete
information about the other players' options. S^Nash equilibrium.

Nash equilibrium A concept central to >game theory, which characterizes any

situation where all the participants in a game are pursuing their best possible strategy
given the strategies of all the other participants. A game is any situation in which
there are participants, strategies for each participant, and pay-offs for each player
associated with the combination of strategies chosen. One might imagine a simple
'game' in a two-person country in which both the people have to decide on which
side of the road to drive. The pay-offs are either 'no crash' (when both drive on the
left or right) or 'crash' (when one drives on the left and the other on the right). In
this situation, two possible Nash equilibria exist: (a) both driving on the left, or (b)
both driving on the right. If one drives on the left and the other on the right, it is
not a Nash equilibrium because, given the choice of the other, each would change
his/her own policy. Popular examples of Nash equilibria arise in >Hotelling's law
and the > prisoner's dilemma (^equilibrium). The Nash equilibria are considered
a rather weak basis for determining the likely outcome of a game, as in some cases
Nash equilibria can involve players choosing >dominated strategies, i.e. strategies
that can easily be bettered. In other cases, the Nash equilibria can be upheld by the
use of implausible threats by one player. Even though the threat would not be likely
to be carried out, it can influence a Nash equilibrium. For these reasons, economists
national accounts | 270

have searched for other notions of 'solving' games. Nash nevertheless represents the
starting-point for all discussion on the subject. ►Nash, J; Selten, R.

national accounts ►social accounting.

National Association of Securities Dealers Automated Quotations system

(NASDAQ) (US) >over-the-counter market.

national debt The total outstanding borrowings of the central government ►Ex¬
chequer. It represents the stock of borrowing as opposed to the annual increase in
total borrowing, represented by the government deficit (►public sector net
borrowing ). In the UK in 1997, it was announced that an explicit goal of ►fiscal
policy would be to stabilize the ratio of debt to ►gross domestic product (GDP).
Under the provisions of the >Maastricht Treaty, countries in the ►European Monet¬
ary Union are expected to keep debt below, or falling towards, 60 per cent of GDP.
Two different definitions of the debt are in common use: (a) net public sector debt,
which measures the ►public sector financial liabilities to the private sector and
abroad, net of short-term financial assets, and (b) gross general government debt - the
variable used in the Maastricht Treaty - which excludes ►nationalized industries
and measures total financial liabilities, before netting off short-term financial assets.
Until r968 the debt was transacted through the ►Consolidated Fund but it now
appears in the >National Loans Fund. The National Debt Commissioners and the
National Investment and Loans Office have certain responsibilities towards the debt.
The UK national debt as a proportion of GDP declined almost continuously from
r945 until r990. In the 1970s, it did not rise despite high levels of government
borrowing as ►inflation eroded the value of the debt; unaided by any such luck in
the r99os, the ratio of gross debt to GDP jumped in the first half of that decade but
has since declined. In 2001/02 public sector net debt as a percentage of the GDP was
30.3. The bulk of sterling market holdings of the national debt consists of government
and government-guaranteed stock and most of the remainder consists of national
savings (►National Savings). Some of the debt is held by government agencies, so
that the net national debt, which excludes debt held by government, is lower than
the gross debt.
The national debt can be divided into three categories: (a) >funded debt, i.e.
► irredeemable securities; this is now only a very small part of the total; (b) ► floating
debt, which in this context refers to short-term borrowings, e.g. ►treasury bills and
►ways and means advances, and (c) other unfunded debt, the largest item of all,
accounting for about three-quarters of the total. It includes principally >dated
securities, some of which are repayable in external currencies (e.g. dollar liabilities),
but also non-marketable securities, e.g. National Savings certificates and premium
savings bonds. The national debt is of great importance in the financial system
of the private sector and plays quite an important role in the interdepartmental
accounting of government. Government securities provide convenient investments
for ►insurance companies, for example, and these securities form an important part
of the reserve assets of banks and other financial institutions. Although it is spoken
of as a burden, the interest paid on the national debt held by UK residents is not a
burden on the nation as a whole, since the interest payments are actually transfers
between those residents who pay taxation and those who also receive the interest.

national income The total incomes of residents of an economy in a given period

 National Insurance

after providing for >»-capital consumption. Also referred to as net national product at
factor cost (>factor cost). Incomes in this calculation include: (a) all payments for
the use of the ►factors of production, i.e. wages, salaries, ►profits in the form of
> dividends and retained profits, ►rents and net income from abroad but excluding
►transfer payments, or (b) the sum of ►value added in all sectors of the economy at
factor cost, or (c) as the sum of expenditure on final consumption and >-investment
goods, plus ^exports and minus ►imports. These three methods should, in theory,
yield the same figure since all incomes should equal total expenditure plus net
►saving or ►investment, which in turn should also equal the value of output
(provided output is defined as value added, i.e. intermediate expenditure is
excluded). In practice, each of the three methods involves estimation and the totals
can diverge significantly, so often an averaging procedure is used. Comparisons of
output and expenditure will be affected, among other things, by the extent of
evasion (►informal economy). National income before capital consumption is equal
to the gross national product and, if net income from abroad is also excluded, it is
equal to the gross domestic product. Comparisons between the national incomes of
various countries are subject to many qualifications: the distribution of income will
differ and so, too, may methods of estimation; moreover, the exchange rates used
may not reflect purchasing-power parities (>purchasing-power parity theory).
National income or other aggregates from the national accounts are regarded as
indicators of national welfare in the market economy, but they are not unambiguous
in this respect. One reason is that some activities that contribute to national welfare
are not included because they are not valued in markets, e.g. the work done by
mothers in bringing up their own children. Environmental costs (e.g. pollution and
the depletion of natural resources) are not included in the accounts (^environmen¬
tal accounting).

national innovation system ►innovation.

National Insurance (Nl) A social security scheme in the UK that provides

►jobseeker’s allowance, sickness benefit, flat-rate pensions, maternity benefits and
other grants or benefits on widowhood or incapacity in return for regular contri¬
butions paid by employees, employers and others. National Insurance made pro¬
vision for benefits not on the basis of a ►means test but on the basis of defined
causes of hardship, for those who had paid NI contributions. National Insurance
has faced serious challenges. It was always necessary to have a means-tested safety-
net system for those in hardship, who had not made contributions. That is the
income support system, with other related benefits like child benefit. Since NI was
introduced, the growth of contingencies (e.g. lone-parenthood) affecting people not
covered by NI has been such that the size of the safety-net scheme approaches that
of the NI. There are now a wide range of non-contributory benefits available outside
NI and a system of tax credits (►income tax).
National Insurance started out with flat-rate contributions and flat-rate benefits.
In r96i, income-related contributions were levied and, to maintain an actuarial
connection between contribution and benefit, income-related pensions were intro¬
duced, and earnings-related premiums to unemployment and sickness insurance in
1966. In the 1970s and 1980s, these were dropped, by which time NI was entirely
based on earnings-related contributions and flat-rate benefits. The actuarial principle
had been all but abandoned.
National Insurance Fund
Li!!
The NI system, however, passes one important test in relation to pensions. Under
NI, there is a flat-rate pension, and a top-up pension scheme, the State Earnings-
Related Pension Scheme (SERPS). This was introduced in 1978. However, it became
apparent that SERPS was unaffordable in the long term, and the government took
measures to encourage people to 'contract out' of SERPS, and put money into
>occupational pensions or ^personal pensions instead. This has reduced SERPS to
little more than a fall-back top-up pension scheme, for those on incomes too low to
make it worth contributing to a private scheme. The SERPS was replaced by a second
State pension from 2002, targeted at low earners. >-demographic time bomb; pension
funds.

National Insurance Fund ^Consolidated Fund.

National Loans Fund A government account opened in r968 for the domestic
lending of government and all the transactions relating to the > national debt. The
payments of the fund include interest, management and expenses of the national
debt, deficit on the ^Consolidated Fund and loans to the nationalized industries
and public corporations, local authorities and the private sector. Receipts include
interest on loans, profits of the Issue Department of the »-Bank of England, interest
transfer from the Consolidated Fund and borrowings.

national product ^national income.

National Savings Since 1996 an executive agency of the ^Treasury, responsible for
the marketing and administration of savings and investment products for individual
citizens. The National Savings Bank offers ordinary and investment accounts and
►Individual Savings Accounts. National Savings certificates pay interest and bonuses,
some are index-linked (^indexation) and all income is free of tax. National Savings
offers other products, including Pensioners' Guaranteed Income Bonds and Premium
Bonds. First introduced in 1956, Premium Bonds participate in a lottery for tax-free
prizes, drawn from a national interest of 3.5 per cent, and savers can cash in their
bonds at any time.

National Savings Bank (NSB) >National Savings.

National Savings certificates >National Savings.

nationalized industries State-owned enterprises in the market sector of an

economy (e.g. a post office), as distinct from State activity in ^-public goods, e.g.
defence. In the UK, most nationalized industry was literally private industry that
was taken into public ownership (i.e. nationalized) e.g. British Steel, British Leyland
and Rolls-Royce. In the UK, as in other European countries, most of the public
utilities (e.g. electricity, water, coal, transport and communications) undertakings
are, or were, in State ownership, although several countries, led by the UK, have
engaged in a programme of denationalization (►privatization). The growth of
nationalization largely began after the Second World War and has always been a
subject of controversy in the UK, e.g. the steel industry was nationalized in rpsr,
denationalized in ^53 and renationalized in 1967. The heads of these industries
have often complained of political interference, e.g. in the interests of broader
>macroeconomic objectives. Whatever the relative merits of State versus private
 neo-classical synthesis

enterprise, some form of ^regulation in many nationalized industries is inevitable

given their economic importance and ^monopoly powers.

natural monopoly An industry in which technical factors preclude the efficient

existence of more than one producer (>monopoly). Examples are the public utilities
such as water, gas and electricity, where there is a requirement for a network of pipes
or cables. In order to derive the efficient (^economic efficiency) results of >-perfect
competition from a market that is necessarily monopolistic, various suggestions of
control have been made, notably government regulation if the firm is in private
ownership, ^public ownership and >franchising. Under any of these, control is
enhanced if the monopoly can be divided regionally, allowing performance compari¬
son between different regions (^yardstick competition). Alternatively, licensing
arrangements can be set up so that a dominant supplier runs a network (e.g. pipes
or cables), but is obliged to lease the use of it to competing suppliers, ^privatization;
regulation.

natural rate of growth >-growth theory; Harrod-Domar model.

natural resources Commodities or assets with some economic lvalue that exist
without any effort of mankind. The value they have is usually only realized, however,
when they are exploited, i.e. dug out of the ground, processed or refined. Natural
resources are necessary ingredients of all economic activity. Natural resources can
be of three types: (a) non-renewable, e.g. oil and coal, stocks of which will eventually
run out (^depletion theory); (b) renewable, e.g. water and fish, which are reproduc¬
ible, and (c) non-expendable, i.e. not used up in the consumption process as, for
example in the case of a landscape of outstanding beauty that yields > utility for
those seeing it, and tourist income for the owner, ^-environmental economics.

near money An >asset which like s-money acts as a store of value but which is
not immediately acceptable as a medium of exchange, for example a >building
society deposit. What constitutes money and what does not, however, is contro¬
versial and important for defining the >money supply.

neo-classical economics A school of economic thought imbued with behaviour

consistent with >microeconomic theory, constructed to explore conditions of
►static equilibrium (>comparative static equilibrium analysis). Neo-classical
models are based around maximizing behaviour of individual firms and consumers,
with decisions at the margin (^-marginal analysis) often most important. Statements
about macro-events are often derived from the aggregation of micro-relationships,
and this has led to criticism, particularly from the ^-Cambridge School. In contrast
to >-Keynes, the neo-classical economists consider that savings and investment
naturally balance as the rate of interest changes; and full employment is achieved
in the labour market by changes in >factor prices. Essentially, the Neo-classical
School has been concerned with the problems of equilibrium and growth at full
employment, again in contrast to Keynes, who was primarily concerned with the
underemployment of resources. »► Keynesian economics; Samuelson, P. A.

neo-classical synthesis Description given to the dominant economic consensus

in > macroeconomics during the 1960s, between those supporting > Keynesian econ¬
omics, and those basing their opinions on >neo-classical economics. The compro¬
mise doctrine essentially held that, in principle, the economy did have natural
net assets | 274

mechanisms to ensure full employment, but that, in practice, > Keynes' analysis
of the potential persistence of unemployment without government action was
well-founded. In principle, the economy can find full employment, because even if
there is a spiral of falling demand and falling prices (the Keynesian case of the
►liquidity trap) people should eventually feel richer as their wealth becomes worth
more, and that should lead them to spend. In practice, Keynes receives credit under
the synthesis, as market frictions imply that the wait for natural mechanisms to
work can be interminable. ►economic doctrines.

net assets The >-capital employed in a business. It is calculated from the >-balance
sheet by taking fixed ►assets plus current assets less current ►liabilities. Often used
as a basis for calculating ►rate of return on ►capital.

net capital employed ►capital employed.

net capital formation ►capital formation.

net cash flow >cash flow.

net domestic product ►gross domestic product less capital consumption.

net income Net >profit on earnings after tax and, where appropriate, after ►min¬
ority interest.

net investment Gross expenditure on ►►capital formation minus the amount

required to replace obsolete and worn-out plant and equipment. It measures the
change in the ►capital stock.

net national product ►national income.

net output >value added.

net present value ►present value.

net profit ►profit.

net tangible asset ratio ►financial ratios.

net tangible assets (NTA) Fixed ►assets plus current assets minus intangible
assets such as goodwill and minus current ►liabilities.

net worth ►balance sheet.

net worth ratio ►financial ratios.

neutrality of money The inability of changes in the stock of >money in an

economy to affect anything except the general level of prices. If money is neutral, a
io per cent increase in the ►money supply causes a one-off ro per cent rise in all
prices but stimulates no growth in the real level of output. The issue of whether
money is neutral or not is central to debates in ►macroeconomics. In ►classical
economics and under ►monetarism, money is held to be neutral. >Keynes and his
followers, however, have had a more complicated attitude to monetary neutrality.
On the one hand, they have downgraded the importance of money in influencing
^aggregate demand; on the other, they have argued that aggregate demand has an
important role in influencing real ►variables. Because of this latter belief, modern
 new classical economics

Keynesian economics is associated with asserting that money is not neutral. It would
be more accurate, however, to say that it asserts aggregate demand is not neutral.
In order to explain why money might have some real impact on the economy, it
is easiest to assume that certain prices or wages are fixed in nominal terms. For
example, imagine what happens if the money supply authorities print extra cash,
expanding the money supply by, for example, io per cent. People will have high
money balances that they may attempt to spend on, for example, computers. First,
if all prices are flexible, the growth in money supply leads to a shift in the ^demand
curve for computers which leads to an immediate rise in computer prices. This
should encourage firms to deliver more computers. However, the increase in the
money supply increases prices throughout the economy, so the suppliers' costs also
rise. This causes a shift in the computer suppliers' >supply curve, so leading to a
reduction in supply. This also increases prices and so takes the quantity sold back to
where it started. The story ends with higher prices, and the same output as before, so
money is neutral. Suppose, however, that computer manufacturers are contractually
obliged to provide goods to retailers at pre-set prices. In response to extra demand,
the computer retailers this time increase their prices, but can supply more without
suffering higher costs. There is no shift in their supply curve. In this case, the extra
money leads prices up less than before, and output rises. The economy grows.
Even without the pre-set prices, money could have a real effect if the effect of the
extra demand only dawns on the shops and suppliers very slowly. They might have
found themselves selling more before they realized demand was rising everywhere,
or the extra money could have had an effect if there is >-money illusion. If all prices
and wages went up, but people nevertheless mistakenly felt richer as a result, then
they might have increased the supply of labour, sending costs down and the com¬
puter supply curve up. The view that money is neutral stems from a belief that
market forces function reasonably effectively and fast (i.e. that computer suppliers
do not fix their prices in advance), and that economic agents are rational (suffer no
money illusion), ^-economic doctrines; menu costs; monetarism; policy ineffec¬
tiveness theorem; rational expectations; superneutrality of money; supply-side
economics.

new arrangements to borrow (NAB) ^International Monetary Fund.

new classical economics A theory of >macroeconomics that emphasizes the role

of > rational expectations in decision-making and the natural rate of unemployment
(^unemployment, natural rate of) in >equilibrium growth. The central view of
new classical economists is the > policy ineffectiveness theorem that argues govern¬
ments can only have an impact on the economy in so far as their policies are
unanticipated. Unlike the monetarists, therefore, proponents of this view argue that
government demand-management intervention is ineffective even in the short run.
Growth can only be enhanced by influencing >supply. This has been an influential
doctrine in >macroeconomics in the past two decades. Its prime advantage over
other accounts of the economy is that it is well founded in > microeconomics, using
the economic tradition of assuming individuals are rational. This means that, unlike
other approaches, its principal conclusions do not rely on the assumption that
people are systematically fooled into behaviour counter to their own true desires.
Contrast it with, for example, the notion that prices are sticky, accounting for money
having some effect on real output (^neutrality of money). While the assumption of
 New Deal | 276

rational expectations may appear extreme, it is perhaps best to think of new classical
economics as arguing that, although policy may have a short-term effect, in the
long term the short term becomes very short indeed as people see the way policy
operates. >#*Akerlof, G.; economic doctrines; Lucas critique; supply-side economics.

New Deal The US Federal government under President Roosevelt began, in 1933, a
number of projects designed to give financial assistance and work to the large number
of people thrown out of employment by the great ►depression, that followed the
stock-market collapse on Wall Street in r929. The New Deal met with a certain amount
of opposition because it led to budget deficits Obalanced budget). »*Keynes, J. M.

new economy Narrowly, new activities created by information and communi¬

cation technologies (ICTs) including computer hardware and software, telecom¬
munications and other aspects of the digital revolution, notably the Internet. These
new activities are seen to be distinct from those of the old economy (steel, cars, food
processing, services etc.) though for the present they are only a very small part of
total output. The borderline between the new and old economies is increasingly
hard to draw as the old economy adopts the technology of the new, e.g. on-line
ordering by consumers from food multiple retailers. The driving force behind ICTs is
the rapidly declining cost of semiconductor chips. In the past 30 years the processing
power of these chips has doubled about every r8 months and this is expected to
continue for some time (Moore's Law, named after Gordon Moore, founder of
INTEL). The US price index for semiconductors has fallen by a factor of about to,000
since T974.
In a wider sense, the new economy is thought by some to permanently boost
growth rate prospects by raising productivity and global trade by removing or
reducing >-inflation and labour market flexibility constraints. Faith in the benign
consequences of the new economy has been weakened by the puncturing of the
dot.com boom in March 2001 and subsequent revelations of false accounting by a
number of new economy companies. In the USA, ►productivity growth did acceler¬
ate in the second half of the T990S, but the bulk of productivity increases have been
concentrated in computer-producing sectors. There is little evidence of a global
impact on productivity, and certainly not of the improved economic stability that
was predicted.
Despite these caveats, ICTs will undoubtedly have profound long-term effects on
the economy, perhaps comparable to those resulting from the adoption of electricity
from the T920S. ►electronic commerce; knowledge economy.

new-issue market That part of the ►capital market serving as the market for new
long-term > capital. Those institutions needing capital (industrial, commercial and
financial companies and public authorities) offer ►shares and ►securities that are
then purchased by each other and the general public. Internally generated funds
provide about 70 per cent or more of the capital required by business and the
new-issue market is not large, accounting on average for about 5 per cent, although
it is of some importance. The new-issue market does not include certain other
sources of new long-term external finance, e.g. >mortgages and other Moans from
financial institutions. Borrowers in the new-issue market may be raising capital for
new ►investment, or they may be converting private capital into public capital; this
is known as 'going public' (>flotation).
fill newly industrialized country

The largest concerns are able to issue stocks and shares direct to the public. These
stocks and shares will normally be quoted on the >stock exchange. Other concerns
will raise their new capital through an Mssuing house that will either underwrite
the issue or first purchase the securities and then offer them for sale to the public
(►unlisted securities markets). In all cases the issues will actually be handled by an
tissuing broker. A full prospectus describing the company and its prospects as well
as public advertising are necessary and, for smaller issues, costs can be reduced by
private placing, i.e. by selling the shares to ^insurance companies or other investors.
Quoted companies may issue unquoted shares in this way. Rather larger amounts
are raised by private placing by other >public companies that have no quoted
securities, but > private companies have no access to the new-issue markets, since
they cannot achieve quotations while retaining their private status. Well-established
companies can greatly reduce the cost of raising new capital by offering shares to
their existing shareholders by what are known as 'rights issues' (>rights issue). Rights
issues save the cost of advertising, issuing brokers and underwriting commissions,
although the shares will normally have to be offered at well below market price to
ensure the issue is fully taken up. The difficulty that smaller quoted and unquoted
companies experience in raising new long-term capital was noted in the T93T Mac¬
millan Report (►Macmillan Committee), although unlisted securities markets have
developed further and a number of new institutions have since emerged to meet
this need outside the new-issue market. The >commercial banks have also greatly
increased their lending to ► small business.
The new-issue market, sometimes called primary market (> secondary market), like
the rest of the capital market, is increasingly becoming an international one and
public companies and the public sector raise money in overseas capital markets.

new Keynesianism The economics of those who combine the assumption of

►rational expectations with the stickiness of prices and wages much discussed in
► Keynesian economics. New Keynesians stress the existence of insititutions that
may quite rationally lead to sticky prices, e.g. >menu costs, or long-term contracts
in which prices are fixed well in advance and cannot thus be changed in response
to economic events. They do not believe that money is neutral (> neutrality of
money) and believe that the ►business cycle can partially be explained by changes
in >aggregate demand. The sticky nature of prices means any change in demand
does not lead to an automatic or rapid change in prices; it can lead to a change in
output or employment. This position is distinct from the >-new classical economics,
which shares the rational expectations assumption, but assumes prices adjust more
quickly and as a result that only unanticipated changes in aggregate demand have a
real effect. »S^Akerlof, G.; economic doctrines; policy ineffectiveness theorem.

New York Stock Exchange (NYSE) The leading New York stock exchange and
largest in the world in terms of ►market capitalization. Some 3000 domestic and
foreign companies and 5000 ►securities are listed. The NYSE is a self-regulating
body, though it has to secure compliance with the requirements of the ►Securities
and Exchange Commission. The second US exchange, also in New York, is the
American Stock Exchange. The NYSE is also referred to as the Big Board and as
Wall Street.

newly industrialized country (NIC) A country that is not a >developing country

 NIC | 278

but has not yet achieved the status of the ►advanced countries. Malaysia and
Mexico, for example, are usually counted as NICs, but some earlier examples (e.g.
Singapore), have >per capita income similar to the levels of members of the ►Organ-
ization for Economic Cooperation and Development.

NIC ►newly industrialized country.

Nice, Treaty of ►European Union.

NNP Net national product (►national income).

Nobel Prize The sixth Nobel Prize, for Economics, in memory of Nobel (1833—96),
the Swedish chemist, was introduced in 1969 and is financed by the Swedish National
Bank. The following economists have been awarded this prize in each year: 1969,
Tinbergen and ►Frisch; 1970, ►Samuelson; 1971, ►Kuznets; 1972, ►Hicks and ►Ar¬
row; 1973, ► Leontief; 1974, ►von Hayek and ►Myrdal; 1975, Kantorovich and
►Koopmans; 1976, ►Friedman; 1977, ►Meade and ►Ohlin; 1978, ►Simon; 1979,
► Schultz and ► Lewis; 1980, ►Klein; 1981, ►Tobin; 1982, >Stigler; 1983, ►Debreu;
1984, ►Stone; 1985, ►Modigliani; 1986, ►Buchanan; 1987, ►Solow; 1988, ►Allais;
1989, >Haavelmo. In r99o the prize was won by three American finance economists,
►Markowitz and ►Sharpe for their development of the ►capital asset pricing model,
and ►Miller (►Modigliani-Miller theorem). Since then the prize has been domi¬
nated by the University of Chicago (►Chicago School); ►Coase won the prize in
1991. ►Becker won it in 1992. ►Fogel, and >North, collected it jointly in 1993. Three
►game-theory pioneers won it in T994: ►Harnsanyi, ►Selten and ►Nash. ►Lucas
won it in 1995, and in 1996 the British economist ►Mirlees and American ►Vickrey.
For their work on option pricing models, ►Merton and ►Scholes won in 1997.
►Sen won it in 1998 for his work on development economics and ►Mundell for
international macroeconomics in 1999. In 2000, the prize was shared between
►Heckman and ►McFadden for advances in micro-econometrics. In 2001, ►Akerlof,
►Spence and ►Stiglitz shared the award for their work on the analysis of markets.
In 2002, the prize was shared between ►Smith and ►Kahneman for their work on
the analysis of the rationality of human behaviour.

nominal gross domestic product The value of the ►gross domestic product
(GDP) at ►current prices. Many economists, notably >Meade, have suggested that
the government should set a target for nominal GDP; if workers take low pay rises,
this target will be reached by real output increases; if workers take high pay rises,
then the nominal GDP rise will almost entirely consist of ►inflation.

nominal value The ►face value of a ►share or ►bond, which may be more or less
than its market price. S^par value.

nominal yield The return or ►yield on a ►security in which ►dividend or

► interest is expressed as a percentage of the ►nominal value of the security as
opposed to its market price.

non-accelerating inflation rate of unemployment (NAIRU) ►unemploy¬

ment, natural rate of.

non-domestic rates ►local taxation.

non-price competition Attracting or attempting to attract business from rivals

 normal good

by means other than selling at lower prices, e.g. by the use of advertising or
product differentiation (^differentiation, product). Non-price competition is found
commonly under conditions of >oligopoly, where price-cutting could lead to a
damaging price war, thus the use of free gifts, coupons and special offers.

non-substitution theorem A theorem that states that, if there are no economies

or diseconomies of scale in an economy, if there are no >joint products and if all
inputs that are not themselves produced are used equiproportionately in production
of everything, then competitive prices will reflect only technology and cost, and
demand will have no impact on them.

non-tariff barriers (NTBs) Obstacles to imports other than Vquotas or >-tariffs.

Examples include health, safety, construction and use regulations that favour do¬
mestic over imported products; legal requirements that providers of insurance ser¬
vices should be domiciled within national boundaries, and deliberate delay or
obstruction at customs facilities, ^barriers to entry; protection; voluntary export
restraints.

normal distribution Also referred to as the Gaussian distribution. It was first

discovered by de Moivre in T763 but remained unnoticed until it was independently
again discovered by Gauss. It is a continuous, symmetrical, bell-shaped curve (see
diagram) at the heart of probability and sampling (>sample) theory. If, for example,

a random sample of tax returns were taken from a population and the mean
(>average) income of the sample were calculated, then these tax returns were
returned and another sample taken and the mean income of these calculated and
so on, a series of mean incomes would be derived that would eventually generate a
normal curve when plotted against the frequencies with which each mean occurs.
This mathematical fact (i.e. that a normal curve emerges from the continuous
random, unbiased, sampling of a population variable) is used to test whether a given
value has been derived from a particular population. In a normal distribution, 5 per
cent of the observations are more than 1.96 times the ^standard deviation away
from the mean. If a new income observation falls into this area of the curve, it can
be said that the sample has a ^probability of 5 per cent of having been drawn from
the same population as the previous samples. »-log-normal distribution.

normal good ^inferior good.

 normal profit

normal profit ► profit.

normative economics Economics concerned with judgements about 'what ought

to be' in contrast to ►positive economics, which is concerned with 'what is'. A
normative statement would be that 'industry should be more concentrated'. Such a
statement should rest upon a positive assertion about the existing level of ►con-
centration and a lvalue judgement that fewer firms would lead to greater efficiency
or some other benefit.

North American Free Trade Agreement A Wree trade area set up from 1994,
comprising Canada, the USA and Mexico. >Import tariffs, ►quotas and other trade
barriers (>non-tariff barriers) between the member countries are to be phased out
over a period of up to 15 years. The agreement also includes environmental provisions
relating to the use of renewable resources, health and pollution.

North, Douglass C. (b. 1920) Economic historian, at Washington University,

St Louis, Missouri, and a joint winner of the ►Nobel Prize for Economics in 1993.
North, like his fellow winner, ► Fogel, has been important in promoting the impor¬
tance of, and explaining, the institutions in which an economy operates. He main¬
tains that new institutions are created when groups see an opportunity for profit
that cannot be realized under prevailing conditions. Attaching some weight to the
context in which economic mechanisms operate, as much as to the mechanisms
themselves, became fashionable in the context of former Eastern-bloc nations
(►transition, economies in) and their attempts to emulate Western nations. North
himself was an adviser to the government of the Czech Republic.
NTA ►net tangible asset.

NTB >non-tariff barrier.

null hypothesis A proposition assumed to be valid, unless evidence is found to

the contrary. A common null hypothesis used in ►econometrics is that there is no
relationship between two variables, i.e. that a ►parameter being estimated has the
value zero. The null hypothesis will be accepted if the statistical evidence is weak for
the relationship; it will be rejected if the relationship is convincingly found to exist
in the data provided that is within acceptable bounds of statistical likelihood, given
that the study is usually based on a ►sample. A null hypothesis has always to be set
against an alternative hypothesis, with the null hypothesis usually representing the
'status quo'. The legal equivalent would be the proposition that someone is innocent
unless proven guilty. It is generally incumbent on those trying to demonstrate the
validity of a new theory to show it to be true, rather than for those doubting the
point having to show it not to be true. W^beta; confidence interval.

NYSE ►New York Stock Exchange.

 o
objective function >-Lagrange multiplier.

obsolescence A reduction in the useful life of a >capital good or consumer durable

through economic or technological change or other external (^durable goods)
changes, as distinct from physical deterioration in use (^depreciation). For example,
a new process or machine may be developed that renders existing equipment uneco¬
nomic because a firm could significantly reduce its costs by scrapping its existing
machinery even though it might still have many years of physical life. Then the old
equipment has become obsolescent.

occupational pension schemes >personal pension.

OECD ^Organization for Economic Cooperation and Development.

OEEC Organization for European Economic Cooperation (^Organization for Eco¬

nomic Cooperation and Development).

Office of Fair Trading ^competition policy.

OFT Office of Fair Trading (^competition policy).

Ohlin, Bertil (1899-1979) Born in Sweden, Professor Ohlin studied at the University
of Lund and the Stockholm School of Economics. He was appointed to a Chair of
Economics at Copenhagen University in 1925. In 1930, Professor Ohlin moved to the
Stockholm School of Economics where he remained until his retirement in 1965. He
was a Member of Parliament from 1938 until 1970 and Chairman of the Swedish
Liberal Party for many years. He was awarded the >Nobel Prize in Economics in 1977
(jointly with >Meade). His major contribution - to >international trade theory -
was published in Interregional and International Trade (1933). Professor Ohlin refined
the theory of ^-comparative advantage by building upon the work of Heckscher
(>^Heckscher-Ohlin principle). He also made important contributions to >macro-
economic theory, in many ways anticipating in the 1930s the work of >Keynes.

Okun, Arthur M. (1928-80) Professor Okun graduated from Columbia University

in 1956 and became Professor of Economics at Yale in 1963. From 1969 until his death
he was Senior Fellow at the Brookings Institute. His major publications include
The Political Economy of Prosperity (1970) and Prices and Quantities: a macro-economic
analysis (1981). Professor Okun argued that >supply and >demand are not neces¬
sarily brought into ^equilibrium by lowering prices but they are by adjusting output.
Excess capacity may not lead to lower prices in an economy. In Potential GNP, Its
Measurement and Significance (1968), he analysed US gross national product for (GNP)
 Okun's law | 282

the 1950s and 1960s. He discovered that a 1 per cent increase in unemployment was
associated with a 3 per cent drop in the ratio of actual GNP to full-capacity GNP.
This relationship has become known as Okun's law.

Okun's law >Okun, A. M.

oligopoly A market which is dominated by a few large suppliers (^concentration).

Oligopolistic markets are often characterized by heavy >-product differentiation
through advertising and other marketing ploys, with long periods of price stability
intermittently disrupted by keen price competition. Petrol sales and soap powder
are notable oligopoly industries in which free offers, competitions and advertising
are more heavily used than price competition for attracting custom.
There is no single theory of oligopoly equivalent to that of ^perfect competition
or >-monopoly because the behaviour of oligopolistic firms is determined by the
reaction and behaviour of their rivals, and the assumptions they make about those
reactions. Instead, there is a number of alternative theories.

(r) A theory developed by >Cournot assumed that each firm sets its price and output
on the assumption that its rival does not react at all. In such a situation, each
firm will leap-frog past the other, lowering price and increasing output to gain a
higher market share. The result, is nevertheless, a market in which prices are
higher and output lower than each would be if the firms behaved as perfect
competitors.
(2) That of >Bertrand competition, in which keen price competition drives firms to
the perfectly competitive outcome.
(3) That firms recognize their interdependence, and one among them leads in price
setting with others following. In this case, the leader enjoys higher profits than
any followers, but all firms benefit from the stability and predictability of the
industry.
(4) That all firms attempt to act as leader; then they all earn lower profits than they
would under Cournot's solution (^-prisoner's dilemma).
(5) That firms assume their rivals will follow their prices down but not follow their
price if it rises; in this situation, firms will be very reluctant to change their prices.
It could account for the fact that prices are often stable in oligopolistic industries
despite large changes in costs.
(6) That in which firms collude and between them achieve the outcome that would
occur if a ^monopoly existed in the industry. However, if one firm colludes, it
always pays another to cheat and sell more than agreed, so that maintaining
collusive agreements may be difficult in situations where firms cannot monitor
each other's behaviour. Otherwise, hefty State penalties for collusion can deter
oligopolists from making agreements that have negative effects on consumers.

Other approaches to oligopoly exist, notably >game theory has been used to simu¬
late the reactions of firms to each other's behaviour. anti-trust; Nash equilibrium;
Organization of Petroleum Exporting Countries.

Olson, Mancur (1932-98) Economist who investigated the workings and implica¬
tions of how collective action can frustrate the public interest. Born in North Dakota,
USA he graduated from the State University in r954. After 2 years as a Rhodes Scholar
at Oxford followed by military service, he was an Assistant Professor at Princeton.
 open economy

In 1969 he joined the University of Maryland where he was Distinguished Professor

of Economics until his death. In 1990, he founded the Center for Institutional
Reform and the Informal Sector (IRIS) that carries out research, training and con¬
sultancy in ^developing countries and former Communist countries (^transition,
economies in).
The kernel of all Olson's subsequent work lies in his first book The Logic of Collective
Action (1965), which was based on his doctoral dissertation. The book explores
the relationships between members of special interest groups, their size and the
interaction of their incentives and actions on each other and the wider public
welfare, effectively a rich exercise in >game theory. In The Rise and Decline of
Nations: economic growth, stagflation and social rigidities (1982), Olson showed how
distributional coalitions could secure benefits for the group (e.g. by lobbying success¬
fully for »-subsidies or > tariff protection) at the expense of those outside the group.
Special interest groups proliferate and become more deeply entrenched over time.
The longer a society goes without an upheaval, the more powerful these organiza¬
tions become and the more they slow down economic expansion. The dismption of
these institutions following the Second World War was a more important factor in
explaining the rapid postwar growth of Germany and Japan than the replacement
of physical plant and infrastructure with state-of-the-art equipment. According to
Olson, his thesis that the formation of dense networks of collusive, cartelistic (^car¬
tel) and lobbying organizations helps to explain the slow growth of the American
north-eastern and older mid-western regions, and the UK, and the faster growth of
the American south and west.
A Not-So-Dismal Science (2000), a collection of articles edited by Olson and Kali-
konen, a director of IRIS, appeared posthumously. The theme of the book is that it
is the economic policies and organizational (^-governance) arrangements of a society
that mainly determine how innovative and prosperous it is. In Olson's words, 'goods
and services can be obtained not only by making, but also by taking, and that
makes societies less efficient'. In an article by Olson, 'Dictatorship, Democracy and
Development', American Political Science Review (T993) reproduced in the book, it is
shown that in a world of roving banditry there is little incentive for anyone to
produce or accumulate anything that may be stolen. It is in the interest
('encompassing interest') for the banditry to settle down, provide law and order and
other »-public goods and incentives for production so that output and the 'take' can
be maximized. By extension, the same emphasis on individual rights that is necessary
for lasting democracy is also necessary for securing rights to property and enforcing
contracts. Democracies, however, help to prevent an excessive extraction of the
social surplus by their leaders. Olson was committed to a multi-disciplinary approach
to economic problems using sociology, law and politics and worked in the tradition
of ^institutional economics.

on cost The contribution of the >cost of ^overheads added to the direct costs of
production.

OPEC >Organization of Petroleum Exporting Countries.

open economy A situation in which foreign trade (>exports and >-imports) and
payments and movements of labour and capital into and out of a country are
unrestricted. The term is also used to refer to countries for which foreign trade is a
 open-ended fund

large percentage of the >• gross domestic product. The degree of openness of an
economy may act as a constraint on the freedom of governments to pursue particular
types of economic policy, e.g. the reduction of interest rates to stimulate expansion
may, in an open economy, lead to a flight of capital to other countries, depressing
the ^exchange rate with adverse consequences for >inflation.

open-ended fund An investment company in which units may be purchased

from, or sold to, the fund manager, as in a >-unit trust. The fund is open in the sense
that its size continuously depends upon its success in selling units, in contrast to a
>-closed-end fund like an > investment trust.

open-ended investment company (OEIC) An >open-ended fund listed on a

^stock exchange at a single unit price; like an ^investment trust, but it can issue or
redeem ^redemption) >-shares to match demand in a similar way to a >unit trust.
Common in Continental European countries and the USA, and permitted in the
UK from 1995.

open-market operation The purchase or sale of ^securities by the ^central

bank to influence the supply of funds in the >capital market, and so interest rates
and the volume of credit.

operating cost (US) A term for prime or > variable costs.

operating profit 1 Profit on current activities. 2 The difference between total

revenue and total operating costs (or > variable costs) and before deduction of >-fixed
costs. »► inflation accounting; profit.

operating ratios Various measures of the efficiency of a business, e.g. the

operating rate or ^capacity utilization rate, the stock-sales ratio, > labour turnover
ratio, the creditor-debtor ratio and other ^financial ratios.

operations research (OR) A multidisciplinary approach to the solution of quanti¬

fiable business or administrative problems, e.g. the determination of ^optimum
levels of > inventories, quality control and vehicle routeing. Operations research
usually involves the use of computer models to test alternative solutions and the
basic discipline of OR personnel may be mathematics, engineering or economics. A
number of techniques used in economics are of this type, e.g. >-critical-path analysis,
discounted cash flow (>-present value) and >Tinear programming.

opportunity cost The value of that which must be given up to acquire or achieve
something. Economists attempt to take a comprehensive view of the cost of an
activity. If a firm invests undistributed ^profits to spend £1000 on new machinery
that requires less electricity than the equipment it replaces, the cost of that machin¬
ery is not the outlay of £rooo alone: what could be earned from the best alternative
use of the money also has to be taken into account. If, for example, the firm is paying
T2 per cent interest on an overdraft and the saving in electricity is less than firzo a
year, it would be better for the firm to pay off its overdraft than to invest in the new
machinery. If a self-employed person makes a ^profit of £20,000 a year without a
wage, he/she needs to consider the alternative use to which his/her time could be
put. He/she might, for example, be able to earn £25,000 a year working for someone
else, this is the opportunity cost of his/her time. Accounting costs, as in these examples,
normally allow only for cash outlays, but cash outlays will only approximate to
 optimum

opportunity costs when competition ensures that the prices of all Mactors of pro¬
duction are equal to those for their best alternative use (>Wieser, F. von). (Under
the assumptions of ^perfect competition, the self-employed person would be aware
that he/she could earn more in employment and, since we assume profit maximiz¬
ation, would do so.) Economists also distinguish between private costs and >social
costs and costs in >real terms and money terms, ^-average cost; imputed cost;
prime costs; shadow price.

optimal-growth theory The area of economics concerned with analysing the

level of economic growth that maximizes social welfare. The starting-point is known
as the golden rule of capital accumulation (>golden rule) which, under a large number
of assumptions, suggests that the optimal-growth path will be the one that
maximizes consumption per worker over time. To vary consumption per worker,
society can vary its stock of capital per worker: if there is too much capital, main¬
taining the capital-labour ratio will require such high levels of investment that
workers would have to save a lot and refrain from consumption. If there is too little
capital, however, while it is easy to maintain the stock, the product of workers is low
because they are poorly equipped. The rule suggests that the optimal position is one
in which the rate of growth of population equals the ^-marginal productivity of
capital, or which, in a perfectly competitive economy, equals the rate of profit. An
alternative way of expressing the same rule is to say that the rate of saving should
equal the rate of profit. The golden rule is limited in its application to a society in
which >balanced growth is achieved from an ideal starting-point. It does not suggest
how growth should proceed in the absence of an optimal starting-point or whether
balanced growth is itself desirable.
Alternative rules and principles have been developed, notably that of Ramsey in
r928 that the ^marginal productivity of capital should equal the proportionate
decline in the marginal utility of consumption. Other theoreticians have attempted
to show that it is sometimes optimal to adopt the maximum or near maximum
possible balanced growth path; this allows an economy to move from an unsatisfac¬
tory state to a more satisfactory one very quickly even if consumption is lower in
the interim than it is at either the starting- or finishing-point. Known as turnpike
theorems (turnpike being an American term for motorway), such theorems imply
that the quickest route between two states of the economy may not be the shortest
in distance terms, as is the case with many motorway journeys. Optimal-growth
theory is an area of economics grounded in complicated mathematics, in contrast
to the more popular debate about whether growth is desirable at all. ^economic
growth theory.

optimum A position in which the aim of any economic unit is being served as
effectively as it possibly can be, within the constraints applying. Where a situation
is not optimal, gains in welfare (^welfare economics) can be made for some without
any sacrifice by others. Essential to the meaningful application of the concept of an
optimum is the existence of some objective (e.g. the maximization of futility) and
some constraint on the pursuit of that objective, e.g. a specified set of prices and a
given income. While it is possible to have two conflicting objectives (e.g. money
and leisure), an optimum can only be attained with respect to both of them if some
desired trade-off between them can be expressed; this is roughly equivalent to
finding a single criterion by which both can be judged and optimizing with
 optimum currency area | 286

respect to that criterion. Individuals, trade unions, firms and countries are generally
assumed to be rational in economic theory and thus exhibit optimizing behaviour,
^economic efficiency; linear programming; Lagrange multiplier.

optimum currency area ►Mundell, R.

option An agreement with a seller or buyer permitting the holder to buy or sell a
financial instrument or ►commodity at a given ►price within a given period. In
the > stock exchange, an option may be purchased from a dealer, giving the right to
purchase a certain number of ►shares at a certain price within a certain time, e.g. a
3-month option. If, in the meantime, the price falls by more than the cost of the
option, then the dealer will lose and the purchaser gain, and vice versa. An option
to buy is a >'call option', an option to sell is a put option, and one to buy or sell is a
double option. Trade in option contracts (hence traded options) in ►securities markets,
►money markets and commodity exchanges has expanded enormously in recent
years (>London International Financial Futures Exchange). There are major op¬
tions markets in Chicago and other financial centres. J^Black-Scholes formula;
derivatives.

OR >operations research.

ordinal utility A measure of consumer satisfaction expressed in terms of rankings

of preferred combinations of commodities rather than through the assignment
of values to them of some absolute futility measure (►►Marshall, A.). Until the
beginning of the nineteenth century, economists assumed that individuals had a
cardinal measure of utility, with the consumer able to give a mark to each basket of
products to reflect the pleasure it generates. It came to be realized, however, that no
sensible meaning could be given to statements of the form: 'This apple provides me
with twice as much utility as it provides you.' Fortunately, no such scale was
necessary for a consumer theory to be derived. All that is required is that consumers
list bundles of commodities in order of preference and group bundles between
which they have no preference. The difference between the two approaches can be
highlighted by contrasting the way in which they show that a rise in the price of a
product leads consumers to >demand less of it. The cardinal approach holds that
rational consumers will equalize the utility derived from the marginal unit of cash
spent on each item. A rise in the price of eggs thus implies that consumers raise the
marginal utility they derive from eggs. Given the assumption of ►diminishing
marginal utility, the only way to effect such an increase is to cut consumption to a
point at which eggs are more appreciated than they were and their marginal utility
rises. The ordinal approach is only concerned with the relative attractiveness of
items. It is the ratio of marginal utilities that is important and neither the consumer
nor the economist needs to rely on a concept of utilities of some absolute value. In
this approach, consumers will ensure that the ratio of prices of items equals the
ratio at which the consumer would choose to swap the items with indifference,
►►indifference-curve analysis; marginal rate of substitution; Pareto, V. F. D.; Pigou,
A. C.; Slutsky, E.; social-welfare function.

ordinary least-squares estimation ►least-squares regression.

ordinary share Shares in the ►equity capital of a business entitling the holders
287 | output gap

to all distributed > profits after the holders of > debentures and ^preference shares
have been paid.

Organization for International Economic Cooperation ^Council for

Mutual Economic Aid.

Organization of Economic Cooperation and Development (OECD) The

organization that came into being in r96i, renaming and extending the Organization
for European Economic Cooperation (OEEC). It was based on the convention signed
in Paris in r96o by the sixteen original European member countries of the OEEC,
plus Spain, the USA and Canada. By 20or, there were thirty member countries. The
aims of the OECD are: (a) to encourage economic growth and high employment
with financial stability among member countries, and (b) to contribute to the
economic development of the less advanced member and non-member countries
and the expansion of world multilateral trade (>-multilateralism). The OECD carries
out its functions through a number of committees (i.e. the Economic Policy Commit¬
tee, the Committee for Scientific Research, the Trade Committee and the Develop¬
ment Assistance Committee) serviced by a secretariat. It publishes regular statistical
bulletins covering the main economic statistics of member countries and regular
reviews of the economic prospects of individual members. It also publishes ad hoc
reports of special studies covering a wide range of subjects, e.g. world ^population
growth and agricultural surpluses. The OECD has been particularly important as a
forum for the industrial countries to discuss international monetary problems and in
promoting aid and technical assistance for ^developing countries. ^International
Energy Agency; International Monetary Fund.

Organization of Petroleum Exporting Countries (OPEC) A group of eleven

countries that are major producers and exporters of crude petroleum. The OPEC,
set up in r96o, acts as a forum for discussion of, and agreement on, the level at which
the member countries should fix the price of their crude petroleum ^-exports by
production quotas. The OPEC also acts as a co-ordinator for determining the level
of aid to >developing countries granted by the members. In 2002, the member
countries were Algeria, Indonesia, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi
Arabia, the United Arab Emirates and Venezuela. These countries account for about
78 per cent of total world crude-oil reserves, ^-international commodity agreements;
International Energy Agency.

origin ^certificate of origin; European Free Trade Association,

origin principle >value-added tax.

OTC !► over-the-counter market.

output gap The difference between the actual level of activity in an economy,
and the sustainable amount of activity given the capacity of the economy. An output
gap is measured as a percentage. It may be negative (equivalent to a >deflationary
gap) or it may be positive, implying that the economy was operating unsustainably
fast - that it was >overheating (in an ► inflationary gap). The output gap is expressed
as a percentage of the level of >gross domestic product (GDP). Unfortunately, it is
not possible to observe potential activity; it is only the actual activity we can record.
 overdraft

So, proponents of output-gap analysis typically have to estimate potential output.

This is usually extrapolated as follows:

(1) Find a year in the past when the economy was neither booming nor in recession.
Assume that the output gap then was zero and that, in that year, potential GDP
was the same as actual GDP.
(2) To derive potential GDP in subsequent years, assume that it grows from the base
year by a constant rate. That constant rate is ► trend growth. In any subsequent
year, actual GDP can then be compared to the extrapolated potential GDP
measure, to derive the gap.

Proponents of the output gap make one additional plausible assumption: that, when
companies operate in excess of their capacity, they attempt to raise their real prices;
and, when they operate below their capacity, they tend to cut their real prices (Meal
terms). The inflation rate tends to rise when actual output is above potential. It
tends to fall when actual output is below potential. The gap is useful in assessing
► monetary policy, because it assumes that any increase in ^aggregate demand in
the economy will generate extra output if actual GDP is below potential, and will
generate inflation if actual output exceeds potential. The gap is useful in explaining
why an economy can grow fast for several years with falling inflation. If output
started well below potential, then even if growth is fast, it might remain below
potential and thus inflation should still be coming down.
It is also useful in assessing how much a government can reasonably borrow.
Borrowing tends to go up or down across the >business cycle (>built-in stabilizers).
Estimating the output gap can give a clue as to the Xstructural budget deficit.
Estimates of the output gap for all main developed economies are produced by the
►Organization of Economic Cooperation and Development, ^unemployment,
natural rate of.

overdraft A Moan facility on a customer's ►current account at a bank permitting

him to overdraw up to a certain agreed limit for an agreed period. ► Interest is
payable on the amount of the loan facility actually taken up, and it may, therefore,
be a relatively inexpensive way of financing a fluctuating requirement. The terms of
the loan are normally that it is repayable on demand, or at the expiration of the
agreement, and it is thus distinct from a >term loan.

overfunding ►funding.

overheads ►fixed costs.

overheating A situation in which >aggregate demand in the economy is growing

at a rate likely to lead to ►inflation. It refers to a situation in which the >output
gap is close to zero, or is positive. P recession; stabilization policy.

overseas aid ►foreign aid.

overseas banks 1 Banks operating in, say, the UK but which are incorporated
outside the UK. and not UK-controlled. There are over 600 overseas banks rep¬
resented in the UK. 2 Banks from, for example, the UK that conduct their business
mainly abroad. Many of these banks are subsidiaries of the ►commercial banks.

overseas investment ►foreign investment.

 ownership

over-subscription Where a new issue of ^shares is made and the demand for the
shares exceeds the number on offer, the issue is said to be over-subscribed. It is, of
course, extremely difficult for the Mssuing house to estimate precisely the price at
which a share issue will be fully taken up, and new issues are usually either over- or
under-subscribed. It is very common for an attractive issue to be 10 times or more
over-subscribed, especially because of purchases by stags, i.e. speculators who sub¬
scribe to new issues in the expectation that they will be over-subscribed and that
dealings will begin at a ^-premium. Very often new issues that start at a premium
fall back to below the issue price as a result of > profit-taking by stags.

over-the-counter (OTC) market 1 A group of licensed dealers who provide

two-way trading facilities in company Securities outside the Stock exchange. The
term originated in the USA in the 1870s when stocks were first purchased across
bank counters. Today the OTC in the USA is an elaborate electronic dealing system,
with >market makers across the country, called the National Association of Securi¬
ties Dealers Automated Quotations system, ^unlisted securities markets. 2 More
generally, any securities trading activity carried out outside stock exchanges, e.g.
OTC ^-options written by a single seller for a single buyer under a private and
confidential arrangement, as distinct from traded options.

overtrading A firm is said to be overtrading when it has insufficient >working

capital to meet the needs of its present level of business. For example, a firm
that doubled its production, and then found that it could not meet all its current
expenditure because too much >-capital was tied up in stocks and work in progress,
would be overtrading, even though it had correctly forecast the demands for its
products. In such circumstances, the firm's >current ratio would probably be less
than unity.

overvalued currency ^undervalued currency.

ownership >-Coase theorem; separation of ownership from control.

Paasche index An >index number that employs weights (W^weighted average)
derived from current statistics rather than from those of some past period (>-Laspey-
res index). As an example, an annual Paasche price index would calculate the price
change (the price relative) of each commodity or service included in the index
between the current year and a base year, and then derive the weighted average of
these price relatives, each weight being the amount spent on each commodity in the
current year.

paid-up capital That part of the »-issued capital of a company that has been paid
up by the shareholders. Except for partly paid ^privatization issues, it is rare among
shares dealt with on the London >stock exchange for the issued capital not to be
paid up, and the phrase is sometimes used loosely as a synonym for issued capital
to distinguish it from ^-authorized capital.

panel data Data that consists of both >-time series and cross-section values
(>cross-section analysis), e.g. a dataset that consists of spending by a large sample
of households for several years. >*► econometrics; regression analysis.

paper profit An unrealized >money increase in the >value of an basset or assets.

An individual, for example, will have made a paper profit on his/her house if it is
worth more now than when it was bought.

paradox of thrift The phenomenon that if too many people try to increase their
saving simultaneously, spending and national income can fall, with the effect that
people have less income to save. In the extreme case, the volume of savings could
even fall. In principle, under models built around >neo-classical economics, there
should be no paradox, as any extra supply of savings should drive down interest
rates and encourage extra investment spending, thus keeping national income up.
However, under the assumptions of > Keynesian economics, there is little reason to
expect investment to grow in response to higher saving.

paradox of value The paradox that certain items that are very valuable to mankind
(e.g. water) are very cheap to buy, while other less useful items (e.g. diamonds) are
expensive. The supposed paradox is a widely used illustration of some key principles
in economics. The reason prices do not reflect our intuitive notion of value is that
they are set by conditions of supply as well as demand: water may be very important,
but there is an awful lot of it, so it does not have to be highly priced. This is to repeat
the conclusion that prices are set by the marginal value of an item - the value of
consuming yet more of it - not by the value of consuming it all. If we had to give up
 parameter

all consumption of either diamonds or water, we would clearly choose to give up

diamonds.

paradox of voting The paradox (also referred to as 'Condorcet's paradox', after the
eighteenth-century French philosopher) that a majority voting system can produce a
set of inconsistent social preferences from a set of individually consistent prefer¬
ences. Suppose electors Anne, Bill and Caroline rank three options - defence, edu¬
cation and social security, as follows:

Anne Bill Caroline

Defence I 2 3
Education 2 3 I

Social security 3 I 2

When the options, taken in pairs, are voted on defence beats education, education
beats social security but social security beats defence. In each case, two of the voters
rank the winning option higher than its opponent, thus ensuring its victory. As a
result, the electors could either never determine which of the three options to put
first, or their choice will merely depend on the order in which voting takes place -
the social ranking does not possess Mransitivity. As transitive preferences are a
precondition for the meaningful derivation of ^indifference curves, the paradox is
one indication that the theory of optimal behaviour for individuals cannot easily
be extended to 'democratic' societies, ^impossibility theorem; social-welfare
function.

par value The >-price at which a >-share or other >security is issued, i.e. the Mace
value of the ^investment. A share is said to be standing above par if its quoted price
on the >stock exchange is greater than that at which the share was issued. The term
was also used to describe the official fixed >exchange rate of currencies in terms of
gold and US dollars, as declared to the Mnternational Monetary Fund.

parallel imports >Imports of a product into a country and its sale outside the
existing franchised sales network for the product and without the approval of its
manufacturer. It occurs when the price at which the product is sold in one country is
higher than in another. There is then an opportunity for >arbitrage. This ^arbitrage
would eventually reduce the differences in prices between countries, unless there
were technical, legal or other obstacles to this trade.

parallel money markets Markets in short-term securities other than ^treasury

bills, Mills of exchange and Monds dealt with on the Miscount market. Until the
mid 1950s, the discount market alone provided the main market for short-term
money. Since 1955, when local authorities were no longer allowed to borrow at will
from the Public Works Loan Board, a large market in short-term loans to local
authorities has developed. Other markets have developed in >eurocurrency, ►certi¬
ficates of deposit, finance-house deposits and inter-company and interbank loans,
^►interbank market; inter-company loans market; unlisted securities markets.

parameter The values in a mathematical function that remain constant against

movements in the variables of the function. For example, in the demand equation
Pareto, Vilfredo Federico Damaso

d = aY + bp + c, d (quantity demanded), Y (disposable income) and p (price) are

variables, and a, b and c are parameters (constants). >beta; ^regression analysis.
Pareto, Vilfredo Federico Damaso (1848-1923) An Italian born in Paris, Pareto
was trained as, and practised as, an engineer. He succeeded his father to a post in
the Italian railways, and in 1874 was appointed Superintendent of Mines for the
Banca Nazionale, Florence. He succeeded >Walras to the Chair of Economics in
the Faculty of Law at Lausanne University in 1892. His publications include Corns
d'economie politique (1896-7) and Manuale di economica politica (1906). He retired in
1907. He developed analytical economics from the foundation laid by Walras. He
pointed out the shortcomings of any theory of Vvalue in so far as it rested upon
assumptions of measurable or 'cardinal' rather than >ordinal utility. He demon¬
strated that an effective theory of consumer behaviour and exchange could be
constructed on assumptions of ordinal utility alone. Exchange would take place in
a competitive >-market between individuals such that the ratios of the >marginal
utilities of the goods traded equalled the ratio of their prices. An optimum point of
exchange could be defined without the need to compare one individual's total
futility with another's. He defined an increase in total welfare as occurring in those
conditions in which some people are better off as a result of the change, without at
the same time anybody being worse off ^compensation principle). Pareto's work
in this field, coupled with the development of >■ indifference-curve analysis,
invented by Edgeworth, became the foundation upon which modern ^-welfare
economics is based. A study of the distribution of personal incomes in an economy
led him to postulate what became known as Pareto's law, i.e. that whatever the
political or ^taxation conditions, > income will be distributed in the same way in all
countries. He noted that the distribution of the number of incomes is concentrated
heavily among the lower income groups, and asserted that the number of incomes
fell proportionately with the size of income. Pareto's law has not, in fact, proved
valid in its strict sense but it has given rise to the realization that a relatively small
proportion of a firm's customers generate the most profit and firms have designed
their marketing strategy accordingly, ^economic efficiency; income, distribution
of; Slutsky, E.

Pareto-optimal ^economic efficiency.

Pareto's law >Pareto, V. F. D.
Paris Club >International Monetary Fund.

partial correlation The >correlation between two variables, after having adjusted
for any correlation either or both the variables may have with a third variable. For
example, observations of the quantity of a commodity sold over a number of years
may be highly correlated with consumers' disposable income over the period. A
simple correlation between the two would be misleading if, during the same period,
there was a substantial fall in price, so that there was also a strong simple correlation
between quantity and price. The correlation between income and quantity is calcu¬
lated, after having deducted the correlation between quantity and price, to obtain
the partial correlation.

partial-equilibrium analysis The study of the behaviour of ^variables that

ignores the indirect effects that changes in the variables have on themselves through
 pay-as-you-earn

the impact they have on the rest of the economy. When we study, for example, the
market for pet dogs, we do not consider the impact that a change in the number of
dogs sold has on the profits of pet food manufacturers. This and other effects will
have an impact on prices, income and taxation and, through these, have a feedback
effect on the demand for dogs. The usual partial-equilibrium approach is considered
adequate for the study of most markets because such feedback effects are swamped
by the direct effects of events in any individual market and are considered negligible.
This approach contrasts with >general equilibrium analysis. Marshall, A.

participation rate >labour force.

partnership An unincorporated business formed by the association of two or more

persons who share > risks and >profits. Except in a limited partnership, each partner
is liable for the >debts and the business actions of the others, to the full extent of
own ► resources (although taxed as an individual). Partnerships are a common form
of organization in the professions and in businesses in which ►capital requirements
are relatively small, e.g. retail shops and other service trades. Partnerships, with sole
traders (>sole proprietorship) (i.e. self-employed persons working on their own)
account for about 85 per cent of the total number of businesses. For the tax treatment
of partnerships, ^corporation tax. The Limited Liability Partnership Act 2000 offers
►limited liability to members of partnerships in return for similar treatment in
disclosure of financial information and other matters.

patents A temporary >monopoly conferred on an inventor by government for

the exploitation of the product or process. Inventors may use the results of their
work exclusively themselves, usually for a period of 20 years, or they may license
their use to others for a lump sum or against royalties. For example, a biotechnology
company may license the rights to manufacture and distribute a product to a large
pharmaceutical firm. By providing inventors with economic rewards safe from others
who might simply copy inventions, it is hoped that >research and development
(R&D) and invention will be encouraged to the benefit of society at large. In
practice, there are many problems: the patenting process, particularly if international
protection is to be achieved, is costly, and not all countries observe patent conven¬
tions. Not all patents are 'watertight' and in any event the legal costs of recovering
damages for the unauthorized use of an invention may be prohibitive, especially for
an individual inventor or a ►small business. There is also a growing conviction
among some economists that patents restrict competition and the diffusion of new
products and processes. Patents are a form of intellectual property rights analogous to
copyrights for the arts but, unlike these, patented ideas must have novelty, not be
obvious and have an industrial application. Patent statistics are often used as proxies
for the rate of innovative activity (>innovation) and can be used, for example, to
analyse the results of R & D by > multinational corporations.

pay-as-you-earn (PAYE) System of collecting ►income tax in the UK through

regular deduction by the employer from weekly or monthly earnings. Confiden¬
tiality of the taxpayer's private circumstances is preserved through the use of code
numbers which, in conjunction with tax tables, enable the employer to calculate
the amount of tax to be deducted. The system was introduced in 1944 and had been
recommended by ►Keynes. It is thought to be a stabilizing factor in the economy,
since the tax yield automatically varies directly and rapidly with ►income and
pay-as-you-go | 294

employment, whereby the government tends to spend proportionately more tax

yield in recession (►depression) and less in time of high demand and employment,
►►built-in stabilizers; self-assessment.

pay-as-you-go ►pension funds.

pay-back The period over which the cumulative net revenue from an ►investment
project equals the original investment. It is a commonly used but crude method for
analysing ►capital projects. Its main defects are that it takes no account of the
►profits over the whole life of the investment, nor of the time profile of the ►cash
flow, ^investment appraisal.

PAYE ►pay-as-you-earn.

payment in kind Payment in goods or services instead of money ►wages; made

illegal by the Truck Acts. >*• fringe benefits.

payments, balance of ►balance of payments.

payroll tax A >tax levied on employers' ►wage bills. It is now regarded by many
economists in developed economies as a means of encouraging capital intensiveness
(►capital-intensive) at the expense of employment. This type of tax as such is not
used in the UK, although >-National Insurance contributions are a form of payroll
tax. A flat-rate employment tax (selective employment tax) was introduced in 1966 and
abolished in 1973 on the introduction of >-value-added tax.

peak pricing The setting of higher prices than average when supplying services
during a period of peak demand. For example, enough electricity capacity must be
installed to satisfy demand at peak times because electricity cannot be stored. At
off-peak times the cost of electricity is lower at the margin than at the peak at
which less efficient power stations have to be switched in to meet the demand.
► marginal-cost pricing.

peg ► exchange rate.

pendular arbitration ►arbitration.

pension funds Sums of money laid aside and normally invested to provide a regular
► income on retirement, or in compensation for disablement, for the remainder of
a person's life. Nearly all developed countries have State pension schemes, e.g. the
British >National Insurance scheme. Unlike State schemes - which operate on a pay
as you go basis with contributions from those in employment paying for the pensions
of the retired - private pension schemes - for which contributions attract favourable
tax treatment - are usually funded, i.e. placed in managed invested funds. Many
private pension schemes are based upon >assurance.
Occupational pension schemes may be contributory or non-contributory by the
employee; the benefits of private schemes are normally related to the length of
service of the employee and the level of salary or contributions, i.e. they are defined
pension benefits of, for example, 50 per cent of final salary. In defined pension contri¬
bution schemes, employers and/or employees pay regular contributions, but the
pension finally paid is determined by the performance of the fund in which contri¬
butions are invested. On maturity, these funds are used to purchase an ►annuity.
 perfect competition

Since annuity rates vary from time to time, this introduces further uncertainty about
the amount of the pension. Pension funds had >net assets of about £800 billion in
2000, of which 40 per cent was invested in >ordinary shares. >^personal pensions.

PEP Personal equity plan {>individual savings account).

per capita income Income per head, normally defined as the ^national income
divided by the total population. > purchasing-power parity; real exchange rate.

percentile The xth percentile is that value of a distribution of numbers below

which are x per cent of the number of observations. For example, the 50th percentile
is the value below which there are 50 per cent of the observations (this is called the
median) (^average). The quartiles are at 25 per cent and 75 per cent. Similarly, deciles
subdivide the distribution into ioths.

perfect competition A model of industrial structure in which many small firms

compete in the supply of a single product. Three primary features characterize a
perfectly competitive industry: (a) there is a multitude of firms (buyers as well as
sellers) that are all too small to have any individual impact on market price,resulting
in > marginal revenue and >price being equal; (b) all firms aim to maximize > profit,
and (c) firms can costlessly enter and exit the industry. Also, it is assumed that the
outputs traded are homogeneous.
Perfect competition is economically efficient in three ways (^economic
efficiency):

(1) In the >-short mn, profit maximization ensures that each firm will set its output
so that its ^marginal cost is equal to its ^marginal revenue (>firm, theory of
the). To produce when marginal cost exceeds marginal revenue implies that
cutting back production would save more than the revenue lost, and to produce
when marginal revenue exceeds marginal cost implies that expanding production
would increase revenue more than costs. Thus, marginal revenue will equal
marginal cost. Moreover, under the price-taking assumption, the effect is that
marginal cost equals price. This is efficient for the allocation of resources because
it ensures that no consumer will be deterred from buying something which he/
she values more than it cost to make.
(2) In the long run, freer entry and exit ensures new entrants will be attracted into
any industry in which high profits are made. The effect of these new entrants is
to increase supply and bid down price until no profit is made (apart from a
normal entrepreneurial return), i.e. when average revenue equals average cost.
The zero profit result means that no entrepreneur or factor of production earns
more than it just needs to be persuaded into an industry.
(3) Again, in the long run, as average revenue equals marginal cost (from the profit
maximization assumption) and average revenue equals average cost (from the
free entry and exit assumption), we can deduce that average cost equals marginal
cost. The only point on the average cost curve for which this is true is at the
bottom of it, i.e. at the lowest cost point. Finally, therefore, perfect competition
ensures minimum-cost production.

Although the features of perfect competition make it look a poor description of

modern industry, it is a realistic description of world commodity markets where
many traders deal in a homogeneous product. Moreover, its very powerful results
permanent-income hypothesis

indicate that the achievement of even a partially competitive market can be advan¬
tageous. Thus, the simple perfect competition model provides a good starting-point
for illuminating the forces underlying the real behaviour of firms, ^-contestability;
imperfect market; marginal-cost pricing; monopoly.

permanent-income hypothesis The theory proposed by >-Friedman that sug¬

gests that, however variable their income, consumers will attempt to smooth out the
pattern of their consumption (^consumption function). If, for example, someone's
income varies between zero and £20,000 a year, averaging £ro,ooo, he/she will spend
at a constant rate equivalent to a constant £10,000. Given that the >-marginal utility
of money declines with the increasing amounts of spending, it is sensible to transfer
spending from bountiful times to those when one is poor. By saving in some periods
and 'dissaving' in others, this can be achieved. The theory has several implications:

(1) If one has a permanent increase in income, the ^marginal propensity to consume
out of it will equal the >average propensity to consume.
(2) A large increase in short-run >-incomes will not lead to corresponding increases
in consumption. Any extra pound a consumer gets will be treated not as a cause
for a quick spending spree, but as a temporary bonus that should raise lifetime
consumption by the value of the pound spread over a lifetime.
(3) This explains why high income households save more than low income house¬
holds: the high income group is likely to contain the very people who are enjoying
transient high incomes that they are thus storing away for the day when their
income drops.

personal disposable income ^disposable income.

personal equity plan (PEP) ^individual savings account.

personal loan A >bank loan made without >-collateral security to a private

customer for specific purposes.

personal pension 1 A regular income after a certain age and usually after retire¬
ment from work, provided by a State or private scheme. The flat-rate State retirement
pension is paid to men aged over 65 and women aged over 60 who have paid
appropriate ^National Insurance contributions. There is also the State Earnings
Related Pension Scheme (SERPS), (^National Insurance) and an old age pension,
the latter for those who have not participated in the National Insurance scheme.
There are two broad types of private pension schemes:

(1) Occupational pension schemes, provided by employers, that usually involve 'con¬
tracting out' of SERPS and provide a guaranteed minimum pension. These
schemes, known as defined benefit schemes (>pension funds), are either contribu¬
tory or non-contributory; in the latter the employee pays no pension contri¬
butions. The schemes are based on trust funds in which contributions are
invested either directly or through ^financial intermediaries, e.g. life > insurance
companies.
(2) Personal annuity schemes, for the »-self-employed or others who are not members
of an occupational scheme.

2 A private pension scheme of the personal > annuity kind. Under these schemes,
individuals pay contributions into a fund managed by an ^insurance company or
 Phillips, Alban William Housego

other ►institutional investor which provides a cash lump sum at retirement age,
part of which, if it is to qualify for tax relief on the premiums, must be used to
purchase an annuity. The Social Security Act r986, which initiated a run-down of
SERPS, also introduced portable pensions. After 6 April 1988 employers were no
longer able to make membership of a contributory occupational pension scheme a
condition of employment. All employees have the option of paying premiums into
a personal private-sector scheme of their own choice in much the same way as for
the personal-annuity schemes for the self-employed. This means that the employee
will be able to transfer his/her pension scheme if changing employers. These schemes
are known as defined contribution schemes (^pension funds), ^-stakeholder pension.
Up to stated limits, pension contributions by individuals and employers qualify
for >-income tax and ►corporation tax relief. >Pension funds may also receive
favourable tax treatment but institutions can no longer claim tax credits on divi¬
dends (►corporation tax), a withdrawal of a benefit worth about £5 billion per
annum. Pension schemes may be funded - a capital-reserve system, in which contri¬
butions are paid into a fund that is invested in ►securities and other >assets and
from which pensions are ultimately paid - or unfunded, as in the National Insurance
scheme, where pensions for retirees are paid out of the contributions of those in
work (pay-as-you-go system).

personal sector Households and individuals. In the national accounts this sector
includes unincorporated businesses, ^ private sector.

Petty, Sir William (1623-87) The pioneer of numerical economics. His main
interest lay in public finance, and he made important contributions to monetary
theory and ►fiscal policy. His approach to these subjects contributed to the develop¬
ment of ►classical economics and from his work in the field of comparative data
has descended the modern field of economic statistics. His best-known work is
Political Arithmetic (1691). The so-called Petty's law was a remarkably far-sighted
statement of the tendency for the proportion of the working population engaged in
►services to increase as an economy develops.

Petty's law ► Petty, Sir W.

PFI ^private finance initiative.

Phillips, Alban William Housego (1914-75) After a number of jobs in electrical

engineering, and after serving in the Royal Air Force during the Second World War,
Phillips began lecturing in economics at the London School of Economics in r950.
From r958 until ^67, he was Tooke Professor of Economics, Science and Statistics in
the University of London. In 1968 he accepted the Chair of Economics at the Austra¬
lian National University. Professor Phillips published many articles exploring the
relationships between the ►multiplier and accelerator in mathematical ►models
(^accelerator-multiplier model) with various time lags, and applied the engineer¬
ing technique of closed-loop control systems to the analysis of ►macroeconomic
relationships.
In 'The Relation between Unemployment and the Rate of Change of Money Wage
Rates in the United Kingdom, r86r-r957' (Economica, 1958), Professor Phillips set out
empirical evidence to support the view that there was a significant relation between
the percentage change of money wages and the level of >unemployment - the
Phillips curve | 298

lower the unemployment, the higher the rate of change of wages. This relationship,
which became known as the Phillips curve, has attracted considerable theoretical and
empirical analysis. Its main implication is that, since a particular level of unemploy¬
ment in the economy will imply a particular rate of wage increase, the aims of low
unemployment and a low rate of ^inflation may be inconsistent. The government
must then choose between the feasible combinations of unemployment and
inflation, as shown by the estimated Phillips curve, e.g. 3 per cent unemployment
and no inflation, or 1.5 per cent unemployment and 8 per cent inflation, etc.
Alternatively, it may attempt to bring about basic changes in the workings of the
economy, e.g. a Vprices and incomes policy, in order to reduce the rate of inflation
consistent with low unemployment. However, the relation between unemployment
and inflation has not been sufficiently stable in practice to permit exact judgements
to be made.

Phillips curve ^Phillips, A. W. H.

physical controls Direct controls on production and >-consumption, licensing

of buildings or Mmports, and the rationing of goods are examples of physical
controls. These controls are alternatives to the use of monetary or fiscal measures
(►fiscal policy), that control production and consumption through the price mech¬
anism (►price system). M^quotas.

Physiocrats A group of eighteenth-century French economists, led by ►Quesnay,

who later became known as the Physiocrats or ‘les Economistes'. They believed in the
existence of a natural order and regarded the State's role as simply that of preserving
property and upholding the natural order. They held that agriculture was the only
source of ►wealth and therefore this sector only should be taxed by Vimpot unique.
In this, and in their advocacy of free trade, their views were directly opposed to
those of the mercantilists (►mercantilism). In their belief in >laissez-faire, they had
much in common with, and certainly influenced, British ►classical economics, and
especially >Smith. Quesnay's Tableau economique (1758), has in it the origins of
modern ideas on the circulation of wealth and the nature of interrelationships in
the economy. »*-Cantillon, R.; Leontief, W. W.; Mill, J. S.

Pigou, Arthur Cecil (1877-1959) A pupil of ►Marshall, whom he succeeded to the

Chair of Political Economy at Cambridge University in 1908 until he retired in 1944.
His major publications include Principles andMethods of Industrial Peace (1905), Wealth
and Welfare (1912), Unemployment (1914), Economics of Welfare (i9r9), Essays in Applied
Economics (1923), Industrial Fluctuations (1927), The Theory of Unemployment (1933) and
Employment and Equilibrium (i94r). His work on monetary theory, employment and
the > national income, which was in the tradition of the > Classical School, led him
into controversy with ►Keynes. He was the first to enunciate clearly the concept of
the real balance effect, which as a consequence became known as the Pigou effect.
The Pigou effect is a stimulation of employment brought about by the rise in the
real value of ► liquid balances as a consequence of a decline in prices - as the
real lvalue of >-wealth increases, so ►consumption will increase, thus increasing
income and employment. This was one of the processes by which the classical
►model envisaged that full-employment >equilibrium could be obtained as a
result of a reduction in real wages. Although his work on ►macroeconomics was
partly superseded by Keynes, Pigou made a lasting contribution with his original
 policy ineffectiveness theorem

work in ^welfare economics. He resisted strongly the belief that practical

policies based on propositions from welfare economics were impossible, because
interpersonal comparisons of >utility cannot be made. He argued that, though
this may be true for individuals, it was possible to make meaningful comparisons
between groups. His distinction between private and social product now plays an
important role in the formation of government economic policy in the field of
>-public expenditure.

Pigou effect >Pigou, A. C.

placing The sale of a new issue of >shares or >stock (>new-issue market), usually
to >institutional investors, by a financial intermediary (e.g. a firm of stockbrokers)
acting on behalf of the company issuing the shares. This method of 'private placing'
of shares minimizes the cost of a new issue, since it does not involve the advertising
and other costs associated with an offer for sale or subscription. For shares that are
to be quoted on the >stock exchange there are limitations on the total market
>capitalization of shares that can be issued by this method.

planned economy An economy in which State authorities rather than market

forces directly determine prices, output and production. Although planned econo¬
mies can take a variety of forms, their most important features usually include: (a)
production targets for different sectors of the economy that determine the >supply
of different commodities; (b) rationing of certain commodities to determine >dem-
and for them; (c) price- and wage-fixing by State bodies, and (d) (sometimes), a
conscripted Mabour market in which workers take jobs assigned to them.
When all or nearly all economic activity is governed by the State, two advantages
can prevail: (a) the external costs and benefits of all activities that are not reflected
in prices and are ignored by the market economy can be taken into account by the
authorities (>externalities), and (b) a distribution of income (>income distribution)
nearer to many people's view of that which is just can be achieved. There are,
however, disadvantages of planning: (a) the practical problem of setting optimal
prices in all markets (>*-price system) - too often, the authorities set excessively low
prices causing goods to be rationed by queues; (b) the lack of worker and manage¬
ment motivation that attends a system in which earnings are not performance-
related and ^-profits not retained by the companies making them, and (c) when
wages and prices differ from their market levels, substantial control of individual
activities is required. >J“-free-market economy; State planning; transition, economies
in.

ploughing back ^self-financing.

poison pill A damaging action, (e.g. sales of ► assets) which a company threatens
to inflict upon itself in the event of >take-over by another firm. A poison pill serves
to deter other firms from attempting an acquisition in the first place, because to do
so would immediately lower the value of the company they are attempting to buy.
^merger.

policy ineffectiveness theorem The idea that if there are flexible prices and
wages, and if the public hold > rational expectations, then any government policies
to stimulate >aggregate demand can have no real effect on output or employment
unless the policy measures are unanticipated by the public. Increasing demand only
political economy

generates extra ^inflation. The theorem is the basis of >new classical economics
and can be thought of as positing that money is neutral in its effects (^neutrality of
money) when a change in money supply is anticipated. Academic economists are divided
on whether monetary and fiscal policies are ineffective, or have some effect in the
short or long term. Economists are almost unanimous in believing that unanticipated
injections of demand can increase output and employment in at least the short
term, ^economic doctrines; new Keynesianism.

political economy ^economics.

poll tax >local taxation.

polluter-pays principle The idea that polluting emissions should be taxed in

order that those who create them bear the costs of their actions. The principle of
allowing pollution to occur, but taxing it, derives from >Pigou in 1932. It is an
approach that contrasts with banning pollution outright or allowing it within certain
limits. The advantage of taxing it is that if the tax rate covers the damage or suffering
caused by the pollution, it will pay firms to pollute only if the benefits of them so
doing outweigh the costs. The tax will also generate revenue that can be used to
compensate those who suffer most. An example of a pollution tax would be a tax
on the carbon content of fossil fuels to offset the atmospheric warming effect of the
carbon dioxide they produce - a carbon tax. While, under perfect information,
pollution taxes can produce > economic efficiency, it may be difficult to set the tax
level correctly, and the cost of making mistakes, of allowing too much pollution, for
example, may be very high.

pooled equilibrium >Stiglitz, J.

popular economy ^informal economy.

population 1 In statistics, a term applied to any class of data of which counts are
made or samples taken, e.g. a car population. 2 The number of people living in any
specified geographical area, e.g. New York or India or the world. The study of the
characteristics of human populations is called demography. The United Nations (UN)
estimated that the total world population in 2003 was 6.3 billion. Although the rate
of growth is falling, the UN expects that world population will reach about 8.9
billion by 2050. The fall in the rate of growth is a reflection of the drop in fertility
rates (J^birth rate) and the rise in life expectancy (>death rate). The actual increase
in numbers is expected to be confined to the >developing countries in which
population is expected to increase by 65 per cent; more advanced countries will
experience overall stable population, with the major exception of the USA. Whereas
the population of the > European Union (EU) in 2003 will fall from 380 million to
370 million in 2050, that of the USA is expected to grow from 294 million to 409
million. The increase in world population not only raises the issue of the ability of
agriculture and fisheries to continue to meet the demand for food (>Malthus, T. R.)
but also the effect of increasing pressure on other resources, e.g. water and the
environment. Further, the change in the age structure of population has important
implications for growth.
The population of the UK is expected by the Office for National Statistics to rise
from 59.8 million in 2000 to 65 million in 2026. As with the population of the EU as
a whole, the population of the UK is getting older. In i96r, about 12 per cent of the
 positional goods

population was over 65 years of age; in 2000, it was 16 per cent and, by 2026, it is
expected to rise to 21 per cent. The average ages of the populations of the fifteen
countries of the EU and the USA are similar but with higher expected immigration
to, and higher fertility rates in, the USA a considerable gap is expected to emerge by
2050, when the USA will have a median age of 39.7, and the EU, 47.1. Population
ageing raises questions about the likely effects on economic growth through, for
instance, changes in the propensity to save (>®»-average propensity to save), and the
financing of pensions (> pension funds). >demographic time bomb; dependency
ratio; labour force; migration; population, census of.

population, census of A count of the number of inhabitants in a country. In the

UK, a census has been taken every 10 years since i8or (except in 1941). The next
decennial census of the UK will be in 2011. Enumerators visit every house in areas
assigned to them and leave census forms. Information is collected on place of
residence, age, sex, marital status, occupation, and certain supplementary infor¬
mation on living conditions, education and occasionally other matters. All advanced
countries have regular censuses, but many ^developing countries are now in the
process of organizing them for the first time. It is not possible to obtain information
accurately by other means. Calculations based on births, deaths and migration have
not proved, in the past, to be very precise means of estimation, except as a means of
interpolation between censuses, ^population.

portfolio The collection of >securities held by an investor.

portfolio theory A branch of financial economics that analyses the most efficient
amounts of different assets an investor should hold. Underlying portfolio theory is
the assumption that investors like high returns and dislike risk (>^risk aversion).
Risk represents a likelihood of the actual return on an asset deviating from the
expected return. In general, therefore, investors will have to expect a higher return
from a risky asset than a safe one in order to be persuaded to hold it, although, of
course, a risky asset may actually deliver a return either higher or lower than it was
expected to yield in advance.
An efficient >-portfolio is one that delivers the highest expected possible return for
a given amount of risk, or the smallest possible risk for a given expected return. In
general, by holding a variety of assets, the risk of a portfolio can be reduced, because
when one asset happens to perform badly, it may be that others will be doing well.
Thus, ^diversification does pay, and this explains the popularity of >unit trusts.
However, diversification can succeed in reducing risk only if the performances of
the assets in a portfolio do not coincide: in so far as the assets' returns move together
(because, for example, they are all affected by the state of the national economy)
there will always be some systematic risk remaining that cannot be diversified away.
It is the development of these basic principles that is the concern of portfolio theory,
^capital asset pricing model.

positional goods Goods that are necessarily scarce and the scarcity of which
cannot be reduced by increased productivity. They were described by Hirsch in his
book The Social Limits to Growth (1977). He distinguished those positional goods, the
value of which derives from their intrinsic usefulness but which are limited in their
supply (e.g. holiday homes in beautiful places) and those not yielding pleasure from
their absolute qualities but from their scarcity, e.g. original paintings by famous
positive economics

artists. Allocation of these goods is a >zero-sum game. They can explain why we
still have high levels of material frustration even as our affluence grows.

positive economics The study of economic propositions that can, at least in

principle, be verified by observation of events or states of the real world, i.e. without
reference to lvalue judgements. Broadly, positive economics is descriptive and
can either consist of statements like 'unemployment is very high' or conditional
statements like 'if the economy is reflated, unemployment will fall'. Prescriptive
statements, in contrast, like 'unemployment ought to be cut', fall into the sphere of
>normative economics. In practice, the distinction between the two is not a sharp
one, because those who make what sound like prescriptive statements may reason¬
ably claim that, in fact, they are implicitly making conditional statements, e.g.
'unemployment ought to be cut if overall welfare is to be enhanced'. This has the
form of a descriptive statement but is no more devoid of opinion than the first clause
taken alone.

poverty The situation facing people whose material needs are least satisfied. Poverty
can be defined by some absolute measure (earnings below some specified minimum
level) or in relative terms, e.g. the number of the poorest ro per cent of households.
Poverty exists not merely because incomes are low, but also because the needs of
some low-income households are high. A single person earning £100 a week may
not be in poverty, though a family of four on the same income would be. In a r992
report, the US Bureau of the Census defined the poverty line as $6932 for a single¬
person household and as $T3,924 for a four-person household. The report pointed
out that the number below this line was increasing. A similar trend has occurred in
the UK and other ^advanced countries. The percentage of the UK population
with income below half the national average doubled between T96T and r99r and
continued to increase in the 1990s.
The World Bank has estimated that 40 per cent of the world's labour has annual
incomes of less than $r6oo. This contrasts with the average income of $T7,ooo
received by the 8 per cent of the total who are unskilled workers in the advanced
countries. The life expectancy (>death rate) in some Central African states is 40
years compared with over 78 years in some developed countries, ^inequality;
minimum wage; Sen, A.; social security.

poverty trap The combination of losing State-benefit entitlement and paying tax
that can ensure that poor families keep very little of any extra money they earn.
Under any social security system using >means tests, as the poor earn more, they
lose State benefits. For example, a poor family may lose 6op of benefit for every extra
£1 it earns, and it may also pay 2op in tax on that pound. In this case, the family
benefits by only 2op of the extra pound. Apart from the inefficiency of suppressing
the incentive for people in the poverty trap to work, concern exists over the debilitat¬
ing human effects of removing from people the power to alter their own living
standards. »»income, distribution of; marginal tax rate; poverty; social security;
unemployment trap.

PPP >private finance initiative.

precautionary motive The factor that causes people or firms to hold a stock of
 preference shares

>money to finance unforeseen expenditures. It is one of the three motives for

holding money outlined by >Keynes.

(r) A firm may know what its average pay-outs are each month but, if these payments
fluctuate, given that there are costs to being short of the cash necessary to finance
them, firms will keep money in excess of what they need for the average month.
The amount they keep will first depend upon the ^interest rate. This represents
the cost of keeping money that would earn a return if it was invested.
(2) It will depend upon the probability of overshooting the foreseeable expenditures
- the higher the probability the more money firms will hold.
(3) It will depend upon the size of the firm's average spending - a big firm will keep
more than a small firm.
(4) It will depend on the cost of not having cash to meet unforeseen pay-outs - the
higher the cost, the more precautions a firm will take.

^►liquidity preference; speculative motive; transactions demand for money.

precautionary principle The precautionary principle may be invoked by coun¬

tries for the protection of the environment and human, animal and plant health. It
was first established as an acceptable argument by the United Nations Charter
for Nature in 1982 and has subsequently been incorporated in other international
agreements, e.g. as by the >World Trade Organization (WTO). The European Com¬
mission (^European Union) has set out guidelines for the appropriate procedures
to be adopted when carrying out procedures based on the precautionary principle.
The WTO accepts that each member country has the right to impose restrictions
to protect the environment and health from perceived threats as it sees fit. The
precautionary principle may be employed where the scientific evidence of a threat is
sufficient to give concern, although with significant uncertainty, and any restrictions
should be non-discriminatory. Arguments for the imposition of restrictions based
on the precautionary principle should be sufficiently robust to avoid the charge of
using the precautionary principle as a concealed means of trade ^-protection. >risk
assessment.

predatory pricing Setting ^prices at very low levels with the objective of weaken¬
ing or eliminating competitors or to keep out new entrants to a >market. Since
prices will be raised again once these objectives have been achieved there is no
permanent benefit to the consumer. Predatory pricing is a means of establishing or
maintaining >■ monopoly power.

preference shares Holders of preference shares precede the holders of ^ordinary

shares, but follow >debenture holders, in the payment of ^dividends and in the
return of ^capital if the issuing company is liquidated (^liquidation). Preference
shares normally entitle the holder only to a fixed rate of dividend, but participating
preference shares also entitle the holder to a share of residual >-profits. Preference
shares carry limited voting rights and they may be redeemable or not (^redeemable
securities).
Cumulative preference shares carry forward the right to preferential dividends, if
unpaid, from one year to the next. From the investor's point of view, preference
shares lie between debentures and ordinary shares in terms of >risk and >income,
while to the issuing company they permit some flexibility in distribution policy at
preferential duty 304

a lower cost than debentures. Preference shares now account for a very small pro¬
portion of issues (>-new-issue market), but are frequently used in the provision of
>-risk capital.

preferential duty ^tariffs, import.

premium 1 The difference, where positive, between the current >-price or > value
of a >security, or > currency, and its issue price or Vpar value. 2 A regular payment
made in return for an reinsurance policy.

premium bonds ^National Savings.

prepayments Payments for services (e.g. rent and rates) made in one accounting
period for consumption wholly or partly in a following period and written into the
balance sheet as a current basset.

present value The discounted value of a financial sum arising at some future
period. For example, if the discount rate is ro per cent per annum, the present value
this year of £rro earned next year is £roo. £roo this year is equivalent to £rro next
year because £roo invested at the going »rate of interest of ro per cent yields £rro in
r year. If there are financial flows over a number of years, the discounted sums are
additive. For example, if £rro were earned in each of 2 years, the present value would
be: £rro earned in year 2, discounted to year r = £rro/r.ro; this sum is then to be
discounted, again, to the base year = (£rro/r.ro) x r.ro = £rro/(r.ro2). Finally, to this
sum must be added the discounted value of the sum earned in year r, i.e. £rro/r.ro.
The present value, therefore, is £rro/(r.ro2) + £rro/r.ro. In general:

X X X3
present value (PV) =-— +-2— +
(1 + r) (1 + r)2 (1 + r)3 + ''' (1 + r)"
where X„ is the financial flow in year n, and r is the rate of interest (discount rate).
The net present value is the difference between the present value of a future flow of
profits arising from a project and the capital cost of the project. »* investment
appraisal.

price What must be given in exchange for something. Prices are expressed usually
in terms of a quantity of >money per unit of a ^commodity (a good or service) but
in >barter the price of a good is what another good or other goods it can be
exchanged for. Price changes are the means by which the competitive process
determines the allocation of resources in the Mree-market economy. >*► price
system; price theory; shadow price.

price discrimination The selling of the same commodity to different buyers at

different prices. Several conditions must prevail for it to be profitable: (a) there must
be a separation between markets that does not allow buyers in one to resell the item
in another (no >arbitrage must be possible); (b) the seller must possess some degree
of monopoly power (^monopoly) in at least one market for, under competitive
conditions, prices will be driven down to the level of costs in all markets, and (c)
buyers in different markets must have a different level and elasticity of demand for
the good. The monopolist who discriminates will set output for each market where
^marginal cost is equal to the ^marginal revenue in that market. Sales will be at a
higher price in markets where elasticity is generally low than where it is high. The
 price support

monopolist, in effect, takes advantage of the fact that in one market consumers are
prepared to pay more for his/her item than in the other, without losing sales in the
other market. In perfect price discrimination the monopolist charges a different price
to every individual consumer and effectively has a sales revenue equivalent to the
area under the ►demand curve for the product.

price-earnings ratio (P/E ratio) The quoted price of an >>ordinary share divided
by the most recent year's learnings per share. The P/E ratio is thus the reciprocal of
the earnings ►yield and a measure of the price that has to be paid for a given income
from an > equity share. A company whose 25P ordinary shares were quoted at £r.oo
on the >stock exchange and which, in the previous year, had earnings of iop per
share, would have a P/E ratio of ro to 1, i.e. the price of every penny in earnings
would be iop, or the earnings yield would be ro per cent. The price of earnings will
vary with the stock market's assessment of the growth potential involved. Thus, a
company with good growth prospects might have a P/E of 15/1 or more, but a
company with a poor record might have a P/E ratio of considerably less than that.

price elasticity of demand ►elasticity.

price elasticity of supply ►elasticity.

price index ►index number.

price level, average A term used in ►macroeconomics to refer to a base from

which changes in the exchange value of ►money can be measured (>index number).
It is a useful concept, but not literally calculable: an ►average of the unit ►prices of
all goods and services on offer in the economy would, in itself, be a meaningless
number.

price maintenance ►resale price maintenance.

price mechanism >price system.

price regulation A form of regulation, common for >public utilities in the UK,
in which the prices of the supplier are not allowed to rise above a certain level.
The regulation is designed to prevent the abuse of a >monopoly position. United
Kingdom price regulation has applied to telephone, gas, electricity and water pro¬
viders. In each case the design has shared certain common features: (a) allowed price
rises are set out for a few years in advance, typically 4 or 5; (b) there is a review at the
end of each period, at which the regime governing the next period is decided, and
(c) allowed price rises are specified relative to the ►retail prices index (RPI), and
might, for example be RPI minus 4.5 per cent each year. (This protects the regulated
firm against ►inflation.) Under price regulation, if firms can keep their costs low
they can earn big profits. This gives them an incentive to be efficient that does not
exist under ►rate-of-return regulation. But it has been suggested that, in each
periodic review, the regulator looks at the rate of return to decide what new price
formula should be applied, thus reducing the difference between the two types of
scheme. >^Averch-Johnson effect; monopoly; natural monopoly; regulation.

price schedule ►cost schedule.

price support A system of agricultural support by which market prices are fixed
at above ►free-market levels and the government buys unsold surpluses, thus
price system

supporting the price and raising farmers' incomes. VCommon Agricultural Policy;
farm subsidies.

price system The mechanism that sends prices up when >demand is in excess
and prices down when >supply is in excess (>resource allocation). The mechanism
referred to is not some co-ordinated control from a central authority, but relies on
the disparate decisions made by independent agents; it is the mechanism that makes
a butcher reduce the price of a leg of lamb he/she is unable to sell, or an ice-cream
salesperson raise the price of cornets on a hot day. It is usually assumed that one
price eventually settles in each market until some disturbance in costs or demand
occurs (Equilibrium). The importance of the price system is: (a) that it serves as a
means of rationing limited supplies among consumers, and (b) that it signals to
producers where money is to be made and thus what they ought to be producing.
W»* comparative static equilibrium analysis; economic efficiency.

price theory The area of economics concerned with the determination of prices
in individual markets. It is an area of >microeconomics and is not directly connected
to the study of >inflation. The two components of price theory are the >demand
side and the >-supply side; it is the interaction of the two that determines Equilib¬
rium output and price in any market. On the demand side, the theory of demand
(»#-demand, theory of) explains consumer behaviour in terms of rational agents
maximizing >utility. On the supply side, various alternative market structures are
investigated: > perfect competition, > monopolistic competition, >oligopoly, and
^-monopoly. There are also alternative theories, of the behaviour of firms, that do
not assume that profit maximization is the sole goal of producers (>-behavioural
theory of the firm), infirm, theory of the; Marshall, A.; resource allocation.

prices and incomes policy A policy of restraining price or wage increases by

regulated limits on the increases that are allowed. In most developed countries, it
was used in some form or another to counter the problem of > stagflation that
emerged in the T970S. Sometimes it was used in conjunction with price controls.
In the UK, some sort of incomes policy was in force for almost the whole period
1965-79- For the first few years it was legally enforced, but under the Labour govern¬
ment of 1974-9, pay increases were limited by voluntary agreement of the unions.
In the r98os, prices and incomes controls were abandoned in favour of a free-market
approach.
Limiting wage increases is seen as a means of reducing the problem of >inflation
associated with a given level of ^unemployment. The difficulty faced by those
trying to implement incomes policy is that it distorts the market for labour. Pressure
for pay rises can also build up at the end of a period of controls, as the collapse of
the pay policy of the late 1970s amid strikes and labour unrest testified. The long-term
effectiveness of limiting increases in the prices of goods in the shops is to be doubted.
The problem with price freezes is that of empty shelves. Either producers reduce the
goods they sell or consumers buy up everything available as the prices of things no
longer adequately ration the supply. 3*J**-price control; repressed inflation.

pricing policy The method used by firms-for determining their prices. In this area,
there appears to be a discrepancy between the suggestions of theory and the observed
practice of firms:
 prisoner's dilemma

(1) In theory, firms in ^ perfect competition take the market price as given - which
will equal the marginal cost of production - without being able to influence that
price. A >-monopoly or any firm in >monopolistic competition first determines
its output and only then sets a price at the level that just sells the output chosen.
(2) In practice, firms appear to use 'rules of thumb' rather than accurate assessments
of ^marginal revenue and costs. >-Cost-plus pricing, for example, involves charg¬
ing the average cost of producing an item, plus a profit margin, the size of which
is loosely determined by market conditions.

Much debate on pricing policy has surrounded the appropriate policy for > national¬
ized industries, in particular whether they should attempt to emulate the >marginal-
cost pricing of perfect competition (^ Hotelling, H.; menu costs; peak pricing).

primary market >new-issue market.

prime costs Strictly, ^variable costs plus administrative and other >fixed costs
that can be avoided in the short or long term if there is no output, even while
the firm remains in business. Often used loosely as a synonym for variable costs,
^supplementary costs.

prime rate (US) The Mate of interest charged by ^commercial banks to first-class-
risk corporate borrowers for short-term Moans. The prime rate is the basis of the
whole structure of commercial interest rates in the USA.

principal-agent problem The problem that arises in many spheres of economic

activity, when one person (the principal) hires an agent to perform tasks on his/her
behalf but cannot ensure that the agent performs them in exactly the way the
principal would like. The efforts of the agent are impossible or expensive to monitor
and the incentives of the agent differ from those of the principal. It does not arise if
an enforceable ^contract can be drawn up to specify all the duties of the agent
(^incomplete contract). Examples of the problem include: (a) the management
of assets on behalf of investors; (b) the management of companies on behalf of
shareholders by executives, and (c) the running of public services by private firms
under ^regulation by government authorities. The principal-agent relationship is
characterized by >asymmetric information, ^information, economics of; Amoral
hazard.

prior charges >-Debenture and >preference shareholders have a prior claim over
^ordinary shareholders to ^profits or ^capital repayments. The amount of these
claims is known as 'prior charges on the company'.

prisoner's dilemma A situation in which it pays each of several economic agents

individually to behave in a particular way, even though it would pay them as a
group to behave in some other way. The prisoner's dilemma is a classic and funda¬
mental concept in >game theory. It is best exemplified by the story from which it
derives its name: A sheriff picks up two suspected criminals and puts them in separate
cells. He gives each the chance to confess to having committed the crime with the
other, and tells them their fate as follows:

(1) If you don't confess and your partner doesn't confess, you will get 3 years in gaol.
(2) If you confess and your partner confesses, you will get 4 years in gaol.
(3) If your partner confesses and you don't, you will get r2 years in gaol.
private company

(4) If your partner doesn't confess and you do, you will get 2 years in gaol.

Criminal B

Confess Don't confess

Criminal A Confess 4,4 2,12

Don't confess 12,2. 3,3

These results are summarized in the table, where the left-hand number in each pair
is criminal A's sentence, and the right-hand number is criminal B's. Given these four
choices, the optimal one is for them not to confess and get 3 years each. However, if
they each believed the other was to behave in this way, it would pay them to confess
in the hope of getting 2 years. Indeed, scrutiny of the choices shows that if one
believes his/her partner is going to confess, he/she ought to confess also (avoiding
the 12 years), and if one believes the other is not going to confess, he/she still ought
to confess in order to get 2 years instead of 3. This compelling logic will drive both
criminals to confess unless they genuinely have as much concern for each other as
they do for themselves.
Although it recurs in many contexts, the prisoner's dilemma is usually seen as a
way of characterizing >oligopo!y. Here, it may pay firms to collude and jointly act
as a monopolist, but it will pay individual firms to cheat on the colluding deal and
produce more than they agreed to. >#*-Nash equilibrium; repeated game; tit-for-tat.

private company A type of business organization that permits a limited number

of shareholders to enjoy ► limited liability and to be taxed as a company. Unlike the
►public company - the only other incorporated form of business in the UK -
a private company may not offer ► shares for public subscription but, unlike a
►partnership, and if it requires the protection of limited liability, it is obliged to file
accounts. Smaller private companies are exempted from certain of the so-called
disclosure requirements ( ►company law). At the end of 2000/01 the number of private
companies registered in the UK was 1,442,300, 32 per cent more than 4 years earlier,
though probably about 50 per cent of these were virtually inactive, while some of
them were >subsidiaries of larger ►enterprises, ►►company law.

private enterprise Economic activity in the private, as distinct from the public,
sector (►public enterprise), ►►capitalism; mixed economy.

private equity >risk capital.

private finance initiative (PFI) A policy introduced by the UK government in

r992 to harness private sector capital and expertise in the delivery of public services
by ►contracting out. One of a range of co-operative ventures between government
and the private sector that are called public private partnerships and include, in
addition to PFI, joint ventures and concessions and the sale of equity stakes in
State-owned businesses. An example is the sale of a large stake in the National Air
Traffic Control System to a consortium of private airlines. Before 1992 capital that
was provided by a private supplier (e.g. for building prisons, roads or new hospitals)
was counted as public borrowing.
The UK ►Treasury has always insisted that PFI contracts must expose the private
sector to sizeable risk and this, as well as a determination not to pay market rates of
 probability

return, has led to tortuous negotiations. There are over 400 PFI contracts currently
in force, committing departments to future expenditure of around £100 billion.
Most of these contracts are in their early stages. A recent study by the National Audit
Office of i2r PFI projects found that 81 per cent of the public sector bodies that
signed the deals said that value for money was satisfactory or better, but there was
some decline since the letting of the contract. In a few cases contractors have enjoyed
large gains and the Treasury's objective is that the public sector should share gains
on new contracts 50:50.

private net product A term first used by >-Pigou for the net ►national income
or product to distinguish it from the Asocial net product.

private sector That part of the economy in which economic activity is carried on
by ►private enterprise as distinct from the ►public sector. The private sector
includes the > personal sector and the corporate sector.

privatization Principally, the sale of government-owned >equity in ►national-

ized industries or other commercial enterprises to private investors, with or without
the loss of government control in these organizations. Since 1981, shares in the
following - among other enterprises - have been sold by the UK government:
British Aerospace, Amersham International, Cable & Wireless, National Freight
Corporation, Britoil, British Coal, Enterprise Oil, Associated British Ports, Jaguar
Cars, Sealink, British Gas, British Telecom, British Airways, British Shipbuilders,
British Steel, British Airports Authority, Railtrack, Rolls-Royce, the electricity boards
and the regional water authorities. Companies in public ownership accounted for
12 per cent of ►gross domestic product in 1979 but only about 2 per cent by ^97.
United Kingdom government revenue from sales of equity in State-owned enter¬
prises rose from £377 million in T979/80 to £7.1 billion in 1988/89, though it fell back
later as fewer enterprises were available for sale (►public sector financial deficit).
Similar policies were pursued in many other countries worldwide but not on the
same scale as in the UK.
Other types of privatization may take the form of deregulation of a State-supported
►cartel or the subcontracting to the private sector of work previously carried out by
State employees. Where public utilities have been privatized, leaving them in a
monopoly position, new forms of ►regulation have been introduced. The pace of
privatization in most countries has slowed down in recent years, not only because
fewer companies are now available for sale but also because of increased investor
scepticism and weaknesses in stock markets, ►►contracting out; natural monopoly.

probability The average number of times an event occurs as a proportion of the

number of times it could occur. For example, the probability of a 6 turning up in
any given throw of a dice is 1 in 6. All probabilities take a value from o (impossible)
to r (certain). Probability is important in several areas of economics. There is a
whole theory associated with consumers and >risk (►expected utility), and in the
economics of ►finance the notion of risk is important in explaining asset prices
(►capital asset pricing model). In ►econometrics, probability theory underlies the
statistical tests used to ascertain the significance of the results derived from ►empir¬
ical testing.
There are two major ways of viewing probability: (a) that it represents the random
element of a process, and (b) the view more associated with the Bayesian School
producer good

(> Bayes' theorem) that it represents a degree of ignorance about a process. In this
view, when we ascribe a probability to something we do so given a certain level of
knowledge about it. The probability we specify says as much about our knowledge
of the event as it does about the event itself. >normal distribution.

producer good A Commodity used in the production of other goods and services
as distinct from final or consumer goods. Whether or not a good is a producer or
consumer good will depend not upon the good but upon the use to which it is put.
For example, a pencil bought for use in a drawing-office is a producer good, but one
bought for a child is a consumer good. Producer goods are also known as 'intermedi¬
ate goods'.

producer's surplus The excess of the revenue received by a supplier of a Com¬

modity over the minimum amount he/she would be willing to accept to maintain
the same level of supply. It is a similar concept to Consumer surplus (see diagram
below), ^economic rent; quasi-rent.

product differentiation ^differentiation, product.

production, census of In the UK, the survey of output that has been carried out
annually since 1970; prior to that year, it was taken at 5-year intervals. The census
covers all firms in manufacturing, construction, utilities and extraction industries
employing twenty people or more. Although still referred to as a census, sampling
techniques (Candom sample) are used for firms employing fewer than a hundred
 productivity

people. The results of the census are used in compiling national accounts (> social
accounting), input-output tabulations (^input-output analysis) and the weights
used in calculating the index of production and producer price index numbers.
>*► index number.

production, factors of ^factors of production.

production function The mathematical relationship between output of a firm or

economy and the inputs (^factors of production) used to produce that output. In
mathematical notation it is written q = f (L, C, t ... ) where q is the dependent
>■ variable (output) and L,C,t. .. etc. are independent variables (inputs). The amount
of inputs (e.g. labour, capital, raw materials, etc.) required to produce a given output
depends on technology and this will be reflected in the form of the function. For
example, it may be linear (^linear relationship) or non-linear. An example of the
latter is the »>Cobb-Douglas function. A production function of the form q = all1.
C1describes a technology with constant returns to scale, i.e. if inputs are increased
by x, output is increased by x. Similarly, a function may exhibit increasing returns to
scale (e.g. q = aC.L) in which if inputs are, for example, doubled, output increases by
2x2 = 4 times), and diminishing returns to scale (e.g. q = aCALA, in which, if inputs
are increased by, for example, 8 times, output increases by only 4 times). The above
functions are termed 'homogeneous of degree n’; a given increase (x) in each of the
inputs (independent variables) increases output (dependent variable) by x". If n is
greater than r, the function reflects increasing returns to scale-, if it is less than 1,
diminishing returns to scale; if it is equal to r, constant returns to scale, ^ homogeneous
in degree n.

production possibility curve ^transformation curve.

production, theory of The economic analysis of the transformation through a

^production function of >inputs (e.g. >labour and ^capital) into outputs. Pro¬
duction possibilities (J^isoquant; transformation curve) will depend on technology,
the mix and level of factor prices and marginal productivities, and the level and
price of output demanded. >► economies of scale; firm, theory of the.

productivity The relationship between the output of goods and services and the
inputs of resources (>-factors of production) used to produce them. Productivity
usually is measured by ratios of changes in inputs to changes in outputs using
>index numbers. For example, changes in labour productivity - the most common
measure - are measured by an index of man-hours divided into an index of output.
If the production index stands at 150 (1990 = roo) and the index of man-hours worked
stands at 125, then the labour productivity index stands at 120, i.e. labour productivity
has increased by 20 per cent over 1990 levels. This is known as a partial productivity
index, and it does not, in fact, measure changes in the productivity of labour alone
unless inputs of land and capital have remained constant.
The calculation of total factor productivity is difficult in practice since the pro¬
portions of the different factor inputs do not remain constant over time and their
individual contribution to output change is difficult to disentangle. Comparisons
between labour productivity in different sectors of the economy (e.g. between
^capital-intensive manufacturing and >-labour-intensive services) need to be inter¬
preted with care for the same reason. Another problem in productivity calculations
product life cycle | 312

is that the quality of unit inputs may vary, e.g. the use of more highly trained labour
may lead to higher output without any increase in the number of man-hours.
Since changes in productivity are affected by the level of capacity utilization, the
underlying trend of productivity growth may be very different from that indicated
by short-term movements in productivity indexes. In the long run, productivity
advance is the main cause of increases in real >per capita income. (The measures
mentioned relate to average productivity; marginal productivity is the change in
output caused by an increase or decrease of one unit of the factors of production.)
Mnterest, productivity theories of.

product life cycle The theory that new manufactured products are first developed
in high-income countries that have large markets for technologically advanced
products and the scientists and engineers to develop them. After a time, the products
are exported and later produced abroad, perhaps by subsidiaries, then imitated by
less advanced countries, the labour costs of which enable them to export to the
original first mover (> first-mover advantage). This does not mean that the first
mover suffers, because it can develop new products that begin their own cycle. The
product life cycle theory was first put forward by Posner and Vernon to explain
leadership and decline by US ^multinational corporations in the r96os. Although
subject to criticism, the theory does reflect experience in the production of some
products (e.g. motor cars or electric typewriters) that began on a large scale in the
USA and that are now manufactured in many countries, some of which export to
the USA. However, in some cases (e.g. video cassette recorders from Japan) the
first-mover advantage has been retained, while in others (motor cycles from the UK)
it has been lost. The real significance of the theory is that it recognizes the inter¬
actions between domestic and international markets and the roles of new technology
and technological diffusion among nations, that are much more complicated than
suggested by the s»-Heckscher-Ohlin principle.

profit 1 The residual return to the ^entrepreneur. In traditional economic theory,

profit does not include any of the return to >land, > labour or ^-capital (the >factors
of production), but is the surplus remaining after the full ^opportunity costs of
these factors have been met, formally total sales revenue minus total costs. Two
types of profit are distinguished in economics: (a) normal profit which is the opportu¬
nity cost of the entrepreneur, i.e. the minimum amount necessary to attract him/
her to an activity or to provide inducement to remain in it, and (b) super-normal
profit or economic profit which is any profit over and above normal profit, will be
earned only in the >-short run, and is a return to > monopoly power which, unless
there are ^barriers to entry, will be eroded by new entrants, ^-economic rent. 2 In
the accounting sense of the term, net profit (before tax) is the residual after deduction
of all >money costs, i.e. sales revenue minus wages, salaries, rent, fuel and raw
materials, etc., Mnterest on Moans and ^depreciation. Net profit after tax is after
deduction of ^corporation tax or, in the case of a Mole proprietorship or »-part-
nership, »-income tax. (However, ^assessable profits.) Gross profit is net profit before
depreciation and interest. Accounting profit and economic profit will be the same
only where all the factors of production have been credited with their full opportu¬
nity costs. The reported profits of quoted companies (>public company) consist
mainly of the return on capital for the shareholders that is not profit in the economic
sense of the term. If a company is receiving a subsidized loan from the government,
 propensity to import

for example, or is paying ► rent below the market rate because it has a long leasehold
interest, it would also be necessary for the economist to deduct full ►imputed costs
for these returns to factors of production, rather than simply the actual money
outlays from revenue in arriving at profit. A firm may, therefore, be making an
accounting profit while operating at an economic loss.

profit, falling rate of The early classical economists (►classical economics)

believed that it was a feature of the economic system for the general rate of >profit
to decline. >Smith argued that ►capital accumulation took place at a faster rate than
the growth of total output. Although the absolute level of profits rose, competition
lowered the >rate of return on capital. For ►Ricardo, the decline of the general rate
of profit was induced by the decline in the marginal productivity of >• land, to which
all profits were linked. >Marx took up ideas similar to Smith's, and predicted a fall
in the rate of profit because of an intensification of competition between capitalists
(>capitalism). There would follow, he concluded, a strong pressure to reduce real
wages (►real terms).

profit-and-loss account ►double-entry bookkeeping.

profit-related pay (PRP) >employee share-ownership schemes.

profit-sharing The name given to describe any scheme under which workers in a
firm receive a remuneration that is explicitly conditional upon the future ►profits
of the firm. Typical profit-sharing schemes would give workers a profit-related bonus
at the end of the year or would pay workers an amount based on a formula in
which profit was a component. Two primary motivations underlie arguments for
profit-sharing: (a) the desire for workers' wages to be flexible and reflect the perform¬
ance of their company - if remuneration automatically falls when profits fall, the
need for redundancies will be minimized, and (b) the desire for workers to identify
their interests with those of their employer - to feel that they have a personal stake
in the success of the company. Against profit-sharing, it can be argued that: (a)
workers desire stable ►income and that any risk of company failure should be borne
by the shareholders, and (b) that, in a properly functioning free >labour market,
wages would be flexible anyway, ^employee share-ownership schemes.

profit-taking The sale of ► shares on the ► stock exchange in order to realize

►capital appreciation. When share prices rise and then fall back again as sellers
appear - including those who bought the shares in the expectation that the price
would rise - the fall-off in prices is said to be the result of profit-taking. M^stag.

progressive tax A ►tax that takes an increasing proportion of ►income as income

rises.

promissory note A legal document between a lender and a borrower whereby the
latter agrees to certain conditions for the repayment of the sum of money borrowed.
When one borrows from a ►commercial bank, one signs a promissory note. Particu¬
lar forms of promissory notes, known as commercial paper, can be bought and sold.
They are usually issued by large corporations, but in some countries (e.g. Spain and
Japan) promissory notes are a common form of ►small business finance.

propensity to import A relationship between ►income and ►import levels. The

►demand of a ►household for foreign goods depends on its income as does its
propensity to save | 314

demand for domestically produced goods. Similarly, we would expect firms'

demands for foreign goods (e.g. raw materials, machine tools, components, etc.) to
depend on their output. The whole economy's demand for imports thus depends
on ^national income:

(r) The average propensity to import: the ratio of the total value of imports to national
income. It is the proportion of national income spent on imports.
(2) The marginal propensity to import: the proportion of an increase in national income
that is spent on imports. For example, if national income increased by £100, and
imports increased by £20, then the marginal propensity to import would be
20/100 = 1/5. The marginal propensity to import is a useful concept in two ways:
(a) if it can be accurately measured and it is relatively constant over time, it can
be used to predict the increase in imports which will result from an increase in
income - to continue the above example, if the marginal propensity to import is
estimated as 1/5 and national income is expected to increase by £10 billion, we
can predict that imports will increase by £2 billion, and this may be very useful
from the point of view of control of the economy and the ►balance of payments,
and (b) the marginal propensity to import determines, among other things, the
value of the >multiplier, and an estimate of it will therefore be required to
estimate the effects on national income of a change in ►investment, government
expenditure (►budget), exports or > taxation.

Though, in the short run, the average and marginal propensities to import may be
taken as relatively constant, it must be remembered that they reflect demands for
foreign goods from firms and households, and are therefore influenced by: (a) relative
prices of foreign and domestic goods, and (b) the willingness of domestic agents to
borrow from abroad to finance their spending.

propensity to save >average propensity to save.

property bond >bond.

proportional tax A >-tax which is levied at the same rate at all >income levels.
Hence, it is intermediate between a > progressive tax and a ►regressive tax.

proprietorship ►sole proprietorship.

protection The imposition of ^tariffs, ►quotas or other devices (►non-tariff

barriers) to restrict the inflow of > imports. Arguments in favour of protectionism and
against ►free trade have their origin in the earliest periods of economic discussion
(►•mercantilism). The arguments take many forms. Domestic industries, especially
agriculture, must be maintained at a high level in case foreign sources are cut off
during a war. Key industries that have a significant defence role should be protected
to avoid reliance on a foreign supplier. In conditions of ►excess capacity, protection
increases employment by switching demand away from foreign to domestic pro¬
duction and, through an increase in the surplus on the ►balance of payments,
enables aggregate ►income to be raised through the ►multiplier effect. Protection
also enables new industries to develop to an optimum size - the ►infant-industry
argument. Protection can be used as a counter to ►dumping (►►contingent protec¬
tion) and as a retaliatory measure against other countries' restrictions. The case for
protection for the ►developing countries was put forward by Prebisch (i9or-86).
ml public expenditure

The developing countries had experienced a long-run decline in their >terms of

trade. Their demand for imported manufactures grew much more rapidly as their
>real incomes rose than do the advanced countries' demand for their exports, with
a consequent pressure on their balance of payments. Protection would improve their
terms of trade by causing a reduction in the price of their imported manufactures
arising from their reduced demand, and it could also be used as a means for allocating
the limited supply of >foreign exchange. Protection has also been proposed as a
means by which the >advanced countries could prevent a fall in the real incomes of
their unskilled labour occasioned by low-cost imports from the developing countries
(>► income, distribution of), ^barriers to entry; customs union; General Agreement
on Tariffs and Trade; precautionary principle.

PRP Profit-related pay (>employee share-ownership schemes).

prudential regulation ^capital adequacy.

PSBR ^public sector borrowing requirement.

PSFD >public sector financial deficit.

public-choice theory The area of ^welfare economics concerned with the ways
in which society makes - and ought to make - decisions on issues such as regulation
and public goods. For ^economic efficiency, it is important that there is an appropri¬
ate level of provision of ^public goods (e.g. defence), but it is not possible for
individual consumers to make those decisions. It is not easy to turn everybody's
individual preferences for defence into a single figure for society as a whole, or to
charge people for defence in proportion to their strength of preference (>■ free-rider
problem). Some kind of State institutions will make these decisions, using some kind
of rules to translate public desires into an overall social decision. Public choice theory
is concerned with voting mechanisms and constitutions that might be more or less
efficient in delivering public desires. But the theory is most closely associated with
the Public Choice School and Buchanan (»► Buchanan, J.). This views government
not as some kind of benevolent agent of the public, doing its best to serve, but instead
as some kind of Leviathan, aiming to maximize its revenue, exploits its monopoly
power and expand its own power. Buchanan supports constitutional limits on the
ability of governments to tax, borrow and print money, ^impossibility theorem;
paradox of voting; social-welfare function; welfare economics.

public company An incorporated business enterprise with limited liability and

that is not a »-private company. A public company may be quoted or unquoted
(>quotation). Under the 1985 Companies Act in the UK, the >Memorandum of
Association of a public company must state that it is a 'public limited company' or
use the abbreviation 'pic'; there must be at least two subscribers, and the nominal
share capital must be at least £50,000. At the end of 2000/r, r2,8oo public companies
were registered in the UK. ^company law.

public debt >-national debt.

public enterprise Economic activity in the market carried on by ^enterprises

owned or controlled by the State, ^nationalized industries.

public expenditure Spending by general government (>public sector). Quite

apart from the practicalities of public spending, economists have been concerned
public finance

with the principles justifying it (^public goods), the mechanisms for allocating it
(►►public-choice theory) and the authorities responsible for it (>► fiscal federalism).
Public spending in the UK was equivalent to 38.3 per cent of gross domestic product
(GDP) in 2000/or, down from a peak of 48.1 per cent in 1975/76. About half represents
transfers to the private sector in the form of, for example, subsidies and social
security benefits. Comparable figures internationally for 20or were: the USA (30.4
per cent of GDP), Australia (33.1 per cent), Japan (36.9 per cent), Canada (38.2 per
cent), Italy (45.7 per cent), Germany (45.9 per cent) and France (48.6 per cent).
In the UK, Parliament approves Estimates, which give the government the auth¬
ority to spend money and, more recently, to use resources, ( ►►resource accounting
and budgeting). The first formal request to Parliament for funds is in the Main
Estimates presented at the time of the >-budget. During the year, Supplementary
Estimates may be presented. After the end of the financial year, the government
publishes the Public Expenditure Outturn White Paper, outlining what has been
spent. The Public Accounts Committee and the National Audit Office attempt to
verify that the funds have been used honestly and effectively.
The broadest aggregate of public spending is called Mtotal managed expenditure.
This is divided into departmental expenditure limits (DELs) accounting for just
over half of public spending, and this is allocated to departments in major spending
reviews announced every 2 years. (Departments receive a rolling 3-year allocation,
with the periods of each spending review overlapping each other.) The other major
spending aggregate is called ^annually managed expenditure and accounts for items
like debt interest, social security benefits, and payments to the »► European Union.
The DELs are themselves divided up into current spending totals, and capital spend¬
ing totals, with capital spending representing under 10 per cent of the total. >gener-
ational accounting; public sector net borrowing; public sector net cash requirement.

public finance A branch of economics concerned with the identification and

appraisal of the means and effects of government financial policies. It attempts to
analyse the effects of government ^taxation and expenditure on the economic
situations of individuals and institutions, and to examine their impact on the
economy as a whole. It is also concerned with examining the effectiveness of
policy measures directed at certain objectives, and with developing techniques and
procedures by which that effectiveness can be increased. Ms-budget; cost-benefit
analysis; fiscal policy.

public goods Commodities the consumption of which has to be decided by society

as a whole, rather than by each individual. Public goods have three characteristics:
(a) they yield non-rivalrous consumption - one person's use of them does not deprive
others from using them; (b) they are non-excludable - if one person consumes them
it is impossible to restrict others from consuming them, e.g. public television is
non-excludable although, if devices are made for scrambling television pictures,
except to those who own picture decoding cards, television becomes an excludable
service, and (c) public goods are often non-rejectable - individuals cannot abstain
from their consumption even if they want to. National defence is a public good of
this sort, although television is not. Non-excludability and non-rejectability mean
that no market can exist and provision must be made by government, financed by
►taxation.
Many items are partly public and partly private goods. A developed patent system,
 purchasing-power parity

for example, has public-good properties, benefiting not only the community as a
whole, but especially inventors who take out patents. > impossibility theorem;
paradox of voting; ^externalities.
public ownership >nationalized industries.
public private partnerships ^-private finance initiative.
public sector Comprises central government and local authorities {general govern¬
ment), together with the nationalized industries or public corporations. Central
government includes all those departments and other bodies for whose activities a
minister of the Crown or other responsible person is accountable to Parliament,
^privatization.

public sector borrowing requirement (PSBR) ^public sector net borrowing;

public sector net cash requirement.
public sector financial deficit (PSFD) The excess of >public sector spending
over ^-taxation revenues and other receipts. It differs from the >-public sector
borrowing requirement in that it includes the proceeds of capital transactions, e.g.
the sale of assets (^privatization).
public sector net borrowing A broad measure of the government's deficit, that
includes the deficits of central government, local government and public corpor¬
ations. Public sector net borrowing is similar to >public sector net cash requirement
(PSNCR), but it is more in line with principles of accruals accounting (>accrued
expenses) >resource accounting and budgeting. For example, whereas the PSNCR
is improved if the government sells an asset (as the sale proceeds count as income
just as taxation does), public sector net borrowing is not flattered by such an action.
public sector net cash requirement (PSNCR) Formerly called the public sector
borrowing requirement. A measure of the government deficit, in terms of the cash
needed to fill the gap between receipts and spending. This was seen as the primary
measure of fiscal policy in the UK during the 1980s and much of the 1990s, especially
during the period when the impact of public borrowing on money supply was
considered an important component of anti-inflation policy. The measure was
downgraded in r998, replaced by >-public sector net borrowing and the >golden
rule.
public utility An industry supplying basic public services to the market and
possibly enjoying ^monopoly power. Usually, electricity, gas, telephones, postal
services, water supply and rail and often other forms of transport are regarded as
public utilities. These services all require specialized capital equipment and elaborate
organization, ^natural monopolies; regulation.
pump priming The injection of small amounts of government spending into a
depressed economy with the aim of boosting business confidence and encouraging
larger-scale private-sector investment. It was the policy pursued by Roosevelt in the
USA during the 1930s before ^Keynesian economics was accepted by policymakers.
>► multiplier.
purchasing-power parity (PPP) An >-exchange rate between two currencies
such that the same basket of goods and services could be bought in each country if
 purchasing-power parity theory

the cost were converted at that exchange rate. For example, if a loaf of bread cost £i
in the UK and $2 in the USA the purchasing-power parity exchange rate would be
£1 to $2. Market exchange rates are determined by a mix of forces and can fluctuate
considerably. This makes accurate comparisons of international economies using
market exchange rates difficult. The use of PPP is a preferred alternative, although
not without its own problems of measurement. The ► World Bank ranks all countries
by ►gross national product per capita using this method and the ►Organization for
Economic Cooperation and Development also publishes comparable international
economic data based on PPP.

purchasing-power parity theory A theory that states that the ► exchange

rate between one >currency and another is in >equilibrium when their domestic
purchasing powers at that rate of exchange are equivalent. For example, the rate of
exchange of £r = $1.70 would be in equilibrium if £r will buy the same goods in the
UK as $r. 70 will buy in the USA. If this holds tme, purchasing-power parity exists. The
theory has its source in the mercantilist (>mercantilism) writings of the seventeenth
century, but it came into prominence in the early :900s through the writings of the
Swedish economist, W^Cassel. The basic mechanism implied is that, given complete
freedom of action, if Sryo buys more in the USA than £r does in the UK, it would
pay to convert pounds into dollars and buy from the USA rather than in the UK.
The switch in demand would raise prices in the USA and lower them in the UK, and
at the same time lower the UK exchange rate until equilibrium and parity were
re-established. Cassel interpreted the theory in terms of changes in, rather than
absolute levels of, prices and exchange rates. He argued that the falls in the ►foreign-
exchange markets in the postwar period were a result of ►inflation due to unbal¬
anced ►budgets increasing the quantity of ►money. In practice, the theory has
little validity because exchange rates, which are determined by the >demand and
► supply of currency in the foreign-exchange markets, are related to such forces
as ^balance of payments disequilibria, ►capital transactions, ►speculation and
government policy. Many goods and ►services do not enter into international trade,
and so their relative prices are not taken into account in the determination of the
exchange rate. >► index-number problem; Mises, L. E. von; real exchange rate.
pure strategy ►mixed strategy.

put option ►option,

pyramiding ►holding company.

q theory A theory of ►investment behaviour which suggests that firms invest as
long as the value of their >shares exceeds the replacement cost of the physical assets
of the firm. Developed by >Tobin, q theory is attractive because it encompasses
other theories of investment in a simple framework. The q referred to is the ratio of
two numbers: (a) the value of a firm to its shareholders - this is equivalent to the
expected future profits of the firm, and (b) the replacement cost of the assets of the
firm, machines, buildings, etc. If (a) exceeds (b) (i.e. q is greater than r) the firm
should want to expand as the profits it expects to make from its assets are greater
than the cost of its assets. If q is less than i, the shares of the firm are worth less than
the assets and it will pay the firm to engage in ^divestment to sell the assets rather
than try to use them. Firms should invest or divest until q is approximately equal
to T.

quality adjusted life years (qalys) A calculation of benefit to assist in determining

the optimum allocation of resources in medicine. In considering the outcome of
any particular medical procedure consideration is given not only to the number of
years life is prolonged but also its quality. The costs of alternative procedures are
compared with their qalys and other benefits that are expected to be gained from
the different procedures (►►cost-benefit analysis) to help to choose the preferred
option. The use of qalys does not imply that other aspects of decision-making in
medicine are not included in assessment, e.g. the question of the need for procedures
to be seen to be equitable between different classes of people. > death rate.

quality adjusted price indices ►hedonic price index.

quantitative restrictions ►quotas.

quantity rationing The name given to one of four states of an economy that can
exist when ►excess demand or >excess supply persist in the > labour market or in
the markets for goods and services. Quantity rationing is an area of ►macroeconom¬
ics in the tradition of ►Keynes (>Keynesian economics). It focuses on the study
of ►disequilibrium, in contrast to ►neo-classical economics or >new classical
economics (>economic doctrines) which are predominantly concerned with the
behaviour of economies in which all markets clear. In quantity-rationing theory,
markets that have become dislodged from an equilibrium may not find that equilib¬
rium again, even if prices are generally flexible. The reason is that when one market
is out of equilibrium, the price mechanism in other markets may not work properly.
For example, unemployed workers may be willing to work for £300 a week, and
employers may be willing to employ them for £300 a week, but to do that, employers
quantity theory of money | 320

need to know that the workers will spend their new-found income. But as the
workers have no work and have no income, they cannot signal to employers that
they would be buying new products if only they could be employed. The disequilibria
are mutually reinforcing. Another way of expressing the same point is that in a
market out of equilibrium, buyers or sellers are rationed in how much they can buy
or sell, and in this case, quantity signals matter as well as price signals.
Four different possible regimes are held to apply: (a) >repressed inflation: excess
demand exists in both the labour and good markets (buyers are rationed in both);
(b) >Keynesian unemployment: excess supply exists in both the labour and goods
markets (sellers are rationed in both and don't sell everything they would like to
sell); (c) >classical unemployment: excess supply exists in the labour market, and
excess demand in the goods market, and (d) >underconsumption: excess demand
exists in the labour market, and excess supply exists in the goods market, inform¬
ation, economics of.

quantity theory of money The theory that changes in the >money supply have
a direct influence on prices and nothing else. The theory is derived from the identity
MV = PT (called the >Fisher equation) where M = stock of money, V = velocity with
which the money circulates (>-velocity of circulation), P = average >price level, and
T = the output of goods and ^services. All this equation says is that the amount of
money spent equals the amount of money used. It is not a theory, it is a truism. The
theory itself has two key elements: (a) that the velocity with which money circulates
is stable, at least in the short term, and (b) that the number of transactions (which
is closely related to the level of physical output) is fixed by the tastes of individuals,
and the real behaviour of firms in equilibrium. In this case, increases in M can only
lead to increases in P, i.e. money supply increases cause ^inflation. The theory
provided the basis for >macroeconomics prior to >• Keynes' General Theory of Employ¬
ment, Interest and Money (1936), and had a plausibility about it in the eyes of early
proponents of >neo-classical economics, who strongly believed in the power of
markets to settle at equilibrium points. It was largely superseded by the ^Keynesian
economics, under which both elements of the theory came under attack. Increases
in M were held to lead to falls in V - and, in some circumstances, increases in real
income. However, in the 1960s the quantity theory re-emerged in a more sophisti¬
cated form through the work of >-Friedman. He accepted the Keynesian view that V
could alter when M altered, but said that it did so only in stable and predictable
ways. On the second postulate, whereas Keynes said that unemployment could exist
at an equilibrium of the national economy and therefore an increase in the money
supply could increase real output, Friedman, although admitting unemployment
could persist, held that this was caused by structural factors in the economy (>unem-
ployment, natural rate of) and could not be influenced by .^aggregate demand
measures, at least not for very long, ^economic doctrines; monetarism.

quartile Vpercentile.

quasi-money >near money.

quasi-rent A term applied by ^Marshall to the earnings of capital, the supply of

which is fixed in the short run. It is the excess made in the short run by a firm from
the difference between the selling price and the > prime cost of the product. For
example, suppose that a firm can make pens at a cost of iop in labour and raw
 quoted company

materials, and it can sell them at 4op. A quasi-rent of 3op is earned. This is not,
however, the profit of the firm, because there are costs of fixed inputs that have to
be covered by sales, even though they don't add to the cost of making extra pens. A
lossmaking firm can earn quasi-rents.
Quasi-rent is analagous to ►economic rent because it represents a return in excess
of that necessary to keep the firm in production - whenever price exceeds avoidable
costs. It differs from economic rent, however, in that it is a temporary phenomenon.
It can exist because in the short run competing firms do not have time to enter an
industry, and firms do not have time to exit an industry either, and may have
irretrievable >sunk costs. ►barriers to exit.

Quesnay, Francois (1694-1774) A surgeon by profession, Quesnay held the post

of secretary of the French Academy of Surgery and edited its official journal. He
became physician to Madame de Pompadour. His major economic works appeared
in various articles in the Encyclopedic (1756, 1757), and in the Journal de I'agriculture,
du commerce et des finances (1765, 1767). The Tableau economique and Maximes (1758),
a commentary on the Tableau, set out three classes of society, and showed how
transactions flowed between them. The three classes were: (a) landowners; (b)
farmers, and (c) others, called the 'sterile class'. Only the agricultural sector produced
any surplus value, the rest only reproducing what it consumed (>Marx, K.). He
anticipated >Malthus' fear of underconsumption arising from excessive >-savings.
Net >-income would be reduced if the flows in the Tableau were interrupted by
delays in spending. This was the first attempt to constmct a >-macroeconomic
input-output ►model of the economy (►input-output analysis). In fact, progress
in this field had to await the application of >matrix algebra and computerization
(►Leontief, W.W.). Quesnay suggested a single tax, I'impdt unique, on the net income
from land, arguing that the nation would thereby save tax-collecting costs. Only
agriculture yielded a surplus, and therefore ultimately it bore all taxes anyway (►Mill,
J. S.). He was a central figure in the group of economists called the ►Physiocrats, who
flourished in France between T760 and 1770.

quotas In ►international trade the quantitative limits placed on the importation

of specified ►commodities. The ►protection afforded by quotas is more certain
than can be obtained by raising import ►tariffs as the effect of the latter will depend
on the price ►elasticities of the imported commodities. Quotas, like tariffs, can also
be used to favour a preferred source of supply (^General Agreement on Tariffs and
Trade; imports). The term also applies to quantitative restrictions on production
which may be set by ►cartels or colluding oligopolists (►collusion; oligopoly).

quotation The privilege granted to the issuer of a ►security by a ►stock exchange

of placing the price of that security on the official list. A quoted security is for this
reason referred to as a ►listed security. Only public companies fulfilling certain
requirements designed to safeguard the investing public are granted quotations.
Lesser standards apply in the ►unlisted securities markets, but companies for which
►market makers post prices in these markets are not properly described as quoted
companies-, in the UK, this term is reserved for those on the official list of a recognized
► stock exchange.

quoted company >quotation.

 R

R & D >research and development.

Raddiffe Report The Committee on the Working of the Monetary System was
set up in May 1957, under the chairmanship of Lord Radcliffe, with wide terms of
reference. It published its report in August 1959. The report received considerable
critical acclaim for the high standard of its description of the UK financial system
and its institutions. At the same time, however, it gave rise to some criticism that
the report had not given sufficient weight to the importance of regulating the
quantity of money (^monetary policy) as part of economic and financial policy.
The Radcliffe Report concluded that monetary policy should give priority to control¬
ling the > liquidity of the monetary system, and not the quantity of money in the
system: 'Rejecting from among such measures (i.e. monetary measures to control
> inflation) any restriction of the supply of money, we advocate measures to strike
more directly and rapidly at the liquidity of spenders. We regard a combination of
controls of S-capital issues, bank advances and »-consumer credit as being most
likely to serve this purpose.' Reasons for taking this view were the 'theoretical
difficulties' of identifying 'the supply of money' and the 'haziness that lies in the
impossibility of limiting' the income >velocity of circulation. Nevertheless, the
report did not dismiss the quantity of money as unimportant, but rather believed
that given proper control of liquidity it would look after itself. In external policy,
the report was in favour of fixed ^exchange rates. 'It would be more difficult, if
there were no fixed rate to be defended, to keep domestic costs in line with costs
abroad, and the need to devalue might result from the very ease with which the
external value of the currency could be adjusted.'

Ramsey pricing >inverse elasticity rule.

random sample A >sample in which every member of the population (simple

random sample) or some subset of the population (> stratified sample) being tested
has an equal chance of being included in the sample. The purpose of sampling is to
be able to infer, from the sample taken, the attributes of the population as a whole.
Only if the sample is random can the probability be calculated that a sampled
attribute applies to the population as a whole, ^normal distribution; »»Heckman,
J.; quota sample.

random walk The path of a variable over time that exhibits no predictable pattern
at all. For example, if a price, p, moves in a random walk, the value of p in any period
will be equal to the value of p in the period before, plus or minus some random
variable. That random variable is normally distributed (> normal distribution) with
 rate of interest

a constant >variance and is entirely independent of the value of p. To predict the

value of p tomorrow, we can do no better than look at its value today. Certain
variables (e.g. share prices), are held to follow a random walk because, if anyone
could predict that prices were going to rise tomorrow, they would buy shares today
in order to sell them tomorrow at the higher price. They would go on buying them
until today's price had been driven up so high that it was no longer expected that
prices would rise tomorrow. The only thing that will affect the price of a share is
news about the firm which could not have been anticipated, and is thus random,
^efficient markets hypothesis; rational expectations.

rate of exchange ^exchange rate.

rate of interest The proportion of a sum of money that is paid over a specified
period of time in payment for its loan. It is the price a borrower has to pay to enjoy
the use of cash he/she does not own, and the return a lender enjoys for deferring
consumption or parting with liquidity. The rate of interest is a price that can be
analysed in the normal framework of >demand and >supply analysis. It may be
seen as a price in two different markets:

(r) The market for >investment funds. It equalizes the demand for such funds, which
is for investment, and the supply, which is ^saving. If investors believe that they
can earn a return of ro per cent on borrowed money by building a factory, and
the rate of interest is 5 per cent, they will demand all the funds that are available,
indeed will eventually offer more than 5 per cent to obtain cash which will earn
them a profit at any rate up to ro per cent. Savers, on the other hand, have a rate
of >time preference reflecting the compensation they require for putting money
aside for the future and not spending it in the present. If they need only 4 per
cent to be induced to save, and the rate of interest is 8 per cent, there will be so
much money put into savings that the rate will be driven down. The rate of interest
thus adjusts to ensure that investment equals saving, with saving reflecting the
weight people attach to current consumption over future consumption, and
investment the amount of extra future production that can be expected to result
from building new plant and machinery.
(2) The market for liquid assets (>liquidity). Firms and consumers may prefer their
assets to be in a readily available form - they would prefer money worth £r
million to a factory worth the same. However, most borrowers will need cash for
long-term use, and will need the certainty that they won't have to pay it back
at short notice. Thus, to compensate people for giving up ready access to the
money they lend (their loss of liquidity), interest is paid. This means that the
interest rate has an important influence on the demand for money, and on very
liquid assets.

The interest rate is thus affected by ^liquidity preference and >-time preference.
>-Keynes introduced the idea of its importance in the demand for money and
emphasized it in this role. Classical economists ignored liquidity preference, believ¬
ing it to be in the market for investment that the rate of interest was determined.
The problem of bringing the money market and the investment market to equilib¬
rium with one price was at the heart of Keynesian economics. It would be surprising
if a satisfactory equilibrium was achieved in both markets simultaneously. In simple
theory, only one interest rate should prevail in the economy - if, for example, one
 rate of return | 324

bank offers a lower return than another, investors would move their cash from the
first until it has so little money that it is forced to raise its rate (►arbitrage). However,
for two main reasons, many rates prevail at any one time:

(1) ►Financial intermediaries charge for their services by adding to the interest rate
they charge borrowers or subtracting from the rate they pay lenders. This means
there is an interest-rate differential: lenders get less than borrowers pay if a
financial intermediary arranges the loan.
(2) Interest rates also carry a risk premium: those lending money will want a higher-
than-market rate of return if their investment has an uncertain return (►risk).

>► capital asset pricing model; interest, abstinence theory of; interest, classical theory
of; interest, natural rate of; interest, productivity theories of; interest, time preference
theory of; liquidity trap; term structure of interest rates.

rate of return Usually, net >profit after ►depreciation as a percentage of average

►capital employed in a business. This is the ►return on capital employed. One of a
number of ►financial ratios used to measure the efficiency of a business as a whole,
or of particular >investment projects. The rate of return may be calculated using
profit before or after ►tax, and there are a number of other variations of the concept.
Profit may be defined as net of tax but not of depreciation and interest (i.e. profits
available for ►equity shareholders), or as operating profit, i.e. to exclude investment
income and >capital gains. Capital employed may be defined to exclude ►loan
capital, in which case the return measured is that on equity capital; sometimes
►working capital is excluded. The use of simple rates of return in the analysis of
alternative investment projects is open to the serious criticism that it does not take
account of the timing of capital outlays and earnings, and hence does not allow for
the time value of money (►investment appraisal). Strictly speaking, the rate of
return on capital employed in a business does not measure the return to capital
alone or the efficiency of the use of ►resources by that business, since the returns
to each of the ►factors of production cannot be separated out. However, in normal
circumstances a firm that is earning a long-term rate of return lower than its cost of
capital (►capital, cost of) could be said to be using resources inefficiently.

rate-of-return regulation A form of >regulation, common for ►public utilities

in the USA, under which firms are prevented from earning too high a >rate of
return. Under such a regime, price rises are capped to levels at which the target rate
of return will be exceeded. This price will invariably be lower than the price a
profit-maximizing monopolist would charge. >^Averch-Johnson effect; price regu¬
lation.

rate of technical substitution (RTS) The increase in production of one com¬

modity an economy can achieve by cutting the production of another commodity
by one unit. If a country could transfer resources from making one spoon to make
two forks, the rate of technical substitution between spoons and forks is 2. The
rate of technical substitution between commodity A and B usually diminishes as
production of A increases. If, at production of twenty aircraft and 20 million loaves
of bread, society can produce a million loaves with equal ease to one aircraft, at
production of thirty aircraft and 10 million loaves the production of one aircraft
will require a much larger sacrifice in terms of loaves. Graphically, the RTS is the
32SJ Rawls, John

slope of the ^transformation curve. Mathematically, it is the ratio of the

^marginal products of producing two items, ^-economic efficiency; marginal rate
of substitution.

rates >local taxation.

rational expectations The assumption that the behaviour of economic agents is

based on an understanding of the economy, and a forecast of future events, that are
not systematically falsified by actual economic events. Nobody can predict the future
with perfect foresight because unforeseen, random happenings are bound to occur.
However, someone with rational expectations will construct their expectations so
that on average they are correct, i.e. they will be wrong only because of random,
non-systematic errors. The disadvantage of other ways in which individuals may be
assumed to predict the future is that they allow them to make systematic errors.
>-Adaptive expectations, for example, postulate that individuals predict next year's
price inflation on the basis of last year's, and the rate of change up to last year. At a
time of increasing inflation, their expectation will perpetually lag behind the actual
inflation rate - but despite this, under the hypothesis of adaptive expectations,
everybody carries on using this predictive method although it produces biased
forecasts.
The theory of rational expectations has stimulated debate in economics because
it has controversial implications.

(1) It appears to demolish any case for government policy aimed at stimulating
demand in the economy: if the government expands the money supply by 5 per
cent, everybody will believe that prices will rise as a consequence. This will make
them add 5 per cent to their wage demands or prices and a 5 per cent price
inflation occurs without there being any positive effect on output or employment
(>policy ineffectiveness theorem).
(2) Markets behave efficiently (^efficient markets hypothesis). The price of the
shares of a company reflects the profits the company is expected to make. If
expectations are rational, the price at any time is based on expectations that have
taken into consideration all possible information about the company. This means
that if some 'news' arrives that indicates the company's fortunes are likely to
change, that information will cause the price to change immediately. Moreover,
as the 'news' that arrives can reflect only random, not systematic, events, the
price of the company's shares must follow a random path (>random walk).

The interesting implications of rational expectations should not necessarily make

them appear a plausible description of people's behaviour. Nevertheless, like >per-
fect competition in ^microeconomics, rational expectation provides an extreme
but simple assumption that provides a benchmark against which the behaviour of
people in the real world can be judged. Moreover, in the very long term, the
hypothesis that systematic forecasting errors are not made appears by no means
implausible, ^expectations; Lucas critique; new classical economics.

Rawls, John (1921-2002) American political theorist, whose main work, A Theory
of Justice (:1971), outlined a basis for ranking social outcomes - an implicit >social-
welfare function. His notion was that social welfare should simply be defined in
terms of the welfare of the least well off - a so-called >maximin strategy. The welfare
 real balance effect | 326

of the rest of the population should only be treated as a tie-breaking rule for ranking
different outcomes that were irrelevant to the least well off. Rawls derived this idea
by postulating that it is the principle we would choose to live by, if we were
asked to make such a choice before finding out whether we ourselves were to be rich
or poor.

real balance effect >-Pigou, A. C.

real business cycle theory The argument that the >business cycle is caused not
by fluctuations in ^aggregate demand, as generally supposed, but by shocks in the
conditions under which producers supply their products (Xsupply-side economics).
It is associated with ^rational expectations, and the idea that markets generally
function very smoothly; thus, any ups and downs in economic activity must reflect
the outcome of rational decisions made by many individuals. In real business cycle
theory, the ups and downs are caused by technology or some other shock to the
supply-side of the economy. Suppose a new productivity-enhancing device comes
along; employers will want to invest, expand output and employ more people. That
will lead to a boom. There may be other times when new advances are lacking, or
productivity is low, and at that point employers will rationally choose not to produce
as much and there will be a recession. The downturn is simply the optimal reaction
of individuals to the lack of productive opportunities. For proponents of the theory,
the economy will be busier in high productivity times than low productivity times,
just as construction workers do more work in the summer than the winter. Of course,
booms are nicer than recessions, but there is no need to react to either as they
represent the best use of the opportunties available. While influential and contro¬
versial, real business cycle theory has not attracted much empirical support.

real exchange rate An ^exchange rate between two currencies calculated by

valuing a given basket of goods and services in terms of the two currencies and
dividing the two resulting sums. Suppose there is a ro per cent increase in prices in
the UK, no ^inflation in the USA and a io per cent depreciation of the pound
against the dollar; then the real exchange rate between the pound and the dollar is
constant, ^effective exchange rate; purchasing power parity.

real income >real terms.

real terms A > money value adjusted for changes in ^prices. The nominal value
of the > national income may rise by io per cent over a year with a similar increase
in personal expenditure, but if consumer prices have risen by 8 per cent the quantity
of goods and services that are purchased by the consumer will have increased only
by about 2 per cent. Thus, to convert money values to constant prices or real terms it
is necessary to deflate (^deflation) data at current prices by an appropriate J^index
number. In the same way, money wages or other forms of income can be adjusted
to real wages or real income to allow for changes in the purchasing power of earnings.
>^money illusion.

real time gross settlement (RTGS) A settlement system based on the immediate
payment for a transaction, which is not reduced to take account of offsetting
payments in the reverse direction. Its principal merit is that it protects against default
by the debtor and hence >systemic risk. The system is used for large-value payment
transfers between organizations such as ^central banks.
!fll_ reducing balance

real wages Meal terms.

receiver ►bankruptcy.

recession An imprecise term given to a sharp slowdown in the rate of economic

growth or a modest decline in economic activity, as distinct from a slump or
►depression which is a more severe and prolonged downturn. Recessions are a
feature of the ^business cycle. Two successive declines in seasonally adjusted (Mea-
sonal adjustment), quarterly, real ►gross domestic product would constitute a
recession.

reciprocal demand ►equation of international demand.

recognized investment exchanges (RIEs) ^Financial Services Act 1986.

recursive model A system of equations in which >endogenous, or »-dependent,

variables in one equation appear as ^exogenous, or ^independent, variables in
others, but in which there are no subsets of equations which each cross-refer to
endogenous variables. For example, the following two-equation system is recursive:

a = f,(z)
b = f2(a)

while the following system is not:

a = fj(fc)
b = f2(fl)

The significance of the recursive model is the ease with which it can be solved in
terms of exogenous variables: values for all the endogenous variables can be found
straightforwardly if the equations are solved in the right order. In the above example,
the first equation gives a value for the endogenous variable a given a value of the
exogenous variable z. The resulting value for a then becomes the value of the now
exogenous variable a in the second equation to obtain the value of the endogenous
variable b. ►dependent variable.

redeemable securities >Stock or >bonds that are repayable at their ►par value
at a certain date, dates or specified eventuality. Most fixed-interest ^securities are
redeemable, though Monsols bear no redemption date. ►Ordinary shares and some
►preference shares are irredeemable, ►►redemption date.

redemption date The date at which a Moan will be repaid or release given from
other obligations, ^redeemable securities.

redemption yield ►yield.

red tape ►compliance costs.

reducing balance A means of recording ►depreciation expenses in which the

original Most of an ►asset is 'written down' by a fixed fraction each year. In this
way, the amount of depreciation allowed falls each year, e.g. a machine costing £500
could be written down by 20 per cent per annum (i.e. £roo in the first year) and then
20 per cent on its written-down value of £400 (i.e. £80 in the following year) and so
on. A rate can be chosen to write down an asset to an expected residual value in a
chosen period of years (e.g. 5 years and £50) which in our example would require an
 reflation | 328

annual depreciation rate of about 37 per cent. Although the reducing-balance system
gives a lighter depreciation charge in later years when maintenance and repair costs
as well as risk of ►obsolescence may be higher (as opposed to the straight-line
method, where equal depreciation is charged every year), it is unlikely to accord
very closely with actual depreciation. However, the taxation authorities in the UK
and other countries base ►tax allowances for certain ► capital investment on a
reducing balance (►capital allowances).

reflation A ► macroeconomic policy of increasing ► aggregate demand in the

economy in order to reduce unemployment. The argument for reflation can most
clearly be seen in terms of > Keynesian interpretations of the economy. When a
deflationary gap exists, unemployment exists, indicating that there is spare
capacity in the economy. Additional demand leads to a rise in spending, itself
boosted by the ► multiplier, with a consequential rise in the number employed.
Criticisms have been made of reflation as a policy prescription, however, often
associated with the doctrine of ►monetarism. The argument is as follows: the reflation
is generated by either printing money or by increased borrowing (►public sector
borrowing requirement). If it is through printing money, no non-monetary variables
can change. The level of aggregate demand rises; prices rise; more labour is sought to
produce the extra demand, so wages rise; at the end of the process real wages (deal
terms) are constant, as are all relative prices. Nothing changes except the absolute
price level. If, on the other hand, the reflation is financed by borrowing, every pound
the government borrows the private sector lends, and thus for every extra pound of
government spending there is a pound less of private spending. This is called ►crowd-
ing out, and it occurs because, when the government borrowing increases, >-interest
rates rise, squeezing private investment (^classical economics). These criticisms
rely on a belief that market forces work effectively and that unemployment is at its
natural rate (►unemployment, natural rate of), suggesting that a deflationary gap
could never exist. They also imply that private investment is highly responsive to
interest-rate changes and that interest rates themselves are highly sensitive to
changes in the supply of government bonds. Keynesian unemployment.

Regional Development Agencies Organizations established by the UK govern¬

ment in 1999 in nine regions of England. Their purpose is to encourage inward
investment and employment in their regions in line with regional economic stra¬
tegies approved by the government. Regional financial assistance is channelled
through the agencies, including funding from European Union sources, ►assisted
areas; regional policy.

regional policy The framework for measures taken in the attempt to reduce
disparities between economic development in general and ►unemployment in
particular among different parts of the country. All countries have prosperous and
depressed regions, though in some the disparities are greater than in others. In most
cases, depressed areas result from the decline of once important industries or other
economic activities. Governments have attempted to restore prosperity by creating
incentives for new industry to move into these areas and by improvements in local
►infrastructure, though these policies have had only limited success. More recently,
attention has shifted towards the scope for stimulating self-regeneration capacity by
the promotion of ► small business, ►assisted areas.
 regulation

regression analysis A mathematical technique for estimating the ^parameters

of an equation from sets of data of the independent and independent variables. For
example, in the demand equation q = aY + bP + c, in which q = quantity bought of a
good, Y = income and P = price, the parameters a, b and c can be estimated, provided
there is a sufficient number of actual observations of the variables, q, Y and P.
Regression analysis finds the values of a, b and c, which when substituted in the
expression aY + bP + c yields the least error in estimating q. Regression analysis is
used widely in >-econometrics. »► auto-correlation; beta; dummy variable; heterosc-
edasticity; latent variable; least-squares regression; multicollinearity.

regression model ^regression analysis.

regressive tax A >tax which takes a decreasing proportion of > income as income
rises.

regulated utilities The UK has a number of bodies for the regulation of utilities
and other public services. The Office for the Regulation of Electricity and Gas,
the Office of Water Services and the Office of Telecommunications are the most
prominent but there are many others, including the Postal Services Commission,
the Independent Television Commission, the Occupational Pensions Regulatory
Authority and the Office of the Rail Regulator. For the utilities proper, prices are
regulated so that they change in line with the ^retail prices index minus an x factor
to take account of productivity improvements. This procedure differs from the US
regulatory model which is on the basis of cost plus a reasonable rate of return. The
British system also is based on single person regulators instead of the US multi-person
commission.

regulation The supervision and control of the economic activities of ^-private

enterprise by government in the interest of economic efficiency, fairness, health
and safety. Regulation has a long history, pre-dating the Industrial Revolution, and
takes many different forms. >Externalities such as noise and pollution have made
it necessary (among other reasons) to regulate road and air transport. The temptation
for producers to collude (>oligopoly) or exploit other instances of ^monopoly
power also requires intervention (^competition policy). More recently, economists
have been interested mostly in the regulation of private ^natural monopolies, e.g.
utilities. This has become the predominant model of ensuring the public interest,
replacing public ownership (^nationalized industries). The choice between different
regulatory regimes - >price regulation, >rate of return regulation or sometimes
^yardstick competition - are all different approaches to the task. The system of
regulation of financial services has also been under recent review. There has also
been recent interest in the justification for, and consequences of, a broader range of
regulatory instruments. These other forms of regulation include measures to safe¬
guard the rights of employees (e.g. the Employment Protection Acts), to regulate the
trade unions, the financial system, personal privacy (the Data Protection Act), the
Ffealth and Safety at Work Act, fishing rights, the ^Consumer Credit Act, town and
country planning, food and drugs, industrial training, the licensing of street traders
and taxi-cabs.
Regulation may be imposed simply by enacting laws and leaving their supervision
to the normal processes of the law, by setting up special regulatory agencies or by
encouraging self-regulation by recognizing, and in some cases delegating powers to,
 Regulations of the European Union | 330

voluntary bodies. Though regulation may be regarded as necessary to prevent the

abuse of monopoly power, or for preserving health and safety, or to correct Eexter-
nalities or other instances of Emarket failure, there may yet be a risk that the
> compliance costs and other costs of regulation may exceed the > social benefits.
These other costs include administration costs in government or regulatory agencies
and what economists call excess burdens. Excess burdens are costs imposed on society
as a whole through regulatory obstruction of the workings of markets, e.g. by the
creation of Ebarriers to entry and reduction in competition and ^innovation. The
measurement of excess burdens is necessarily imprecise. Attempts have been made
to measure consumer prices and innovative activity before and after deregulation,
which indicate that these costs may be substantial. The rapid growth of regulation
since the Second World War has led to increasing concern about the costs of
regulation and a call for the reform and even abolition of regulatory requirements,
i.e. deregulation. There has been some deregulation, but new demands for regu¬
lation arise all the time. >Ecompliance; free trade; regulatory capture.

Regulations of the European Union ^Directives of the European Union.

regulatory capture The situation that occurs when regulators advocate the
interests of the producers they are intended to regulate, ^regulation.

re-intermediation disintermediation.

relative-income hypothesis A theory of ^consumption and Esaving which

suSSests that individuals are more concerned with their consumption relative to
other people's than they are with their absolute living standard. If everybody wants
to 'keep up with the Joneses' in their consumption, the poor will spend a higher
proportion of their income than the rich. This is observed to be the case. However,
as society as a whole gets richer, no one will feel able to consume less, because
everybody will also be getting richer. This too is observed. The relative-income
hypothesis, developed by Duesenberry, is an alternative, and rather less widely
accepted theory for reconciling the Mime series and > cross-section evidence on
consumption within different countries, compared to the Epermanent-income
hypothesis and the >life-cycle hypothesis. Nevertheless, the insight that relative
income matters to futility is not to be disregarded. Most people would consider
that someone today on the average Ereal income of 1930 would genuinely be
poorer than his 1930s' counterpart, if only because certain types of important social
interaction (such as joining in the daily chat at the office) require possession of the
means to share experiences (such as having a TV to watch, and DVDs to discuss),
consumption function.

remittances Emigration.

rent 1 The income accruing to the owner for the services of a Edurable good, e.g.
a piece of land, property or computer (>► Ricardo, D.). 2 Eeconomic rent.

rentier Someone who receives his income in the form of >interest and ^-dividends
rather than in wages or salary and who does not otherwise participate in the process
of production. A provider of Ecapital and person of independent means.

rent-seeking behaviour Behaviour that improves the welfare of someone at the

expense of the welfare of someone else. The most extreme example of rent-seeking
 resale price maintenance

behaviour is that of a protection racket, in which one group betters themselves

without creating any welfare-enhancing output at all. Not all examples are criminal,
however: the behaviour of labour or management when they put more effort into
increasing their share of >turnover, rather than into increasing the total volume of
turnover, can be described as rent-seeking.

repeated games A strategic interaction between a small number of players that

occurs in the same form many times. The distinguishing features of repeated games
are that the players can learn about the strategies of the other players by looking at
what they do in earlier rounds, and that the players can punish or reward co¬
operative behaviour in early rounds by adopting certain strategies in later rounds,
substantially changing the nature of the game. This is of more significance in games
that go on being repeated indefinitely than those that are played a known number
of times. >*-game theory; prisoner's dilemma; tit-for-tat.

replacement-cost accounting ^inflation accounting.

replacement rate ^unemployment trap.

repo Sale and repurchase agreement under which funds are borrowed through the
sale of short-term securities (>-money market) on condition that the instruments
are repurchased at a given date. Used between >central banks and the money market
as part of >open-market operations. First developed in the USA, repos are also
used widely as a borrowing method by large corporations, banks and non-banking
institutions. M»gilt repo.

repressed inflation The state of a set of markets or an economy in which there is

persistent ^-excess demand for goods and services. If prices are below their market¬
clearing levels, demand will outweigh the available supply; this should drive prices
up, causing ^inflation. If, however, prices are prevented from rising (e.g. because of
price controls (>prices and incomes policy)) the inflation can be prevented but
consumers will not be able to obtain as much of the things as they want. Features of
markets suffering repressed inflation will thus be queues, explicit State rationing,
constant shortages or black markets.
While the term can be used to refer to a state of any set of markets in which excess
demand is not removed by price increases, more specifically it is one of four forms
of ^quantity rationing in the macroeconomy; the others are >Keynesian unemploy¬
ment, > classical unemployment and ► underconsumption. In terms of these models
of the economy, repressed inflation is one in which buyers in both the labour and
goods markets are rationed: households cannot get the goods they want and firms
the labour they want. It can be cured by freeing prices and wages and letting them
rise, so that they meet equilibrium prices, or by cutting aggregate demand so that
the equilibrium price in each market moves down to the level of the actual price,
^planned economy.

resale price maintenance (RPM) The practice whereby a manufacturer requires

the distributors of his product to resell at certain >-prices, or at not less than
minimum prices, which he has set for his products. There have been a number of
UK governmental inquiries into the practice to determine whether or not it was in
the public interest. The arguments in favour were that price-fixing set ^profit
margins that ensured fair returns, both to the manufacturer and to the distributors
 research and development | 332

for their services, and that no government had the right without very good reason
to interfere with the freedom of private citizens to make contracts. In r955, the
Monopolies and Mergers Commission (►competition policy) recommended that
RPM, collectively enforced by manufacturers, should be made illegal, although
individual manufacturers should be permitted to continue the practice. The report
served as the basis for the ► Restrictive Trade Practices Act r956. The Resale Prices Act
1964 was passed under which all resale price agreements were assumed to be against
the public interest unless it could be proved otherwise to a court, ^competition
policy; vertical restraints.

research and development (R & D) Activity that includes: (a) basic or pure
research intended to increase knowledge without any particular application in view,
e.g. research into the properties of materials; (b) applied research directed at a
particular objective, e.g. searching for a new material for a product, or (c) experi¬
mental or development work on new inventions or the improvement of existing
products and processes. All three types of R & D are carried out by government
research laboratories, universities, research institutes and company research estab¬
lishments. About 2 per cent of the employed ^labour force is engaged in R & D work
in the USA and about half that percentage in Europe. However, these figures relate
to professional, recorded R & D workers only; a substantial amount of R & D is carried
on by amateurs and in small firms that goes unrecorded. Research and development
activity is important because of its role in defence policy and commercial ►innov¬
ation. While it is the case that some countries may have an interest in avoiding the
costs of R & D while enjoying the benefits of investments in it by other countries
(►free-rider problem), academics in the area surmise that a minimum national
investment in R & D is necessary even to adopt or replicate other nations' technol¬
ogy. That basic minimum may be seen as an 'entry-ticket' to the modern world.

reserve asset ratio ►capital adequacy.

reserve currency A ►currency governments and international institutions are

willing to hold in their >gold and foreign-exchange reserves and that finances a
significant proportion of ►international trade. These two conditions normally
require that: (a) the value of the currency must be stable in relation to other cur¬
rencies, (b) the currency is that of a country holding an important share of world
trade; (c) there exists an efficient ►foreign-exchange market in which the currency
may be exchanged for other currencies, and (d) the currency is convertible (►con¬
vertibility). According to the ►International Monetary Fund, the major reserve
currency at the end of 2000 was the US dollar which accounted for 69 per cent of
the total, followed by the Euro at r3 per cent, the Japanese yen at 5 per cent and UK
sterling at 4 per cent, ^international liquidity.

reserve ratio ►capital adequacy.

reserve requirement ►capital adequacy.

resource accounting and budgeting The initiative launched in the UK

►budget of November r993 designed to recast the accounting practices of the public
sector. The system of resource accounting and budgeting was finally fully imple¬
mented in April 2oor, and brings the public sector more into line with private sector
accounting practice, most notably in accounting for resources at the time they
 retail prices index

are used, rather than when cash relating to resources changes hands. Formerly,
government departments had just produced information and planned its activities
on the basis of the >-cash flow. The most important distinction between the two
relates to >-capital assets, which incur a large cash flow in one year but not such a
large real flow of resources. The hope is that the bulk of such assets in the public
sector can be valued in order that an annual charge can be levied for the »-cost of
capital incurred by the department over time, ^-private finance initiative; public
expenditure.

resource allocation The choices made about how scarce ^factors of production
should be used in an economy. It is the fact that resources are scarce (> scarcity) that
leads to the need for allocation. Any allocation of inputs determines the composition
and size of an economy's output, so each allocation therefore can be defined in two
ways: either (a) by the use made of inputs, or (b) by the mix of total output. In a
world consisting of only two goods (e.g. milk and honey), each possible allocation
may be represented by a point on a graph with output of one of the commodities
on each axis. Society, probably through a >price mechanism, or through central
planning (^planned economy) chooses one of the combinations. If, in such an
economy, no more milk could be produced without a fall in the output of honey,
the allocation is efficient and lies on the ^transformation curve of the economy. If
it were possible to allocate resources in a different way so that there was more milk
and more honey produced, resources would be being used inefficiently, ^economic
efficiency.

resources Scarce inputs that can yield futility through production or provision
of goods and services (> depletion theory; factors of production; natural resources;
production function; resource allocation).

restriction, exchange >exchange control.

Restrictive Practices Court ^Restrictive Trade Practices Acts.

Restrictive Trade Practices Acts The UK Act of 1956 (later consolidated in 1976),
based on the recommendations of the >-Monopolies and Mergers Commission's
1955 report on Collective Discrimination - A Report on Exclusive Dealing, Aggregated
Rebates and Other Discriminatory Trade Practices. This Act required the registration of
all agreements between two or more firms, whether buyers or sellers, which contain
restrictions on >prices, quantities or quality of goods traded or on channels of
distribution. It set up a Restrictive Practices Court. The Act was replaced by the
Competition Acts r98o and 1988 and the new approach is not to register agreements
but to punish those who make anti-competitive agreements, ^competition policy.

retail banking ^wholesale banking.

retail prices index An index (>-index number) of the prices of goods and services
purchased by consumers to measure the rate of ^inflation or the cost of living. The
weights used in the index are revised annually and based on the proportion of
>household expenditure spent on each item, information on which is obtained in
the UK from the Family Expenditure Survey. The prices of these items are collected,
and the index updated, monthly. Changes in the index have an important effect on
the economy because they may influence wage and salary awards and may affect
 retail trade | 334

the value of index-linked assets and pensions, ^harmonized indices of consumer

prices; indexation; underlying inflation.

retail trade The final link in the chain of distribution from the manufacturer to
the final consumer. The economic functions of the retailer are to hold stocks at a
location convenient to the consumer so as to provide him/her with choice, guidance
and after-sales service and, where appropriate, credit facilities (>consumer credit).
In providing these services, the retailer adds value to the goods he/she purchases
from the wholesaler or direct from the manufacturer (>value added). There were
221,000 retail businesses registered for > value-added tax at the end of 1994 in the
UK (not all retailers need to register for VAT) but the number of small retailers has
fallen substantially since 1950, mainly as a result of competition from the large
multiple retailers that enjoy »-economies of scale in operation and in purchasing
from their suppliers ^countervailing power; wholesale trade).

retained earnings Undistributed Vprofits. w^self-financing.

retentions Undistributed profits. >*»-self-financing.

return on capital employed >s»-rate of return,

return on investment (ROI) J^rate of return.

returns to scale The proportionate increase in output resulting from proportion¬

ate increases in all inputs. If the number of workers, raw materials and machines
used by a firm are all doubled, three situations can result: (a) decreasing returns to
scale would hold if output less than doubled; (b) constant returns to scale would exist
if output exactly doubled, and (c) increasing returns to scale would hold if output
more than doubled. Decreasing returns to scale should not be confused with the law
of ^diminishing returns, which traces the response of output to an increase in one
individual input with all others held constant, ^economies of scale; production
function.

revaluation ^devaluation; exchange rate.

revealed preference An approach to demand theory that derives the traditional

laws of demand using only information on the choices the consumer makes in
different price and income situations coupled with the assumption that such choices
are made rationally. It can be seen as a third approach to consumer behaviour, in
contrast to the cardinal approach (^marginal utility) — which requires there to be
an absolute, single, measure of utility - and the >>ordinal utility approach (based on
> indifference-curve analysis) - which requires there to be some measure of relative
utility, albeit one that does not require actual magnitudes of utility to be ascribed to
bundles of commodities.
The revealed-preference approach holds that only two types of information are
theoretically necessary to predict the behaviour of consumers and derive the laws of
demand: (a) the observed spending of a consumer in different price-income situ¬
ations - this reveals which bundles of commodities are preferred to others, and
(b) the assumption that the consumer's behaviour accords to certain axioms of
rationality - to predict how someone will spend their money we must know
that they will not behave erratically (^transitivity). It can be shown that, if such
information were available in full, an indifference map could be constructed for
lifj Ricardo, David

the consumer. Implicitly, therefore, the approach does construct at least a partial
indifference map of the form used in indifference-curve theory and should best be
seen as an alternative expression of this theory rather than a replacement for it.
^►demand, theory of; Samuelson, P. A.

revenue reserves ^company reserves.

reverse take-over The acquisition or > take-over of a public company by a private

one. Often also used to refer to the acquisition of a company by another, smaller,
one.

reverse yield gap >yield gap.

Ricardian equivalence The idea originally expounded by >Ricardo, and more

recently by Barro, that government deficits have little real economic effect because
private citizens anticipate the fact that any borrowing now has to be repaid later
and thus increase their saving with that in mind. The essence of the proposition is
that individuals can unravel the effect of government policy. If the government
consumes more and borrows the money to do so, and if the private sector did not
want overall consumption to rise, the private sector would save more now so that,
when the debts had to be repaid, the money was available. The government might
as well have taxed people rather than borrow the money. Ricardian equivalence can
be seen as part of a thread of economic thinking which holds that only decisions
about real variables (e.g. consumption and production) matter, and that decisions
about financing will, in perfectly functioning markets, never have an effect.
»*crowding-out; deficit financing; Modigliani-Miller theorem; rational expec¬
tations.

Ricardo, David (1772-1823) The son of Jewish parents who were connected with
the ►money market, first in The Netherlands and later in London, Ricardo had little
formal education. At the early age of 14, however, he was already working in the
money market himself. It was James Mill (the father of >Mill, J. S.) who persuaded
Ricardo, himself diffident about his own abilities, to write. Nevertheless, Ricardo
succeeded in making a fortune on the >-stock exchange, sufficient for him to be able
to retire at 42. Not surprisingly, many of his earlier publications were concerned
with money and banking. In 1810, he published a pamphlet on The High Price of
Bullion, a Proof of the Depreciation of Bank Notes; in 1811 appeared the Reply to Mr
Bosanquet's Practical Observations on the Report of the Bullion Committee, and in 1816
Proposals for an Economical and Secure Currency. However, his work on monetary
economics did not have the originality or exert the influence comparable to his
studies in other branches of economics. His Essay on the Influence of the Low Price of
Com on the Profits of Stock (1815), was the prototype for his most important work The
Principles of Political Economy and Taxation (1817) that was to dominate English
►classical economics for the following half-century. In his Principles, Ricardo was
basically concerned 'to determine the laws which regulate the distribution (between
the different classes of landowners, capitalists and labour) of the produce of industry'.
His approach was to construct a theoretical ►model which abstracted from the
complexities of an actual economy so as to attempt to reveal the major important
influences at work within it. His economy was predominantly agricultural. With
►demand rising as a result of increasing >population, and a level of subsistence
 Ricardo, David

which tended, by custom, to rise also over time, more and more less-fertile >land
had to be brought into cultivation. The return (in terms of the output of corn) of
each further addition of >-capital and >Tabour to more land fell (>diminishing
returns, law of). This process continued until it was no longer considered sufficiently
profitable to bring any additional plots of land under cultivation. However, >oppor-
tunity costs and >profits must be the same on all land, whether or not it was
marginal. Labour cost the same wherever it was applied. If profits were higher at one
place than at another, it would encourage capital to be invested at the place of high
return, until by the process of diminishing returns, profit fell into line with profits
elsewhere. Therefore, as costs and profits were the same throughout, a surplus was
earned on the non-marginal land, and this was >rent (shaded in the diagram).

The consequence of this was that, as the population expanded and more less-fertile
land was brought into cultivation, profits became squeezed between the increasing
proportion of total output that went in rent and the basic minimum level of subsist¬
ence allocated to the wages of labour. Ricardo assumed that prices were determined
principally by the quantity of labour used during production (>value, theories of).
However, he recognized that capital costs did nevertheless, also have an influence
on prices and that the effect of a rise in wages on relative prices depended on the
proportion of these two ^factors of production in the various ^commodities. With a
rise in wages, ^capital-intensive goods became cheaper relative to >labour-intensive
goods, with a consequent shift in the demand and output in favour of the former
(>Ricardo effect).
In the theory of > international trade Ricardo stated explicitly for the first time
the law of comparative advantage. This law can best be illustrated by means of the
example of two countries A and B producing two commodities, e.g. cloth and wine.
 Ricardo effect

If the relative cost of cloth to wine is the same in both countries, then no trade will
take place because there is no gain to be had by exchanging wine (or cloth) for cloth
(or wine) produced abroad for that produced at home. Trade will take place where
cost differences exist. These can be of two kinds: (a) if wine is cheap in country A
and cloth in B, A will specialize in wine and B in cloth, and exchange will take place
to their mutual advantage, and (b) the law of comparative advantage states the
condition under which trade will take place, even though both commodities may
be produced more cheaply in one country than another.

Man-hours per unit of output

Country Wine Cloth

A 120 IOO

B 80 90

Country B exports one unit of wine to A, and imports in exchange 120/roo units of
cloth. If country B had devoted the 80 man-hours employed in making wine for
exports to making cloth instead, it would have produced only 80/90 units of cloth.
Country B therefore gains from trade by the difference ((r2o/roo) - (80/90)) units of
cloth. As long as country B can exchange wine for cloth at a rate higher than 80/90,
it will therefore gain from the trade. If country A exports a unit of cloth to B, it will
obtain in exchange 90/80 units of wine. If the roo man-hours required by A to
produce a unit of cloth had been devoted to the home production of wine, only
T00/120 units of wine would be obtained. The gain from trade therefore is (90/80) -
(100/120) units of wine. Provided, therefore, country A can exchange cloth for wine
at a rate higher than ioo/r2o, it will gain from the trade. Within the range of exchange
of wine for cloth of 120/100 and 80/90, both countries therefore benefit.
The law of comparative advantage survives as an important part of the theory of
international trade today. Otherwise, Ricardo's main contribution is the analytical
approach of theoretical model-building that has contributed substantially to econ¬
omists' methodological toolkits. >► equation of international demand; Heckscher-
Ohlin principle; Ricardian equivalence.

Ricardo effect The idea, supported by >von Hayek that, if the > prices firms
received for their outputs increased more than the >opportunity costs of their raw
materials and wages, the average rate of >profit on ^-capital employed per year
increased more for those firms with a short, than for those with a long, turnover
period. This can best be illustrated by a simple arithmetical example. If the rate of
profit per year is 5 per cent, £100 of capital will yield £ros in 1 year and £110 in 2 years
(approximately, ignoring »compound interest). If output prices rise by, say, 1 per
cent, the > yield rises to £6 for 1 year and to £11 in 2 years. The rate of profit, therefore,
rises to 6 per cent per annum for the capital that can be turned over in 1 year, but only
to 5Vi per cent per annum for capital with a 2-year turnover period. Consequently, in
a boom, when ^commodity prices rise faster than wages, firms are discouraged from
investing in capital goods industries because of the long production time required.
This reaction is called the Ricardo effect because of its affinity to Ricardo's argument
that, if >real wages fall, firms tend to substitute Mabour for machinery. This
conclusion contrasted sharply with >Keynes' views based on the principle of the
accelerator ^acceleration principle).
 RIE

RIE Recognized investment exchange (^Financial Services Act 1986).

rights issue An offer of new >-shares to existing shareholders. A company will

offer the 'rights' in a certain proportion to existing holdings, depending upon the
amount of new > equity capital it wishes to raise. Thus, in a 'one for one rights issue',
each shareholder would be offered a number of new shares equal to the number
already held. To ensure that the issue is taken up, the new shares are typically offered
at well below the market price of the existing shares. The choice of the discount
below the ruling price is not as critical in normal circumstances as is often supposed,
because when the rights issue is announced, the market price of the shares will
adjust to the market's view of the value of the rights price. Rights issues are a
relatively cheap way of raising > capital for a quoted company since the costs of
preparing a brochure, ^underwriting commission or press advertising involved in
a new issue are avoided. Moreover, because existing shareholders are given the right
of first refusal, they ensure that companies cannot issue new shares at a price that
effectively reduces the value of existing shares. >*-new-issue market.

risk A state in which the number of possible future events exceeds the number of
events that will actually occur, and some measure of ^probability can be attached
to them. This definition distinguishes risk from ^uncertainty, in which the prob¬
abilities are unknown. A gambler, for example, faces risk because he/she could
either be very much richer tomorrow or (more likely) slightly poorer, depending on
whether a roulette wheel spins the ball into the right hole - and the odds of the
roulette wheel are known. ^Bernoulli's hypothesis; probability.
It is normally assumed that economic agents dislike risk (>*-risk aversion) and in
the market for financial assets the riskier an asset, the higher the expected return
investors will require of it (>-expected utility; portfolio theory), ^sovereign risk;
systemic risk.

risk adjusted assets >-capital adequacy.

risk assessment A measure of the risks of a course of action, and the costs and
benefits of reducing those risks. Risk assessment has been promoted as a means of
preventing economic activity that creates more dangers than are reasonable. But
perhaps more importantly, it can prevent the error of creating 'too much safety' -
the imposition of costly safety mechanisms that reduce risks less than is worthwhile,
given the cost. Economists argue that it is not worth investing millions of pounds
in, for example, a rail safety system, if it is expected to save one life a year, if the
money could have saved more lives invested elsewhere. »S*cost-benefit analysis;
precautionary principle; quality-adjusted life years.

risk aversion The placing of a higher value on a prospect arriving with certainty
than on an uncertain prospect that has the same expected outcome but with some
»-risk or > uncertainty attached. If you would prefer to be given £10 with certainty
than to have a 50 per cent chance of £15 and a 50 per cent chance of £5 (which
gives an average of £10) then you are risk-averse. Economists normally assume
that consumers are risk-averse on account of ^diminishing marginal utility. The
displeasure of losing £5 outweighs the pleasure of winning an extra £5 because the
richer we are, the less we probably value £5 (^Bernoulli's hypothesis). Risk aversion
explains why people normally insure against disaster. Gambling, on the other hand,
 Robinson, Joan Violet

is risk-loving behaviour; people at casinos on average pay out more than they win
back. >#«-Allais, M.; expected utility.

risk capital Medium- and long-term funds invested in enterprises particularly

subject to >risk, as in new ventures. Sometimes used as a synonym for >equity
capital, it is also used instead of the term venture capital, a somewhat more precise
term meaning equity and >doan capital provided for a new or >small business
undertaking by persons other than the proprietors. Neither term is unambiguous,
since all capital except that secured by fixed assets is at risk. Venture capital is
provided by private investors, sometimes known as business angels, and by a number
of specialized venture-capital institutions of which there are over 120 in the UK,
some owned by banks or other financial institutions (captives). In the USA the term
'venture capital' is restricted to seed or development capital for new or young
enterprises and does not include capital for ^management buy-outs, as in the UK.
In the USA, and more recently elsewhere, venture capital plus capital for buy-outs
(known there as leveraged buy-outs) is known as private equity.

Robbins, Lionel, Baron Robbins of Clare Market (1898-1984) Lord Robbins

became a lecturer at the London School of Economics after graduating there. After
a brief period as a lecturer at New College, Oxford, in 1924, and again from 1927 to
1929, he was appointed in T929 to the Chair of Economics at the London School of
Economics, a position he held until 1961. During the Second World War he was,
from 1941 to 1945, Director of the Economics section of the Cabinet Office. In 1961,
he became chairman of the Financial Times newspaper. He chaired the Committee
on Higher Education. An economist in the tradition of the English ^Classical School,
he defined economics as 'a science which studies human behaviour as a relation
between ends and scarce means which have alternative uses' in An Essay on the
Nature and Significance of Economic Science (1932). Economic analysis should beware
of including propositions based on value judgements, i.e. it should be a scientific
logical process without ethical or moral overtones (^normative economics; positive
economics). His other publications include The Great Depression (1934), Economic
Planning and International Order (1937), The Economic Problem in Peace and War (1947),
The Economist in the Twentieth Century (1956), Robert Torrens and the Evolution of
Classical Economics (1958), Politics and Economics (1963), The Evolution of Modem Econ¬
omic Theory (1970) and Autobiography of an Economist (1971).

Robinson, Joan Violet (1903-83) Educated at Girton College, Professor Robinson

took up a post as assistant lecturer at Cambridge University in 1931, becoming Reader
in 1949. She was elected to the Chair of Economics in 1965 on the retirement of her
husband, Professor Sir E. A. G. Robinson, and remained in this post until 1971.
Economic theorists in the T920S were much concerned with the problem of the
meaning of a theory of lvalue based on >-perfect competition. In particular, it was
felt of doubtful validity to assume a situation in which there were so many firms
supplying a ^commodity that none of them individually could affect the >price -
in face of the existence of the economies of large-scale output. Professor Robinson
broke out of the analytical framework of perfect competition and built up her
analysis on the basis of firms in 'imperfect competition' (^monopolistic compe¬
tition). Each firm had a > monopoly in its products that was based on the preferences
of consumers (^consumer preference) in spite of the existence of very close
Robinson-Patman Act

substitutes produced by other firms. (»**-Chamberlin, who developed similar ideas

simultaneously and independently.) These ideas were set out in her book Economics
of Imperfect Competition (t933). Her other published works include AnEssay on Marxian
Economics (1942), Accumulation of Capital (4956), Essays on the Theory of Economic
Growth (1963), Collected Economic Papers (3 vols, T95r, i960 and 1965), Economics: an
awkward comer (1966), Freedom and Necessity (1970), Economic Heresies (1971), Contri¬
butions to Modem Economics (1978) and Aspects of Development and Underdevelopment
(1979). Government economic controls are confined to the regulation of aggregate
effective >demand, and the allocation of the country's economic >-resources is left
to Mree-market competition. There is, however, no more reason to suppose that
competition efficiently allocates available resources, given the political and social
aims of society, better than it can regulate >aggregate demand. Professor Robinson
played a dominant role in the ^Cambridge School of economic thought, with
the development of post-Keynesian ^macroeconomics linked to the early classical
period of >Ricardo and >Marx (>capital re-switching).

Robinson-Patman Act >anti-trust.

ROCE Return on capital employed. >-rate of return.

ROI Return on investment (>rate of return).

roll -over ^corporation tax.

Rostow, Walt Whitman (1916-2003) Educated at Yale, and at Oxford as a Rhodes

Scholar, Rostow served during the Second World War in the Office of Strategic
Services, and was the assistant chief of the Division of German-Austrian Economic
affairs of the US Department of State from 1945 to t946. He was Pitt Professor of
American History at Cambridge University for 1949-50, Professor of Economic His¬
tory of Massachusetts Institute of Technology from 1950 to 1965 and finally Professor
of Economics and History at the University of Texas. He was appointed special
assistant to the US President in 1966. His major publications include Essays on the
British Economy of the Nineteenth Century (1948), The Processes of Economic Growth
(1952), The Growth and Fluctuations of the British Economy 1790-1850 (1953), Stages of
Economic Growth (i960), Politics and the Stages of Growth (1971), How It All Began -
Origins of the Modem Economy (1975), Why the Poor Get Richer and the Rich Slow Down
(1980) and British Trade Fluctuations 1868-1896 (1981). He postulated that societies
passed through five stages of economic development: (a) the traditional society; (b)
the pre-conditions for take-off; (c) the take-off, when growth becomes a normal
feature of the economy; (d) the drive to maturity and, some 60 years after take-off
begins, (e) maturity, reached in the age of high mass >consumption. ^economic
growth, stages of; growth theory.

'roundabout methods of production' >Bohm-Bawerk, E. von; capital.

rounding error The discrepancy that sometimes arises when numbers are shown
to fewer digits than those in which they were calculated. When suppressing a decimal
place it is usual to round down when a number is below 0.5 and to round up when
it is above 0.5. The same principle applies to the rounding of whole numbers. For
example, the following numbers total 6.68 to two decimal places or 6.7 to one decimal
 RTS

place. If each is rounded to the nearest whole number the total of 7 is still retained,
although the rounded numbers add to 8.

1.64 2
1.66 2
1.69 2
1.69 2

6.68 8

RPI minus X >-price regulation.

RPIX ^underlying inflation.

RPM Presale price maintenance,

r-squared ^multiple correlation coefficient.

RTCS >real time gross settlement.

RTS >rate of technical substitution.

 s

saddle point 1 A combination of values of the ►independent variables in a

function such that the resulting value of the function is a maximum in one dimen¬
sion and a minimum in another. Imagine a function Y = f(X,Z). If Y rises, then falls
as X rises, and if it falls and then rises as Z rises, the function could have a saddle
point where it is at its peak with regard to X, and its trough with regard to Z. (See
diagram in which the saddle point is indicated by SP.) 2 An ►equilibrium that is
stable (>stability analysis) in some directions, but not in others. For example, we
can ask whether there is a tendency for the price in an industry to converge towards
the equilibrium price. If it is true that it converges only when it starts at certain
levels, but does not converge if it starts from other points, the equilibrium is known
as a saddle point.

sales promotion ►advertising.

sales tax A tax levied as a proportion of the retail ► price of a ►commodity at the
point of sale. An indirect tax (►direct taxation), the term is sometimes used to refer
to all taxes on expenditure, i.e. to include ►value-added tax, which is levied at all
levels of production and distribution. There are no single-stage sales taxes as such
in the UK, though they are levied in the USA and some other countries. Sales taxes
may be general (i.e. levied on all sales) or targeted, i.e. levied on a selective basis.
>► fiscal neutrality; taxation.
 saturation point

sample The study of a few members of a ►population for the purpose of identifying
attributes applicable to the population as a whole. The advantage of sampling is that
it is cheaper than a study covering the entire population, Moreover, testing the
entire population may be impractical, e.g. when the test procedures are destructive
as, for example, in food-tasting. Provided the sampling procedures are designed
properly, the margin of error in the estimates may be calculated, and the degree to
which the error may be reduced by increasing the sample size. >normal distribution;
s^-quota sample; random sample; stratified sample.

Samuelson, Paul Anthony (b. 1915) Professor Samuelson was appointed to the
Chair of Economics at Massachusetts Institute of Technology in ^47. He served in
the US Treasury for 7 years after the end of the Second World War. In 1970, he
received the >-Nobel Prize in Economics. His publications include Foundations of
Economic Analysis (1947), Economics (1948) and Linear Programming and Economic
Analysis (with Dorfman and ►Solow) (1958). Samuelson developed the >Heckscher-
Ohlin principle by showing how an increase in the ►price of a > commodity can
raise the »-income of the ► factor of production used most intensively in producing
it (^capital-intensive). This led to his formulating the factor price equalization theorem,
which states the conditions under which, as >free trade in commodities narrows
differences in commodity prices between countries, the prices (incomes) of factors
of production are also brought into line, i.e. free trade is a substitute for the free
mobility of factors of production. Professor Samuelson has made important contri¬
butions to the development of mathematical economics, general Equilibrium
theory and the theory of > consumer behaviour. To free the last from what he
considered to be the constraint of the traditional concept of futility, he invented
►revealed preference. In macroeconomic theory (►macroeconomics), he was, in
'Interactions between the Multiplier Analysis and the Principle of Acceleration',
published in Review of Economics and Statistics (1939), the first to formulate the
interaction between the accelerator and the multiplier. He was a leading figure on
the side of ►neo-classical economics in the debate with the ►Cambridge School
regarding the integration of classical (►classical economics) microeconomics and
modern macroeconomics in growth theory (►accelerator-multiplier model; social-
welfare function; turnpike theorem).

satisficing Behaviour that attempts to achieve some minimum level of a particular

►variable, but which does not strive to achieve its maximum possible value. The most
common application of the concept in economics is in the ►behavioural theory of
the firm, which, unlike traditional accounts, postulates that producers do not treat
►profit as a goal to be maximized, but as a constraint. Under these theories, although
at least a critical level of profit must be achieved by firms, thereafter priority is attached
to the attainment of other goals, abounded rationality; optimum; Simon, H. A.

saturation point A level beyond which the relative absorption of a product or

service is not expected to increase. It is defined in terms of a ratio, e.g. ownership of
videos per household or per hundred persons. Once the saturation point is reached,
the growth of demand slows down to levels determined by population growth and
replacement, although in some cases predictions of saturation points have been
falsified by the emergence of multiple ownership, e.g. of cars and television sets,
^logistic curve; market share.
saving | 344

saving >Income not spent. At the end of any period, saving is equal to income in
that period minus ►consumption, and could be negative if expenditure exceeds
income (►dissaving). Note that paying off debt is a form of saving in the economic
sense of the term. Saving can occur in the ►public sector when tax revenues exceed
final consumption by government plus ►transfer payments and ►subsidies, and in
the company sector where ►profits are not distributed (►self-financing), as well as
in the ►household, though typically the public sector is a net borrower (►public
sector borrowing requirement) while the personal sector and industrial and commer¬
cial companies are net lenders.
For the economy as a whole, if total saving is equal to total ►investment, then
expenditure by firms and individuals will be in Equilibrium (for simplicity we
ignore the public sector and foreign trade); if saving exceeds investment, expenditure
from wages, salaries and dividends will not return to firms in the form of payments
for goods and services (including investment goods) and output will have to fall,
thus reducing incomes and bringing saving and investment into balance (► circular
flow of income). What determines the level of saving is, therefore, important in
►macroeconomics. There are several interpretations of this problem, e.g. that saving
will be a function of the level of income (>consumption function) (this assumption
underlies the mechanism of ^income determination just outlined), and that
changes in savings will be used to maintain a steady rate of consumption (►perman¬
ent-income hypothesis), ^savings ratio.

savings and loan (S & L) associations (US) >savings bank.

savings bank A bank that accepts >interest-bearing ►deposits of small amounts.

The earliest savings banks were established in the private sector but later were set up
or supported by governments, to encourage individual ►savings. In the UK, there
is a ►National Savings Bank, and the ►building societies share the basic objectives
of savings banks elsewhere. In the USA savings banks are also called 'thrift insti¬
tutions' or savings and loan associations, many of which are ►mutual companies.

savings certificates ►National Savings certificates.

savings function ►savings ratio.

savings ratio The proportion of household income that is saved (►saving) usually
expressed as a percentage of total household ►disposable income. It may be calcu¬
lated gross or net. In the latter case, a deduction is made for the ►depreciation of
household fixed assets. The savings ratio in the UK fell from about io per cent in the
early r99os to about 3 per cent in 2oor. Declines were also experienced in many other
countries in this period (e.g. in the USA) from about 8 to under 2 per cent. The
savings ratio differs significantly between countries as well as over time. The ratio
will depend on: (a) the proportion of old people in the ►population, as young
people have more incentive and greater means to save; (b) the rate of ►inflation, as
expectations of rising prices encourage people to spend or invest in fixed assets, and
(c) the tax regime (►individual savings account). The savings function gives the
relationship between aggregate savings, that include non-personal savings, and
►income, and is the inverse of the ►consumption function.

Say, Jean-Baptiste (1767-1832) A practical businessman, Say developed an interest

in economics and began lecturing in the subject in 1816. In r8rp, he was appointed
 Schengen Treaty

to the Chair of Industrial Economy at the Conservatoire National des Arts et Metiers.
In r83r, he was appointed Professor of Political Economy at the College de France.
His most important published works are Traite d'economie politique (1803) and Corns
complet d'economie politique pratique (r82(?). Although he can claim some credit for
the introduction of the concept of an ^entrepreneur into economic theory, and
also the division of the fundamental ^-factors of production into three - >land,
> labour and >capital - his fame and notoriety spring from his ‘loi des debouches’, or
'law of markets'. It is probable that his 'law' would not figure so prominently in
economics today had not > Keynes accused the > Classical School of being gravely
misled by accepting it as the pivot of their macroeconomic theory (> macroeconom¬
ics). According to Keynes, the law said that the sum of the values of all ^commodities
produced was equivalent (always) to the sum of the values of all commodities
bought. By definition, therefore, there could be no under-utilization of >• resources
- 'supply created its own demand'. However, there is some considerable doubt about
what Say actually meant. Several versions have been put forward, and some are
incontrovertible platitudes, e.g. 'in barter a seller must also be a buyer', and 'if
a good is sold somebody must have bought it'. Probably the most meaningful
interpretation is that of Keynes, but only as a condition that must be satisfied for
►equilibrium to exist. ►►Walras, M. E. L.

Say's law of markets >Say, J.-B.

scarce currency >hard currency.

scarcity A situation in which the needs and wants of an individual or group of

individuals exceed the resources available to satisfy them. In the presence of scarcity,
choices have to be made between those wants that can be satisfied and those that
cannot be; the available resources must in some way be rationed, either through
price or some central distribution system. In the absence of scarcity, no difficult
choices would need to be made, no prices would need to be attached to anything,
and the study of economics would be rendered entirely unnecessary. As the econom¬
ist uses the term, scarcity is present in any society in which there is anyone whose
desires are not all completely satisfied; it is not a concept of any more relevance to a
poor society where want and deprivation are rife, than a rich one in which even a
scarcity of Rolls-Royces is considered a shortcoming worthy of attention. >► price
system; resource allocation; resources.

Schedule D ^-income tax.

Schedule E >income tax.

Schengen Treaty A treaty signed at Schengen, Luxembourg in r99o, the terms of

which were subsequently embodied in the Treaty of Amsterdam, agreed by the
member countries of the ►European Union (EU) in T997. The member countries
agreed: (a) to abolish customs and immigration border controls at their common
frontiers; (b) to establish a common list of countries, the nationals of which would
require visas for entry, and (c) to grant their police the right of pursuit across their
common frontiers. At the same time, they promised to tighten controls on their
external frontiers and to co-operate in judicial and police matters. All members of
the EU are parties to the agreements and, in addition, Norway and Iceland. However,
 Scholes, Myron S.

Ireland and the UK, although agreeing to co-operation on law enforcement, have
opted out of aspects of the agreement relating to controls at their frontiers.

Scholes, Myron S. (b. 1941) Professor Scholes is a finance specialist and joint
winner of the 1997 Nobel Prize for Economics for his work in deriving methods
of valuing complex financial instruments, e.g. ►options. His work, the result of
collaboration with Black, produced the path-breaking ►Black-Scholes formula, that
itself was generalized by Merton OMerton, R.). Their work led to the development
of a significant new financial market that enables traders to diversify risk and allocate
it in far more flexible ways than had hitherto been possible. In addition, insurance
and guarantees comprise forms of option, and thus these too can be valued more
accurately. Professor Scholes' most famous paper is 'The Pricing of Options and
Corporate Liabilities', Journal of Political Economy (1972), with Black. Scholes' career
varied between the Massachusetts Institute of Technology, Chicago University and
Stanford University.

Schultz, Theodore W. (b. 1902) After graduation in economics at the South

Dakota State College, Professor Schultz obtained a Ph.D at the University of Wis¬
consin. In 1943, he accepted a Chair in Economics at the University of Chicago,
where he remained until his retirement in 1974. He was awarded the ►Nobel Prize
in Economics in r979 (jointly with >Lewis). His major publications include Agricul¬
ture in an Unstable Economy ^945), The Economic Organisation of Agriculture (1953),
The Economic Value of Education (1963), Transforming Traditional Agriculture (1964),
Economic Crises in World Agriculture (1965), Economic Growth and Agriculture (r968) and
Investment in Human Capital: the role of education and research (1971). Professor Schultz
developed the ideas of human-capital theory in his work on the economics of
education and made major contributions to the analysis of agriculture in >develop-
ing countries. He highlighted the distortion of policy in taxation and trade that biases
development against agriculture, condemning the sector to subsistence farming.

Schumacher, Ernst Friedrich (1911 -77) ^intermediate technology.

Schumpeter, Joseph Alois (1883-1950) In r9i9, Schumpeter was appointed Pro¬

fessor of Economics at Czernowitz, subsequently moving to Graz. He was appointed
Minister of Finance in the Austrian Republic for a short period after the First World
War. From r925 until r932, he held the Chair of Public Finance at Bonn. From 1932
until his death he was at Harvard University. His major publications include Theory
of Economic Development (1912), Business Cycles: a theoretical, historical and statistical
analysis of the capitalist process (1939) (in which he reviewed the work of >Kondratiev
cycle), Capitalism, Socialism and Democracy (1942) and History of Economic Analysis,
which appeared posthumously and unfinished in 1954. He built up a theory of the
►business cycle that was based on three time periods - short, medium and long - to
each of which he attributed different causes. He tested his theory against actual
fluctuations from the eighteenth to the twentieth century. Although it was reason¬
ably successful, he was doubtful of the predictive efficiency of his theory for future
periods. He attempted to work out a theory of economic growth and fluctuation
around an explicit recognition of the contribution of technical ►innovation. He
tried to argue that, without the latter, an economy would reach a static ►equilibrium
position of a circular flow' of goods with no net growth. He emphasized the evol¬
utionary nature of the capitalist system (>capitalism). He argued that, under ►mon-
 second best, theory of

opoly capitalism, firms would place less emphasis on > price competition but would
increasingly compete in technical and organizational innovation, thus sending
'gales of creative destruction' through the economic system. He predicted that
capitalism would evolve gradually into socialism.

screening The use of a mechanism that allows someone to judge the characteristics
of someone or something even though they cannot see those characteristics directly.
In situations of > asymmetric information, one party to a transaction may wish to
know about some feature of the other party (e.g. how hard-working they are) which
cannot easily be judged before employing them. A screening device is one that
can be observed directly, and correlates with the unobservable characteristics. For
example, if hard-working people enjoy school and spend many years there, and lazy
people hate it and leave as soon as possible, the number of years spent at school may
provide a device for screening hard-working from lazy people. However, the device
can work only as long as the extra pay that hard-working people get is not so
attractive to lazy people that they choose to suffer spending more time at school
anyway. This is known as the >incentive compatibility condition, ^-information,
economics of; signalling; Stiglitz, J.

scrip issue An issue of new >shares to shareholders in proportion to their existing

holdings made, as distinct from a >rights issue, without charge. A scrip or bonus
issue does not raise new >capital. It is merely an adjustment to the capital structure
that capitalizes reserves, usually consisting of past »>profits. The word 'scrip' is an
abbreviation of 'subscription certificate', ^ capitalization.

SDR Especial drawing rights.

SEAQ Stock Exchange Automated Quotation (>stock exchange).

seasonal adjustment The elimination from a >time series of fluctuations that

exhibit a regular pattern at a particular time during the course of a year that are
similar from one year to another. For example, unemployment rises in the winter
months because of the interruption of work by winter weather conditions. From a
study of a series of winter periods, the percentage effect this has on the numbers
unemployed may be estimated, and the time series of unemployment statistics may
be offset by this percentage. The resultant, adjusted, series gives a clearer picture of
the underlying trend in unemployment. Amoving average.

seasonal unemployment ^Unemployment that varies with the season as in the

construction, tourist and agricultural sectors, ^seasonal adjustment.

second best, theory of A theory formulated by Lipsey and Lancaster in The

General Theory of Second Best (1956), that posits that, in the absence of being able to
attain all the conditions necessary for the existence of the most desirable possible
economic situation, the second-best position is not necessarily one in which the
remaining conditions will hold. In an efficient economy, for example, price will
equal >-marginal cost in all industries. This will ensure that no consumer who values
a commodity more than it costs society to produce it will be deterred from buying
it (>marginal-cost pricing). If in one industry, however, price is higher than marginal
cost, the theory of the second best suggests that it is not efficient for price to be
equal to marginal cost in all the other industries, for this would encourage too
second pension

much consumption of those items relative to the more highly priced one. In the
second-best world, all other items would be taxed so that everything was priced in
excess of marginal cost, and consumers would allocate their budgets closely to that
in a world of full marginal-cost pricing, ^-welfare economics.

second pension ^National Insurance.

secondary bank A financial institution that accepts deposits and makes loans but
that has relatively few branches (in the UK) and therefore does not play a major role
in the payments system as far as the general public is concerned. Included in
the term are the ►merchant banks, and other money-market banks, the British
►overseas banks, consortium banks, and some ►finance houses. There was a second¬
ary banking crisis in 1973 when a number of minor banks (mainly deposit-taking
finance houses and other institutions heavily lent to the property sector) got
into difficulties when ►monetary policy was tightened following the oil crisis,
^►banking.

secondary market A >market in which >assets are resold and purchased, as

distinct from a primary market in which assets are sold for the first time. The ►stock
exchange is a secondary market in which financial ►securities are traded, although
it is also a primary market where these securities are issued for the first time (►new-
issue market). Another example is the secondary >mortgage market in the USA, in
which holders of mortgages who need funds can dispose of their holdings before
maturity. Secondary markets are typically larger than primary markets and perform
an important function, since purchasers of new issues of securities would be reluctant
to purchase and would offer a lower price for them (a bigger ►discount) unless they
were confident that they could, if necessary, dispose of them in the secondary
market.

secular trend A long-term directional movement in the trend of an economic

>time series, as distinct from effects generated by the fluctuations of the ►business
cycle or seasonality (►seasonal adjustment). Such movements could, for example,
be due to changes in tastes or technology or the contraction of an industry due to
the growth of overseas competitors.

securities 1 In the widest sense, documents giving title to property or claims on

►income that may be lodged, e.g. as security for a >bank loan. 2 Income-yielding
and other paper traded on the ► stock exchange or in ► secondary markets. Usually
a synonym for ►stocks and ►shares. An essential characteristic of a security is
that it is saleable. The main types of security are: (a) fixed interest: ^debentures,
►preference shares, stocks and ►bonds (including all ►government securities and
local authority securities) - sometimes a distinction is made between >gilt-edged
securities and other fixed-interest securities, though in both cases the holder nor¬
mally receives a predetermined and unchanging rate of interest on the ►nominal
value of the stock, which is what is meant by fixed interest; (b) variable interest:
►ordinary shares, and (c) other: ►bills of exchange, ► assurance policies, ►warrants.
Securities may be ►redeemable or ►irredeemable, quoted or unquoted (►quot¬
ation). >^bond; equities; gilt-edged securities.

Securities and Exchange Act (1934) ►Securities and Exchange Commission.

 self-financing

Securities and Exchange Commission (SEC) The US Federal agency for the
>• regulation of the markets in ^securities, set up in 1934 to administer the Securities
and Exchange Acts 1933 and 1934, that require most securities offered for sale to be
registered. The SEC also enforces the Investment Company Act 1940, and the Investment
Adviser Act 1940 - that regulates advisers on securities investments and requires them
to register with the SEC - and other legislation. The SEC has a chairman, designated
by the president, and four commissioners, all appointed by the president with the
advice and consent of the Senate for 5-year terms. The SEC has five main divisions: (a)
corporation finance (corporate new issues, registration, disclosure, etc.); (b) market
regulation (overseas brokers, self-regulating organizations and other market partici¬
pants, e.g. ^-commercial banks); (c) investment management (^-institutional inves¬
tor and investment adviser supervision); (d) enforcement, and (e) compliance
inspections and examinations. The SEC has eleven district offices.

Securities and Investments Board (SIB) >Financial Services Act 1986.

securitization The substitution of >securities for Moans. Banks and other >fin-
ancial intermediaries, for example, have packaged house mortgages and (in the USA)
>credit card loans in this way so that borrowers continue to pay interest that is
received by the investor in the security representing the underlying loans. Securitiz¬
ation converts inflexible assets (e.g. long-term bank loans) into readily saleable
paper.

Select Committee on Estimates A select committee of the British House of

Commons, the purpose of which is to investigate whichever of the >-estimates of
projected government expenditure it thinks should be examined. Its purpose is
essentially to determine if any economies may be achieved consistent with the
policies implied in the estimates.

self-assessment Method of assessing income-tax liability by letting individuals

calculate and declare their income at the year end, and then pay whatever has not
been deducted from their wages during the year. It is used in the USA and has been
adopted in the UK and many other countries. In the UK, from 1996/97, >income
tax payers could opt to calculate their own tax liability and make provisional
payments on 3r January and 3r July. Penalties are charged for late returns. Persons
whose whole income is taxed under the >pay-as-you-eam system are not affected.
Under the new system, the >-self-employed are assessed on their income on a
current-year basis, after a transition system, and no longer on the preceding-year
basis which gave rise to considerable complications. Self-assessment was introduced
for >corporation tax in 1993 and >value-added tax is self-assessed.

self-employed Working on his/her own account. The number of self-employed

persons in the UK is estimated to have risen from 1.9 million in r979 to 3.5 million
in 2001 and now accounts for about 12 per cent of the Mabour force. A self-employed
person may be a proprietor of an unincorporated business either with or without
employees.

self-financing Generating ^capital from Mncome. A firm that is self-financing is

generating its ^investment funds from internal sources, i.e. the ploughing back
of retained >-profits (or retentions), and ^depreciation, as opposed to external
borrowing. A quoted company has the choice of financing fixed-capital formation
self-financing ratio | 350

or increasing its stocks and work in progress or acquiring other companies or > shares
in them, either by borrowing on the >■ stock exchange (or from other sources,
including banks) or by using undistributed income. If it borrows, it will have to pay
^interest or >-dividends and issuing costs on new issues. If it uses undistributed
income, it is choosing to pay its ordinary shareholders a lower dividend, i.e. to
distribute less of its income. Unquoted companies do not have the alternative of
new issues of shares, although they may take further Vequity from private, and
borrow from other, sources. In fact, the bulk of capital expenditure is financed
from internal sources. Of total sources of funds of UK industrial and commercial
companies, over 70 per cent in recent years has been provided from internal sources.
The remainder comes from >new issues, >-bank loans, ^mortgages, inward invest¬
ment (Moreign investment) and capital transfers.

self-financing ratio investment funds derived from undistributed income as

a proportion of total investment funds in any accounting period, ^self-financing.

self-liquidating A term used to describe a low-risk financial transaction or ioan

that incorporates a procedure for simultaneous termination and clearing indebted¬
ness. A >hire-purchase transaction is self-liquidating in that regular payments culmi¬
nate in a final instalment that clears the Vdebt. More generally, the term is applied
to any form of finance to fill a temporary shortfall of funds, e.g. >bills of exchange,
or a bridging loan by a bank to a customer in the process of selling one house and
buying another.

selling costs ^Opportunity costs incurred in >marketing and distributing a

product, including the costs of advertising, sales promotion, packaging and sales
staff.

Selten, Reinhard (b. 1930) A German economist, who has specialized in >*game
theory, and jointly won the >Nobel Prize for Economics in 1994. Selten has been
one of the economists most concerned with defining the characteristics of an
^equilibrium in a game. >Nash, a fellow prize-winner, had developed one such
equilibrium (>Nash equilibrium), but Selten was the first to refine the concept for
analysing dynamic situations. One problem with Nash's equilibrium concept had
been its inclusion of intuitively unsatisfactory strategic combinations. In particular,
if one party to a game makes an untenable threat to the other, and the other is
deterred by that threat from some course of action, it is a Nash equilibrium even if
the threat was unlikely to be carried out. That did not seem a likely outcome to
an interaction. Selten introduced the refined notion of sub-game perfection, which
essentially counted only those Nash equilibria that would also be Nash in each and
every segment of a game taken on its own. In effect, only credible threats should be
taken into account. He also devised the notion of the trembling hand equilibrium,
which is a Nash equilibrium that still holds, even if the players assume one of the
players may have a 'trembling hand' and make a mistake as to which rational strategy
to follow.

Sen, Amartya (b. 1933) The world's most celebrated welfare economist, Master of
Trinity College Cambridge and winner of the Nobel Prize for Economics in 1998.
Professor Sen has held posts at the Universities of Delhi and Calcutta, and at the
London School of Economics, Oxford and Harvard, among others. Among his main
 Serra, Antonio

works are Collective Choke and Social Welfare (1970), On Economic Inequality (1973) and
Poverty and Famines: an essay on entitlement and deprivation (1981). He is perhaps best
known for his work on famines and the finding that they are not always associated
with shortages of food, but that sometimes they reflect the economic predicament
of particular groups. Sen has also contributed to the study of Asocial welfare func¬
tions, and has devised measures of >poverty and welfare, in both cases taking into
account inequalities (inequality) among the poor, or across society generally. He
has also tried to cast individual welfare not in terms of goods consumed, but in those
of capabilities enjoyed. Under this view, goods are welfare enhancing because they
provide capabilities. Owning a DVD player, for example, gives us the capability of
being able to interact with our friends, having some common interests to talk about.
Under this view, someone who does not have a DVD player in a rich country where
most people do have one, is poorer than a person without a DVD player in a country
where no one does. All Sen's work has been characterized by a concern for the least
well-off, and a strong inclination to philosophical methods of enquiry.

Senior, Nassau William (1790-1864) Educated at Oxford University, Senior was

called to the Bar in 1819 and became a Master in Chancery in 1836. In 1825, he was
appointed the first Drummond Professor of Political Economy at Oxford. He held
this position twice, the first time until r83o, and the second from 1847 to 1852. He
served on many royal commissions. His major work on economics was an Outline of
the Science of Political Economy (1836). He is remembered mainly for his abstinence
theory of >interest. Interest was a reward for abstaining from the unproductive use
of ^savings. The creation of new capital involved a sacrifice. A positive return must
therefore be expected to make the sacrifice worth while. Senior can be regarded as
one of the first pure theorists in economics. He attempted to elaborate economic
theory on the basis of deductions from elementary propositions.

separating equilbrium >Stiglitz, J.

separation of ownership from control The situation in which the owners of

a corporation do not actively participate in its management. In its earliest form,
business was owned and managed by the same people. Economic and technological
development led to the advent of the joint-stock company in the seventeenth
century to meet the need for larger amounts of >capital. This began the process of
the separation of ownership from control that continued with the introduction of
>limited liability for both >-public companies and >private companies, and the
gradual emergence of the modern giant corporation in which none of the directors
or managers has more than a minority financial interest. This process has given rise
to the possibility that the interests of those who control business and those who
own it may conflict, a subject of continuing controversy among economists since
the publication by Berle and Means of The Modem Corporation and Private Property
(1932). W^-firm, theory of the; Galbraith, J. K.; moral hazard; principal-agent problem.

SEQUENCE >stock exchange.

serial correlation > auto-correlation.

Serra, Antonio (15?—16?) A Neapolitan writer in the mercantilist tradition ^mer¬

cantilism), who was the first to analyse and fully use the concept of the ^balance of
trade, both visible and >■ in visible. He explained how the shortage of precious metals
services | 352

in the Neapolitan kingdom was a result of a deficit on the >-balance of payments.

In so doing, he rejected the idea, current at the time, that the ►scarcity of money
was due to the unfavourable ►exchange rate. The solution was to be found in the
encouragement of >exports.

services Intangible economic goods as distinct from physical ►commodities.

Services are difficult to define unambiguously. The output of some services from, for
example, a bank may take a physical form (a cheque or bank statement) while,
although many services are consumed at the point of sale and are not, therefore,
transferable (e.g. a concert or a haircut), a service in which knowledge is imparted
(e.g. a medical consultation or tax advice) may be transferable freely from one
consumer to another. Moreover, many manufacturing companies enhance their
product attraction by offering services in support of their product, e.g. computer
suppliers who offer on-line software advice to their customers. The intangible nature
of much of the output of the service sector creates difficulties in the calculation of
unit ►productivity. Generally speaking, the service sector of the economy is more
► labour-intensive than the manufacturing sector, but even this generalization is
misleading because, with computerization and the development of telecommunica¬
tions, automated warehouses, special-purpose buildings and other plant and equip¬
ment, much of the service sector now employs more ►capital per worker than
manufacturing industry. The service sector also contributes proportionately less to
exports compared with its domestic market than does manufacturing, but ►invisible
exports are of growing importance and world trade in services is growing faster than
that in physical commodities. Some parts of the service sector and that sector as a
whole, on average, have lower levels of >concentration than the manufacturing or
extractive industries, but some (e.g. >banking) are highly concentrated. Parts of the
sector, notably distribution, banking, business services and communications, have
been growing very rapidly. The relative decline of agriculture and manufacturing
has given rise to fears of >de-industrialization, though these fears are probably
misplaced. The relative faster growth of services compared with other sectors of the
economy has been characteristic of all »-advanced countries. In the UK, for example,
the service sector now accounts for about 70 per cent of >national income.
►►Baumol effect; General Agreement on Trade in Services; Petty, Sir W.

servicing debt ►debt.

shadow economy ►informal economy

shadow price The ►opportunity cost to a society of engaging in some economic

activity. It is a concept applied to situations in which actual prices cannot be charged,
or where actual prices charged do not reflect the real sacrifice made when some
activity is pursued. Suppose, for example, there is unemployed labour in the econ¬
omy: the cost of using that labour to society is virtually zero - by employing it no
sacrifice is made in terms of other goods produced. The shadow price of labour is zero,
even though the workers, if employed, would have to be paid a wage. Alternatively,
suppose there is an ►excess demand for labour: at the going wage rate, labour is in
short supply. In this case, employing a worker may cost a firm only the going wage,
but the cost to society of that firm employing that worker is the production the
worker could have produced in an alternative occupation; this will be worth more
than the wage rate if labour is in excess demand. The shadow price of labour in this
 short run

case is higher than the wage rate. In effect, it reflects the benefit that would result
from relaxing the constrained supply of workers by one unit. Of course, in a perfectly
functioning economy, market prices will be equal to >marginal cost (>perfect
competition), and marginal cost itself represents the true cost to society of producing
one extra unit of a commodity; it is equivalent to the value of the items that could
have been made as alternatives to the last unit of the commodity produced, with
the same resources. In the competitive economy, therefore, the market price of an
item is equal to the opportunity cost of producing that item. There is no shadow
price, distinct from actual prices.
Shadow prices are used in valuing any item that is implicitly rationed or con¬
strained in some way. Shadow prices can be derived using ► linear programming
techniques and can be used in social > cost-benefit analysis, which attempts to
achieve an optimal > resource allocation in the absence of an effective >price
system.

share One of a number of equal portions in the nominal ^capital of a company

entitling the owner to a proportion of distributed >profits and of residual > value if
the company goes into liquidation; a form of > security. Shares may be fully
>paid-up or partly paid, >voting or non-voting (sometimes called 'A' shares).
>*-bearer bonds; ordinary shares; preference shares; stocks.

share certificate A document showing ownership of >shares in a company.

>*-CREST; transfer deed.

share indices »dndex numbers indicating changes in the average prices of >-shares
on the >stock exchange. The indices are constructed by taking a selection of shares
and 'weighting' (>weighted average) the percentage changes in prices together as
an indication of aggregate movements in share prices. Roughly speaking, a share
index shows percentage changes in the ►market value of a ►portfolio compared
with its > value in the base year of the index. Index numbers are published in several
daily papers and weekly journals. »►Financial Times share indices.

share options ►option.

shareholders' interest ►balance sheet.

Sharpe, William (b. 1934) An economist at Stanford University in California,

William Sharpe, was a pioneer of the ►capital asset pricing model, from his article
'Capital Asset Prices: a theory of market equilibrium under conditions of risk', Journal
of Finance (1964). He jointly won the ►Nobel Prize for Economics in r9$>o for that
achievement, which built upon the foundations laid in ►portfolio theory by one of
his fellow winners, >Markowitz, /•►envelope theorem.

Shephard's lemma >envelope theorem.

Sherman Act ►anti-trust.

shock therapy ►transition, economies in.

short-dated securities >dated securities.

short run A period of time in which only some >variables change or economic
processes work. It is a concept that strictly can be defined only in the particular
context in which it is applied, because its meaning depends on which variables or
short-run cost curves | 354

processes the user of the term has in mind as flexible. Its most common use is in the
theory of the firm (>firm, theory of the), where it is defined as the period in which
the quantity of certain >■ factors of production employed (e.g. plant and machinery)
is fixed and only, say, the number of workers hired can be changed. The specific
period of time being referred to as the 'short run' also varies with every application
of the term, because, for example, it takes different amounts of time to build the
plant and machinery for different industries. »>-impact effect; long run; Marshall, A.

short-run cost curves A graphical representation of the relationship between the

output of a firm and the cost of producing that output with the firm's given level of
fixed assets. For example, a company making CDs may have one factory capable of
producing any number up to r million. The short-run cost curve shows how much
it would cost to make any number of CDs with that plant up to its maximum
capacity, taking into account the extra labour and raw materials required to produce
a given quantity (>firm, theory of the). Another factory would have a different
short-run cost curve.
Any short-run cost curve can be broken down into two elements: (a) short-run
fixed costs: the payments incurred independently of the level of production, and (b)
short-run variable costs: e.g. raw materials and labour costs which vary with the level
of output. The sum of these produces short-run total costs. This cost function may
be depicted as an average cost curve (in which case it is generally assumed that as
production rises it falls to a minimum, and then rises), ^marginal analysis.

short-term capital ^business finance.

short-term gains ^capital gains.

SIB Securities and Investments Board. ^Financial Services Act 1986.

SIC >Standard Industrial Classification.

signalling The use of a mechanism by which someone indicates to someone else

that he/she has certain characteristics, even though these characteristics are not
directly observable. A signal is the converse of a screen (^screening). Advertising is
seen as signalling the quality of a product to consumers, because it is only those
with faith in their product, and who think it will be in production for many years,
who will find it worth engaging in expensive advertising. The engagement ring is a
signal of commitment to the fiancee for, as long as it is expensive enough, it would
not pay the man to buy the ring unless he was serious about getting married.
Economists have been increasingly inclined to explain economic and non-economic
phenomena as signals, ^asymmetric information; information, economics of;
Spence, M.

Simon, Herbert A. (1916-2001) A graduate of the University of Chicago, Professor

Simon held the post of Director of Administrative Measurement Studies at the
Bureau of Public Administration of the University of California from 1939 to 1942, in
which year he moved to the Illinois Institute of Technology, becoming a professor
of political science there in 1947. In 1949, Professor Simon was appointed Professor
of Administration and Psychology at the Carnegie Mellon University, becoming
Professor of Computer Science and Psychology in T955. He was awarded the >Nobel
Prize in Economics in 1978 for his research into decision-making processes within
 Sismondi, Jean Charles Leonard Simonde de

organizations. His major publications include Administrative Behaviour (1947), Public

Administration (4950), Organisations (1958), The New Science of Management Decisions
(i960), The Shape of Automation for Men and Management (1965), Models of Discovery
(1977) and Models of Bounded Rationality and Other Topics in Economics (1982). Simon
argued that the central assumption in economic theory of a rational 'economic
man', who maximizes benefits and minimizes costs, is unrealistic. Any decision
faced by an individual, in a household or in a firm, is bounded by uncertainties and
ignorance. Individuals 'satisfice' (>satisficing). They adjust their behaviour and
ambitions continually in the light of experience. More importantly, large organiza¬
tions that combine many different interests and groups will not generally pursue
one goal as consistent or as simple as profit-maximization as economic theory
usually assumes.

simple interest >compound interest.

simple random sample >random sample.

simulation The construction of a »*model that describes mathematically the

structure and processes of a real-world situation to be studied and the inputting of
values of ^variables in the model in order to generate appropriate out-turns. The
model enables the results of a process to be simulated without the need to test the
process in an actual situation. W^Monte Carlo method; operations research.

Single European Act The legislation passed into law by, and became effective in,
each member state of the ^-European Union (EU) in 1987. By this Act, each state
agreed to the aim of a single market throughout the EU. The programme involved
the abolition of exchange controls, the recognition of qualifications, the abolition
of restrictions on internal transport (^cabotage), liberalization of the market in air
services, public procurement tendering, life insurance and banking services, and
the abolition of frontier controls (>-Schengen Treaty). The Act also widened the

I application of qualified majority decision-making, as against unanimity, in the EU.

A number of areas (e.g. taxation) still required a unanimous decision from member
states for any policy changes to be made. The European Commission monitors

I
competition to ensure that no enterprise acts in such a way as to restrict the free
movement of goods and services in the EU or to exploit a dominant market position
(>competition policy).

single market A trading zone in which roughly homogeneous items are traded in
roughly uniform conditions of supply and demand. It is likely that in a single market
the Maw of one price will prevail, ^-market.

sinking fund ^amortization.

Sismondi, Jean Charles Leonard Simonde de (1773-1842) A Swiss historian

and economist, who after a period in exile in England began lecturing at Geneva
Academy in 1809 on history and economics. His economic works include Richesse
commerciale (1803), Nouveauxprincipes d'economiepolitique (1819) and Etudes surl'econo-
mie politique (1837). Sismondi argued against the doctrine of >laissez-faire in favour
of State intervention. He recommended >unemployment and sickness benefits
and pension schemes for workers. With >Malthus, he attacked >Ricardo for not
recognizing the possibility of economic crisis developing from underconsumption.
size distribution of firms | 356

He tried to emphasize the dynamic nature of the economic process, compared with
the comparative statics of Ricardo (^comparative static equilibrium analysis), and
was the first to use sequence analysis as an analytical device. Increased output in
one period, he argued, is faced with a level of > income generated by a lower level
of output in the previous period. Total demand falls short of the available supply.
Lags in the economic system, therefore, could give rise to underconsumption.

size distribution of firms Concentration ratio.

Slutsky, Eugen (1880-1948) Slutsky was appointed a professor at Kiev University

in r9r8, where he remained until r926. In T934, he accepted a post at the Mathematics
Institute of the Academy of Sciences of the USSR, where he remained until his death.
He published an article ('Sulla Teoria del bilacio del consummatore') in the Italian
journal Giomale degli economisti in r9r5 on consumer behaviour in which he showed
how the concept of > ordinal utility could be used to build a theory of consumer
behaviour of the same scope as that of ^Marshall, but without the underlying
assumption of the measurability of >utility. However, the article lay unnoticed until
►Hicks and Allen rediscovered it in ^34. In Value and Capital (1939), Hicks applied
Slutsky's name to the mathematical formulae that illustrate how a consumer would
react to >price and >-income changes (Consumer behaviour; Pareto, V. F. D.).
Slutsky did little further work in economic theory, but made important contributions
to statistics and > probability theory that are of relevance to economics. He empha¬
sized the danger of assuming causes for observed fluctuations in Cime series by
showing how regular cycles could be generated in the derivation of Amoving
averages from a series, even though the latter was made up of random numbers. He
also made important advances in the study of Cuto-correlation.

small and medium enterprises (SME) >small business.

small business A firm, managed in a personalized way by its owners or part-owners,

that has only a small share of its market and is not sufficiently large to have access
to the Ctock exchange in raising Capital. Given that small and medium enterprises
(SMEs) typically have little recourse to institutional sources of finance other than
the Commercial banks and rely heavily upon the personal savings of the pro¬
prietors, their families and friends, the long-term growth in ^taxation on income
and wealth is believed by some economists to have inhibited the growth of the
small-firm sector. Small and medium enterprises play important roles in the econ¬
omy, in a dynamic as well as a static sense, and create a disproportionate number of
new jobs. A few SMEs grow to challenge existing large firms (cf. >Schumpeter's 'gale
of creative destruction'), change and renewal being an essential feature of the
Cree-market economy. It is estimated that in 20or, all but 6800 of the 3.7 million
private sector enterprises in the UK each employed fewer than 250 persons. Enter¬
prises employing fewer than 250 persons account for about 55 per cent of non¬
government employment. Most small businesses are Cole proprietorships and
>partnerships, but the vast majority of the UK's active ^private companies are
small firms. In the European Union as a whole in 1998 there were almost 20 million
enterprises of which SMEs (fewer than 250 employees) accounted for 66 per cent of
private sector employment. The balance was accounted for by the 38,000 large firms,
^enterprise; entrepreneur; establishment; self-employed.
 Smith, Adam

smart card >credit card.

SME ►small business.

Smith, Adam (1723-90) A Scotsman brought up by his mother at Kirkcaldy, he

became a student under Francis Hutcheson at Glasgow University at the age of 14
and won a scholarship to Oxford, where he spent 6 years until 1746. He lectured at
Edinburgh University from r748 to 1751. From r75i until 1763 he was at Glasgow, first
in the Chair of Logic and a year later the Chair of Moral Philosophy, which he took
over from Hutcheson. From ^64 to 1766 he toured France as tutor to the Duke of
Buccleuch. His major work on economics, An Inquiry into the Nature and Causes of
the Wealth of Nations, appeared in 1776. This work became the foundation upon
which was constructed the whole subsequent tradition of English > classical econ¬
omics, which can be traced from >Ricardo through ►Marshall to ►Pigou. Smith
was primarily concerned with the factors that led to increased ►wealth in a com¬
munity and he rejected the ^Physiocrats' view of the pre-eminent position of
agriculture, recognizing the parallel contribution of manufacturing industry. He
began his analysis by means of a sketch of a primitive society of hunters. If it cost
twice the labour to kill a beaver as it does a deer, one beaver would exchange for two
deer. ►Labour was the fundamental measure of ►value, though actual >-prices of
►commodities were determined by >supply and >demand on the ►market
(►Marx, K.; Ricardo, D.). There were two elements in the problem of increasing
wealth: (a) the skill of the ►labour force (►sow's ear effect), and (b) the proportion
of productive to unproductive labour. (According to Smith, the ►service industries
did not contribute to real wealth.) The key to (a) was the ►division of labour. To
illustrate his point, he quoted the example of the manufacture of pins. If one man
were set the task of carrying out all the operations of pin manufacture - drawing
the wire, cutting, head-fitting and sharpening - his output would be minimal. If,
however, each man specialized in a single operation only, output would be increased
a hundredfold. The size of the output need only be limited by the size of its market.
The key to (b) was the accumulation of ►capital. Not only did this enable plant and
machinery to be created to assist labour, but it also enabled labour to be employed.
Capital for the latter was the wages fund (►wage-fund theory). The workers must be
fed and clothed during the period of production in advance of the ►income earned
from their own efforts. Smith believed that the economic system was harmonious
and required the minimum of government interference (► laissez-faire). Although
each individual was motivated by self-interest, they each acted for the good of the
whole, guided by a 'hidden hand' (►'invisible hand') made possible by the free play
of competition (►Mandeville, B. de). Free competition was the essential ingredient
of the efficient economy. However, from his Wealth of Nations it is clear that not
only did his scholarship range widely over the fields of history and contemporary
business, but that, at the same time, he was a very practical man. He was quite aware,
for example, of the forces that were at work to limit competition:

People of the same trade seldom meet together even for merriment and diversion,
but the conversation ends in a conspiracy against the public, or on some contrivance
to raise prices. It is impossible indeed to prevent such meetings by any law which
either could be executed, or would be consistent with liberty and justice. But though
the law cannot hinder people of the same trade from sometimes assembling together,
Smith, Vernon L. | 358

it ought to do nothing to facilitate such assemblies, much less render them necessary
(Book one, chapter X, part 2).

In his discussions of >-public finance, he laid down four principles of ^taxation:

(a) equality (taxes proportionate to ability to pay); (b) certainty; (c) convenience,
and (d) economy. ^Hume, D.

Smith, Vernon L. (b. 1927) Professor of Economics and Law at George Mason
University in Virginia, and pioneer of experimental economics, the branch of the
subject concerned with setting up laboratory trials to test particular propositions.
For both advancing good experimental method in economics, and in actually carry¬
ing out some interesting tests, Smith won jointly with >-Kahneman the >Nobel
Prize in 2002. His methods involve repeated experiments (so that subjects can
familiarize themselves with the 'rules of the game'), and generous monetary incen¬
tives (to induce subjects to treat tests as though they matter and to impose the exact
incentives being tested).
In particular, Smith has conducted practical experiments using people acting out
competitive markets. He has found that the predictions of economic theory hold up
rather well. He has also tested different designs of auction in carefully controlled
conditions, and found that some predictions of economic theory do not hold up,
perhaps because factors like suspense of waiting in an auction affect behaviour.
Smith has also tested different designs of market mechanism for deregulated or
privatized industries.
He has held academic posts at Purdue University, the University of Massachusetts
and at the University of Arizona, among others. His publications include 'An
Experimental Study of Competitive Market Behaviour', Journal of Political Economy
(1962) and 'Experimental Economics: induced value theory', American Economic
Review (1976).

Smithsonian Agreement An agreement concluded in December r97i between

the Group of Ten of the ^International Monetary Fund at the Smithsonian Institute,
Washington. Under the agreement, the major currencies were restored to fixed parities
but with a wider margin, ±2.25 per cent of permitted fluctuation around their par
values. The dollar was effectively devalued by about 8 per cent and the dollar price of
gold increased to $38 per ounce. Sterling was set at $2.6057 (>-exchange rate).

Smithsonian parities ^Smithsonian Agreement.

social accounting The presentation of the >-national income and expenditure

accounts in a form showing the transactions during a given period between the
different sectors of the economy. The tabulations are set out in the form of a > matrix
showing the source of ^inputs of each sector or part of a sector and the distribution
of their outputs. The production sector, for example, shows for an industry how
much of its inputs were bought from other home industries, how much it imported
and how much it spent on wages, salaries and ^-dividends. At the same time, it
shows how much of its output it sold to other industries, how much it exported and
how much was consumed by private individuals or the government sector. These
transactions of the producers' sector are counterbalanced by corresponding trans¬
actions of the other sectors. For example, the personal sector shows the value and
sources of Vincomes earned from the producers' sector and others, as well as the
 social welfare

way these incomes are saved or spent on the outputs of the various industries or on
fimports. input-output analysis; Leontief, W. W.

social benefits The total increase in the welfare of society from an economic
action. In effect, it is the sum of two benefits: (a) the benefit to the agent performing
the action, e.g. the fproducer's surplus or fprofit made, and (b) the benefit
accruing to society as a result of the action, e.g. an increase in tax revenues (fexter-
nalities). The phrase is sometimes used to describe the second of these on its own.
^•►social welfare.

social capital The total stock of a society's productive assets, including those that
allow the manufacture of the marketable outputs that create private-sector profits,
and those that create non-marketed outputs, e.g. defence and education, ^capital.

Social Charter A Social Charter and Social Action Programme was drafted by the
Social Affairs Commissioner of the then European Community (> European Union)
in 1989 for discussion by the member states. The programme included: (a) health and
safety at work; (b) freedom of movement of workers throughout the Community; (c)
equality of opportunity; (d) part-time and temporary work; (e) contractual con¬
ditions of employment; (f) management consultation of employees; (g) social secur¬
ity, and (h) immigrant workers. A separate protocol to the >• Maastricht Treaty on
social policy was adopted by eleven member states in 1991, the UK not being a
signatory. European Monetary Union.

social cost The total cost to society of an economic activity. It is the sum of the
f opportunity costs of the ^resources used by the agent carrying out the activity
plus any additional costs imposed on society from the activity. For example, when
people drive their cars they incur the private cost of petrol and wear and tear on the
vehicle, but the social cost of them driving also adds wear and tear on the roads, and
the congestion and pollution they cause, which they do not pay for directly. By
taxation, social costs can be incorporated into private costs so that market prices
properly represent the true costs to the community. >► externalities; Pigou, A. C.;
shadow price.

social net product The difference between the f social benefits and the fsocial
cost arising from the use of some f factor of production or from some form of
economic activity.

social overhead capital ^infrastructure.

social security A system of government-financed income transfers designed to

effect a distribution of income considered desirable. The main component of most
social security systems is welfare benefits, given to those in fpoverty. This can be
done in two ways: (a) by identifying groups that are likely to be poor, and giving
benefits to them (e.g. the unemployed, the elderly and the disabled) irrespective of
their actual income, (b) by identifying, through > means tests, people who are poor.
Approach (b) is a less expensive method of eradicating poverty but leads to the
problem of the fpoverty trap. ^-National Insurance. >► life-cycle hypothesis; mini¬
mum-wage laws.

social welfare The total wellbeing of a community. It is not measurable because

it is not possible to sum the benefits or futilities enjoyed by the individuals
social-welfare function

composing the community. It is possible, however, for the community to judge

whether it prefers one situation to another, ^compensation principle; indifference-
curve analysis; Pigou, A. C.; social-welfare function; welfare economics.

social-welfare function An expression of society's taste for different economic

states. The analysis of social welfare is analogous to >indifference-curve analysis for
individuals. Just as the individual's taste can be defined by his/her ranking of
different combinations of commodities, social priorities can be defined by a list of
preferences of alternative national combinations of commodities. The com¬
parison between individual and social-welfare functions can be taken no further,
however, because the individual only has to decide how much of each commodity
to consume. Society has to choose how much of each commodity should be
produced, and how it should be distributed. For this reason, unlike the individual's
utility function - which is expressed in terms of commodity quantities - the social-
welfare function is usually expressed in terms of the utility of the members of society.
A social-welfare function is used to determine the relationship between overall
welfare, and the welfare of different citizens. The function may, for example, be the
simple sum of all individual preferences or it might attach a high weighting to
the preferences of a particular group of citizens and a low weight to the rest.
>-Value judgements are necessarily made in determining what is held to constitute
social welfare.
The importance of the social-welfare function is that it provides a criterion for
choosing between different economically efficient (>economic efficiency) states.
Suppose moving from an efficient allocation, A, to another efficient allocation, B,
makes one person better off and another worse off; the social-welfare function can
be used to determine which of state A or B is to be preferred. This is more flexible
than using other criteria for deciding between A and B, notably > Pareto optimality
or the ^-compensation principle criteria.
There are two approaches to the derivation of the social-welfare function: (a) to
impose it from on high: by using the social-welfare function of each individual -
representing an own ranking of different allocations of resources - a government,
monarch or dictator could produce one for society as a whole, or (b) to devise a
constitution or voting system that can turn the rankings of each individual into a
single social ranking. To find such a constitution that can guarantee to provide
consistent, appealing and decisive results is, however, not possible, as > Arrow shows
in the S-impossibility theorem. It is this issue that has dominated discussion of
social-welfare functions in economic literature. >Sen, A.; welfare economics.

socialism A social and economic system in which the means of production are
owned collectively and equality is given a high priority. There are various forms of
socialism, from >Marxism to the social-democrat systems in Western Europe, but
all share a belief in the necessity for collective intervention in economic affairs.
>&*planned economy; State planning.

soft currency A s-currency whose >exchange rate is tending to fall because of

persistent >-balance of payments deficits or because of the building up of speculative
selling of the currency in expectation of a change in its exchange rate. Governments
are unwilling to hold a soft currency in their foreign-exchange reserves. Preserve
currency.
 special drawing rights

soft loan A >loan bearing either no Mate of interest, or an interest rate that is
below the true cost of the >capital lent. It is the policy of the > International Bank for
Reconstruction and Development working through its affiliate, the > International
Development Association, to give 'soft' loans to ►developing countries for long-term
capital projects.

sole proprietorship, sole trader An unincorporated business owned by one

person that may or may not have employees. The majority of small firms are sole
traders or ^partnerships, ^company law; self-employed.

Solow, Robert M. (b. 1924) Having been educated at Harvard University, from
which he also received his Ph.D in r95r, Solow remained in Cambridge, Massachu¬
setts, taking a position at the Massachusett's Institute of Technology where, with
the exception of those periods spent visiting academic institutions abroad, he has
remained. He received the >-Nobel Prize for Economics in ^87. His major works
include Linear Programming and Economic Analysis (with Dorfman and >Samuelson)
(1958), Capital Theory and the Rate of Return (1963), The Nature and Sources of Unemploy¬
ment in the US (1964) and Growth Theory: an exposition (1970). He has also published
numerous articles on ^depletion theory, including 'The Economics of Resources or
the Resources of Economics', American Economic Review (1974). Above all, he has
played a dominant role in debates on >-growth theory, developing a standard
growth model based on ^neo-classical economics that contrasted in its assump¬
tions with that of the then prevalent >Harrod-Domar model. He has also questioned
the effectiveness of »-market forces in clearing the labour market. »*»capital
re-switching.

sources and uses of funds An accounting statement describing the >capital flows
of a business. Sources of funds are >profits from trading operations, depreciation
provisions, sales of bassets and borrowing, including capital issues. Uses of funds
are purchase of fixed or financial assets (including dash), and distribution of
►income. 3*#-self-financing.

sovereign risk The hazard that political risk may arise in a country, threatening
overseas investments or trading.

sow's ear effect The inability of a country to raise its ^productivity or per capita
►gross domestic product relative to other countries of comparable development in
spite of policy adjustments in > macroeconomic variables (e.g. the ►exchange rate
or Mate of interest) because of deficiencies on the supply side of the economy, e.g.
an inadequately educated labour force (>-supply-side economics). The term refers to
the old saying 'You can't make a silk purse out of a sow's ear'. >► convergence;
economic development; institutional economics; Smith, A.

special drawing rights (SDRs) The instruments for financing international trade
after the Second World War were predominantly the deserve currencies (e.g. dollars
and sterling) and gold. Dependence on the latter, as >Keynes pointed out, was an
anachronism that had been successfully terminated as far as domestic economies
were concerned. The problem of depending on the former was that the supply of
these currencies was regulated by their countries' ^balance of payments deficits or
surpluses. The deficit on the US balance of payments had been an important source of
the flow of ^liquidity into ^central bank reserves. The difficulty was that persistent
specialization | 362

deficits led to doubts about the maintenance of the currency's »-exchange rate and
made central banks less willing to hold dollars. This problem came to a head in
August 1971, when the US government imposed various measures to correct its
balance-of-payments deficit. In December r97r, the dollar was devalued by about
10 per cent.
Keynes had put forward the idea of an international currency, to be called
>bancor, regulated by a central institution (>Keynes Plan). This idea was turned
down then for fear that the creation of liquidity would generate >-inflation. In 1969,
the Group of Ten (^International Monetary Fund) (IMF) agreed to establish SDRs,
which are similar in principle to Keynes' original idea, and their agreement was
ratified by the IMF. The SDR was linked to gold and equivalent to $1 US at the gold
rate of exchange of $35 per ounce. Until December r97r an SDR was equivalent to
$r but, with the effective devaluation of the dollar following the >Smithsonian
Agreement, the rate became 1 SDR = $1.08571. With the subsequent breakdown of
the fixed-parity system, the IMF valued the SDR in terms of a 'basket' of sixteen
currencies, so that, as from July 1974, the rate in relation to the dollar 'floated'. In
1981 the SDR was simplified to a weighted ► average of currencies that is revised
periodically. In 200T, the weights were US dollars (45 per cent), euro (29 per cent),
Japanese yen (15 per cent), and UK sterling (n per cent). Special drawing rights are a
very small proportion of countries' >gold and foreign currency reserves and their
main function is as a unit of account (>money).

specialization >division of labour.

specie points The limits between which the >exchange rate between two >curr-
encies on the >gold standard fluctuated. For instance, before the First World War
the same amount of gold could be bought in London for £r and in New York for
$4.87, and therefore the par rate of exchange was £1 for $4.87. If the pound fetched
less than $4.87 in London, it would be cheaper for a merchant to ship gold to the
USA to settle his debts (rather than settle in dollars), provided the cost of freight
and insurance were less than the difference between the par rate and the London
rate. Therefore, in practice the rate never fell by an amount more than the cost of
shipment. Similar forces applied in reverse to prevent the rate rising by an amount
in excess of the cost of shipment.

specific tax >tax, specific.

speculation Buying and selling with a view to buying and selling at a ^profit later
when >• prices have changed, ^arbitrage; bear; bull; stag.

speculative bubble A deviation between the price of an »-asset in the market,

and the price justified by the inherent >value of the asset, sustained by a belief on
the part of buyers that they will be able to sell at an inflated price. The interesting
thing about a bubble is that, as long as everyone believes in it, the bubble need not
burst. The price can indefinitely deviate from fundamental value. While some have
suggested bubbles are a sign of irrationality in the financial markets, creating more
variability in the price of assets than is merited by fundamental swings in values,
attempts have been made to account for them as rational phenomena.

speculative motive The reason causing people or firms to hold a stock of >money
in the belief that a capital gain or the avoidance of a loss can be achieved by so
 Sraffa, Piero

doing. It is one of three motives for holding money outlined by >• Keynes. When
the price of bonds falls, the attraction of holding them increases; this is because
people will expect their price to rise again, and anyone owning them will make a
capital gain when this happens. People will tend to buy bonds when their prices are
low and will thus hold little money. When the price of bonds is high, on the other
hand, they will believe their price could fall and hold more money. The amount of
money held under this motive thus varies with the price of bonds; as the >rate of
interest varies inversely with the bond price, the speculative motive for money varies
inversely with interest rates, ^liquidity preference; liquidity trap; portfolio theory;
precautionary motive; transactions motive.

Spence, A. Michael (b. 1943) Economist from Stanford University credited with
devising the theory of ^signalling, for which he jointly won the S^Nobel Prize for
Economics in 20or. His work, based on his Ph.D thesis from the early 1970s, centred
on the example of education as an observable signal of various unobservable charac¬
teristics that we might want to exhibit. In particular, clever people might struggle
to show employers how clever they are, so going to college may be seen as a signal
of cleverness. This might justify going to college, even if the substantive benefit of
the teaching was itself minimal. The signal will work as long as clever people find it
easier to sit through college than less clever people. The account was published in
'Job Market Signaling', Quarterly Journal of Economics (1973) and Market Signaling
(1974). The account Spence devised turned out to be very complementary to the
work of >Akerlof and >Stiglitz, and between them the economics of information
(^►information, economics of) became one of the most potent topics of study
through the next three decades.

spillover effect ^externalities.

spot market A >market in which goods or ^securities are traded for immediate
delivery, as distinct from a ^forward market. 'Spot' in this context means 'immedi¬
ately effective', so that spot price is the price for immediate delivery.

spot price >spot market.

spot sterling ^forward exchange market.

Sraffa, Piero (1898-1983) Sraffa was a Turin-born socialist who came to the UK in
the 1920s and settled in Cambridge. He had a reclusive nature, but was broad in his
intellectual company, mixing with >Keynes and the philosopher Wittgenstein. His
three main published contributions are 'The Laws of Returns under Competitive
Conditions', Economic Journal (1926), as editor of the eleven-volume Works and
Correspondence of David Ricardo (1971), begun in r93o with most of the sub¬
stance being published in the 1950s, and Production of Commodities by Means of
Commodities (i960).
His primary preoccupation in the 1920s was to expose the flaws in the theory of
the firm (>-firm, theory of the) of ^Marshall. He inspired others to develop theories
of production that were not embedded in >-perfect competition, which he did
not think adequately reflected the true state of capitalist society. His Production of
Commodities book was a contribution to the perennial problem of finding an
invariable measure of value (lvalue, theories of). He presented a model in which
prices of goods reflected costs of production, a return to a notion of value reminiscent
of >-classical economics. These prices would be determined by technology and stated
in terms of a standard commodity, a composite of the commodities used in what is
assumed to be equal proportions in the production of everything. In this, the Sraffa
model can be said to adopt the assumptions and derive the conclusions of the
►non-substitution theorem.
Some of his results derive from a particular assumption that the ratio of investment
to profits is an ►exogenous variable, which has led some to conclude that Sraffa's
model is a special case of a more general model of economic activity attributable to
von Neumann. »► Ricardo, D.

SRO Self-regulating organization (►Financial Services Act 1986).

stability analysis The study of the behaviour of ►variables in ►disequilibrium

to see whether they have a tendency to converge on an ►equilibrium level (►dynam¬
ics). Most equilibria considered in economics are stable, but models have been
developed that are unstable, ►►cobweb model; Harrod-Domar model.

Stability and Growth Pact Agreement, reached in r996, among members of the
►Economic and Monetary Union to comply with strict rules controlling fiscal
deficits. The thinking behind the agreement was that if one member irresponsibly
inflated its budget deficit, the ►European Central Bank would have to raise the rate
of interest, which would not be appropriate to the economies of the other members
(►free-rider problem). The pact determined that member countries' budgets should
be in balance or in surplus in the medium term. In addition, any budget deficit
should never exceed 3 per cent of ►gross domestic product (GDP). If a country
should run such a deficit, it would receive a warning and should put measures in
place within 4 months and the deficit reduced within a year. Failure could lead to a
fine of up to 0.5 per cent of GDP.

stabilization policy 1 Government action aimed at reducing fluctuations in

►national income. Such policy - to expand demand when ►unemployment exists
and reduce demand when ►inflation threatens - became the norm after the Second
World War in all Western economies, and the low rates of unemployment prevailing
during the 1950s coupled with high rates of economic growth were seen as a testi¬
mony to its success. In the 1960s, however, the UK faced difficulties sustaining a
stabilization policy, with a >stop-go cycle by which >reflation would occur, the
economy would 'overheat' and then a rapid >deflation would be necessary. In the
1970s >stagflation developed, and the traditional-style stabilization policy became
obsolete. In the 1980s, it was replaced in the UK by an explicit non-stabilizing policy
in the form of the medium-term financial strategy.
Stabilization policy fell out of favour for two main reasons:

(r) There are immense practical difficulties in implementing it, primarily because of
a lack of sufficient information. All that is known about the economy is how it
was behaving several months ago, but actions have to be taken several months
in advance. The problem has been likened to attempts at controlling the temper¬
ature of water coming out of a shower when any twist of the hot or cold tap takes
half a minute to affect the temperature of that coming out of the nozzle.
(2) It is argued that the temptation to attempt to keep unemployment below its
market level (►unemployment, natural rate of) inevitably causes ever-
 standard costing

accelerating inflation. Instead, it is suggested, if the ^equilibrium level of unem¬

ployment is too high, measures affecting the supply of labour, rather than
demand, are necessary (>-supply-side economics).

Despite the criticisms, stabilization returned to a significant extent in the r9$>os in

Western economies; this time it was in the hands of central banks; it was >monetary
policy that was the tool, and low inflation that was the stated objective. The reason
this amounts to stabilization is that any decisions on whether inflation is likely to
rise or fall away from its target inevitably involve judgements about whether the
economy is overheating or not (>output gap). So policy is designed to keep the
economy growing at a sustainable rate. In addition, in >-fiscal policy, there are
automatic stabilizing factors (>built-in stabilizers) (e.g. in recession, unemployment
benefits paid out rise, causing an increase in government spending) that will never
be removed.
2 The action of government or trade associations to stabilize the prices of certain
commodities. By holding stocks of the item in question, the authorities can, at least
temporarily, affect demand and supply in the market and maintain a constant price.
^ international commodity agreements.

stag A speculator (^speculation) who subscribes to new issues in the expectation

of selling his allotment of insecurities at a profit when dealings in them begin.
>*»-new-issue market.

stagflation The simultaneous existence of ^unemployment and ^inflation. In

the early postwar era, it was believed that stagflation would never occur. Either
there would be an >inflationary gap or a ^deflationary gap, with inflation or
unemployment, respectively, but never the two together. In the 1970s, the problem
emerged, largely as the natural rate of unemployment (>unemployment, natural
rate of) rose with strong wage pressure. The idea that there cannot be >Keynesian
unemployment at the same time as inflation is still credible.

stakeholder pension A low-cost pension vehicle introduced in the UK by legisla¬

tion and operating from April 20or. Contributions in 2002/03 were subject to a
maximum of £3600 a year gross of tax benefit. Stakeholder pensions are 'defined
contributions' schemes (>-personal pensions). They are available whether the indi¬
vidual is employed or unemployed, with some exceptions; previously only those
with taxable incomes could benefit from the tax allowances on pension contri¬
butions. A maximum annual management charge of r per cent only of the indi¬
vidual's pension fund may be made. Any employer with five or more employees,
unless offering an occupational pension scheme (^pension funds) must provide
each employee with access to a stakeholder pension provider.

stamp duty (UK) A form of indirect taxation (>direct taxation) that used to
involve the fixing of prepaid stamps to legal and commercial documents. The tax
may be ad valorem (>tax, ad valorem), as on the conveyancing of property, or specific
(>tax, specific), as on declarations of trust. Stamp duty is a very ancient form
of taxation but is now of diminishing importance except for property and share
transactions.

standard costing >management accountancy.

standard deviation | 366

standard deviation A measure of the spread of a series of values of a >variable

around its mean (^average). It is defined as the square root of the >*variance. The
formula for the standard deviation is:

where x, is the ith value, x is the mean and n is the number of observations.
Standard Industrial Classification (SIC) A categorization of economic activity
used in compiling and presenting official statistics. The UK Standard Industrial
Classification of Economic Activities was first introduced in r948 and has been
revised regularly since. The Nomenclature des activites etablies dans les Communautes
Europeennes (NACE) was revised in r990 and the >-European Union issued a regu¬
lation for it to be applied in all member countries. Accordingly, the UK SIC was
revised in t992 (with minor revisions in r997) to bring it into line with NACE. The
classification is hierarchical with sections, subsections, divisions, groups, classes and
subclasses. These classifications follow the same principles as the International
Standard Industrial Classification of all Economic Activities of ^89 issued by the
United Nations.

standard of living The quantity of goods and >services consumed by an individual

or a household. A general measure of standard of living made for comparisons between
countries or between different time periods is >gross national income per head of
population, ^externalities; income, distribution of; poverty; retail prices index.
State Earnings-Related Pensions Scheme (SERPS) >National Insurance.
State planning The regulation of any sector or sphere of an economy by public
administrators rather than the > price system. If State planning is comprehensive, a
> planned economy is said to exist. In many countries, however, there is partial
planning, that can take one of two broad forms:

(r) Very detailed planning in certain key sectors of an economy. For example, the
UK National Health Service is controlled by administrators rather than prices:
queues ration the supply of certain operations, and the wages and activity of
health workers are determined by the administrators, albeit after consideration
of where demand is greatest and what supply of labour is available.
(2) Limited planning covering virtually all sectors of the economy, with production
targets, performance monitoring and some State subsidies, and in the form of
a national plan, ^input-output analysis; nationalized industries; transition,
economies in.

static equilibrium > Equilibrium in which the relevant >variables do not change
over time (in contrast to dynamic equilibrium in which the variables do change over
time), ^-balanced growth.

statistical inference The method of discovering information about a statistical

population by sampling procedures (>sample).

steady-state growth A feature of an economy in which all ^-variables grow (or

contract) at a constant rate, e.g. population may rise at 3 per cent a year, national
income at 4 per cent and the capital stock at 5 per cent. If these rates are maintained
indefinitely, steady-state growth exists. It is distinct from x-balanced growth in
 Stiglitz, Joseph E.

which all variables grow at the same constant rate. Steady-state growth is an > equilib¬
rium concept, and much of > growth theory has been concerned with whether it is
likely to be achieved, ^economic growth; Harrod-Domar model.

Stigler, George Joseph (1911-91) Professor Stigler graduated from the University
of Washington in 1931 and, after a year at the Northwestern University, obtained his
Ph.D at the University of Chicago. In 1936, he was appointed Assistant Professor in
Economics at Iowa State University and in T938 moved to the University of Minne¬
sota. In r947, he was appointed to the Chair of Economics at Columbia University,
where he stayed until r959, in which year he returned to the University of Chicago
as Professor of American Institutions. Professor Stigler was awarded the >Nobel Prize
in Economics in 1982. His publications include Production and Distribution Theories
(I94I)> The Theory of Prices (1942), Five Lectures on Economic Problems (1948), Capital
and Rates of Return in Manufacturing Industries (1963), Essays in the History of Economics
(1965), The Organisation of Industry (1968), Domestic Servants in the USA (1974), The
Citizen and the State: essays on regulation (197s), Demand and Supply of Scientific Personnel
(1975) and The Economist as Preacher (1982). Professor Stigler analysed the cost of
obtaining economic information by firms faced with a range of prices offered by
competitive suppliers. He contributed to the analysis of ^unemployment, pointing
up the need for workers to devote time to look for the highest available pay rates for
the work and conditions they require. He advocated a more empirical approach to
the study of government ^regulation and demonstrated that often regulations set
for the benefit of consumers will rather turn out in practice to benefit producers.
>information, economics of.

Stiglitz, Joseph E. (b. 1943) Economist from the Columbia University in NewYork,
former chief economist at the World Bank, and joint winner of the >Nobel Prize
with >-Akerlof and >Spence in 20or. There is little that Stiglitz has not written about.
His Nobel prize was granted for his contribution to the economics of information
(^information, economics of) and in particular for his work on the subject of
»-screening in the context of >asymmetric information. He showed how an
insurance company might sift high-risk clients from low-risk ones by offering
alternative policies with different levels of policy excess and different premiums (the
high risk clients would choose a small excess amount, knowing themselves to be
likely to claim). In this account, Stiglitz and his co-authors also introduced the
concept of the pooled equilibrium (where all customers are treated identically) and
the separating equilibrium, where the different types of customer are segmented
into different product groups. These concepts have transpired to have widespread
application. Stiglitz was primarily responsible for extending the economics of infor¬
mation to accounts of the market for credit; he found it may pay banks to ration
credit quantitively, rather than to raise interest rates to limit lending, because higher
interest rates may simply cause bad credit risks to choose to borrow selectively, in
the expectation they may not be paying any interest anyway. Stiglitz was primarily
responsible for developing efficiency wage theory, again building on information
deficiencies. If an employer is unable routinely to tell how much effort workers are
providing, he/she may pay them above the going rate, so that in the event they are
seen to be shirking, they will suffer a big loss by losing their jobs. Stiglitz has also
made contributions to public economics and been a vocal critic of the International
Monetary Fund during the 1990s.
stochastic process | 368

Some of his most notable papers are: 'Equilibrium in Competitive Insurance

Markets: an essay on the economics of imperfect information’ with Rothschild,
Quarterly Journal of Economics (1976), 'Credit Rationing in Markets with Imperfect
Information' with Weiss, American Economic Review (r98r) and 'Equilibrium
Unemployment as a Worker Discipline Device' with Shapiro, American Economic
Review O1984).

stochastic process A process subject to random influences (>probability; random

sample). For example, a dependent ► variable may be determined by an independent
variable, x, plus a random element, so that the process generating y is not fully
determined by x and predictable by x. The process is stochastic because the value of
y depends partially on chance.

stock 1 A particular type of > security, usually quoted in units of £100 value rather
than in units of proportion of total ^capital, as in >shares. Stock, or stocks and
shares, have now become synonymous with securities, and the original distinction
between shares and stock has become blurred. The term, however, is now coming
to mean exclusively a fixed-interest security, i.e. loan stock in a company or local or
central government stock. 2 An accumulation of a >commodity. ^inventory.
3 (US) A share in the ownership of a company, i.e. equity.

stock appreciation Increase in the value of stock (^inventories) resulting from

an increase in market prices.

stock exchange A ^market in which Securities are bought and sold. There are
stock exchanges in most capital cities, as well as in the larger provincial cities, in
many countries. The largest in terms of >-market capitalization is the >New York
Stock Exchange, followed by London. Other important markets include the >Tokyo
Stock Exchange, >NASDAQ (>-over-the-counter market), and the Association of
Exchanges of the Federal Republic of Germany (Deutsche Borse) (>German Stock
Exchange). Continental European exchanges are often referred to as bourses (Fr.).
The economic importance of stock exchanges is that they facilitate > saving and
Mnvestment: (a) by making it possible for investors to dispose of securities quickly
if they wish to do so, and (b) in channelling savings into productive investment.
Ready marketability requires that new issues (>new-issue market): (a) should be
made or backed by reputable borrowers or institutions; (b) that information should
be available on existing securities, and (c) that there should be both a legal framework
and market rules to prevent fraud and sharp practice (> Financial Services Act
1986). Stock exchanges have their own rules and conventions, but their functioning
depends also on the existence of company and other law and > financial intermedi¬
aries, e.g. the ^issuing houses. In recent years, stock exchanges have been deregu¬
lated (>deregulation) and most trading floors have given way to electronic trading
systems (though not on the New York Stock Exchange). Trading in many ^securities
is now a global market (>globalization).
The London Stock Exchange, founded in ^73, developed from informal exchanges
in coffee houses in the City of London. The London Stock Exchange is now a quoted
company (^quotation). Member-shareholders are formed into a declining number
of firms now including major ^-merchant banks, the ^commercial banks and other
financial intermediaries, many of which are foreign-owned. The traditional trading
floor where broker-dealers gathered to buy and sell closed following the >Big Bang.
 stratified sample

All business is conducted between members by telephone through an automated

screen trading system (WMLREST). The Stock Exchange Automated Quotation ser¬
vice allows »-market makers and others to see competing quotations on their screens
and >stockbrokers to select the best bid/offer for their clients. A new system,
the Stock Exchange Trading System introduced in 1997, based on the SEQUENCE
platform, allows electronic matching of buy and sell orders.

Stock Exchange Automated Quotation (SEAQ) >stock exchange.

stock-sales ratio inventories; turnover.

stock split An issue of new >shares to shareholders without increasing total

>capital. The object of a stock split is to reduce the average quoted price of shares
to promote their marketability.

stock turnover inventories; turnover.

stockbroker A member of the itock exchange, who buys and sells >shares on
his/her own account, or for non-members, in return for a > commission on the
>price of the shares. broker; market maker.

Stone, Sir J. Richard (1913-91) Sir Richard Stone started his career at Cambridge
University as an undergraduate, obtained a D.Sc., and became a Fellow and eventu¬
ally Emeritus Professor there. His academic life was interrupted by a period in the
statistical section of the Office of the War Cabinet between r940 and 1945, and he
held visiting posts at different institutions around the world, including Princeton's
Center for Advanced Study. He was awarded the >Nobel Prize in Economics in
1984. He has written widely on the measurement of national accounts data and
econometric analysis of consumer demand, including Natiorial Income and Expendi¬
ture, with »-Meade U944), The Role of Measurement in Economics (r95i) and The
Measurement of Consumers' Expenditure and Behaviour in the United Kingdom 1920-1938
with Rowe etal. (1954), and many articles, including 'Linear Expenditure Systems and
Demand Analysis', Economic Journal (1954). One of his main contributions was to lay
the foundation of >national income accounting. He also bridged the gulf between
the theory of consumer demand (> demand, theory of) and > empirical testing of
the subject with what is known as the 'linear expenditure system'. He saw that, by
making various assumptions, a tractable system of equations could be used to
estimate consumer demand for different groups of commodities more reliably than
by estimating the demand for each group in isolation.

stop-go A phrase used to describe the attempted management of ^aggregate

demand in the UK during the postwar period and particularly in the 1960s as the
period of fixed ^exchange rates drew to a close. The exchange rate came under
pressure during periods of rising economic activity, but as > fiscal policy and >mone¬
tary policy were applied to reduce aggregate demand and improve the imbalance of
payments it soon became necessary to stimulate the economy again to counteract
> recession. The stop-go cycle tended to amplify movements in the > business cycle.

stratified sample A method of sampling (>-random sample) used when the

population to be sampled is not homogeneous and the nature of the population's
heterogeneity is pertinent to the characteristic of the population about which infor¬
mation is sought. For example, we may wish to find out the percentage of households
structural adjustment programmes | 370

(the population) owning dish-washers. Households are not homogeneous; they may
be classified into subgroups or strata by, for example, social group or income level
and, moreover, these subgroups are likely to differ in their ownership of consumer
durables, such as dish-washers. Rather than take a random sample of the whole
population of households, the population is first subdivided into the appropriate
categories, or strata, and random samples taken from each. If the population is
heterogeneous a stratified sample will give more accurate results than a simple
random sample of the same size.

structural adjustment programmes ^economic development.

structural budget deficit A measure of the level of government borrowing, after

the effects of the > business cycle have been taken into account. It is what the level
of borrowing would be if the year in question were a year without Precession or
boom. It is the government's budget deficit in a year in which the Poutput gap is
zero. As there can be no precise measure of the output gap, there can be no precise
measure of the structural budget deficit. Pbuilt-in stabilizers; cyclically adjusted
budget; public sector borrowing requirement; Stability and Growth Pact.

structural unemployment ^Unemployment arising from changes in Pdemand

or Ptechnology that lead to an oversupply of labour with particular skills or in
particular locations. Structural unemployment does not result from an overall
deficiency of demand and therefore cannot be cured by Preflation, but only by
retraining or relocation of the affected workforce, some of whom may find work at
low wages in unskilled occupations (Pclassical unemployment). Structural un¬
employment is distinct from Pfrictional unemployment, which is essentially a
short-term phenomenon.

structure-conduct-performance theory Pcompetition policy.

stylized fact A broad generalization, true in essence, though perhaps not in detail.
It is perhaps the most important, and least acknowledged, form of ^empirical
testing in economics. Economic >-models are judged by their ability to account for
real-world phenomena. While some models attempt to capture the detail of a
situation, or apply precise estimates of ^parameter values and are tested using
^econometrics, many models are designed simply to explain behaviour at its sim¬
plest, and can be judged only against the broad truth, rather than the detail. An
example of stylized fact is the following: 'the profit rate - the level of profits in the
economy, relative to the value of the capital stock - is constant in the long run'.
This is a fact that traditional models of growth are held to explain. >growth theory.

Sub-Chapter S > corporation tax.

subsidiaries Companies legally controlled by other companies. Although a

shareholding of less than 50 per cent may be sufficient to control a company
effectively, it is not correctly described as a subsidiary unless between 50 and roo
per cent of the >• shares are owned by another. Companies may choose to retain
subsidiaries rather than to integrate them fully into their own organizations for a
variety of reasons, e.g. the desire to allow local participation, a wish to conceal a
business connection or to avoid the cost and complication of integrating an acquired
company, ^holding company.
 substitution effect

subsidiarity The notion that political authority should vest in the most local
jurisdiction possible. Under subsidiarity, problems that affect only a town should
be decided by the town, those that extend beyond the town should be decided by
the county, those that extend beyond the county should be handled nationally and,
in the case, for example of the ^European Union (EU), those that extend beyond
the member country to the EU. The twin precepts of subsidiarity are that: (a)
everyone affected by an issue should be in the jurisdiction with responsibility for it,
and (b) that as few people as possible not affected by an issue should be in the
jurisdiction responsible for it. »"public-choice theory.

subsidy Government grants to suppliers of goods and services. A subsidy may be

intended to keep prices down (i.e. to raise >real incomes of buyers), to maintain
incomes of producers or to maintain a service or employment. An essential character¬
istic of a subsidy, as distinct from a ^transfer payment, is that it has the object of
keeping prices below the > factor cost of production. Subsidies, by distorting market
>-prices and >opportunity costs, may lead to a misallocation of resources, although
they may be justified in certain circumstances (e.g. to correct for > externalities) and
may be used instead of > tariffs to protect new industry (>infant-industry argument)
where not banned by international agreements. It may be possible to achieve the
objectives of subsidies by alternative means that have less distorting effects, e.g. by
direct income support through the ^taxation system. W^cross-subsidy.
subsistence theory of wages >-wage-fund theory.

substitute A product that at least partly satisfies the same needs of consumers.
Products are defined as substitutes in terms of cross-price effects between them. If,
when the price of cassettes goes up, sales of CDs rise, CDs are said to be a substitute
for cassettes, because consumers can to some extent satisfy the need served by
cassettes with CDs. This account is complicated by the fact that, when the price of
an item changes, it affects both the >real income of consumers and the relative
prices of different commodities. Strictly, one product is a substitute for another if it
enjoys increased demand when the other's price rises and the consumer's income is
raised just enough to compensate for the drop in living standards caused. One
product is a gross substitute for another if it enjoys an increase in demand when the
price of the other rises and no compensating rise in income is made.
Substitution is not a relationship that only holds between individual commodities
- groups of commodities can also be substitutes for each other. Vodka may be a
substitute for gin, while spirits in general may be a substitute for wine. Both together
may be a weak substitute for restaurant meals. Substitution (but not gross substi¬
tution) is a symmetric relationship: if apples are a substitute for bananas, bananas
are a substitute for apples, ^complementary goods; cross-price elasticity of demand.
substitution effect The rate at which consumers switch spending to or from a
commodity when its relative price changes but the total futility of consumers is
left constant (>^cross-price elasticity of demand). The substitution effect measures
how much consumers would switch their spending away from, or towards, an item,
its price having changed, if the resultant change in purchasing power were offset by
a compensating transfer of income that would allow them to maintain their total
utility (enough to keep them on their >indifference curve). It thus isolates
the impact of a change in relative prices from the Mncome effect. In terms of
'sun-spot' theory

>indifference-curve analysis, the substitution effect represents a swivel of the budget

line around a single indifference curve while the income effect represents a parallel
shift of the budget line on to a new indifference curve.
The substitution effect is always negative: consumers always switch spending away
from items, the prices of which rise as they attempt to shield their living standards
from the impact. If the price of butter rises by io per cent, no great loss is incurred
by the consumer who can switch to margarine. The substitution effect is not a
concept unique to consumer theory. It arises in many areas of economic analysis
including, for example, the demand for >labour and Eapital by firms. >*-giffen
good; inferior good; substitutes.

'sun-spot' theory >Jevons, W. S.

sunk costs ^Opportunity costs incurred in the past that are irretrievable and
therefore not relevant to current decisions; in >Jevons' famous phrase 'bygones are
for ever bygones'. For example, a small bakery might buy an oven at a fixed cost, but
which it could sell at some future date should it want to. It also might pay out a
large amount in advertising its services. However, this latter cost could not be
recovered later on - once paid for, the advertising has gone, whether or not the
promotion is successful. Sunk costs represent a ^barrier to entry in an industry
because they scare potential entrants from entering - should they fail, they would
have wasted all the sunk costs, incontestability.

super-normal profit >-profit.

supplementary costs A now little-used synonym for >fixed costs or >-overheads.

supply The quantity of a good (or service) available for sale at any specified >price.
Supply is determined by a number of influences: (a) price: the higher the price, the
more profitable it is, other things being equal, for producers to sell a good and the
more they will attempt to sell; (b) cost of inputs: the lower the costs, the more
profitable it is to sell a good at a given price and more will be offered for sale, and (c)
the price of other goods: when the price of other goods rises, the supplier of a good
may find it advantageous to switch production to the supply of the newly high-priced
goods rather than stay in the relatively less profitable industry, where supply will
fall. It should be noted that supply is planned supply, not necessarily what is actually
sold. The latter depends on Equilibrium in the market. The conditions of supply
constitute but one aspect of the determination of the quantities sold and market
price, the other being the conditions of ^demand, infirm, theory of the; Marshall,
A.

supply curve A graphical representation of the quantity of a good or service

supplied at different price levels. With >price on the vertical axis and quantity
supplied on the horizontal axis, supply curves normally slope upwards for two
reasons: (a) higher prices allow profits to be made at higher levels of production for
firms already in the market, and (b) if profits are made, new entrants are attracted
into a market.
Supply curves can be drawn for the >short term and the >long term. In the short
term, new firms do not have time to enter a market and higher output results only
from an increase in production by market incumbents. In the long term, however,
new entry occurs. The long-term supply curve links demand-supply equilibrium
 supply-side economics

short-run supply

quantity

points on these short-run curves, which (as shown in the diagram above) will be
steeper than the long-run curve. infirm, theory of the.

supply-side economics The study of the factors affecting, and the policies appro¬
priate for, influencing the real economy, i.e. the physical behaviour of economic
agents, and its response to changes in the structure of relative >prices rather than
nominal prices. Supply-side economics is roughly based on a positive and negative
thesis. On the negative side, supply-side economists tend to deny a role to a > stabiliz¬
ation policy. Because, they believe, economic agents are only concerned with their
real income and because markets have a tendency to clear at their >equilibrium
levels, an artificial increase in >aggregate demand cannot achieve anything. When
demand is boosted, the price of all goods rises and, out of a desire to feed the extra
demand, more labour will be sought, requiring an increase in wages. Out of all this,
nothing changes in real terms: >real wages are the same as they were, as are relative
prices; all economic agents behave in the same way as they did before, even though
the absolute price level might have changed, and possibly some temporary aberra¬
tion from market equilibria occurred. The positive views of such economists relate to
the policies that they believe can be effective in influencing the performance of an
economy. Anything that attempts to influence the supply of > labour or the supply
of goods can be called a supply-side measure. Such policies could include: (a) cutting
taxes to improve incentives (affecting people's personal trade-off between going out
to work and staying at home); (b) legislating heavily against ^monopoly in order
to encourage free competition, low prices and incentives to be efficient; (c) dimin¬
ishing the ability of trade unions to inhibit the workings of a free labour market;
(d) restricting the growth of the >money supply to control inflation, improve
economic stability and encourage investment; (e) increasing the mobility of labour
support ratio | 374

(►labour, mobility of), and (f) cutting the benefits available to those out of work to
improve their incentive to take on work (►unemployment trap).
It would be wrong, however, to believe that supply-side measures are only the
concern of free-market economists. State interference in the economy can be classed
as on the supply side, and measures of this sort might include: (g) increases in
spending on education to retrain employees; (h) the introduction of >profit-sharing
as a means of removing industrial conflict, and (i) the establishment of a State
investment bank for subsidizing high-risk, new-technology firms. In general, supply-
side measures can be justified in terms of the findings of ►microeconomics, which
is concerned with the behaviour of individual workers and firms rather than the
behaviour of economic aggregates (^macroeconomics). Free-market supply-side
economics emerged as a body of thought in the early 1980s as a doctrine complemen¬
tary to > monetarism, which first provided a macroeconomic case against demand-
management; it was strengthened by the theoretical revolution that arrived in the
form of > rational expectations. >► Laffer curve; sow's ear effect.

support ratio ^dependency ratio.

surplus value >Marx, K.

sustainable development The notion that economic development should pro¬

ceed at a pace and in a manner that will conserve the environment and depletable
natural resources. In its extreme form (steady state growth) human ►population
would be stabilized and renewable resources only would be employed, ►environ¬
mental economics.

swap A transaction in which ►securities of a certain value are sold to a buyer in

exchange for the purchase from the buyer of securities having the same value, the
purpose being to obtain an improvement, in the eyes of either of the parties, in the
quality of the security, or to anticipate a change in ►yield. ►Currency as well as
securities are swapped in this way.

systemic risk A situation in which problems in any one financial institution or

market may spread, widely endangering the whole system. This risk is a preoccu¬
pation of ►central banks and is the subject of prudential regulation (►capital
adequacy).
Tableau economique The table with which ►Quesnay analysed the circulation of
>-wealth in the economy by setting out the different classes of society. The table
showed how the produit net produced by the agricultural sector circulated between
the owners of the Mand, the tenant farmers and other classes, e.g. artisans and
merchants. Only agriculture produced any net additions to wealth, all other activities
were 'sterile'. The table showed, too, how output is annually reproduced. The sterile
classes were essential in that they created the necessary demand for the agricultural
sector. 3^-Cantillon, R.; Leontief, W. W.; Physiocrats.

take-off in economic development ►economic growth, stages of.

take-over The acquisition of one company by another. Take-overs are sometimes

financed by paying ►cash at an offer ►price in excess of the ►market price of the
►shares, but, more frequently for large acquisitions, by the exchange of shares or
loan ►stock, possibly with some cash adjustment, issued by the acquiring company
for the shares of the acquired company. The term is normally used to imply that the
acquisition is made on the initiative of the acquirer and often without the full
agreement of the acquired company; as distinct from a ►merger, ►►competition
policy; reverse take-over.

Take-Over Panel A UK committee responsible for supervising compliance with

the City Code on Take-Overs and Mergers, a non-statutory code issued in r968 and
revised subsequently. The code is intended to protect the interests of ►shareholders
(►mergers). One requirement of the code is that any company acquiring 30 per cent
or more of the ►shares in a quoted company (►quotation) must make a full bid at
a price not lower than the highest price paid for its shareholding. The ►European
Union had not yet reached agreement in 2002 on a pan-European take-over code.

tap issue An issue of ►treasury bills to government departments and others at a

fixed ►price and without going through the ►market; as distinct from a tender issue
(►tenders).

tariffs, import Taxes imposed on commodity ►imports. They may be levied on

an ad valorem basis (i.e. as a certain percentage of ►value) or on a specific basis, i.e.
as an amount per unit. Their purpose may be solely for raising revenue, in which case
the home-produced product corresponding to the import would bear an equivalent
compensatory tax. However, import duties are generally applied for the purpose of
carrying out a particular economic policy, and in this context may be used to serve
many functions:
tatonnement process 376

(1) To reduce the overall level of imports by making them more expensive relative
to their home-produced > substitutes, with the aim of eliminating a ^balance of
payments deficit. >► devaluation.
(2) To counter the practice of > dumping by raising the import price of the dumped
commodity to its economic level.
(3) To retaliate against restrictive measures imposed by other countries (> beggar-my-
neighbour policy).
(4) To protect a new industry until it is sufficiently well established to compete with
the more developed industries of other countries (>infant-industry argument).
(5) To protect 'key' industries (e.g. agriculture) without which the economy would
be vulnerable in time of war.

For example, in respect of members compared with non-members of a ^common

market, tariffs are preferential. It is an accepted principle under the ►most-favoured
nation clause of the ►General Agreement on Tariffs and Trade (GATT) that tariffs
should be non-discriminating and any concessions agreed between two or more
countries should automatically be extended to all. It has, however, been accepted
that this principle may be waived in the interests of the developing countries.
Significant progress has been made through the GATT in the reduction of tariff
levels by means of a series of negotiations, of which the ►Uruguay round of trade
negotiations was the latest (>-Doha round of trade negotiations; generalized system
of preferences; World Trade Organization).

tatonnement process The tatonnement process was suggested by ►Walras to illus¬

trate that equilibrium in perfect markets (^perfect competition) can be attained at a
particular set of prices no matter what the original disequilibrium position of the
markets and the route by which prices move before reaching equilibrium. Buyers and
sellers make known their prices in the first round. In the second round, buyers and
sellers increase their published prices where there is excess demand, and reduce them
where there is a shortfall in demand. The process continues until there is a balance of
demand and supply in all markets. It is not until this stage that actual transactions take
place; no trade is done until equilibrium is reached. Wo-price system.

Taussig, Frank William (1859—1940) Apart from a period from 1917 to 1919 when
he was chairman of the US Tariffs Commission, Taussig spent his whole career at
Harvard University. His works on economics include Tariff History of the United
States (1888), Wages and Capital (1896), a textbook, Principles of Economics (1911) and
International Trade (1927). An economist in the tradition of > Ricardo and >Marshall,
he attempted to relate his theory to established statistical data.
tax ► taxation.

tax, ad valorem An indirect tax (^taxation) expressed as a proportion of the

► price of a ►commodity - hence it is 'by value'. > Value-added tax is an ad valorem
tax. >***sales tax.

tax, 'cascade' ►turnover tax.

tax, progressive ►progressive tax.

tax, proportional ^proportional tax.

tax, regressive ►regressive tax.

 tax tolerance

tax, specific A tax (»-taxation) of an absolute amount levied per unit of a ^com¬
modity sold or produced. Examples are >stamp duty and >excise duties. An indirect
tax (>direct taxation), not to be confused with a >tax, ad valorem. Where tax rates
are applied at very high rates on a commodity (e.g. cigarettes, in the UK) specific
duties do not unduly penalize higher quality brands of the commodity, which cost
a little more before tax, but would be hugely more expensive after tax if an ad valorem
duty were applied.

tax, turnover ^turnover tax.

tax and price index A UK >index number that measures the percentage change
in gross income required by taxpaying individuals to maintain their real disposable
income (>real terms). The index takes into account the movement in the >retail
prices index and changes in ^-direct taxation and employee National Insurance
contributions.

tax avoidance Arranging one's financial affairs within the law so as to minimize
taxation ^-liabilities, as opposed to tax evasion, which is failing to meet actual tax
liabilities through, for example, not declaring > income or ^-profit.

tax base The quantity or coverage of what is taxed. The tax base for >income tax
is the assessed income of the whole population. The tax base for >value-added tax
does not include sales of most foods, books and financial services.

tax burden The amount of >money an individual, institution or group must pay
in >-tax. It should include all costs to the taxpayer that he incurs in paying the tax
(e.g. the net-of-tax cost of employing an accountant to complete a tax form) as well
as the tax itself (^compliance cost). In most policy discussion, the tax burden is
taken as the proportion of >-gross domestic product levied by the government in
taxation.

tax equalization account ^company reserves,

tax evasion >tax avoidance, ^informal economy.

tax expenditures The costs of tax allowances and reliefs. It has been argued that
tax allowances are similar to Subsidies and may be seen as a form of >public
expenditure. However, tax expenditures can never be more than estimates since it
cannot be assumed that the >*tax base would remain unaltered if the allowances
were abolished. There is a wide range of allowances and reliefs, most of which
probably lead to the loss of some revenue and all of which complicate the adminis¬
tration of the tax system and raise ^compliance costs. Tax allowances and reliefs
necessitate higher rates of tax than would otherwise be necessary and lead to distor¬
tions in factor markets {>factors of production) and probably also to higher >tax
avoidance, and there is increasing interest, among economists if not among poli¬
ticians, in reducing them.

tax impact ^taxation, incidence of.

tax tolerance The willingness or ability of a population to support high or

increasing levels of taxation. Tax tolerance - and its inverse, tax resistance - has
become a fashionable topic among economists interested in ^public-choice theory.
It is argued that the public have rebelled against the desires of political leaders to
tax yield | 378

raise extra revenue, and the resistance has been shown in the election of governments
committed to lower taxation, the growth of the >informal economy, and specific
voter initiatives to limit the authority of the state government to levy local property
taxes, e.g. Proposition 13 in California in 1978. It has been argued that the growth of
government budget deficits (>public sector borrowing requirement) has been caused
by the inability of governments to curb spending growth, and the unwillingness of
populations to pay higher taxes. ȣ-Buchanan, J. M.; hypothecation.

tax yield The amount of »-money that results when the rate of >tax is applied to
the money value of the >tax base, minus the costs of collecting the tax.

taxation A compulsory transfer of >money (or occasionally of goods and >servi-

ces) from private individuals, institutions or groups to the government. It may be
levied upon >wealth or >income, or in the form of a surcharge on >-prices. In the
first case, it would be called a >direct tax; in the latter, an indirect tax. Taxation is
one of the principal means by which a government finances its expenditure. While
it seems obvious what is tax and what is not, there is an awkward boundary. The TV
licence is effectively a tax; but are contributions to the estate Earnings-Related
Pension Scheme? And would compulsory saving to purchase, for example, a pension,
not be equivalent in spirit to taxation? Or, if the government were to apply high
prices to the output of ^nationalized industries, in order to raise revenue? M^air
passenger duty; capital gains; corporation tax; hypothecation; income tax; inherit¬
ance tax; insurance premium tax; local taxation; public goods; sales tax; self-
assessment; stamp duty; tax expenditures; tax, specific; unit tax; value-added tax.

taxation, incidence of The ultimate distribution of the burden of a tax. The

initial tax impact, or formal incidence of an > excise duty on tobacco, for example,
may be on the importer or wholesaler who has to pay over the tax to the authorities,
but he/she is likely to pass on some or all of the tax in the form of higher prices to
the retailer and the consumer. Whether or not a tax is wholly shifted forward will
depend upon the price >elasticity of demand and supply for tobacco. If the con¬
sumer does not reduce purchases following the increase in price, he/she will bear
the whole of the tax. If the consumer does reduce purchasing, the wholesaler and
the retailer will also be worse off and will be bearing part of the tax. There are two
general rules of incidence: (a) in general, a tax on any company must be paid by its
shareholders, its employees or its customers - the company itself does not pay tax,
and (b) in the very long term, tax ends up being borne by people in proportion to
their ability to transfer the inputs they provide to an economy, or their consumption,
from one jurisdiction to another. If capital can move anywhere, governments will
find themselves unable to capture revenue from providers of capital. On this account,
jurisdictions with high taxes on capital will simply have less capital, and capital will
thus earn high pre-tax returns.

Taylor rule A simple rule for setting interest rates with a view to keeping inflation
stable. The rule, produced by Taylor of Stanford University, says:
Short term interest rate = 2

+ inflation rate
+ 0.5 (deviation of inflation from target)
+ 0.5 (output gap)
 term structure of interest rates

The ‘i’ is derived from the historical average real interest rate. Add this to today's
inflation, and you achieve the long-term real average. The next two lines say that
rates should be higher than this - the higher inflation is above target the higher the
economy is operating above its long-term capacity (>output gap). If inflation was
on target and the output gap was zero, real interest rates would be 2 per cent.
Taylor wrote about this rule as both an approximate description of what central
banks actually do when they set rates, and as a possible prescription of what a
sensible, responsive monetary policy rule might consist of. In practice, the rule needs
calibrating for different countries, and the 'output gap' is not an easily observable
variable.
Central banks prefer to maintain an air of intelligent discretion over the conduct
of their policies than to follow rules, but to some extent they do unwittingly follow
a Taylor rule. This makes the rule a useful benchmark against which actual policies
can be judged.

technical analysis >chartist.

technical substitution, rate of Mate of technical substitution.

technology The sum of knowledge of the means and methods of producing goods
and services. Technology is not merely applied science, because it often runs ahead
of science - things are often done without precise knowledge of how or why they
are done except that they are effective. Early technology - craft skill - was almost
entirely of this sort. Modern technology is increasingly science-based, however, and,
rather than relying on acquired skill, is easily communicable by demonstration
and printed material to those qualified to receive it. It also includes methods of
organization as well as physical technique. Technological change and the diffusion
of technology are important in economics because new methods, including those
embodied in investment, play an important part in theories of ^economic growth.
There is, however, some controversy about the extent to which technological devel¬
opment is an autonomous factor in economic growth. Because it is so difficult to
measure, there is also room for doubt about whether or not technological change is,
or has recently been, accelerating, ^-endogenous growth theory, ^research and
development.

tenders Offers to supply at a fixed >-price. A >discount house tendering for an

issue of >treasury bills, for example, will offer to take up so many bills at a certain
price, ^contracting out.

term loan A bank advance for a specific period (normally 3-10 years) repaid, with
^interest, usually by regular periodical payments. Term loans are common practice
in the US commercial banking system for business finance, and for larger borrowings
the Moan may be syndicated, i.e. the provision of funds and the interest earned are
shared between several banks. Similar facilities are available in the UK, mainly from
the ^-commercial banks or other institutions, but >overdrafts are still a common
form of >bank loan, and may be a cheaper form of finance. Unlike an overdraft, the
interest of a term loan is fixed and the loan cannot be recalled in advance of its
maturity date.

term structure of interest rates The relationship between the interest rate paid
on a >bond and the number of years until the bond is repaid. Suppose, for simplicity,
terms of trade | 380

bonds are held for either r or 2 years. People wanting to invest for 2 years can do so
either by buying a 2-year bond or by buying a i-year bond now and then buying a
new one when that one expires. The term structure compares the annual yield on
each type of bond. It is affected by a number of factors. Most important, if interest
rates are expected to rise next year, the 2-year bond will have to offer a higher annual
return than the i-year bond. Otherwise, everyone would sell 2-year bonds and hold
a i-year bond this year and a higher-yielding i-year bond next year (>^yield curve).
► Inflation expectations also determine the term structure (>credibility). In general,
if ^fiscal policy and ►monetary policy are 'tight' (i.e. tending to have a deflationary
effect) (►deflation), then long-term rates will be lower than usual, relative to short¬
term rates. M»-yield curve.

terms of trade The ratio of the index of ►export prices to the index of ►import
prices. An improvement in the terms of trade follows if export prices rise more
quickly than import prices (or fall more slowly than import prices). >► United
Nations Conference on Trade and Industry.

theories of value > value, theories of.

theory of distribution ►distribution, theory of.

theory of games ►game theory.

theory of income determination >income determination, theory of.

theory of production ^production, theory of.

theory of second best ►second best, theory of.

theory of the firm >-firm, theory of the.

Third World A synonym for >developing countries.

Thornton, William Thomas (1813-80) ►wage-fund theory.

Thiinen, Johann Heinrich von (1783-1850) A member of the landowning Prussian

class of Junkers, after completing his education at agricultural college he attended
the University of Gottingen. For the remainder of his life he farmed his estate at
Mecklenburg. Volume 1 of Der isolierte Staat in Beziehung auf Landwirtschaft und
Nationalokonomie was published in 1826, and part 1 of volume 2 in 1850. The rest of
volume 2 and volume 3 appeared in 1863. He used his farm as a source of facts for his
theoretical work in agricultural economics. He built a theoretical >model that he
used to find the important factors that determined the most profitable location of
various branches of agriculture in relation to their sources of ^demand. In so doing,
he devised a theory of ►rent similar to that of >Ricardo. He set out a theory of
► distribution based on marginal productivity, using calculus, which was consider¬
ably ahead of his own time, and he could be considered one of the founders of
► marginal analysis, ^location theory.

tie-in sales Sales of a product that have a condition that some other item will be
purchased at the same time. An example would be the condition that in order to
subscribe to the services of a telephone utility, you have also to rent or buy one of
their telephones. It is an example of a ►vertical restraint. >► full-line forcing.

tied aid The practice by which countries grant aid to ►developing countries on
 time preference

condition that they use the aid to buy from the donor country's own suppliers.
Moreign aid.

tied loan A Moan made on condition that certain purchases are made from the
lender. In the brewing industry tied loans are made to pubs and clubs for fitting out
bars and restaurants on the understanding that beer is supplied by the brewer making
the loan. In Moreign aid, loans are made on favourable terms on condition that
capital equipment or services are purchased from the lending country.

tight money >dear money.

time deposit (US) Money in a bank account for which the bank may require
notice of withdrawal, usually of up to 3 months. ^deposit account.

time inconsistency A change in preferences that occurs quite predictably after a

certain situation has been arrived at. For example, a government that wants to deter
the taking of hostages may say that it will never negotiate with hostage-takers, but
finds that once a hostage has been taken, it pays to negotiate whatever its preference
beforehand. Or a government that wants to encourage investment and is thus willing
to promise tax concessions to firms opening new plants finds that once the new
plants are open it would prefer to remove the tax concessions.
Unless they can commit themselves to the original course of action, the existence
of time-inconsistent preferences can prevent certain measures of government, or
other economic agents, being credible. Whenever agents lay out >sunk costs, it is
possible that their options will change and they will exhibit time inconsistency. The
problem has been analysed in >game theory, ^-principal-agent problem.

time preference The amount by which consumers value immediate Monsump¬

tion in preference to deferred or postponed consumption. Suppose an individual
has £roo; he/she can either spend it now or put it aside and spend it next year. The
rate of time preference of that consumer is the amount of money necessary just to
persuade him/her to save the £100. If expecting to do very well next year and having
no need to save, or out of fear of nuclear war believes the world will no longer exist
next year, there will be a requirement for a large amount of compensation to
persuade him/her not to spend the £roo. If, on the other hand, the consumer feels
perfectly well off at the moment and conditions are unlikely to change much, he/
she may think a rather small amount of compensation makes saving worthwhile.
Several factors affect the time preference of consumers.

(1) The level of consumption consumers enjoy in the present. Other things being
equal, the more consumption there is now, the lower the compensation needed
for ^-saving. As saving implies a fall in current consumption, the more that is
saved, the higher the required level of compensation.
(2) A corollary of (r) above, is the level of consumption expected to be enjoyed in
the future. If great wealth is expected tomorrow, a lot of reward will be needed
to induce saving today. Again, as saving today implies higher consumption in
the future, the more that is saved, the higher the required level of compensation.
(3) The risk the consumer attaches to the arrival of the future: if tomorrow is unlikely
to come, huge compensation is needed to cause saving.
(4) Consumer taste will influence the time-preference rate - some people may believe
time series

that they can only enjoy spending money when they are young, others might
believe the reverse.

The market >rate of interest expresses the amount a consumer will actually be
compensated for saving, and rational consumers will save enough for their time-
preference rate to equal the interest rate. If the interest rate exceeds their time-
preference rate, they should save more, raising their time-preference rate until it is
equal to the market interest rate. The reverse would be true if their time-preference
rate exceeded the interest rate. If the interest rate is lower than their time-preference
rate even when they are saving nothing, it is rational for them to borrow money
and pay interest on it; this raises current consumption and lowers future consump¬
tion and thus lowers their time-preference rate. Optimal consumption through time
can be analysed with the help of ^-indifference curves, depicting the bundles of
consumption today and in the future between which the consumer is indifferent.
S^Fisher, I.; marginal utility of money.

time series The values of a particular >-variable at consecutive periods of time.

time-series analysis The application of statistical methods to find explanations

of movements of ^-variables over time. >► cross-section analysis.

times covered > dividend cover.

Tinbergen, Jan (1903-94) A Dutch economist, from The Netherlands School of

Economics in Rotterdam, Tinbergen jointly won, with >Frisch the first ►Nobel
Prize in Economics in 1969, 'for having developed and applied dynamic models for
the analysis of economic processes'. He spent 10 years as director of The Netherlands
Central Planning Bureau, where he formulated some important ideas on the conduct
of economic policy. He is associated with the central principle that there must be as
many instruments as there are targets of policy.

tit-for-tat A strategy in a repeated ►prisoner's dilemma game (^repeated game) by

which a player agrees to be co-operative in the first round of the game, and for each
subsequent round to do whatever the other player did the round before. The strategy
has been shown empirically to be effective when the prisoner's dilemma is repeated
a large number of times, or when it continues for an unknown number of rounds.
Its importance in »-game theory is to have shown that there are circumstances when
the co-operative outcome can be sustained in situations that are structurally similar
to the prisoner's dilemma. It is not, however, a >dominant strategy.

Tobin, James (1918-2002) Professor Tobin studied at Harvard University, obtaining

his Ph.D in 1947. He moved to Yale in 1950 and was appointed Sterling Professor of
Economics. He was awarded the >Nobel Prize in Economics in 1981. Professor Tobin's
major published works include Liquidity Preference as Behaviour towards Risk (1958),
National Economic Policy (1966), Financial Markets and Economic Activity (1967), Essays
in Economics: macroeconomics (1971), Economics, One Decade Older (1974), Essays in
Economics: consumption and econometrics (1975), Asset Accumulation and Economic
Activity (1980) and Essays in Economics: theory and policy (1982). Professor Tobin has
made important contributions to the theory of finance through his analysis of the
demand for financial assets (^liquidity preference). He criticized ►monetarism for
its narrow emphasis on money, arguing that there is a range of financial assets that
 tournament theory

investors may be willing to hold in their portfolios - not only money but bonds and
equities. Precise investor preferences for different assets are determined by their
preferences against risk and in favour of higher returns.
Professor Tobin also explored the links between the mix of financial portfolios
and the real assets of firms to show how government and central bank policy impinge
on real >• gross national product and employment. In particular, for Tobin, the
mechanism by which money may affect the real economy would not so much be
the direct relationship of extra money being spent on extra real goods and services
(as monetarists are wont to believe), but by extra money leading to higher prices for
shares, thus promoting investment by firms in real expansion {>q theory; trans¬
mission mechanism).
Tobin also contributed to the theory of >econometrics: Tobit, a statistical analyti¬
cal technique for the estimation of variables subject to ^probability, was named
after him. >J*Tobin tax.

Tobin tax A tax on ^foreign exchange transactions originally proposed by XTobin.

World foreign exchange transactions are very large and it has been estimated that
only 2 per cent are connected with trade in goods; most, therefore, are related to
^investment or >speculation. Concern has been expressed that the high proportion
of this, which is of a short-time nature, could lead to serious instability in ^exchange
rates because of the speed with which it could switch from one economic region to
another in turn (>hot money). It has been suggested that a tax would not only help
to control these flows but also be a useful source of revenue. Although much
discussed, such a tax is probably not a practicable proposition, if only because there
would need to be international agreement to introduce it.

Tokyo Stock Exchange The Securities market in Tokyo. It is one of the world's
largest and is one of the three central Japanese Stock exchanges - Osaka and
Nagoya are the other two. There are also five regional exchanges in Japan, though
Tokyo which, unlike London, still has a trading floor, accounts for well over 80 per
cent of all transactions. Non-Japanese dealing firms were permitted to become
members of the exchange in 1986. Japan's »-Big Bang was announced in T996, but
implementation is still incomplete. In iggg, an ^unlisted securities market-Mothers
Market - was introduced.

total factor productivity > growth accounting; productivity.

total managed expenditure (TME) A measure of total ^public expenditure in

the UK, comprising >departmental expenditure limits and ^annually managed
expenditure. Total managed expenditure includes some elements of spending by
public corporations, which are inside the public sector but outside what is termed
'general government'. Hence, TME tends to be larger than other measures of public
spending.

tournament theory The piece of economic thinking that suggests rewards can
usefully be based upon the relative performance of economic agents, rather than on
their absolute performance. It is sometimes used to explain behaviour observed in
the > labour market, where patterns of reward are often more subtle than traditional
theories (^marginal productivity theory of wages) would suggest. In particular,
those traditional accounts argue that there should be a close relationship between
trade barrier

the value of the output of a worker and the wage the worker receives. But in practice,
the ►productivity of workers varies, and companies find it hard to observe the
individual output of every worker. So under tournament theory, it is argued, com¬
panies can rank workers and pay them on their relative standing. That gives them
each an incentive to perform well but does not require as detailed a profile of
everybody's performance. Because workers are effectively competing against each
other, they are in a tournament. The approach can also be applied to the > regulation
of ►monopoly utilities, where it becomes ^yardstick competition. It is one of
many pieces of economic thinking that attempts to justify and explain real-world
behaviour on the grounds that the information facing decision-makers is incom¬
plete. >»-efficiency-wage hypothesis; screening; signalling.

trade barrier A general term covering any government limitation on the free
international exchange of merchandise. These barriers may take the form of, for
example, > tariffs, >quotas, Mmport deposits, restrictions on the issue of >-import
licences or stringent regulations relating to health or safety standards, ^precaution¬
ary principle; protection.

trade credit The s-credit extended by business firms to other business firms. It
may occur explicitly through the issue of a >bill of exchange or may arise from the
delay of receipts and payments for services performed, ^factoring.

trade cycle >business cycle.

trade discount The percentage below the published retail >price at which a
manufacturer sells to distributors (wholesale or retail) or at which a wholesaler sells
goods to a retailer. In addition, further discounts are sometimes given on a scale
related to the quantities of the goods taken. A 'concealed' discount is one granted by
a manufacturer or wholesaler to favoured customers and not made publicly known
in order to prevent accusations of unfair trading, ^resale price maintenance.

trade diversion and trade creation >customs union.

trade gap The excess of the value of >imports of goods and services over the value
of ^exports of goods and services, ^balance of payments.

trade investments >Shares held by one company in another; normally minority

holdings in customers or suppliers.

trade promotion authority Authority granted by the US Congress to the Presi¬

dent to facilitate US international trade negotiations. Authority was granted by the
Trade Act 2002 for a period of 5 years. Under the Act, while the President must
consult Congress during the course of negotiations, he is assured that any inter¬
nationally agreed trade agreement put to Congress by the President would not be
amended. Such authority was first granted in T974 and subsequently renewed, with
the last such Act expiring in 1994.

trading currency Currency in which >international trade is invoiced, ^reserve

currency.

transactions costs The costs associated with the process of buying and selling.
These are small frictions in the economic sphere that often explain why the price
system does not operate perfectly. Transactions costs may affect decisions by an
 transfer earnings

organization to make or buy (^contracting out) and the study of transactions-costs

economics, associated notably with Williamson, has implications for a wide range
of issues affecting ^industrial organization, including > competition policy.
>9^Coase, R.; menu costs.

transactions demand for money The holding of cash by people or firms to

finance foreseeable expenditures. When people are paid, they probably put their
salaries into bank accounts, from which they can spend them very easily, using
cheques or cash taken from machines. If they wanted to, however, instead of putting
it in the bank's current account, they could invest it in, say, government bonds,
which would pay interest. People, however, keep much of their money in easy-access,
low-return accounts. This is the transactions demand for money.
The transactions demand depends on three factors.

(r) The volume and pattern of transactions to be financed. A rich person requires
more ready cash than a poor man, because he/she spends more. The pattern of
transactions matters too: if spending and income were £20 a day, virtually no
money would be kept for transactions, but if spending were £20 a day and income
£r40 a week, a positive balance would be kept for the first 6 days of the week.
(2) The rate of interest has an effect, because it represents the sacrifice made from
not investing money.
(3) The cost of making transactions in interest-bearing assets, e.g. the brokerage fees,
costs of acquiring information, etc.

The foregoing applies equally to the corporate demand for money. It is generally
believed that the transactions demand relates to the function of money as a medium
of exchange (>money) and that, of the various possible definitions of money supply,
the most relevant to this demand is a 'narrow' one of very liquid assets (>*-money
supply). Although it was seen as the only possible reason for holding money by
classical economists, it was >-Keynes who introduced the idea that the interest rate
might be important in determining the demand for money, and outlined other
motives for holding cash too. ^precautionary motive; speculative motive; Tobin, J.

transactions motive The factor causing people or firms to hold a stock of money
to finance their foreseeable expenditures. It is one of three motives for holding
money outlined by Keynes. >*«-precautionary motive; speculative motive; trans¬
actions demand for money.

transfer costs The total >► opportunity costs of moving goods or materials from
one place to another including loading/unloading costs and administrative costs as
well as transport costs.

transfer deed A legal document by which ownership of ►securities is transferred

from the seller to the buyer. In the UK, it is no longer necessary for both parties to
sign such a document when disposing of a share. The seller gives authority to the
issuer of the security to remove his/her name from the records while the buyer's
►broker simply informs the issuer of the purchaser's name. »>-CREST.

transfer earnings The minimum payment necessary to keep a >factor of pro¬

duction in its existing use and deter movement to other employment. Earnings in
excess of transfer earnings are >-e'conomic rent.
transfer payments | 386

transfer payments Grants or other payments not made in return for a productive
service, e.g. pensions, unemployment benefits (►jobseeker's allowance) and other
forms of income support, including charitable donations by companies. Transfer
payments are a form of income redistribution, not a return to the ► factors of
production. ►Social security cost the UK government £96.6 billion in 1996/-/, the vast
bulk of transfer payments in the country. »-Subsidies that are paid by government to
producers are not counted as transfer payments.

transfer pricing Internal (as distinct from ►market) prices used in large organiza¬
tions for transactions between semi-autonomous divisions. A >multinational cor¬
poration, for example, will have to set transfer prices for the supply of components
from one subsidiary to another. Transfer prices between subsidiaries acting as profit
centres may approximate to market prices or may be set above or below them so as
to minimize the payment of ►tariffs or to shift ►profit from a high- ►taxation
country to a low-taxation one.

transformation curve (production possibility curve) A graphical represen¬

tation of the maximum amount of one good or service that an economy can produce
by reducing production of a second good or service and transferring the resources
saved to the production of the first good (see diagram). For example, an economy
might be capable of building and equipping fifty hospitals if it does not build any
schools, or eighty schools if it builds no hospitals. Either of these combinations
would be a point on the transformation curve, which can be plotted on a graph with
the number of hospitals built and equipped on one axis, and the number of schools
on the other. It traces the number of schools that can be built and equipped using
the resources required for any given level of hospital building.
A transformation curve is normally assumed to be concave to (i.e. bulge away

0 schools
 transmission mechanism

from) the origin. This is because the >-rate of technical substitution declines the
more a commodity is produced: a larger number of schools can be built and equipped
for the sacrifice of one hospital if no schools are being built to start with, because
the best locations can be used and the people good at building and equipping
schools, but poor at hospital building, can be transferred to building schools pro¬
ductively. However, suppose that only one hospital is being built and the rest of the
economy is geared to school building - transferring resources from hospital building
to school building will have hardly any effect on the rate of build of schools. Thus,
the rate at which hospitals can be transformed into schools declines as school
building rises. >► economic efficiency.

transition, economies in Countries in transition from a >planned economy to

a >free-market economy. Specifically refers to Russia and the members of the former
USSR and other Communist states in Eastern and Central Europe. The process began
in October ^89 with the opening of the Berlin Wall between East and West Germany.
The countries in transition, unlike > developing countries, have highly educated
populations, substantial, though generally rundown, ►infrastructure and large
manufacturing sectors. The economies are dominated by heavily indebted State
enterprises with low > productivity and generally uncompetitive products and ser¬
vices. Most are characterized by high ^inflation and > unemployment and ^balance
of payments deficits. Output in some countries is still below r989 levels, partly
because of the disruption of trade patterns between these countries. The countries
most advanced in the process of transition include Poland, Hungary and the Czech
and Slovak Republics, which have negotiated special relationships with the ►Euro¬
pean Union and aspire to membership. These countries achieved quite rapid growth
rates in the second half of the r99os.
The economic policies being pursued by countries in transition vary and are
controversial. These policies have been heavily influenced by the international
institutions and ^Organization for Economic Cooperation and Development
member states that are providing them with financial aid (Moreign aid) and techni¬
cal assistance. Some economists have advocated shock therapy to free prices from
controls, removal of ►subsidies, convertibility of currencies, rapid >privatization
of State enterprises, and stringent ►monetary policies. Others advocate a more
gradualist approach that would focus more on the development of appropriate
institutions first, e.g. property rights and the banking system (► institutional econ¬
omics). The gradualists argue that the shock approach will be politically disruptive
and ineffective until institutions develop to allow market forces to work.

transitivity A characteristic of rational preferences that holds that if a combination

of goods, A, is preferred to another combination, B, and B is preferred to a third
combination, C, then A must be preferred to C. Transitivity is also assumed to hold
for the indifference relation between combinations of goods. >► indifference-curve
analysis; paradox of voting.

transmission mechanism The process by which changes in the money supply -

or changes in the >rate of interest on short-term assets - affect the level of ►aggregate
demand. There are different ways in which the mechanism can operate: (a) with
extra cash (or lower interest rates) people may choose to spend more and save less,
and (b) and more indirectly, with extra cash, people may buy more ► bonds or
transnational corporation | 388

equities, as a means of storing their new wealth. This increase in the demand for
bonds will push their prices up and interest rates down and this will stimulate
new investment. ►Monetarism concentrates on the more direct process, while
►Keynesian economics has tended to play down the power of money, believing
that its effects work only through (b). In an ►open economy, the transmission
mechanism can also operate through the »-exchange rate. An increase in >-money
supply, or a reduction in interest rates, tends to lead to a ^depreciation of the
exchange rate, and promotes exports.

transnational corporation ►multinational firm.

Treasury The UK Ministry of Finance. Managed on a day-to-day basis by the

Chancellor of the > Exchequer, though the First Lord of the Treasury is the Prime
Minister, this department co-ordinates national economic policy (including
► monetary policy), and controls ►public expenditure. Some of its functions passed
to the Department of Economic Affairs (DEA) when it was set up in T964, but returned
to it in r969 when the DEA was closed. Also, prior to the establishment of the Civil
Service Department in r970, the Treasury was responsible for the management of
the Civil Service, but this role is now performed by the Management and Personnel
Office in the Cabinet Office.

treasury bills Instruments for short-term borrowing by the government. The bills
are promissory notes to pay to the bearer £5000 upwards 9r days from the date of
issue. The bills are issued by tender to the ►money market and to government
departments through >tap issues. ^Tenders are invited every week from bankers,
► discount houses and >brokers. On the one hand, treasury bills provide the govern¬
ment with a highly flexible and relatively cheap means of borrowing > money to
meet its fluctuating needs for >cash. On the other hand, the bills provide a sound
►security for dealings in the money market, and the > Bank of England, in particular,
can operate on that market by dealing in treasury bills.

Treaty of Rome > European Union.

trend growth The level of ►economic growth of an economy that is sustainable

over the long term, without any tendency for the rate of > inflation to rise or fall. It
is sometimes held to be the rate at which the productive capacity of the economy -
its potential for production - expands. It could equally be taken as a measure of the
growth of the ►supply side. It is also interpreted as the long-term growth rate, as it
is assumed that in the long term, the economy must perform according to its
potential. The rate is affected by growth in the labour force, and the growth in
productivity, itself primarily determined by technology and social institutions.
Actual growth in any year may exceed, or under-perform trend growth, usually
because fluctuations in ►aggregate demand affect actual ►gross domestic product
more than they affect the long-term capacity of the economy to produce things.
Trend growth is a useful benchmark for whether the economy is growing too quickly
(►overheating) or too slowly. In the UK ►budget of 2002, Britain's trend growth
rate was officially declared to be 2.75 per cent, a quarter point higher than had
hitherto been assumed. The government still decided to act upon the assumption
that it was 2.5 per cent for the sake of caution. Estimates of this magnitude are
regarded as reasonable for most highly developed economies, but it recognized that
 turnpike theorem

developing countries may outperform this level for a sustained period of catch-up.
Trend growth is a concept more often used by policymakers than theoretical econ¬
omists. It has largely been ignored by the different theories of growth (>growth,
theories of), and should not be confused with the natural rate of growth, used in the
► Harrod-Domar model; output gap.

truck system > fringe benefits.

trust 1 >Money or property vested with an individual or group of individuals to

administer in the interest of others. Trusts of this kind are usually set up to continue
interests in accordance with the general instructions of the initiator and to protect
them from outside interference and for tax reasons. Thus, people set up trusts or
appoint trustees to administer their estates after their death. Certain newspapers are
administered by trusts. Banks act as trustees for a fee, and a similar service is provided
by the Public Trustee, established in rpo8. The term is a legal one. 2 Financial
trusts are also established for commercial purposes in which particular protection is
required against fraud, e.g. >unit trusts or ^investment trusts. 3 (US) A very large
amalgamation of firms. ►►anti-trust.

TSE >Tokyo Stock Exchange.

Turgot, Anne Robert Jacques, Baron de I'Aulne (1727-81) Educated for the
Church, he became an abbe at the Sorbonne in Paris but then took up a career in
the Civil Service, where he remained for the rest of his life. He was the Administrator
of the District of Limoges from 1761 to 1774, when he became Secretary of State for
the Navy. For a short time he held the post of Controller of Finance. His economic
work appeared in Reflexions sur la formation et la distribution des richesses (1766). In
this work he gave a clear analysis of the law of >diminishing returns. He demon¬
strated how more and more applications of a ►factor of production (^capital) to a
constant factor (land) will first increase, then decrease, the return at the margin. He
was the first to equate capital accumulation with > saving, a view that became a
central feature of ^classical economics.

turnover The total sales revenue of a business.

turnover tax A >tax levied as a proportion of the >price of a >commodity on

each sale in the production and distribution chain; also called a cascade tax. Such a
tax encourages >vertical integration. Turnover taxes were widespread in Europe
(e.g. in Germany) before the introduction of the >>value-added tax now standard
throughout the ►European Union.

turnpike theorem ►optimal-growth theory.

unavoidable costs ^Opportunity costs that have to be borne even if no output
is produced, infixed costs.

uncalled capital >Authorized capital issued to the public, but not called (Rail)
and not ►paid-up capital.

uncertainty The state in which the number of possible outcomes exceeds the
number of actual outcomes and when no probabilities can be attached to each
possible outcome. It differs from Risk, which is defined as having measurable
probabilities. Where probabilities are measurable, insurance can be taken out to
cover the worst contingencies - the risk of them occurring is spread among many
people or taken on by someone who can reasonably be certain to bear them. In the
case of uncertainty, however, no insurance company could properly assess what
premium to charge to cover bad outcomes - it is simply a possibility that has to be
faced. It is the role of the entrepreneur to face each uncertainty when setting up a
new company that justifies >profit as a reward. >Risk.

UNCTAD ►United Nations Conference on Trade and Development.

undated securities Securities not bearing a Redemption date or ►option,

hence ►irredeemable securities.

underconsumption ► quantity rationing.

underdeveloped country ►developing country,

underground economy Rnformal economy.

underlying inflation The rate at which prices are rising in the economy, once
the impact of erratic effects on price measurements has been removed. There is no
precise definition of underlying inflation. In the UK, it is often used to label the
measure used as the basis of the government's ^inflation target. That is the measure
known as RPIX, equivalent to all the items in the >► retail prices index excluding
mortgage interest payments. It has been argued that a better measure of underlying
inflation would also exclude the effect of changes in indirect taxation (^direct
taxation) and such a measure, RPIY, is compiled although not much publicized
outside of the »**Bank of England's Inflation Report. >harmonized index of
consumer prices.

undervalued currency A ^currency, the ^exchange rate of which is below either

its Rree-market level or the ►equilibrium level it is expected to reach in the
►long term. Conversely, an overvalued currency may develop as a consequence of
 unemployment, natural rate of

balance-of-payments deficits, ^devaluation; revaluation; ^exchange rate over¬

shooting.

underwriting The business of insuring against Aisk. An underwriter in return

for a >commission or > premium agrees to bear a risk or a proportion of a risk.
Specifically, an underwriter is a member of ^Lloyd's, who joins with others to
underwrite the risk of damage or loss to a ship or cargo - if the ship sinks and is not
recoverable, he/she will pay a proportion of the cost of the loss to be insured - but
the term is generally used to describe the basic activity of >insurance. An ^issuing
house also underwrites directly or indirectly a new issue of > shares - if the public
does not take up the whole issue, the balance will be taken up by the underwriters
(>new-issue market).

unemployment The existence of a section of the labour force able and willing to
work but unable to find gainful employment. Unemployment is measured as the
percentage of the total labour force out of work. Four distinct causes of unemploy¬
ment can be distinguished:

(1) >Frictional unemployment is caused by people taking time out of work, being
between jobs or looking for a job.
(2) >-Classical unemployment is caused by excessively high wages.
(3) > Structural unemployment refers to a mismatch of job vacancies with the supply
of labour available, caused by shifts in the structure of the economy.
(4) > Keynesian unemployment results from the existence of a deficiency of Aggre¬
gate demand that is simply not great enough to support full employment. A fall
in wages - which should cause an increase in the > demand for ^labour - merely
reduces aggregate demand further because it reduces the spending power of the
employed, and thus fails to clear the excess supply of workers. Much economic
debate has centred on whether, in the long term, cuts in wages cannot in fact
increase demand (»Aeal balance effect), and thus whether Keynesian unemploy¬
ment is not just a special case of classical unemployment in which workers are
simply pricing themselves out of jobs.

Monetarist and neo-classical economists have tended to argue that all unemploy¬
ment is either classical or voluntary (^-unemployment, natural rate of). Either, they
assert, the market fails to clear because wages are artificially held too high; or, if the
market does clear, the unemployed have chosen not to take a job at the going rate.
However, in practice, it has been shown that at times persistent unemployment can
be cured by a boost in aggregate demand. The labour market is widely recognized as
being slower to adjust than any other; excess supply in this market persists in a way
that it could not elsewhere, despite the high social and human costs of unemploy¬
ment. In recent years, attention has focused on the particular problem of >-long-term
unemployment, especially among the unskilled. It is surmised that the market wage
of manual workers - especially those in heavy physical occupations - has declined
(>weightlessness) and that work incentives have correspondingly diminished,
too. ^-unemployment trap. >**-claimant count; employment, full; hysteresis; ILO
unemployment; labour force; labour-force survey; labour, mobility of; sow's ear
effect.

unemployment, natural rate of The level of ^-unemployment in an economy

unemployment trap | 392

that is just consistent with a stable rate of ►inflation. It is the unemployment that
prevails when all markets in the economy are in equilibrium and there is no
deficiency of ^aggregate demand. It can be thought of as the unemployment rate
when output in the economy is just at its potential, no more and no less (►output
gap). The point about the natural rate is that it is not easily solvable by >fiscal policy
or ►monetary policy. It is a supply-side feature of the economy (► supply-side
economics), a reflection of labour-market institutions.
The concept of the natural rate was central to the monetarist critique to the
policies motivated by >Keynesian economics (►monetarism). It arises out of the
failures of policy in the 1950s and r96os to sustain low levels of unemployment in
the r970s. Somehow, demand had to be stoked up to ever higher levels to maintain
the same level of unemployment. The economy appeared to exhibit a natural
tendency towards some level, and it was not possible to get that level lower by
allowing higher inflation. At best, it appeared possible to get it below the natural rate
temporarily, or by ever-accelerating rates of inflation. Indeed, on modern accounts,
macroeconomic policy cannot even take unemployment below the natural rate at
all (>policy ineffectiveness theorem).
Today, the natural rate is accepted by academics of most ►economics doctrines,
and it certainly motivates the conduct of economic policy day-to-day throughout
the Western world. Some think of the natural rate as being the correct definition of
'full employment'. To get the actual level of unemployment below it, it is argued,
requires government to consider such factors as: (a) the level of benefits for the
out-of-work; (b) the ease with which workers can change jobs, and (c) the stigma
attached to being out of work. The natural-rate hypothesis has increased the atten¬
tion given to ►active labour-market policies. The ►Organization of Economic
Cooperation and Development has stressed the need for nations to make their labour
markets 'flexible'. It estimates that the UK's natural rate has fallen well below that
of other European nations as a result of policies of ►deregulation of the labour
market.
Because unemployment cannot be held below the natural rate without accelerat¬
ing inflation, it is often called the non-accelerating inflation rate of unemployment.
unemployment trap The existence of ►social security benefits for the out-of-
work that erode any incentive for the unemployed to take a job. The incentive for
the unemployed to find a job can depend on: (a) the generosity of State benefits; (b)
the level of pay offered, and (c) the tax paid on that pay. >► poverty trap.
unfunded »pension funds; personal pension.
uniform business rate >10031 taxation,
unit banking ►branch banking,
unit cost ^average cost.

United Nations Conference on Trade and Development (UNCTAD) A

United Nations conference first convened in 1964 in response to a growing anxiety
among ► developing countries over the difficulties they were facing in their attempts
to bridge the ►standard-of-living gap between them and the ^advanced countries.
Since then, full conferences have been held every 3 or 4 years. The tenth UNCTAD
was held in Bangkok in 2000. The goal of the conference is to improve prospects for
393 unlisted securities market(s)

developing countries' trade and to encourage investment. The UNCTAD offers

support and advice to assist developing countries in their trade negotiations with
the advanced countries, assists them in the promotion of international investment,
and offers its expertise through technical assistance projects. The UNCTAD was
instrumental in gaining the acceptance of preferential duties on imports from
developing countries without having to extend these preferences to all the con¬
tracting parties of the >-General Agreement on Tariffs and Trade (^generalized
system of preferences). The UNCTAD, which has 191 member states and a budget of
about US$70 million, has a permanent secretariat based in Geneva and publishes
regularly papers on development problems and an annual report.

unit of account >money.

unit trust An organization that invests funds subscribed by the public in ^secur¬
ities, and in return issues units that it will repurchase at any time. The units, which
represent equal shares in the trust's investment ^portfolio, produce >income and
fluctuate in value according to the Cnterest and ^-dividends paid and the >stock
exchange prices of the underlying > investments. The trustees holding the securities
are usually banks or >insurance companies, and are distinct from the management
company. The subscriber to a unit trust does not, unlike a shareholder in an Cnvest-
ment trust, receive any of the >profits of the organization managing the trust.
Management derives its income from a regular service charge as a percentage of the
income of the trust's investments and the difference between the (bid) price at which
it buys in units and the (offer) price at which it sells them, which may include an
initial charge. Unit trusts in the UK are strictly controlled by the Investment Man¬
agers' Regulatory Organization (^Financial Services Act 1986), which must give its
approval to a trust before units can be offered to the public, and which sets maximum
management charges and generally supervises the operation of the trusts. Unit trusts
were introduced in the UK as long ago as 1930, but they have grown particularly
rapidly since the late 1950s. In January 1996, unit trust holdings had funds of well
over £100 billion under management. Unit trusts are directed particularly at the
investor with small sums at his/her disposal. Units are easily purchased and resold,
and risks are widely spread, it being usual for holdings of any one security to be kept
below 5 per cent of the total. The investor also benefits from expert management,
although the performance of the trusts varies enormously. Trusts may be fixed or
flexible, i.e. their portfolio may remain the same or be altered as market conditions
dictate. Some unit trusts specialize in small companies or Clue chip shares, others
in Commodities or foreign companies or countries. Some are designed to maximize
income, others Capital growth. The latter offer the option of distributed or rein¬
vested income, and there are also trusts incorporating life assurance which can be
subscribed to by regular payments (^assurance).

universal bank A bank (Canking) that provides a wide range of financial services
in one largely unified structure. In some continental European countries, some
large banks have combined the roles of Commercial banks, ^investment banks,
Cnsurance and ^brokerage. Although in the distant past these functions were
performed in the UK by independent organizations, they are now increasingly
offered by partly integrated financial Conglomerates.

unlisted securities market(s) (USMs) 1 Generally, the markets for shares of

unredeemable securities

►public companies not included in the Official List for the main market (or first
tier) of the >stock exchange. Most of the Vadvanced countries have organized
lower-tier markets or informal 'placing markets' in which unlisted shares are traded.
These markets are less stringently regulated and perform an important function
in providing a stepping-stone to the main markets (^►over-the-counter market;
quotation). 2 Specifically, a market set up in r98o by the London Stock Exchange to
trade in designated unlisted securities and closed in r996. The Alternative Investment
Market (AIM) opened on r9 June 1995 to replace the USM and the Rule 4.2 market
(in which members of the stock exchange were allowed to deal in unlisted shares).
The AIM's admission requirements are less stringent than those for the former USM
and the Official List, and the costs of > flotation are much lower.

unredeemable securities ^irredeemable security.

Uruguay round of trade negotiations The eighth round of trade negotiations

of the >-General Agreement on Tariffs and Trade (GATT) opened at Punta del Este,
Uruguay in r986. The aim, as with previous rounds, was to reduce trade restrictions
and to encourage >free trade on a multilateral basis. The negotiations sought
to obtain agreements in the following main subject areas: (a) the reduction in
trade-distorting agricultural subsidies; (b) the reduction of restrictions on >imports
of tropical produce; (c) the reduction of > tariffs on industrial goods; (d) the
reduction of restrictions on Moreign investment; (e) the review of the rules gov¬
erning the origin of imports (>certificate of origin); (f) a review of the rules governing
the application of anti-dumping measures; (g) the reduction of restraints on trade
in services, e.g. banking, insurance, transport, tourism and telecommunications
(^►invisibles); (h) the international protection of intellectual property rights, e.g.
patents, trade marks, copyright, and (i) the review of the >Multi-Fibre Arrangement
(MFA). The negotiations were concluded and agreement signed in r994. Industrial
tariffs in >developed countries were to be reduced from an average of 6.3 to 3.9 per
cent and the proportion of imports free of tariffs was to be increased from 20 to 43
per cent. All tariffs were to be 'bound', i.e. never raised. The MFA was to be phased
out. For the first time, services were to be, in principle, subject to the same multilateral
trading rules as industrial products. However, agreement could not be reached on
telecommunications, financial services and shipping. Under the GATT, agriculture
had been excluded from many provisions that applied to other products, e.g. those
relating to export subsidies and import quotas. The Uruguay Agreement brought
agriculture into the multilateral system of trading rules. ►Non-tariff barriers were
converted into tariffs and these tariffs were to be reduced by 36 per cent over a 6-year
period. Countries could not impose quotas, minimum import prices, restrictive
licences, or variable levies on imports. Constraints were placed on subsidies that
distort trade which will become more stringent over time. Agricultural export sub¬
sidies were to be reduced (>Common Agricultural Policy; farm subsidies). The
► World Trade Organization was set up to replace GATT. >Doha Round of Trade
Negotiations.

USM >unlisted securities market.

utilitarianism The philosophy by which the purpose of government was the

maximization of the sum of f utility, defined in terms of pleasure and pain, in the
community as a whole. It was not hedonistic (>hedonism) in so far as pleasure
 utility function

could include, for example, the satisfaction of helping others. The purpose of govern¬
ment was to ensure the 'greatest happiness of the greatest number'. It implied that
utility could be measured and interpersonal comparisons made. Its chief advocate
was >Bentham.

utility The pleasure or satisfaction derived by an individual from being in a

particular situation or from consuming goods or services. Utility is defined as the
ultimate goal of all economic activity, but it is not a label for any particular set of
pursuits, e.g. sensual pleasure or the acquisition and use of material goods. >Ben-
tham described it as that which appears 'to augment or diminish the happiness of
the party whose interest is in question', but this barely illuminates the issue, given
that the notion of happiness used is a complex one. Some things that appear to
make people unhappy, like sad films, can generate utility while other things appear
to make people happy but do not. As no single measure of utility exists (►ordinal
utility), it is by their choices of combinations of available commodities that con¬
sumers reveal what it is that generates utility for them. Economists ignore possible
circularities in the concept and rarely argue about what consumers enjoy, taking it
as a matter of psychological fact, ^endogenous preferences; Hicks, J. R.; indiffer¬
ence-curve analysis; marginal utility, diminishing; von Neumann-Morgenstern util¬
ity function; Parento, V. F. D.; Slutsky, E.

utility function >-von Neumann-Morgenstern utility function.

V

value The worth of something to its owner. Two concepts of value have been
distinguished in economics: (a) value in use: the pleasure a commodity actually
generates for its owner, and (b) value in exchange: the quantity of other commodities
(or, more usually, ►money) a commodity can be swapped for. Water, for example,
has high value in use, but low value in exchange, ^paradox of value; value,
theories of.

value, theories of Explanations of what determines the ►value of different

commodities. The different approaches have tended to distinguish two notions of
value: (a) that determined by the futility it gives a consumer and reflected in the
►demand for it (high utility, high value (>Galiani, F.)), or (b) the cost of producing
the commodity reflected by the >supply of it (high cost, high value).
The >013551031 economists held that, in the long term, price and, hence, the
exchange value of an item, is determined by its costs of production (supply), but
that it is the fact that a demand exists for it that determines whether an item has
any value at all. > Ricardo developed a Mabour theory of value, asserting that value
derives from the effort of production, again based on supply. The novelty of his
approach was in showing that all costs of production reduce to labour costs, either
paid directly or stored in the form of capital. However, there is a need to reward
those who store labour, and thus defer consumption, and this undermined his
theory. Late nineteenth-century economists like ► Marshall subverted theories of
value to theories of price, determined by demand and supply, with each determined
by ►marginal utility or >marginal cost. Since then, the theories of price and value
have not been separated except by followers of >Marx. »Gossen, H. H.; Jevons,
W. S.; Walras, M. E. L.

value accounting Mnflation accounting.

value added, or net output The difference between total revenue of a firm, and
the cost of bought-in materials, services and components. It thus measures the
►value the firm has 'added' to these bought-in materials and components by its
processes of production. Since the total revenue of the firm will be divided among
►capital charges (including ►depreciation) - ►rent, ^dividend payments, wages
and the costs of materials, services and components - value added can also be
calculated by summing the relevant types of cost and subtracting that total from
total revenue. Although 'value added' and ‘net output' are often used synonymously,
net output in the census of production (►production, census of) is calculated by
subtracting the value of materials purchased (allowing for stock changes) from the
397 |
value added tax

value of each industry's sales. Payments for services rendered by other firms (e.g.
►research and development work and hire of machinery), are not deducted, so that
in this technical sense, 'net output' is distinguished from 'value added', a term
used to describe the contribution of an industry to the ►gross domestic product.
^ value-added tax.

value added tax (VAT) A general tax (►taxation) applied at each point of ►exch¬
ange of goods or ►services from primary production to final consumption. It is
levied on the difference between the sale price of the goods or services (outputs) to
which the tax is applied, and the cost of goods and services (>inputs) bought in for
use in its production. The cost of these inputs is taken to include all charges,
including all taxes except VAT itself. The method of payment and collection in the
UK is as follows. Each registered trader sells his/her outputs at a price increased by
the appropriate percentage of VAT. He/she is then liable to HM Customs and Excise
for the payment of the tax so obtained from customers, but can claim a refund of
any VAT included in the invoices for the inputs purchased from suppliers. His/her
customers do likewise, and so on down to the final consumer. At each point of
exchange the tax is passed on in the form of higher prices. Being at the last point in
the chain of exchange, the final consumer bears the whole tax. The traders within
the chain, of which there are r.7 million in the UK, act as collecting agencies,
although they may lose out from the existence of the tax (>tax incidence). Traders
with a turnover of taxable supplies of less than £55,000 need not register (2002/03).
Value-added tax was introduced in the UK in 3973 because it is the form of
►indirect taxation applied in the ►European Union (EU) and is the basis of contri¬
bution to the Community budget. It replaced existing indirect taxes, e.g. purchase
tax and selective employment tax. Basic foodstuffs, housing, books, most financial
services, education, health and ► exports are excluded from the tax. Value-added
tax may be applied to different goods or services or in different industries at different
rates, including zero and exempt. The difference between the latter two is that only
with the former can refunds be claimed. Value-added tax is the largest single source
of government current revenue after Mncome tax, though only slightly more than
►social security contributions. In the UK, the standard rate of tax was 8 per cent
from July 1974 until June 1979, when it was raised to 15 per cent. In April 3991, VAT
was raised to t7.5 per cent, and there is now also a reduced rate of 5 per cent. Some
other countries have several rates including a low rate for basic necessities and a
higher rate for 'luxury' goods (^turnover tax). Supplies by a UK trader to a customer
registered elsewhere in the EU are zero-rated and the customer charges VAT at the
country's VAT rate. This is known as the destination principle. The intention is
ultimately to move to the origin principle under which VAT will be charged at the
rate prevailing in the country of supply. This will result in some gain or loss of tax
revenue in the receiving country, depending upon whether its rate is higher or lower
than in the country of origin. Given the political impracticability of completely
harmonizing VAT rates in the medium term, the shift from destination, to origin,
principle has proved controversial and probably some sort of clearing mechanism
to restore the balance of tax revenues would be necessary. Value-added tax is a good
revenue raiser and has been adopted by many countries, notable exceptions being
Switzerland and the USA. Value-added tax does impose heavy ►compliance costs
on ►small businesses, much more than a ►sales tax, which mainly affects retailers.
value judgement 398

Japan does not use the European invoice method for VAT but calculates >value-
added and the tax thereon from company accounts.

value judgement A proposition that cannot be reduced to an arguable statement

of fact but that effectively asserts that something is good or that something ought
to happen. Economists usually attempt to draw a distinction between facts and
value judgements, but the two often merge. For example, the statement: 'We can
control inflation by cutting the money supply', is clearly arguable but not a value
judgement. However, the statement: 'Therefore, we ought to cut the money supply',
may be a value judgement (based on the belief that inflation is an evil per se) or
alternatively could be an economic judgement made on the basis of a belief that
the control of inflation stimulates long-term economic growth. In practice, all
statements of economists can be of two types: (a) descriptive statements, e.g.
unemployment is falling, or (b) prescriptive, e.g. unemployment should be cut. The
former should be devoid of any value judgements. The latter will always be a
combination of value and economic judgement. Usually, but not always, the value
judgements contained in prescriptive statements are either uncontroversial or
explicit enough for the reader to make a clear assessment of them, ^normative
economics; positive economics; Robbins, L.

variable A number that may take different values in different situations. For
example, quantity of a good demanded will vary according to its price, ^dependent
variable.

variable costs Costs that vary directly with the rate of output, e.g. > labour costs,
raw-material costs, fuel and power. Also known as operating costs, prime costs, on costs
or direct costs.

variance A measure of the degree of dispersion of a series of numbers around their

mean (>average). The larger the variance, the greater the spread of the series around
its mean. The formula is as follows:

1 N
variance = -X (x, -x)2

where x is the mean (^average), x, is the value of the ith item and N is the number
of items in the series. For example, consider the two series: (a) 8, ro, 12, and (b) 2,10,
18. The mean of both (a) and (b) is ro. The variance of (a) is [(-2)2 + (2)2]/3 = 2.67. The
variance of (b) is [(—8)2 + (S)2]^ = 42.67. The variance of (b) is greater than (a),
reflecting the wider spread of the (b) series, ^standard deviation.
VAT value-added tax.

Veblen, Thorstein Bunde (1857-1929) >conspicuous consumption; institutional

economics.

vector A set of numbers (elements) arranged as a row or a column. For example, [1,
5, 8] is a row vector, and [5] is a column vector. A vector of n elements is referred to
as n-dimensional. The above vectors, therefore, are three-dimensional. The null vector
has all its elements equal to zero. A unit vector is a vector with one element equal to
unity and the rest all equal to zero. There are, therefore, n unit vectors possible for
an n-dimensional vector. There is an algebra for vectors, with appropriate rules for
addition and multiplication. >► matrix.
 vertical restraints

velocity of circulation The speed with which the money in an economy circu¬
lates. Each £10 note that exists is used many times, and each time it is used a
transaction of value £10 occurs. It is possible to imagine two economies, one with
twice as much money in it as the other, but where on average the money is used
half the number of times. The total value of all transactions in each economy would
be the same because it equals the value of the stock of money multiplied by the
velocity with which it circulates. The income velocity equals the money value of
^national income divided by the stock of money in the economy.
The velocity of circulation is related to the demand for money (»• money, demand
for): if people hold cash, it circulates slowly. If, on the other hand, they do not wish
to hold cash, they dispose of money holdings and the circulation of money increases.
The velocity of money is central to the debate between ^monetarism and 3*-Keyne-
sian economics. Monetarists hold that >interest rates do not much affect the
demand for money or its velocity. They claim that institutional factors (e.g. the
frequency with which people are paid or the number of people who have bank
accounts) affect it and these factors are unlikely to change in the short term.
Keynesians, on the other hand, believe that the velocity of money varies substantially
with the interest rate. Under both doctrines, however, a higher than expected
^inflation rate would increase the velocity. This is seen in an extreme form in an
economy enduring > hyperinflation, in which anyone holding money is holding a
depreciating asset; everybody attempts to rid themselves of cash and acquire goods,
the values of which are stable, ^deflation; ^neutrality of money.

venture capital >risk capital.

venture capital trust (VCT) Qualifying ^investment trusts holding at least 70

per cent of their investments in unlisted companies (>unlisted securities market(s)).
Individual investors receive >income tax relief at 20 per cent when new >ordinary
shares in the VCTs are subscribed for up to a limit of £roo,ooo in the amount
subscribed, provided the shares are held for not less than 3 years. Venture capital
trusts are exempt from tax on their >-capital gains, as are shareholders on disposal
of their shares in the VCT.

vertical integration The extent to which successive stages in production and

distribution are placed under the control of a single ^enterprise. Oil companies that
own oilfields, tankers, refineries and filling stations exhibit a high degree of vertical
integration. Firms move to integrate, either forward toward retailing or backward
toward sources of raw materials, in order to eliminate the profit margins of intermedi¬
aries or to secure sources of supply or markets.

vertical restraints Restrictions or conditions imposed on the seller or buyer of

an item. Common restraints are >-resale price maintenance and > tie-in sales. They
are usually either: (a) structured to extend a »-natural monopoly in one market to a
more competitive market, e.g. when national telephone operators demand that
customers obtain their telephone handset from them, or (b) designed to affect the
retail conditions in which a product is sold, e.g. when perfume makers refuse to
supply down-market stores with their produce. Competition authorities have been
concerned to limit the application of these restrictions, although it has been argued
more recently that in most cases vertical restraints are as much against the producer's
vicious circle of poverty

interest as the public interest where they are against the public interest at all.
►►Chicago School; competition policy.

vicious circle of poverty ►economic development.

Vickrey, William (1914-96) A Canadian-born economist, who was based at Col¬

umbia University in New York, Vickrey was a joint winner of the ►Nobel Prize just
days before his death. His most enduring legacy will be the design of auction named
after him (>auction). It was just one example of his interest in designing economic
mechanisms for overcoming the problems associated with ►asymmetric infor¬
mation (in that case, the fact that the seller of an item does not know the true value
placed on it by potential buyers). The main design feature of his auction was the fact
that it gave potential buyers the incentive to tell the truth about how much they
value the item being sold. Other economists have designed similar mechanisms for
other contexts, ^incentive compatibility.

Viner, Jacob (1892-1970) ^customs union.

visible balance The ►balance of payments in >visible trade (>imports and

►exports of merchandise).

visible trade Mnternational trade in merchandise, >imports and ►exports,

►►invisible.

von Neumann-Morgenstern utility function A representation of a consumer's

preferences that maps outcomes of the world, and the ►utility the consumer enjoys.
The approach pioneered by von Neumann and Morgenstern in 1947 imposed various
assumptions to the ►utility function, to derive some appealing results. In particular,
the von Neumann-Morgenstern approach is applied to consumer choice under
uncertainty. For example, it allows us to predict which of two lottery tickets a
particular consumer would prefer, without the consumer having to make a specific
choice between them. Suppose lottery r offers a prize of £rooo but a potential loss of
£rooo (each with a 50 per cent chance) and that lottery 2 offers a £roo win or £100
loss. (Note that each lottery has the same average outcome - no gain and no loss.)
Under the von Neumann-Morgenstern approach, we can answer which lottery is
preferred. The first ticket yields expected utility E{UJ,

E(U\) = 50 per cent x U{£ 1000) + 50 per cent x [/(-£ 1000)

where U(x) is the utility function that maps £x to the consumer's overall welfare.
Similarly,

E(UZ) = 50 per cent x U(£ 100) + 50 per cent x U(-£ioo)

Note that £([/,) is not equal to U(50 per cent x £1000 + 50 per cent x -£1000)
(►expected utility). Lottery 1 is preferred if EiUJ is greater than E(U2). The key
advantage of this approach is that it allows us to work out which uncertain outcome
is preferred from a utility function that has no uncertainty built into it at all. In
practice, of course, it is not particularly realistic at describing human choice under
uncertainty (►behavioural economics).

voting shares ►Equity shares entitling holders to vote in the election of directors
of a company. Normally all ► ordinary shares are voting shares, but sometimes a
company may create a class of non-voting ordinary shares if the holders of the
 voting shares

equity wish to raise more equity capital but exclude the possibility of losing control
of the business, ^preference shares are rarely, and >debenture shares never, voting
shares.
w
wage drift The difference between wage rates set by national agreements and the
total earnings received by workers, which includes overtime pay, special bonuses
and commissions. If wage negotiations take place between union leaders and man¬
agement bodies at a national level, whatever the outcome of those negotiations in
certain areas of the country, the wage agreed may not be high enough to attract all
the workers demanded. In this case, local employers will attempt to entice workers
with side payments that do not directly infringe national agreements. If wage drift
could lead to cuts in pay as well as increases, it would be a more economically
efficient means of introducing pay flexibility. As it happens, though, wage drift has
the consequence of making a nationally agreed pay rate the bare minimum anyone
receives, with 'top ups' the norm, ^bargaining theory of wages.

wage-fund theory The idea that >Smith took over from the > Physiocrats, i.e.
that wages are advanced to workers in anticipation of the sale of their output. Wages
could not be increased unless the >capital destined to pay them was increased.
Capital, in turn, was determined by >savings. The >Classical School developed its
theory of wages around these ideas. In the short mn, there was a given number of
workers and a given amount of savings to pay their wages. The two together deter¬
mined the average wage. In the long mn, the supply of ^-labour was related to the
minimum of subsistence needed to sustain the Mabour force. (This subsistence level
was not simply physiological; it was related to a ^standard of living accepted by
custom.) If the wage rate rose above this, the >population increased; if it fell below
it, it contracted. In the long run, the level of the demand for labour was determined
by the size of the wage fund, and this, in turn, by the level of savings. This meant
that, as >Mill put it, 'the demand for ^commodities is not the demand for labour'.
If you increased ^consumption you reduced savings and therefore the wage fund.
>Productivity did not influence >real wages - what mattered was the level of
►profits, for savings depended on profits. The argument assumed that savings flowed
into fixed capital and variable (wage) capital in equal proportions so that what
>Marx called the 'organic composition of capital' remained constant. >Ricardo
worried about this point in his analysis of the effect of machinery on employment.
Investment bypassed the wage fund and the demand for labour was reduced. Thorn¬
ton criticized the wage-fund doctrine on the ground that wages were determined by
^supply and ►demand in the market. Mill accepted some of Thornton’s points and
admitted that the wage-fund theory might be more appropriate in the context of
a discontinuous production process (akin to seed-time to harvest) rather than a
continuous flow of output, which was the true state of affairs. There was some
 wealth

popular confusion at the time, because it was thought the economists meant there
existed a definite fund available for wages so that there was no hope of workers
obtaining higher average earnings.

wage rates learnings.

Wall Street (US) >New York Stock Exchange.

Walras, Marie Esprit Leon (1834-1910) A mining engineer by training, Walras

accepted the offer of a newly created Chair of Economics in the Faculty of Law at
Lausanne University in 1870. He held this post until he was succeeded by >Pareto
upon his retirement in 1892. His publications include Elements d'economie politique
pure (1874-7), Etudes d'economie sociale (1896) and Etudes d'economie politique appliquee
(1898). One of the three economists to propound a >marginal utility theory in the
1870s, he set out the theory of diminishing marginal utility and showed how ^prices
at which ^commodities exchanged are determined by the relative marginal utilities
of the people taking partin the transaction (>»>-Gossen, H. H.;Jevons, W. S.; Menger,
C.). He also constructed a mathematical ►model of »-general equilibrium as a system
of simultaneous equations in which he tried to show that all prices and quantities
are uniquely determined. This is regarded as one of the foremost achievements in
mathematical economics, of which Walras is considered the founder. Arrow, K.J.;
tatonnement process.

warranted rate of growth >growth theory; Harrod-Domar model.

warrants »-Securities giving the holder a right to subscribe to a >share or a >bond

at a given price and from a certain date. Warrants, which are commonly issued 'free'
alongside the shares of new investment trusts when launched, and carry no income
or other rights to >-equity, immediately trade separately on the >stock exchange,
but at a price lower than the associated share or bond. This provides the investor in
warrants with an element of > gearing since, if the associated share or bond price
ultimately rises above the subscription price it will have a value corresponding to
the difference between the subscription price at which the warrant rights may be
exercised and the market price of the share or bond. Similar to an ►option.

wasting assets >Assets with strictly limited, though not necessarily determinate,
lives, e.g. a mine, timber lands or a property on lease. Wasting assets have many of
the characteristics of >► current assets, but they are normally included under fixed
assets.

watering, stock The issue of the nominal capital of a company in return for less
than its money value, thus overstating the capital of the company and reducing its
apparent return on capital (>rate of return).

wealth A stock of assets held by any economic unit that yields, or has the potential
for yielding, income in some form. Wealth can take a multitude of forms, e.g. cash,
bank deposits, loans or shares are all financial assets. Diamonds, factories and houses
are examples of physical assets. To these should be added human wealth, which
consists of the earnings potential of individuals (> human capital). These forms of
wealth can be divided into those that constitute a liability to another economic
agent (e.g. loans) and those that do not, e.g. physical assets. For the community as
a whole, it is only really the latter that constitute net wealth, just as in a family, if a
weighted average

brother owes his sister £roo, it comprises part of the sister's wealth but not that of
the family as a whole. ^Ricardian equivalence.
In perfect markets, assets should be priced at the >present value of the future
income they are expected to earn. However, the notion of income is general and
would include, for example, the pleasure the owners of a picture would derive from
its display (^income). The bulk of most individuals' wealth is held in the form of a
house or accumulated assets invested in a pension fund, ► personal pension.

weighted average An >average in which each item in the series being averaged
is multiplied by a 'weight' relevant to its importance, the result summed and the
total divided by the sum of the weights. For example, suppose the price of meat has
risen by ro per cent and of vegetables by 20 per cent, the average rise is 15 per cent,
being the arithmetic mean of 10 and 20. This could be misleading if we were
considering the effect of the price increases on a particular household. The above
mean assumes that the household regards meat and vegetables as equally important.
If, however, the household spends £10 on vegetables for every £25 on meat, a more
accurate representation of the average price change would be a weighted average,
i.e. [(ro per cent x 25) + (20 per cent x ro)]/(25 + 10) = 450/35 = 12.9 per cent. In the
example the weights are 25 (for meat) and 10 (for vegetables), so that the result is
more in keeping with the importance the household attaches to meat in its budget.
At the extreme, if no vegetables were bought at all, the 'vegetable' weight would be
zero. »■ index number.

weightlessness The term used to describe the decreasing material component in

the value of world output. The decline of heavy industry (>de-industrialization)
and the relative growth of the services industries in richer countries (^economic
growth, theories of) account for the decline in physical lvalue added. In particular,
it is argued, more value derives from 'knowledge-based' industries. The software for
a computer game is the more important component of its value, and the resources
for writing the software are those that are most scarce, as opposed to those deployed
in the manufacture of the consol on which the game is played. One important
consequence of weightlessness is the potential for activity and value to flow across
national boundaries without incurring a burden of transport costs; another is the
tendency for workers whose main attribute in the > labour market is physical
strength, to suffer a relative decline in attainable income. »-globalization.

weights >weighted average.

welfare economics The study of the social desirability of alternative arrangements

of economic activities and allocations of ►resources. It is, in effect, the analysis of
the optimal behaviour of individual consumers at the level of society as a whole.
Just as, at the level of the individual, there is a need for a subj ective ranking of bundles
of goods dependent on the consumer's taste (!►► indifference-curve analysis), at
the level of a society there is a need for a ranking of economic states, and this will
usually rely on subjective or >normative criteria - judgements of taste about how
society should look. Carrying the methods of indifference analysis from individuals
to groups of individuals is not straightforward, however (^social-welfare function)
and thus welfare economics is a broader subject than the theory of demand (►dem¬
and, theory of).
The study of welfare economics consists of the following: (a) the determination
 Wicksell, Knut

of efficient states in which no individual can be made better off without an offsetting
loss to another individual (►economic efficiency); (b) the choice between the many
efficient states that can exist, either through a decision imposed by a dictator,
or through democratically determined decisions (►►impossibility theorem; social
welfare; social-welfare function), and (c) coverage of a number of other smaller
topics, e.g. the optimal provision of >public goods, >extemalities, and the theory
of the second best (►second best, theory of). All these topics share the common aim
of helping to show when it is desirable to move from one economic state to another,
►►compensation principle; cost-benefit analysis; Pigou, A. C.; Sen, A.

welfare to work ►►active labour-market policies.

wholesale banking The making of loans or acceptance of deposits on a large scale

between banks and other financial institutions, especially in the ►interbank market.
As distinct from retail banking, a term for the business of the ►commercial banks
carried out with customers of their branches, ►►overseas banks.

wholesale markets Generally a ►market in which goods or services are bought

and sold on a large scale among professionals. The financial wholesale markets ('the
financial markets') include the >money market, the ►foreign-exchange market and
the ►stock exchange.

wholesale trade Enterprises in the distributive trades which in principle sell to

other businesses. Wholesalers act as middlemen between retailers (►retail trade)
and manufacturers and other suppliers. Wholesalers perform important economic
functions by buying in bulk on advantageous terms and selling-on in smaller quanti¬
ties. They handle imports and exports, may offer credit, and are particularly impor¬
tant sources of supply for small retailers, who can buy many lines from one source
and more cheaply than they could buy direct. There are well over 100,000 wholesalers
in the UK - almost one for every retailing enterprise. Despite the increasing share of
multiple retailers - which tend to buy direct from manufacturers - the number of
wholesalers shows no tendency to decline.

Wicksell, Knut (1851-1926) Educated at Uppsala University in Sweden, where

he studied mathematics and philosophy, Wicksell was appointed to the Chair of
Economics at Lund University in 1904, a post he held until 1916. His major publi¬
cations include Uber Wert, Kapital undRente (1893) and Geldzins und Giiterpreise (1898).
A synthesis of his work was published in 1901 and 1906 with the English title of
Lectures on Political Economy. He assimilated the ►general equilibrium analysis of
►Walras with the work of ►Bohm-Bawerk and worked out a theory of ►distribution
based on the new ►marginal analysis of ►Jevons, Walras and >Menger. In addition,
he had a significant influence on monetary theory. He pointed out that high ►rates
of interest often coincided with high prices, which was contrary to what current
theory predicted. He drew attention to the significance of the relative level of interest
rates rather than their absolute level. Prices were related to the difference between
changes in the real or natural rate of ►interest (which was determined by the
expected rate of >profits) and the money rate. The >central bank had an important
influence over the price level through its operations on the discount rate (>bank
rate). These theories were incorporated into his theory of the >business cycle.
►► interest, natural rate of; Wicksell effect, price.
Wicksell effect, price

Wickseil effect, price A phenomenon noted by ►Wicksell in discussing the

derivation of ► factor prices from the value of ►marginal products. He pointed out
that in equilibrium the rate of interest would be greater than the value of the
marginal product of capital. This is because the whole of the existing stock of capital
is revalued when rates of interest change (►capital re-switching).

Wieser, Friedrich von (1851-1926) Wieser succeeded ►Menger in the Chair of

Economics at Vienna University in 1903 after a period at Prague University. His most
important works include Liber den Ursprung und die Hauptgesetze des Wirtschaftlichen
Wertes (1884), Der naturliche Wert (1889) and Theorie der gesellschaftlichen Wirtschaft
(1914). He developed a law of costs which became known later as the principle of
Opportunity cost - ^factors of production would be distributed by competition
such that, in ►equilibrium, the value of their marginal outputs would be equal. The
costs of production of any ►commodity reflect the competing claims in other uses
for the services of the factors needed to produce it. The law became an important
element in the theory of >resource allocation (^-economic efficiency).

Williamson, Oliver ►transaction costs.

windfall tax Specifically, a once-and-for-all direct tax (►direct taxation) on privat¬

ized (►privatization) utility companies imposed by the UK government in 1997.
Generally, any tax imposed on persons or organizations deemed to have benefited
from external events outside the normal course of their economic activities. The
justification is generally made on the ground that the taxpayers have benefited
unfairly from gains that are due to society as a whole. There are precedents: the US
government, for example, imposed a special tax on oil companies following the
sudden increase in oil prices by the >Organization of Petroleum Exporting Countries
in the r970s, and in r98i, the UK government imposed a special levy on bank deposits,
partly on the ground that the banks were largely exempt from ►valued-added
tax. Increases in land prices following the grant of planning permission have also
been taxed.
Windfall taxes are highly controversial. It is usually difficult to design taxes that
will extract from the ultimate beneficiaries revenue proportionate to the gains made.
This is both because of the usual problem of establishing incidence (►taxation,
incidence of) and for other reasons: in the case of the UK windfall tax, for example!
many beneficiaries would have sold their shares in utilities before plans for the tax
were announced. A theoretical justification for windfall taxes is that they are unlikely
to distort behaviour or resource allocation because they are once and for all (►life-
cycle hypothesis). They may also be argued to promote 'social justice' in a rough-and-
ready way, even though they breach the convention that taxes should not be
imposed retrospectively (►Smith, A.).

winding up ►liquidation.

window dressing Financial adjustments made solely for the purpose of account¬
ing presentation, normally at the time of auditing of company accounts, e.g. the
sale of ►securities so as to show large holdings of cash at the ►balance sheet date,
only to repurchase them immediately afterwards.

withholding tax ►Taxation deducted from payments to non-residents. With¬

holding taxes are usually in the form of a standard rate of ► income tax applied to
 writing-down allowance

> dividends or other payments by companies and are often reclaimable against tax
liabilities in the country of residence of the recipient under a double-taxation
agreement.

workers' participation industrial democracy.

workfare Programmes that make the receipt of unemployment-related benefits

conditional upon participation in some local work scheme. Workfare, an example
of an >active labour-market policy, can reduce >long-term unemployment. This is
partly because participation in any kind of work, has been shown to improve
labour-market prospects of the unemployed (countering >hysteresis), and also
because it encourages benefit claimants who have viable options to work to take
them. The relative weight of the 'carrot-and-stick' elements can be tailored scheme
by scheme.

working capital That part of current ^-assets financed from long-term funds,
^current ratio.

Working Families Tax Credit >income tax.

World Bank Group ^International Bank for Reconstruction and Development;

International Development Association; International Finance Corporation; Multi¬
lateral Investment Guarantee Agency.

World Trade Organization The World Trade Organization (WTO) was set up in
Geneva in r995 following the conclusion of the ^Uruguay round of trade negoti¬
ations. It replaced the >-GeneraI Agreement on Tariffs and Trade (GATT). The WTO
is charged with further development of, and policing of, the multilateral trading
system along the principles followed by the eight rounds of trade negotiations
concluded under the GATT. It provides the resources and the legal status for the
resolution of trade disputes through independent disputes panels. A member may
appeal to the WTO Appeals Tribunal but must accept its ruling. The failure of a
member country to accept the WTO ruling would subject it to trade sanctions. The
WTO is financed by contributions from its member states based on their shares of
international trade. In 2002, the total budget was SFr 143 million and there were 144
members >-Doha Round of Trade Negotiations.

writing-down allowance >-capital allowances.

X

X-efficiency The effectiveness of a firm's management in minimizing the cost of

producing a given output or maximizing the output produced by a given set of
inputs. There is often a discrepancy between the efficient behaviour of firms as
implied by economic theory, and their observed behaviour in practice. This is
frequently a result of a lack of the competitive pressures assumed. It was called
X-efficiency by Liebenstein in 1966. >firm, theory of the.
 Y

yardstick competition A device used in the ►regulation of an industry, domi¬

nated by a number of regional >monopoly producers. Although the companies do
not compete with each other directly, the regulator can use the performance of all
the local monopolies as a benchmark for judging each of them. For example, in
deciding what level of costs is a reasonable level to be reflected in the price (>► price
regulation), a regulator can take the average cost of the companies. Those who can
achieve lower costs would then be able to make larger profits than the others. This
gives the companies an incentive to cut costs while allowing the regulator a firm
basis for deciding what can reasonably be expected of a producer, ^ tournament
theory.

yield The >income from a ►security as a proportion of its current market price.
Thus, the dividend yield is the current »- dividend as a percentage of the market price
of a security. The earnings yield is a theoretical figure, based on the last dividend paid
as a percentage of the current market price. The redemption yield is normally applied
only to fixed-interest securities, and is the interest payment over the remaining life
of the security, plus or minus the difference between the purchase price and the
redemption value, i.e. it is the earnings yield adjusted to take account of any >-capital
gain or loss to redemption. With fixed-interest securities, the nominal interest, or
►coupon, is unlikely to be the same as the actual yield. An >irredeemable security
in the form of a government bond having a flat yield of 3 per cent with a > par value
of £roo but a market price of £50 provides an earnings yield of 6 per cent. The
earnings yield will fluctuate with the price of the security, rising as security prices
fall, and vice versa. >► gilt-edged securities.

yield curve A graphical representation of the relationship between the annual

return on an asset and the number of years the asset has to run before expiring.
Longer-term assets usually offer some premium over short-term ones and yield
curves thus typically slope upwards. This effect is more pronounced if short-term
interest rates are expected to rise. >^term structure of interest rates.

yield gap The >yield on ►ordinary shares minus the yield on ►gilt-edged securi¬
ties, e.g. 2% per cent irredeemable ►consols. If the latter exceeds the former, it is
called the reverse yield gap.
z

zero-sum game A game (>game theory) in which one player's gain is equal to
other players' losses, whatever strategy is chosen. The players can only compete for
slices of a fixed cake; there are no opportunities of overall gain through collusion.
The sum of gains will always equal the sum of losses, the whole summing to zero,
^bilateral monopoly.
 THE PENGUIN DICTIONARY
OF ECONOMICS

Whether you want to follow the economic discussions in the

media today, or study economics or need some knowledge
of it at work (in business, finance or the public sector), this
wide-ranging and accessible dictionary will prove invaluable.
It explains a host of economic terms, from acceleration
principle to X-efUciency, globalization to venture capital,
and from Euro to zero-sum game. Revised and updated for
its seventh edition. The Penguin Dictionary of Economics is
detailed, practical and international in scope. Its entries
include:

• General economic terms

• Economic theory, including coverage of development

economics, industrial organization, finance and game theory,
as well as international monetary and welfare economics

• Coverage of applied economics and major financial institutions

• History of economics

• Entries on individual economists who have made a definable

contribution to contemporary economic thought

SEVENTH EDITION
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