Economics

Theories

•Invisible Hand Theory

            Economically speaking, nations can be roughly classified based on the economic systems they have. Regardless of political preferences, prices in an economy may be set by the government (which would denote a planned economy) or perhaps by custom (which would denote a traditional economy). However, in a third system, prices may not be set at all, but may "float" based on the wills of supply and demand. This economic system, the market economy is that espoused (roughly) by America (but, these days, it's espoused - to some extent - by nearly all nations). Invisible Hand Theory, proposed by Adam Smith in the 18th century, helps to explain how the market economy that we all know and love works, even with its chaotic nature.

            Mr. Smith reasoned that a market economy's resources were guided metaphorically by an "Invisible Hand." This wasn't the hand of God or some other deity, but simply represented pricing through competition. So, for example, a person might look at the competitive environment, see that he had an advantage in selling clothes, and therefore would enter some kind of industry related to clothes. Instead of the government (for example, a mandated quota) or custom (for example, a hereditary trade) dictating the best use of his resources, the individual would direct his resources based on competitive sense of supply and demand.

As with any economic system, Smith's Invisible Hand Theory and market economy attempts to answer three basic questions: what should be produced? For whom should things be produced? and how will things be produced? The Invisible Hand of competition proposed that these questions could best be answered by looking at the 'advantages' that different people and different resources have. The first kind of advantage that Smith formulated was the "absolute advantage" - simply, the person who can produce an item with the least cost has the absolute advantage, and therefore should produce in the industry and drive other less efficient people out of the market. So, if one person could make a pair of shoes for $3.00, and another person could make it for $.50 cents, then obviously, the person who could make the shoes for less would have a dramatic advantage, could make more shoes or reap greater profits.

According to Smith, nations or individuals would have few absolute advantages, and the market would always balance it. So, the shoemaker (who was good at making shoes) would make shoes for the benefit of the breadmaker (who was good at making bread, but not so good at shoes), and this would be more efficient than either making their own bread and shoes. If consumers didn't want shoes, for example, they would demand less shoes, and so the shoemaker might naturally have to redirect his efforts.

The first inaccuracy in his argument came with the fact that all nations are NOT equal - in our modern world, China and India have absolute advantages over any other nation in labor-intensive production, because they have the largest populations. However, it would not be economically sound for China and India simply to produce everything that requires manual labor. Imagine, for example, if the breadmaker was simply quicker and better at both baking bread and cobbling shoes. It wouldn't make sense for him to do all the work and the slower shoemaker to do nothing. So Adam Smith's absolute advantage theory was modified with the idea of comparative advantage, which compared two or more production rates. With this, resources were determined to be best spent based on comparisons: how many shoes the shoemaker could make in terms of loaves of bread he didn't make (or vice versa for the breadmaker: how many loaves of bread baked in cost of the shoes he didn't make. The benefit with comparative advantage was that, although one nation or individual could have absolute advantages in both bread production and shoe production, they would only have one comparative advantage.

The second inaccuracy in the invisible hand argument was that this hand would correct errors. However, without government restrictions, great abuses occurred unchecked. The free market, for example, couldn't say anything about worker safety rights, which were a cost to corporations (and thus a cut in profit margins). Additionally, the free market compounded failures (such as the Great Depression or even our recent housing crisis). So now, even in economic systems that are roughty market systems, the invisible hand is not left unchecked. Rather, the market economy is tempered with some government planning in order to curb excesses and deficiencies.

•Population Theory

            Thomas Robert Malthus was a British economist and demographer, whose famous Theory of Population highlighted the potential dangers of overpopulation. In his famous An Essay on the Principles of Population, Malthus stated that while 'the populations of the world would increase in geometric proportions the food resources available for them would increase only in arithmetic proportions'. In simple words, if human population was allowed to increase in an uncontrolled way, then the number of people would increase at a faster rate than the food supply. A point would come when human population would reach the limit up to which food sources could support it. Any further increase would lead to population crash caused by natural phenomena like famine or disease.

Malthus put forth his ideas in in six editions of his famous treatise 'An Essay on the Principle of Population'. His thinking took shape under the influence of the optimistic ideas of his father and his friends mainly Rousseau, about future improvement of the society. In the first edition of his treatise, Malthus put forth his views that opposed the belief of scholars like Marquis de Condorcet and William Godwin who were optimistic about population growth in England. During the Industrial Revolution, England experienced a steep increase in its population. In his book The Enquirer, William Godwin promoted population growth as a means for human beings to attain equality. According to him, an increased population would create more wealth that would provide food for the whole humanity. Scholars of such school of thought believed that, both man and society could be made perfect. In contrast to this viewpoint, Malthus interpreted overpopulation as an evil that would reduce the amount of food available per person.

Malthus' theory was based on the assumption that the power of population is much greater than the power of the earth to provide subsistence for man. In his own words 'passion between the sexes is an inevitable phenomenon' hence, when unchecked, population would grow at such a high rate that it would outstrip food supply. According to Malthus, disease, food shortage and death due to starvation, were nature's way to control population. He proposed that human beings adopt measures like infanticide, abortion, delay in marriage and strict following of celibacy to check population growth.

According to him, human society could never be perfected. He believed that man is a lazy animal, who would lead a satisfied life and procreate as long as his family was well fed. However, as soon as human population would feel constraints in food supply due to increase in population, he would again work hard to provide enough for his family. This might lead to an increase in agricultural production to provide for all, but at the same time man would be back to his complacent stage, where all his needs would be fulfilled. This would start the cycle of overpopulation and food shortage, all over again. Having been a clergy, Malthus validated his theory on moral grounds that suffering was a way of making human beings realize the virtues of hard work and moral behavior. Such kind of suffering due to overpopulation and food supply was inevitable.

•Theory of Comparative Advantage

            In economics, the law of comparative advantage says that two countries (or other kinds of parties, such as individuals or firms) can both gain from trade if, in the absence of trade, they have different relative costs for producing the same goods. Even if one country is more efficient in the production of all goods (absolute advantage), it can still gain by trading with a less-efficient country, as long as they have different relative efficiencies.

For example, if, using machinery, a worker in one country can produce both shoes and shirts at 6 per hour, and a worker in a country with less machinery can produce either 2 shoes or 4 shirts in an hour, each country can gain from trade because their internal trade-offs between shoes and shirts are different. The less-efficient country has a comparative advantage in shirts, so it finds it more efficient to produce shirts and trade them to the more-efficient country for shoes. Without trade, its cost per shoe was 2 shirts; by trading, its cost per shoe can reduce to as low as 1 shirt depending on how much trade occurs (since the more-efficient country has a 1:1 trade-off). The more-efficient country has a comparative advantage in shoes, so it can gain in efficiency by moving some workers from shirt-production to shoe-production and trading some shoes for shirts. Without trade, its cost to make a shirt was 1 shoe; by trading, its cost per shirt can go as low as 1/2 shoe depending on how much trade occurs.

            Comparative advantage was first described by David Ricardo who explained it in his 1817 book On the Principles of Political Economy and Taxation in an example involving England and Portugal.[4] In Portugal it is possible to produce both wine and cloth with less labor than it would take to produce the same quantities in England. However the relative costs of producing those two goods are different in the two countries. In England it is very hard to produce wine, and only moderately difficult to produce cloth. In Portugal both are easy to produce. Therefore while it is cheaper to produce cloth in Portugal than England, it is cheaper still for Portugal to produce excess wine, and trade that for English cloth. Conversely England benefits from this trade because its cost for producing cloth has not changed but it can now get wine at a lower price, closer to the cost of cloth. The conclusion drawn is that each country can gain by specializing in the good where it has comparative advantage, and trading that good for the other.

•Keynesian Theory

            Is a macroeconomic theory based on the ideas of 20th century English economist John Maynard Keynes.

Keynesian economics argues that private sector decisions sometimes lead to inefficient macroeconomic outcomes and therefore advocates active policy responses by the public sector, including monetary policy actions by the central bank and fiscal policy actions by the government to stabilize output over the business cycle. The theories forming the basis of Keynesian economics were first presented in The General Theory of Employment, Interest and Money, published in 1936; the interpretations of Keynes are contentious, and several schools of thought claim his legacy.

Keynesian economics advocates a mixed economy—predominantly private sector, but with a moderate role of government and public sector—and served as the economic model during the later part of the Great Depression, World War II, and the post-war economic expansion (1945–1973), though it lost some influence following the stagflation of the 1970s.

            According to Keynesian theory, some microeconomic-level actions—if taken collectively by a large proportion of individuals and firms—can lead to inefficient aggregate macroeconomic outcomes, where the economy operates below its potential output and growth rate. Such a situation had previously been referred to by classical economists as a general glut. There was disagreement among classical economists (some of whom believed in Say's Law—that "supply creates its own demand"), on whether a general glut was possible. Keynes contended that a general glut would occur when aggregate demand for goods was insufficient, leading to an economic downturn resulting in losses of potential output due to unnecessarily high unemployment, which results from the defensive (or reactive) decisions of the producers. In such a situation, government policies could be used to increase aggregate demand, thus increasing economic activity and reducing unemployment and deflation. Most Keynesians advocate an activist stabilization policy to reduce the amplitude of the business cycle, which they rank among the most serious of economic problems. This does not necessarily mean fine-tuning, but it does mean what might be called 'coarse-tuning.' For example, when the unemployment rate is very high, a government can use a dose of expansionary monetary policy.

Keynes argued that the solution to the Great Depression was to stimulate the economy ("inducement to invest") through some combination of two approaches: a reduction in interest rates and government investment in infrastructure. Investment by government injects income, which results in more spending in the general economy, which in turn stimulates more production and investment involving still more income and spending and so forth. The initial stimulation starts a cascade of events, whose total increase in economic activity is a multiple of the original investment.

A central conclusion of Keynesian economics is that, in some situations, no strong automatic mechanism moves output and employment towards full employment levels. This conclusion conflicts with economic approaches that assume a strong general tendency towards equilibrium. In the 'neoclassical synthesis', which combines Keynesian macro concepts with a micro foundation, the conditions of general equilibrium allow for price adjustment to eventually achieve this goal. More broadly, Keynes saw his theory as a general theory, in which utilization of resources could be high or low, whereas previous economics focused on the particular case of full utilization.

The new classical macroeconomics movement, which began in the late 1960s and early 1970s, criticized Keynesian theories, while New Keynesian economics has sought to base Keynes' ideas on more rigorous theoretical foundations.

Some interpretations of Keynes have emphasized his stress on the international coordination of Keynesian policies, the need for international economic institutions, and the ways in which economic forces could lead to war or could promote peace.

•Monetary Theory

            A set of ideas about how monetary policy should be conducted within an economy. Monetary theory suggests that different monetary policies can benefit nations depending on their unique set of resources and limitations. It is based on core ideas about how factors like the size of the money supply, price levels and benchmark interest rates affect the economy. Economists and central banking authorities are typically those most involved with creating and executing monetary policy.

            In many developing economies, monetary theory is controlled by the central government, which may also be conducting most of the monetary policy decisions. In the U.S., the Federal Reserve Board sets monetary policy without government intervention. The Federal Reserve operates on a monetary theory that focuses on maintaining stable prices (low inflation), promoting full employment and achieving steady growth in gross domestic product (GDP). The idea is that markets function best when the economy follows a smooth course, with stable prices and adequate access to capital for corporations and individuals.

•Social Responsibility Theory

            Social responsibility is an ethical ideology or theory that an entity, be it an organization or individual, has an obligation to act to benefit society at large. This responsibility can be passive, by avoiding engaging in socially harmful acts, or active, by performing activities that directly advance social goals.

Businesses can use ethical decision making to secure their businesses by making decisions that allow for government agencies to minimize their involvement with the corporation. (Kaliski, 2001) For instance if a company is proactive and follows the United States Environmental Protection Agency‎ (EPA) guidelines for emissions on dangerous pollutants and even goes an extra step to get involved in the community and address those concerns that the public might have; they would be less likely to have the EPA investigate them for environmental concerns. “A significant element of current thinking about privacy, however, stresses "self-regulation" rather than market or government mechanisms for protecting personal information” (Swire , 1997) Most rules and regulations are formed due to public outcry, if there is not outcry there often will be limited regulation.

Critics argue that Corporate social responsibility (CSR) distracts from the fundamental economic role of businesses; others argue that it is nothing more than superficial window-dressing; others argue that it is an attempt to pre-empt the role of governments as a watchdog over powerful multinational corporations though there is no systematic evidence to support these criticisms. A significant number of studies have shown no negative influence on shareholder results from CSR but rather, a slightly positive correlation with improved shareholder returns.

•Theories of Business Cycle

            Business cycle theory are a class of macroeconomic models in which business cycle fluctuations to a large extent can be accounted for by real (in contrast to nominal) shocks. Unlike other leading theories of the business cycle, RBC theory sees recessions and periods of economic growth as the efficient response to exogenous changes in the real economic environment. That is, the level of national output necessarily maximizes expected utility, and government should therefore concentrate on the long-run structural policy changes and not intervene through discretionary fiscal or monetary policy designed to actively smooth out economic short-term fluctuations.

According to RBC theory, business cycles are therefore "real" in that they do not represent a failure of markets to clear but rather reflect the most efficient possible operation of the economy, given the structure of the economy. RBC theory differs in this way from other theories of the business cycle such as Keynesian economics and Monetarism that see recessions as the failure of some market to clear.

•Malthusian Theory

            States that unchecked breeding of men causes population to grow by geometric progression whereas food supply can not grow rapidly or more than in arithmetic ratio.

            Malthus also said that there is a good effect in wars and disasters because it helps lessen population. He proposed positive remedies like birth control, abstinence and late marriage to relieve such problems.

•Keynesian Theory of Employment

            States that employment is determined by aggregate or total demand for goods and services. When people, together with the business and government sectors, purchase more goods and services, it simply means there is a very good market. Such situation induces more production. Clearly, to be able to produce more goods and services, more workers are needed. Thus, employment rises. On the other hand, a decrease in general demand is mailnly due to fall in real income. Naturally, when people have less purchasing power due to inflation or low wages, they can buy less number of goods.

•Theory of Scientific Social Evolution

            Karl marx stated that in the beginning – when society was still primitive - there was social equiibrium. However, when new ideas and new tools were introduced, the old system was disturbed. As a result, man became greedy for power and wealth. Man was greatly concerned with material wealth. This led to  class struggle between the workers and the capitalist. The latter wante to amass wealth at the expense of the workers.

•Innovation Theory

            States the role of the innovator as the key to economic development. The innovator is the leader or entrepreneur who has the vision and courage to handle old system and be able to transform theory into practice.

Laws

•Law of Demand

            As price increases, quantity demanded decreases, and as price decreases, quantity demanded increases.

•Law of Supply

            As price increases, quantity supply also increases, and as price decreases, quantity supply also decreases.

•Law of Supply and Demand

            When supply is greater than demand, price decreases. When demand is greater than supply, price increases. When supply is equal to demand, price remains constant.

•Law of Diminishing Returns

            States that when successive units of a variable input work with a fixed input, beyond a certain point the additional product produced by each additional unit of a variable, input decreases.

•Law of Diminishing Marginal Utility

A law of economics stating that as a person increases consumption of a product - while keeping consumption of other products constant - there is a decline in the marginal utility that person derives from consuming each additional unit of that product.

This is the premise on which buffet-style restaurants operate. They entice you with "all you can eat," all the while knowing each additional plate of food provides less utility than the one before. And despite their enticement, most people will eat only until the utility they derive from additional food is slightly lower than the original.

For example, say you go to a buffet and the first plate of food you eat is very good. On a scale of ten you would give it a ten. Now your hunger has been somewhat tamed, but you get another full plate of food. Since you're not as hungry, your enjoyment rates at a seven at best. Most people would stop before their utility drops even more, but say you go back to eat a third full plate of food and your utility drops even more to a three. If you kept eating, you would eventually reach a point at which your eating makes you sick, providing dissatisfaction, or 'dis-utility'.

•Campbell’s Law

            "The more any quantitative social indicator is used for social decision-making, the more subject it will be to corruption pressures and the more apt it will be to distort and corrupt the social processes it is intended to monitor."

The social science principle of Campbell's law is sometimes used to point out the negative consequences of high-stakes testing in U.S. classrooms.

What Campbell also states in this principle is that "achievement tests may well be valuable indicators of general school achievement under conditions of normal teaching aimed at general competence. But when test scores become the goal of the teaching process, they both lose their value as indicators of educational status and distort the educational process in undesirable ways. (Similar biases of course surround the use of objective tests in courses or as entrance examinations.)"

Campbell's law was published in 1976 by Donald T. Campbell, an experimental social science researcher and the author of many works on research methodology. Closely related ideas are known under different names, e.g. Goodhart's law, and the Lucas critique.

Technically schooled people often use the term "Heisenberg" as a shorthand to represent concepts such as Campbell's law. This is taken from the concept of Heisenberg uncertainty in quantum physics where the act of measuring something changes what is being measured.

•Goodhart’s Law

            Although it can be expressed in a variety of formulations, states that once a social or economic indicator or other surrogate measure is made a target for the purpose of conducting social or economic policy, then it will lose the information content that would qualify it to play such a role. The law was named for its developer, Charles Goodhart, a former advisor to the Bank of England and Emeritus Professor at the London School of Economics.

The law was first stated in a 1975 paper by Goodhart and gained popularity in the context of the attempt by the United Kingdom government of Margaret Thatcher to conduct monetary policy on the basis of targets for broad and narrow money, but the idea is considerably older. Closely related ideas are known under different names, e.g. Campbell's Law (1976), and the Lucas critique (1976). The law is implicit in the economic idea of rational expectations. While it originated in the context of market responses the Law has profound implications for the selection of high-level targets in organisations.

•Verdoorn’s Law

            Verdoorn's law is named after Dutch economist, Petrus Johannes Verdoorn. In economics, this law pertains to the relationship between the growth of output and the growth of productivity. According to the law, faster growth in output increases productivity due to increasing returns. Verdoorn (1949, p. 59) argued that “in the long run a change in the volume of production, say about 10 per cent, tends to be associated with an average increase in labor productivity of 4.5 per cent.” The Verdoorn coefficient close to 0.5 is also found in subsequent estimations of the law. Nicholas Kaldor (1966, p. 289) reports a 0.484 coefficient.

It is important to note that Verdoorn's law undermines the “the usual hypothesis … that the growth of productivity is mainly to be explained by the progress of knowledge in science and technology” (Kaldor, 1966, p. 290), as it is typical in neoclassical models of growth (e.g. the Solow model). Further, Verdoorn's law is usually associated to cumulative causation models of growth, in which demand rather than supply determined the pace of accumulation.

Nicholas Kaldor and Anthony Thirlwall developed models of export-led growth based on Verdoorn's law. For a given country an expansion of the export sector may cause specialisation in the production of export products, which increase the productivity level, and increase the level of skills in the export sector. This may then lead to a reallocation of resources from the less efficient non-trade sector to the more productive export sector, lower prices for traded goods and higher competitiveness. This productivity change may then lead expanded exports and to output growth.

Thirlwall (1979) shows that for several countries the rate of growth never exceeds the ratio of the rate of growth of exports to income elasticity of demand for imports. This implies that growth is limited by the balance of payments equilibrium. This result is known as Thirlwall's law.

Sometimes Verdoorn's law is called Kaldor-Verdoorn's law or effect.

•Iron Law of Prohibition

            The Iron Law of Prohibition is a term coined by Richard Cowan which states that "the more intense the law enforcement, the more potent the prohibited substance becomes." This is based on the premise that when drugs or alcohol are prohibited, they will be produced only in black markets in their most concentrated and powerful forms. If all alcohol beverages are prohibited, a bootlegger will be more profitable if he smuggles highly distilled liquors than if he smuggles the same volume of small beer. In addition, the black-market goods are more likely to be adulterated with unknown or dangerous substances. The government cannot regulate and inspect the production process, and harmed consumers have no recourse in law.