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.
