Development economics

From Wikipedia, the free encyclopedia

Development economics is a branch of economics which deals with economic aspects of the development process in low income countries. Its focus is not only on methods of promoting economic development, economic growth and structural change but also on improving the potential for the mass of the population, for example, through health, education and workplace conditions, whether through public or private channels.

 

Development economics involves the creation of theories and methods that aid in the determination of policies and practices and can be implemented at either the domestic or international level. This may involve restructuring market incentives or using mathematical methods such as intertemporal optimization for project analysis, or it may involve a mixture of quantitative and qualitative methods.

Unlike in many other fields of economics, approaches in development economics may incorporate social and political factors to devise particular plans. Also unlike many other fields of economics, there is no consensus on what students should know. Different approaches may consider the factors that contribute to economic convergence or non-convergence across households, regions, and countries.

Theories of development economics

Mercantilism and physiocracy

World GDP per capita, from 1400 to 2003 CE

The earliest Western theory of development economics was mercantilism, which developed in the 17th century, paralleling the rise of the nation state. Earlier theories had given little attention to development. For example, scholasticism, the dominant school of thought during medieval feudalism, emphasized reconciliation with Christian theology and ethics, rather than development. The 16th- and 17th-century School of Salamanca, credited as the earliest modern school of economics, likewise did not address development specifically. 

Major European nations in the 17th and 18th century all adopted mercantilist ideals to varying degrees, the influence only ebbing with the 18th-century development of physiocrats in France and classical economics in Britain. Mercantilism held that a nation's prosperity depended on its supply of capital, represented by bullion (gold, silver, and trade value) held by the state. It emphasised the maintenance of a high positive trade balance (maximising exports and minimising imports) as a means of accumulating this bullion. To achieve a positive trade balance, protectionist measures such as tariffs and subsidies to home industries were advocated. Mercantilist development theory also advocated colonialism. 

Theorists most associated with mercantilism include Philipp von Hörnigk, who in his Austria Over All, If She Only Will of 1684 gave the only comprehensive statement of mercantilist theory, emphasizing production and an export-led economy. In France, mercantilist policy is most associated with 17th-century finance minister Jean-Baptiste Colbert, whose policies proved influential in later American development.

Mercantilist ideas continue in the theories of economic nationalism and neomercantilism.

Economic nationalism

Alexander Hamilton, credited as Father of the National System

Following mercantilism was the related theory of economic nationalism, promulgated in the 19th century related to the development and industrialization of the United States and Germany, notably in the policies of the American System in America and the Zollverein (customs union) in Germany. A significant difference from mercantilism was the de-emphasis on colonies, in favor of a focus on domestic production. 

The names most associated with 19th-century economic nationalism are the American Alexander Hamilton, the German-American Friedrich List, and the American Henry Clay. Hamilton's 1791 Report on Manufactures, his magnum opus, is the founding text of the American System, and drew from the mercantilist economies of Britain under Elizabeth I and France under Colbert. List's 1841 Das Nationale System der Politischen Ökonomie (translated into English as The National System of Political Economy), which emphasized stages of growth, proved influential in the US and Germany, and nationalist policies were pursued by politician Henry Clay, and later by Abraham Lincoln, under the influence of economist Henry Charles Carey. 

Forms of economic nationalism and neomercantilism have also been key in Japan's development in the 19th and 20th centuries, and the more recent development of the Four Asian Tigers (Hong Kong, South Korea, Taiwan, and Singapore), and, most significantly, China. 

Following Brexit and the United States presidential election, 2016, some experts have argued a new kind of "self-seeking capitalism" popularly known as Trumponomics could have a considerable impact on cross-border investment flows and long-term capital allocation.

Post-WWII theories

The origins of modern development economics are often traced to the need for, and likely problems with the industrialization of eastern Europe in the aftermath of World War II. The key authors are Paul Rosenstein-Rodan, Kurt Mandelbaum, Ragnar Nurkse, and Sir Hans Wolfgang Singer. Only after the war did economists turn their concerns towards Asia, Africa and Latin America. At the heart of these studies, by authors such as Simon Kuznets and W. Arthur Lewis was an analysis of not only economic growth but also structural transformation.

Linear-stages-of-growth model

An early theory of development economics, the linear-stages-of-growth model was first formulated in the 1950s by W. W. Rostow in The Stages of Growth: A Non-Communist Manifesto, following work of Marx and List. This theory modifies Marx's stages theory of development and focuses on the accelerated accumulation of capital, through the utilization of both domestic and international savings as a means of spurring investment, as the primary means of promoting economic growth and, thus, development. The linear-stages-of-growth model posits that there are a series of five consecutive stages of development which all countries must go through during the process of development. These stages are "the traditional society, the pre-conditions for take-off, the take-off, the drive to maturity, and the age of high mass-consumption" Simple versions of the Harrod–Domar model provide a mathematical illustration of the argument that improved capital investment leads to greater economic growth.

Such theories have been criticized for not recognizing that, while necessary, capital accumulation is not a sufficient condition for development. That is to say that this early and simplistic theory failed to account for political, social and institutional obstacles to development. Furthermore, this theory was developed in the early years of the Cold War and was largely derived from the successes of the Marshall Plan. This has led to the major criticism that the theory assumes that the conditions found in developing countries are the same as those found in post-WWII Europe.

Structural-change theory

Structural-change theory deals with policies focused on changing the economic structures of developing countries from being composed primarily of subsistence agricultural practices to being a "more modern, more urbanized, and more industrially diverse manufacturing and service economy." There are two major forms of structural-change theory: W. Lewis' two-sector surplus model, which views agrarian societies as consisting of large amounts of surplus labor which can be utilized to spur the development of an urbanized industrial sector, and Hollis Chenery's patterns of development approach, which holds that different countries become wealthy via different trajectories. The pattern that a particular country will follow, in this framework, depends on its size and resources, and potentially other factors including its current income level and comparative advantages relative to other nations. Empirical analysis in this framework studies the "sequential process through which the economic, industrial and institutional structure of an underdeveloped economy is transformed over time to permit new industries to replace traditional agriculture as the engine of economic growth."

Structural-change approaches to development economics have faced criticism for their emphasis on urban development at the expense of rural development which can lead to a substantial rise in inequality between internal regions of a country. The two-sector surplus model, which was developed in the 1950s, has been further criticized for its underlying assumption that predominantly agrarian societies suffer from a surplus of labor. Actual empirical studies have shown that such labor surpluses are only seasonal and drawing such labor to urban areas can result in a collapse of the agricultural sector. The patterns of development approach has been criticized for lacking a theoretical framework.

International dependence theory

International dependence theories gained prominence in the 1970s as a reaction to the failure of earlier theories to lead to widespread successes in international development. Unlike earlier theories, international dependence theories have their origins in developing countries and view obstacles to development as being primarily external in nature, rather than internal. These theories view developing countries as being economically and politically dependent on more powerful, developed countries which have an interest in maintaining their dominant position. There are three different, major formulations of international dependence theory: neocolonial dependence theory, the false-paradigm model, and the dualistic-dependence model. The first formulation of international dependence theory, neocolonial dependence theory, has its origins in Marxism and views the failure of many developing nations to undergo successful development as being the result of the historical development of the international capitalist system.

Neoclassical theory

First gaining prominence with the rise of several conservative governments in the developed world during the 1980s, neoclassical theories represent a radical shift away from International Dependence Theories. Neoclassical theories argue that governments should not intervene in the economy; in other words, these theories are claiming that an unobstructed free market is the best means of inducing rapid and successful development. Competitive free markets unrestrained by excessive government regulation are seen as being able to naturally ensure that the allocation of resources occurs with the greatest efficiency possible and the economic growth is raised and stabilized.

It is important to note that there are several different approaches within the realm of neoclassical theory, each with subtle, but important, differences in their views regarding the extent to which the market should be left unregulated. These different takes on neoclassical theory are the free market approach, public-choice theory, and the market-friendly approach. Of the three, both the free-market approach and public-choice theory contend that the market should be totally free, meaning that any intervention by the government is necessarily bad. Public-choice theory is arguably the more radical of the two with its view, closely associated with libertarianism, that governments themselves are rarely good and therefore should be as minimal as possible.

Academic economists have given varied policy advice to governments of developing countries. See for example, Economy of Chile (Arnold Harberger), Economic history of Taiwan (Sho-Chieh Tsiang). Anne Krueger noted in 1996 that success and failure of policy recommendations worldwide had not consistently been incorporated into prevailing academic writings on trade and development.

The market-friendly approach, unlike the other two, is a more recent development and is often associated with the World Bank. This approach still advocates free markets but recognizes that there are many imperfections in the markets of many developing nations and thus argues that some government intervention is an effective means of fixing such imperfections.

Topics of research

Development economics also includes topics such as third world debt, and the functions of such organisations as the International Monetary Fund and World Bank. In fact, the majority of development economists are employed by, do consulting with, or receive funding from institutions like the IMF and the World Bank. Many such economists are interested in ways of promoting stable and sustainable growth in poor countries and areas, by promoting domestic self-reliance and education in some of the lowest income countries in the world. Where economic issues merge with social and political ones, it is referred to as development studies.

Economic development and ethnicity

A growing body of research has been emerging among development economists since the very late 20th century focusing on interactions between ethnic diversity and economic development, particularly at the level of the nation-state. While most research looks at empirical economics at both the macro and the micro level, this field of study has a particularly heavy sociological approach. The more conservative branch of research focuses on tests for causality in the relationship between different levels of ethnic diversity and economic performance, while a smaller and more radical branch argues for the role of neoliberal economics in enhancing or causing ethnic conflict. Moreover, comparing these two theoretical approaches brings the issue of endogeneity (endogenicity) into questions. This remains a highly contested and uncertain field of research, as well as politically sensitive, largely due to its possible policy implications.

The role of ethnicity in economic development

Much discussion among researchers centers around defining and measuring two key but related variables: ethnicity and diversity. It is debated whether ethnicity should be defined by culture, language, or religion. While conflicts in Rwanda were largely along tribal lines, Nigeria's string of conflicts is thought to be – at least to some degree – religiously based. Some have proposed that, as the saliency of these different ethnic variables tends to vary over time and across geography, research methodologies should vary according to the context. Somalia provides an interesting example. Due to the fact that about 85% of its population defined themselves as Somali, Somalia was considered to be a rather ethnically-homogeneous nation. However, civil war caused ethnicity (or ethnic affiliation) to be redefined according to clan groups.

There is also much discussion in academia concerning the creation of an index for "ethnic heterogeneity". Several indices have been proposed in order to model ethnic diversity (with regards to conflict). Easterly and Levine have proposed an ethno-linguistic fractionalization index defined as FRAC or ELF defined by:

${\displaystyle 1-\sum _{i=1}^{N}s_{i}^{2},}$

where s_i is size of group i as a percentage of total population. The ELF index is a measure of the probability that two randomly chosen individuals belong to different ethno-linguistic groups. Other researchers have also applied this index to religious rather than ethno-linguistic groups. Though commonly used, Alesina and La Ferrara point out that the ELF index fails to account for the possibility that fewer large ethnic groups may result in greater inter-ethnic conflict than many small ethnic groups. More recently, researchers such as Montalvo and Reynal-Querol, have put forward the Q polarization index as a more appropriate measure of ethnic division. Based on a simplified adaptation of a polarization index developed by Esteban and Ray, the Q index is defined as

${\displaystyle Q=1-\sum _{i=1}^{N}\left({\frac {{\tfrac {1}{2}}-s_{i}}{\tfrac {1}{2}}}\right)^{2}\times s_{i},}$

where s_i once again represents the size of group i as a percentage of total population, and is intended to capture the social distance between existing ethnic groups within an area.

Early researchers, such as Jonathan Pool, considered a concept dating back to the account of the Tower of Babel: that linguistic unity may allow for higher levels of development. While pointing out obvious oversimplifications and the subjectivity of definitions and data collection, Pool suggested that we had yet to see a robust economy emerge from a nation with a high degree of linguistic diversity. In his research Pool used the "size of the largest native-language community as a percentage of the population" as his measure of linguistic diversity. Not much later, however, Horowitz pointed out that both highly diverse and highly homogeneous societies exhibit less conflict than those in between. Similarly, Collier and Hoeffler provided evidence that both highly homogenous and highly heterogeneous societies exhibit lower risk of civil war, while societies that are more polarized are at greater risk. As a matter of fact, their research suggests that a society with only two ethnic groups is about 50% more likely to experience civil war than either of the two extremes. Nonetheless, Mauro points out that ethno-linguistic fractionalization is positively correlated with corruption, which in turn is negatively correlated with economic growth. Moreover, in a study on economic growth in African countries, Easterly and Levine find that linguistic fractionalization plays a significant role in reducing national income growth and in explaining poor policies. In addition, empirical research in the U.S., at the municipal level, has revealed that ethnic fractionalization (based on race) may be correlated with poor fiscal management and lower investments in public goods. Finally, more recent research would propose that ethno-linguistic fractionalization is indeed negatively correlated with economic growth while more polarized societies exhibit greater public consumption, lower levels of investment and more frequent civil wars.

Economic development and its impact on ethnic conflict

Increasingly, attention is being drawn to the role of economics in spawning or cultivating ethnic conflict. Critics of earlier development theories, mentioned above, point out that “ethnicity” and ethnic conflict cannot be treated as exogenous variables. There is a body of literature which discusses how economic growth and development, particularly in the context of a globalizing world characterized by free trade, appears to be leading to the extinction and homogenization of languages. Manuel Castells asserts that the "widespread destructuring of organizations, delegitimation of institutions, fading away of major social movements, and ephemeral cultural expressions" which characterize globalization lead to a renewed search for meaning; one that is based on identity rather than on practices. Barber and Lewis argue that culturally-based movements of resistance have emerged as a reaction to the threat of modernization (perceived or actual) and neoliberal development.

On a different note, Chua suggests that ethnic conflict often results from the envy of the majority toward a wealthy minority which has benefited from trade in a neoliberal world. She argues that conflict is likely to erupt through political manipulation and the vilification of the minority. Prasch points out that, as economic growth often occurs in tandem with increased inequality, ethnic or religious organizations may be seen as both assistance and an outlet for the disadvantaged. However, empirical research by Piazza argues that economics and unequal development have little to do with social unrest in the form of terrorism. Rather, "more diverse societies, in terms of ethnic and religious demography, and political systems with large, complex, multiparty systems were more likely to experience terrorism than were more homogeneous states with few or no parties at the national level".

Recovery from conflict (civil war)

Violent conflict and economic development are deeply intertwined. Paul Collier describes how poor countries are more prone to civil conflict. The conflict lowers incomes catching countries in a "conflict trap." Violent conflict destroys physical capital (equipment and infrastructure), diverts valuable resources to military spending, discourages investment and disrupts exchange.

Recovery from civil conflict is very uncertain. Countries that maintain stability can experience a "peace dividend," through the rapid re-accumulation of physical capital (investment flows back to the recovering country because of the high return). However, successful recovery depends on the quality of legal system and the protection of private property. Investment is more productive in countries with higher quality institutions. Firms that experienced a civil war were more sensitive to the quality of the legal system that firm similar firms that had never been exposed to conflict.

Growth indicator controversy

Per capita Gross Domestic Product (GDP per head) is used by many developmental economists as an approximation of general national well-being. However, these measures are criticized as not measuring economic growth well enough, especially in countries where there is much economic activity that is not part of measured financial transactions (such as housekeeping and self-homebuilding), or where funding is not available for accurate measurements to be made publicly available for other economists to use in their studies (including private and institutional fraud, in some countries). 

Even though per-capita GDP as measured can make economic well-being appear smaller than it really is in some developing countries, the discrepancy could be still bigger in a developed country where people may perform outside of financial transactions an even higher-value service than housekeeping or homebuilding as gifts or in their own households, such as counseling, lifestyle coaching, a more valuable home décor service, and time management. Even free choice can be considered to add value to lifestyles without necessarily increasing the financial transaction amounts.

More recent theories of Human Development have begun to see beyond purely financial measures of development, for example with measures such as medical care available, education, equality, and political freedom. One measure used is the Genuine Progress Indicator, which relates strongly to theories of distributive justice. Actual knowledge about what creates growth is largely unproven; however recent advances in econometrics and more accurate measurements in many countries is creating new knowledge by compensating for the effects of variables to determine probable causes out of merely correlational statistics.

Recent developments

Recent theories revolve around questions about what variables or inputs correlate or affect economic growth the most: elementary, secondary, or higher education, government policy stability, tariffs and subsidies, fair court systems, available infrastructure, availability of medical care, prenatal care and clean water, ease of entry and exit into trade, and equality of income distribution (for example, as indicated by the Gini coefficient), and how to advise governments about macroeconomic policies, which include all policies that affect the economy. Education enables countries to adapt the latest technology and creates an environment for new innovations. 

The cause of limited growth and divergence in economic growth lies in the high rate of acceleration of technological change by a small number of developed countries. These countries' acceleration of technology was due to increased incentive structures for mass education which in turn created a framework for the population to create and adapt new innovations and methods. Furthermore, the content of their education was composed of secular schooling that resulted in higher productivity levels and modern economic growth. 

Researchers at the Overseas Development Institute also highlight the importance of using economic growth to improve the human condition, raising people out of poverty and achieving the Millennium Development Goals. Despite research showing almost no relation between growth and the achievement of the goals 2 to 7 and statistics showing that during periods of growth poverty levels in some cases have actually risen (e.g. Uganda grew by 2.5% annually between 2000–2003, yet poverty levels rose by 3.8%), researchers at the ODI suggest growth is necessary, but that it must be equitable. This concept of inclusive growth is shared even by key world leaders such as former Secretary General Ban Ki-moon, who emphasises that:

"Sustained and equitable growth based on dynamic structural economic change is necessary for making substantial progress in reducing poverty. It also enables faster progress towards the other Millennium Development Goals. While economic growth is necessary, it is not sufficient for progress on reducing poverty."

Researchers at the ODI thus emphasise the need to ensure social protection is extended to allow universal access and that active policy measures are introduced to encourage the private sector to create new jobs as the economy grows (as opposed to jobless growth) and seek to employ people from disadvantaged groups.

Notable development economists

• Daron Acemoglu, professor of economics at the Massachusetts Institute of Technology, and 2005 Clark Medal winner.
• Philippe Aghion, professor of economics at Harvard University, co-authored textbook in economic growth, forwarded Schumpeterian growth, and established creative destruction theories mathematically with Peter Howitt.
• Bina Agarwal is a prize-winning development economist and Professor of Development Economics and Environment at the Global Development Institute at The University of Manchester.
• Abhijit Banerjee, professor of economics at the Massachusetts Institute of Technology and Director of Abdul Latif Jameel Poverty Action Lab.
• Pranab Bardhan, professor of economics at the University of California, Berkeley, author of texts in both trade and development economics, and editor of the Journal of Development Economics from 1985–2003.
• Kaushik Basu, professor of economics at Cornell University and author of Analytical Development Economics.
• Peter Thomas Bauer, professor of economics at the London School of Economics, author of Dissent on Development.
• Jagdish Bhagwati, a frequent commentator on international trade and noted supporter of free trade
• Nancy Birdsall is the founding president of the Center for Global Development (CGD) in Washington, DC, USA, and former executive vice-president of the Inter-American Development Bank.
• David E. Bloom, professor of economics and demography at the Harvard School of Public Health.
• Ha-Joon Chang, author of Kicking Away the Ladder and Bad Samaritans; Rich Nations, Poor Policies and the Threat to the Developing World which use historical evidence to critique neoliberal development economics.
• Paul Collier, author of The Bottom Billion which attempts to tie together a series of traps to explain the self-fulfilling nature of poverty at the lower end of the development scale.
• Esther Duflo, Director of Abdul Latif Jameel Poverty Action Lab, professor of Economics at the Massachusetts Institute of Technology, 2009 MacArthur Fellow, 2010 Clark Medal winner, advocate for field experiments.
• William Easterly, author of The Elusive Quest for Growth: Economists' Adventures and Misadventures in the Tropics^[43][44] and White Man's Burden: How the West's Efforts to Aid the Rest Have Done So Much Ill and So Little Good.^[45]
• Diane Rosemary Elson is a British economist, sociologist and gender and development social scientist.
• Sakiko Fukuda-Parr (サキコ・フクダ・パー、福田 咲子) is a development economist who has gained recognition for her work with the United Nations Development Programme (UNDP).
• Celso Furtado, Brazilian structuralist economist.
• Oded Galor, Israeli-American economist at Brown University; editor-in-chief of the Journal of Economic Growth, the principal journal in economic growth. Developer of the unified growth theory, the newest alternative to theories of endogenous growth.
• Jayati Ghosh is a development economist and Professor of Economics at the Centre for Economic Studies and Planning, School of Social Sciences, at the Jawaharlal Nehru University, in New Delhi, India.
• Stephany Griffith-Jones is an economist specialising in international finance and development. She is currently financial markets director at the Initiative for Policy Dialogue, based at Columbia University in New York and associate fellow at the Overseas Development Institute.
• Barbara Harriss-White is an English economist and emeritus professor of development studies.
• Peter Howitt, Canadian economist at Brown University; past president of the Canadian Economics Association, introduced the concept of Schumpeterian growth and established creative destruction theory mathematically with Philippe Aghion.
• Dean Karlan, American economist at Northwestern University; co-director of the Global Poverty Research Lab at the Buffett Institute for Global Studies; founded Innovations for Poverty Action (IPA), a New Haven, Connecticut, based research outfit dedicated to creating and evaluating solutions to social and international development problems.
• Naila Kabeer (Bengali: নায়লা কবির) is an Indian-born British Bangladeshi social economist, research fellow and writer.
• Justin Yifu Lin, Chinese economist at Peking University; former chief economist of World Bank, one of the most important Chinese economists.
• W. Arthur Lewis, with T. W. Schultz, winner of the 1979 Nobel Prize in Economics for work in development economics.
• Utsa Patnaik is an Indian Marxist economist.
• Raúl Prebisch, founding Secretary General of the United Nations Conference on Trade and Development and influential dependency theorist.
• Lant Pritchett, professor at Harvard University's Kennedy School of Government, and has held several prominent research positions at the World Bank.
• Dani Rodrik, professor at Harvard University's Kennedy School of Government, has written extensively on globalization.
• Mark Rosenzweig, a professor at Yale University and director of Economic Growth Center at Yale
• Walt Whitman Rostow, modernization theorist, author of The Stages of Economic Growth: A Non-communist Manifesto.
• Jeffrey Sachs, author of The End of Poverty: Economic Possibilities of Our Time (preview) and Common Wealth: Economics for a Crowded Planet.
• Amartya Sen, Indian economist, Nobel Prize winner, author of Development as Freedom.
• Hans Singer, who dealt with how unequal terms of trade disproportionately affect producers of primary products. His thesis, combined with the work of Raúl Prebisch, form the basis for dependency theory.
• Hernando de Soto Polar, proponent of property rights in the developing world, author of The Mystery of Capital: Why Capitalism Triumphs in the West and Fails Everywhere Else.
• Frances Stewart, current president of the Human Development and Capability Association.
• Joseph Stiglitz, Nobel Prize winner and former chief economist at the World Bank.
• Finn Tarp, Danish Professor of Development Economics at the University of Copenhagen and Director of UNU-WIDER, Helsinki, Finland.
• Erik Thorbecke, a co-originator of Foster–Greer–Thorbecke poverty measure who also played a significant role in the development and popularization of social accounting matrix.
• Michael Todaro, known for the Todaro and Harris–Todaro models of migration and urbanization; Economic Development.
• Robert M. Townsend, professor at the Massachusetts Institute of Technology known for his Thai Project, a model for many other applied and theoretical projects in economic development.
• Mahbub ul Haq, Pakistani economist, creator of the Human Development Report.
• Muhammad Yunus, Nobel Prize winner and founder of the Grameen Bank.

Macroeconomics

From Wikipedia, the free encyclopedia

Macroeconomics (from the Greek prefix makro- meaning "large" + economics) is a branch of economics dealing with the performance, structure, behavior, and decision-making of an economy as a whole. This includes regional, national, and global economies. Macroeconomists study aggregated indicators such as GDP, unemployment rates, national income, price indices, and the interrelations among the different sectors of the economy to better understand how the whole economy functions. They also develop models that explain the relationship between such factors as national income, output, consumption, unemployment, inflation, saving, investment, international trade, and international finance. 

While macroeconomics is a broad field of study, there are two areas of research that are emblematic of the discipline: the attempt to understand the causes and consequences of short-run fluctuations in national income (the business cycle), and the attempt to understand the determinants of long-run economic growth (increases in national income). Macroeconomic models and their forecasts are used by governments to assist in the development and evaluation of economic policy.

Macroeconomics and microeconomics, a pair of terms coined by Ragnar Frisch, are the two most general fields in economics. In contrast to macroeconomics, microeconomics is the branch of economics that studies the behavior of individuals and firms in making decisions and the interactions among these individuals and firms in narrowly-defined markets.

Basic macroeconomic concepts

Macroeconomics encompasses a variety of concepts and variables, but there are three central topics for macroeconomic research. Macroeconomic theories usually relate the phenomena of output, unemployment, and inflation. Outside of macroeconomic theory, these topics are also important to all economic agents including workers, consumers, and producers. 

Circulation in macroeconomics.

Output and income

National output is the total amount of everything a country produces in a given period of time. Everything that is produced and sold generates an equal amount of income. The total output of the economy is measured GDP per person. The output and income are usually considered equivalent and the two terms are often used interchangeably,output changes into income. Output can be measured or it can be viewed from the production side and measured as the total value of final goods and services or the sum of all value added in the economy.

Macroeconomic output is usually measured by gross domestic product (GDP) or one of the other national accounts. Economists interested in long-run increases in output study economic growth. Advances in technology, accumulation of machinery and other capital, and better education and human capital are all factors that lead to increased economic output over time. However, output does not always increase consistently over time. Business cycles can cause short-term drops in output called recessions. Economists look for macroeconomic policies that prevent economies from slipping into recessions and that lead to faster long-term growth.

Unemployment

A chart using US data showing the relationship between economic growth and unemployment expressed by Okun's law. The relationship demonstrates cyclical unemployment. Economic growth leads to a lower unemployment rate.

 

The amount of unemployment in an economy is measured by the unemployment rate, i.e. the percentage of workers without jobs in the labor force. The unemployment rate in the labor force only includes workers actively looking for jobs. People who are retired, pursuing education, or discouraged from seeking work by a lack of job prospects are excluded. 

Unemployment can be generally broken down into several types that are related to different causes.

• Classical unemployment theory suggests that unemployment occurs when wages are too high for employers to be willing to hire more workers. Other more modern economic theories suggest that increased wages actually decrease unemployment by creating more consumer demand. According to these more recent theories, unemployment results from reduced demand for the goods and services produced through labor and suggest that only in markets where profit margins are very low, and in which the market will not bear a price increase of product or service, will higher wages result in unemployment.
• Consistent with classical unemployment theory, frictional unemployment occurs when appropriate job vacancies exist for a worker, but the length of time needed to search for and find the job leads to a period of unemployment.
• Structural unemployment covers a variety of possible causes of unemployment including a mismatch between workers' skills and the skills required for open jobs. Large amounts of structural unemployment commonly occur when an economy shifts to focus on new industries and workers find their previous set of skills are no longer in demand. Structural unemployment is similar to frictional unemployment as both reflect the problem of matching workers with job vacancies, but structural unemployment also covers the time needed to acquire new skills in addition to the short-term search process.
• While some types of unemployment may occur regardless of the condition of the economy, cyclical unemployment occurs when growth stagnates. Okun's law represents the empirical relationship between unemployment and economic growth. The original version of Okun's law states that a 3% increase in output would lead to a 1% decrease in unemployment.

Inflation and deflation

The ten-year moving averages of changes in price level and growth in money supply (using the measure of M2, the supply of hard currency and money held in most types of bank accounts) in the US from 1875 to 2011. Over the long run, the two series show a close relationship.

 

A general price increase across the entire economy is called inflation. When prices decrease, there is deflation. Economists measure these changes in prices with price indexes. Inflation can occur when an economy becomes overheated and grows too quickly. Similarly, a declining economy can lead to deflation. 

Central bankers, who manage a country's money supply, try to avoid changes in price level by using monetary policy. Raising interest rates or reducing the supply of money in an economy will reduce inflation. Inflation can lead to increased uncertainty and other negative consequences. Deflation can lower economic output. Central bankers try to stabilize prices to protect economies from the negative consequences of price changes. 

Changes in price level may be the result of several factors. The quantity theory of money holds that changes in price level are directly related to changes in the money supply. Most economists believe that this relationship explains long-run changes in the price level. Short-run fluctuations may also be related to monetary factors, but changes in aggregate demand and aggregate supply can also influence price level. For example, a decrease in demand due to a recession can lead to lower price levels and deflation. A negative supply shock, such as an oil crisis, lowers aggregate supply and can cause inflation.

Macroeconomic models

Aggregate demand–aggregate supply

A traditional AS–AD diagram showing a shift in AD and the AS curve becoming inelastic beyond potential output.

 

The AD-AS model has become the standard textbook model for explaining the macroeconomy. This model shows the price level and level of real output given the equilibrium in aggregate demand and aggregate supply. The aggregate demand curve's downward slope means that more output is demanded at lower price levels. The downward slope is the result of three effects: the Pigou or real balance effect, which states that as real prices fall, real wealth increases, resulting in higher consumer demand of goods; the Keynes or interest rate effect, which states that as prices fall, the demand for money decreases, causing interest rates to decline and borrowing for investment and consumption to increase; and the net export effect, which states that as prices rise, domestic goods become comparatively more expensive to foreign consumers, leading to a decline in exports.

In the conventional Keynesian use of the AS-AD model, the aggregate supply curve is horizontal at low levels of output and becomes inelastic near the point of potential output, which corresponds with full employment. Since the economy cannot produce beyond the potential output, any AD expansion will lead to higher price levels instead of higher output. 

The AD–AS diagram can model a variety of macroeconomic phenomena, including inflation. Changes in the non-price level factors or determinants cause changes in aggregate demand and shifts of the entire aggregate demand (AD) curve. When demand for goods exceeds supply there is an inflationary gap where demand-pull inflation occurs and the AD curve shifts upward to a higher price level. When the economy faces higher costs, cost-push inflation occurs and the AS curve shifts upward to higher price levels. The AS–AD diagram is also widely used as a pedagogical tool to model the effects of various macroeconomic policies.

IS-LM

In this example of an IS/LM chart, the IS curve moves to the right, causing higher interest rates (i) and expansion in the "real" economy (real GDP, or Y).

 

The IS–LM model gives the underpinnings of aggregate demand (itself discussed above). It answers the question “At any given price level, what is the quantity of goods demanded?” This model shows represents what combination of interest rates and output will ensure equilibrium in both the goods and money markets. The goods market is modeled as giving equality between investment and public and private saving (IS), and the money market is modeled as giving equilibrium between the money supply and liquidity preference.

The IS curve consists of the points (combinations of income and interest rate) where investment, given the interest rate, is equal to public and private saving, given output. The IS curve is downward sloping because output and the interest rate have an inverse relationship in the goods market: as output increases, more income is saved, which means interest rates must be lower to spur enough investment to match saving.

The LM curve is upward sloping because the interest rate and output have a positive relationship in the money market: as income (identically equal to output) increases, the demand for money increases, resulting in a rise in the interest rate in order to just offset the insipient rise in money demand.

The IS-LM model is often used to demonstrate the effects of monetary and fiscal policy. Textbooks frequently use the IS-LM model, but it does not feature the complexities of most modern macroeconomic models. Nevertheless, these models still feature similar relationships to those in IS-LM.

Growth models

The neoclassical growth model of Robert Solow has become a common textbook model for explaining economic growth in the long-run. The model begins with a production function where national output is the product of two inputs: capital and labor. The Solow model assumes that labor and capital are used at constant rates without the fluctuations in unemployment and capital utilization commonly seen in business cycles.

An increase in output, or economic growth, can only occur because of an increase in the capital stock, a larger population, or technological advancements that lead to higher productivity (total factor productivity). An increase in the savings rate leads to a temporary increase as the economy creates more capital, which adds to output. However, eventually the depreciation rate will limit the expansion of capital: savings will be used up replacing depreciated capital, and no savings will remain to pay for an additional expansion in capital. Solow's model suggests that economic growth in terms of output per capita depends solely on technological advances that enhance productivity.

In the 1980s and 1990s endogenous growth theory arose to challenge neoclassical growth theory. This group of models explains economic growth through other factors, such as increasing returns to scale for capital and learning-by-doing, that are endogenously determined instead of the exogenous technological improvement used to explain growth in Solow's model.

Macroeconomic policy

Macroeconomic policy is usually implemented through two sets of tools: fiscal and monetary policy. Both forms of policy are used to stabilize the economy, which can mean boosting the economy to the level of GDP consistent with full employment. Macroeconomic policy focuses on limiting the effects of the business cycle to achieve the economic goals of price stability, full employment, and growth. 

Monetary policy

Central banks implement monetary policy by controlling the money supply through several mechanisms. Typically, central banks take action by issuing money to buy bonds (or other assets), which boosts the supply of money and lowers interest rates, or, in the case of contractionary monetary policy, banks sell bonds and take money out of circulation. Usually policy is not implemented by directly targeting the supply of money. 

Central banks continuously shift the money supply to maintain a targeted fixed interest rate. Some of them allow the interest rate to fluctuate and focus on targeting inflation rates instead. Central banks generally try to achieve high output without letting loose monetary policy that create large amounts of inflation. 

Conventional monetary policy can be ineffective in situations such as a liquidity trap. When interest rates and inflation are near zero, the central bank cannot loosen monetary policy through conventional means. 

An example of intervention strategy under different conditions

 

Central banks can use unconventional monetary policy such as quantitative easing to help increase output. Instead of buying government bonds, central banks can implement quantitative easing by buying not only government bonds, but also other assets such as corporate bonds, stocks, and other securities. This allows lower interest rates for a broader class of assets beyond government bonds. In another example of unconventional monetary policy, the United States Federal Reserve recently made an attempt at such a policy with Operation Twist. Unable to lower current interest rates, the Federal Reserve lowered long-term interest rates by buying long-term bonds and selling short-term bonds to create a flat yield curve.

Fiscal policy

Fiscal policy is the use of government's revenue and expenditure as instruments to influence the economy. Examples of such tools are expenditure, taxes, debt. 

For example, if the economy is producing less than potential output, government spending can be used to employ idle resources and boost output. Government spending does not have to make up for the entire output gap. There is a multiplier effect that boosts the impact of government spending. For instance, when the government pays for a bridge, the project not only adds the value of the bridge to output, but also allows the bridge workers to increase their consumption and investment, which helps to close the output gap.

The effects of fiscal policy can be limited by crowding out. When the government takes on spending projects, it limits the amount of resources available for the private sector to use. Crowding out occurs when government spending simply replaces private sector output instead of adding additional output to the economy. Crowding out also occurs when government spending raises interest rates, which limits investment. Defenders of fiscal stimulus argue that crowding out is not a concern when the economy is depressed, plenty of resources are left idle, and interest rates are low.

Fiscal policy can be implemented through automatic stabilizers. Automatic stabilizers do not suffer from the policy lags of discretionary fiscal policy. Automatic stabilizers use conventional fiscal mechanisms but take effect as soon as the economy takes a downturn: spending on unemployment benefits automatically increases when unemployment rises and, in a progressive income tax system, the effective tax rate automatically falls when incomes decline.

Comparison

Economists usually favor monetary over fiscal policy because it has two major advantages. First, monetary policy is generally implemented by independent central banks instead of the political institutions that control fiscal policy. Independent central banks are less likely to make decisions based on political motives. Second, monetary policy suffers shorter inside lags and outside lags than fiscal policy. Central banks can quickly make and implement decisions while discretionary fiscal policy may take time to pass and even longer to carry out.

Development

Origins

Macroeconomics descended from the once divided fields of business cycle theory and monetary theory. The quantity theory of money was particularly influential prior to World War II. It took many forms, including the version based on the work of Irving Fisher: 

${\displaystyle M\cdot V=P\cdot Q}$

In the typical view of the quantity theory, money velocity (V) and the quantity of goods produced (Q) would be constant, so any increase in money supply (M) would lead to a direct increase in price level (P). The quantity theory of money was a central part of the classical theory of the economy that prevailed in the early twentieth century.

Austrian School

Ludwig Von Mises's work Theory of Money and Credit, published in 1912, was one of the first books from the Austrian School to deal with macroeconomic topics.

Keynes and his followers

Macroeconomics, at least in its modern form, began with the publication of John Maynard Keynes's General Theory of Employment, Interest and Money. When the Great Depression struck, classical economists had difficulty explaining how goods could go unsold and workers could be left unemployed. In classical theory, prices and wages would drop until the market cleared, and all goods and labor were sold. Keynes offered a new theory of economics that explained why markets might not clear, which would evolve (later in the 20th century) into a group of macroeconomic schools of thought known as Keynesian economics – also called Keynesianism or Keynesian theory. 

In Keynes's theory, the quantity theory broke down because people and businesses tend to hold on to their cash in tough economic times – a phenomenon he described in terms of liquidity preferences. Keynes also explained how the multiplier effect would magnify a small decrease in consumption or investment and cause declines throughout the economy. Keynes also noted the role uncertainty and animal spirits can play in the economy.

The generation following Keynes combined the macroeconomics of the General Theory with neoclassical microeconomics to create the neoclassical synthesis. By the 1950s, most economists had accepted the synthesis view of the macroeconomy. Economists like Paul Samuelson, Franco Modigliani, James Tobin, and Robert Solow developed formal Keynesian models and contributed formal theories of consumption, investment, and money demand that fleshed out the Keynesian framework.

Monetarism

Milton Friedman updated the quantity theory of money to include a role for money demand. He argued that the role of money in the economy was sufficient to explain the Great Depression, and that aggregate demand oriented explanations were not necessary. Friedman also argued that monetary policy was more effective than fiscal policy; however, Friedman doubted the government's ability to "fine-tune" the economy with monetary policy. He generally favored a policy of steady growth in money supply instead of frequent intervention.

Friedman also challenged the Phillips curve relationship between inflation and unemployment. Friedman and Edmund Phelps (who was not a monetarist) proposed an "augmented" version of the Phillips curve that excluded the possibility of a stable, long-run tradeoff between inflation and unemployment. When the oil shocks of the 1970s created a high unemployment and high inflation, Friedman and Phelps were vindicated. Monetarism was particularly influential in the early 1980s. Monetarism fell out of favor when central banks found it difficult to target money supply instead of interest rates as monetarists recommended. Monetarism also became politically unpopular when the central banks created recessions in order to slow inflation.

New classical

New classical macroeconomics further challenged the Keynesian school. A central development in new classical thought came when Robert Lucas introduced rational expectations to macroeconomics. Prior to Lucas, economists had generally used adaptive expectations where agents were assumed to look at the recent past to make expectations about the future. Under rational expectations, agents are assumed to be more sophisticated. A consumer will not simply assume a 2% inflation rate just because that has been the average the past few years; she will look at current monetary policy and economic conditions to make an informed forecast. When new classical economists introduced rational expectations into their models, they showed that monetary policy could only have a limited impact. 

Lucas also made an influential critique of Keynesian empirical models. He argued that forecasting models based on empirical relationships would keep producing the same predictions even as the underlying model generating the data changed. He advocated models based on fundamental economic theory that would, in principle, be structurally accurate as economies changed. Following Lucas's critique, new classical economists, led by Edward C. Prescott and Finn E. Kydland, created real business cycle (RBC) models of the macroeconomy.

RBC models were created by combining fundamental equations from neo-classical microeconomics. In order to generate macroeconomic fluctuations, RBC models explained recessions and unemployment with changes in technology instead of changes in the markets for goods or money. Critics of RBC models argue that money clearly plays an important role in the economy, and the idea that technological regress can explain recent recessions is implausible. However, technological shocks are only the more prominent of a myriad of possible shocks to the system that can be modeled. Despite questions about the theory behind RBC models, they have clearly been influential in economic methodology.

New Keynesian response

New Keynesian economists responded to the new classical school by adopting rational expectations and focusing on developing micro-founded models that are immune to the Lucas critique. Stanley Fischer and John B. Taylor produced early work in this area by showing that monetary policy could be effective even in models with rational expectations when contracts locked in wages for workers. Other new Keynesian economists, including Olivier Blanchard, Julio Rotemberg, Greg Mankiw, David Romer, and Michael Woodford, expanded on this work and demonstrated other cases where inflexible prices and wages led to monetary and fiscal policy having real effects.

Like classical models, new classical models had assumed that prices would be able to adjust perfectly and monetary policy would only lead to price changes. New Keynesian models investigated sources of sticky prices and wages due to imperfect competition, which would not adjust, allowing monetary policy to impact quantities instead of prices. 

By the late 1990s economists had reached a rough consensus. The nominal rigidity of new Keynesian theory was combined with rational expectations and the RBC methodology to produce dynamic stochastic general equilibrium (DSGE) models. The fusion of elements from different schools of thought has been dubbed the new neoclassical synthesis. These models are now used by many central banks and are a core part of contemporary macroeconomics.

New Keynesian economics, which developed partly in response to new classical economics, strives to provide microeconomic foundations to Keynesian economics by showing how imperfect markets can justify demand management.

Microeconomics

From Wikipedia, the free encyclopedia

Microeconomics (from Greek prefix mikro- meaning "small" + economics) is a branch of economics that studies the behaviour of individuals and firms in making decisions regarding the allocation of scarce resources and the interactions among these individuals and firms.

 

One goal of microeconomics is to analyze the market mechanisms that establish relative prices among goods and services and allocate limited resources among alternative uses. Microeconomics shows conditions under which free markets lead to desirable allocations. It also analyzes market failure, where markets fail to produce efficient results.

Microeconomics stands in contrast to macroeconomics, which involves "the sum total of economic activity, dealing with the issues of growth, inflation, and unemployment and with national policies relating to these issues". Microeconomics also deals with the effects of economic policies (such as changing taxation levels) on microeconomic behavior and thus on the aforementioned aspects of the economy. Particularly in the wake of the Lucas critique, much of modern macroeconomic theories has been built upon microfoundations—i.e. based upon basic assumptions about micro-level behavior.

Assumptions and definitions

Microeconomic theory typically begins with the study of a single rational and utility maximizing individual. To economists, rationality means an individual possesses stable preferences that are both complete and transitive. 

The technical assumption that preference relations are continuous is needed to ensure the existence of a utility function. Although microeconomic theory can continue without this assumption, it would make comparative statics impossible since there is no guarantee that the resulting utility function would be differentiable.

Microeconomic theory progresses by defining a competitive budget set which is a subset of the consumption set. It is at this point that economists make the technical assumption that preferences are locally non-satiated. Without the assumption of LNS (local non-satiation) there is no 100% guarantee but there would be a rational rise in individual utility. With the necessary tools and assumptions in place the utility maximization problem (UMP) is developed. 

The utility maximization problem is the heart of consumer theory. The utility maximization problem attempts to explain the action axiom by imposing rationality axioms on consumer preferences and then mathematically modeling and analyzing the consequences. The utility maximization problem serves not only as the mathematical foundation of consumer theory but as a metaphysical explanation of it as well. That is, the utility maximization problem is used by economists to not only explain what or how individuals make choices but why individuals make choices as well. 

The utility maximization problem is a constrained optimization problem in which an individual seeks to maximize utility subject to a budget constraint. Economists use the extreme value theorem to guarantee that a solution to the utility maximization problem exists. That is, since the budget constraint is both bounded and closed, a solution to the utility maximization problem exists. Economists call the solution to the utility maximization problem a Walrasian demand function or correspondence. 

The utility maximization problem has so far been developed by taking consumer tastes (i.e. consumer utility) as the primitive. However, an alternative way to develop microeconomic theory is by taking consumer choice as the primitive. This model of microeconomic theory is referred to as revealed preference theory. 

The supply and demand model describes how prices vary as a result of a balance between product availability at each price (supply) and the desires of those with purchasing power at each price (demand). The graph depicts a right-shift in demand from D₁ to D₂ along with the consequent increase in price and quantity required to reach a new market-clearing equilibrium point on the supply curve (S).

 

The theory of supply and demand usually assumes that markets are perfectly competitive. This implies that there are many buyers and sellers in the market and none of them have the capacity to significantly influence prices of goods and services. In many real-life transactions, the assumption fails because some individual buyers or sellers have the ability to influence prices. Quite often, a sophisticated analysis is required to understand the demand-supply equation of a good model. However, the theory works well in situations meeting these assumptions. 

Mainstream economics does not assume a priori that markets are preferable to other forms of social organization. In fact, much analysis is devoted to cases where market failures lead to resource allocation that is suboptimal and creates deadweight loss. A classic example of suboptimal resource allocation is that of a public good. In such cases, economists may attempt to find policies that avoid waste, either directly by government control, indirectly by regulation that induces market participants to act in a manner consistent with optimal welfare, or by creating "missing markets" to enable efficient trading where none had previously existed. 

This is studied in the field of collective action and public choice theory. "Optimal welfare" usually takes on a Paretian norm, which is a mathematical application of the Kaldor–Hicks method. This can diverge from the Utilitarian goal of maximizing utility because it does not consider the distribution of goods between people. Market failure in positive economics (microeconomics) is limited in implications without mixing the belief of the economist and their theory.

The demand for various commodities by individuals is generally thought of as the outcome of a utility-maximizing process, with each individual trying to maximize their own utility under a budget constraint and a given consumption set.

Basic microeconomic concepts

The study of microeconomics involves several "key" areas:

Demand, supply, and equilibrium

Supply and demand is an economic model of price determination in a perfectly competitive market. It concludes that in a perfectly competitive market with no externalities, per unit taxes, or price controls, the unit price for a particular good is the price at which the quantity demanded by consumers equals the quantity supplied by producers. This price results in a stable economic equilibrium.

Measurement of elasticities

Elasticity is the measurement of how responsive an economic variable is to a change in another variable. Elasticity can be quantified as the ratio of the change in one variable to the change in another variable, when the later variable has a causal influence on the former. It is a tool for measuring the responsiveness of a variable, or of the function that determines it, to changes in causative variables in unitless ways. Frequently used elasticities include price elasticity of demand, price elasticity of supply, income elasticity of demand, elasticity of substitution or constant elasticity of substitution between factors of production and elasticity of intertemporal substitution.

Consumer demand theory

Consumer demand theory relates preferences for the consumption of both goods and services to the consumption expenditures; ultimately, this relationship between preferences and consumption expenditures is used to relate preferences to consumer demand curves. The link between personal preferences, consumption and the demand curve is one of the most closely studied relations in economics. It is a way of analyzing how consumers may achieve equilibrium between preferences and expenditures by maximizing utility subject to consumer budget constraints.

Theory of production

Production theory is the study of production, or the economic process of converting inputs into outputs. Production uses resources to create a good or service that is suitable for use, gift-giving in a gift economy, or exchange in a market economy. This can include manufacturing, storing, shipping, and packaging. Some economists define production broadly as all economic activity other than consumption. They see every commercial activity other than the final purchase as some form of production.

Costs of production

The cost-of-production theory of value states that the price of an object or condition is determined by the sum of the cost of the resources that went into making it. The cost can comprise any of the factors of production: labour, capital, land, entrepreneur. Technology can be viewed either as a form of fixed capital (e.g. plant) or circulating capital (e.g. intermediate goods). 

In the mathematical model for the cost of production, the short-run total cost is equal to fixed cost plus total variable cost. The fixed cost refers to the cost that is incurred regardless of how much the firm produces. The variable cost is a function of the quantity of an object being produced.

Opportunity cost

The economic idea of opportunity cost is closely related to the idea of time constraints. You can do only one thing at a time, which means that, inevitably, you’re always giving up other things. 

The opportunity cost of any activity is the value of the next-best alternative thing you may have done instead. Opportunity cost depends only on the value of the next-best alternative. It doesn’t matter whether you have 5 alternatives or 5,000.

Opportunity costs can tell you when not to do something as well as when to do something. For example, you may like waffles, but you like chocolate even more. If someone offers you only waffles, you’re going to take it. But if you’re offered waffles or chocolate, you’re going to take the chocolate. The opportunity cost of eating waffles is sacrificing the chance to eat chocolate. Because the cost of not eating the chocolate is higher than the benefits of eating the waffles, it makes no sense to choose waffles. Of course, if you choose chocolate, you’re still faced with the opportunity cost of giving up having waffles. But you’re willing to do that because the waffle's opportunity cost is lower than the benefits of the chocolate. Opportunity costs are unavoidable constraints on behaviour because you have to decide what’s best and give up the next-best alternative.

Market structure

The market structure can have several types of interacting market systems. Different forms of markets are a feature of capitalism and market socialism, with advocates of state socialism often criticizing markets and aiming to substitute or replace markets with varying degrees of government-directed economic planning. 

Competition acts as a regulatory mechanism for market systems, with government providing regulations where the market cannot be expected to regulate itself. One example of this is with regards to building codes, which if absent in a purely competition regulated market system, might result in several horrific injuries or deaths to be required before companies would begin improving structural safety, as consumers may at first not be as concerned or aware of safety issues to begin putting pressure on companies to provide them, and companies would be motivated not to provide proper safety features due to how it would cut into their profits. 

Some examples of markets:

• commodity markets
• insurance markets
• bond markets
• energy markets
• flea markets
• debt markets
• stock markets
• online auctions
• media exchange markets
• real-estate market.

Perfect competition

Perfect competition is a situation in which numerous small firms producing identical products compete against each other in a given industry. Perfect competition leads to firms producing the socially optimal output level at the minimum possible cost per unit. Firms in perfect competition are "price takers" (they do not have enough market power to profitably increase the price of their goods or services). A good example would be that of digital marketplaces, such as eBay, on which many different sellers sell similar products to many different buyers. Consumers in a perfect competitive market have perfect knowledge about the products that are being sold in this market.

Imperfect competition

In economic theory, imperfect competition is a type of market structure showing some but not all features of competitive markets.

Monopolistic competition

Monopolistic competition is a situation in which many firms with slightly different products compete. Production costs are above what may be achieved by perfectly competitive firms, but society benefits from the product differentiation. Examples of industries with market structures similar to monopolistic competition include restaurants, cereal, clothing, shoes, and service industries in large cities.

Monopoly

A monopoly is a market structure in which a market or industry is dominated by a single supplier of a particular good or service. Because monopolies have no competition they tend to sell goods and services at a higher price and produce below the socially optimal output level. However, not all monopolies are a bad thing, especially in industries where multiple firms would result in more costs than benefits (i.e. natural monopolies).

• Natural monopoly: A monopoly in an industry where one producer can produce output at a lower cost than many small producers.

Oligopoly

An oligopoly is a market structure in which a market or industry is dominated by a small number of firms (oligopolists). Oligopolies can create the incentive for firms to engage in collusion and form cartels that reduce competition leading to higher prices for consumers and less overall market output. Alternatively, oligopolies can be fiercely competitive and engage in flamboyant advertising campaigns.

• Duopoly: A special case of an oligopoly, with only two firms. Game theory can elucidate behavior in duopolies and oligopolies.

Monopsony

A monopsony is a market where there is only one buyer and many sellers.

Oligopsony

An oligopsony is a market where there are a few buyers and many sellers.

Game theory

Game theory is a major method used in mathematical economics and business for modeling competing behaviors of interacting agents. The term "game" here implies the study of any strategic interaction between people. Applications include a wide array of economic phenomena and approaches, such as auctions, bargaining, mergers & acquisitions pricing, fair division, duopolies, oligopolies, social network formation, agent-based computational economics, general equilibrium, mechanism design, and voting systems, and across such broad areas as experimental economics, behavioral economics, information economics, industrial organization, and political economy.

Labor economics

Labor economics seeks to understand the functioning and dynamics of the markets for wage labor. Labor markets function through the interaction of workers and employers. Labor economics looks at the suppliers of labor services (workers), the demands of labor services (employers), and attempts to understand the resulting pattern of wages, employment, and income. In economics, labor is a measure of the work done by human beings. It is conventionally contrasted with such other factors of production as land and capital. There are theories which have developed a concept called human capital (referring to the skills that workers possess, not necessarily their actual work), although there are also counter posing macro-economic system theories that think human capital is a contradiction in terms.

Welfare economics

Welfare economics is a branch of economics that uses microeconomics techniques to evaluate well-being from allocation of productive factors as to desirability and economic efficiency within an economy, often relative to competitive general equilibrium. It analyzes social welfare, however measured, in terms of economic activities of the individuals that compose the theoretical society considered. Accordingly, individuals, with associated economic activities, are the basic units for aggregating to social welfare, whether of a group, a community, or a society, and there is no "social welfare" apart from the "welfare" associated with its individual units.

Economics of information

Information economics or the economics of information is a branch of microeconomic theory that studies how information and information systems affect an economy and economic decisions. Information has special characteristics. It is easy to create but hard to trust. It is easy to spread but hard to control. It influences many decisions. These special characteristics (as compared with other types of goods) complicate many standard economic theories.

Applied

United States Capitol Building: meeting place of the United States Congress, where many tax laws are passed, which directly impact economic welfare. This is studied in the subject of public economics.

 

Applied microeconomics includes a range of specialized areas of study, many of which draw on methods from other fields. Industrial organization examines topics such as the entry and exit of firms, innovation, and the role of trademarks. Labor economics examines wages, employment, and labor market dynamics. Financial economics examines topics such as the structure of optimal portfolios, the rate of return to capital, econometric analysis of security returns, and corporate financial behavior. Public economics examines the design of government tax and expenditure policies and economic effects of these policies (e.g., social insurance programs). Political economy examines the role of political institutions in determining policy outcomes. Health economics examines the organization of health care systems, including the role of the health care workforce and health insurance programs. Education economics examines the organization of education provision and its implication for efficiency and equity, including the effects of education on productivity. Urban economics, which examines the challenges faced by cities, such as sprawl, air and water pollution, traffic congestion, and poverty, draws on the fields of urban geography and sociology. Law and economics applies microeconomic principles to the selection and enforcement of competing legal regimes and their relative efficiencies. Economic history examines the evolution of the economy and economic institutions, using methods and techniques from the fields of economics, history, geography, sociology, psychology, and political science.