The Economics Book (DK) (Part 3)

People are Not 100% Rational (Behavioral Economics). People sometimes make irrational decisions. They are affected by ‘whether they stand to gain or lose, and how the question is framed.’ Many are generally risk averse. However, in reality people are risk averse when they are winning and risk seeking when they are losing. How the question is framed also matters. This is where mass media can come in. The stages and outcomes in each stage also matter. Prospect theory in action. People place a lot more on things they already own. This is the ‘endowment effect’.

One may discover that the relative attractiveness of options varies when the same decision problem is framed in different ways. – Amos Tversky, Daniel Kahneman

Tax Cuts Can Increase the Tax Take (Taxation and Economic Incentives). In some cases, cutting taxes can result in government collecting more and not less money. Supply side economists believe that to improve the economy it is necessary to regulate less and free suppliers from high tax. Therefore, if the number of worked hours reduced outweighs the tax rate, then overall revenue will drop. There will exist a point where government will maximize revenue.

If a government takes no tax, it will get no revenue. If it takes 100% of tax, it will get no revenue wither, since no one will work. – Arthur Laffer

Prices Tell You Everything (Efficient Markets). Eugene Fama predicted that since markets are efficient, it is not possible to beat the market consistently. This is known as the EMH. Everyone has the same information. However, investors suffer from overconfidence and the ‘Herd’ instinct.

In an efficient market at any point in time the actual price of a security will be a good estimate of its intrinsic value. – Eugene Fama

Over Time, Even the Selfish Cooperate with Others (Competition and Cooperation). Cooperation is beneficial most of the time. Would it to better to cooperate or to stay selfish? ‘Tit-for –tat’ strategy can work. Axelrod was the leader in this field. In reality, it was shown that cooperation can produce mutually beneficial outcome.

Most Cars Traded Will be Lemons (Market Uncertainty). The buyer has limited information and therefore is uncertain. He is unwilling to pay a high price for a second-hand good. Sellers withdraw their products, leaving only lemons behind. This is a failure of the market. Adverse selection is at work in the insurance market.

The Government’s Promises are Incredible (Independent Central Banks). Governments should avoid using discretionary policy but clear and simple ones. Discretionary policy will cause individuals to adjust their behavior. Modern individuals look forward, not just backwards. Discretionary policies can work when individuals are surprised. This is covered in one of the earlier chapter, on people’s rational expectations. The solution is to introduce independent central banks.

The Economy is Chaotic Even When Individuals are Not (Complexity and Chaos). This is the Lorenz’ effect or butterfly effect. ‘Tiny changes in initial conditions can cause large changes in outcomes.’ ‘No system yet discovered guarantees a good return in the stock market.’ The economic model is no longer simply linear. Complexity theory has been developed. The way individuals interact with each other, sometimes not rationally, causes the economy to seem complex and difficult to predict.

Social Networks Are a Kind of Capital (Social Capital). The initial definition of capital is physical capital or human capital. In modern times, there is now social capital. Social capital facilitate skills development and knowledge sharing. ‘Social Capital is now generally accepted as a significant element of economic performance.’

Education is Only a Signal of Ability (Signalling and Screening). A better level of education has a signaling function. Screening is when the buyer wants to find out more information from the seller by asking questions. Both signaling and screening happen all the time. ‘If person 1 has more information than person 2 in a transaction, person 1 is likely to send a signal to allow person 2 to make a more informed decision.’

The East Asian State Governs the Market (Asian Tiger Economies). It was long understood that for poor countries to emerge, the state needed to invest in infrastructure and industries. The five tigers, South Korea, Hong Kong, Singapore, Taiwan and Malaysia grew dramatically after WWII. By the 20th century, their standard of living was comparable to those in Europe. ‘East Asia miracle’. The governments shaped development by steering investment towards strategic industries. Shift from agriculture to manufacturing sector. They supported markets. Defence and Schooling helped correct market failures. Performance criteria was set as well. A few nations chose to lead markets, even those there was no competitive advantage initially. Initially, there is a need to resist private interests. ‘An authoritarian government that was responsible for promoting the private sector and exports.’

Beliefs can Trigger Currency Crises (Speculation and Currency Devaluation). A currency crisis is when one currency loses a lot of its value suddenly. This is usually caused when there is a large sell off, when many people withdraw funds. They are hard to predict. High inflation can also cause currency to devalue. Another way is when commodities devalue. When government policies are inconsistent with the exchange rate, it happens. An example includes printing too much money in a fiscal deficit. Shadow rate is what the exchange rate will be without government intervention. It is possible to speculate by buying all the foreign reserves of the country. The exchange rate will move from the shadow one to the fixed exchange rate. Currencies can collapse if they are pegged to another. It is also possible for crises to emerge without a speculative attack. Crises could also emerge if ‘banks borrow in foreign currency and lend in local currency.’ In the event of currency devaluation, they would be unable to pay. This makes it vulnerable to a speculative attack. The 3 main factors for currency collapse are when ‘foreign capital inflow is low, when central bank’s foreign currency reserves are low, and domestic credit growth is high.’

Auction Winners Pay Over the Odds (The Winner’s Curse). Usually, auction winner is the one with the highest bid over the true value. Since the actual value is actually the middle of the bids, the winner ends up paying more. There are three types ‘English auction’, ‘Dutch auction’ and ‘First price auction’. All 3 kinds yield the same revenue for the seller, this is known as ‘revenue equivalence theory’. It is optimal for bidders to bid below their valuations. This is called ‘shading’. There is one kind of auction, similar to the ‘first price auction’, that involves the winner only paying as much as the second-highest bid.

Stable Economies Contain the Seeds of Instability (Financial Crises). Crises are usually caused by excessive debt and falling prices. Institutions have a big role to play in a crises. Bankers try to innovate too much. The invention of CDO and CDS. It was getting harder for governments to control money supply. During times of growth, people become overconfident and take on more risks. There are speculative borrowers, who keep buying property and think the prices will go up forever. Know the idea of Ponzi schemes. The moment of the crisis, when the bubble bursts, is known as ‘Minsky moment’. When institutions stop lending to each other, the economy is in deep trouble. The central bank could act as the lender in the last resort. Second method would be to increase debt to stimulate the economy. The last would be to subject the market to further regulation.

Money is a veil behind which the action of real, economic forces is concealed. – Arthur Pigou

The peculiar behavioral attributes of a capitalist economy centre around the impact of finance upon system behavior. – Hyman Minsky

Businesses Pay More than the Market Wage (Incentives and Wages). Firms pay more than the market wage to get more from their employees. Because of moral hazard, employers can’t monitor employees all the time. This is the concept of ‘efficient wages’. Higher wages are associated with less turnover and better morale

Real Wages Rise During a Recession (Sticky Wages). Wages in real terms are ‘sticky’ and will respond slowly (in the long run) to change in market conditions. ‘Wage stickiness could coexist with rational individuals’. ‘Menu costs’ cause prices to be more sticky.

If you were going to turn to only one economist to understand the problem facing the economy, there is little doubt that the economist would be John Maynard Keynes. – Greg Mankiw

Finding a Job is Like Finding a Partner or a House (Searching and Matching). Finding a used product, a house etc is not easy and involves cost. ‘Individuals cannot search indefinitely, so they will work most effectively if they search within a range.’ When buyers and sellers can’t find each other, this is known as the ‘search theory’. In reality, there is a cost to searching. People should set a reservation wage and not accept anything below this. Once the wage offered is above this, they should accept it. A tiny cost involved in a search will lead to an increase in prices.

The Biggest Challenge For Collective Action is Climate Change (Economics and the Environment). The Kyoto Protocol was ratified in 1997. Burning of fossil fuels release CO2. Some argue that the costs of combating climate change is more damaging to economic prosperity. However, there are economists which calculate that it is beneficial to care for the environment in a GDP sense. Since the cost of pollution is deferred, some countries don’t care. Climate change affects everyone, therefore there is a need for collective action. Atmosphere is a public good. To combat climate change, emission policy is possible. However, it is difficult to find one policy that will solve everything. Taxing polluters is one way, so it tradable permits. Many have ratified the Kyoto Protocol but they can’t meet the targets in the Protocol.

Price-type approaches like harmonized taxes on carbon are powerful tools for coordinating policies and slowing global warming. – William Nordhaus

GDP Ignores Women (Gender and Economics). GDP is subject to problems. GDP measures goods bought and sold, but does not take into account depletion of natural resources, deforestation etc. Women who do housework are not counted in the GDP calculation, as it is not paid. Cooking to sell food is an economic activity, whereas cooking at home is not.

We women are visible and valuable to each other, and we must, now in our billions, proclaim that visibility and that worth. – Marilyn Waring

Comparative Advantage is an Accident. Producers attract other producers. Production has economies of scale. Once someone starts it first, has the first mover advantage, it is hard for other countries to compete.

Regions that for historical reason have a head start as centres of production will attract even more producers. – Paul Krugman

Like Steam, Computers have Revolutionized Economies (Technological Leaps). There are two kinds of technology, the first is general purpose and the second is specific purpose. General purpose is like electricity, where all can enjoy. Specific purpose is just limited to a certain industry.

We can Kick-start Poor Economies by Writing Off Debt (International Debt Relief). Rich countries should not lend to corrupt countries and should just write off the debt. The poor countries can’t pay anyway. IMF is an example of one which lends money to poor nations. The nation is technically not responsible as it is just a few corrupt individuals which are responsible. Austerity measures are passed in Europe, with no writing off of debt.

Pessimism Can Destroy Healthy Banks (Bank Runs). Even healthy banks can suffer. If banks have long term investments, they will have a liquidity problem when depositors withdraw funds. They will have to sell investments at a loss, causing a bank run. It is logical that banks will want to offer deposits. People’s expectations can manifest themselves into a self fulfilling prophecy. There are ways to prevent this. One is deposit insurance. Restricting people on withdrawing is another, so is depending on the central bank for bailout. Regulation can prevent moral hazard. In a bank run, only the first few depositors can get their money back.

A bank run in our model is caused by a shift in expectations, which could depend on almost anything. – Douglas Diamond; Philip Dybvig

In the history of modern capitalism, crises are the norm, not the exception. – Nouriel Roubini, Stephen Mihm

Savings Gluts Abroad Fuel Speculation At Home (Global Savings Imbalances). Ben Bernanke believed that the imbalance in savings and spending can cause crises. Deficits can be funded with funds from foreign investments, or by running down bank reserves. He believed that the Chinese saved too much, while the US was running a huge deficit. Countries with surpluses usually lend to others with deficits. He claimed that an excess of funds in the US caused people to not save and to spend more. Many have challenged his theory. Derivatives were at fault for the crisis. China likes to devalue its currency so as to make exports attractive.

More Equal Societies Grow Faster (Inequality and Growth). The widening income disparity, the more the poor will want the government to tax the rich and redistribute the wealth to them. More equal societies faster. Is taxation set to maximize government revenue or for pleasing the median person in society.

The greater the inequality of wealth and income, the higher the rate of taxation, and the lower growth. – Alberto Alesina; Dani Rodrik

Even Beneficial Economic Reforms Can Fail (Resisting Economic Change). Reform is difficult and nobody likes it. It is even harder if the government is corrupt. Corrupted governments will come up with policies to redistribute the wealth among themselves. Reforms are effective in clean governments. However, the citizens might reject and vote the party in power out.

The Housing Market Mirrors Boom and Bust (Housing and the Economic Cycle). Boom and bust is usually over 3 to 7 years. Housing prices has a lag effect, they do not respond so quickly to a drop in demand. A decline in demand for housing is a sign of recession. When people believe that their housing price will rise, this signals recovery. Based on housing prices, it is possible to predict when a recession will strike. However, in 2008, it was clear that a housing bubble burst.

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