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- ECONOMICS
- The “dismal science”, according to Thomas Carlyle, a 19th-century Scottish writer. It has been described in many ways, few of them flattering. The most concise, non-abusive, definition is the study of how society uses its scarce resources.
- ECONOMIES OF SCALE
- Bigger is better. In many industries, as output increases, the AVERAGE cost of each unit produced falls. One reason is that overheads and other FIXED COSTS can be spread over more units of OUTPUT. However, getting bigger can also increase average costs (diseconomies of scale) because it is more difficult to manage a big operation, for instance.
- EFFECTIVE EXCHANGE RATE
- See TRADE-WEIGHTED EXCHANGE RATE.
- EFFICIENCY
- Getting the most out of the resources used. For a particular sort of efficiency often favoured by economists, see PARETO EFFICIENT.
- EFFICIENCY WAGES
- WAGES that are set at above the market clearing rate so as to encourage workers to increase their PRODUCTIVITY.
- EFFICIENT MARKET HYPOTHESIS
- You can’t beat the market. The efficient market hypothesis says that the PRICE of a financial ASSET reflects all the INFORMATION available and responds only to unexpected news. Thus prices can be regarded as optimal estimates of true investment value at all times. It is impossible for investors to predict whether the price will move up or down (future price movements are likely to follow a RANDOM WALK), so on AVERAGE an investor is unlikely to beat the market. This belief underpins ¬ARBITRAGE PRICING THEORY, the CAPITAL ASSET PRICING MODEL and concepts such as BETA.
- The hypothesis had few critics among financial economists during the 1960s and 1970s, but it has come under increasing attack since then. The fact that financial prices were far more volatile than appeared to be justified by new information, and that financial bubbles sometimes formed, led economists to question the theory. BEHAVIOURAL ECONOMICS has challenged one of the main sources of market efficiency, the idea that all investors are fully rational HOMO ECONOMICUS. Some economists have noted the fact that information gathering is a costly process, so it is unlikely that all available information will be reflected in prices. Others have pointed to the fact that ARBITRAGE can become more costly, and thus less likely, the further away from fundamentals prices move. The efficient market hypothesis is now one of the most controversial and well-studied propositions in ECONOMICS, although no consensus has been reached on which markets, if any, are efficient. However, even if the ideal does not exist, the efficient market hypothesis is useful in judging the relative efficiency of one market compared with another.
- ELASTICITY
- A measure of the responsiveness of one variable to changes in another. Economists have identified four main types.
- • PRICE ELASTICITY measures how much the quantity of SUPPLY of a good, or DEMAND for it, changes if its PRICE changes. If the percentage change in quantity is more than the percentage change in price, the good is price elastic; if it is less, the good is INELASTIC.
- • INCOME elasticity of demand measures how the quantity demanded changes when income increases.
- • Cross-elasticity shows how the demand for one good (say, coffee) changes when the price of another good (say, tea) changes. If they are SUBSTITUTE GOODS (tea and coffee) the cross-elasticity will be positive: an increase in the price of tea will increase demand for coffee. If they are COMPLEMENTARY GOODS (tea and teapots) the cross-elasticity will be negative. If they are unrelated (tea and oil) the cross-elasticity will be zero.
- • Elasticity of substitution describes how easily one input in the production process, such as LABOUR, can be substituted for another, such as machinery.
- EMERGING MARKETS
- See DEVELOPING COUNTRIES.
- ENDOGENOUS
- Inside the economic model; the opposite of EXOGENOUS (see also GROWTH).
- ENGEL'S LAW
- People generally spend a smaller share of their BUDGET on food as their INCOME rises. Ernst Engel, a Russian statistician, first made this observation in 1857. The reason is that food is a necessity, which poor people have to buy. As people get richer they can afford better-quality food, so their food spending may increase, but they can also afford LUXURIES beyond the budgets of poor people. Hence the share of food in total spending falls as incomes grow.
- ENRON
- In a word, all that was wrong with American CAPITALISM at the start of the 21st century. Until late 2001, Enron, an energy company turned financial powerhouse based in Houston, Texas, had been one of the most admired firms in the United States and the world. It was praised for everything from pioneering energy trading via the internet to its innovative corporatate culture and its system of employment evaluation by peer review, which resulted in those that were not rated by their peers being fired. However, revelations of accounting fraud by the firm led to its BANKRUPTCY, prompting what was widely described as a crisis of confidence in American capitalism. This, as well as further scandals involving accounting fraud (WorldCom) and other dubious practices (many by Wall Street firms), resulted in efforts to reform coporate governance, the legal liability of company bosses, accounting, Wall Street research and REGULATION.
- ENTERPRISE
- One of the FACTORS OF PRODUCTION, along with LAND, LABOUR and CAPITAL. The creative juices of CAPITALISM; the ANIMAL SPIRITS of the ENTREPRENEUR.
- ENTREPRENEUR
- The life and soul of the capitalist party. Somebody who has the idea and ENTERPRISE to mix together the other FACTORS OF PRODUCTION to produce something valuable. An entrepreneur must be willing to take a RISK in pursuit of a PROFIT.
- ENVIRONMENTAL ECONOMICS
- Some people think CAPITALISM is wholly bad for the environment as it is based on consuming scarce resources. They want less CONSUMPTION and greater reliance on renewable resources. They oppose FREE TRADE because they favour self-sufficiency (AUTARKY), or at least so-called FAIR TRADE, and because they believe it encourages poorer countries to destroy their natural resources in order to get rich quick. Although few professional economists would share these views, in recent years many attempts have been made to incorporate environmental concerns within mainstream economics.
- The traditional measure of GDP incorporates only those things that are paid for; this may include things that reduce the overall quality of life, including harming the environment. For instance, cleaning up an oil spill will increase GDP if people are paid for the clean-up. Attempts have been made to devise an alternative environmentally friendly measure of NATIONAL INCOME, but so far progress has been limited. At the very least, traditional economists increasingly agree that maximising GDP growth does not necessarily equal maximising social WELFARE.
- Much of the damage done to the environment may be a result of externalities. An EXTERNALITY can arise when people engaged in economic activity do not have to take into account the full costs of what they are doing. For instance, car drivers do not have to bear the full cost of making their contribution to global warming, even though their actions may one day impose a huge financial burden on society. One way to reduce externalities is to tax them, say, through a fuel tax. Another is prohibition, say, limiting car drivers to one gallon of fuel per week. This could result in black markets, however. Allowing trade in pollution rights may encourage “efficient pollution”, with the pollution permits ending up in the hands of those for which pollution has the greatest economic upside. As this would still allow some environmental destruction, it might be unpopular with extreme greens.
- There may be a case for international eco markets. For instance, people in rich countries might pay people in poor countries to stop doing activities that do environmental damage outside the poor countries, or that rich people disapprove of, such as chopping down the rain forests. Choices on environmental policy, notably on measures to reduce the threat of global warming, involve costs today with benefits delayed until the distant future. How are these choices to be made? Traditional COST-BENEFIT ANALYSIS does not help much. In measuring costs and benefits in the far distant future, two main things seem to intervene and spoil the conventional calculations. One is uncertainty. We know nothing about what the state of the world will be in 2200. The other is how much people today are willing to pay in order to raise the welfare of others who are so remote that they can barely be imagined, yet who seem likely to be much better off materially than people today. Some economists take the view that the welfare of each future generation should be given the same weight in the analysis as the welfare of today’s. This implies that a much lower DISCOUNT RATE should be used than the one appropriate for short-term projects. Another option is to use a high discount rate for costs and benefits arising during the first 30 or so years, then a lower rate or rates for more distant periods. Many studies by economists and psychologists have found that people do in fact discount the distant future at lower rates than they apply to the near future.
- EQUILIBRIUM
- When SUPPLY and DEMAND are in balance. At the equilibrium PRICE, the quantity that buyers are willing to buy exactly matches the quantity that sellers are willing to sell. So everybody is satisfied, unlike when there is DISEQUILIBRIUM. In CLASSICAL ECONOMICS, it is assumed that markets always tend towards equilibrium and return to it in the event that something causes a temporary disequilibrium. GENERAL EQUILIBRIUM is when supply and demand are balanced simultaneously in all the markets in an economy. KEYNES questioned whether the economy always moved to equilibrium, for instance, to ensure FULL EMPLOYMENT.
- EQUITIES
- See SHARES.
- EQUITY
- There are two definitions in ECONOMICS.
- 1 The capital of a firm, after deducting any liabilities to outsiders other than shareholders, who are typically the legal owners of the firm’s equity. This ownership right is the reason SHARES are also known as equities.
- 2 Fairness. Dividing up the economic pie. Economists have been particularly interested in this with regard to how systems of TAXATION work. They have examined whether taxes treat fairly people with the same ability to pay (HORIZONTAL EQUITY) and people with different abilities to pay (VERTICAL EQUITY).
- The fairness of other aspects of how the gains from economic activity are distributed through society have also been debated by economists, especially those interested in WELFARE ECONOMICS. Some economists start with the presumption that the free-market outcome is inherently inequitable, and that equity (sharing out the pie) must be traded off against EFFICIENCY (maximising the size of the pie). Others argue that it is inequitable to take money away from someone who has created economic value to give to people who have been less skilled or industrious.
- EQUITY RISK PREMIUM
- The extra reward investors get for buying a SHARE over what they get for holding a less risky ASSET, such as a government BOND. Modern financial theory assumes that the premium will be just big enough on AVERAGE to compensate the investor for the extra RISK. However, studies have found that the average equity premium over many years has been much larger than appears to be justified by the average riskiness of shares. To solve this so-called equity premium puzzle, some economists have suggested that investors may have greater risk aversion towards shares than traditional theory assumes. Some claim that the past equity premium was mismeasured, or reflected an unrepresentative sample of share PRICES. Others suggest that the high premium is evidence that the EFFICIENT MARKET HYPOTHESIS does not apply to the stockmarket. Some economists think that the premium fell to more easily explained levels during the 1990s. Nobody really knows which, if any, of these interpretations is right.
- EURO
- The main currency of the EUROPEAN UNION, launched in January 1999 and in general circulation since 2002 (see ECONOMIC AND MONETARY UNION).
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