• PRINCIPAL-AGENT THEORY
• See AGENCY COSTS.
• PRISONERS' DILEMMA
• A favourite example in GAME THEORY, which shows why co-operation is difficult to achieve even when it is mutually beneficial. Two prisoners have been arrested for the same offence and are held in different cells. Each has two options: confess, or say nothing. There are three possible outcomes. One could confess and agree to testify against the other as state witness, receiving a light sentence while his fellow prisoner receives a heavy sentence. They can both say nothing and may be lucky and get light sentences or even be let off, owing to lack of firm evidence. Or they may both confess and probably get lighter individual sentences than one would have received had he said nothing and the other had testified against him. The second outcome would be the best for both prisoners. However, the RISK that the other might confess and turn state witness is likely to encourage both to confess, landing both with sentences that they might have avoided had they been able to co-operate in remaining silent. In an OLIGOPOLY, FIRMS often behave like these prisoners, not setting PRICES as high as they could do if they only trusted the other firms not to undercut them. As a result, they are worse off.
• PRIVATE EQUITY
• When a firm’s SHARES are held privately and not traded in the public markets. Private equity includes shares in both mature private companies and, as VENTURE CAPITAL, in newly started businesses. As it is less liquid than publicly traded EQUITY, investors in private equity expect on average to earn a higher EQUITY RISK PREMIUM from it.
• PRIVATISATION
• Selling state-owned businesses to private investors. This policy was associated initially with Margaret Thatcher’s government in the 1980s, which privatised numerous companies, including PUBLIC UTILITY businesses such as British Telecom, British Gas, and electricity and water companies. During the 1990s, privatisation became a favourite policy of governments all over the world.
• There were several reasons for the popularity of privatisation. In some instances, the aim was to improve the performance of publicly owned companies. Often NATIONALISATION had failed to achieve its goals and had become increasingly associated with poor service to customers. Sometimes privatisation was part of transforming a state-owned MONOPOLY into a competitive market, by combining ownership transfer with DEREGULATION and LIBERALISATION. Sometimes privatisation offered a way to raise new CAPITAL for the firm to invest in improving its service, MONEY that was not available in the public sector because of constraints on PUBLIC SPENDING. Indeed, perhaps the main attraction of privatisation to many politicians was that the proceeds from it could ease the pressure on the public purse. As a result, they could avoid (in the short-term) doing the more painful things necessary to improve the fiscal position, such as raising taxes or cutting public spending.
• PROBABILITY
• How likely something is to happen, usually expressed as the ratio of the number of ways the outcome may occur to the number of total possible outcomes for the event. For instance, each time you throw a dice there are six possible outcomes, but in only one of these can a six come up. Thus the probability of throwing a six on any given throw is one in six. The fact that you threw a six last time does not alter the one-in-six probability of throwing a six next time (see RISK).
• PRODUCER PRICES
• See FACTORY PRICES.
• PRODUCER SURPLUS
• The difference between what a supplier is paid for a good or service and what it cost to SUPPLY. Added to CONSUMER SURPLUS, it provides a measure of the total economic benefit of a sale.
• PRODUCTION FUNCTION
• A mathematical way to describe the relationship between the quantity of inputs used by a firm and the quantity of OUTPUT it produces with them. If the amount of inputs needed to produce one more unit of output is less than was needed to produce the last unit of output, then the firm is enjoying increasing RETURNS to scale (or increasing MARGINAL product). If each extra unit of output requires a growing amount of inputs to produce it, the firm faces diminishing returns to scale (diminishing marginal product).
• PRODUCTIVITY
• The relationship between inputs and OUTPUT, which can be applied to individual FACTORS OF PRODUCTION or collectively. LABOUR productivity is the most widely used measure and is usually calculated by dividing total output by the number of workers or the number of hours worked. Total factor productivity attempts to measure the overall productivity of the inputs used by a firm or a country.
• Alas, the usefulness of productivity statistics is questionable. The quality of different inputs can change significantly over time. There can also be significant differences in the mix of inputs. Furthermore, firms and countries may use different definitions of their inputs, especially CAPITAL.
• That said, much of the difference in countries’ living standards reflects differences in their productivity. Usually, the higher productivity is the better, but this is not always so. In the UK during the 1980s, labour productivity rose sharply, leading some economists to talk of a “productivity miracle”. Others disagreed, saying that productivity had risen because unemployment had risen – in other words, the least productive workers had been removed from the figures on which the AVERAGE was calculated.
• There was a similar debate in the United States starting in the late 1990s. Initially, economists doubted that a productivity miracle was taking place. But by 2003, they conceded that during the previous five years the United States enjoyed the fastest productivity growth in any such period since the second world war. Over the whole period from 1995, labour productivity growth averaged almost 3% a year, twice the average rate over the previous two decades. That did not stop economists debating why the miracle had occurred.
• PROFIT
• The main reason FIRMS exist. In economic theory, profit is the reward for RISK taken by ENTERPRISE, the fourth of the FACTORS OF PRODUCTION – what is left after all other costs, including RENT, WAGES and INTEREST. Put simply, profit is a firm’s total revenue minus total cost.
• Economists distinguish between normal profit and excess profit. Normal profit is the opportunity cost of the ENTREPRENEUR, the amount of profit just sufficient to keep the firm in business. If profit is any lower than that, then enterprise would be better off engaged in some alternative economic activity. Excess profit, also known as super-normal profit, is profit above normal profit and is usually evidence that the firm enjoys some MARKET POWER that allows it to be more profitable than it would be in a market with PERFECT COMPETITION.
• PROFIT MARGIN
• A firm’s PROFIT expressed as a percentage of its turnover or sales.
• PROFIT MAXIMISATION
• The presumed goal of FIRMS. In practice, business people often trade off making as much profit as possible against other goals, such as building business empires, being popular with staff and enjoying life. The growing popularity in recent years of paying bosses with SHARES in their firm may have reduced the AGENCY COSTS that arise because they are the hired hands of shareholders, making them more likely to pursue profit maximisation.
• PROGRESSIVE TAXATION
• TAXATION that takes a larger proportion of a taxpayer’s INCOME the higher the income is. (See VERTICAL EQUITY.)
• PROPENSITY
• ECONOMICS abounds with propensities to do various things: consume, save, invest, import, and so on. In each case, it is important to distinguish between the AVERAGE propensity and the MARGINAL one. The average propensity to consume is simply total CONSUMPTION divided by total INCOME. The marginal propensity to consume measures how much of each extra dollar of income is consumed: the percentage change in consumption divided by the percentage change in income. The value of the marginal propensity to consume, which determines the MULTIPLIER, is harder to predict than the value of the average propensity to consume.
• PROPERTY RIGHTS
• Essential to any market economy. To trade, it is essential to know that the person selling a good or service owns it and that ownership will pass to the buyer. The stronger and clearer property rights are, the more likely it is that trade will take place and that PRICES will be efficient. If there are no property rights over something there can be severe consequences. A solution to the costly EXTERNALITY of clean air being polluted may be to establish property rights over the air, so that the owner can charge the polluter to pump smoke into the atmosphere.
• Private property rights are often more economically efficient than common ownership. When people do not own something directly, they may have little incentive to look after it. (See the TRAGEDY OF THE COMMONS.) Strikingly, in Russia after COMMUNISM, the establishment of a well-functioning market economy proved difficult, partly because it was unclear who owned many of the country’s resources, and those property rights that did exist often counted for little. Businesses would often have their products stolen by criminal gangs or be forced to hand over most of their profits in protection money. It is no coincidence that an effective judicial system, as well as property rights for it to enforce, is a feature of all advanced market economies.
• That said, nowhere are property rights absolute. For instance, TAXATION is a clear example of the state infringing taxpayers’ ownership of their money. The economic cost of infringing property rights underlines how important it is that governments think carefully about the consequences for economic GROWTH of their tax policies.
• PROSPECT THEORY
• A theory of “irrational” economic behaviour. Prospect theory holds that there are recurring biases driven by psychological factors that influence people’s choices under uncertainty. In particular, it assumes that people are more motivated by losses than by gains and as a result will devote more energy to avoiding loss than to achieving gain. The theory is based on the experimental work of two psychologists, Daniel Kahneman (who won a NOBEL PRIZE FOR ECONOMICS for it) and Amos Tversky (1937–96). It is an important component of BEHAVIOURAL ECONOMICS.
• PROTECTIONISM
• Opposition to FREE TRADE. Although intended to protect a country’s economy from foreign competitors, it usually makes the protected country worse off than if it allowed international trade to proceed without hindrance from trade barriers such as QUOTAS and TARIFFS.
• PUBLIC GOODS
• Things that can be consumed by everybody in a society, or nobody at all. They have three characteristics. They are:
• • non-rival – one person consuming them does not stop another person consuming them;
• • non-excludable – if one person can consume them, it is impossible to stop another person consuming them;
• • non-rejectable – people cannot choose not to consume them even if they want to.
• Examples include clean air, a national defence system and the judiciary. The combination of non-rivalry and non-excludability means that it can be hard to get people to pay to consume them, so they might not be provided at all if left to MARKET FORCES. Thus public goods are regarded as an example of MARKET FAILURE, and in most countries they are provided at least in part by GOVERNMENT and paid for through compulsory TAXATION. (See also GLOBAL PUBLIC GOODS.)
• PUBLIC SPENDING
• Spending by national and local GOVERNMENT and some government-backed institutions. See FISCAL POLICY, GOLDEN RULE and BUDGET.
• PUBLIC UTILITY
• A firm providing essential services to the public, such as water, electricity and postal services, usually involving elements of NATURAL MONOPOLY. Food is essential, but because it is provided in a competitive market, food SUPPLY is not usually regarded as a public utility. Because public utilities have some MONOPOLY power, they are typically subject to some REGULATION by GOVERNMENT, such as PRICE controls and perhaps an obligation to provide their services to everybody, even to those who cannot afford to pay a market price (the universal service obligation). Public utilities are often owned by the state, although this has become less common as a result of PRIVATISATION.
• PUBLIC-PRIVATE
• Using private FIRMS to carry out aspects of GOVERNMENT. This has become increasingly popular since the early 1980s as governments have tried to obtain some of the benefits of the private sector without going as far as full PRIVATISATION. The gains have been greatest when SERVICES have been allocated to private firms through competitive bidding. They have been smallest, and arguably even negative, in cases when the main contribution of the private firm has been to raise finance. That is because governments can usually borrow more cheaply than private firms, so when they ask them to raise money the question that springs to mind is: are they doing this to make their public borrowing look smaller?
• PURCHASING POWER PARITY
• A method for calculating the correct value of a currency, which may differ from its current market value. It is helpful when comparing living standards in different countries, as it indicates the appropriate EXCHANGE RATE to use when expressing incomes and PRICES in different countries in a common currency.
• By correct value, economists mean the exchange rate that would bring DEMAND and SUPPLY of a currency into EQUILIBRIUM over the long-term. The current market rate is only a short-run equilibrium. Purchasing power parity (PPP) says that goods and SERVICES should cost the same in all countries when measured in a common currency.
• PPP is the exchange rate that equates the price of a basket of identical traded goods and services in two countries. PPP is often very different from the current market exchange rate. Some economists argue that once the exchange rate is pushed away from its PPP, trade and financial flows in and out of a country can move into DISEQUILIBRIUM, resulting in potentially substantial trade and current account deficits or surpluses. Because it is not just traded goods that are affected, some economists argue that PPP is too narrow a measure for judging a currency’s true value. They prefer the fundamental equilibrium exchange rate (FEER), which is the rate consistent with a country achieving an overall balance with the outside world, including both traded goods and services and CAPITAL flows. (See BIG MAC INDEX.)