• NAFTA
• Short for North American Free-Trade Agreement. In 1993, the United States, Mexico and Canada agreed to lower the barriers to trade among the three economies. The formation of this regional TRADE AREA was opposed by many politicians in all three countries. In the United States and Canada, in particular, there were fears that NAFTA would result in domestic job losses to cheaper locations in Mexico. In the early years of the agreement, however, most studies found that the economic gains far outweighed any costs.
• NAIRU
• The non-accelerating-inflation rate of unemployment (see NATURAL RATE OF UNEMPLOYMENT).
• NASH EQUILIBRIUM
• An important concept in GAME THEORY, a Nash equilibrium occurs when each player is pursuing their best possible strategy in the full knowledge of the strategies of all other players. Once a Nash equilibrium is reached, nobody has any incentive to change their strategy. It is named after John Nash, a mathematician and Nobel prize-winning economist.
• NATION BUILDING
• Creating a country that works out of one that does not - because the old order has collapsed (as in the former Soviet Union), or been destroyed by war (Iraq), or never really functioned in the first place (Afghanistan). To transform a failed country can involve establishing order through the rule of law and creating legitimate GOVERNMENT and other effective social institutions, as well as a credible currency and a functioning market economy. Nation building is rarely easy, and often fiendishly difficult, especially where there are deep ethnic, religious or political divisions in the population or the country has no history of ever functioning effectively. Outside expertise, such as from the WORLD BANK, and MONEY (as in, most famouly, the MARSHALL PLAN) can help, but they are no guarantee of success.
• NATIONAL DEBT
• The total outstanding borrowing of a country’s GOVERNMENT (usually including national and local government). It is often described as a burden, although public DEBT may have economic benefits (see BALANCED BUDGET, FISCAL POLICY and GOLDEN RULE). Certainly, debt incurred by one generation may become a heavy burden for later generations, especially if the MONEY borrowed is not invested wisely. The national debt is a total of all the money ever raised by a government that has yet to be paid off; this is very different from an annual public-sector budget DEFICIT. In 1999, the American government celebrated a huge budget surplus, yet the country still had a national debt equal to nearly half its GDP.
• NATIONAL INCOME
• Shorthand for everything that is produced, earned or spent in a country (see GDP and GNP).
• NATIONALISATION
• When a GOVERNMENT takes ownership of a private-sector business. Nationalisation was a fashionable part of the mix in countries with a MIXED ECONOMY between 1945 and 1980, after which the PRIVATISATION of state-owned FIRMS became increasingly popular. The amount of public ownership in different countries has always varied considerably. Nationalisation has taken place for various reasons, ranging from socialist ideology to attempts to remedy examples of MARKET FAILURE.
• The performance of nationalised firms has often, but not always, been poor compared with their private-sector counterparts. State-owned businesses often enjoy a legally protected MONOPOLY, and the lack of COMPETITION means the firms face little pressure to be efficient. Politicians often interfere in important management decisions, making it harder to take unpopular actions on pay, factory closures and job cuts, particularly when there are strong public-sector trade UNIONS and a union-friendly government. Politically imposed financial constraints may also force public-sector firms to underinvest. Although privatisation has not been universally beneficial, on balance it has increased economic EFFICIENCY.
• NATURAL MONOPOLY
• When a MONOPOLY occurs because it is more efficient for one firm to serve an entire market than for two or more FIRMS to do so, because of the sort of ECONOMIES OF SCALE available in that market. A common example is water distribution, in which the main cost is laying a network of pipes to deliver water. One firm can do the job at a lower AVERAGE cost per customer than two firms with competing networks of pipes. Monopolies can arise unnaturally by a firm acquiring sole ownership of a resource that is essential to the production of a good or service, or by a government granting a firm the legal right to be the sole producer. Other unnatural monopolies occur when a firm is much more efficient than its rivals for reasons other than economies of scale. Unlike some other sorts of monopoly, natural monopolies have little chance of being driven out of a market by more efficient new entrants. Thus REGULATION of natural monopolies may be needed to protect their captive consumers.
• NATURAL RATE OF UNEMPLOYMENT
• A controversial phrase, which actually means little more than the lowest rate of UNEMPLOYMENT at which the jobs market can be in stable EQUILIBRIUM. Keynesians, encouraged by the PHILLIPS CURVE, assumed that a GOVERNMENT could lower the rate of unemployment if it was willing to accept a little more INFLATION. However, economists such as MILTON FRIEDMAN argued that this supposed inflation-for-jobs trade-off was in fact a trap. Governments that tolerated higher inflation in the hope of lowering unemployment would find that joblessness dipped only briefly before returning to its previous level, while inflation would rise and stay high. Instead, they argued, unemployment has an equilibrium or natural rate, determined not by the amount of DEMAND in an economy but by the structure of the LABOUR market. This is the lowest level of unemployment at which inflation will remain stable. When unemployment is above the natural rate demand can potentially be increased to bring it to the natural rate, but attempting to lower it even further will only cause inflation to accelerate. Hence the natural rate is also known as the non-accelerating-inflation rate of unemployment, or NAIRU.
• At first, the NAIRU became synonymous with the view that MACROECONOMIC POLICY could not conquer unemployment. It was often used to justify policy inaction even when unemployment rose to more than 10% of workers in industrialised countries during the 1980s and 1990s, even though economists’ estimates of the NAIRU differed hugely. More recently, economists looking for ways to reduce unemployment have started to ask whether, and under what circumstances, the natural rate might change. Most solutions have stressed the need to make more people employable at the prevailing level of WAGES, in particular by increasing LABOUR MARKET FLEXIBILITY. Econ¬omists still disagree over what jobless rate at any particular point in time is the NAIRU, but nobody any longer thinks that the natural rate is fixed. Indeed, some think the concept has no meaning at all.
• NEGATIVE INCOME TAX
• A way of building redistribution into the TAXATION system by taking MONEY from people with high incomes and paying it to people with low incomes. Because it takes place automatically through the tax system, it may attach less stigma to the receipt of financial help than some other forms of WELFARE assistance. However, it may also discourage recipients from working to increase their INCOME (see POVERTY TRAP), which is why some countries have introduced a form of negative income tax that is available only to the working poor. In the United States, this is known as the earned income tax credit.
• NEO-CLASSICAL ECONOMICS
• The school of ECONOMICS that developed the free-market ideas of CLASSICAL ECONOMICS into a full-scale model of how an economy works. The best-known neo-classical economist was ALFRED MARSHALL, the father of MARGINAL analysis. Neo-classical thinking, which mostly assumes that markets tend towards EQUILIBRIUM, was attacked by KEYNES and became unfashionable during the Keynesian-dominated decades after the second world war. But, thanks to economists such as MILTON FRIEDMAN, many neo-classical ideas have since become widely accepted and uncontroversial.
• NET PRESENT VALUE
• A measure used to help decide whether or not to proceed with an INVESTMENT. Net means that both the costs and benefits of the investment are in cluded. To calculate net present value (NPV), first add together all the expected benefits from the investment, now and in the future. Then add together all the expected costs. Then work out what these future benefits and costs are worth now by adjusting future cashflow using an appropriate DISCOUNT RATE. Then subtract the costs from the benefits. If the NPV is negative, then the investment cannot be justified by the EXPECTED RETURNS. If the NPV is positive, it can, although it pays to make comparisons with the NPVs of alternative investment opportunities before going ahead.

• NETWORK EFFECT
• When the value of a good to a consumer changes because the number of people using it changes. For instance, owning a phone becomes more valuable as more people are plugged into the telephone network. Network effects are sometimes called network EXTERNALITY, although this implies, often wrongly, that the benefits from being part of a network are a sort of MARKET FAILURE. They give a huge COMPETITIVE ADVANTAGE to the firm that owns the network. This INCUMBENT ADVANTAGE arises because a new entrant must persuade people to join a network that starts with fewer members, and thus may be less valuable to them than the network they are currently in. This is why markets for products with network effects are often dominated by only a few firms or a single MONOPOLY. Some economists argue that many recent technological innovations, notably the Internet, have large positive network effects, which make possible much higher PRODUCTIVITY and growth than in the past.
• NEUTRALITY
• See FISCAL NEUTRALITY and MONETARY NEUTRALITY.
• NEW ECONOMY
• In the last years of the 20th century, some economists argued that developments in information technology and GLOBALISATION had given birth to a new economy (first, in the United States), which had a higher rate of PRODUCTIVITY and GROWTH than the old economy it replaced. Some went further, adding that in the new economy INFLATION was dead, the BUSINESS CYCLE abolished and the traditional rules of ECONOMICS were redundant. These claims were highly controversial. Other economists pointed out that similar predictions had been made during earlier periods of rapid technological change, yet the nature of economics was not fundamentally altered.
• With the bursting of the dotcom stockmarket BUBBLE in 2000, the phrase fell into disuse, although PRODUCTIVITY continued to soar, thanks not least to new technology, especially in the United States.
• NEW GROWTH THEORY
• See GROWTH.
• NEW TRADE THEORY
• Although most economists support FREE TRADE, in the 1970s a growing number of them became increasingly puzzled by the large differences between the predictions of free trade theory and real-world trade flows. Their solution to this puzzle is known as new trade theory.
• One mystery was that trade was growing fastest between industrial countries with similar economies and endowments of the FACTORS OF PRODUCTION. In many new industries, there was no clear COMPARATIVE ADVANTAGE for any country. Patterns of production and trade often seemed matters of chance. Trade between two countries would often consist mostly of similar goods, for example, one country would sell cars to another country from which it would import different models of cars.
• One explanation, associated in particular with Paul Krugman of the Massachusetts Institute of Technology, drew on ADAM SMITH’s idea that the DIVISION OF LABOUR lowers unit costs. ECONOMIES OF SCALE within firms are incompatible with the PERFECT COMPETITION assumed by traditional trade theory. A more realistic assumption is that many markets have MONOPOLISTIC COMPETITION. When a monopolistically competitive market expands, it does so through a mixture of more firms (greater product variety) and bigger firms, with bigger-scale economies. Free trade expands market size beyond national borders and so allows firms to reap bigger economies of scale, to the benefit of consumers, workers and shareholders.
• The upside may be greater the more similar are the trading economies. This may explain why trade LIBERALISATION is easier to achieve between similar countries. Thus, for example, the free-trade agreement between the United States and Canada produced only minor local complaints, whereas its subsequent expansion to include the very different economy of Mexico was much more controversial (see NAFTA).
• NGO
• Short for non-government organisation. Although such groups have existed for generations (in the early 1800s, the British and Foreign Anti-Slavery Society played a powerful part in abolishing slavery laws), recent social and economic shifts have given these typically voluntary, non-profit, “issue-driven” organisations new life. The collapse of COMMUNISM, the spread of democracy, technological change and economic integration (GLOBALISATION, in short) have each helped NGOs grow. Globalisation itself has exacerbated a host of worries about the environment, LABOUR rights, human rights, consumer rights, and so on. Democratisation and technological progress have revolutionised the way in which citizens can unite to express their disquiet.
• Governments have been at the sharp end of pressure from NGOs. Arguably, however, it is inter-governmental institutions such as the WORLD BANK, the IMF, the UN agencies and the WORLD TRADE ORGANISATION (WTO) that have felt it more, owing to their lack of political leverage. Few parliamentarians will face direct pressure from the IMF or the WTO, but every policymaker faces pressure from citizens’ groups with special interests. Add to this the poor public image that these technocratic, faceless bureaucracies have developed, and it is hardly surprising that they are popular targets for NGO “swarms”. How governments and inter-governmental organisations respond to NGOs could have huge implications, including for the world’s economies. Equally important will be how NGOs themselves respond to greater scrutiny and to growing concern about how accountable they are, and to whom.
• NOBEL PRIZE FOR ECONOMICS
• The sixth annual prize established in memory of Alfred Nobel. Strictly speaking, this is not a fully fledged Nobel prize, as it was not mentioned in Nobel’s will, unlike the five prizes established earlier for peace, literature, medicine, chemistry and physics. Still, the title of Nobel laureate and the $1m award stumped up each year by Sweden’s CENTRAL BANK make it worth winning. Since 1969, when its first (joint) winners hailed from Norway and the Netherlands, it has been won mostly by American economists, many of them of the CHICAGO SCHOOL.
• NOMINAL VALUE
• The value of anything expressed simply in the MONEY of the day. Since INFLATION means that money can lose its value over time, nominal figures can be misleading when used to compare values in different periods. It is better to compare their real value, by adjusting the nominal figures to remove the inflationary distortions.
• NON-PRICE COMPETITION
• Trying to win business from rivals other than by charging a lower PRICE. Methods include ADVERTISING, slightly differentiating your product, improving its quality, or offering free gifts or discounts on subsequent purchases. Non-price competition is particularly common when there is an OLIGOPOLY, perhaps because it can give an impression of fierce rivalry while the FIRMS are actually colluding to keep prices high.
• NORMAL GOODS
• When average INCOME increases, the DEMAND for normal goods increases, too. The opposite of INFERIOR GOODS.
• NORMATIVE ECONOMICS
• economics that tries to change the world, by suggesting policies for increasing economic WELFARE. The opposite of POSITIVE ECONOMICS, which is content to try to describe the world as it is, rather than prescribe ways to make it better.
• NPV
• See NET PRESENT VALUE.
• NULL HYPOTHESIS
• A statement that is being put to the test. In ECONOMETRICS, economists often start with a null hypothesis that a particular variable equals a particular number, then crunch their data to see if they can prove or disprove it, according to the laws of STATISTICAL SIGNIFICANCE. The null hypothesis chosen is often the reverse of what the experimenter actually believes; it may be put forward to allow the data to contradict it.

• OECD
• The Organisation for Economic Co-operation and Development, a Paris-based club for industrialised countries and the best of the rest. It was formed in 1961, building on the Organisation for European Economic Co-operation (OEEC), which had been established under the MARSHALL PLAN. By 2003, its membership had risen to 30 countries, from an original 20. Together, OECD countries produce two-thirds of the world’s goods and SERVICES. The OECD provides a policy talking shop for governments. It produces forests-worth of documents discussing public policy ideas, as well as detailed empirical analysis. It also publishes reports on the economic performance of individual countries, which usually contain lots of valuable information even if they are rarely very critical of the policies implemented by a member GOVERNMENT.
• OFFSHORE
• Where the usual rules of a person or firm’s home country do not apply. It can be literally offshore, as in the case of investors moving their MONEY to a Caribbean island TAX HAVEN. Or it can be merely legally offshore, as in the case of certain financial transactions that take place within, say, the City of London, which are deemed for regulatory purposes to have taken place offshore.
• OKUN'S LAW
• A description of what happens to UNEMPLOYMENT when the rate of GROWTH of GDP changes, based on empirical research by Arthur Okun (1928–80). It predicts that if GDP grows at around 3% a year, the jobless rate will be unchanged. If it grows faster, the unemployment rate will fall by half of what the growth rate exceeds 3% by; that is, if GDP grows by 5%, unemployment will fall by 1 percentage point. Likewise, a lesser, say 2%, increase in GDP would be associated with a half a percentage point increase in the jobless rate. This relationship is not carved in stone, as it merely reflects the American economy during the period studied by Okun. Even so, in most econo mies Okun’s Law is a reasonable rule of thumb for estimating the likely impact on jobs of changes in OUTPUT.
• OLIGOPOLY
• When a few FIRMS dominate a market. Often they can together behave as if they were a single MONOPOLY, perhaps by forming a CARTEL. Or they may collude informally, by preferring gentle NON-PRICE COMPETITION to a bloody PRICE war. Because what one firm can do depends on what the other firms do, the behaviour of oligopolists is hard to predict. When they do compete on price, they may produce as much and charge as little as if they were in a market with PERFECT COMPETITION.
• OPEC
• The Organisation of Petroleum Exporting Countries, a CARTEL set up in 1960 that wrought havoc in industrialised countries during the 1970s and early 1980s by forcing up oil prices (which quadrupled in a few weeks during 1973–74 alone), resulting in high INFLATION and slow GROWTH. A lot of productive CAPITAL equipment that had been viable at lower oil prices proved to be unprofitable to run at the higher prices and was shut down. Some economists reckon that MARKET FORCES would have driven up oil prices anyway and that OPEC merely capitalised on the opportunity. Since the early 1980s, OPEC's influence has waned. Many firms have switched to production methods that need less oil, or less energy altogether. Non-OPEC producers such as the UK have brought new oil fields on stream. And some individual members of the cartel have broken ranks by failing to restrict their oil production, resulting in lower oil prices.
• OPEN ECONOMY
• An economy that allows the unrestricted flow of people, CAPITAL, goods and SERVICES across its borders; the opposite of a CLOSED ECONOMY.
• OPEN-MARKET OPERATIONS
• CENTRAL BANKS buying and selling SECURITIES in the open market, as a way of controlling INTEREST rates or the GROWTH of the MONEY SUPPLY. By selling more securities, they can mop up surplus MONEY; buying securities adds to the money supply. The securities traded by central banks are mostly GOVERNMENT BONDS and TREASURY BILLS, although they sometimes buy or sell commercial securities.
• OPPORTUNITY COST
• The true cost of something is what you give up to get it. This includes not only the money spent in buying (or doing) the something, but also the economic benefits (UTILITY) that you did without because you bought (or did) that particular something and thus can no longer buy (or do) something else. For example, the opportunity cost of choosing to train as a lawyer is not merely the tuition fees, PRICE of books, and so on, but also the fact that you are no longer able to spend your time holding down a salaried job or developing your skills as a footballer. These lost opportunities may represent a significant loss of utility. Going for a walk may appear to cost nothing, until you consider the opportunity forgone to use that time earning money. Everything you do has an opportunity cost (see SHADOW PRICE). ECONOMICS is primarily about the efficient use of scarce resources, and the notion of opportunity cost plays a crucial part in ensuring that resources are indeed being used efficiently.
• OPTIMAL CURRENCY AREA
• A geographical area within which it would pay to have a single currency. An optimal currency area can come in many sizes. Some may span several countries and others may be smaller than an individual country. The benefits of having one currency are lower foreign exchange and currency HEDGING costs and more transparent pricing (because every PRICE is expressed in the same currency). But unless the single currency is used within an optimal currency area, these benefits may be dwarfed by the costs. A single currency means a single MONETARY POLICY and no opportunity for one part of the currency area to change its EXCHANGE RATE with the other parts. This can be a big problem if a country or region is likely to suffer from ASYMMETRIC SHOCKS that affect it differently from the rest of the single-currency area, because it will no longer be able to respond by loosening its national monetary policy or devaluing its currency. This may not be an insuperable problem if workers in the affected country are able and willing to move freely to other countries; if WAGES and prices are flexible and can adjust to the shock; or if FISCAL POLICY can shift resources to areas hurt by a shock from areas that are not hurt. For a currency area to be optimal, ideally asymmetric shocks should be rare, implying that the economies involved are on similar BUSINESS CYCLES and have similar structures. Moreover, the single monetary policy should affect all the constituent parts in the same way (an INTEREST RATE cut should not, say, reduce UNEMPLOYMENT in one part and increase INFLATION in another). There should be no cultural, linguistic or legal barriers to LABOUR mobility across frontiers; there should be wage flexibility; and there should be some system for transferring resources to regions that are suffering. In practice, few of the parts of the world that have a single currency are optimal currency areas, probably including the EURO ZONE, although having a single currency often makes them become gradually more alike and thus more optimal.
• OPTIMUM
• As good as it gets, given the constraints you are operating within. For the concept of optimum to mean anything, there must be both a goal, say, to maximise economic WELFARE, and a set of constraints, such as an available stock of scarce economic resources. Optimising is the process of doing the best you can in the circumstances.
• OPTION
• See DERIVATIVES and BLACK-SCHOLES.
• OUTPUT
• The fruit of economic activity: whatever is produced by using the FACTORS OF PRODUCTION.
• OUTPUT GAP
• How far an economy’s current OUTPUT is below what it would be at full CAPACITY. On average, INFLATION rises when output is above potential and falls when output is below potential. However, in the short run, the relationship between inflation and the output gap can deviate from the longer-term pattern and can thus be misleading. Alas for policymakers – because nobody really knows what an economy’s potential output is, the size and even the direction of the output gap can easily be misdiagnosed, which can contribute to serious errors in MACROECONOMIC POLICY.
• OUTSOURCING
• Shifting activities that used to be done inside a FIRM to an outside company, which can do them more cost-effectively. Big firms have outsourced a growing amount of their business since the early 1990s, including increasingly OFFSHORING work to cheaper employees at firms in countries such as India. This has become politically controversial in countries that lose jobs as a result of offshoring. However, a firm that outsources can improve its efficiency by focusing on those activities in which it can create the most value; the firm to which it outsources can also increase efficiency by specialising in that activity. That, at least, is the theory. In practice, managing the outsourcing process can be tricky, particularly for more complex activities.
• OUTWARD INVESTMENT
• Investing abroad; the opposite of INWARD INVESTMENT.
• OVER THE COUNTER
• In the case of drugs, those that can be purchased without a prescription from a doctor. In the case of financial SECURITIES, those that are bought or sold through a private dealer or BANK rather than on a financial exchange.
• OVERHEATING
• When an economy is growing too fast and its productive CAPACITY cannot keep up with DEMAND. It often boils over into INFLATION.
• OVERSHOOTING
• The common tendency of PRICES in FINANCIAL MARKETS initially to move further than would seem strictly necessary in response to changes in the fundamentals that should, in theory, determine value. One reason may be that in the absence of perfect INFORMATION, investors move in herds, rushing in and out of markets on rumour. Eventually, as investors become better informed, the price usually returns to a more appropriate level. Overshooting is especially common during significant realignments of EXCHANGE RATES, but there are plenty of other examples. For instance, following the abolition of CAPITAL CONTROLS by some DEVELOPING COUNTRIES, the prices of EQUITIES in those countries initially soared to what proved to be unjustified levels as foreign CAPITAL rushed in, before settling in the longer-term at more sustainable valuations.

. PARETO EFFICIENCY
A situation in which nobody can be made better off without making somebody else worse off. Named after Vilfredo Pareto (1843–1923), an Italian economist. If an economy’s resources are being used inefficiently, it ought to be possible to make somebody better off without anybody else becoming worse off. In reality, change often produces losers as well as winners. Pareto efficiency does not help judge whether this sort of change is economically good or bad.
PARIS CLUB
The name given to the arrangements through which countries reschedule their official DEBT; that is, money borrowed from other governments rather than BANKS or private FIRMS. The club is based on Avenue Kléber in Paris. Its members are the 19 founders of the OECD as well as Russia. Other institutions such as the WORLD BANK attend in an ¬informal role. Rescheduling requires the consensus agreement of members and must not favour one CREDITOR nation over another. Private debt re¬scheduling takes place through the London Club.
PATENTS
In 1899 the commissioner of the American Office of Patents recommended that his office be abolished because “everything that can be invented has been invented”. The fact that there has been so much INNOVATION during the subsequent 100 years may owe something to the existence of patents. Economists reckon that if people are going to spend the time and MONEY needed to think up and develop new products, they need to be fairly confident that if the idea works they will earn a decent PROFIT. Patents help achieve this by granting the inventor a temporary MONOPOLY over the idea, to stop it being stolen by imitators who have not borne any of the development RISK and costs. Like any monopoly, patents create inefficiency because of the lack of COMPETITION to produce and sell the product. So economists debate how long patent protection should last. There is also debate about which sorts of innovation require the encouragement of a potential monopoly to make them happen. Furthermore, the pace of innovation in some industries has sharply reduced the number of years during which a patent is valuable. Some economists say that this shows that patents do not play a large part in the process of innovation.
PATH DEPENDENCE
History matters. Where you have been in the past determines where you are now and where you can go in future. Indeed, even small, apparently trivial, differences in the path you have taken can have huge consequences for where you are and can go. In ECONOMICS, path dependence refers to the way in which apparently insignificant events and choices can have huge consequences for the development of a market or an economy.
Economists disagree over how widespread path dependence is, and whether it is a form of MARKET FAILURE. One focus of this debate is the QWERTY keyboard. Some argue that the QWERTY design was deliberately made slow to use so as to overcome a jamming-at-speed problem in early typewriters. Much faster alternative layouts of keys have failed to prosper, even though the anti-jamming rationale for QWERTY has been defunct for years. Others say that the QWERTY system is as efficient a layout of keys as any other and that its success is a triumph of MARKET FORCES. Having invested in learning to make and use the QWERTY keyboard, it makes no economic sense to switch to an alternative that is no better than QWERTY.
PEAK PRICING
When CAPACITY is fixed and DEMAND varies during a time period, it may make sense to charge above-AVERAGE PRICES when demand peaks. Because this will divert some peak demand to cheaper off-peak periods, it will reduce the total amount of capacity needed at the peak and reduce the amount of capacity lying idle at off-peak times, thus resulting in a more efficient use of resources. Peak pricing is common in SERVICES with substantial fixed capacity, such as electricity supply and rail transport, as anybody who pays higher fares to travel during rush hours knows only too well.
PERCENTAGE POINT
A unit of size, a one-hundredth of the total. Not to be confused with percentage change. When something increases by 1 percentage point this may be quite different from a 1% increase. For instance, if GDP grew last year by 1% and this year by 2%, the GROWTH rate this year increased by 1 percentage point compared with last year (the difference between 1% and 2%) and also by 100% (2% is double 1%). A 1% increase would mean that the growth rate this year was only 1.01%.
PERCENTILE
Part of the “ile” family that signposts positions on a scale of numbers (see also QUARTILE). The top percentile on, say, the distribution of INCOME, is the richest 1% of the POPULATION.
PERFECT COMPETITION
The most competitive market imaginable. Perfect COMPETITION is rare and may not even exist. It is so competitive that any individual buyer or seller has a negligible impact on the market PRICE. Products are homogeneous. INFORMATION is perfect. Everybody is a price taker. FIRMS earn only normal PROFIT, the bare minimum profit necessary to keep them in business. If firms earn more than that (excess profits) the absence of barriers to entry means that other firms will enter the market and drive the price level down until there are only normal profits to be made. OUTPUT will be maximised and price minimised. Contrast with MONOPOLISTIC COMPETITION, OLIGOPOLY and, above all, MONOPOLY.
PERMANENT INCOME HYPOTHESIS
Over their lives, people try to spread their spending more evenly than their INCOME. The permanent income hypothesis, developed by MILTON FRIEDMAN, says that a person’s spending decisions are guided by what they think over their lifetime will be their AVERAGE (also known as permanent) income. A sharp increase in short-term income will not result in an equally sharp increase in short-term CONSUMPTION. What if somebody unexpectedly comes into money, say by winning the lottery? The permanent income hypothesis suggests that people will save most of any such WINDFALL GAINS. Reality may be somewhat different. (See LIFE-CYCLE HYPOTHESIS.)
PHILLIPS CURVE
In 1958, an economist from New Zealand, A.W.H. Phillips (1914–75), proposed that there was a trade-off between INFLATION and UNEMPLOYMENT: the lower the unemployment rate, the higher was the rate of inflation. Governments simply had to choose the right balance between the two evils. He drew this conclusion by studying nominal wage rates and jobless rates in the UK between 1861 and 1957, which seemed to show the relationship of unemployment and inflation as a smooth curve.
Economies did seem to work like this in the 1950s and 1960s, but then the relationship broke down. Now economists prefer to talk about the NAIRU, the lowest rate of unemployment at which inflation does not accelerate.
PIGOU EFFECT
Named after Arthur Pigou (1877–1959), a sort of WEALTH EFFECT resulting from DEFLATION. A fall in the PRICE level increases the REAL VALUE of people’s SAVINGS, making them feel wealthier and thus causing them to spend more. This increase in DEMAND can lead to higher employment.
PLAZA ACCORD
On September 22nd 1985, finance ministers from the world's five biggest economies - the United States, Japan, West Germany, France and the UK - announced the Plaza Accord at the eponymous New York hotel. Each country made specific promises on economic policy: the United States pledged to cut the federal DEFICIT, Japan promised a looser monetary policy and a range of financial-sector reforms, and Germany proposed tax cuts. All countries agreed to intervene in currency markets as necessary to get the dollar down. Perhaps not surprisingly, not all the promises were kept (least of all the American one on deficit cutting), but even so the plan turned out to be spectacularly successful. By the end of 1987, the dollar had fallen by 54% against both the D-mark and the yen from its peak in February 1985. This sharp drop led to a new fear: of an uncontrolled dollar plunge. So in 1987 another big international plan, the Louvre Accord, was hatched to stabilise the dollar. Again specific policy pledges were made (the United States to tighten FISCAL POLICY, JAPAN TO LOOSEN MONETARY POLICY). AGAIN THE PARTICIPANTS PROMISED CURRENCY INTERVENTION IF MAJOR CURRENCIES MOVED OUTSIDE AN AGREED, BUT UNPUBLISHED, SET OF RANGES. THE DOLLAR PROMPTLY ROSE.

POPULATION
At the beginning of the 20th century the population of the world was 1.7 billion. At the end of that century, it had soared to 6 billion. Recent estimates suggest that it will be nearly 8 billion by 2025 and 9.3 billion by 2050. Almost all of this increase is forecast to occur in the developing regions of Africa, Asia and Latin America. For what economists have had to say about this, see DEMOGRAPHICS.
POSITIONAL GOODS
Things that the Joneses buy. Some things are bought for their intrinsic usefulness, for instance, a hammer or a washing machine. Positional goods are bought because of what they say about the person who buys them. They are a way for a person to establish or signal their status relative to people who do not own them: fast cars, holidays in the most fashionable resorts, clothes from trendy designers. By necessity, the quantity of these goods is somewhat fixed, because to increase SUPPLY too much would mean that they were no longer positional. What would owning a Rolls-Royce say about you if everybody owned one? Fears that the rise of positional goods would limit GROWTH, since by definition they had to be in scarce supply, have so far proved misplaced. Entrepreneurs have come up with ever more ingenious ways for people to buy status, thus helping developed economies to keep growing.
POSITIVE ECONOMICS
ECONOMICS that describes the world as it is, rather than trying to change it. The opposite of NORMATIVE ECONOMICS, which suggests policies for increasing economic WELFARE.
POVERTY
The state of being poor, which depends on how you define it. One approach is to use some absolute measure. For instance, the poverty rate refers to the number of households whose INCOME is less than three times what is needed to provide an adequate diet. (Though what constitutes adequate may change over time.) Another is to measure relative poverty. For instance, the number of people in poverty can be defined as all households with an income of less than, say, half the AVERAGE household income. Or the (relative) poverty line may be defined as the level of income below which are, say, the poorest 10% of households. In each case, the dividing line between poverty and not-quite poverty is somewhat arbitrary.
As countries get richer, the number of people in absolute poverty usually gets smaller. This is not necessarily true of the numbers in relative poverty. The way that relative poverty is defined means that it is always likely to identify a large number of impoverished households. However rich a country becomes, there will always be 10% of households poorer than the rest, even though they may live in mansions and eat caviar (albeit smaller mansions and less caviar than the other 90% of households).
POVERTY TRAP
Another name for the UNEMPLOYMENT TRAP.
PPP
See PURCHASING POWER PARITY.
PRECAUTIONARY MOTIVE
Keeping some MONEY handy, just in case. One of three motives for holding money identified by KEYNES, along with the transactional motive (having the cash to pay for planned purchases) and the speculative motive (you think ASSET prices are going to fall, so you sell your assets for cash).
PREDATORY PRICING
Charging low PRICES now so you can charge much higher prices later. The predator charges so little that it may sustain losses over a period of time, in the hope that its rivals will be driven out of business. Clearly, this strategy makes sense only if the predatory firm is able eventually to establish a MONOPOLY. Some advocates of anti-DUMPING policies say that cheap IMPORTS are examples of predatory pricing. In practice, the evidence gives little support for this view. Indeed, in general, predatory pricing is quite rare. It is certainly much less common in practice than it might appear from the propaganda of FIRMS that are under pricing pressure from more efficient competitors.
PREFERENCE
What consumers want (see REVEALED PREFERENCE).
PRESENT VALUE
See NET PRESENT VALUE
PRICE
In EQUILIBRIUM, what balances SUPPLY and DEMAND. The price charged for something depends on the tastes, INCOME and ELASTICITY of demand of customers. It depends on the amount of COMPETITION in the market. Under PERFECT COMPETITION, all FIRMS are price takers. Where there is a MONOPOLY, or firms have some MARKET POWER, the seller has some control over the price, which will probably be higher than in a perfectly competitive market. By how much more will depend on how much market power there is, and on whether the firm(s) with the market power are committed to PROFIT MAXIMISATION. In some cases, firms may charge less than the profit-maximising price for strategic or other reasons (see PREDATORY PRICING).
PRICE DISCRIMINATION
When a firm charges different customers different PRICES for the same product. For producers, the perfect world would be one in which they could charge each customer a different price: the price that each customer would be willing to pay. This would maximise PRODUCER SURPLUS. This cannot happen, not least because sellers do not know how much any individual would pay.
Yet some price discrimination is possible if an overall market can be segmented into somewhat separate markets and the EQUILIBRIUM price in each of these markets is different, perhaps because of differences in consumer tastes, perhaps because in some segments the firm enjoys some MARKET POWER. But this will work only if the market segments can be kept apart. If it is possible and profitable to buy the product in a low-price segment and resell it in a high-price segment, then price discrimination will not last for long.
PRICE ELASTICITY
A measure of the responsiveness of DEMAND to a change in PRICE. If demand changes by more than the price has changed, the good is price-elastic. If demand changes by less than the price, it is price-inelastic. Economists also measure the ELASTICITY of demand to changes in the INCOME of consumers.
PRICE MECHANISM
The process by which markets set PRICES.
PRICE REGULATION
When PRICES of, say, a PUBLIC UTILITY are regulated, giving producers an incentive to maximise their profits by reducing their costs as much as possible. Contrast with RATE OF RETURN REGULATION.
PRICE/EARNINGS RATIO
A crude method of judging whether SHARES are cheap or expensive; the ratio of the market PRICE of a share to the company’s earnings (PROFIT) per share. The higher the price/earnings (P/E) ratio, the more investors are buying a company’s shares in the expectation that it will make larger profits in future than now. In other words, the higher the P/E ratio, the more optimistic investors are being.

• 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.)

• Q THEORY
• See TOBIN.
• QUANTITY THEORY OF MONEY
• The foundation stone of MONETARISM. The theory says that the quantity of MONEY available in an economy determines the value of money. Increases in the MONEY SUPPLY are the main cause of INFLATION. This is why Milton FRIEDMAN claimed that “inflation is always and everywhere a monetary phenomenon”.
• The theory is built on the Fisher equation, MV = PT, named after Irving Fisher (1867–1947). M is the stock of money, V is the VELOCITY OF CIRCULATION, P is the average PRICE level and T is the number of transactions in the economy. The equation says, simply and obviously, that the quantity of money spent equals the quantity of money used. The quantity theory, in its purest form, assumes that V and T are both constant, at least in the short-run. Thus any change in M leads directly to a change in P. In other words, increase the money supply and you simply cause inflation.
• In the 1930s, KEYNES challenged this theory, which was orthodoxy until then. Increases in the money supply seemed to lead to a fall in the velocity of circulation and to increases in real INCOME, contradicting the classical dichotomy (see MONETARY NEUTRALITY). Later, monetarists such as Friedman conceded that V could changein response to variations in M, but did so only in stable, predictable ways that did not challenge the thrust of the theory. Even so, monetarist policies did not perform well when they were applied in many countries during the 1980s, as even Friedman has since conceded.
• QUARTILE
• Part of the “ile” family that signposts positions on a scale of numbers (see also PERCENTILE). The top quartile on, say, the distribution of INCOME, is the richest 25% of the POPULATION.
• QUEUEING
• Market failure? Not necessarily. Usually a queue reflects a PRICE that is set too low, so that DEMAND exceeds SUPPLY, so some customers have to wait to buy the product. But a queue may also be the result of deliberate rationing by a producer, perhaps to attract attention – by a restaurant that wants to appear popular, say. Customers may regard a queue, such as a waiting list for health treatment, as a fairer way to distribute the product than using the PRICE MECHANISM.
• QUOTA
• A form of PROTECTIONISM. A country imposes limits on the number of goods that can be imported from another country. For instance, France may limit the number of cars imported from Japan to, say, 20,000 a year. As a result of limiting SUPPLY, the PRICE of the imported good is higher than it would be under FREE TRADE, thus making life easier for domestic producers.

• R SQUARED
• An indicator of the reliability of a relationship identified by REGRESSION ANALYSIS. An R2 of 0.8 indicates that 80% of the change in one variable is explained by a change in the related variable.
• RANDOM WALK
• Impossible to predict the next step. EFFICIENT MARKET THEORY says that the PRICES of many financial ASSETS, such as SHARES, follow a random walk. In other words, there is no way of knowing whether the next change in the price will be up or down, or by how much it will rise or fall. The reason is that in an efficient market, all the INFORMATION that would allow an investor to predict the next price move is already reflected in the current price. This belief has led some economists to argue that investors cannot consistently outperform the market. But some economists argue that asset prices are predictable (they follow a non-random walk) and that markets are not efficient.
• RATE OF RETURN
• A way to measure economic success, albeit one that can be manipulated quite easily. It is calculated by expressing the economic gain (usually PROFIT) as a percentage of the CAPITAL used to produce it. Deciding what number to use for profit is rarely simple. Likewise, totalling up how much capital was used can be tricky, especially if it is expanded to include INTANGIBLE ASSETS and HUMAN CAPITAL. When FIRMS are evaluating a project to decide whether to go ahead with it, they estimate the project’s expected rate of return and compare it with their COST OF CAPITAL. (See NET PRESENT VALUE and DISCOUNT RATE.)
• RATE OF RETURN REGULATION
• An approach to REGULATION often used for a PUBLIC UTILITY to stop it exploiting MONOPOLY power. A public utility is forbidden to earn above a certain RATE OF RETURN decided by the regulator. In practice, this often encourages the utility to be inefficient, slow to innovate and quick to spend money on such things as big offices and executive jets, to keep down its PROFIT and thus the rate of return. Contrast with PRICE REGULATION.
• RATINGS
• A guide to the riskiness of a FINANCIAL INSTRUMENT provided by a ratings agency, such as Moody’s, Standard and Poor’s and Fitch IBCA. These measures of CREDIT quality are mostly offered on marketable GOVERNMENT and corporate DEBT. A triple-A or A++ rating represents a low risk of DEFAULT; a C or D rating an extreme risk of, or actual, default. Debt PRICES and YIELDS often (but not always) reflect these ratings. A triple-A BOND has a low yield. High-yielding bonds, also known as junk bonds, usually have a rating that suggests a high risk of default.
• A series of financial market crises from the mid-1990s onwards led to growing debate about the reliability of ratings, and whether they were slow to give warning of impending trouble. After the ENRON debacle, which again the ratings agencies had failed to predict, some critics argued that the big three agencies had formed a cosy OLIGOPOLY and that encouraging more COMPETITION was the way to improve ratings.
• RATIONAL EXPECTATIONS
• How some economists believe that people think about the future. Nobody can predict the future perfectly; but rational expectations theory assumes that, over time, unexpected events (SHOCKS) will cancel out each other and that on average people’s expectations about the future will be accurate. This is because they form their expectations on a rational basis, using all the INFORMATION available to them optimally, and learn from their mistakes. This is in contrast to other theories of how people look ahead, such as ADAPTIVE EXPECTATIONS, in which people base their predictions on past trends and changes in trends, and BEHAVIOURAL ECONOMICS, which assumes that expectations are somewhat irrational as a result of psychological biases.
• The theory of rational expectations, for which Robert Lucas won the NOBEL PRIZE FOR ECONOMICS, initially became popular with monetarists because it seemed to prove that KEYNESIAN policies of DEMAND management would fail. With rational expectations, people learn to anticipate GOVERNMENT policy changes and act accordingly; since macroeconomic FINE TUNING requires that governments be able to fool people, this implies that it is usually futile. Subsequently, this conclusion has been challenged. However, rational and near-rational expectations have become part of the mainstream of economic thought.
• RATIONALITY
• See ECONOMIC MAN.
• RATIONING
• Although economists say that rationing is what the PRICE MECHANISM does, what most people think of as rationing is an alternative to letting PRICES determine how scarce economic resources, goods and SERVICES are distributed (see also QUEUEING). Non-price rationing is often used when the distribution decided by MARKET FORCES is perceived to be unfair. Rationing may lead to the creation of a black market, as people sell their rations to those willing to pay a high price (see BLACK ECONOMY).
• REAL BALANCE EFFECT
• Falling INFLATION and INTEREST rates lead to higher spending (see WEALTH EFFECT).
• REAL EXCHANGE RATE
• An EXCHANGE RATE that has been adjusted to take account of any difference in the rate of INFLATION in the two countries whose currency is being exchanged.
• REAL INTEREST RATE
• The INTEREST RATE less the rate of INFLATION.
• REAL OPTIONS THEORY
• A newish theory of how to take INVESTMENT decisions when the future is uncertain, which draws parallels between the real economy and the use and valuation of financial options. It is becoming increasingly fashionable at business schools and even in the boardroom.
• Traditional investment theory says that when a firm evaluates a proposed project, it should calculate the project’s NET PRESENT VALUE (NPV) and if it is positive, go ahead.
• Real options theory assumes that FIRMS also have some choice in when to invest. In other words, the project is like an option: there is an opportunity, but not an obligation, to go ahead with it. As with financial options, the interesting question is when to exercise the option: certainly not when it is out of the money (the cost of investing exceeds the benefit). Financial options should not necessarily be exercised as soon as they are in the money (the benefit from exercising exceeds the cost). It may be better to wait until it is deep in the money (the benefit is far above the cost). Likewise, companies should not necessarily invest as soon as a project has a positive NPV. It may pay to wait.
• Most firms’ investment opportunities have embedded in them many managerial options. For instance, consider an oil company whose bosses think they have discovered an oil field, but they are uncertain about how much oil it contains and what the PRICE of oil will be once they start to pump. Option one: to buy or lease the land and explore? Option two: if they find oil, to start to pump? Whether to exercise these options will depend on the oil price and what it is likely to do in future. Because oil prices are highly volatile, it might not make sense to go ahead with production until the oil price is far above the price at which traditional investment theory would say that the NPV is positive and give the investment the green light.
• Options on real ASSETS behave rather like financial options (a SHARE option, say). The similarities are such that they can, at least in theory, be valued according to the same methodology. In the case of the oil company, for instance, the cost of LAND corresponds to the down-payment on a call (right to buy) option, and the extra investment needed to start production to its strike price (the money that must be paid if the option is exercised). As with financial options, the longer the option lasts before it expires and the more volatile is the price of the underlying asset (in this case, oil) the more the option is worth. This is the theory. In practice, pricing financial options is often tricky, and valuing real options is harder still.
• REAL TERMS
• A measure of the value of MONEY that removes the effect of INFLATION. Contrast with NOMINAL VALUE.
• RECESSION
• Broadly speaking, a period of slow or negative economic GROWTH, usually accompanied by rising UNEMPLOYMENT. Economists have two more precise definitions of a recession. The first, which can be hard to prove, is when an economy is growing at less than its long-term trend rate of growth and has spare CAPACITY. The second is two consecutive quarters of falling GDP.
• RECIPROCITY
• Doing as you are done by. A grants B certain privileges on the condition that B grants the same privileges to A. Most international economic agreements, for example, on trade, include binding reciprocity requirements.
• REDLINING
• Not lending to people in certain poor or troubled neighbourhoods – drawn with a red line on a map – simply because they live there, regardless of their CREDIT-worthiness judged by other criteria.
• REFLATION
• Policies to pump up DEMAND and thus boost the level of economic activity. Monetarists fear that such policies may simply result in higher INFLATION.
• REGIONAL POLICY
• A policy intended to boost economic activity in a specific geographical area that is not an entire country and, typically, is in worse economic shape than nearby areas. It can include offering FIRMS incentives to provide jobs in the region, such as SOFT LOANS, grants, lower taxes, cheap LAND and buildings, subsidised LABOUR and worker training. Is it necessary? A region's problems should be somewhat self-correcting. After all, simple theories of SUPPLY and DEMAND would suggest that firms will move to areas of low WAGES and high UNEMPLOYMENT to take advantage of cheaper labour and surplus workers, or that workers will move away from such areas to where more and better-paid jobs exist. But some economic theories suggest that rather than moving to areas where wages are lowest, firms often cluster together with other successful businesses. Regional policy may need to be extremely generous to tempt firms to give up the advantages of being in a cluster.
• REGRESSION ANALYSIS
• Number-crunching to discover the relationship between different economic variables. The findings of this statistical technique should always be taken with a pinch of salt. How big a pinch can vary considerably and is indicated by the degree of STATISTICAL SIGNIFICANCE and R SQUARED. The relationship between a dependent variable (GDP, say) and a set of explanatory variables (DEMAND, INTEREST rates, CAPITAL, UNEMPLOYMENT, and so on) is expressed as a regression equation.
• REGRESSIVE TAX
• A tax that takes a smaller proportion of INCOME as the taxpayer’s income rises, for example, a fixed-rate vehicle tax that eats up a much larger slice of a poor person’s income than a rich person’s income. This goes against the principle of VERTICAL EQUITY, which many people think should be at the heart of any fair tax system.
• REGULATION
• Rules governing the activities of private-sector enterprises. Regulation is often imposed by GOVERNMENT, either directly or through an appointed regulator. However, some industries and professions impose rules on their members through self-regulation.
• Regulation is often introduced to tackle MARKET FAILURE. EXTERNALITIES such as pollution have inspired rules limiting factory emissions. Regulations on the selling of financial products to individuals have been introduced as protection against unscrupulous financial FIRMS with better INFORMATION than their customers. RATE OF RETURN REGULATION and PRICE REGULATION have been used to combat NATURAL MONOPOLY, sometimes instead of NATIONALISATION. Some regulation has been motivated by politics rather than ECONOMICS, for instance, restrictions on the number of hours people can work or the circumstances in which an employer can dismiss employees.
• Even when introduced for sound economic reasons, regulation can generate more costs than benefits. Regulated firms or individuals may face substantial compliance costs. Firms may devote substantial resources to REGULATORY ARBITRAGE, which would leave consumers no better off. Regulation may lead to MORAL HAZARD if people believe that the government is keeping an eye on the behaviour of the regulated business and so do less monitoring of their own. Regulation may be badly designed and thus lock an industry into an inefficient EQUILIBRIUM. Rigid regulation may hold back INNOVATION. There is also the danger of REGULATORY CAPTURE. In short, then, REGULATORY FAILURE may be even worse for an economy than market failure.
• REGULATORY ARBITRAGE
• Exploiting loopholes in REGULATION, and perhaps making the regulation useless in the process. This is often done by international investors that use DERIVATIVES to find ways around a country’s financial regulations.
• REGULATORY CAPTURE
• Gamekeeper turns poacher or, at least, helps poacher. The theory of regulatory capture was set out by Richard Posner, an economist and lawyer at the University of Chicago, who argued that “REGULATION is not about the public interest at all, but is a process, by which interest groups seek to promote their private interest ... Over time, regulatory agencies come to be dominated by the industries regulated.” Most economists are less extreme, arguing that regulation often does good but is always at RISK of being captured by the regulated firms.
• REGULATORY FAILURE
• When REGULATION generates more economic costs than benefits.
• REGULATORY RISK
• A RISK faced by private-sector FIRMS that regulatory changes will hurt their business. In competitive markets, regulatory risk is usually small. But in NATURAL MONOPOLY industries, such as electricity distribution, it may be huge. To ensure that regulatory risk does not deter private firms from offering their services, a GOVERNMENT wishing to change its regulations may have good reason to compensate private firms that suffer losses as a result of the change.
• RELATIVE INCOME HYPOTHESIS
• People often care more about their relative well being than their absolute well being. Someone who prefers a $100 a week pay rise when a colleague gets $50 to both of them getting a $200 increase, for example. Poor people may consume more of their INCOME than rich people do because they want to reduce the gap in their CONSUMPTION levels. The relative income hypothesis, set out by James Duesenberry, says that a household’s consumption depends partly on its income relative to other families. Contrast with PERMANENT INCOME HYPOTHESIS.
• RENT
• Confusingly, rent has two different meanings for economists. The first is the commonplace definition: the INCOME from hiring out LAND or other durable goods. The second, also known as economic rent, is a measure of MARKET POWER: the difference between what a FACTOR OF PRODUCTION is paid and how much it would need to be paid to remain in its current use. A soccer star may be paid $50,000 a week to play for his team when he would be willing to turn out for only $10,000, so his economic rent is $40,000 a week. In PERFECT COMPETITION, there are no economic rents, as new FIRMS enter a market and compete until PRICES fall and all rent is eliminated. Reducing rent does not change production decisions, so economic rent can be taxed without any adverse impact on the real economy, assuming that it really is rent.

• RENT-SEEKING
• Cutting yourself a bigger slice of the cake rather than making the cake bigger. Trying to make more money without producing more for customers. Classic examples of rent-seeking, a phrase coined by an economist, Gordon Tullock, include:
• • a protection racket, in which the gang takes a cut from the shopkeeper’s PROFIT;
• • a CARTEL of FIRMS agreeing to raise PRICES;
• • a UNION demanding higher WAGES without offering any increase in PRODUCTIVITY;
• • lobbying the GOVERNMENT for tax, spending or regulatory policies that benefit the lobbyists at the expense of taxpayers or consumers or some other rivals.
• Whether legal or illegal, as they do not create any value, rent-seeking activities can impose large costs on an economy.
• REPLACEMENT COST
• What it would cost today to replace a FIRM’s existing ASSETS.
• REPLACEMENT RATE
• The fertility rate required in a country to keep its population steady. In rich countries, this is usually reckoned to be 2.1 children per woman, the extra 0.1 reflecting the likelihood that some children will die before their parents. In poorer countries with higher infant mortality, the replacement rate may be much higher. In may countries, since the early 1990s the fertility rate has fallen below the replacement rate. There has been much debate about why, and much agreement that, if this trend continues, those countries may face long-term problems such as a relatively growing proportion of retired older people having to be supported by a relatively shrinking proportion of younger people.
• REPO
• An agreement in which one party sells a security to another party and agrees to buy it back on a specified date for a specified PRICE. CENTRAL BANKS deal in short-term repos to provide LIQUIDITY to the FINANCIAL SYSTEM, buying SECURITIES from BANKS with cash on the condition that the banks will repurchase them a few weeks later.
• REQUIRED RETURN
• The minimum EXPECTED RETURN you require from an INVESTMENT to be willing to go ahead with it.
• RESCHEDULING
• Changing the payment schedule for a DEBT by agreement between borrower and lender. This is usually done when the borrower is struggling to make payments under the original schedule. Rescheduling can involve reducing INTEREST ¬payments but extending the period over which they are collected; putting back the date of repayment of the loan; reducing interest payments but increasing the amount that has to be repaid eventually; and so on. The rescheduling may or may not require the lender to bear some financial loss. The rescheduling may or may not require the lender to bear some financial loss. The rescheduling of loans to countries usually takes place through the PARIS CLUB and London Club.
• RESERVATION WAGE
• The lowest WAGE for which a person will work.
• RESERVE CURRENCY
• A foreign currency held by a GOVERNMENT or CENTRAL BANK as part of a country’s RESERVES. Outside the United States the dollar is the most widely used reserve currency. Everywhere the EURO is increasingly widely used.
• RESERVE RATIO
• The fraction of its deposits that a BANK holds as RESERVES.
• RESERVE REQUIREMENTS
• Regulations governing the minimum amount of RESERVES that a BANK must hold against deposits.
• RESERVES
• MONEY in the hand, available to be used to meet planned future payments or if some other need arises. FIRMS may put their reserves in a BANK, as a deposit. For a bank, reserves are those deposits it retains rather than lending them out.
• RESIDUAL RISK
• When you buy an ASSET you become exposed to a bundle of different RISKs. Many of these risks are not unique to the asset you own but reflect broader possibilities, such as that the stockmarket average will rise or fall, that INTEREST rates will be cut or increased, or that the GROWTH rate will change in an entire economy or industry. Residual risk, also known as alpha, is what is left after you take out all the other shared risk exposures. Exposure to this risk can be reduced by DIVERSIFICATION. Contrast with SYSTEMATIC RISK.
• RESTRICTIVE PRACTICE
• A general term for anything done by a firm, or FIRMS, to inhibit COMPETITION. Generally against the law. (See ANTITRUST and CARTEL.)
• RETURNS
• The rewards for doing business. Returns usually refer to PROFIT and can be measured in various ways (see RATE OF RETURN and TOTAL RETURNS).
• REVEALED PREFERENCE
• An example of a popular joke among economists: two economists see a Ferrari. “I want one of those,” says the first. “Obviously not,” replies the other. To get a smile out of this it is necessary (but not, alas, sufficient) to know about revealed preference. This is the notion that what you want is revealed by what you do, not by what you say. Actions speak louder than words. If the economist had really wanted a Ferrari he would have tried to buy one, if he did not own one already.
• Economists have three main approaches to modelling DEMAND and how it will change if PRICES or INCOMES change.
• • The cardinal approach involves asking consumers to say how much UTILITY they get from consuming a particular good, aggregating this across all goods and SERVICES, and calculating how demand would change on the assumption that people will consume the combination of things that maximises their total utility.
• • The ordinal approach does not require consumers to say how much utility they get in absolute terms from consuming a particular good. Instead, it asks them to indicate the relative utility they get from consuming one item compared with another, that is, to say if they prefer one basket of goods to another, or are indifferent between them.
• • The third approach is revealed preference. To model demand it is only necessary to be able to compare an individual’s CONSUMPTION decisions in situations with different prices and/or incomes and to assume that consumers are consistent in their decisions over time (that is, if they prefer wine to beer in one period they will still prefer wine in the next).
• RICARDIAN EQUIVALENCE
• The controversial idea, suggested by David RICARDO, that GOVERNMENT deficits do not affect the overall level of DEMAND in an economy. This is because taxpayers know that any DEFICIT has to be repaid later, and so increase their SAVINGS in anticipation of a tax bill. Thus government attempts to stimulate an economy by increasing PUBLIC SPENDING and/or cutting taxes will be rendered impotent by the private-sector reaction.
• RICARDO, DAVID
• The third of 17 children of a wealthy banker, David Ricardo (1772–1823) was disinherited at the age of 21 after he married a Quaker against the wishes of his parents. He became a stockbroker and did so well that he retired at 42 to concentrate on writing and politics.
• A friend of fellow classical economists Thomas Malthus and Jean-Baptiste Say (see SAY'S LAW), he developed many economic theories that are still in use today. The most influential was COMPARATIVE ADVANTAGE, the theory underpinning the case for FREE TRADE. In his 1817 book, The Principles of Political Economy and Taxation, he outlined a theory of distribution of output in an economy. In this he argued that the allocation of factors of production to any area of economic activity is determined by the level of economic RENT that can be earned from it. As this gradually falls because of DIMINISHING RETURNS, CAPITAL and other resources shift to more profitable projects. He examined the split between WAGES and PROFIT, arguing that “there can be no rise in the value of LABOUR without a fall of profits”. He also claimed that changes in the GOVERNMENT DEFICIT did not affect the level of DEMAND in the economy (RICARDIAN EQUIVALENCE).
• RISK
• The chance of things not turning out as expected. Risk taking lies at the heart of CAPITALISM and is responsible for a large part of the GROWTH of an economy. In general, economists assume that people are willing to be exposed to increased risks only if, on AVERAGE, they can expect to earn higher returns than if they had less exposure to risk. How much higher these EXPECTED RETURNS need to be depends partly on the PROBABILITY of an undesirable outcome and partly on whether the risk taker is RISK AVERSE, RISK NEUTRAL or RISK SEEKING.
• During the second half of the 20th century, economists greatly improved their understanding of risk and developed theories of RISK MANAGEMENT, which suggest when it makes sense to use INSURANCE, DIVERSIFICATION or HEDGING to change risk exposures.
• In FINANCIAL MARKETS the most commonly used measure of risk is the volatility (or STANDARD DEVIATION) of the PRICE of, or more appropriately the TOTAL RETURNS on, an ASSET. Often added to the risk profile are other statistical measures such as skewness and the possibility of extreme changes on rare occasions. (See STRESS TESTING, SCENARIO ANALYSIS and VALUE AT RISK.)
• RISK AVERSE
• Someone who thinks RISK is a four-letter word. Risk-averse investors are those who, when faced with two investments with the same EXPECTED RETURN but two different risks, prefer the one with the lower risk.
• RISK MANAGEMENT
• The process of bearing the RISK you want to bear, and minimising your exposure to the risk you do not want. This can be done in several ways: not doing things that carry a particular risk; HEDGING; DIVERSIFICATION; and buying INSURANCE.
• RISK NEUTRAL
• Someone who is insensitive to RISK. Risk-neutral investors are indifferent between an INVESTMENT with a certain outcome and a risky investment with the same EXPECTED RETURNS but an uncertain outcome. Such people are few and far between.
• RISK PREMIUM
• The extra RETURN that investors require to hold a risky ASSET instead of a risk-free one; the difference between the EXPECTED RETURNS from a risky INVESTMENT and the risk-free rate. (See EQUITY RISK PREMIUM.)
• RISK SEEKING
• Someone who cannot get enough RISK. ¬Risk-seeking investors prefer an INVESTMENT with an uncertain outcome to one with the same EXPECTED RETURNS and certainty that it will deliver them.
• RISK-FREE RATE
• The RATE OF RETURN earned on a risk-free ASSET. This is a crucial component of MODERN PORTFOLIO THEORY, which assumes the existence of both risky and risk-free assets. The risk-free asset is usually assumed to be a GOVERNMENT BOND, and the risk-free rate is the YIELD on that bond, although in fact even a Treasury is not entirely without risk. In modern portfolio theory, the risk-free rate is lower than the EXPECTED RETURN on the risky asset, because the issuer of the risky asset has to offer RISK AVERSE investors the expectation of a higher return to persuade them to forgo the risk-free asset.

• SAFE HARBOUR
• Protection from the rough seas of REGULATION. Laws and regulations often include a safe harbour clause that sets out the circumstances in which otherwise regulated FIRMS or individuals can do something without regulatory oversight or interference.
• SATISFICING
• Settling for what is good enough, rather than the best that is possible. This may occur in any situation in which decision makers are trying to pursue more than one goal at a time. CLASSICAL ECONOMICS and NEO-CLASSICAL ECONOMICS assume that individuals, FIRMS and GOVERNMENTS try to achieve the OPTIMUM, best possible outcome from their decisions. Satisficing assumes they decide for each goal a level of achievement that would be good enough and try to find a way to achieve all of these sub-optimal goals at once. This approach to decision making is commonplace in behavioural economics. It can be regarded as a realist’s theory of how decisions are taken. The concept was invented by Herbert Simon (1916-2001), a Nobel ¬prize-winning economist, in his book, Models of Man, in 1957.
• SAVINGS
• Any INCOME that is not spent. Ultimately, savings are the source of INVESTMENT in an economy, although domestic savings may be supplemented by CAPITAL from foreign savers or themselves be invested abroad.
• In an economic sense, savings include purchases of SHARES or other financial SECURITIES. However, many official measures of a country’s savings ratio--total savings expressed as a percentage of total income--leave out such financial transactions. At times when the demand for financial securities is unusually high, this can give a misleading impression of how much saving is taking place.
• How much individuals save varies significantly among different age groups (see LIFE-CYCLE HYPOTHESIS) and nationalities. Everywhere, people of all ages save more as their income rises. The supply of savings rises when INTEREST rates rise; a rise in interest rates causes DEMAND for funds to invest to fall; a rise in demand for investment funds may cause interest rates, and thus the COST OF CAPITAL, to rise. The level of savings is also influenced by changes in wealth (see WEALTH EFFECT) and by TAXATION policies.
• SAY'S LAW
• SUPPLY creates its own DEMAND. So argued a French economist, Jean-Baptiste Say (1767–1832), and many classical and neo-classical economists since. KEYNES argued against Say, making the case for the use of FISCAL POLICY to boost demand if there is not enough of it to produce FULL EMPLOYMENT.
• SCALABILITY
• The ease with which the SUPPLY of an economic product or process can be expanded to meet increased DEMAND. Recent technological advances have led some economists to talk about the growing importance of instant scalability. For example, once a piece of software has been written it can be made available in an instant over the Internet to unlimited numbers of users for almost no cost. This potentially allows a new product to enter and win market share far more quickly than ever before, intensifying COMPETITION and perhaps accelerating the process of creative destruction (see SCHUMPETER).
• SCARCITY
• Supplies of the FACTORS OF PRODUCTION are not unlimited. This is why choices have to be made about how best to use them, which is where ECONOMICS comes in. MARKET FORCES operating through the PRICE MECHANISM usually offer the most efficient way to allocate scarce resources, with GOVERNMENT planning playing at most a minor role. Scarcity does not imply POVERTY. In economic terms, it means simply that needs and wants exceed the resources available to meet them, which is as common in rich countries as in poor ones.
• SCENARIO ANALYSIS
• Testing your plans against various possible scenarios to see what might happen should things not go as you hope. Scenario analysis is an important technique in RISK MANAGEMENT, helping FIRMS and especially financial institutions to ensure that they do not take on too much RISK. Its usefulness does of course depend on risk managers coming up with the right scenarios.
• SCHUMPETER, JOSEPH
• After growing up in the Austro-Hungarian empire, in which he worked as an itinerant lawyer, Joseph Schumpeter (1883–1950) became an academic in 1909. He was appointed Austrian minister of finance in 1919, presiding over a period of HYPER-INFLATION. He then became president of a small Viennese BANK, which collapsed. He returned to academia in Bonn in 1925 and in the 1930s joined the faculty of Harvard.
• In 1911, while teaching at Czernowitz (now in Ukraine), he wrote the Theory of Economic Development. In this he set out his theory of entrepreneurship, in which GROWTH occurred, usually in spurts, because COMPETITION and declining PROFIT inspired ENTREPRENEURS to innovate. This developed into a theory of the trade cycle (see BUSINESS CYCLE), and into a notion of dynamic competition characterised by his phrase “creative destruction”. In CAPITALISM, he argued, there is a tendency for FIRMS to acquire a degree of MONOPOLY power. At this point, competition no longer takes place through the PRICE MECHANISM but instead through INNOVATION. Perhaps because monopolies often become lazy, successful innovation may come from new entrants to a market, who take it away from the incumbent, thus blowing “gales of creative destruction” through the economy. Eventually, the new entrants grow fat on their monopoly profits, until the next gale of creative destruction blows them away.
• Ever controversial, and often wrong, in his 1942 book, CAPITALISM, SOCIALISM AND DEMOCRACY, he predicted the downfall of capitalism at the hands of an intellectual elite. He is associated with both AUSTRIAN ECONOMICS and, arguably as founding father, EVOLUTIONARY ECONOMICS.
• SDR
• Short for special drawing rights. Created in 1967, the SDR is the IMF's own currency. Its value is based on a portfolio of widely used currencies.
• SEARCH COSTS
• The cost of finding what you want. The economic cost of buying something is not simply the PRICE you pay. Finding what you want and ensuring that it is competitively priced can be expensive, be it the financial cost of physically getting to a marketplace or the OPPORTUNITY COST of time spent fact-finding. Search costs mean that people often take decisions without all the relevant INFORMATION, which can result in inefficiency. Technological changes such as the internet may sharply reduce search costs, and thus lead to more efficient decision making.
• SEASONALLY ADJUSTED
• There are seasonal patterns in many economic activities; for instance, there is less construction in winter than in summer, and spending in shops soars as Christmas approaches. To reveal underlying trends, statistics reflecting only part of the year are often adjusted to iron out seasonal variations.
• SECOND-BEST THEORY
• As we do not live in a perfect world, how useful are economic theories based on the assumption that we do? Second-best theory, set out in 1956 by Richard Lipsey and Kelvin Lancaster (1924–99), looks at what happens when the assumptions of an economic model are not fully met. They found that in situations where not all the conditions are met, the second-best situation – that is, meeting as many of the other conditions as possible – may not result in the OPTIMUM solution. Indeed, reckoned Lipsey and Lancaster, in general, when one optimal equilibrium condition is not satisfied all of the other equilibrium conditions will change.
• Potentially, the second-best equilibrium may be worse than a new equilibrium brought about by GOVERNMENT intervention, either to restore equilibrium to the market that is in DISEQUILIBRIUM, or to move the other markets away from their second-best conditions.
• Economists have seized on this insight to justify all sorts of interventions in the economy, ranging from taxing certain goods and subsidising others to restricting FREE TRADE. Whenever there is MARKET FAILURE, second-best theory says it is always possible to design a government policy that would increase economic WELFARE. Alas, the history of government intervention suggests that although the second best may be improved on in theory, in practice second best is often least worst.
• SECONDARY MARKET
• A market in second-hand FINANCIAL INSTRUMENTS. BONDS and SHARES are first sold in the primary market, for instance, through an initial public offering. After that, their new owners often sell them in the secondary market. The existence of liquid secondary markets can encourage people to buy in the primary market, as they know they are likely to be able to sell easily should they wish.
• SECURITIES
• Financial contracts, such as BONDS, SHARES or DERIVATIVES, that grant the owner a stake in an ASSET. Such securities account for most of what is traded in the FINANCIAL MARKETS.
• SECURITISATION
• Turning a future cashflow into tradable, BOND-like SECURITIES. Creating such ASSET-backed securities became a lucrative business for financial FIRMS during the 1990s, as they invented new securities based on cashflow ranging from future mortgage and credit-card payments to BANK loans, movie revenue and even the royalties on songs by David Bowie (so-called Bowie-bonds). Securitisation has many benefits, at least in¬theory. Issuers gain instant access to MONEY for which they would otherwise have to wait months or years, and they can shed some of the RISK that their expected revenue will not materialise. By selling securitised loans, investment banks are able to finance their customers without tying up large amounts of CAPITAL. Investors can hold a new sort of asset, less risky than unsecured bonds, giving them the risk-reducing benefit of DIVERSIFICATION. But there are dangers. The future cashflow underlying the securities may flow earlier or later than promised, or not at all.
• SEIGNORAGE
• Traditionally, the PROFIT rulers made from allowing metals to be turned into coins. Now it refers in a loosely defined way to the power of a country whose notes and coins are held by another country as a RESERVE CURRENCY.
• SELLER'S MARKET
• A market in which the seller seems to have the upper hand and so can charge a higher PRICE than in a
• SENIORITY
• The order in which CREDITORS are entitled to be repaid. In the event of a BANKRUPTCY, senior DEBT must be paid off before junior debt. Because junior debt has a lower chance of being repaid than senior debt, it carries more RISK, and thus typically pays a higher YIELD.
• SEQUENCING
• Shorthand for implementing economic reforms in the right order. In recent years, this has become a hot topic in DEVELOPMENT ECONOMICS. Some economists argue that introducing the right policies alone is not enough to revive a malfunctioning economy; reforms must be implemented in the right sequence. Thus they debate when in the reform process there should be, say, PRIVATISATION of state enterprises, and in which order, or the lifting of CAPITAL CONTROLS or other trade barriers. Other economists dispute whether there is a right sequence.
• SERVICES
• Products of economic activity that you can’t drop on your foot, ranging from hairdressing to websites. In most countries, the share of economic activity accounted for by services rose steadily during the 20th century at the expense of AGRICULTURE and MANUFACTURING. More than two-thirds of OUTPUT in OECD countries, and up to four-fifths of employment, is now in the services sector.
• SHADOW PRICE
• The true economic PRICE of an activity: the OPPORTUNITY COST. Shadow prices can be calculated for those goods and SERVICES that do not have a market price, perhaps because they are set by GOVERNMENT. Shadow pricing is often used in COST-BENEFIT ANALYSIS, where the whole purpose of the analysis is to capture all the variables involved in a decision, not merely those for which market prices exist.
• SHAREHOLDER VALUE
• Putting shareholders first; the notion that all business activity should aim to maximise the total value of a company’s SHARES. Some critics argue that concentrating on shareholder value will be harmful to a company’s other STAKEHOLDERS, such as employees, suppliers and customers.
• SHARES
• Financial SECURITIES, each granting part ownership of a company. In return for risking their CAPITAL by giving it to the company’s management to develop the business, shareholders get the right to a slice of whatever is left of the firm’s revenue after it has met all its other obligations. This money is paid as a DIVIDEND, although most companies retain some of their residual revenue for INVESTMENT purposes. Shareholders have voting rights, including the right to vote in the election of the company’s board of directors. Shares are also known as equities. They can be traded in the public FINANCIAL MARKETS or held as PRIVATE EQUITY.
• SHARPE RATIO
• A rough guide to whether the rewards from an INVESTMENT justify the RISK, invented by Bill Sharpe, a winner of the NOBEL PRIZE FOR ECONOMICS and co-creator of the CAPITAL ASSET PRICING MODEL. You simply divide the past RETURN on the investment (less the RISK-FREE RATE) by its STANDARD DEVIATION, the simplest measure of risk. The higher the Sharpe ratio is the better, that is, the greater is the return per unit of risk. However, as it is a backward-looking measure, based on what an investment has done in the past, the Sharpe ratio does not guarantee similar performance in future.
• SHOCK
• An unexpected event that affects an economy (see ASYMMETRIC SHOCK).
• SHORT-TERMISM
• Doing things that make you better off in the short-run but worse off in the end. After the bursting of the stockmarket BUBBLE and the failure of ENRON at the start of the 2000s, much like during the 1980s, accusations of short-termism were often made against the stockmarket-focused CAPITALISM of the United States and the UK. During the bubble, it was claimed, investors had become too focused on short-term PROFITS and changes in SHARE prices, and failed to probe deeply enough into long-term performance. As a result, managers did things that made their profits look as good as possible in the short run, often to the detriment of their company's long-term health. Indeed, many FIRMS engaged in misleading and even fraudulent accounting practices to inflate short-term profits. In the 1980s and early 1990s, the complaint took a slightly different form, and was arguably less convincing, namely that short-termism caused lower levels of INVESTMENT by businesses than in countries where the stockmarket was less important, such as Germany and Japan.
• SHORTING
• Selling a SECURITY, such as a SHARE, that you do not currently own, in the expectation that its PRICE will fall by the time the security has to be delivered to its new owner. If the price does fall, you can buy the security at the lower price, deliver it to whoever you sold it to and make a PROFIT. The RISK is that the price rises, leaving you with a loss.
• SIGNALLING
• A solution to one of the biggest sources of MARKET FAILURE: ASYMMETRIC INFORMATION. Often the biggest problem facing sellers is how to convince buyers that what they are selling is as good as they say it is. This problem arises in situations where the qualities of the thing being sold cannot be observed easily by buyers, who thus fear that sellers may be conning them. In such situations, an answer may be for sellers to do something that shows they mean what they say about quality. This something is what economists call signalling.
• Going to a leading university might be worth far more for what it signals to prospective employers about your abilities than for what you learn as a student. Likewise, the fact that a firm is willing to spend a lot of MONEY ADVERTISING its product may say far more about what it thinks of the product than any information included in the actual ad. To be useful, signals must impose more costs on those who use them to send false messages than any gains to be had from lying.
• SIMPLE INTEREST
• INTEREST calculated only on the initial amount ¬borrowed or invested. Contrast with COMPOUND INTEREST.

• SMITH, ADAM
• The founder of ECONOMICS as we know it. Born in Kirkcaldy, Fife, Adam Smith (1723–90) was educated at Glasgow and Oxford, and in 1751 became professor of logic at Glasgow University. Eight years later he made his name by publishing the THEORY OF MORAL SENTIMENTS. His 1776 book, An Inquiry into the Nature and Causes of the Wealth of Nations, is the bible of CLASSICAL ECONOMICS. He emphasised the role of specialisation (the DIVISION OF LABOUR), TECHNICAL PROGRESS and CAPITAL INVESTMENT as the main engines of economic GROWTH. Above all, he stressed the importance of the INVISIBLE HAND, the way in which self-interest pursued in free markets leads to the most efficient use of economic resources and makes everybody better off in the process.
• SOCIAL BENEFITS/COSTS
• The overall impact of an economic activity on the WELFARE of society. Social benefits/costs are the sum of private benefits/costs arising from the activity and any EXTERNALITIES.
• SOCIAL CAPITAL
• The amount of community spirit or TRUST that an economy has gluing it together. The more social capital there is, the more productive the economy will be. Yet, curiously, one of the best-known books to address the role of social capital, "Bowling Alone", by Robert Putnam of Harvard University, pointed out that Americans were far less likely to be members of community organisations, clubs or associations in the 1990s than they were in the 1950s. He illustrated his thesis by charting the decline of bowling leagues. Yet the American economy has gone from strength to strength. This has led some economists to question whether social capital is really as important as the theory suggests, and others to argue that membership of bowling leagues and other community organisations is simply not a good indicator of the amount of social capital in a country.
• SOCIAL MARKET
• The name given to the economic arrangements devised in Germany after the second world war. This blended market CAPITALISM, strong LABOUR protection and union influence, and a generous WELFARE state. The phrase has also been used to describe attempts to make capitalism more caring, and to the use of market mechanisms to increase the EFFICIENCY of the social functions of the state, such as the education system or prisons. More broadly, it refers to the study of the different social institutions underpinning every market economy.
• SOCIALISM
• The exact meaning of socialism is much debated, but in theory it includes some collective ownership of the means of production and a strong emphasis on equality, of some sort.
• SOFT CURRENCY
• A currency that is expected to drop in value relative to other currencies.
• SOFT DOLLARS
• The value of research services that brokerage companies provide “free” to INVESTMENT managers in exchange for the investment managers’ business. Economists disagree on whether or not such hidden payments are economically inefficient.
• SOFT LOAN
• A loan provided at below the market INTEREST RATE. Soft loans are used by international agencies to encourage economic activity in DEVELOPING COUNTRIES and to support non-commercial activities.
• SOVEREIGN RISK
• The RISK that a GOVERNMENT will default on its DEBT or on a loan guaranteed by it.
• SPECULATION
• An attitude to INVESTMENT that is often criticised. According to critics, speculation involves buying or selling a financial ASSET with the aim of making a quick PROFIT. This is contrasted with long-term investment, in which an asset is retained despite short-term fluctuations in its value. Speculators actually play a valuable role in FINANCIAL MARKETS as their appetite for frequent buying and selling provides LIQUIDITY to the markets. This benefits longer-term investors, too, as it enables them to get a good PRICE when they do eventually sell.
• SPECULATIVE MOTIVE
• See PRECAUTIONARY MOTIVE.
• SPOT PRICE
• The PRICE quoted for a transaction that is to be made on the spot, that is, paid for now for delivery now. Contrast spot markets with FORWARD CONTRACTS and futures markets, where payment and/or delivery will be made at some future date. Also contrast with long-term contracts, in which a price is agreed for repeated transactions over an extended time period and which may not involve immediate payment in full.
• SPREAD
• The difference between one item and another. A much used term in FINANCIAL MARKETS. Examples are the differences between:
• • the bid (what a dealer will pay) and ask or offer (what a dealer will sell for) PRICE of a share or other SECURITY;
• • the price an underwriter pays for an issue of BONDS from a company and the price the underwriter charges the public;
• • the YIELD on two different bonds.
• STABILISATION
• GOVERNMENT policies intended to smooth the economic cycle, expanding DEMAND when UNEMPLOYMENT is high and reducing it when INFLATION threatens to increase. Doing this by FINE TUNING has mostly proved harder than KEYNESIAN policymakers expected, and it has become unfashionable. However, the use of automatic stabilisers remains widespread. For instance, social handouts from the state usually increase during tough times, and taxes increase (FISCAL DRAG), boosting government revenue, when the economy is growing.
• STABILITY AND GROWTH PACT
• Budgetary rules agreed to by EURO ZONE countries as a condition of joining the EURO. The pact stipulates that all the countries will run a BALANCED BUDGET in normal times. A GOVERNMENT that runs a fiscal DEFICIT bigger than 3% of GDP must take swift corrective action. And if any country breaches the 3% limit for more than three years in a row, it becomes liable to fines of billions of euros. The pact was supposed to be a powerful political symbol that euro-using countries would not cheat each other. However, Portugal became the first country to break the deficit limit by notching up 4.1% in 2001. When, in 2002, France and Germany also exceeded the 3% limit, some EU members were outraged and others lobbied for the pact to be modified or even scrapped.
• STAGFLATION
• Term coined in the 1970s for the twin economic problems of STAGNATION and rising INFLATION. Until then, these two economic blights had not appeared simultaneously. Indeed, policymakers believed the message of the PHILLIPS CURVE: that UNEMPLOYMENT and inflation were alternatives.
• STAGNATION
• A prolonged RECESSION, but not as severe as a DEPRESSION.
• STAKEHOLDERS
• All the parties that have an interest, financial or otherwise, in a company, including shareholders, CREDITORS, bondholders, employees, customers, management, the community and GOVERNMENT. How these different interests should be catered for, and what to do when they conflict, is much debated. In particular, there is growing disagreement between those who argue that companies should be run primarily in the interests of their shareholders, in order to maximise SHAREHOLDER VALUE, and those who argue that the wishes of shareholders should sometimes be traded off against those of other stakeholders.
• STANDARD DEVIATION
• A measure of how far a variable moves over time away from its AVERAGE (mean) value.
• STANDARD ERROR
• A measure of the possible error in a statistical estimate.
• STATISTICAL SIGNIFICANCE
• There are lies, damned lies and statistics, said Benjamin Disraeli, a British prime minister. Certainly, even if the result of number crunching is statistically significant, it does not actually mean it is true. But it does mean it is much more likely to be true than false. Statistical significance means that the PROBABILITY of getting that result by chance is low. The most commonly used measure of statistical significance is that there must be a 95% chance that the result is right and only a 1 in 20 chance of the result occurring randomly.
• STERILISED INTERVENTION
• When a GOVERNMENT or CENTRAL BANK buys or sells some of its RESERVES of foreign currency this can affect the country’s MONEY SUPPLY. Selling reserves decreases the supply of the domestic currency; buying reserves increases the domestic money supply. Governments or central banks can sterilise (that is, cancel out) this effect of foreign exchange intervention on the money supply by buying or selling an equivalent amount of SECURITIES. For example, if the GOVERNMENT increases reserves by buying foreign currency the domestic money supply will increase, unless it sells securities such as TREASURY BILLS to mop up the extra DEMAND.
• STICKY PRICES
• Petrol-pump PRICES do not change every time the oil price changes, and holiday prices and standard hotel rates are fixed for months. Sticky prices are slow to change in response to changes in SUPPLY or DEMAND. As a result there is, at least temporarily, DISEQUILIBRIUM in the market. The causes of stickiness include MENU COSTS, inadequate information, consumers’ dislike of frequent price changes and long-term contracts with fixed prices. Prices change only when the cost of leaving them unchanged exceeds the expense of adjusting them. In FINANCIAL MARKETS, prices move all the time because the cost of quoting the wrong price can be huge. In other industries, the penalty may be much less severe. Small disequilibria in, say, the pricing of hotel rooms will not make much difference. So hotel prices are often sticky.
• STOCHASTIC PROCESS
• A process that exhibits random behaviour. For instance, Brownian motion, which is often used to describe changes in SHARE prices in an EFFICIENT MARKET (the RANDOM WALK), is a stochastic process.
• STOCKS
• Another term for SHARES. What are called ordinary shares in the UK are known as common stock in the United States. It is also another word for inventories of goods held by a firm to meet future DEMAND.
• STRESS-TESTING
• A process for exploring how a portfolio of ASSETS and/or liabilities would fare in extreme adverse conditions. A useful tool in RISK MANAGEMENT.
• STRUCTURAL ADJUSTMENT
• A programme of policies designed to change the structure of an economy. Usually, the term refers to adjustment towards a market economy, under a programme approved by the IMF and/or WORLD BANK, which often supply structural adjustment funds to ease the pain of transition. Such policies are much criticised in the developing world, sometimes with good reason.
• STRUCTURAL UNEMPLOYMENT
• The hardest sort of UNEMPLOYMENT to cure because it is caused by the structure of an economy rather than by changes in the economic cycle. Contrast with cyclical unemployment, which can, in theory if not always in practice, be cut without sparking INFLATION by stimulating faster economic GROWTH. Structural unemployment can be reduced only by changing the economic structures causing it, for instance, by removing rules that limit LABOUR MARKET FLEXIBILITY.
• SUBSIDY
• MONEY paid, usually by GOVERNMENT, to keep PRICES below what they would be in a free market, or to keep alive businesses that would otherwise go bust, or to make activities happen that otherwise would not take place. Subsidies can be a form of PROTECTIONISM by making domestic goods and SERVICES artificially competitive against IMPORTS. By distorting markets, they can impose large economic costs.
• SUBSTITUTE GOODS
• Goods for which an increase (or fall) in DEMAND for one leads to a fall (or increase) in demand for the other – Coca-Cola and Pepsi, perhaps.
• SUBSTITUTION EFFECT
• When the PRICE of petrol falls people buy more of it. There are two reasons.
• • The INCOME EFFECT: cheaper petrol means that real purchasing power rises, so consumers have more to spend on everything, including petrol.
• • The substitution effect: petrol has become cheaper relative to everything else, so people switch some of their CONSUMPTION out of goods that are now relatively more expensive and buy more petrol instead.
• SUNK COSTS
• When what is done cannot be undone. Sunk costs are costs that have been incurred and cannot be reversed, for example, spending on ADVERTISING or researching a product idea. They can be a barrier to entry. If potential entrants would have to incur similar costs, which would not be recoverable if the entry failed, they may be scared off.
• SUPPLY
• One of the two words economists use most, along with DEMAND. These are the twin driving forces of the market economy. Supply is the amount of a good or service available at any particular PRICE. The law of supply is that, other things remaining the same, the quantity supplied will increase as the price increases. The actual amount supplied will be determined, ultimately, by what the market price is, which depends on the amount demanded as well as what suppliers are willing to produce. What suppliers are willing to supply depends on several things:
• • the cost of the FACTORS OF PRODUCTION;
• • technology;
• • the price of other goods and SERVICES (which, if high enough, might tempt the supplier to switch production to those products); and
• • the ability of the supplier accurately to forecast demand and plan production to make the most of the opportunity.
• SUPPLY CURVE
• A graph of the relationship between the PRICE of a good and the amount supplied at different prices. (See also DEMAND CURVE.)
• SUPPLY-SIDE POLICIES
• Increasing economic GROWTH by making markets work more efficiently. In the 1980s, Ronald Reagan and Margaret Thatcher championed supply-side policies as they attacked KEYNESIAN DEMAND management. Pumping up demand without making markets work better would simply lead to higher INFLATION; economic growth would increase only when markets were able to operate more freely. Thus they pursued policies of DEREGULATION, LIBERALISATION and PRIVATISATION and encouraged FREE TRADE. To reduce UNEMPLOYMENT, they tried to increase the EFFICIENCY of the jobs market by cutting the rate of INCOME TAX and attacking legal and other impediments to LABOUR MARKET FLEXIBILITY. The results of these programmes are much debated. In particular, the belief, apparently supported by the LAFFER CURVE, that cutting tax rates would increase tax revenue did not always stand up well to real-world testing. Even so, it is now recognised that supply-side reforms are a crucial element in an effective economic policy.
• SUSTAINABLE GROWTH
• A term much used by environmentalists, meaning economic GROWTH that can continue in the long term without non-renewable resources being used up or pollution becoming intolerable. Mainstream economists use the term, too, to describe a rate of growth that an economy can sustain indefinitely without causing a rise in INFLATION.
• SWAP
• See DERIVATIVES.
• SYSTEMATIC RISK
• The RISK that remains after DIVERSIFICATION, also known as market risk or undiversifiable risk. It is systematic risk that determines the RETURN earned on a well-diversified portfolio of ASSETS.
• SYSTEMIC RISK
• The RISK of damage being done to the health of the FINANCIAL SYSTEM as a whole. A constant concern of BANK regulators is that the collapse of a single bank could bring down the entire financial system. This is why regulators often organise a rescue when a bank gets into financial difficulties. However, the expectation of such a rescue may create a MORAL HAZARD, encouraging banks to behave in ways that increase systemic risk. Another concern of regulators is that the ¬RISK MANAGEMENT methods used by banks are so similar that they may increase systemic risk by creating a tendency for crowd behaviour. In particular, problems in one market may cause banks in general to liquidate positions in other markets, causing a vicious cycle of LIQUIDITY being withdrawn from the financial system as everybody rushes for the emergency exit at once. (See CAPITAL ASSET PRICING MODEL.)