Much economic theory looks at the question of how the principal can create incentives for agents to act in the way he wants, when these actions are costly to the agents. Other examples of principal–agent problems occur in health markets: the principal (the patient) may be concerned about whether her doctor is recommending a beneficial treatment or merely one that is profitable to him.
Moral hazard
Dave insures his mobile phone, and knowing that he is now covered for any damage by the insurance company, he begins to treat his phone rather carelessly, claiming the costs of fixing various breakages. This situation, in which Dave is able to affect the probability of the event (phone damage) under which the insurance company pays out, is an example of moral hazard. The problem in this case is that the insurance company cannot monitor each of its customers and may end up paying out more than expected: if it could it would charge higher premiums to careless people like Dave. But because it can’t, the company charges higher premiums for everybody. It may even stop selling certain kinds of insurance. The firm’s lack of information hobbles the market.
Many economists have claimed moral hazard contributed to the financial crises that began in 2007: if banks are considered ‘too big to fail’ they may take on overly risky investments, knowing that they will be bailed out by government later on.
Adverse selection
Consider the case of a stallholder selling cheap perfume – his willingness to sell at this price raises suspicions that the perfume may be fake. The problem arises because unlike the seller, the buyer is uninformed about the quality of the perfume. In this situation of ‘adverse selection’, the market tends to push out sound products in favour of bad ones.
To take another example, the condition of a second-hand car may be unknown to the buyer, but owners of duds have more incentive to sell than owners of sound vehicles and so buyers expect that the average quality of cars on offer is low. As a result, they are only willing to pay low prices, and because owners of sound cars can’t get decent prices, fewer of these are offered until eventually only duds are left. Adverse selection also arises in health insurance where people’s health is unknown to the insurer. Those most keen to buy insurance may be the unhealthy ones that the insurer least wants to insure.
Signalling and screening
Markets don’t function well when some people have less information than others, but one theory suggests that informed participants can sometimes ‘make a signal’ that reveals information to solve the problem. For example, firms wish to hire productive workers, but it is hard for firms to observe these characteristics. Workers are aware of their own capabilities and can signal these abilities by gaining qualifications. Suppose that an accountancy firm awards a training contract to a history graduate over an applicant without a degree. The graduate’s studies were unrelated to accountancy and the firm plans to train her in the discipline from scratch, but the degree has acted as a signal of valued characteristics – diligence and ability. If the firm was able to directly observe ability levels, the degree would be redundant. Uninformed parties can also take actions, known as screening, to make others reveal information about themselves. Insurance companies and lenders ask potential customers questions that are designed to reveal how risky they are.
Auctions and the winner’s curse
At an auction, Jane is the winning bidder for an antique clock and pays £50.00 for it. She wins because her bid is higher than all the other bids, but this means that in some sense she paid ‘too much’ for the clock – a phenomenon known as the winner’s curse. If the second-highest bid was £49.00, then Jane would still have won the clock with a bid of £49.01 and so has ended up paying 99 pence more than she needed to.
The analysis of auction strategy has become an important part of economics. One important question concerns the best bidding strategy – might Jane have done better to slightly lower her bidding limit to reduce the probability of paying too much, or would she have risked losing the auction? Another question is how the seller of an item should design auctions to maximize revenue. This gained prominence in the 1990s, when governments sold off radio spectrum rights to mobile phone operators. Insights from auction theory were used to design auctions that maximized returns from the sales.
Searching and matching
In the standard model of markets, prices are what bring demand into line with supply. In the labour market, the number of people who want to work at the going wage should equal the number that employers wish to take on. In reality, however, workers don’t know about all the jobs and salaries available. Acquiring information about job opportunities is costly in terms of time and research, so workers will search for a job until they find a good match – one that fulfils their preferences at an acceptable wage. But because search is costly it is rational for them to limit the amount of time they spend searching and to accept a wage that is ‘high enough’, even if there may be higher-paid jobs available. These costs mean that a range of wages can be found for the same job, rather than a single one. They also explain the phenomenon of ‘frictional unemployment’ – the unemployment that exists even in booming economies simply because of the time it takes for workers to find new jobs.
Game theory and the prisoners’ dilemma
The branch of economics that considers strategic decision-making is known as game theory, and the prisoners’ dilemma is perhaps its best-known example. Two thieves are captured, questioned separately and urged to give evidence against each other. They know that if both stay silent they will receive a light sentence of a year in prison. Alternatively, if one of them betrays their partner and the other stays silent, the former is released and the latter will be sentenced to 20 years. If both betray, however, they will each get 10 years. Since the worst outcome is clearly to get double-crossed, they both end up betraying each other and receive 10 years each. But by acting rationally the thieves have missed out on the best outcome – that of mutual silence. An economic example of a prisoners’ dilemma is a cartel – a group of firms that agree to restrict output to keep prices high. Given high prices, it is rational for a firm to produce more to reap large additional profits, but when all firms do this, output shoots up and prices collapse, undermining the cartel’s original aim.
Credible threats
In many markets, a small number of firms compete and their individual outputs affect prices. In making decisions, therefore, firms must take into account the reactions of competitors. They may try to influence them with threats, but these only work if they are credible.
Consider CemOld, a monopoly supplier of cement that earns large profits through high prices by underproducing. NewCem now considers entering the market and CemOld knows that this would drive down prices. So it threatens to boost production in the event of NewCem’s entry, hitting the profits of both firms. CemOld hopes this will deter the newcomer, but if NewCem does enter the market it would not be rational to carry out its threat: it is not credible. A threat can be made credible by showing commitment to it – CemOld could invest in a new factory, and having made that outlay, it will need to produce cement from the new plant. This could make it profitable to raise output significantly if NewCem do enter.
Profit opportunities encourage NewCem to enter the market, and discourage CemOld from retaliation.
Behavioural economics
Economists often think of consumers and firms as rational, in the sense that they choose actions that maximize benefits over costs, but observation of people’s choices shows this is far from the way people actually behave. The new branch of behavioural economics studies these quirks.
For example, standard economics posits that people have a consistent attitude to risk – often they are risk averse, tending to prefer certain safe outcomes to riskier but more profitable ones. Behavioural economics has shown that people behave differently when facing potential gains or losses – with gains they seem risk-averse, but facing loss they appear risk loving, taking on risk to avoid potential losses. It
seems that people hate losing a certain amount more than they like to gain it. One implication of this is the ‘endowment effect’: people place a higher value on a car that they already own than one they see in the showroom. Rational economic man would have a single valuation of the car, regardless of whether he owned it.
The Allais paradox
French economist Maurice Allais gave his name to a paradox in which economic behaviour violates a basic notion of rationality. Suppose that Sally can choose between a Mars Bar or a Twix, and chooses the Mars Bar. She is then offered a choice between a Mars Bar, a Twix and a Snickers. If she is economically rational, she should choose either the Mars Bar or the new option, the Snickers; the addition of a Snickers to the range of options shouldn’t change her preference for the Mars Bar over the Twix.
Economists call this criterion of rationality ‘independence’. But in more complex situations where people were expected to choose between uncertain outcomes, Allais found that independence would frequently be violated: somehow people were influenced by the inclusion of alternatives that should have made no difference. Allais’s insights have prompted economists to investigate more closely the psychological bases of economic behaviour.
The role of money
A person’s overall wealth may consist of houses and paintings, a portfolio of shares, a fat bank account and sackfuls of cash. But only some of these assets are money – those which can be routinely exchanged for goods and services. What is it that distinguishes money from paintings or houses? Money is first a medium of exchange. Societies that do not have money face a problem known as the ‘double coincidence of wants’: if I want to buy a loaf of bread and have a piece of meat to give in exchange, then I need to find someone with bread who happens to want meat at the same time. Money solves this problem.
Money is also a unit of account. Wages, loan repayments, the prices of wheat or computers are all measured in the same comparable units. When a baker sells a loaf of bread, he earns a pound that he can use later on to buy a newspaper: money therefore acts as a store of value, and it has been central to the emergence of modern economies.
Fiat and commodity money
Money in modern economies is in the form of intrinsically worthless notes. In earlier societies it was made out of precious metals.
So-called commodity money has intrinsic value aside from its monetary value: early forms of money such as gold coins were of this type. Commodity money is costly because it ties up the valuable raw materials used to make it. It is also vulnerable to debasement – mints have an incentive to reduce the precious metal content. The amount of commodity money in circulation also depends on the availability of the commodity – for instance, the economy can be flooded if new metal reserves are found.
Fiat money is a more sophisticated kind of money that avoids these problems – $100 bills and electronic balances are not tied to any underlying commodity: they are money simply because society agrees that they are. When properly managed by a responsible government, fiat money enables monetary policy – the manipulation of interest rates and money supply in order to manage the economy (see Monetary policy). The risk, however, is that profligate governments can print excessive amounts of money, leading to hyperinflation (see Hyperinflation).
Money supply
The money supply is the overall level of monetary assets in an economy. A variety of different kinds of assets can act as money, so the money supply is made up of various components, depending on how different economists or statistical bodies choose to define it.
Reference is often made to ‘narrow’ or ‘broad’ money. Narrow money is made up mainly of the most tangible forms: notes and coins. In developed economies, however, the main component of the money supply is the stock of money in bank accounts, and broader definitions of the money supply can include bank deposits in current and savings accounts. As financial systems become more complex they offer a greater choice of money-like assets. This means that precise control of the money supply by the authorities can be difficult. Different forms of money are sometimes denoted by the terms M0, M1, M2, M3 and M4 from narrow to broad, although once again, organizations may define these categories in different ways.
Money creation
Banks hold only a fraction of their deposits as cash, and this ‘fractional-reserve’ system is used to create money. Suppose that a bank has $1,000 of deposits, contributing $1,000 to money supply. The bank holds just 1/10 of its deposits as cash reserves: it keeps $100 and lends out $900. Savers still have deposits totalling $1,000, but borrowers have $900, an addition to the money supply on top of the original $1,000. The economy is no richer in real terms – the borrowers eventually have to pay back the $900 – but there is now a greater stock of money for use in transactions. When borrowers spend their $900, it ends up with another bank, which keeps a fraction of it as cash before lending out the rest, and so on.
A ‘reserve ratio’ of 1/10 eventually generates a money supply of $10,000 from the original $1,000. The lower the ratio, the more money that is generated. Governments try to control money supply by influencing this process – for example, by changing interest rates or by restricting the reserve ratio.
The demand for money
People can hold their wealth in various forms such as money, shares, property and other assets. Just as we talk of the demand for apples or houses, we can also consider the demand for money. People choose to hold their wealth as money – to demand it – for several reasons. They need money to carry out transactions, to buy food and pay bills, but uncertainty about the future also causes people to hold money to cover unforeseen expenses. The more transactions that need to be carried out, the more money people will demand. So as economies grow, the demand for money tends to increase.
Money – in particular cash – does not pay interest so by holding onto it one forgoes the potential returns from financial assets such as bonds. When the interest rates on offer are higher, one gives up more by holding money, so the demand for money tends to fall as interest rates rise. Inflation in prices also decreases the demand for money, because its purchasing power is reduced.
Interest rates
Interest is paid to holders of financial assets such as bonds. The rate of interest is determined by the supply and demand for money. When rates are high people buy interest-earning financial assets; they are less willing to hold money, while when national income is higher, people need more money for transactions. Suppose the central bank sets a certain level of money supply. The money market comes to rest when demand for money is equal to supply, and for this to happen, the interest rate must adjust to the level at which people are willing to hold an amount of money equal to that supplied by the central bank.
Suppose the central bank now floods the economy with money. Given national income, people don’t need that much money to trade. At the current interest rate they don’t wish to hold all this extra money, so in order for them to keep hold of it interest rates must fall: bonds become less attractive and people become willing to hold the extra money supply, returning the market to balance.
Seigniorage
Governments have a monopoly on the production of money, and the cost to the authorities of printing a bank note is a fraction of that note’s value. The revenue that this creates for the government is known as seigniorage and, along with taxation and borrowing, it is a method by which the state can raise finance. This is what happens when governments finance spending by printing money rather than by borrowing or raising taxes.
But, in fact, seigniorage functions as a sort of tax – printing money raises the money supply and pushes up inflation, so seigniorage can be thought of as an ‘inflation tax’ because higher prices reduce the real value of people’s money. As with any tax, the government boosts its own purchasing power at the expense of everyone else’s. Although seigniorage can be a useful source of revenue it can also be dangerous: if it is taken to an extreme it can lead to hyperinflation (see Hyperinflation).
Money illusion
Unlike gold coins, modern money – in the form of cash and bank deposits – has no intrinsic value. A note is worth $10 only because society agrees it is. What you can buy with it depends on prices. Money illusion happens when people confuse money’s nominal value – a note’s face value of $10, for example – with its real value – the amount of goods and services that it can be used to buy.
Suppose a worker is paid $100 per week: her nominal wage. If she spends all her money on books and the price of books doubles, then her real wage has halved. However, people seem to take more notice of changes to their real wages caused by changing nominal wages than those caused by changing prices: they balk more at a 10 per cent cut in nominal wages than at an equivalent rise in prices with an unchanged wage. Some economists have suggested that during times of inflation, workers supply more labour than they otherwise would because they think their wages are higher than they really are.
Economics in Minutes Page 3
