Approches_Eco_Anal_Cours_2013

other does not, a recession follows. The firm making the price cut makes only $5, while the other firm makes $15.

The essence of this dilemma is that each firm’s decision influences the set of outcomes available to the other firm. When one firm cuts its price, it improves the position of the other firm, because the other firm can then avoid the recession.

The positive impact of one firm’s price cut on the other firm’s profit opportunities might arise from an aggregate-demand externality.

What outcome should we expect in this economy? On the one hand, if each firm expects the other to cut its price, both will cut prices, resulting in the preferred outcome in which each makes $30. On the other hand, if each firm expects the other to maintain its price, both will maintain their prices, resulting in the inferior solution in which each makes$15. Either of these outcomes is possible: economists say that there are multiple equilibria.

The inferior outcome, in which each firm makes $15, is an example of a coordination failure. If the two firms could coordinate, they would both cut their price and reach the preferred outcome. In the real world, unlike in our parable, coordination is often difficult because the number of firms setting prices is large. The moral of the story is that prices can be sticky simply because people expect them to be sticky, even though stickiness is in no one’s interest.

4. 4. Hysteresis and the Challenge to the Natural-Rate Hypothesis

As we have seen, the natural-rate hypothesis is summarized in the following statement: Fluctuations in aggregate demand affect output and employment only in the short run. In the long run, the economy returns to the levels of output, employment, and unemployment described by the classical model.

The natural-rate hypothesis allows macroeconomists to study separately short-run and long-run developments in the economy. Recently, some New Keynesian economists have challenged the natural-rate hypothesis by suggesting that aggregate demand may affect output and employment even in the long run. They have pointed out a number of mechanisms through which recessions might leave permanent scars on the economy by altering the natural rate of unemployment. Hysteresis is the term used to describe the long-lasting influence of history on the natural rate.

99

A recession can have permanent effects if it changes the people who become unemployed. For instance, workers might lose valuable job skills when unemployed, lowering their ability to find a job even after the recession ends.

Alternatively, a long period of unemployment may change an individual’s attitude toward work and reduce the desire to find employment. In either case, the recession permanently inhibits the process of job research and raises the amount of frictional unemployment.

Another way in which a recession can permanently affect the economy is by changing the process that determines wages. Those who become unemployed may lose their influence on the wage-setting process. Unemployed workers may lose their status as union members, for example. More generally, some of the insiders in the wage-setting process become outsiders. If the smaller group of insiders cares more about high real wages and less about high employment, than the recession may permanently push real wages further above the equilibrium level and raise the amount of wait employment.

Hysteresis remains a controversial topic. It is still not clear whether this phenomenon is significant, or why it might be more pronounced in some countries than in others. Yet the topic is important, because hysteresis implies that recessions are much more costly than the natural-rate hypothesis would suggest. Put another way, hysteresis raises the sacrifice ratio.

The rise in unemployment was caused in large part by the policies designed by the Thatcher government to reduce inflation. When the Conservative party won control and Margaret Thatcher became prime minister in 1979, inflation was running almost 18 percent per year. Contractionary monetary and fiscal policies caused the rate of unemployment to rise from 4.3 percent in 1979 to 11.1 percent in 1984. As the Phillips curve predicts, the rise in unemployment lowered inflation to less than 5 percent in 1984.

The puzzle is that unemployment remained high even after inflation had stabilized. Since this high unemployment did not lower inflation further, it appeared that the natural rate of unemployment had risen. Theories of hypothesis provide reasons for why the recession might have raised the natural rate of employment.

100

4. 5. Ignorance, Expectations, and Lucas Critique

The prominent macroeconomist Robert Lucas once wrote, “As an advicegiving profession we are in way over our heads.” Even many of those who frequently advice policymakers would agree with this assessment. Economics is a young science, and there is still much that we do not know. This ignorance suggests that economists should be cautious when advising policymakers. Economists cannot be completely confident when they make assessments about the effects of alternative policies.

Although there are many topics about which economists’ knowledge is limited, Lucas has emphasized the question of how people form expectations of the future. Expectations play a crucial role in the economy because they influence the behaviour of consumers, investors, and other economic actors. People’s expectations depend on many things, including the economic policies being pursued by the government. Thus, estimating the effect of a policy change requires knowing how people’s expectations will respond to the policy change.

Lucas had argued that traditional methods of policy evaluation do not adequately take into account this impact of policy on expectations. This criticism of traditional policy evaluation is known as the Lucas critique.

We saw one example of the Lucas critique above when we discussed the role of rational expectations in the cost of reducing inflation. Traditional estimates of the sacrifice ratio-the percentage points of GDP that must be forgone to reduce inflation by 1 percentage point-rely on the assumption of adaptive expectations. That is, they assume that expected inflation depends on past inflation. Advocates of the rational-expectations approach claim that reducing inflation can be much less costly because expectations will respond to a credible change in policy. In other words, they claim that traditional estimates of the sacrifice ratio are unreliable because they are subject to the Lucas critique.

101

References

(These references are the main textbooks that you can use in order to develop the subjects presented in this course. They do not include all the references cited in the text).

Baumol, W. J. and Blinder, A. S. 2006, Economics, Thomson SouthWestern, Tenth edition.

Blaug, M. 1997, Economic Theory in Retrospect, Cambridge University Press, Fifth edition.

Cleaver, T. 2004, Economics. The Basics, Routledge.

Canto, V. A., Joines, D. H., Laffer, A. B. (eds.) 1983 Foundations of Supply-Side Economics, Academic Press

Lipsey, R.G., Courant, P. N., Purvis, D. D. and Steiner, P. O. 1993,

Economics, Harper Collins College Publishers, Tenth edition.

Mankiw, N. G. 1994, Macroeconomics, Worth Publishers, Second edition.

Screpanti, E. and Zamagni, S. 1995, An Outline of the History of Economic Thought, Clarendon Press, Oxford.

Stiglitz, J. E. and Walsh, C. E. 2006, Economics, W.W. Norton&Company, Fourth edition.

Ülgen, F. 2002, Théories de la firme et stratégies anticoncurrentielles. Firme et marché, Paris : L’Harmattan (2nd edition 2003).

102

GLOSSARY

Absolute price: The amount of money that must be spent to acquire one unit of a commodity.

Agents: Decision makers, including households, firms, and government bodies.

Aggregate demand: Total desired purchases by all the buyers of an economy’s output.

Aggregate production function: The relation between the total amount of each factor of production employed in the nation and the nation’s total output, its GDP.

Aggregate supply: Total desired sales of all the producers of an economy’s output.

Allocation efficiency: A situation in which no reorganization of production or consumption could make everyone better off (or, as it is sometimes stated, make at least one person better off while making no one worse off).

Asymmetric information: A situation in which the parties to a transaction have different (heterogeneous) information and the transaction cannot be established without errors.

Average fixed cost (AFC): Total fixed costs divided by the number of units of output.

Average product (AP): Total product divided by the number of units of the variable factor used in its production.

Average revenue (AR): Total revenue divided by quantity sold; this is the market price when all units are sold at one price.

Average total cost ATC): Total cost of producing a given output divided by the numbers of units of output; it can also be calculated as the sum of average fixed costs and average variable costs.

Average variable cost (AVC): Total variable costs divided by the number of units of output.

Balance of trade: The difference between the value of exports and the value of imports of visible items.

103

Capital: A factor of production consisting of all manufactured aids to further production, including plant, equipment, and inventories.

Centrally planned economy: See command economy.

Command economy: An economy in which the decision of government (as distinct from households and firms) exert the major influence over the allocation of resources.

Commodities: Marketable items produced to satisfy wants. Commodities may either goods, which are tangible, or services, which are intangible.

Complement: Two commodities are complements when they tend to be used jointly with each other. The degree of complementarity is measured by the size of the negative cross elasticity between the two goods.

Consumption: The act of using commodities, either goods or services, to satisfy wants.

Cost (of output): To a producing firm, the value of inputs used to produce output.

Cost minimization: An implication of profit maximization that the firm will choose the method that produces specific output at the lowest attainable cost.

Decreasing returns: A situation in which output increases less than in proportion to inputs as the scale of a firm’s production increases.

Demand: The entire relationship between the quantity of a commodity that buyers wish to purchase per period of time and the price of that commodity.

Demand curve: The graphical representation of the relationship between the quantity of a commodity that buyers wish to purchase per period of time and the price of that commodity, other things being equal.

Economic efficiency: The least costly method of producing any output.

Economic growth: Increases in real, or constant-dollar, potential GDP.

Economies of scale: Reduction of costs per unit output resulting from an expansion in the scale of a firm’s operations so that more of all inputs are being used.

104

Economies of scope: Economies achieved by a firm that is large enough to engage efficiently in multi-product production and associated large-scale distribution, advertising, and purchasing.

Elasticity of demand: A measure of the responsiveness of quantity of a commodity demanded to a change in market price.

Equilibrium condition: A condition that must be fulfilled if some market or sector of the economy, or the whole economy, is to be in equilibrium.

Equilibrium price: A price at which quantity demanded equals quantity supplied.

Excess capacity: The amount by which actual output falls short of capacity output (which is the output that corresponds to the minimum short-run average total cost).

Excess demand: A situation in which, at the given price, quantity demanded exceeds quantity supplied.

Excess supply: A situation in which, at the given price, quantity supply exceeds quantity demanded.

Expectational inflation: Inflation that occurs because decision makers raise prices (so as to keep their relative prices constant) in the expectation that the price level is going to rise.

External economies of scale: Scale economies that cause the firm’s costs to fall as industry output rises bur that are external to the firm and so cannot be obtained by the firm’s increasing its own output.

Externalities: Effects, either good or bad, on parties not directly involved in the production or use of a commodity (third-party effects).

Factor markets: Markets in which the services of factors of production are sold.

Factor mobility: The ease with which factors can be transferred between uses.

Factors of production: Resources used to produce goods and services to satisfy wants; frequently divided into the basic categories of land, labour, and capital.

Firm: The unit that employs factors of production to produce goods and services.

Fixed cost: A cost that does not change with output (overhead cost, unavoidable cost).

105

45° line: In macroeconomics, the line that graphs the equilibrium condition that aggregate desired expenditure should equal national income.

Free-market economy: An economy in which the decisions of individual households and firms (as distinct from the government) exert the major influence over the allocation of resources.

Goods: Tangible commodities, such as CDs or shoes.

Gross domestic product (GDP): National income as measured by the output approach, equal to the sum of all values added in the economy or, what is the same thing, the values of all final goods produced in the economy. It can be valued at current prices to get nominal GDP, which is also called GDP at current, or market, prices; or it can be valued at base-year prices to get real GDP, which is also called GDP at constant prices.

Homogeneous product: In the eyes of purchasers, every unit of product is identical to every other unit.

Incentives: Benefits, or reduced costs, that motivate a decision maker in favour of a particular choice.

Income elasticity of demand: A measure of the responsiveness of quantity demanded to a change in income.

Increasing returns: The output increases more than the increase in inputs when the scale of a firm’s production increases. A firm in this situation, with fixed factor prices, is a decreasing cost firm.

Industry: A group of firms that produce a single product or group of related products.

Inflation: A rise in the average level of prices.

Investment goods: Goods that are produced not for present consumption, i.e., capital goods, inventories, and residential housing.

Keynesians: A label attached to economists who hold the view, derived from the work of John Maynard Keynes, that active use of monetary and fiscal policy can be effective in stabilizing the economy. Often the term encompasses economists who advocate active policy intervention in general.

106

Labor: A factor of production consisting of all physical and mental efforts provided by people.

Laffer curve: A graph relating the revenue yield of a tax system to the marginal or average tax rate imposed.

Laissez faire: Literally, “let do”; a policy advocating the minimization of government intervention in a market economy.

Law of demand: The assertion that market price and quantity demanded in the market vary inversely with one another, that is, that demand curves are negatively sloped.

Law of diminishing returns: The hypothesis that, if increasing quantities of a variable factor are applied to a given quantity of fixed factors, the marginal product and average product of the variable factor will eventually decrease.

Macroeconomics: The study of the determination of economic aggregates, such as total output, total employment, the price level, and the rate of economic growth.

Marginal cost: The increase of total cost resulting from raising the rate of production by one unit (also called incremental cost). That is the increase of the total cost due to the cost of producing the later unit.

Marginal product: The increase of the total output due to the production of the later unit of good (incremental product).

Marginal revenue: The change in a firm’s total revenue resulting from a change in its rate of sales by one unit.

Marginal utility: The additional satisfaction obtained by a consumer from consuming one unit more of a good or service.

Market: Any situation in which buyers and sellers can negotiate the exchange of a commodity.

Market failure: Failure of the unregulated market system to achieve optimal allocative efficiency because of externalities or market imperfections.

Microeconomics: The study of the allocation of resources and the distribution of income as they are affected by the workings of the price system and by government policies.

107

Money price: see Absolute price.

Neutrality of money: The doctrine that the money supply affects only the absolute level of prices and has no effect on relative prices and hence no effect on the allocation of resources or the distribution of income.

Opportunity cost: The cost of a resource, measured by the value of the next-best alternative use of that resource.

Pareto-optimality: A situation in which it is impossible by reallocation of production or consumption activities to make all consumers better off without simultaneously making others worse off (also called Pareto-efficiency).

Perfect competition: A market structure in which all firms in an industry are price takers and in which there is freedom of entry into and exit from the industry. Firms have no control over the market conditions.

Price level: The average level of all prices in the economy (index number).

Price makers: Firms that administer their prices.

Price takers: Firms that can alter their rate of production and sales without significantly affecting the market price of the considered good.

Productive efficiency: Production of any output at the lowest attainable cost.

Purchasing power of money: The amount of goods and services that can be purchased with a unit of money.

Rate of inflation: The percentage rate of increase in some price index from one period to another.

Rational expectations: The theory that people understand how the economy works and learn quickly from their mistakes, so that, while random errors may be made, systematic and persistent errors are not made. Therefore, economic policies which aim to fool economic agents and create surprise-effect in order to affect the level of income are without any real effect.

Relative price: The ratio of money price of one commodity to the money price of another commodity (ratio of two absolute prices).

Resource allocation: The allocation of an economy’s scarce resources of land, labour, and capital among alternative uses.

108