ECONOMICS(OfNobelLaureates)

By

Prof.V.T.Naidu

ECONOMICS(OfNOBELLAUREATES)

DedicatedTo

MyChildrenPadma,Rama&Swamy

AndtheirSpousesRamakrishnarao,PrasadaRao,SivaSri

MyGrandChildrenVidyaSagar,SantoshKumar,Anusha&Dhanesh

By

Prof.V.T.Naidu

“Readnottocontradictandconfute,nortobelieveandtakeforgranted,nortofindtalkanddiscourses,buttoweighandconsider.”

FrancisBacon:Essays,‘OfStudies’

Contents

Preface

Chapters;

EconomicFramework1.EconomicsandNobelEconomists2.NationalIncome;MethodsandAnalysis

ApproachestoEconomics3.Econometrics4.EconomicHistory5.ExperimentalEconomics

MethodsandToolsofEconomics6.GeneralEquillibriumTheory7.LinearProgramming8.GameTheory

BranchesofEconomics9.DemandTheory10.TheoryofMarkets11.MonetaryEconomics12.PublicFinanceandWelfareEconomics13.InternationalEconomics14.FinancialEconomics15.InformationEconomics16.EconomicGrowthandDevelopment

ECONOMICS(OFNOBELLAUREATES)

PREFACE

ThoughmybookonEconomicsisoneamongmany,itisdifferentfromothers,inemphasizingthecontributionsofNobelEconomists.

Ihopemybookservesasasupplement to theprescribed textbooksofEconomics forP.GstudentsofBusiness,commerceandEconomics.Furtherthisbookmightbeofsomeinteresttogeneralreadersalso.IfsomestudentsareinducedtoreadsomeoftheexcellenttextbooksandtheoriginalworksofNobelEconomists,myeffortwouldhavebeenamplyrewarded.

Asusualwithbookwriters, Ihaveborrowedideasandmaterial frommanybooksandI takethisopportunitytothankalltheauthorsandthepublishersofthebooks.

Ioweadeepdebtofgratitudetomyteachers,speciallytoDr.D.N.Rao,Prof.B.S.Rao,Dr.Bhate,Prof.D.L.NarayanaandProf.MarvinSchars. Ihavebeen fortunate inhavingaffectionateandfriendlycolleaguesandwellbehavedstudents.Mythankstoallofthem.

I wish to express my homage to my parents Late.V.Appala Naidu Garu and Late Mrs.Kurmamma towhom Ioweeverything. I recall tomemory theaffectionshown tomebymyadoptive father V.Swamy Naidu and two other uncles V.Satyam Naidu and V.VenkataNaidu.TheaffectionateencouragementofmybrothersSriV.L.Naidu,V.SeethaRamNaiduandsisterParvatammahasbeenasourceofencouragementtomeintheearlystagesofmylife.FinallyallmyeffortsreceivedthesilentapprovalofmywifeSarojini.

ChapterIECONOMICSANDNOBELECONOMISTS

AdamSmith, the founderofEconomics,wrotehisClassicbook,WealthofNations in1776.Thesub-titleofhisbook,“AnEnquiryintoNatureandCausesofTheWealthofNations”maybetakenasSmith’sdefinitionofEconomics.

Lionel Robbins provided in 1935 an analytical definition of Economics. According to him,“Economicsisthesciencewhichstudieshumanbehaviorasarelationshipbetweenendsandscarce means which have alternative uses”. Samuelson in his widely read textbookEconomics(firstpublishedin1948and17thedition,co-authoredwithWilliamNordhusin2001)defines Economics in terms of choice. According to him, “Economics is the study of howsocietiesusescarceresources toproducevaluablecommoditiesanddistribute themamongdifferent people”. Robert Mundell says that whenever alternatives exist, life takes on aneconomicaspect.Wheneverdecisionsaremade,thelawoftheeconomyiscalledintoplay.Inshort,Economicsisthescienceofchoice.

DouglasNorthapprovesofthechoicedefinition,buthecontendsthatthedisciplineneglectstoexplore the contextwithinwhich choiceoccurs. Northopines thatwemust understand thesourcesofhumandecisionmakingandheadvocatesanewinstitutionalEconomics.

Friedman and others would like to restrict the scope of economics to Positive Economics,dealingwith the issuesof the functioningof theeconomicsystemwhileA.K.SenandotherswantthescopeofeconomicstobeextendedtoNormativeandethicalissuesaswell.LucasandotherswanteconomicstobetheoryorientedwhileotherslikeAkerloffwantittobemorepragmatic. It is difficult to give a generally agreed definition of Economics whichaccommodates the divergent opinion among economists and which encapsulates the everwideningfieldsandsub-fieldsofEconomics.

Economicshasbecomeeclectic.Economicsisnowdefinedneitherbyitssubjectmatternorby its method. The Economist, a prestigious weekly, defines Economics as follows:“EconomicsiswhatEconomistsdo–thebestofthem,anyway”.TheNobelEconomists,byandlarge,arethebestamongeconomists.Thisexplainsourwritingofthisbook,Economics,usingthecontributionsofNobelEconomistsandtheirequals.

Nobel prizes have been given annually for Physics, Chemistry, Medicine, Literature andPeace,formorethanonehundredyears.TheNobelEconomicsPrizewasinstitutedin1969by theCentralBankofSweden.Since then, theSwedishAcademyhasbeenawarding theeconomicsprizealongwithotherprizes.ThestatedreasonforinstitutionofEconomicsPrizeistocommemoratethetri-CentennialyearofTheBankofSweden.TherealreasonbehindmightbethattheBankofSwedenhadrealizedthesignificanceofEconomics.

ThewidersignificanceofEconomicsespeciallyofitspracticalapplicationisrecognizedbytheNobelcommitteebyawardingNobelPeacePrizetoNormanE.Borlaugin1970andthe2006NobelPeacePrizetoMuhammadYunusandtotheGrameenBankofBangladesh.Borlaughelped to solve the world food problem and Muhammad Yunus helped the world’s poorthroughGrameenaBankCredittothem.The2009NoblePeacePrizeisawardedtoBarrack

Obama forcreatinganewclimateofpeace in InternationalPolitics. He justlydeserves theprize foranotherreason. Byhisbold fiscalstimuluspolicies,heavertedtheU.S.Economicdisasterandhelpedindirectlytosolvetheworldeconomiccrisisof2008.Byhelpingtosolvethepressingeconomicproblemsoftheworld,theseindividualshavepromotedlastingpeaceintheworld.

KeynesrecognizedthesignificanceofEconomicsmuchearlier.Inhisbook,GeneralTheoryofEmployment,Keynesstatesthus:“TheIdeasofEconomistsandPoliticalPhilosophers,bothwhen they are right andwhen they arewrong, are powerful than is commonly understood.Indeed,theworldisruledbylittleelse.”

Economics, like all Sciences, need facts and theory. Economists collect facts and drawconclusionsfromthem.Ifsomeneededfactsorfiguresarenotavailable,theyareestimatedbystatistical(Econometric)methods.Economictheoryisneededtopreparequestionswhichwewanttoaskofthefacts.Factsarecollectedonthebasisoftheoreticalguidelines.Afterthecollection of facts, they are arranged and analyzed so as to find answers to the questionsraised’.Thus,Economicsuses thedeductivemethodsofLogicandGeometry in formulatingTheoryandinductivemethodsofstatisticalandempirical inferenceinEconomicapplicationswhichincludesEconomicHistory.

Economics isdiscussed in thisbookunderbroadgroups. Theyare:EconomicFramework,Approaches toEconomics,MethodsandToolsofEconomics,andBranchesofEconomics.The topics under each group are listed in the Contents. The topics are explained in onechaptereachusingthecontributionsofNobelEconomists.NamesofNobelEconomistswhohavemadesignificantcontributionstothetopic,figureinthechapterconcerned.

TheNobelEconomistshavemade importantcontributionsnotonly to theareas listed inourclassification,butalsotootherareas,suchasAgriculturalEconomics,Demography,Energy,Ecology and Labor Economics. They have made forays into other disciplines such asSociology, Psychology, Geography, Political Science, Ethics, Law and Philosophy. As thecontributions of Noble Economists are vast, we are constrained to focus on one of theirsignificantcontributionsonly.Itisnotthattheircontributionislessinotherareasbuttheone’susedarerelevanttothetopicsdiscussed.

Many other eminent Economists (other than Nobel Economists) have made notablecontributionstotheareasclassifiedandtootherareas.ThescopeofEconomicsisvastandisexpanding. There is Economics of war and Economics of Peace. There is Economics ofpoverty and there isEconomicsofAffluence.There is aFreakonomics too. StevenDLewittcollaroborated withStephenJ Dubner in writing the books Freakonomics and SuperFreakonomicsThese books deal with everyday issues of modern world such as cheatingcorruptioncrimeprostitutionglobalwarming-allhiddensideofeverthing As rightlynotedbyRobertMundell“Economicsseemstoapplytoeverynookandcrannyofhumanexperience”.

It is said that Economics is not as precise as physics. A high degree precision is acharacteristicfeatureofPhysics.EarnestRutherford,anobleprizewinnerinPhysics,claimedthatScience isPhysics; everything else is not. Sciences differ in their degree of precisionamong them. To deny the label Science to others such as Economics is to falsify truth.ThoughEconomicvariablesaredifficulttomeasure,effortshavebeenmadetomeasurethemwith adequate precision Economists have begun using systematically the experimental

methodintheirinvestigations.In2002NobelPrizeisawardedtothepioneersin‘ExperimentalEconomics’,DanialKahnemanandVernonSmith.WidespreaduseofEconometricmethodsisanotherstepinthedirectionofmakingEconomicsascientificone.

Economics,asdiscussedaboveusesmanymethods,severalapproaches,coversmanyareasandasintegrallinkswithmanydisciplines.Economicsisanuniquesocialscienceandindeedthequeenofsocialsciences.Economicsneednotbeasprecisehasphysics.Prof.A.K.Senrightly says that what Aristotle said of Political science applies equally well to Economics.Aristotlesaidthat“theaccountofthissciencewillbeadequateifitachievessuchclarityasthesubjectmatterallows;forthesameprecisionisnottobeexpectedinallsciences”.

Economicstoohasbecomehighlymathematicalduringthelasthalf-century.Thereisaneedtoexplaintheadvancesmadeineconomictheoriesandmodelstoall–tonon-mathematicalprofessional economists, like this author, to students, lay readers and specially to policymakers–inaneasyandlucidproseandinanengagingstyle.

Onlya fewpolicymakers likeDr.ManmohanSingh,PrimeMinisterof Indiacanunderstandtheesoteric languageof theEconomists. Hebelongs to the twoculturesof topeconomistsand top policymakers. Bridging thewide gap in communication between Economists andpolicymakersisamust.Otherwise,therichcontributionofEconomiststoknowledgebecomeunusedandremaininalimbo.

Chapter–2NATIONALINCOMEANDEMPLOYMENT

(PeterDiamond,DaleMortenstern&ChristopherPissarides)

RichardStonehasdoneextensiveworkonNationalIncomeandAccounts.AlongwithJamesMeade,Stonewrote a book titledNational IncomeandExpenditurewhichappeared first in1944andrevisedmany times lateron. Inplaceofa fiftheditionof theabovebook,RichardStone (with Giovanna Stone) wrote a short book titled National Income and Expenditure.(1960)Intheirbook,theauthorsdefineNationalIncomeas“theincomewhichaccruestotheinhabitants, or normal residents of Country from their participation inWorld production”. Allsuchincomeisincluded,whetheritisreceivedbyindividualsintheformofwages,dividendsinterest, etc., or is retained in private businesses, or accrues to Government bodies as aconsequenceoftheirbusinessactivities.Nootherincomeisincluded,therefore,gifts,grantsand benefits,which are not received for participation in production, are excluded and so isconsumer’sdebt interest.IncomemaycomefromproductiontakingplacewithintheCountryconcernedorfromabroad.TheincomearisingfromtheproductiveactivitythattakesplacewithintheterritorialboundariesofaCountryiscalledDomesticincome.

Hicks, in his book, TheSocial Framework, notes the relationship betweenSocial (National)productandSocial(National)Income.

NetSocialproduct=Wages+Profits=SocialIncomeSocialIncome=Consumption+Saving=Consumption+Investment=NetSocialProduct

SoNationalincomecanbecomputedbyusingproductionmethod(Valueaddedmethod)orbyIncomemethodorbyExpenditureMethod

National IncomeAnalysis:-National IncomeAccounting,classifiedmeaningfullyprovides thebasisforMacro-Economicanalysis.Thedivisionofoutputintofactorpayments(wages,etc.)on theproductionsideprovidesa framework forstudyingaggregatesupply. Thedivisionofincome into Consumption and Investment on the demand side provides the framework forstudying aggregate demand. Keynes is the leading architect of Macro-Economics and hisbook, General Theory of Employment, Interest and Money has revolutionized Macro-Economic thinking. Samuelson had described Keynes as the patron-saint of Macro-Economics.

We shall describe below the classical theory,Keynes theory, contributionsmade toKeynestheory by Samuelson andHicks, and give a pre-view of the ideas ofMonetarists and newclassicaleconomists,whicharediscussedindetailinChapterEleven.

J.B. Say, a French economist said that supply creates its own demand. Savings will getautomaticallyinvested.Therecannotbeanygeneraloverproduction.Classicaleconomistsstarting fromAdamSmith toMarshall and Pigou have subscribed to J.B. Say’s view. Theclassicaleconomistsassumedthatpricesandwagesareflexible.Ifthereisexcesssupplyofgoodsoverdemand,pricesfallresultinginincreaseddemandforgoodsultimatelyleadingtomoreproductionandmoreemployment.Equilibriumwillberestoredinbothproductandlabor

market.Duetotheoperationofthemarketforces,fullemploymentwillprevail.Intheirview,businesscyclesaretemporaryandselfcorrecting.

WeshallnowdescribeKeynestheoryofbusinesscycles,usingtheconceptofmultiplier.ThemultiplierconceptisfirstintroducedbyKhan,acontemporaryofKeynes.Themultiplieristhenumber by which the addition to investment must be multiplied in order to determine theresultingchangeinoutput.Whenaggregateincomeincreases,consumptionofhouseholdsalso will increase but not as much as real income. There must be an amount of currentinvestmentsufficienttoabsorbtheexcessoftotaloutputoverwhattheconsumerschoosetoconsume.Theequilibriumincome(hearafterincomeandoutputareusedinter-changeably)isgivenby theequalityof investmentwith thatofsavings. Themultiplier isdeterminedbythemarginalpropensitytoconsume(m.p.c.)anditiscomputedusingtheformula,1/1-m.p.c.Thedenominator in the formula is themarginalpropensity tosave(m.p.s.). Letuscalculate themultiplier,usingsimpleexamples. Suppose, them.p.c. is0.5. Then them.p.s. isalso0.5.Usingthemultiplierformula,themultiplieris2.Now,letusincreasethem.p.c.(spending)to0.8. The, them.p.s. (saving) decreases to 0.2. Themultiplier increases to 5. Thus, themultiplier increases, when spending increases and when saving decreases. Themultiplierdecreaseswhenm.p.s. (saving) increases. Savings are considered as a leakage from thecircularflowofincome.

InKeynestheory,itistheinvestmentthatgivesrisetoincreasedincomethroughthemultiplierandincome,inturn,determinessavings.Attheequilibriumlevelofoutput,thereceiptsoftheinvestorsareequaltotherequiredreceiptsbythemtoinvestsufficientlytoproduceequilibriumoutput. According toKeynes, investment depends on the rate of interest and themarginalefficiencyofcapital(expectedrateofreturn).Outputfluctuatesduetovolatilityofinvestment.Iftheinvestmentlevelisinsufficient,thelevelofincomefalls.Consequently,savingsfallsuchthat theyequal investmentata low levelof income(output). Theequilibriumlevelofoutputoccurs at full employment (potential output), only by coincidence or design. There is nogeneralrulethattheequilibriumlevelwillbeatfullemploymentlevel.

AtthetimewhenKeyneswrotehisbook,TheGeneralTheory,thegreatdepressionoccurred.Thecompetitivemarketswerecaughtinanunder-employmentequilibrium.

KeynesarguedforenlargementoffunctionsofGovernmenttoinvolveitinthetaskofadjustingtooneanother,thepropensitytoconsumeandtheinducementtoinvest.Whiletheclassicaleconomists want to leave everything to market forces, Keynes wants the Government’sinterventiontosavecapitalism.

Samuelson introduced the concept of accelerator, which says that a change in the rate ofoutput induces a change in demand for investment in the same direction. The process ofmultiplieraccelerator interaction results incontinuousexpansionofoutputuntil theeconomyreaches its full capacity level and then the growth rate of the economy slows down. Theslowergrowthinturn,reducesinvestmentandtheprocessworksinreversedirection.Thus,themultiplier-acceleratorinteractionresultsinbusinesscycles.

In addition to the saving investment balance approach (also knownasKeynesianmultipliermodel)discussedabove, there isasecondwayofshowinghowoutput isdetermined. Themethodiscalledtheconsumption-plus-investment(orC+I)approachoraggregatespending

approach. We can visualize a graph where total spending (C + I measured vertically) isgraphedagainsttotaloutput(measuredhorizontally).

Drawa45degree line though theorigin tohelp to identify theequilibriumoutput. The totalspending (orC+ I)shows the levelofdesiredexpenditurebyconsumers,andbusinesses.TheeconomyisinequilibriumatthepointwheretheC+Icurvecrossesthe45degreeline.Aggregate demand is equal to national income. If the aggregate demand, comprising ofdesired consumption and autonomous investment is less than the equilibrium output,producerswill cut back production. If the aggregate demand (AD) ismore than aggregatesupply (AS), it will lead tomore production as long as unused resources are there. Thus,output adjusts itself to changes in aggregate demand. The total output cannot increasebeyond full employment level. Any increase in AD beyond full-employment level of outputresultininflation.ThisapproachtoKeynestheoryisalsoknownas‘CrossApproach’astheAD curve crosses AS curve at the equilibrium point. The equilibrium indicates a balancebetweenaggregatespendingandactualoutput.Theactualoutputmaybedifferentfromthepotentialoutput.

Synthesis:

HickswellknownarticleonMr.Keynesandclassics(1937)presentsthegistofKeynestheory,compares it with the classical theory and synthesizes Keynes theory. Hicks condensedKeynestheoryintothreeequationsandderivedtheIS-LLcurves.Lateron,HicksIS-LLcurvescametobeknownasIS-LMcurves.Inmanytextbooksoneconomics,interestispresentedontheverticalaxisandincomeonthehorizontalaxis.

The IS curve presents a relation between income and interest. Themarginal efficiency ofcapital schedule determines the value of investment at any given rate of interest and themultipliertellsuswhatlevelofincomewillbenecessarytomakesavingsequaltothevalueofinvestment. The curve IS shows the relation between income and interest that must bemaintained inorder tomakesavingequal to investment. With increased incomesavingwillincreaseandthatimpliesinvestmentshouldincreaseandinvestmentincreasesonlyatlowerinterest rate. As interest rates and income vary in opposite directions, the IS curve slopesdownward.

The LM curve represents equality of money supply to demand for money. As incomeincreases, the transactions demand for money increases. As money supply is fixed, theresidualmoneysupplyforspeculativepurposesdecreases.Tomakemoneysupplyequaltodemand, thedemand for investment (speculativepurpose)shouldalsodecrease. It implieshigher interest rates. Money market equilibrium implies that interest rates and levels ofincomevarytogetherinthesamedirection.AssuchLMcurveslopesupward.

TheIScurverepresentsequilibriuminthegoodsmarketandLMcurveinthemoneymarket.Thepointsof intersectionbetween ISandLMcurvesdetermine theequilibrium interest rateandequilibriumoutput.

ThereisanotherwayofillustratingKeynestheory.TheaggregatedemandADandaggregatesupply(AS)curvesmaybedepictedonagraphmeasuringpriceontheverticalaxisoutputonthe horizontal axis. The AS curve slopes upward and AD curve slopes downward. ThepointerintersectionofASandADcurvesdeterminetheequilibriumpriceandoutput.

One important sourceof business fluctuationsaccording toKeynes, is shocks toaggregatedemand.Theseshocksoccurwhenconsumers,businessesandtheGovernmentchangethetotal spending relative toproductivecapacity. If there isnochange in supplyofgoodsanyadverseshocktoaggregatedemandshiftstheADcurvetotheleft,causingpricesandoutputtodecline.Thustheadverseshocksresultsinarecession.

Differences in the Classical and Keynesian views arise from their assumptions about theAggregateSupplyCurve(AS).TheClassicistsassumedthatthereisalwaysfullemploymentof labor. According to them AS curve is vertical at the full employment level of work andchanges in output take place in the long-run due to growth factors such as technologicalprogress.KeynesassumedhorizontalAggregateSupplycurve(AS),indicatingthatfirmswillsupplywhateveramountofgoodsdemandedattheexistingpricelevel.Theywillbeabletodosobecauseofexistingunemploymentoflabor.IfpricesaremeasuredonverticalaxisandoutputYonhorizontalaxis, thenAScurve ishorizontalat theexistingprice level. Givenaperfectly elastic supply, a fiscal expansion leads to shifting AggregateDemand (AD) to therightcausingoutputtoincreasebutleavetheequilibriumpricelevelunchanged.AccordingtoKeynes, in theshortrun,output isdeterminedbyAggregateDemandalone. IfADisaboveAS,thenoutputexpandsandvice-versa.

Forsimplifyingouranalysis,wehaveusedatwo-sectormodel,consistingofconsumersandbusinesspersonsandtheirexpenditureonconsumptionand investmentrespectively. In thesimplemodel, there isnogovernmentsectorand the restof theworldsector. Actually, thecomponents of aggregate demand (AD) comprises of expenditures of four sectors. Theexpandedversioncanbebrokendownasfollows:

Y=C+I+G+X

WhereCisconsumption,Iisinvestment,GisgovernmentexpenditureandXisnetexports.Treatingeachvariableasanendogenousone,othersconstant,wecancalculatemultipliersfortheendogenousvariable.

For the graphic presentation of the aboveAD–AS curves, I.S. – LMcurves,BP (BalancepaymentscurvediscussedinChapter13)andsuchothers,onemayconsultanyrelevanttextbookreferredintheAppendix.

Samuelson,Galbraith,Hansen andHarris inU.S.A. andHicks, JoanRobinson&Kaldor inU.K., have welcomed Keynes ideas. They are called neo-classical synthesizers or neo-keynesians (some call them early Keynesians.) The early Keynesian theory is calledNewEconomicsandtheKeynesianpoliciestostabilizetheeconomiesheldswayuptothemiddleof1970’s.

Themonetarists and new-classical economists like Lucas, have challenged Keynes ideas.LucasarguedthatKeynesianpoliciesofdemandmanagementare ineffective. The ideasofmonetarists and the new-classical economists are discussed inChapter 11. Based on theLucas model (1977), the Dynamic Stochastic General Equilibrium (D.S.G.E.) models havebeenused inMacroeconomics. TheD.S.G.E.modelsarepredicatedon theassumptionofperfectmarketsandrationalexpectations.

The later dayKeynesians, termed newKeynesians, such asKrugman,Stigltz, andAkerloffhavebeenfocusingonmarketimperfectionsandlessonpriceandwagerigiditiesemphasized

byearlyKeynesians.

Commenting on the crisis facing theworld in 2008-09,Krugmanobserves thatwe are in aliquiditytrapsituationandmonetarypolicycannotbeeffective.Hearguesforfiscalstimuluspolicies. In his book, The Return of Depression Economics, (2010), Krugman opines that‘Keynesismorerelevantthanever’.

AmartyaSenisalsoakeynegian.AmartyaSensaysthatausterityisnotaneffectivewaytoreducepublicdebt.Austerityisessentiallyanti-growth(asKeynesnoted).Weneedeconomicgrowth and not austerity which created joblessness. (www.theStatesmancom.politics theeconomicconsequencesofausterity).

In a commemorative lecture delivered on 20th December, 2008 at the Institute of SocialSciences at Delhi, Stiglitz observed that the world economic crisis of 2008 has beenprecipitatedbyafailureoftheAmericanfinancialsector.Americaneedstodosomethingtosavetheworldfromtheworsteconomiccrisis.Inthatcontext,stiglitz,observesthat“Weareall Keynesians Now”. In his latest book titled Free Fall (2010, Stiglitz commented thateconomicdownturn,thefreefallhasdiscreditedthemanypolicyprescriptionsofmainstreameconomistsandtheirbeliefinperfectmarketsandmarketefficiency.Heemphasizedtheneedfor government intervention. He says that economies need a balance between the role ofmarkets and the role of government. Stiglitz declares that he is in the tradition of JohnMaynardKeynes’.

Wide adoption ofKeynesian policies of fiscal stimulus andmonetary easing policies by thegovernments have put the economies of the industrialized nations on the path of recoveryfromtheRecession.Thoughthegreatrecessionendedtechnicallybytheendof2009,thereisstillhighunemployment.

There is significant empirical evidence that macro-economic fluctuations are dominated byshocks with permanent effects. Since aggregate demand shocks do not have permanenteffects, some argue that aggregate demand fluctuations are less important than aggregatesupply fluctuations. Aggregatesupply fluctuationsarecausedbyshocks to technology. Analternative view is that there are occasional periods of large permanent aggregate supplyshocks, but between theseperiods, aggregate demand shocks, suchas changes inmoneysupply and tax policies predominate. It is observed that temporary shocks move outputaround a stochastic trend, that itself contributes to movements in Gross National Product(G.N.P).

The general Auto-RegressiveMovingAverage (A.R.I.M.A) is found to be useful in studyingbusiness cycles. Econometricians are interested in the effect of shocks and transfermechanisms. Econometrics use lagged valuesof explanatory variablesamongRegressorsandtheireffectonthedependentvariable(sayoutput),distributedovertimeareestimated.ItisobservedthattheTime-seriesmethodsandEconometricmethodscomplementeachotherintheanalysisofbusinesscycles.

Productionrequires inputssuchas labor, landandcapital. Sinceemploymentof laborneedsomeclarificationofconcepts,weshallexaminesomeoftheconceptsofemploymentoflaboranditsempiricalrelationtoproduction.

Wehavediscussedabovethetheoriesofbusinesscycles.Unemploymentusuallymovesintandem with output over a business crisis. Cyclical unemployment is pretty high during aperiodofrecession.Asaggregatedemand(AD)fallsoutputfalls,unemploymentriseseverywhere.

Accordingtothetraditionalbusinesscycleapproach,thetrendlevelofoutputcorrespondstotheoutputproduciblebyworkersat full employment level,whichs termedpotential output.Fluctuationsofoutputaround trend levelare calledbusinesscycles. Thegapbetween theactualoutputandthepotentialoutputistermedoutputgap.

Okuncodifiedanempiricalrelationbetweenunemploymentandoutput,anditisnamedafterhim, Okun’s law states that every 2 percent that the gross domestic product (GDP) fallsrelativetopotentialGDPtheunemploymentraterisesabout1percentagepoint.Okun’slawprovidesthevitallinkbetweentheoutputmarketandthelabormarketintheshortrun.Onepercentmoreofemploymentwillproduce2percentmoreofGDP.

There are other kinds of unemployment, such as frictional unemployment and structuralunemployment. Frictionalunemployment results from increasingmobilityofpeoplebetweenregionsandjobsorthroughdifferentstagesofthelifecycle.Becausefrictionallyunemployedworkers are often moving between jobs, or looking for better jobs, they are treated asvoluntarilyunemployed.

Structural unemployment signifiesamismatchbetween thesupplyanddemand forworkersamongdifferentsectors.Weoftenseestructuralunbalancesacrossoccupationsorregionsascertainsectorsgrowwhileothersdecline.

TheNobelPrizefor2010isawardedjointlytothreelaborEconomists–ProfessorsPeterA.Diamond,DaleT.MortensenandChristopherA.Pissarides. According to them(letus termtheirworkasDMPmodel) labormarketsdonotfunctionsmoothlyasassumedbytraditionaltheory. According to traditional theory, job seekers find available jobs and labors marketensuresmatchingbetweenthetwo.ThethreeNobelLaureateshavecontributedsignificantlytothesearchtheoryandmatchingtheorywhichfacilitatestheanalysisof jobsearchandjobmatching issues. The typical job seeker keeps in touchwith employers whomight offer asuitable jobsandwaitsuntil oneopensup. Theemployerconsidersapplicantsquicklyandmakes a hire. Job seekers remain unemployed until they win suitable jobs. The optimalstrategiesthatworkersshouldfollowinseekingemploymentisknownassearchtheory.Oneof thebasicassumptions insearch theory is thatwagesandworkingconditionsvaryacrossjobs.Ajobseekerwouldnotacceptreadilythefirstjobthatisoffered.Instead,ajobseekercomparesthebenefitofacceptingthefirstjobrightawayagainstthebenefitoftakingabetterjob thatcomesalong laternetofcostofwaitingandtakesadecision in favourof the largerbenefit. Christopher Pissarides deals with the optimal search problems in his book,EquilibriumUnemployment Theory, (Basil Blackwell 1990). PeterDiamond discusses labormarketsissuesinhisbooksonSocialSecurityReform(O.U.P.2002)andPensionReforms.MortensenanalyzeswagesinhisbookWageDispersion(M.I.TPress2004).

Chapter–3ECONOMETRICS

(Frisch,Tinbergen,Klein,Stone,Havelmo,Heckman,Mcfadden,Engle,GrangerandSims)

Samuelson,Koopmans andStone, in a report about the Journal, Econometrica, have said:“Econometricsmay be defined as theQuantitative analysis of actual economic phenomenabased on the concurrent development of theory and observation, related by appropriatemethodsof inference”. Inhiswell-knownText-Book,An Introduction toEconometrics,Kleinobserved,“EconometricsisabranchofEconomicsinwhichmeasurementoftherelationshipsdiscussed in apriory Economic analysis is studied”. Econometric theory mainly deals withestablishing statistical properties of estimators and the development of tests, while appliedeconometricsusesstatisticalmethodstotestandevaluateeconomictheories,andtoforecastfuture values of the variables. When theNobel Prize inEconomicswas first introduced in1969,itwasawardedtothepioneersinEconometrics,RagnarFrischandJanTinbergen.

RagnarFrisch

Frisch first coined the term Econometrics and he had made rich contributions to Multi-ColliniarityproblemsinEconometrics.ThetermMulti-colliniarityisusedbyFrischinhisbookon Statistical Confluence Analysis. The term refers to the existence of perfect or an exactlinearrelationshipamongsomeorall-explanatoryvariablesinaRegressionmodel.TodaythetermMulti-ColliniarityisusedinabroadsensetoincludethecaseofperfectMulti-Colliniarityaswellasthecasewheretheexplanatoryvariablesareinter-correlatedbutnotperfectly.

Itreferstothetendencyofmanyeconomicseriestomovetogetherovertime.EconomictheoryofDemandtellsus that relativepricesand incomeare theexplanatoryvariables inDemandfunction.However,theStatisticianwillnotbeabletoisolatetheirseparatecontributionsiftheymovetogetherinaTime-seriessample.

IfthereisMulti-Colliniarityamongexplanatoryvariables,thestandarderrorsoftheestimatedparameterswillbelarge.FrischdevisedhisConfluenceAnalysistotacklesuchproblems.

Tinbergen

Tinbergen’ssignificantcontributions relate to theanalysisofBusinessCycles.HisStatisticalTesting of Business Cycle Theories is a landmark in that area of Research. Tinbergenformulated the first macro econometric model, Business Cycles in the United States ofAmerica, 1919-32. Another notable contribution of Tinbergen relates to designingDevelopmentPolicy forNational economy.For evaluatingGovernment’s policies, Tinbergenhas suggested instrument target approach. According to Tinbergen, there are four maineconomicvariables,whichapolicymakerhas to take intoaccount.Theyare the targets,orobjectives of economic policy, instruments available to achieve the targets, non-controllablevariablesand irrelevantorneutral variables.Headvocates that theGovernmentshouldusepolicy instruments insuchawayas toachieve thedesired levelsof theTargetvariablesasclosely as possible despite the fact that the time paths of the Target variables are stronglyinfluencedbyfactorswhichare,forthepolicymaker,non-controllable.

Klein

LikeTinbergen,whowroteanexcellent introductorybookonEconometrics,Klein toowroteone elementary but excellent book on Introduction to Econometrics. Besides, Klein wroteearlieranadvancedbooktitled,TextBookofEconometrics.BoththebooksofKleinarewellreceivedandreadbyStudentsofEconometricsallovertheworld.Also,Kleiniswellknownforhis Doctoral Dissertation on Keynesian Revolution. The thesis, with some additions, ispublished.

Klein isaMacro-Econometricmodelbuilder.Aneconometrician first specifies theEconomicmodel.Then,thenexttaskoftheeconometricianistoobtainestimatesoftheparametersofthemodelforthedata.Ifthepredictionsofthemodelareconsistentwithempiricalevidence,heacceptsthetheory;otherwise,hereformulatesthetheoryorproposesnewone.KleinbuiltaModelfortheAmericaneconomy.

RichardStone

Stone’sworkrelatestoStatisticalDemandanalysis.HeestimatedElascitiesofdemandforawide variety of products in U.K.Price Elasticity of demand (own price) is measured bypercentage change in quantity demandeddividedby percentage change in the price of thesame commodity. Cross Elasticity of demand refers to the percentage change in quantitydemanded of a commodity in response to the percent age change in the price of anotherrelated commodity. Percentage change in quantity demanded of the commodity divided bypercentageinIncomeisknownasIncome-Elasticityofdemand.

Havelmo

Havelmo,whoworkedearlierasResearchAssistantwithRagnarFrisch,wontheNobelPrizein1989forhisvaluablecontributionstoProbabilityapproachinEconometrics.AnotherareainwhichHavelmodidvaluableResearchrelatestoasystemofSimultaneousequations.IntheSimultaneous equations approach the particular equation being studied is considered as apart of a relationships describing the simultaneous interactions of the relevant variables.HavelmodevisedastatisticalmethodofreducedformequationstoestimatetheparametersofthesystemofSimultaneousequations.

HeckmanandMcFadden

JamesHeckmanandDanielMcFaddenwereawardedtheNobelprizeinEconomicsin2000.While giving that prize, the Swedish Academy said: “The micro econometric methodsdeveloped by Heckman and McFadden are now part of the standard too-kit, not only ofeconomistsbutalsoofotherSocialScientists”.

SocialScientistsmakegeneralizationsaboutthewholePopulationsonthebasisofSamples.Ifthesamplesareselectedrandomly,thegeneralizationsmadearelikelytobeclosetotruth.However, Heckman argues that often these Samples are not random, people self-selectthemselvesintotheseSamplesandthis leadstobias inresults.For instance, inthecaseofman-=powertrainingprograms,Heckman’sResearchshowsthatoftenthoseemployeeswhoarekeenonimprovingtheirperformancewill jointheTrainingprogram;otherswillnot.Evenwithout training, these who have joined the programme would have performed better than

those who did not. This leads to bias in conclusion. Heckman tackled such selection biasproblems.

McFaddenalsoconductedResearchonmicro-unitsandtheirdecisions.McFaddenworkedonproblemsofdiscretedecisionsanddevelopedStatisticalmethodsfordiscretechoiceanalysis.Thismethodisknownas“conditionalLogitmethod,whichisappliedformakingmanydiscretepolicychoices.Thismethodcanhelptocalculatehowprobable it is thatapersonofcertainage,incomeandeducationwouldchoosetotravelbybus,Sub-wayorcar,takingintoaccountcostsandjourneytime.Hismethodisusedwidely intackling,urbantransportproblemsandTelephoneservices.

EngleandGranger.

Engle and Granger shared the Nobel prize in 2003 for their statistical contributions toeconomicTimeSeries.EnglecontributionsareinareassuchasAuto-RegressiveConditionalHeteroscedasticity (ARCH), co-integration and band-spectrum regression. Granger’scontributionsaremainlytospectralAnalysisofTime-Series.

Granger’s researches are contained in his book, Forecasting Economic Time Series.(AcademicPress,NewYork)

SIMS

Sims developed Vector Auto-Regression (VAR) method. He popularized the Granger-Simscasuality tests to analyse time-series data. The tests are often used to describe the jointbehaviorofavariableXwillGrangercausevariableY, if thesetofcorrelationsbetweenthecurrentinnovationsinYandlaggedinnovationsinXissignificant.(Sims1972AER-62).

Sincesuggestedalternativestyleof identificationofequationsandmodelsto thatofexistinglargescalemodelsof theeconomyprevalentduring1970-80’s. Inapathbreakingarticleonmacroeconomicsandreality(1977),sincediscussedthesimultaneousequationidentificationproblemandissuesinvolvedinconstructingmacroeconomicmodelsofaneconomyforbothdescriptive and forecasting purposes. His article can be downloaded from the internet.(DiscussionpaperNo:77-91,Dec1977UniversityofMinnesota).

Chapter-4ECONOMICHISTORY(FozelandNorth)

Economic history, in thewords ofHicks, is just the applied economics of earlier ages.AnydiscussionofEconomichistoryisincompletewithoutmentioningtheworksofKarlMarxandW.W.Rostow. KarlMarx is a house- holdword inmanyNations and his bookDasKapitalrevolutionizedthethinkingofmenandinfluencedworkingclasseseverywhere.Marxanalysisisanuniquematerialistic interpretationofhistory.Marx’sappliedHegel’sdialecticmethod toeconomics.Thecoreof thedialectic lies in theconceptionof theprocessbywhichchangetakesplace.Theconceptionembracesthecelebratedtriadofthesis,anti-thesisandsynthesis.ThedialecticpatternisbestexemplifiedbyMarxviewofclassstruggleincapitalisticsocietyasthemechanismthroughwhichathesisandanti-thesisinteracttoformasynthesisintheformof communism. What generates the contradiction is the thesis, what represents thecontradiction is theanti-thesisand the synthesis represents thenegationof negationor thereconstructionofaspectsofthethesiswithaspectsoftheanti-thesisintoahighercomposite.

ThegistofMarx’sargumentsare:

Thenatureofindividualsdependsontheirmaterialconditionsofproduction

Themodeofproductioninmateriallifedeterminesthegeneralcharacterofthesocial,politicalandspiritualprocessoflife.

Atacertainstageof theirdevelopment, thematerial forcesofproduction insocietycome inconflictwiththeexistingforcesofproductionviz,withthepropertyrelationswithinwhichtheyhad been at war before. From forms of development of the forces of production, thoserelations turn into fetters. Then comes the period of social revolution. The history of allsocieties has up to now been the history of class struggles. The burgeoise (capitalists)replacedthefeudalnobility.

Capitalist industrial societies would create the conditions for their destruction because ofinherent contradictions. Capitalists in their pursuit ofprofits introducemoreandmore laborsaving machinery; thereby create vast army of unemployed unskilled labor. Increasedcompetition among capitalists leads to concentration of capital and increasing of a labor.Workersreceivesubsistencewages,therateofprofitsdecline.Thereisshortageofdemandfor thesupplyofgoodsproduced.Theconditionsof capitalist societybecome fetters to theproductiveforcesofcapitalism;thereresultsaconflictbetweentheCapitalistsandtheworkingclasses.Thefallofcapitalismandthevictoryoftheproletariatareequallyinevitable.

ThusMarxsuggestedseveralstagesintheevolutionofsocieties:

1.PrimitiveCommunism,2.Theancientslavestate,3.Feudalism,

4.Socialismandfinally5.Communism.

In the early 60’s of lastCentury,W.W.Rostowwrote a book titled theStages of EconomicGrowth(Anon-Communistmanifesto).Heidentifiesallsocieties,intheireconomicdimensions

aslyingwithinoneoffivecategoriesorstagesofGrowth.Theyare:1.thetraditionalsociety2.ThePre-conditionsforTake-Off3.TheTake-Off4.ThedrivetoMaturityand5.TheAgeofhighmassconsumption.

As against the above broad approaches to the study of the evolution of societies, the neweconomichistorysometimescalled‘clio-metrics’useseconometrictechniquestothehistoricalissues.RobertW.FozelandDouglasCNorthmadevaluablecontributionstonew-history.Theywereawarded theNobelPrize in1993 forhaving renewed research ineconomichistorybyapplying economic theory and quantitative methods in order to explain economic andinstitutionalchange.

Fozel’sresearchescenteredroundtwothemes. Thefirstwastomeasurethe impactofkeyscientific and technological innovations, key Governmental policies and importantenvironmentalandinstitutionalchangesonthecourseofeconomicgrowth.Thesecondwasto promote wider use of mathematical models and statistical methods of economics instudyingthecomplex,long-termprocessesthatwerethefocusofeconomichistorians.

Fozel’sapproachtoHistoricalresearchisexemplifiedinhisworks,RailRoadsandAmericanGrowth,theEscapefromHungerandPrematuredeath,1700-2100andothers.

DouglasCNorthisanotherfoundermemberoftheneweconomichistory,calledclio-metrics.He made a comprehensive study of economic growth of U.S. (1790-1860), the gist of theargumentisthatthetimingandpaceofaneconomy’sdevelopmenthasbeendeterminedby:the success of its export sector and the characteristics of the export industry and thedispositionoftheincomereceivedfromexportsector.

Northrealizedthatatheoryofeconomichistoryisneeded.TheexistingNeo-Classicaltheorywas concernedwith the operation ofmarkets andassumed theexistenceof the underlyingcondition needed for the efficient operation of markets. It had nothing to say about howmarkets evolved. The strong points in favour of Neo Classical economics are: its use ofindividualastheunitofanalysisanditsareasofanalysisarecompetitivesituations.Marxismwasexplicitly concernedwith institutions, askedgoodquestions, andhadanexplanationoflong-runchangebutthereweremanyflawsintheMarxianmodel.Makingclassesasaunitofanalysisandfailingtoincorporatepopulationchangeasakeysourceofchange,weremajorshortcomings.

Douglas North’s initial effort to incorporate institutions into historical economic analysisresultedintwobooks(onewithL.Davis)InstitutionalChangeandAmericanEconomicGrowthand other (with Robert Thomas) The Rise ofWesternWorld. In Structure and Change inEconomic History, Douglas North abandoned the notion that institutions were efficient andattemptedtoexplainwhyinefficientruleswouldtendtoexistandbeperpetuated.Hestressedtheneedforapoliticaleconomicframeworktoexplore long-runinstitutionalchangeandthatled to the publication of Institutions, Institutional Change and Economic performance. Heattemptedtoevolveatheoryofinstitutionalchange.

Thefirststepintheevolutionofatheorywastoseparateinstitutionsfromorganizations.Theformer are rules of the game, and the latter are players. In the world of scarcity andcompetition,theorganizationsareincompetitiontosurvive.Thatcompetitionwillleadthemtotrytomodifytheinstitutionalframeworktoimprovetheircompetitiveposition.Thedirectionofchangeof institutions,however,will reflect theperceptionof theactors. North tries toblend

cognitivesciencewith institutionalapproach tohistory inhis recentbook,understanding theprocessofEconomicChange. Whenhumansunderstand their environment as reflected intheir beliefs and construct an institutional framework that enables them to implement theirdesired objectives, then there is consistency between the objectives of those players in apositiontoshapetheirdestinyandthedesiredoutcomes.Northfeelsthatsuchconsistencyisnot automatic and further it is an evolving process over a long period. Because of humanfailurelackofconsistencyoccurs.

TheriseandfalloftheSovietUnionbetween1988to1991isbestexplainedbyitsprocessofchange: its beliefs – institutions – organizations – policies – and finally outcomes. WhileadmittingthatheisnoexpertonSovietUnion,hegiveshighlightsoftheSovietUnion,drawingontheexpertiseofothers.

Gorbachev introduced Perestroika (Reorganization) which gave enterprise directors greaterautonomy.Glasnotoropennesswasintroducedwiththeaimtounderminethepoweroftheparty leaders. Thedeclineanddestructionof thestablepartystructurehas ledtodisorder.GovernmentofficialslostconfidenceinSovietinstitutions.SovietinstitutionswerepulledapartbytheGovernmentofficials.ThecatalystsofStatecollapseweretheagentsofStateitself.Sovietinstitutionsdidnothaveadaptiveefficiency.

Chapter-5EXPERIMENTALECONOMICS(M.Allais,Kahneman,V.Smith)

MauriceAllais

MauriceAllais,aPh.D.inEngineeringandaProf.ofMechanicsatLyonsturnedtoEconomics.MauriceAllais’scontributionstopureTheoryandhisfirstbookInquestofEconomicdisciplineare inFrenchandmanydonotknow thecontents.Allais formally reportsofexperiments ineconomics in his article inEconometrica as early as 1953but the article is also inFrench.What is better known is his work on decision theory, and in particular the so called AllaisParodox

Allais’sParodox

Utility measurement passed through several phases-cardinal utility, Ordinal Utility,Behaviouristic ordinalismand to neo-Classical utility under risk.NuemannandMorgenstern(N-M)havedevisedamethodofmeasuringutilityunderconditionofRisk,AccordingtoN-Mmethod,individualsdonotmaximizeexpectedmoneybutexpectedUtility.BywayofcriticizingN-Mmethod,Allaisraisedaparadoxicaldecisionsituation.

Suppose a person is asked to choose between the following alternatives: Lottery L1 whichoffersRs.2 crores for certainandanother LotteryL2which offers a 10%chanceofwinningRs.10croresand89%chanceofwinningRs.2croresand1%chanceofgettingnothing. Inthiscase,anyonewillchooseL1.Nowconsideranotherchoicesituation.LotteryL3offers11%chanceofwinningRs.2croresand89%chanceofearningnothing.AnotherLotteryL4offers10% chance of earning Rs.10 crores and 90% chance of earning nothing. Let us choosebetweenL3andL4.Manyotherswillchoosesimilarlylikeus.ThepreferenceisforL4overL3.

OurchoicesarenotconsistentwithexceptedUtilitygivenbyprobabilitymultipliedbyutility.Ifthe expected Utility from L1 is greater than L2, then, the expected Utility from L3 must begreater than L4 Denote the Utility values of the outcomes U10, U02 and U0 (the subscriptsindicatetheamountofwinnings).ExpectedutilityofL1ispresentedontheleftsideandL2ontherightsideofEqn.(1).

ThenthechoiceofL1toL2isrepresentedbygreaterthansymbol.

U02>(0.10)U10+(0.89)U02+(0.01)U0Eqn.(1).

Adding(0.89)U0–(0.89)U02tobothsides,weget

(0.11)U02+(0.89)U0>(0.10)U10+(0.90)U0Eqn.(2).

TheexpectedutilityofL3isgivenontheleftsideandthatofL4ontherightsideofEqn.(2).

AsperEqn.(2)L3mustbepreferredtoL4(andnotL4toL3asindicatedbyourchoice)

ThusAllaishasshownthatcertainkindsofriskychoicecouldnotbesquaredwithexpectedutility theory. This and many other anomalies in choice behaviour have been thoroughlyexploredbybothPsychologistsandEconomists.

DanielKahneman

DanielKhaneman,aProfessorofPsychologyatPrincetonUniversity,haveusedinsightsfromPsychology to study human behaviour and to conduct experiments in individual decisionmaking under uncertainty. He argued that in complex decision situations under uncertainty,individuals do not make rational calculations, as assumed by traditional theory. Instead,individuals rely on heuristic short - cuts or rules of thumb. Khaneman (and Tversky) havedeveloped the ‘Prospect theory’ of decision making under un-certainty. In this theory,individualsareassumedtobesensitivetothewayanoutcomedeviatesfromstatusquothanto the absolute level of outcome. And individuals aremore averse to losses relative to thestatusquothantheyarepartialtogainsofthesamesize.

Suppose,youhaveinvestedinastart-upcompany,whichismakingprofits(CompanyP).Youhavea90%chanceofwinningRs.100lakhsanda10%chanceofreceivingnothing.Ifsomeoneofferstobuytheassetfromyou,forRs.85lakhs,mostlikelyyouwouldaccepttheofferbecausethelatteroptionhaslessrisk.Youwouldbeexhibitingriskaversebehaviour.

Nowconsideranothersituationinvolvinghugelosses.Supposeyouhadinvestedinastart-upcompany,which is incurring losses(CompanyL). There isa90%chanceof losingRs.100lakhsbut10%chanceof losingnothing(nil losses).Anotherinvestorofferstotake-overthecompanyifyoupayhimRs.85lakhs(resultinginacertainlossofRs.85lakhs).Youwouldmostlikelyrejecttheofferandchoosetoretainthelossmakingcompany.

Thelossmakingunitcaseisexactlysimilartotheearlierprofitmakingcase.But,intheprofitmakingcase,youexhibitriskaversebehaviourandinthelossmakingcase,youdon’texhibitriskaversebehaviour.Thisiscalled‘aframingeffect’.

ThisProspecttheorycanexplainwhypeopletakeoutexpensivesmallscale insurance,whypeoplebuyexpensiveservicecontractforappliancesthatwouldbecheaptoreplaceandsuchotherindividual(irrational)decisions.

VernonL.Smith

Smith established laboratory experiments as a tool in empirical analysis, especially in thestudy of alternative market mechanisms. Smith (and Knez) tested a ‘strong markethypothesis’,whichstatesthatmarketsequilibrateasifagentswereUtilitymaximiserseveniftheagentsdonotthemselvesbehaveasiftheywereUtilitymaximisers.Theystatethispointofviewasfollows:

“The efficiency and social significance of markets does not depend on the validity of anyparticular theoryof individual demand….Theempirical validity or falsity of efficientmarketstheoryisapropositionthatisentirelydistinctfromtheempiricalvalidityorfalsityoftheoriesofindividualdemandinmarkets”.

Smith(andKnez)conductedexperimentstotestthemarkethypothesisandtheresultsconfirmtheir hypothesis. The behaviour of some individuals might be irrational but the market

behaviour of all is rational and efficient. Smith’s book Bargaining and Market Behaviourcontainshisexperimentalfindings.

Smith’s latest interest is in Neuro-Economics. He uses brain scanning of experimentalsubjectsplayingeconomicgames.TheexponentsofNeuro-Economicsbelievethatbybrainscanningofexperimentalsubjects, theywillbeable topeerdirectly into thebrain topredictbehaviour.

The threeNobel Economists discussed in this chapter are pioneers and key figures in theexperimentaleconomics.Nowadaysexperimentalwork ineconomics isdone inmanyareassuchasinvestigatingtwo-personbargainingproblems;thefreeriderproblemintheprovisionofpublicgoods:andinexaminingauctionmarketsandinprivatizationofpublicmonopolies.

The study of human behavour based on human psychology and experiments falls into thecategory of a newly flourishing field of Behavioral Economics. The new field is againdiscussedintheChapteronMarkets.

Chapter-6THEORYOFGENERALEQUILIBRIUM

(Debreau&W.Leontief)

Debreau

Debreau,wontheNobelPrizeearlierthanhisinspirerAllais.Debreauhasmadeasignificantcontribution to General Equilibrium theory, which is discussed in his short and highlymathematicalbook,TheoryofValue.TheseedsofGeneralEquilibriumtheorycanbetracedtoAdamSmith’sformulationofthelawsofMarkets,where“Theprivateinterestsandpassionsofmenareledbyaninvisiblehandinthedirectionwhichismostagreeabletotheinterestofthewholesociety”.

Smith’sideathateverythingdependsonallotherthingswasnotfollowedinUnitedKingdom.InMarshall’stime,marketswereanalyzedmostlyon-at-a-time–apartialequilibriumanalysis.Theinterconnectionsamongmarketswerenotexplored.

The theory of General Equilibrium is developed thoroughly in 1874 by the Frenchmathematician and economist, LeonWalras andVillfredPareto. They have explained howmillions of individual market decisions can achieve overall equilibrium of the system.Debreau’sresearchinGeneralEquilibriumTheory(DonejointlywithArrow)throwslightonasetofconditionsrequiredunderwhichPerfectMarketcouldexist.TheArrow-Debreauresultsshowthat,givensomepre-conditions,theresultsofmarketmechanismisParetooptimal.

From the works of Arrow – Debreau on General Equilibrium, we learn that a particulareconomic change will have remote repercussions that may be a more significant than theinitialchange.Aftertheirworkthemarketmechanismbecamethepanaceaforall theillsoftheeconomies. In fact, theirassumptionswereveryrestrictive. Ifperfectmarketswerenottheremarketswouldbeinefficient.

Theproofofexistenceofgeneralequilibrium inacompetitivemodelbyArrow–Debreau ishighlymathematical,requiringknowledgeofsettheory.

WassilyLeontief

Wassily Leontief’s work, Input-Output Analysis is a major effort towards empiricalquantificationofGeneralequilibriumtheory.Itstudiesgeneralequilibriumphenomenaintheempirical analysis of production. Input output model seeks to take account of theinterdependent nature of the production plans and activities of many industries whichconstituteaneconomy.Theinterdependencearisesoutofthefactthateachindustryemploystheoutputsofotherindustriesasitsinputsandsuppliesitsoutputstootherindustriesasrawmaterialfortheirproducts.Theresidualoutputisavailableforfinalconsumption.

Input-outputanalysisisausefultoolandservedasbaseforplanninginmanycountries.

Input-Outputanalysisisexplained-belowusinganexample.(Generalreadersmayskiptheillustrationbelow).Suppose,therearetwosectorsAgriculture(A)andmanufacturing(M)and

they use Primary inputs like Labor. Also there is Final Consumption of goods givenexogenously.(C)DetailsofInput-OutputTablearegivenbelow.

Table1,Input-OutputTable

Input Output

Sector A M C X

Agriculture(A) 200 100 150 450

Manufactures(M) 180 120 100 400

Valueadded(Primaryinput) 70 180 - -

GrossIncome 450 400 - 850

IntheaboveTableRowsrepresentoutputflowsofeachSectorandColumnsshowtheinputuseofeachSector.ThegrossNationalIncome(Output)isRs.850crores.

Leontief assumed that all Factor proportions are technologically fixed. Ratio of each inputdivided by output gives theTechnicalCoefficient. for eg. In the first column (and firstRow)200/450givesaTechnicalCo-efficientof0.444,andsoonforothers.

TheTechnologyCo-efficientMatrixispresentedbelow.(MatrixA)

Suppose,aPlannerorPolicymakerwantsthatconsumptionofAgriculturalgoodsshouldbeincreasedtoRs.200andManufacturedgoodstoRs.150.usingtheTechnicalCo-efficientandthechangeconsumptionrequirements,wewritetheequationsandsolveforoutputs.

0.444Xa+0.25Xm+Ca-Xa=0

0.4Xa+0.3Xm+Cm–Xm=0

Wecansolvetheabovesimultaneousequationsbyconventionalmethodsinalgebra.

Solving,wegetXa=618andXm=567

Agricultural sector has to produce output of 618 andManufacturing sector has to produceoutputof567inordertomeetthechangedconsumption.

Those familiar with Matrix methods, they may use the following procedure to solve theequations.

1. DeducttechnologyMatrixfromIdentitymatrix.WegetLeontiefMatrix.

2. CalculatetheInverseforLeontifMatrix

3. WecanfindtheoutputvectorbypostmultiplyingtheInverseofLeontiefMatrixbyconsumptionVector.

Of late, thegeneralequilibriummethod isused inmacro-economicdynamics. Suchmodelsare known asDynamic StochasticGeneral EquilibriumModels (D.S.G.E.models). In theirconstruction advanced mathematical methods are used, such as stochastic difference anddifferentialequations.

Chapter-7LINEARPROGRAMMING

(KoopmanandKantarovich)

Koopman&KantarovicharejointwinnersoftheNobelPrizein1975.Kantarovich,aRussianmathematician, is one of the pioneers in the theory LinearProgramming.His classicworksinclude: Best use of Economic Resouces and Mathematical Methods of Organization andPlanning. Koopman, is an economist and he used the Optimization tools for solving theproblems of production processes or activities. Both Kantarovich and Koopman areresponsible for the extensive literature on Linear Programming, Integrand DynamicProgrammingtechniques.Thesetoolsofoptimizationareveryusefulinprogrammingandplanning; in transportation problems; in product mix problems and resource allocationproblems.

. These Optimization methods are considered as a branch of Mathematics, as a tool ofEconomics,orasapartofOperationsResearch,dependingontheuser.

Asforthesolutiontotheseoptimizationproblems,SimplexmethodisusedforsolvingaLinearprogrammingproblem.Forotherprogrammingproblemsalso,therearemethodsofsolution.AlltheseprogrammingproblemscanbesolvedinfewminutesbytheuseofComputerSoft-ware.

Chapter-8

JohnF.Nash

JohnF.Nashmade significant contribution to theBargaining problems in game theory andintroducedtheconceptofEquilibriumknownafterhim.HeislessknownoutsidethecirclesofMathematiciansandEconomistsbuttowardstheendofthe20thCenturyhebecamepopularandacultfigure.

NashsufferedfromthekillerdiseaseofparanoidSchizophrenia.Throughsheerwillpowerandwith the help of his devoted wife, he recovered well enough from his mental ailment tocontinuehisworkonGame theoryatPrincetonUniversity.He isa living legendofaman’scourageagainstheavyoddsandhisdoggedpersistenceandperseveranceinachievinglife’sgoal.

SylviaNaserwrote in1998anexcellentBiographyofJohnF.Nash titled,ABeautifulMind.TheblurboftheawardwinningBiographysaysthat“itisadramaaboutthemysteryofhumanmind,triumphoverincredibleadversityandhealingpoweroflove.InspiredbyNash’slifestoryGlazierthefamousHollywoodproducerhasproducedafilmtitled‘ABeautifulMind’andthatfilmwontheBestFilmandBestDirectorawardsatthe74annualOscarawardsof2001.NashcametoIndiainJan-2003toparticipateinaseminaronGameTheoryinMumbai

Chapter–8GameTheory

(Nash,Auman,Shelton,Schelling,Hasranyi&Shapely)

Game theory is first formulated by Von Nueman and Morgenstern. Later on John Nash,Richard Shelton and John Hasranyi further developed the game theory and they wereawardedtheNobelPrizejointly1994.TheNobelPrizewasgivenagainin2005toSchellingandAumann for their analysis of “Conflict andCooperation inGameTheory”. Oneway ofrememberingthefiveNobelEconomistsaboveistousethenameNASHasanacronym.Thefirst letter ‘N’stand forNash, ‘A’stands forAuman, ‘S’ forSheltenandSchellingand ‘H’ forHasranyi.

Game theory considers situations, inwhich thereare twoormorePlayers, eachofwhoseactionsinfluencetheoutcomeofcertainevent.Dependingonwhicheventactuallyoccurs,thePlayersreceivevariouspayments(pay-offs).

AfamousexamplecitedinGametheoryisthePrisoner’sdilemmacase.Thestorygoeslikethis.Two individualsareknown tobeguilty togetherofa small theft caseandabigCrime;there isevidence toconvict themforasmall theftbutnot forabigcrime. Theyarekept inseparate cells by the Police. A Public Prosecutor talks to them separately. He tells eachindividualseparatelytheRules.Ifoneprisonerconfessesandtheotherdoesnotthepersonconfessingwillgo freewithoutanypunishment.But theprisonerwhodoesnotconfessgetprisontermfor6years.Iftheybothconfess,theywillbeconvictedfortheCrimebutinviewoftheirgoodbehaviourinconfessing,theprisonerswillgetprisontermfor3yearsonlyinsteadfor6years.Ifneitherconfess,thentherewillbenoevidencetoconvictthemforthecrime.Assuchtheygetshortprisontimeof1yeareachforthetheftcase.

We present below the punishment matrix (which is opposite to pay off). Least punishmentmeanshighpayoff

Prisoner-2

Confess Not-confess

Prisoner–1Confess

Not-Confess

(3,3)

(6,0)

(0,6)

(1,1)

ConsideringPrisoner-1,confessstrategydominatesnot-confessstrategy.Takingthefirstrowandfirstnumberinthecells,3and0intheconfessrowandcomparethemwiththe6and1innot-confessstrategy. 3<6and0<1. Theprison termsare less inbothcases (pay-offsarehigher) in the confess category. As such prisoner-1 prefers to confess. Similarly for thesecondprisoner,takingthesecondnumbersinthecells,columnwise3and0intheconfesscategory and compare them with 6 and 1 in not-confess category. Confess strategy

dominatesthenot-confessstrategy.Soprisoner-2preferstoplayconfessstrategy.Soboththeprisonersconfessandget3yearprisoneach.ThistypeofdominantequilibriumistermedNashequilibrium.

Theprisoners’dilemmaillustratesthatselfinterestprevailsovergroupinterestandmakestheprisonersconfess.Butit theycooperatewitheachotherandbothadoptthestrategyofnot-confessing,theyreducetheprisontermtooneyeareach.

NashEquilibriumisappliedtoCournotDuopolyproblem.Eachfirmchoosesitsbeststrategytotheotherfirm’sbeststrategy.IntheCournotequilibrium,whichisdiscussedinthechapteronMarkets.EachDuopolistproducesanamountthatmaximizeshisprofitsgiventheoutputof its competitor. Neither Duopolist has any incentive to change its output. It is termedCournot-Nashequilibrium.Itisanon-cooperativegame.Gamesinvolvingjointactionandarecontractualaretermedcooperativegames.

HasranyimadesignificantcontributiontogamesofincompleteinformationandSheltonmadecontributions to Extensive Games. Shelling made significant contributions to Strategies ofConflict in game theory andAumannmade valuable contributions to randomized strategiesandCorrelatedequilibrium in game theory. For detailed treatment of game theory, readersmayconsulttheexcellentbooksongametheorymentionedintheAppendix.

InthefirstparaofthisChapter,wementionthattheletter‘S’inNashstandsforSheltonandShelling.Nowtheletter ‘S’standsforShapelytoo.Shapely’scontributionaremostly inco-operative Game Theory. He used a value named after him as Shapely Value to the costallocationproblemindesigningmarkets.WelistedShapelyinthisChapterwhilehisco-sharerofthe2012Nobelprize,AlvinRoathislistedinChapter15onInformationTheory.

Chapter-9

1.Hicks(1904–89)

HickswasknowntomanystudentsofEconomicsinIndia,throughhisworks,especiallyvalueandcapital.Hisworksinclude.ThetheoryofWages,ValueandCapital,RevisionofDemandTheory,TradeCycles,CriticalEssays inMonetaryTheory,Crises inKeyneseanEconomics,Capital And Growth and Wealth and Welfare. He visited India in 1960’s and addressedstudentsattheDelhischoolofEconomicsandaftertheNobelaward,heagaincametoIndiainthe90’sandaddressedIndianstudentsatinteriorplaceslikeKavaliinAndhraPradesh

2.Samuelson(1915–2009)

Every student of Economics, in India knew Samuelson through his classic text bookEconomics. Formore than50yearshisbookhasservedasa standard textbook in classroomsofIndiaandabroad.Hewasanapostleofpuretheory,whichistestifiedbyhisdoctoraldissertationFoundationsofEconomicsandhispapers.HispapersarecollectedandeditedbyJosephStiglitzRobertMertonandNagataniandpublished in several volumes. Samuelsontrained many economists who received the Nobel Prize later on, and inspired many othereminenteconomists.Hislifewaslongandhiscontributionsarelonglasting.

Chapter-9DEMANDTHEORY(Hicks&Samuelson)

J.R.Hicks

The most widely used book of Hicks is Value and Capital. His book uses the GeneralEquilibriumapproachofWalrasandParetoanditcontinuestheirtradition.Here-discoverstheindifference curve technique earlier used by Edgeworth and Pareto. He uses this tool ofIndifference curve to explain the theory of Demand. Dispensing with the Cardinal Utilityconcept,HicksusestheordinalconceptofRankingbasedonIndifferencecurves.

MarshallassumedthataConsumergetssatisfactionfromhisconsumptionofgoodsandhissatisfaction ismeasurable in termsof somany ‘Utils’ of satisfaction.This satisfaction is thefeeling by the consumer and it is introspective. According toMarshall, aConsumer tries tomaximizehisutilityandhespendshismoney insuchawayso thateveryRupeespentoncommodityXandYshouldyieldequalextrasatisfaction,whenconsumed.Thenonlyhisutilitywill bemaximized. Any change from this positionwill result in less satisfaction, the gain inutility inbuying,say,moreof ‘X’willbelessthanthelossofUtility inbuyinglessof ‘Y’.ThisfollowsfromtheprincipleofDiminishingmarginalutilitywhichstateseachsuccessiveunitsofconsumptionyieldsdiminishingextrasatisfaction.Marshall’sargumentleadstotheconclusionthatmarginalutilitiesofcommoditiesmustbeproportional to theirprices.Marshallassumesthat themarginalutilityofmoney is constant.Therefore, themarginalutilityofacommodityanditspriceisaconstantratio.Ifthepricefalls,themarginalutilitymustbereducedtoo.Butbythelawofdiminishingmarginalutility,thisimpliesanincreaseintheamountdemandedandconsumed.AfallinPricethereforeincreasestheamountdemanded.

A fall in the Price of a commodity actually affects the demand for the commodity in twodifferentways.Ontheonehand, itmakestheConsumerbetteroff, it raiseshisreal incomeandthismaybetermedtheIncomeeffect,ontheotherhand,itchangesrelativePrices,andtherefore, apart from changes in real Income, there will be a tendency to substitute thecommoditywhosePricehas fallen forothercommodities.This is thesubstitutioneffect.Thetotal effect on demand is the sumof these two tendencies.Marshall neglected the Incomeeffect while Hicks considered them both in his Theory. The Income effect added to theSubstitutioneffectgivesthePriceeffectonDemand.

For explaining the Theory of Demand, Hicks uses Indifference Curves. Points on anIndifferenceCurverepresentdifferentcombinationsoftwocommoditiesgivingthesamelevelof satisfaction (not the absolute amount). The slopeof an indifference curve represent theratio of marginal utilities of the two commodities and it is the rate of substitution inConsumption.TheslopeofaBudgetlineindicatestheratioofPricesofthetwocommoditiesanditrepresentstherateofsubstitutioninpurchase.ThetangencybetweenthePricelineandtheIndifferencecurveistheexpressionintermsofIndifferencecurves,oftheproportionalitybetweenmarginalUtilitiesandPrices.

Usingthetoolof Indifferencecurves,HicksshowsthePriceeffectonDemand,consistingoftheIncomeeffectandthesubstitutioneffect.

InthecaseofNormalgoods,theIncomeeffectispositive.OnlyinthecaseofInferiorgoods,Income effect is negative. Even if the income effect is negative, it may be small andsubstitutioneffectwillout-weightheIncomeeffect.Thedemandcurveforacommoditymustslopedownwards,morebeingconsumedwhenpricefalls.TheonlyexceptiontotheLawofDemandisthefamousGiffinParadoxwheretheIncomeeffectisnegativeandlarge.

Samuelson

SamuelsonwasagreatgeneraleconomistwhomadesignificantcontributionstomanyareasandfieldsofEconomicssuchasMacro-economictheory,Publicfinance,Trade,FinanceandConsumerbehaviour.

We consider here, Samuelson’s contributions relating to Demand theory. His fundamentalTheorem of Consumption states that the demand for a commodity always changes in thesame directions as that of a change in the income of consumer; positively sloped incomecurvesalwaysimplynegatively inclineddemandcurves.Heavoidsanyreferencetocardinalutility and satisfaction, abandons Hicksian Indifference curves while stating his Law ofdemand.BasedonconsistenceaxiomsofConsumerbehaviour,SamuelsondeducestheLawof Demand, using the Revealed Preference approach. His fundamental Theorem ofConsumptionstatesthat“anygoodthatisknownalwaystoincreaseindemandwhenmoneyincomealonerises,mustdefinitelyshrinkindemandwhenitspricealonerises”.Samuelsonarguedthatobservedconsumerspendingrevealstheconsumers’preferencesofgoods.HistheoryofRevealedPreferencetodemandistermedasBehavioristicOrdinalism.

Chapter-10THEORYOFMARKETS

(Stigler,Simon,OliverWilliamsonandElinorOstrom,JeanTirol)

Inthe1930’s,thedominantPerfectCompetitionmarketstructuredidnotfitthefactofreality.Joan Robinson and Chamberline have developed a new theory of market structure. JoanRobinsonexplainedhertheory inTheEconomicsof imperfectCompetitionandChamberlinediscussed his views in Monopolistic Competition. While Joan Robinson discusses theimperfection in the market structure, Chamberline tries to blend both Monopoly andCompetition and develop a theory of Monopolistic Competition. According to ChamberlineFirms do not start in most cases with Monopoly but they strive to create monopoly bydifferentiatingtheirproducts.

LetusgiveabriefaccountofthemainfeaturesofeachtypeofMarketstructureandexplainhowpricesaredeterminedundereachcategory. InaMonopoly, there isonlyonesellerandtheproductisuniqueandhehasalargedegreeofcontrolinsettingeitherthepriceorquantitysold.TheDuopolistreferstotwosellersandOligopolyreferstomorethantwobutfewsellers,whose products are either differentiated or homogeneous. Monopolistic Competition is amarketwheretherearemanysellers(bothlargeGroupsandSmallGroups)whoseproductsaredifferentiatedbutonlyslightlyandwhohavesomedegreeofcontroloverpriceorquantitysold.TheconventionalmodelofPerfectCompetitionreferstoalargenumberofsellerssellingidenticalproductsandnosinglesellerhasanycontroloverpriceandhisDemandCurve ishorizontal.

UnderPerfectcompetitionthereisafreeentryandeHixitofFirmsandthereisnoscopeforexcess profits by any single Firm in the long run. Since P is given, it’s P = M.R and itmaximizesprofitwhereP=M.R.=L.M.C=A.R=L.A.C. At thegivenprice, the firm’sM.R=A.R.ishorizontal.TheA.R.curveistangenttolong-runA.C.curvefrombelo!?MimiwhatupattheminimalpointofA.CandM.C.curvecutstheA.C.curvefrombelowattheminimalpointofA.C.AsthereisfreeentryandexitofFirms,long-runequilibriumoftheFirmunderPerfectCompetitionisatpointofminimumaveragecost.Inthelong-run,theequilibriumofthefirmisgivenbyP=M.R.=L.M.C.=L.A.C.Therearenoexcessprofits

Amonopolist isasinglesellerandhe is the Industry.Thedemandcurve for hisproduct isdownwardslopingandassuchM.Risalsodownwardsloping.TheMCslopesupwards.Thepoint of intersection of the downward sloping MR and upward sloping MC determines theequilibriumoutput.Thedemanddetermineshisprice.Ascomparedtoperfectcompetition,aMonopolist output is less and price is more. Under Monopolistic, competition, the demandcurvefortheproductofafirmmaybeexpectedtohaveanegativeslope,forcustomerswillhavedifferentdegreesof loyalty to the firmswhoseproductsaredifferentiated. In theshortrun,firmsmayearnexcessprofits.ButinthelongrunFirmswillenterandcompeteawaytheprofits.Firmsearnonlynormalprofits.

CournotmodelofDuopoly

Duopolyreferstoasituationwherethereareonlytwosellersandoligopolytomorethantwosellers(butfew).AugustineCournot,inhisbooktitledMathematicalPrinciplesoftheTheory

ofWealth.,proposedaDuopolymodel,whichisnamedafterhim.Themodelassumes:TwoproducesAandBproduceidenticalproductsandhaveidenticalcosts.Forsimplicity,CostofProductionisassumedtobezeroandthetotaldemandinthemarkettheyshareislinear.BothFirms know exactly what the total demand is. Further both accept the market price andneithersets itandeachDuopolist, inmakinghisownplanofoutputassumesthathisrival’sreactionwillbetomaintainthesamelevelofhisoutputandeachattempttomaximizeprofittheDuopolistsactindependentlyanddonotcollude.

WeshallfollowtheexplanationgivenbyStiglerindiscussingCournot’smodel.

Suppose twoFirmseachownamineral springwhosewater ismuch valuedby customers.Thereareno costsofProduction.Cournot proceeds toanalyse theproblem, subject to theassumptionsmentionedabove.LetthedemandcurvebeP=I00-Q,andretaintheconditionofnoCost.InthecaseofMonopolyhemaximisesthetotalrevenue,PQ(costarezero)

TR=PQ=I00.Q–Q2

MR=I00-2Q(derivativeofTR,wrttoQ)

SettingMR=MC,I00-2Q=O(MC=O),

2Q=I00,Q=50andP=I00–50=50

Ifthereisonlyoneproducer,aMonopolist,hisprofitmaximizingoutputis50andpriceis50.

Usingthesameexample,letusconsiderthecaseofDuopoly.I

OploophiguyoponImin

P=I00-(QA+QB)

StepI.LetAsetanyoutputsay,40whichfetchesapriceof60(P=100–Q)

2).ThenBwilltakeA’soutputasgiven,andseektheoutputthatmaximizeshis(B’s)profits.The market for B will be the remaining part of the demand curve. In the case of a lineardemand curve, the MR curve bisects the horizontal line drawn from the Price axis to thedemandcurve.Supposeatotaldemandcurve(ofbothduopolists)isdrawnandmarktheA’soutputon theXaxisanddrawavertical line tocut thedemandcurve. From thatpointofintersection,ifwedraw,MRcurve(ofB)itwillcuttheremainingpartofthehorizontalaxisintohalf.AsMc=0,itisequaltohorizontalaxis.TheprofitmaximizingoutputforBwillbeexactlyhalfoftheCompetitiveoutput.HencetheoutputofBwillbe½(100-40)=30.ThepriceintheMarketis

100-(40+30)=30

3).ThenAsetshisoutputtomaximizehisprofits,ontheassumptionthatB’soutputwillbe30.ThenAwillproduce½(100-30)=35

4).ItisnowB’sturn.Itwillproduce½(100-35)=32.5

5).ThenAwillproduce33.75;thenBwillproduce33.125andsoon

Thisisaninfiniteseries.ThefinalsolutionwillbeforeachDuopolisttoproduceis331/3units,withamarketpriceof331/3.OutputsuppliedbythetwoDuopolistsis2/3ofthetotalofI00.

TheKinkedOligopolyDemandCurve

Paul Sweezydeveloped theKinkeddemandcurvemodel toexplain theprice rigidityunderOligopoly. Themarket situation contemplatedbySweezy is one inwhich rivalswill quicklymatchPrices reductions,butonlyhesitantlyand incompletely ifatall followprice increases.Thispatternofexpectedbehaviorproducesa‘kink’attheexistingPrice.

There is no incentive for the Firm under Oligopoly to either raise the prevailing Price ordecrease it. That is why Prices underOligopoly remain stable. If themarginal Cost curvepasses over the range of discontinuity of the marginal revenue curve. Output and Pricesremainunchangedattheexistinglevels.

Stigler:

After a thorough analysis of empirical evidence, Stigler concludes that “evidence revealsneitherPriceexperiencesnorthepatternofchangesofPricequotationsthatthetheoryleadsustoexpect”.

OtherModels:

ThereareothermodelsDuopoly&Oligopoly.IntheCollusionmodelthetwoduopolistsactinconcert to maximize their joint profits. In this model maximization proceeds in the samemanner as in multi-plant monopolists. A German Economist Stackel Berg developed aleadership-followership model of duopoly named after him. According to the Stackelbergmodel, a firm which is a follower behaves exactly as the Cournot firm. A leader takesadvantageoftheassumptionsthattheotherfirmisbehavingasafollower.TheMarketsharesmodelofduopolyassumesthatonefirmalwayswishestomaintainafixedshareofthemarketandtheotherfirmiswillingtoletitso.IntheDominantfirmmodelofOligopolythedominantfirm sets theprice for theproduct andother small firmswho cannot haveany influenceonpricewill take thepricesetby thedominant firmasgivenandactasperfectcompetitors indeterminingtheiroutputs.

In a real world situations, we come across other complex situations and pricing practices.Therearemultipleproducts,andJointproducts.Therearepeak-loadpricingofproducts,Fullcost pricing and pricing of bundled goods. There is price discrimination for differentiatedproductsunderimperfectmarketsandtherearedifferentdegreesofpricediscrimination.

ManagerialTheoriesofFirm

Sofar,wehaveanalyzedoptimalpricingandoutputdecisionsofFirmsunderdifferentmarketsstructures, using the assumption of profit maximization as the objective of a firm. As analternative to profit maximization, Baumol suggests that Firms maximize sales revenue,subject to the constraint of earning satisfactory level of profits. O.Williamson in his book,EconomicsofDiscretionaryBehaviourdevelopsamanager’sdiscretionarybehaviourmodel.Hearguesthatamanagerofalargecompany,hasvastcontroloverthemanagementofthecompany vis-à-vis the share holders (owners) of the company, who have little control overmanagement of the company. Williamson suggests that managers attempt to maximizemanagers’utility. Managerialutilityprimarilydependson1) thesalariesandothermonetarybenefits received by the manager, 2) the perquisites enjoyed by the manager, 3) the staff

under the control of the manager, and 4) the extent to which the manager can direct theinvestmentofFirm’sresourses.

HerbertSimon

HerbertSimon,whodidhisDoctorateinPoliticalScience,haswontheNobelEconomicsPrizeforhispioneering research intodecision-makingprocesswithineconomicorganizationsandforhissignificantcontributionstoOrganizationstheory.WhileanalyzingtheFirm’sgoal,SimonofferedanalternativehypothesistothatoftheClassicalassumptionofmaximizationofprofits.Firms, while choosing a particular course of action among several courses available aresatisfiedwitha limitedobjectiveof ‘satisfice’ thanmaximizeprofits. It is adecisionmakingstrategy thataimsatadequate rather thananoptimalone. Thepracticeofa fixedmark-upovercosts indeterminingmarketpricegivesoneexampleofsuchbehaviour. Following theleadofSimon,otherslikeCyertandMarchhaveattemptedtodevelopaBehavioraltheoryofFirm.

TransactionCostEconomicsandTransferPricing

Thoughmanyhavecontributedtothediscussionontransactioncosteconomics,Williamson’scontributions to the subject have been many and important. His book ‘The EconomicInstitutionsofCapitalism’(FreepressNewYork)providesaunifiedtreatmentofthesubjectoftransactioncosts.

Every transaction is placed within the context of a Firm. When undertaking a transaction,parties to the transaction incur several costs like negotiating the contract and drafting thecontractbeforeentering into thecontract. Ex-post costsare incurred inconsummatingandsafeguardingthedealthatwasoriginallystruck.

Transaction costs depend on two types of factors: those pertaining to individuals whoundertake the transaction and factors specific to the particular transaction. Williamsonassumesthathumanbeingsareboundedlyrationalandopportunistic.Theleveloftransactioncostsdependonassetspecificity,frequencyandextentofuncertainty.

Firmsinordertominimizetransactioncost,choosetointegratevertically.Asaresult,wefindfirmsproducingintermediateproductsrequiredinmakingofthefinalproduct.Supposeacarmanufacturerenters intoacontractwithaproducerofrear-viewmirrorswhomakesthemtothespecificationsofthecarmanufacturer.Thecarcompanymightprefertoproduceitsrear-viewmirrorinhouse,forexamplebybuyingthemirrorcompany.Thiswouldreducetimeandresources spent over haggling over profits between parties to the transaction becausedecisionwouldsimplybetakenbyfiat.

Williamson’s theory can be tested against decision by companies to integrate parts of theirsupply chain. Several studies have shown, for instance, that if an electricity generatorproducerbuys itscoal fromanearbycoalmine,who is theonlysupplier, thentheelectricitygenerator company tends to own the coal mine. Pricing of intra-firm transfer productsbetween a parent company and its subsidiary or between divisions of a large company istermedtransferprice.

A Firm corresponds to unified governance. It is a legal entity in whose name varioustransactions are consummated with other firms and with individuals. Firm’s governance

structureneedstomatchtothecharacteristicsofthetransaction.

TransferPricing

Atransferprice is thepriceonesub-unit (segment,department,divisionandsoon)chargesforaproductorservicesuppliedtoanothersub-unitof thesameorganization. Thetransferprice creates revenue for the selling sub-unit and purchase costs for the buying sub-unit,effecting each sub-units income. The product transferred between sub-units of anorganization is called intermediate product. Transfer pricing methods are widely and ablydiscussedinManagerialEconomicsTextbooksandCostAccountingBooksforManagers.

Williamsondiscussedabove,wonthe2009NobelEconomicsprizejointlywithElinorOstrom.WilliamsonborrowsinsightsfromOrganizationalTheoryandBehaviouralEconomicsandusestheminhis theoriesofFirmsandOrganizations. ElinorOstrom,apoliticalscientistdevotedherwholelifeforresearchesinEconomicgovernance,especiallyrelatingtocommonpropertyresources.Standardeconomicmodelspredictthatintheabsenceofclearlydefinedpropertyrights, common property resources such as pastures and fisherieswill be over exp0loited.Overgrazingandoverfishingwillresult.InherbookonGoverningCommons(1990)Ostromargues that people using these common resources formulate rules and regulations ofgovernancewhichworkmuchbetter thanGovernment regulations. Ostromconcludes thattherearewaysofsolvingcollectiveactionproblemswithinthepublicsectoraswellasintheprivate sector. She suggests that we should learn from highly successful policies the bestpolicies to follow as guidelines. Her researches on policy analysis in the future of goodsocieties titled MUSE can be downloaded through the internet(http://muse/hvoedu/gso/summary/ostrom.html)

WilliamsonandOstromhave focusedattentionon transactionswithin firms,householdsandagencies.Theyhaveusedeconomicanalysistoexplaintheseinstitutionalarrangementsandtheirgovernance.

Jean Tirol, a French Economist wins the Nobel Prize in 2014. While awarding the NobleEconomist Prize to Tirol the award committee mentions is research on Market Power andregulation which helped Governments understand and regulate industries dominated by asmallnumberofdominantfirmsareasingleMonopoly.Leftun-regulated,suchmarketsoftenproducedsociallyun-desirable results–priceshigher thancasts,orunproductive firms thatsurvive by blocking entry of new and non productive funds. Tirol analyzed such marketfailures. Hiswork has a strong bearing on howGovernments should dealwithmergers orCastersandhowtheyshouldregulatemonopolies.

InhisbooksDynamicModelsofOligopoly,TheTheoryofIndustrialOrganization,TheTheoryofIncentivesandRegulationandProcurementandinaseriesofarticlesTirolhaspresentedageneralframeworkforregulatorypoliciesforapplicationtonumberofIndustriesrangingfromTeleCommunicationsandBanking.

MiltonFriedman(1912-2006)

FriedmanservedasprofessorofEconomicsattheuniversityof Chicago formore than three decades and he was the leadingfigureofthe“ChicagoSchoolofMonetaryEconomics.”

NexttoKeynes,Friedmanhadmostinfluencedgovernmentpoliciesinmanycountries.FriedmancametoIndiaasanadvisorin1955.

Friedmanchampioned thecauseofFreeMarketsandhepersuasivelyargued to freemen from theshacklesofgovernmentcontrols. He undertook this task as a crusader till his death inNovember,2006.

Chapter-11MONETARYECONOMICS

(Hayek,Friedman,Phelps,Tobin,Lucas,Sargent,Kydland,andPrescott)

Hayek

InthefieldofmonetarytheoryHayekhasmanyworkstohiscredit.Theyare:Thepuretheoryof Capital, Prices and production, Monetary Theory and Trade Cycle and Interest andInvestment.

HistechnicalwritingsinMonetaryEconomicshavenotreceivedmuchrecognitionandpraisefrom his contemporary economists such as Keynes, Hicks andMilton Friedman. However,Hayek’sMonetaryOver-investment theory is discussedwidely and is beingdiscussedevennowinthecontextofBusinessCycles.

Hayek propounded’ additional Credit theory of Trade cycle’. During phases of expansionBankscreateCreditandsuchextensionofcreditlowerstheMarketrateofinterestbelowthe‘Naturalrate’ofinterest.Thismakesproducerstoborrowmoreandinvestmore.Hayektriestoshowhowforcedsaving(creditsexpansion)changesthestructureofproductionbyanartificialincrease in investment. This lengthens the process of production and leads to a dis-proportionality between Consumption and Investment, because the new money spent oninvestment becomes Consumers income and thereby results in increased demand forconsumergoods.The riseof consumergoodspricesand theconsequent fall in realwagesmeans a rise in the rate of profit in the consumer goods industries compared with capitalgoodsproduction.AfallinrealwageswillencouragecapitaliststosubstituteLaborforCapital,thatisshortentheprocessofproduction.TheBoomaccordingtoHayekcollapsesbecauseoftheunwillingnessofBankstocreatecreditanyfurther. InvestmentcanbesustainedonlybyvoluntarysavingsandreducedConsumption.

Hayek,ratherthanKeynesprovidesanexplanationtothe2008Recession,Carmen,Reinhart,KennethRogoffLawrenceWhiteandHymanMinskyhavearguedthat financialcycle ledtoeconomicvolatility.Therewasevidenceof low interest rates leading to financialboomsandmisallocationofresources.Longboomstendedtoresultinexcessiverisktaking.

HayekisatrueLiberal.HeattackedthetrendtowardsStatisminhiswork,RoadtoSerfdom(1944)and theConstitutionof Liberty.(1960)MiltonFriedman regardsHayek “theTwentiethCenturygreatestPhilosopherofLiberty”.

MiltonFriedman

Friedman’s chief contribution is to Monetary Theory. Among his major works in Monetarytheoriesare:

1)StudiesintheQuantityTheoryofMoneyand

2)MonetaryHistoryofUnitedStates(jointlyauthoredwithAnnaSchwarz).

Friedmanhadmany followers suchasModigliani, Tobin andothers. All thesepersonsareknownasmonetarists.Theybelievethatmoneymatters.Modiglianideclaresthat“weareall

monetaristsnow”.

In the 1960’s the controversy betweenMonetarists and the Keynesians is widely debated.Boththesegroupswererepresentedasholdingextremeviews.Monetaristsholdingtheview“thatonlymoneymatters”andtheKeynesiansholdingthat“moneydoesnotmatteratall”Thebone of contention between the Monetarists and Keynesians is in specifying the preciserelationshipbetweenmoneyand income.Keynesianshaveargued thatmoney ismerelyanindicator; itmerelyregistersachange in income.Monetaristscontendthatmoneycanbeorshouldbetargetvariable.

Tomakethepointsinthecontroversyclear,letusbrieflyreviewthequantitytheoryofmoney.IrvingFisher’squantitytheoryisknownasEquationofExchangeanditisgiveninequation(1)

(Eqn.1)MV=P.Y

Fisher assumed that velocity ofmoney (V) is highly stable. According to him,money (M),determinesnominalincome,givenbytheproductofprice(P)andoutput(Y).

InCambridge(England)economists,MarshalandPigoustatedthequantitytheoryasaCash–BalanceEquation,giveninequation(2).

(Eqn.2)M=k.P.Y

Wherekisthecashbalancekeptasaproportionofincome.

Boththeversionsofthequantitytheoriesofmoneydiscussedabovearesimilar,asVelocityofmoney(V)isequalto1/kbydefinition.Rewritingequation(1)wegetequation(3)

(Eqn.3)M=P(Y/V)

WhereVor1/karestableandconstant.

Output (Y) is at a full employment level and is treatedas constant. Hence, an increase inmoneysupplycausesanequi-proportionalincreaseinprices.

While Fisher stressed on the demand for money for transactions purpose, the Cambridgeeconomistsemphasizedonthedemandformoneyasastoreofvalue.Keynes,ontheotherhand, said that money is demanded for transaction purposes, precautionary purposes andspeculativepurposes.Keynesobservedthatthelinkbetweenmoneyandincomeisthroughinterest rates. In a liquidity trap situation, in timesof a recession investorsdonot demandmoneyforinvestmentevenatlowinterestrates.ThisimpliesthattheLMcurveishorizontalandchanges in thequantity ofmoneydonot shift theLMcurve. In suchcases,monetarypolicy will have no effect on either the interest rate or the level of income. This explainsKeynesargumentthatmoneydoesnotmatter.MonetaristsarguethatwhentheLMcurveisvertical,monetarypolicyhasamaximal effect on incomeand fiscal policyhasnoeffect onincome.Thisexplainsthemonetaristsargumentthat‘onlymoneymatters’.Monetaristsusethe frameworkof thequantity theoriesofmoneydiscussedabove. Themonetaristsbelievethattheincomevelocityofmoneyisregular,predictableandalmostaconstant.Hence,theyargue that money supply is the main determinant of output. In course of time, both themonetaristsandKeynesiansgaveup theirextremepositions in thedebateandbegan tobeaccommodativetoother’sopinion.

In his re-formulation of Quantity theory, Friedman provided a framework for the modernPortfolioapproachtothedemandforMoney.Hebeginsbypostulatingthatmoneylikemanyotherassetsyieldsaformofservicetothepersonwhoholdsit.

Friedmanmakesthedemandformoneydependontherealrateofinterestonfinancialassets,therateofreturnonnominalmoney,which is takentobetherateofchangeofPriceLevel,P/P,therealincome,Y,theratioofnon-humantohumanCapital,Wandatastevariable,u.Friedman’sdemandfunctionformoneyis:

(Eqn.3)M/P=f(I,∆P/P,Y,W,u)

The basic difference between Friedman and Keynesians are empirical, not theoretical.Friedman(alongwithAnnaSchwartz)studiestherelationbetweenthestockofMoneyanditschanges and the Business Cycles. Friedman suggested that holders of money can beregardedasadjustingthenominalamountofmoneytheydemandtotheirviewsoftheirlong-termincomestatus(whichisameasureoftheirWealth),of thelong-runlevelofPrices,andthereturnsonalternativeassets.Neglectingthereturnsonalternativeassets,FriedmanandSchwartzusethefollowingequation(4)forempiricalanalysis:

(Eqn.4)LogM(T)=log.a+logP(T)+blogy(T)

whereaandbarenumericalconstants(ormoregenerally,functionsofomittedvariablessuchasreturnstootherassets).MismoneysupplyandTistime.

Theyhaveestimatedthemoney–multiplierortheratioofpercentagechangeinincometotheassociatedpercentagechangeinthestockofmoney.FormajorBusinessCyclesstudied,theMoney–multiplierestimateis1.84.

Monetarists believe that, changes in the quantity of money are the dominant influence onchanges in nominal income and, for the short-run changes in the real income as well.Accordingtothemmoneycausesbusinesscycles.Theyarguethatstabilityinthebehaviourofmoney stock would go a longway towards producing stability in income growth. Friedmanwantsaconstantgrowthrateinmoneystock.Monetaristsbelievethatthedemandformoneyisastablefunctionofpermanentlevelofincome;hencevelocityofmoneyisalsostable.Asacorollary to constant Velocity any excessive increase inmoney supply leads to increase inpricelevelandthereforeinflation.

Monetarists believe that Fiscal policy on the other hand has a limited effect onGNP of aneconomybecauseof thecrowding–outhypothesis.The increases inGovernmentspendingincreasesaggregatedemand initially.As incomebegins torise, the transactionsdemandformoney also increases. With the money stock fixed, increased demand for it results in anupwardpressureon interest rates.Thiscausesprivate investment todecreasesubstantially.ThusaccordingtoMonetarists, increasedGovernmentspendingleadstodecreaseinprivatespending,whichistermedascrowding-out.Furthermonetaristsbelieveinlessergovernmentthanmore.

Friedmanwasa truechampionofCapitalism. InhisCapitalismandFreedom,hewrites thatthegreatachievementofCapitalism isnot theaccumulationofpropertyandwealthbut theopportunities it offered toman andwoman to extend develop and improve their capacities.Friedmanwasatruelibertarian.

Inanarticlespublishedin1958,A.W.PhilipsindicatedonthebasisofU.K.datathattherewasastrongnegative relationshipbetween the rateofchangeofmoneywagesand the levelofunemployment.Soonafter,itwasalsoarguedtherewasalsoasignificantandstablenegativerelationshipbetween therateofchangeofprices(inflation)and the levelofunemployment.Graph depicting inverse relationship between the above two variables is known as Philipscurve.

FriedmanandEdmundPhelpsagreewithPhilip’snotionof trade-offbetweenunemploymentandinflationintheshort-run.Theyassumethatpricesandwagesareflexible.Inthelongrunthey argue that un-employment rate will gradually return to the natural rate, and anyexpansionarypolicywillonlyresultinhigherinflationrate.

In the short run, unemployment could be cut by offering highermoney wages to workers.Highermoneywagestranslatesintohigherprices.ButasEdmundPhelpssaysthat“Manisathinkingexpectantbeing”.Soon,workersbargainformoneywageincreasestooffsetthefallinrealwagesexperienced.Theresultingincreaserestoresrealwagesbutthreatenstocauseareturnofunemployment,asemployersshedlabor.Theeconomywillrecoveritsequilibriumonlywhenworkersexpectationsarefulfilledandpricesturnoutasanticipated.Phelpsarguedthat inflationwill not settle until unemployment reaches to its ‘natural rate’ (full employmentrate).With‘real-wagebargaining’,thelong-runPhillipscurveisverticalbecausethereisonlyoneunemploymentrate(thenaturalrate)atwhichactualandexpectedinflationmatch.Theonlyeffect of increaseddemand in the long-runwouldbe to increase inflation for the samelevelofunemployment.

Themonetaristsarguethattheinfluenceofthemoneystockisprimarilyonthepricelevelandothernominalvariables.Realvariablessuchasoutputandemploymenthavetimetoadjusttotheirnaturallevelsinthelong-run.Thenaturalratesofoutputandemploymentdependonrealvariablessuchasfactorsuppliesandtechnology.ThisisthereasonforSupplysideeconomicsadvocated by Laffer and practiced by Regan and Margaret Thatcher in U.S.A and U.K in1970’s and 1980’s respectively. In essence supply side economics is concerned withincreasing aggregate supply of goods. They argue for policies such as tax-cuts, removingunnecessary regulations, maintaining efficient legal system and encouraging technologicalprogress. Supply sidepolicies combinedwith soundmonetary policies, have succeeded in1970’sinsolvingtheproblemofstagnationinproductioncoupledwithinflation–stagflation.

TobinModel

Tobin agreed with Friedman in the statement that money matters but he disagreed withFriedman’sopinionthatmoneyalonematters.

Therationaleforthedemandformoneyasanasset,Tobinpointed,liesinitsroleinreducingtheriskinessofgeneralportfolioofassets.InasimplifiedversionofTobin’smodel,therearetwoassets,MoneywhichisrisklessbutithasZeroreturn,andariskyasset,perpetualBonds,whichhasapositiveexpected rateof return.Byholdingmoney inhisPortfolio thewealth–holdercan reducehisPortfolio risk,butat theexpenseofsacrificingsomeexpected return.Tobinfollowedthegeneralequilibriumapproachindevelopinghisportfoliochoicetheory.Thistheorysuggestedthatassetsshouldberegardedasimperfectsubstitutesforeachother,withtheir differences in expected yields reflectingmarginal risks. Tobins portfolio approach has

providedacornerstone forspecificationof financialsector. Thewhole IS–LM–ClassicalapproachcametobeknownasPortfoliobalanceMacroeconomicapproach.

NewClassicalApproach:

Somemacroeconomiststookexpectationsasstaticorfixed.Otherssawthatexpectationsasadaptingtopastchanges.MuthintroducedtheconceptofRationalexpectationsin1961andtheconceptisgeneralizedanddevelopedbyLucas.BasedonRationalexpectationsandonimperfect information assump0tion, Lucas developed his supply curve. The implications ofLucassupplycurveisfirstspeltoutbyThomasSargentandNeilWallace.TheapproachofLucasandothersiscalledNewClassicalapproach.

The‘Rationalexpectationsmodel’ofLucasassumesthatagentsmakebestuseofwhateverinformationisavailabletothemandthatexpectationsareformedinamannerconsistentwiththewaytheeconomyactuallyoperates.Expectationsaremadesubjecttoforecasterrorwhichonaverageiszero.

The Rational expectations model has the very strong prediction that anticipated monetarypolicy should have no effect on output, only un-anticipated changes in the money stockincreaseoutput.Forinstance,ifpeoplecorrectlyanticipate,inflation,theyaskforhigherwagesassoonasthepolicyisenacted(orevenbefore).Theirdemandsforhigherwagesleadstoashift in Labor supply reducing employment and output. Thus, government’s policy becomesineffective.

Economyreactstoanticipatedandun-anticipatedchangesinthemoneysupplydifferently.Inresponse to an anticipate change money supply, agents will expect an equi-proportionatechange in theprice level.Both theactualprice level ‘p’and theexpectedprice levelPewillchange inproportion to thechange inmoneysupply, the realmoneysupplywill remainun-changed, and output is restored to its initial natural level. In contrast, the un-anticipatedchangesinmoneysupplywillhaveitsfullaggregatedemandandaggregatesupply(AD-AS)effects–preciselybecauseanun-anticipatedchangewillnotaffectexpectedpricePe. Itwillhowever raise the actual price level, thereby stimulates output expansion. Since onlyunanticipatedpolicychangeshaverealeffects,DemandManagementpoliciesareuseless.

At firstsight, the implicationofLucasmodelseems tobealmost thesameas theClassicalmodel.Bothmodelspredictpolicy irrelevance–thatneithermonetarypolicynorfiscalpolicycanaffecttheequilibriumlevelofincomeinthelong-run.TheLucasmodelismoreinterestingthan the classical model, though, because it allows at least transitory deviations from full-employment.However these temporary deviations are the result of expectations errors andtheylastonlyaslongastheerrorslastandthatcannotbeverylong.

RobertLucasJr.andThomasSargentarguethatexistingKeynesianmacroeconomicmodelscannotprovidereliableguidanceintheformulationofmonetary,Fiscalorothertypesofpolicy.WhileKeynesarguedthatmostunemploymentisinvoluntary,Lucasviewsunemploymentasmostlyvoluntary.InLucasopinion,laborsupplydecisionisachoicethateachworkermakesbetween labor and leisure. If expected real wages are lower than normal, they takemoreleisureandwaituntilrealwagesrisebeforeworking.Suppose,theCentralBankdecreasesmoneysupply,resultingindecreasesinwagesandprices.Thedecreaseinmoneywagesisexperienced by workers but the decrease in the general price level is not known to theworkers. Workersthinkthat theirrealwageshavegonedownbelowtheirexpectedwages.

They supply less labor and turn down job offers with low wages. Thus, unemployment isexplainedasavoluntarychoicemadebyworkerswhoarewaitingforrealwagestorisetoitsnormal level. As workers are rational, their mistake would be corrected in due course.Unemployment is looked at as a temporary disequilibrium that will remedy itself. Just likeFriedman, who was Lucas teacher, Lucas also assume market clearing. Lucas approachcametobeknownascompetitivebusinesscycleapproach.

Surgentandhisco-authorNeilwallacehaveputforwardthepolicyineffectivenesspropositionaccording to which the Government could not successfully intervene in the economy ofattempting to manipulate output. They argued that agents would foresee the effects ofmonetary expansion, leaving the economy exactly what it was in real terms. What theGovernment needs a stochastic shock-that is unanticipated change in policy to influenceoutput.LucasandEdwardPrescotaregoodfriendsanddidcollaborativeresearchondynamicEconomicsandtheirjointworkistitledRecursiveMethodsInDynamicEconomics.

Kydland&Prescot:

In the context of Rational expectations Kydland and Prescot have discussed the Time-inconsistentprobleminMonetarypolicy.

CountriessuchasU.S.A.,whichfollowamodestactivistdiscretionarypolicyseemtohaveabiastowardstoomuchInflation.TheFederalReserveBanks(TheCentralBankofUSA)hadfollowed during 1970’s a policy of accepting rising inflation for a short-term decrease inunemployment. Thepreference forshort-termgainswillbe inconsistentwith theeconomy’slong run interests. FinnKydlandandE.Prescot, havedrawnour attention to this dynamicinconsistency problem. We know there is a short-run tradeoff between inflation andunemployment given by the short-run Phillips curve. But in the long-run, there is no suchtradeoffbetween the twobecauseof inflationaryexpectations. While thepolicymakermaychoosethebest long-runpositionfor theeconomyof fullemploymentwithzero inflation, thedecisionmakerseeksintheshort-runtolowerunemploymentandslightlyhigherinflation.Itisthis split between announced and executed plans that gives rise to dynamic inconsistencyproblem.

In general an economic policy is said to be time inconsistentwhena future policy decisionforms part of an optimal plan formulated at some initial date is no longer optimal whenconsideredatsomelaterdate.

Theinconsistencyofoptimalplanshaveledthemtoargue(in1977)thatCentralBankshouldobeytransparentrulesratherthanhavediscretion.Theyargueforpre-commitmentovershortsightedpolicymaking.AttheCarnegieRochesterConferenceonpublicpolicyin1993,JohnTaylorhasobservedthatwecandesignrulesthathavecountercyclicalfeatureswithoutatthesametime,leavinganydiscretionabouttheiractionstopolicymakers.Taylorproposedonesuchrule,whichisdiscussedinhisMacro-economicstextbookreferredintheAppendix.

Chapter-12

AmartyaK.Sen:

Born, 3rd Nov. 1933 at Santi Niketan, India. He is a non-resident Indian, residing in USA.A.K.Sen is a many sided genius, a poly-math, who distinguished himself in the fields ofEconomics,PhilosophyandEthics.HisprincipalcontributionistocollectivechoiceandSocialwelfare,whichisdiscussedinthischapterandhisothercontributionsarenolesssignificant.They relate to Famines, Poverty, Inequalities, Entitlements and Capabilities, which arediscussedinChapter16.

Prof.Sen isapersonofmany Identities. He isaneminentscholar,best teacher,a leadingthinker,anargumentativeIndian,agentlemanandahumanitarian.

HeisawardedtheNobelprize inEconomics in1998.Hereceivedthetitleof ‘BharatRatna’thehighestcivilianhonourfromGovernmentofIndia.

AFestschriftvolume,Choice,WelfareandDevelopment,isbroughtoutinhonourofA.K.SenbyhisformerstudentsandCollegues(ed.K.Basuet.al,O.U.P.) ItcontainsmoredetailsaboutA.K.Sen’sbiographicaldetailsandBibliographicaldetails

May God bless Prof. Sen, in the remaining part of his autumnal life, with sound health,fulfillmentandpeace.

Chapter-12PUBLICFINANCE&WELFAREECONOMICS(JamesBuchanan,Coase,ArrowandSen)

JamesBuchanan

Buchanan’s works relate primarily to the area of Public Finance., specially to an area ofcollective decision making. According to Buchanan, Public finance as a field of study, isessentiallyastudyofpoliticaleconomy.Economicandpoliticalanalysismustjoininstudyingtheeffectsofpoliticalorcollectivedecisionsontheeconomy.

Buchanan has written an excellent introductory text book, The Public Finances. In it he discusses new topics not found in any conventional text book, such as political basis ofdecisions, simple and complex models of majority voting and fiscal Constitution. His mostsignificantpublicationsintheareaofPublicFinanceinclude:

The demand and supply of PublicGoods, Fiscal Theory and Political Economy and PublicFinanceinDemocraticProcess.

Buchananhasnofaithongovernment’sactionswhichonlysetslimitsonindividualactions.SohewantsConstitutionalconstraintsonGovernment’sactions.

Buchanan’smethodologyisindividualism.Individualsarefinaldecisionmakersandtheyneedmaximumfreedomofchoice.Asindividualsdifferintastes,capacitiesandtheirenvironmentalsettingtheirexpectationsofeventsandtheirknowledgeof informationisnotuniform.Hencetheirdecisionsaresubjectiveinnature.

Buchanan believes that individuals, through exchange can achieve improvements in theirposition. Exchange can only be effective, Buchanan argues, if individuals acknowledge themutualexistenceofothersandadmittheirpropertyrights.MutualagreementisfundamentalinBuchanan’sanalysisofcollectiveaction.HisconceptofStateispurelyindividualist.Collectiveaction is takenwhenindividualschoosetouseGovernment toachievesomepurpose jointlyratherthenactingindividually.

Buchanan is mainly concerned with how property rights arise (between individual sandbetweenindividualsandtheState)andhowtheyaremodified.Withintherealmofcollectiveaction, he focuses on individuals responses to different collective institutions. His subjectmaterispositivePublicchoice,amongindividuals,holdingpropertyrightsandapropensitytotrade;whoenterintovoluntarycontractstotheirmutualbenefit.

How laws arise to uphold contracts between individuals and how they are modified andenforcedareexaminedbyBuchananinhismajorworks.TheLimitsofLiberty,andFreedominconstitutionalcontract.Followingthecalculusofconsentindividualsformulateasetofrules,aconstitution.FromtheformationofasocialContracttwodistincttypesofGovernmentemerge.Self-interest leadsan individual todefaultoncontractualagreementswhenhebelieves thatthis can be achieved unilaterally. Consequently, at the Constitutional stage, an agency iscreated to perform the function of enforcing contractual agreements. Buchanan terms thisagency the protective State. At the post-Constitutional stage, individuals may choose to

provide a good collectively rather than through private or voluntary organizations. So aproductivestateisdevisedtoprovidepublicgoods.

So long as the Governmental action is restricted to largely if not entirely, to protectingindividualrights,personsandpropertyandenforcingvoluntarilynegotiatedprivatecontracts,theMarketprocessdominateseconomicbehaviour,andensuresthatanyeconomicrentsthatappear will be dissipated by forces of competitive entry. If however, Governmental actionmoves significantly beyond the limits defined by the minimal or protective state, if theGovernmentinterferesonalargescaleinthemarketadjustmentprocess,thesolutionliesinconstitutionrevolution.

Coase:

Coase too believes in the Market mechanism to resolve any divergence between PrivatecostsandSocialcosts.Thestandardexampleforexternaleconomiesisthatofafactory,thesmoke from which has harmful effect on those of neighbouring properties. There will bedivergencebetweenprivatecostsandSocialcosts.Insuchcases,thesuggestionoftenmadebymanyisthatitwouldbedesirable,tomaketheownerofthefactoryliableforthedamagecaused,oralternatively,toplaceataxonthefactoryownerortoexcludethefactoryfromtheResidential areas. It is Coase’s contention that the suggested courses of action areinappropriate in that they lead to results, which are not necessarily or even usuallydesirable.Coasearguesthatregardlessofthespecificinitialassignmentofpropertyrights,thefinaloutcomewillbeefficientprovidedthattheinitiallegalassignmentiswelldefinedandthatthepartiescanreachandenforceanagreementatzerocost.Solongasthelegalrightsaremarketable and well defined, the ‘Invisible-hand’ of market forces leads the parties to anefficient outcome. A Pareto optimal allocation can come about regardless of how propertyrightsareinitiallyassignedprovidedthenegotiationsrequiredarefeasible.

WelfareEconomicsoriginatedwiththeethical hedonismofBentham,Sidgewick,EdgeworthandMarshall.ThetraditionalWelfareeconomicsisbasedonUtilitarianism.Thistraditionwascriticized by Gunnar Myrdal and Lionel Robbins as involving inter-personal comparison ofUtility.ThishasledtothemodificationofUtilitariantradition.InfactanimportantpartofthesocallednowWelfare-Economicshadexplicit use for only one criterionof social improvementViz; theParete criterion. TheParete criterion of social state ‘X’ is to be judged better thensocialstate‘Y’,ifatleastonepersonhasmoreutilityin‘X’then‘Y’andeveryonehasatleastasmuchUtility in ’X’as in ‘Y’.Kaldor,HicksandSchitovskyhavesuggestedCompensationcriteriaofSocialchoice.TheKaldorcriterionstatesthatachangeisanimprovementifthosewhogainevaluatetheirgainsatahigherfigurethanthevaluewhichtheloserssetupontheirlosses.AccordingtoHicks,state‘A’issociallypreferableto‘B’,ifthosewhowouldlosefrom‘A’cannotprofitablybribethegainers intonotmakingthechangefrom‘B’ to ‘A’.Schitovskysuggestedacriterionrequiringadoubletest.State’A’issociallypreferableto‘B’ifthegainerscanbribethelosersintoacceptingthechangeandsimultaneouslytheloserscannotbribethegainers into not making the change. In this criterion, if the change from one situation toanotherpassesbothpartsofthedoubletest,thenonlythemoveisanimprovement.Bergsonsuggestsadifferentapproach.Hesuggests formulationofasetofexplicitvalue judgments.His suggestion amounts to the construction of an indifference map, ranking differentcombinationsofUtilitywhichmayaccruetomemberofasociety.Suchanindifferencemapis

called a Social Welfare function. The modern theory of Welfare – Economics, founded byBergsonhasbeenfurtherdevelopedbySamuelsonandJdeV.Graff.

Arrow

KennethArrowwon theNobelPrize for his contributions toWelfareEconomics specially toSocialchoicetheory,acollectivechoicemadebyentiresociety.Arrow’spath-breakingarticle“socialChoice and Individual Values” iswell – known as ‘Impossibility Theorem’. Arrow didawaywithrealvaluedwelfarefunctionandhesaidthatrankingisenough.Arrowformulatedhis ‘Social–ChoiceProblem’using individualpreferencesandcall itas ‘GeneralPossibilityTheorem’.ArrowconsideredasetofconditionsrelatingSocialchoicesorsocialjudgmentstothesetof individualpreferencesandshowed that it is impossible tosatisfy thoseconditionssimultaneously.ThatiswhyArrow’stheoremcametobeknownas‘ImpossibilityTheorem’.

Arrow defines a Social Welfare function as a functionalrelation which specifies one Socialordering R, for any set of individual preference orderings. Arrow proposed the followingconditions which social choicesmust meet in order to reflect individual’s preferences. 1)UnrestricteddomainoftheSocialWelfarefunction.Thedomainshouldincludeeverypossiblecombinationofindividualorderings.ThenumberofdistinctSocialorderingsshouldbeatleastthree.2)FulfillmentofweakParetoprinciple.Ifeveryoneprefersanyxtoanyy,thenthatxis socially preferred to that y. 3) Social choicemust be transitive in the sense that if X ispreferredtoYandYispreferredtoZ,thenXwillbepreferredtoZ.4)Anotherconditionis thatofnon-dictatorship,which requires that thesocialorderingshallnotcoincidewith theorderingofanyparticularindividualregardlessoftheorderingofothers.

Arrow’s‘Impossibilitytheorem’statesthattheredoesnotexistanysocialwelfarefunctionthatsimultaneously fulfills the above conditions. The standard procedure for reaching groupdecisions is by voting and the criterion of choice is majority rule. Let us suppose threepersons:Anu,Dhanesh&Santosh vote for three candidates,X,Y&Z. Their preferencesindicatedbyRankingamongthecandidatesare

ThereisatwotoonemajorityinfavorofXoverYandYoverZ.AnuandSantoshpreferredXoverY.AnuandDhaneshpreferredYoverZ.BytransitivityruleXshouldbepreferredtoZ.ButDhaneshandSantoshpreferredZ overX and it is intransitive. Thus it is impossible tomakeSocialChoicesonthebasisofindividualorderofpreferencesalone.

A.K.Sen:

Now, coming back to general discussion of Arrow’s problem, exclusive reliance on UtilityinformationandtheParetocriterionmaketheinformationbasenarrow.Non-Utilityinformationondistributional inequality,orpositiverightandfreedoms,for instancecanenrichamodifiedArrowframework.A.K.Sensuggestedtheuseofnon-utilityinformation..

With the distancing of Ethics from Economics, Welfare – Economics role became veryrestricted. The traditionalWelfare Economics has Pareto optimality as the only criterion ofjudgment,andself–seekingbehaviourastheonlycriterion.Assuch,SenfeelsthatthescopeforsayingsomethinginterestingandusefulinWelfareEconomicsbecameexceedinglysmall.

According to Sen, personsmay have reasons for pursuing goals other than personal well-beingor individualself-interest.This is theagencyaspectof theperson.Further,well-beingneednotalwaysbejudgedbyUtility,Itcanbebasedonsomeobjectivecircumstancessuchas a person’s functioning achievements. Finally a person’s freedom can be seen as beingvaluableinadditiontohisorherachievements.Alltheseethicalissuesmustbeborneinmindwhiletakingindividualandpublicdecisions.SenarguesforclosercontactbetweenEthicsandEconomics.

In his book, The Idea of Justice, Prof. Sen reiterated the need for social norms. Besidesmutualbenefit,socialnormsareespeciallyrelevantforcooperationamongsmallhomogenousgroups.

Prof.Ostrom,anotherNobelLaureate,observedmanycasesofcollectivecooperation. Shedescribesinherbook,GoverningtheCommons,theadvantagesofcooperativebehaviourandthe vindication of that behaviour through voluntary restraint of members of a group. Prof.Ostrom’sfieldobservationscorroboratesProf.Sen’shypothesisofSocialnorms.

Chapter-13INTERNATIONALECONOMICS

(Ohlin,Meade,R.MundellandKrugman)

Inter National Trade is one of the oldest branches of Economics. Leaving aside the exactdatingof itsorigin, letusstartwith theTheoryofComparativeCost in theearly19-century.ThegistofthetheoryisthatwheretwoCountriesspecializeinproducinggoodsinwhichtheyhaveaComparativeadvantage,bothCountriesgainfromtrade.

According to Ricardo, Labor Cost determines domestic value of any commodity. InInternationalTradehowever,thelaborcostprincipledoesnotgovernvalueinexchange.ItisdeterminedbyComparativeadvantagearisingoutofdifferencesinlaborproductivity.RicardoassumesthefollowingfiguresforlaborcostsofproductionforwineandclothinPortugalandEngland.

CostsofproducingbothcommoditiesarelowerinPortugal.Inspiteofthat,itwillpayPortugalto specialize in the production of wine and exchange it for Clothmade in England. For bydoingso,PortugalwouldprocureCloth foranoutlayof80daysofLabor (man-years)whatwouldcosther90days toproduce. Bothwouldgain from theexchange.This theory lendssupporttofreetradeargument.

If labor were the only factor of production as the Ricardian model assumes, comparativeadvantagecouldariseonlybecauseofinternationaldifferenceinlaborproductivity.Intherealworld,however,whiletradeispartlyexplainedbydifferenceinlaborproductivity,italsoreflectsdifferenceincountriesresources.HeckscherandhisstudentsOhlinhavedevelopedatheorywhich states that international trade takes place largely due to difference in countriesresources.ThistheoryisoftenreferredtoasHeckscher–Ohlintheory(H-Otheory).ThisH-Omodelsays,inOhlin’swords.

“Commoditiesrequiringfortheirproductionmuchofabundantfactorsofproductionandlittleofscarce factors are exported in exchange for goods that call for factors in the oppositeproportions.”

Further,H-OtheoryimpliestheFactorpriceEqualizationTheorem,whichstatesthatexportsresultinthedecreaseofsomefactorsofproductionandimportsincreasecertainotherfactors. The newly created export industry will raise the relative prices of the domesticallyabundant cheap factor required in its production; imports will reduce the returns to thedomesticallyrelativelyscarceandexpensivefactorpreviouslyutilizedinitshomeproduction.Undercertain restrictiveassumptions, this results in the internationalequalizationof factorprices.

Ricardo’sexampleofTradebetweenPortugalandEnglandreflectsinter-industrytrade.But,much of the International Trade takes the form of intra-industry trade. In the intra-industrytrade countries will export as well as import differentiated manufactured goods, ifmanufactures isamonopolisticallycompetitive industry. ForexampleGermanyexportsandimports cars fromFrance. Intra-industry trade is driven largely byeconomiesof scale. Byproducingfewervarietiesofgoodsacountrycanproduceeachata largescale,withhigherproductivity and lower costs. International trade thus leads to reduced prices and a widerchoiceofgoodstotheconsumers.Krugman,winnerofthe2008NobelPrize,explainedthecausesandpatternsofInternationaltradebyfocusingattentiononeconomiesofscaleandtheeconomics of imperfect competition. His analysis reveals that similarly placed countries incapital labor ratios, skill levels etc., such as EEC countries should trade, as opposed tocountries that are different. Most trade occurred between countries with similar factorendowmentsandofteninvolveddifferentvarietiesofproductsfromwithinthesameindustry.

Internationaltradeandcapitalflowsgivesrisetoproblemsofsurplusesanddeficits,causingBalanceofPayments(B.P)dis-equilibrium.Meade’sbookBalanceofPaymentsisaclassiconthe subject. TheB.P is a comprehensive record of economic transaction of residents of acountry inquestion(sayIndia)whohavereceivedexternalcurrency(purchasingpower)andhow it is used.Since the payments side of the account enumerates all the useswhich aremadeofthetotalforeigncurrency(purchasingpower)acquiredbyIndiainagivenperiod,andsince the receipts side of the B.P account enumerate all the sources from which foreigncurrencyisacquiredbyIndiainthesameperiod,twosidesmustbalance.

BalanceofPaymentsAccountsaredividedintoCurrentaccountandCapitalAccount.AlsotheCurrentAc.(CA)isequaltothedifferencebetweenNationalIncomeandDomesticResidentsspending which is known as Domestic absorption.(C+I+G).Further in a closed economySavingisequaltoInvestment.InanopeneconomyS=I+CAwhereCAisCurrentAccountbalance.DevelopingCountries canborrow from foreignnations for investmentpurposeandmakegoodtheCurrentAc.Deficit.ThatiswhytheC.Asurplus(Ordeficit)isreferredasNetforeigninvestment.

Thecurrentandcapitalaccountstogethermake-uptheoverallBalanceofPayments.IfBPisindeficit, theCentralBank losesForeignReservesand ifBP is insurplus theCentralBankgainsForeignReserves.TheBPalwaysbalancesbecausethestatementofBPincludesthemonetarymovementsandotherbalanceitems.

InanOpeneconomy,sustainableB.Ppositionovertimeisanimportantobjectivetogoalongwitheconomicgrowth,lowunemploymentandaslowinflation.Theeffectsofpolicyinstrumentinachievingtheobjectivesdependontheexchangeratesystem;thesystemmaybeafixedexchange rate system; a floating exchange rate system and a managed exchange ratesystem.

NowletusconsidertheeffectofMonetaryandFiscalinstrumentsontheinternalandexternalobjectives of a country.Mundell extended the Keynesian IS*- LM framework, referred to inchapter 2, by incorporating a Balance Payments Schedule. While Keynesian aggregativedemand approach focuses entirely upon Current account, Mundell’s model (and also ofFleming)takesintoaccountCapitalflowsaswell.TheoverallBP,istheCurrentaccountplusCapital account. The Current account gets worse as National Income (Y) rises, just as inKeynesiansystem.Thus, ifBPequilibrium is tobemaintained (atZero)asnational Income

rises, the domestic rate of interest must also rise so that improved Capital accountcompensatesforcurrentaccountdeficit.ThescheduleofExternalBalanceCurve(EB)orBPCurveisalocusofzerooverallBPpositions.AddtheEBcurvetoIS–LMcurves,wegettheMundellmodel.

Visualizeagraphshowinginterestrateontheverticalaxisandincomelevelonthehorizontalaxis; the IScurvedownwardslopingandLMcurveupwardsloping. Assumeperfectcapitalmobility so that domestic and foreign interest rates tend to be equal. At that point only, acountry can have external balance of Zero. Add, a horizontal BP (EB) Line at the point ofintersectionofIS-LMcurves.

FixedExchangeRates:

Letusassumethatacountrycannotinfluenceworldinterestratesandtheeconomyishavingexternal balance but not full-employment level of income. The Government attempts toeradicateunemploymentthroughexpansionaryFiscalpolicy.FiscalexpansionshiftsIScurveupandtotherighttendingtoincreaseboththeinterestrateandthelevelofoutput.Therisein domestic interest rates sets off a capital inflow from abroad. This would lead to thedomestic currency toappreciate. But underFixedExchange rates this cannot happen. Tomaintainexchangerate, theCentralBankbuysForeignCurrency(sellsdomesticcurrency).Hence,moneysupply in theeconomy increasescausingLMcurve toshiftdownand to theright,therebycausingoutputtoincreasealittlemore.Addingboththeoutputexpansions,wegetalargeincreaseinoutput.Toconclude,Fiscalexpansionunderfixedexchangerateswithperfectcapitalmobilityiseffectiveinincreasingoutput.

In thecaseofMonetaryexpansion, theLMcurveshifts to the rightand thiswould result inreduced interest and capital flight. It results in BP deficit and hence, pressure for theexchange rate to depreciate. To maintain fixed exchange rate, the Central Bank mustintervene,sellingforeigncurrencyandreceivingdomesticcurrencyinexchange.Thiscausesdeclineinthesupplyofdomesticcurrencyintheeconomy.AsaresultLMcurveshiftsbackupandtotheleft.Theprocesscontinuesuntiltheinitialequilibriumpointisreached.Hence,outputdonotexpand.

FlexibleexchangeratesandPerfectCapitalmobility

ThesituationisdifferentunderFlexibleexchangerates.Marketdeterminestheexchangerateand there is no need for a Central Bank to intervene in the market. Without any suchintervention, any deficit in the Current account of BP, must be financed by private Capitalinflows, and in the case of Surplus in Current account it should be balanced by Capitaloutflows. As for perfect Capital mobility, any slight rise in domestic interest rate above theWorldinterestratesleadstomassiveinflowofCapitalfromabroadmakingEB(BP)schedulehorizontal at World interest rate. Assuming price stability domestically, let us consider theeffectofexpansionaryFiscalandMonetarypolicyinstrumentsunderflexibleexchangerates.Theeffectsofcontractionarypoliciesaresimilarbutreverse.

AtaxcutoranincreaseinGovernmentspendingwouldleadtoanexpansionofdemandfordomestic goods. This shifts the IS curve to the right. Fiscal expansion leads to increasedGovernment borrowing and thus leads to a rise of domestic interest rates. This results ininflow of foreign capitalwhich in turn leads to exchange rates appreciation. Consequently,domesticexportswilldecreaseandimportswillincrease.BalanceofTradeworsens.IScurve

shiftsbacktotheoriginalposition.ButLMcurveremainsthesame,assupplyofmoneyunderflexibleexchangerateisexogenous.ThereisnoobligationfortheCentralBanktointerveneinforeignexchangemarket.TheunchangingLMcurveandtheshiftedbackIScurvetotheoriginalpositioninteractattheoldequilibriumposition.Hence,outputdonotchangeduetoFiscalexpansionunderflexibleexchangerates.

MonetaryexpansionunderFlexibleExchangeratesresultsinincreasedrealstockofmoney.This results in reduced domestic interest rates which in turn results in capital out flows toforeigncountries. This leads toexchangeratedepreciation, increasedexportsandreducedimports.TheI.S.curveshiftstotherightandoutputwillincrease.

TosummarizetheeffectsofpolicyinstrumentsMonetarypolicyhasnoimpactonoutputunderfixedexchangerates,whilefiscalpolicyhasnoeffectonoutputunderflexibleexchangerates.Ontheotherhand,fiscalpolicyhasastrongeffectonoutputunderfixedexchangerates,whilemonetary policy has a strong effect on output under flexible exchange rates.” If theassumptionsandparameterschange then theeffectsofpoliciesonoutputandemploymentwillalsoalter.

There is a conflict among the three policies of full capitalmobility, fixed exchange rate andmonetarypolicyindependence;termedas‘impossibletrinity’.ThisisadirectimplicationoftheMundell-Fleming (IS –LM-BP) framework wherein capital in fully mobile and the domesticinterest rate is tied to the foreign interest rate.However, these threepolicies, taken inpairs,arefeasibleandpracticable.

I.M.F.andIBRD

During the inter-war years, the great Depression took place leading to widespreadunemploymentandworldwiderecession.The1930’sweremarkedbymajortradeinbalanceswhich in turn led to widespread Protectionism, the adoption of deflationary policies,competitivedevaluationsandabandonmentofGold-exchangeStandard.

In this context representatives of 44 Countries met in July 1944 at Brettenwoods, newHampshireanddecidedtosetupInter-NationalMonetaryFund(IMF)andInternationalBankfor Reconstruction andDevelopment (IBRD). The IMF agreement tries to provide sufficientflexibilityinexchangeratestoallowCountriestoattainexternalbalanceinanorderlyfashion,withoutsacrificinginternalobjectivesoffixedexchangerates.

Thearticlesofagreementagreedbythemembercountriesprovidedforthecreationofapoolofinternationalreservesthatcountrieswithtemporarypaymentsimbalancescoulddrawupon.InthecaseoffundamentaldisequilibriuminB.P.PositionIMFpermitsthecountrytochangetheexchangerates.

ItisbelievedthatbothIMFandWorldbankfollowedapolicyof‘Liberalisation,minimalStateand toughness in Monetary and Fiscal matters”. This came to be known as Washingtonconsensus. In hisWIDERLectureStiglitz hasattacked total regulationofFinancialmarketsand supported their intelligent regulations. He suggested better focussing of Governmentaction on fundamentals of economic policies: basic education, health and sustainabledevelopment and equitable and democratic government. He criticized the policy of marketfundamentalism of IMF. To a large extent Stiglitz is responsible for the transition from theWashingtontopost-Washingtonconsensus.

BoththeIMFandIBRDcameintobeinginaneraoffixedexchangeratesandstableCapitalflows. IMFwasdesignedtomeet temporaryCurrentaccountdeficitofmemberCountriesbyprovidingaccessto itsCredit facility.TheseBrettonwood institutionsnowfind themselves ill-equipped todealwith theproblemsof instabilityandvolatility inexchange ratesandcapitalflows.

TheIMFmakingeffortstobuild-upitsrevenuesandstrengthenitsfinances.Itisservingasaplatform for the deliberations of G.20 countries. It is restructuring itself to make it morerepresentativebygivingmoresaytodevelopingcountriesintheconductofitsaffairs.

TradePolicies

Governmentsadoptseveralpolicies towards InternationalTradesuchasTariffs,QuotasandSubsidies.

OneofthebasicargumentsinfavorofdirectcontrolsoverInter-NationalTradeinthe‘Second-bestargument’.It isarguedthatweshouldnotremoveoneparticularTariffsorTradecontrolsolongassomeotherTarifforTradecontrolordomesticdutyorotherdivergencesbetweenmarginalvaluesandcostsremaininoperation.Itisarguedthatmaintenanceofoneparticulardivergencebetweenmarginalvaluesandcostsmayhelp tooffset theevileffectsofanotherdivergence. As a precept for practical policy, Meade does not find this argument verycompelling. The only type of practical Inter-National welfare policy is to remove barriers toTrade,arguesMeade.Meadewantsre-buildingofliberalinter-Nationaleconomicorder.

GlobalTradenegotiationstakeplaceperiodicallyundertheaegisofGATT,nowcalledWorldTradeOrganization.ThelastTradenegotiationswereheldatDoha.

JosephStiglitz,coauthoredwithAndrewCarlton,abooktitled‘FairTradeforAll’.InthatbookStiglitzarguesforestablishingaglobaltraderegimewhichrepresentsfairtradeforall–bothdeveloped and developing countries. The authors argue that if there is to be widespreadsupportforthecontinuingagendafortradereformandliberalization,thedevelopedworldmustmake a stronger commitment than it has in the past to give assistance to the developingworld. The developed countries should reduce their tariffs and subsidies on the goods ofinteresttothedevelopingcountries.

MundellhaspioneeredthetheoryofOptimalCurrencyAreaandwasinfluentialinshapingtheEuropeanUnion (E.U). ThebirthofEuropeanMonetaryUnion (EMU) in1999 resulted inasingle currency,Euro forall its 16members. By joining theEMU,countrieshaveachievedExchangeRatestability,foregoingindependenceofmonetarypolicies.CountrieslikeEnglandwishingtoretainmonetaryflexibilitypreferredtostayoutoftheEuropeanMonetaryUnion.

Inrecentyears,severalbilateralFreeTradeAgreementhavebeenconcludedinAsia.Severalcountries includingChinaandJapanhavesigned tradedealswith theAssociationofSouthEastAsianNations(ASEAN).

PaulKrugman’sexcellenttextbook(coauthoredwithObstfeld)titled,InternationalEconomicsdealsexhaustivelywiththetheoryofeconomicsofscale,thepoliticalaspectsoffreetradeandthe geographical aspects of economic development and many other policy issues ofInternationalTrade.

Chapter–14FINANCIALECONOMICS

(Modigliani,Markowitz,MertonMiller,Sharpe,RobertMertonandScholes,EugeneFama,LarsPeterHansen,RobertJ.Shiller)

Of the financial economistswho received theNobel Prize in Economics, FrancoModiglianiwas the first to receive theprize in1985.Hewas followedbyMarkowitz,MertonMillerandSharpe who received the Nobel Prize together in 1990. And in 1997, Robert Merton andMyronScholesreceivedtheprize.

Franco Modigliani and Merton H. Miller are popular through their widely discussed theorynamed as Modigliani – Miller Theory (referred to here after as M and M theory). In theirpioneeringarticle“Dividendpolicy,GrowthandTheValuationofShares”,(inJ.B.Oct,1961)M&Mhaveshowedtheirrelevanceofdividendpolicy.MandMassumedaworldwithouttaxes,transactioncostsorothermarketimperfections.

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*Fn ThisChapter iswritten bymy daughter,Dr.V.RamaDevi,who has beenworking sinceJune2008asProfessor in theSchoolofManagementStudies,K.L.C.E.(KLCEbecameK.L.University in 2009,Guntur-2 (A.P.). Earlier, sheworkedasAssociateProfessor,CollegeofManagement,GITAMUniversity,VisakhapatnamandasAsst.ProfessoratICFAIUniversity,Hyderabad.SheisnowworkingasProfessorinManagementinSikkimCentralUniversity.Anadapted version of this Chapter is published in Southern Economist, 1st Dec., 2008,Bangaluru.

ThecruxofMM’sposition is that theeffectofdividendpaymentsonshareholderswealth isoffsetexactlybyothermeansoffinancing.Wherethefirmhasmadeitsinvestmentdecision,itmustdecidewhethertoretainearningsortopaydividendsandsellthenewstockinordertofinancetheinvestments.Buttheissueofanadditionalstockofshareswillcauseadeclineinthe terminal value of shares. What is gained by the investors as a result of payment ofdividendswillbeneutralizedcompletelybythereductionintheterminalvalueofshares.MMsuggestthatthesumofdiscountedvaluepershareafterfinancinganddividendspaidisequalto themarket value per share before the payment of dividends. In otherwords, the stock’sdeclineinmarketpricebecauseofexternalfinancingoffsetsexactlythepaymentofdividends.ThereforetheinvestorsaccordingtoMMwillhavenopreferencebetweengettingtheincreaseinwealth in the formofdividendsnowor capital appreciation later.Thedividendpayout isirrelevant.

1)IrrelevanceofCapitalStructure:

ModiglianiandMilleralsoshowedtheirrelevanceofcapitalstructureforinvestmentdecisionsinperfectmarkets.Themarketvalueofafirmisindependentofitscapitalstructure.Thesumof thepartsmustequal thewhole;soregardlessof financingmix, the totalvalueof the firmstaysthesame,accordingtoMM.ThebasicpremiseofMMapproachisthat,thetotalvalueofafirmmustbeconstantirrespectiveofthedegreeofleverage

Ifthemarketvaluesofanytwofirmsdifferthentheprocessofarbitrageoperatestoequalizethevaluesofthetwocompanies.ThecentralpropositionofMMisthattheweightedaveragecostofcapital(WACC)isindependentofthedebt-equityratioandequaltothecostofcapitalwhich the firmwould havewith no gearing in its capital structure.MMargue that companyvalueandtheoverallrequiredreturn,Ko,areinvarianttocapitalstructure.

Markokwitz and Sharpe are widely known for their path breaking contributions to portfoliotheory.AccordingtoMarkowitz’smean-variancemaxim,aninvestorshouldseekaportfolioofsecuritiesthatliesontheefficientfrontier.Aportfolioisnotefficientifthereisanotherportfoliowithahigherexpectedvalueofreturnandwiththesameoralowerstandarddeviationorthesame expected value with lesser risk. If inefficient portfolios are deleted, we get a set ofefficient portfolios or efficient frontier. It is possible to draw a Risk-Return indifferencemapsuch that the investor is indifferent between any combination of risk and return on anyindifference curve. The slope of the indifference curve is the investor’s marginal rate ofsubstitution between risk and earnings. The point of tangency between the efficient frontierandtheindifferencecurveistheoptimalportfoliocombination.

Markowitz devisedanalgorithm, usingquadratic programming to calculate a set of efficientportfolios. His model is extremely demanding in its data needs and computationalrequirements.

Sharpe views that relationship between securities occurs mostly through their individualrelationships with some index. This is known as Sharpe’s Index model. Sharpe’s modelreducesthedatarequirementconsiderably.

Inanarticletitled“Asimplifiedmodelforportfolioanalysis,”publishedin1961,Sharperelateseachstocks return to themarket asawhole rather than toeveryother stock. Oneway tocapturethisrelationshipisthemarketmodel.Thiscanbeexpressedas

rs=ά+βrI+e

wherers=returnonsecurity

ά=interceptterm

β=slope

rI=returnonmarketIndexand

e=error

Thismarketmodelspecifies thateveryriskysecurity inaportfolio isrelatedto thereturnonthemarketindexsuchasSENSEX.ThemarketmodelassumesthatthereturnonasecurityissensitivetothemovementsofthemarketIndex(factor).Hence,themarketmodelisalsocalledIndexmodelorFactormodel.

CapitalAssetPricingModel(CAPM):

TheCAPMshowstherelationbetweenriskandexpectedreturnforefficientportfolios.IntheCAPM graph, we represent returns on the vertical axis and risk of the Portfolio on thehorizontalaxis.Efficientportfolios,plotalongthelinegoingfromriskfreereturnthroughtheMarketPortfolio. EfficientPortfoliosconsistofalternativecombinationsof riskandexpected

returns obtainable by combiningmarket portfoliowith risk free borrowing and lending. ThelenearefficientsetoftheCAPMisknownastheCapitalMarketLine(CML).

Becauseall investors face the sameefficient set, theonly reason theywill choosedifferentportfolios is that theyhavedifferent preferences towards risk and return resulting in distinctindifferencecurves.Althoughthechosenportfolioswillbedifferenteachinvestorwillchoosethesamecombinationofriskysecurities.Asaresulteachinvestorwillspreadhisorherfundsamongriskysecuritiesinthesamerelativeproportions,addingriskfreeborrowingorlendingin order to achieve a personally preferred combination of risk and return. The tangencyportfolioisreferredtoasmarketportfolioanditissameforallinvestors.Onlytherewillbeacertain amount of either risk free borrowing or lending that depends on that person’sindifference curves. The optimal combination of risky assets for an investor can bedeterminedwithoutanyknowledgeoftheinvestor’spreferencestowardriskandreturn.ThisfeatureoftheCAPMisoftenreferredtoastheseparationtheorem.

InCAPM,themarketwillultimatelyachieveequilibrium.Inequilibriumtheproportionsofthetangency portfolio will correspond to the proportions of themarket portfolio. The tangencyportfolioiscommonlyreferredtoasmarketportfolio.

TheverticalinterceptoftheCapitalMarketLine(CML)istheriskfreerateofreturnwhichisoften referred toas the reward forwaiting. Theslopeof theCML isequal to thedifferencebetween theexpectedreturnof themarketportfolioand therisk freesecuritydividedby thedifferenceintheirrisk.TheslopeoftheCMLisoftenreferredtoastherewardperunitofriskborne.TheinterceptandslopeofCMLcanbethoughtofasthepriceoftimeandthepriceofrisk.Inessence,securitymarketsprovideaplacewheretimeandriskcanbetraded,withthepricesdeterminedbysupplyanddemand.

Wehaveseen that themarketmodel (Indexmodel)usesmarket Index,whereas theCAPMinvolves the market portfolio. In practice the composition of the market portfolio is notpreciselyknown;soamarketIndexmustbeused.AssuchbetadeterminedbyusingmarketIndexisusedasanestimateofbetadeterminedbymarketportfolio.

TheCapitalMarketLine(CML)representstheequilibriumrelationshipbetweentheexpectedreturn and standard deviation for efficient portfolios. The relation between covariance ofsecuritywith themarketandexpected return isknownasSecurityMarketLine (SML). Thesecuritieswithlargercovariancewiththemarketwillbepricedsoastohavehigherexpectedreturns.Supposethebetaofanindividualsecurityis1.5,therequiredrateonthemarketis15%andriskfreerateis6%perannum.Thentherequiredrateofreturnforthesecurityis

0.06+1.5(0.15–0.06)=0.195or19.5%

TheexpectedreturnforasecurityistheproductofbetaandthemarketriskpremiumplustheRiskfreerateofreturn.

MYRONSCHOLESANDROBERTMERTON:

Inthe1970’s,FischerBlack,MyronScholesandRobertMertonmadeamajorcontributiontothepricingofstockoptions. Before theirwork is recognisedby theWorld,Blackdied. TheremainingtworeceivedtheNobelPrizein1997.Oftheirwork,themostpopularmodelistheBlack-Scholes model. The Black-Scholes formula (BS formula) for pricing European CallOptiononanon-dividendpayingstockisgivenbelow.ThebuyerofCallOptiongetstheright

but not the obligation to buy the Stock at a certain price. European call options can beexercisedonlyontheexpirationdateonly.TheBSOformulaforcalloptionsisgivenbelow.

C=S0.N(d1)–K.e–r.t.N(d2)

WhereCisthevalueofthestockoption

S0isthecurrentstockpriceattimezero.

KistheexercisepriceoftheoptionN(d)isthevalueofthecumulativeNormaldensityfunctioneisanexponential,equalto2.718ristheshort-termannualinterestratecontinuouslycompoundedtisthelengthoftimetotheexpirationoftheoption,usuallyexpressedasaproportionofanyear

Forthecomputationofd1andd2,theformulasare

Whereln=ThenaturalLogarithm

σ=Thestandarddeviationoftheannualrateofreturnonthestock

The BSO formula is taken from the well known text book by Hull. The formulas appeardifferentlyinothertextbookslikeRedheadbook.Buttheyareoneandthesame.

ForStocksprovidingadividendyieldatrateQ,theBSOformulaforEuropeanCalloptionsismodified on the basis of results derived byMerton. In the revised formula, Stock price isreducedfromS0toS0.e-QTwhereQisdividendandd1computationalsochangedaccordingly.

TherevisedBSO(Merton)formulacanbeusedforcalculatingEuropeanCalloptionforStockIndex.S0isthevalueoftheindexandKistheexercisepriceoftheindexandQisequaltotheannualizeddividendyieldontheindex.

ForcurrencyoptionsalsoweusethesameBSO(Merton)formula.WedefineS0asthespotexchangerateandreplaceQ(dividendrate)withrf,foreignriskfreeinterestrate.

InthecaseofAmericanCalloptionsonStocks,therighttobuythestockcanbeexercisedatanytimeuptotheexpirationdateoftheoption.WhentherearenodividendsonStocks,theAmericanandEuropeanCalloptionpricesareequalandtheBSOformulacanalsobeappliedto determine the price of American Call options on Stocks. When there are dividends onstocks,Blacksuggestedanapproximateprocedure todetermine thepriceofAmericanCalloption.

WhiletheCalloptionsgivetheright,butnottheobligationtobuystock(underlyingasset)ataspecified strike price on a future expiry date, the Put options give the right but not theobligation to sell the stock at a specified price on a future date. SoPut options are exact

oppositesofCalloptions.SoBSOformulaofCalloptionscanbeusedforPutoptionsalso,bychangingsignsofformulaCandrewritingtheformulaforPutoption.Thecalculationofd1andd2remainthesame.

TheGlobalFinancialcrisisof2008hasledtoblamingtheFinancialmodelsandquestiontheirunderlying assumptions, that markets function efficiently. Actually, the financial industryconsistingofBanks, InvestmentFunds,Hedge fundsandsuchothersare tobeblamed forcausing the Financial crisis. Fiscal stimulus policies and liquidity injection policies haveavertedtheFinancialcrisisdeepeningintoaDepression.

EugeneFama,LarsPeterHansen,RobertJ.ShillerwontheNobelPricefor2013fortheirworkonpredictionsinFinancialMarketandalsoforspottingtrendsinFinancialMarkets.

Chapter15INFORMATIONECONOMICS

(Mirrlees,WilliamVickrey,Akerloff,Spence,Stiglitz,Hurwitz.Myerson,Maskin&AlvinRoath)

In the 1950’s George Stigler explained that price differences of products are due toexpensiveness of search and information. Since then, information economics has grownsteadly.

Stiglitz observes that information is costly and further it is asymmetric. Because ofasymmetics of information between buyers and sellers, markets fail and misallocateresources.AssuchStiglitzarguesforgovernmentintervention.

Threemain themesarise insituation inwhichasymmetric informationexists inacontractualrelationship, that is tosay, inwhichoneparticipantknowssomething thatanotherdoesnot.Theyare:MoralHazard,Adverse,SelectionandSignaling. In theContractual relationship inwhichtheparticipantscouldbeindividuals,institutionsorfirm,letusrefertotheparticipantsasPrincipal andAgent. ThePrincipal is responsible for designing and proposing theContract,whiletheAgent,whoiscontractedtocarryoutsometaskdecides,ifheisinterested,insigningornot.

InthecontextofInformationasymmetry,MoralHazardproblemshavetodowiththebehaviourof theAgentduring thecontractual relationship.TheAgent’sbehaviour isnotobservablebythePrincipal,itisnotverifiable(foraCourtofLaw).ThefirstformalpapersonMoralHazardarethoseofMirrlees.AclassicexamplehereisFireinsurancewheretheinsure(agent)mayormaynottakeadequatecarewhilestoringtheflammablematerials.ItispossiblefortheFireinsurancecompanytosend inspectorstoseethat the insurer takespropercare.Butperfectmonitoringisnotpossible.

AgentsfrequentlydonotactinthebestinterestsofthePrincipals.Againsttheinterestoftheemployer(Principal), theworkersmaynotbeworkingveryhard,preferringto idleawaytimebydoingworkataslowpace.Similarly,inacompany,theshareholdersareownersandthemanagers are the agents. Themanagers (agents)may pursue goals other than that profitmaximization.Theresultinginefficiencyduetosuchconflictinggoalsistermed‘X’inefficiency.

Suchproblemscanbetackledbypropermonitoringoftheperformanceoftheagentsbytheprincipals. Further, there must be incentives for the agents to behave in the principalsinterests.Thus,managers’salariescouldbelinkedtofirms’profitability.

William Vickery won the Noble Prize jointly with Mirrless in 1996. Vickry deals with theproblemsofdesignmechanismineconomics,especiallywiththewritingofContractsamongparties who will come to have private information. Vickery suggested a designmechanismknownas‘Second-PriceSealedBidAuction’.,termedas‘Vickery‘sAuction’

InthistypeofauctionsystemsuggestedbyProf.Vickreythepersonwhoiswillingtopaythehighestpricegetsthechancetobuythegoodandhepaysthesocialopportunitycost,which

is the secondhighestbid. Hence, thisauctiondesign is socially efficient. Thebiddersareinducedtorevealtheirtruevaluationsofthegood.

The‘AdverseSelection’problemispresent,whenbeforesigningtheContract, thepartythatestablishestheconditionsoftheContract(thePrincipal)haslessinformationthantheAgentonsomeimportantcharacteristicsaffectingthevalueoftheContract.

Early important contributions to ‘Adverse Selection’ problems came from Akerloff. Akerloffgives the illustration of the used cars, which are in good condition (Peaches) and in badCondition (Lemons). In a secondhand carmarket, there is a tendency of ‘BadUsed cars’drivingoutthegoodcars.

Ifthegoodandbadcarsaresoldatthesameprice,ownersaremorelikelytoofferabadcarforsalethanagoodone.Potentialbuyersofusedcardssuspectthatthecarsonthemarketarebad.Accordingly,theyreducethepricetheyarewillingtopay.Atthereducedprices,thesellerswillhavenoincentivetosellgoodcars. Insuchaviciouscircle, themarketforusedcarsmayevencollapse.

Whileinformationisimperfectandasymmetric,personscantakestepstoprovideotherswiththe signals or proxies for the relevant variable. Michael Spence in a path-breaking articlepointsoutthateducationofcandidatesforajobservesasasignaltotheemployer.Employerhas no prior information about the ability of candidates. They initially believe that personshavingeducation,saydegreearemoreablethanothers.,whoarebelievedtobelessable.

On thisbasis, theemployersofferhigherwagesor salary tomoreablecandidatesand lowwages to less able persons. The candidates in turn fulfill the employers expectations. It isassumedthatthecostofeducation(acquiringadegree)ishigherforlessablepersonsastheytakemore time to get it than the less able persons. In such a context, only themore ablepersonsfinditworthwhiletoacquiretheneededdegreeasasignalabouttheirability.AndForthe Employer taking the degree as a signal of their ability offers higher wages to all thosecandidateshavingadegree.

In the Moral hazard example, we referred to Employer and Employee relationship. TheEmployer(Principal)designs thecontract to inducehighefforton thepartof theAgent. Theagentsexpectedpay-offforhigheffortmustbeatleastasgreatashispay-0fffromloweffort.Thiskindofinequalityiscalledtheincentivecompatibilityconstraint.

Inthecarexampleaboveitwasassumedthatthebuyerhadnoinformationaboutthequalityof thecar.However, thebuyer (thePrincipal)whiledesigning thecontract canmotivate theseller (theagent) to revealhisprivate informationabout thequalityof thecar.TheContractspecifiesaguaranteeforthecar’.Thesellerwouldacceptthecontractonlyifthecarisagoodquality.

The2007NobelPrizeisawardedtoHurwitz,MyersonandMaskinfortheirContributionstomechanismdesigntheory.Animportantfeatureofcollectivedecisionmakingisthat it takesinto account individual preferences. But the individual preferences are not publiclyobservable. How the information can be elicited, and the extent to which the informationrevealation problem constrains the ways in which collective decisions can respond toindividualpreferences,isknownasmechanicaldesignproblem.AsEngineersdesignbridgesand machines, analogously economists design exchange mechanisms such as telephone

exchanges and auction markets. According to Hurwitz, the theory attempts to achieveincentivecompatibilityamongtheagents.MeyersonRevealationPrinciple inducespeople toreveal their private information truthfully. Maskins Implementation theory clarifies whenmechanismscanbedevisedthatonlyproduceNashequilibriumthatisincentiveefficient.

The work of these Nobel Economists of 2007 is closely related to that of non-cooperativegame theories of Hasranyi, Nash and Selten and to the theories of Vickrey and Mirrleesreferredearlierinthischapter.

Asdesign theories forma constituent of game theory, books and chapters ongame theorymaybeconsultedformoredetails.

TheNobelPrize2012isawardedjointlytoProfessorsShapely&AlvinRoath.WhileShapelyused Game Theory to analyze different matching methods in the 1950’s & 960’s, Roathappliedmatchingmethodsforallocationsandthepracticeofmarketdesign.ThoseinterestedinknowingmoreaboutRoath’scontributionstheymayreadhisbook(Co-editedwithJ.Kagel),HandbookofExperimentalEconomics,PrincetonUniversitypress,1995.

Designtheories,GametheoriesandExperimentalEconomicsareinterrelated.

Chapter16

W.ArthurLewis(1915–1991)

Arthur Lewis was born in 1915 at St. Lucia, an island in theCaribbian and other America’s Region. He had faced manydifficultiesduringhischildhooddays.Hisfatherdiedwhenhewassevenyearsoldandhismotherbroughthimup. HewasaBlackand fromaColonial country. Naturallyhe faced initialdifficulties.Hemadebestuseofwhatopportunitiescameinhisway.

He graduated from London School of Economics and worked asProfessor in the Universities of Manchestor, U.K. and Princeton,U.S.A.Hespentseveralyearsinadministrationalso.HebecameacitizenofU.K.

Chapter16ECONOMICGROWTHANDDEVELOPMENT

(Solow,Lewis,Kuznets,Schultz,Becker,Myrdal,AngusDeaton)

The genesis of Growth theory in the last Century can be traced to. Harrod and DomarModel.sAs theyaresimilarwediscuss. Harrod- model.ExplanationsofHarrodmodelaremany and the one given byA.K.Sen, in his Introduction toGrowthEconomics, is brief andexcellent.Assuch,wefollowSen’sexplanationofHarrodmodel.

Itcanbeshownthatthefollowingrelationholdsbetweentheactualandtheexpectedgrowthrate.

1)gt≥ĝt,accordingasĝt≥s/C

Theactualgrowthrategt,isequaltoexpectedgrowthrateĝtifandonlyiftheexpectedgrowthrate,isequaltothewarrantedrateofgrowth,s/Cwhere‘s’isthesavingrateand‘C’iscapital-output ratiootherwise therewillbeHarrod’s instabilityproblem. If the investorsexpectmorethan thewarranted rate of growth, s/C then the actual growth rate of demandwill exceedexpectedgrowthrate.

Suppose, the saving rate is a 20%and theCapital-Output ratioC is 4, then thewarrantedgrowthrateis5%.Supposethecurrentoutputlevelis95,sothata5%increasewill,meanamovement to 100(approximately). If the investors in fact expect an output of 100, they willinvest20units,(5.4) tocreateanadditionalcapacity foranadditionalunitsofdemand. Theinvestment of 20 units will generate a demand level of 100,so that expectations will berealized.Suppose, the investors expectmore, say 102units of demand theyhave to createcapacitytomeetadditionaldemandof7units(102-95).Theyinvest28units(7.4)andthroughthemultiplier investmentof28unitswillgenerateademandlevelof28.5=140Investorswillfeel that theyhaveexpected too littledemand.Similarly if the investorsexpect less,say98,thentheywill invest12units(3.4)and itwillgeneratedemandofonly60units.Sotheyfeelthattheirexpectationsareveryhigh.

Harrod employs another growth rate, the ‘Natural’ rate of growth. Harrod’s Natural rate ofgrowthisthemaximumsustainablerateofgrowthinthelongrungivenbytherateofgrowthoftheLaborforce,‘n’andtherateoflabor-savingTechnicalprogress,‘m’.ifthewarrantedrateofgrowthgivenbys/cisequaltothenaturalrate,thereisnoproblem.Butifthewarrantedrate‘Gw’isgreaterthantheNaturalrate,Gn,thenactualreachesaceilinglimitoffull-employment,whichmay result in departures fromequilibrium.On theother handGw<Gn then a, growingportionofun-employmentwillemerge.

ThusaccordingtoHarrodaneconomyachievesasteadygrowthataconstantrateonlywhenthesaving rate is equal to theproduct of theCapital-Output ratioand rateof growthof the(effective)Laborforce.

DissatisfiedwithHarrod’scrucialassumptionsanditsmainconclusions,Solowpublishedhisclassicarticle”AcontributiontotheTheoryofEconomicGrowth”in1956.Hisarticlemarksthe

beginningoftheNeo-ClassicalModelofEconomicGrowth”;thegistofthearticleispresentedbelow.

Solow’sgrowthmodelispresentedinthefollowingfundamentalEquation.

r1+n.r=sF(r,1)orr1=sF(r,1)–n.r

Where‘r1’istherateofchangeincapital-laborratio.

ThefunctionF(r,1)givesthetotalproductasvaryingamountsofcapitalareemployedwithoneunitoflabor.Alternatively,itgivesoutputperworkerasafunctionofcapitalperworker.

Considertherighthandsideoftheequation.weknowsF(r,1)issimplysavingperworkerandsinceinthismodel,savingautomaticallybecomeinvestment,itcanbeinterpretedastheflowof investmentperworker.Thesecondterminequation,n.r is theamountof investment thatwouldbe required to keep thecapital – labor ratio ‘r’ constant, given that the labor force isgrowingat a constant proportional rate of n. Thus the rate of changeof the capital – laborratio,(r|) isdeterminedbythedifferencebetweentheamountofsaving(andinvestment)perworkerand theamountrequired tokeepthecapital– laborratioconstantas the labor forcegrows.

Whenthetwoareequal,rwillbeconstantattheequilibriumvalue,re(r1=0).

Using the above equilibrium point, there is a simple mechanism to make the equilibriumstable. Suppose for example; there is a departure from equilibrium value, re. If savings fallshortoftherequiredinvestmentnr,thenCapital laborratiodecreasestowardtheequilibriumvalue. If savings exceed the required investment, then the Capital-labor ratio will increasetowardtheequilibriumvalue.

ThefollowingconclusionsaredrawnfromSolow’smodel.

1. Thelong-runrateofgrowthoftheCapitalstockandtheNationalincomeistherateofgrowthofLaborforce,whichisassumedtobeexogenousandconstant,n.

2. The economy invariably tends to a Balanced growth path, whatever the initialCapital-Laborratio.

3. Outputperworker,Capitalperworker,consumptionperworker,areallconstantinthe long-run. This is called steady state. At the steady state aggregate incomegrowsatthesamerateasPopulation.

4. Anincreaseinthesavingsrateraisesthegrowthrateofoutputintheshort-run.Itdoesnotaffectthelong-rungrowthrateofoutput,butitraisesthelong-runlevelofoutputandoutputperhead.

Solow and other Neo-Classical writers argued that relative shares of Labor and Capitaldepend on the ratio of marginal and average productivities of the Factors. The share of aFactorofProduction isequal to theelasticityofproductionwithregardto that factor. Undertheassumptionof constant returns toscaleandcompetitivemarkets,Solowsuggested thatthe rateofgrowthofoutput isequal to the rateofgrowthof labormultipliedby its share inoutputplus rateofgrowthofcapitalmultipliedby itsshare inoutputplus the residual. ThisSolow’s residual is termed multifactor productivity growth. It is observed that in U.S. the

output-capital ratio is relatively constant for a long period. This implies a positive Solowresidual,equalroughly to the laborsharetimestherateofgrowthof laborproductivity. TherateofchangeofmultifactorproductivityofSolowresidualisestimatedtobe1.7inU.S.during1950to1975,accountingforapproximatelyhalfofthegrowthoftheprivateeconomyofU.S.overthewholeperiod.Thesourceoftheresidualisnotknown.

Modern Growth theory is devoted to analyzing properties of Steady-states in industrialeconomies. However, Growth Theories provide useful insights to growth problems ofdevelopingCountriesalso.Solow’sendogenousmodelofgrowthhasrelevancefordevelopingcountriesanditisdiscussedbelow.

Solow’sEndogenousmodelofGrowth

In theSolow’sexogenousmodel discussedearlier, the relative rateofPopulationgrowth intreated as constant, n. Later, Solow relaxes this assumption and make Population anendogenousvariable. Thismodel isdiscussedinhisbookGrowthTheory(2000).Suppose,for example, for very low levels of income per-capita the (real wage) Population tends todecrease; for the next stage higher levels of income, it begins to increase and that for stillhigherlevelsofincome,therateofPopulationgrowthlevelsoffandstartstodecline.Therateofgrowthofpopulationdependsonthelevelofper-capitaincome.Sinceper-CapitaincomeisgivenbyY/L=F(r.1), theupshot is that therateof growthof the labor forcebecomesn=n(r).TheearlierFundamentalEq.nowbecomes:

r1=sF(r,1)–n(r).r

Thus, the rate of change capital/labor is constant if per capita savings are equal to theinvestmentrequirement.WithPopulationgrowthnr(r),theinvestmentrequirementrisesslowly,thensharplyandeventuallyflattensout.Theper-capitasavingsremainsthesame.

Theinvestmentrequirementmayequalthesavingsatlowandhighpointsr1andr2.Pointr1isthePovertytrappoint,withhighPopulationgrowthandlowincome.Theequilibriumpointr1isstable. If the initialCapital-labor ratio is less than r2 thesystemwillmoveback towards r1.Pointr2isunstable.Iftheinitialcapital-laborratiocanberaisedsubstantiallybyinvestinginabigway, so as tomake it gobeyond the critical level r2, then economy experiences a self-sustaining growth with increased income. The economy can avoid the Poverty trap byincreasingsavingsandreducingtherateofPopulationgrowth.

W.A.Lewis

W.A.Lewisclassicarticle,“EconomicDevelopmentwithUnlimitedSupplyofLabor”publishedin1954,gaverisetoenormousResearchonthecontemporaryproblemsoflargeareasoftheearth(ofdevelopingcountries).Assuchthesalientpointsinthatarticlearepresentedhere.

Lewis, like Classical writers, assumed the existence of disguised labor in agriculture indevelopingcountries.IntheLewismodeltherearetwosectors-theagriculturalsectorandthemanufacturingsector.Thetwosectorsmayaswellbedescribedas‘subsistencesector’andthe ‘capitalist sector’. The Capitalist sector is that part of the economy which usesreproduciblecapitalandpays for theuse thereof.The remainingpartof theeconomy is thesubsistencesector.

The Capitalist sector can expand indefinitely at a constant wage rate for un-skilled labor,drawnfromtheAgriculturalsector.Theactualwageratewillbedeterminedbyearningsinthesubsistencesector,whichisequaltoaverageproductandnotmarginalproduct.Itisbecauseby convention everyone in a household received an equal share of what is produced.Capitalistwill have to pay somemargin-perhaps 30%above average of a subsistence paybecause thesurplusworkers inagricultureneedsome incentive tomove tourbanareas forbeing employed in the manufacturing sector. Supply of labor is perfectly elastic to themanufacturingsectoratthecurrentwagesodeterminedattheinstitutionalwageinagriculture.

In theCapitalist sector, themarginalproductcurvewillbeconcave (fromorigin)andwillbedecreasing. In theCapitalistic laborwillbeemployedup topointwhere itsmarginalproductequals wage. The Capitalist will get Producer’s surplus. The surplus is reinvested by thecapitalist which raises the schedule of marginal productivity of labor. And the processcontinuesaslongasthereissurplusof labor.TheLewismodel, ineffectsaysthatunlimitedsuppliesoflaborareavailableataconstantrealwageandifanypartofprofitsisreinvestedinproductive capacity, profits will grow continuously relative to national income and capitalformationwillalsogrowrelativelytonationalincome.

The central fact of economic development is rapid capital accumulation. Lewis modelpopularizedtheconceptofDualisminwhichasmallindustrialsectorgrowstoabsorbgreateramountsofagriculturalsurpluslabor,withoutadverselyaffectingagriculturalproduction.

And, extending the migration mechanism suggested in Lewis model, Michael Todarodeveloped two-sectormigrationmodel. In the Lewis schema, peoplemigrate from rural tourbanareasinresponsetoassuredurbanemployment,andwithoutarealwagedifferential.In Todaro model, however, the parameters become variables. According to Todaro, anindividual’s decision to migrate is a function of income gain of an urban job weighted bylikelihoodof findingsuch job.Lewis&TodaromodelsofDualismaremorerealistic than theearlierSociologicalDualism,proposedbyDr.Boeke.AccordingtoDr.Boeke;“SocialDualismis the clashing of an imported social system with an indigenous social system of anotherstyle”.TheimportedsocialsystemofhighCapitalism(fromtheWest),clasheswiththeexistingpre-Capitalistsystem(intheEast).AccordingtoBoeke,DualismarisesfromaclashbetweenEastandWest,speciallybetweentheCulturaltraitsoftheirsocieties.

Kuznets

KuznetsiswellknownforhissignificantcontributionstoEconomicGrowth.ABibliographyofhisworks isgiven inhis latestbook (publishedposthumously),EconomicDevelopment, theFamilyandIncomeDistribution.

As thebooksofKuznets are available andaccessible to Indian students andnon-technicaland understandable there is no point in giving all the findings of Kuznets researches.WepresentoneimportantempiricalfindingbyKuznets.

Based on Kuznets empirical findings and conclusions a tentative hypothesis is formulatedwhich states that income inequality first rises and then falls with development. A plot ofinequality(onverticalaxis)againstameasureofdevelopmentsuchasper-capitaincome(onhorizontalaxis)wouldthenlooklikeaninverted‘U’(lookslike‘∩’.

GunnarMyrdal

Gunnar Myrdal’s methodology is characterized by an interdisciplinary approach, to socialproblems. Inanalyzingsocialproblemshe takes intoconsiderationnotonly ‘pureeconomicfactorsbutalsothesocial,demographicandinstitutionalaspects’,Further,hestateshisvaluepremisesexplicitly.

Myrdal’s contributions toMonetaryEconomicsare significant.But his contributions topolicyissues of developing countries are widely known and appreciated. He is responsible forpopularizing the concept of vicious circle. In his seminal work on U.S.Race Relations: AnAmericanDilemma, he explained theRace relations in termsof ‘WhitePrejudice’ and ‘LowNegrostandards’.Theseforcesoperate inacircularway inastaticcontext,balancingeachother. White Prejudice and the consequent discrimination against the Negros, block theireffortstoraisetheirlowplaneofliving.Thisontheotherhand,formspartofthecausationoftheprejudiceoftheWhites.

This hypothesis of circular causation is used by Myrdal again in his works on economicdevelopmentofBackwardCountries.Hearguesthattheprincipleofcircularinterdependencewithinaprocessof cumulative causationhas validity over theentire fieldof social relationsand economic development. The problem of Economic development, according to Myrdal,consists in generating cumulative movement in an upward direction. In such a case, thecircularconstellationofforces,insteadofbeingviciouswillbecomebeneficient.

MyrdalwrotemanybooksandhisMagnus-opusisAsianDrama-AnEnquiryintothePovertyofNations.ManyhaveacclaimedMyrdalasAdamSmithofPoverty.

Myrdal disagreed with the Inter-National Trade theory proposed by Heckscher-Ohlin. Theyargued that tradeworked for equalization of Factor prices and income.Myrdal argued thatInter-NationalTrade(andCapitalmovements)willgenerally tend tobreed inequalityandwilldo so the more strongly when substantial inequalities are already established. DevelopedCountries with higher productivity and incomes will continually acquire more internal andexternaleconomicsanddevelop,further,whileunder-developedcountrieswillfaceback-washeffectsfromdevelopedCountriesandtheycontinuetoremainunderdeveloped.

Critics of Free Trade includes Paul Prebisch and others. Prebisch divides the World intoCentre and Periphery; the Centre comprises of Industrial Countries and the PeripheryencompassestheUnderdevelopedWorld.TradebetweenthetworesultsinadversetermsofTradeforthePeriphery.

The Dependency School of writers argued that foreign Trade, foreign investments wouldentangle the Periphery into Capitalistic network of Centre and profits arising from theseinvestmentswouldbetransferredassurplusfromthePeripherytotheCentre,aggravatingthePovertyofthePeriphery.

Robert E. Lucas has proposed a new theory of growth in his book Lectures on EconomicGrowth (2002). He developed the human capital model. It involves an external effect ofhumancapitalpatternedontheexternaleffectsofknowledgecapitalthatRomerintroduced.The central idea in Lucas book is that the successful transformation from an economy oftraditionalagriculturetoamoderngrowingeconomydependscruciallyonan increase in therateofhumancapitalaccumulation.

EconomicsofEducation

T.W.Schultz

Economists have long known that people are an important part of the wealth of nations.Investment in human capital will further the economic growth and development of nations.ModerneconomistshavenotpaidasmuchattentiontohumanresourcesineconomicgrowthasdidsomeofthegreatClassicaleconomistslikeAdamSmithandMarshall.

T.W.Schultzfeltthatinvestmentinhumanbeingshasseldombeenincorporatedintheformalcoreofeconomicseventhoughitsrelevanceisrecognized.InhisPresidentialaddressattheannual meeting of the American Economic Association (28, Dec.1960). Schultz has drawnattentiontotheneedforinvestmentinhumancapital.

Hearguesthatworkerneedskillsandknowledgewhichislargelyaproductof investmentineducation and improved skills of the workers, account predominantly for the productivesuperiorityofthetechnicallyadvancednations.

Whenwetakeaccountofinvestmentineducation,wecanfindexplanationsforthefollowingapparentparadoxes.:

When farmpeople takenon-farm jobs theyearnsubstantially less than industrialworkersofthesamerace,ageandsex,thisdifferenceinearningscorrespondcloselytotheirdifferenceineducationlevels.

Schultzarguesthattheobservedgrowthinproductivityperworkerandalargeincreaseinrealearningsofworkersispartlyduetoimprovementsininvestmentinphysicalcapitalbutlargelyduetosteadilygrowingamountofhumancapitalperworker.

GaryBecker

Becker also stressed the importance of investment in human capital. In his classic work,Human Capital: A Theoretical and Empirical Analysis, he provided a general analysis ofinvestmentinhumancapital.Inhisbookhediscussesofinvestmentin,onthejobtrainingandalso of investments in schooling, information and health. The concept of human capitalembracessuchactivitiesas thepurchaseofhealthcare, timespentsearching forbetter jobthanacceptingthefirstavailablejob,migration,andacceptanceoflowpayingjobswhichhavea large element of learning on the job. According to Becker, in the long-run, all suchinvestmentsinhumancapitalwillbeundertakenuptothepointwherethemarginalreturnstosuchinvestmentsareequaltothemarginalcostofinvestmentfunds.

The growing realization of the need forHuman development has led to the construction ofHuman Development Index (HDI) byWorld Bank. Prior to the construction of the HDI, theWorld Bank advocated ‘Basic needs’ approach. Human Development goes beyond ‘Basicneeds’inthatitisconcernedwithallhumanbeings-notlimitedonlytothePoorPersonsandPoorCountries.Ofcourse,themaintargetgroupsarethePoorinallCountries.

HumanDevelopmentIndex:

HumanDevelopmentReports have been released annually under the auspicious ofUNDP.ThepreparationoftheHumanDevelopmentReportsismadepossibleduetocollectiveeffortof many individuals and organizations. Sen served as Advisor for preparing the HumanDevelopmentReportsand fruitfully interactedwithmanyeconomists likeMahabub–ul-haq,

Sudheer Anand, Paul Streeten &Richard Jolly. Sen, in collaboration with Sudheer Anandprovidesadetailedanalysis ofHumanDevelopment Index,MethodologyandMeasurement(Occasionalpaper12,UNDP)

HDIandIndia

TheHDIisbasedonthreeindicatorsasmeasuredby

1. Lifeexpectancyatbirth(years).

2. Educationalattainment,asmeasuredbyacombinationofadultliteracy(two-thirdsweight)andcombinedprimary,Secondaryandtertiaryenrolmentratios(one-thirdweight)

3. StandardofLiving,asmeasuredbyrealGDPpercapita(PPP$)

TheaverageofthethreeindicesistheHDI

HDIin1994=.605+.528+.206/3=.1339/3=0.446

TheHDIvaluein1999forIndiais0.571(HDIrankis115)TheHDIvalueofIndiain2005is0.6butIndia’srankdeclinedto127in2005andimproveditsrankto126thin2006.(ThetopcountryinHDIgetsrank1).Basedon2007data,theHDIforIndiaisestimatedtobe0.612anditsHDIrankis134outof182countries.

TheHumanPovertyIndex(HPI)focusingontheproportionofpeoplebelowcertainthresholdlevel ineachof thedimensionsof theHDI isestimatedat 28% for India. UsingHPI, Indiaranks88thoutof135countries.

Even the HDI is viewed as inadequatemeasure of humanwell being. Recently PresidentSarkozyofFrancehassetupacommissioninJuly2008tosuggestalternativemeasuresofeconomicandsocialprogress.TheCommissionhasJosephStiglitzasChairman,A.K.Senas Chair advisor and an impressive list of eminent economists and social scientists. TheCommission submitted its report in September, 2009, which is titled as “Report by theCommissionontheMeasurementofEconomicPerformanceandSocialProgress”.Thereportattempts to measure quality of the life of people. The report argues for concentration onHouseholdincomes,consumptionandwealthratherthantotalproduction.

Angus Deaton Daniel Kahneman (also a Nobel Economist) distinguish between Emotionalwell-being and life evaluation. Emotional well-being (sometimes called hedonic well-being)refers to the emotional polity of an individuals everyday experience – the frequency andintensityofexperiencesof joy, fascination,anxiety,sadness,angerandaffection thatmakesone’slifepleasantandunpleasant.Lifeevaluationreferstoaperson’sthoughtsabouthislife.It ismeasuredusingCantril’sself-anchoringscale,whichhas therespondent ratehisorhercurrentlifeonaladderscaleinwhich‘0’istheworstpossiblelifeforyouand‘10’isthebestpossible life for you. The authors conclude that when plotted against log of income, highincomeincludesevaluationoflife.Highincomeresultsinanincreaseinemotionalwell-beingalso,but there issatiationpointbeyondwhich there isnoprogress inemotionalwell-being.Lowincomeisassociatedbothwithlowlifeevaluationandlowemotionalwell-being.Forthat,highincomebuyslifesatisfactionbutnothappiness.(inanarticle,10thSeptember,2010.)

AngusDeatonwins theNobelPrize inEconomics in2015 “forhisAnalysisofConsumptionpoverty and welfare”. The Royal Swedish Academy of Sciences has said that “byemphasizingthelinksbetweenindividualconsumptionsdecisionsandoutcomesforthewholeeconomy” is work has helped transform modern Micro Economics, Macro Economics andDevelopmentEconomics.

According to Deaton, we must first understand individual consumption choices to designeconomicpolicythatpromoteswelfareandreducespoverty.Individualconsumptionslevelsofsource can be used to get a better understanding of their leaving standards and possiblepathsforeconomicdevelopment.Hisresearch,contributionsaremanyandvaried.LookatthelistofpublicationsofDeaton,PrincetonUniversity.

A.K.Sen

Senwasbornin1933atShantiniketaninBengalandspenthischildhoodatDhaka.AsachildhewitnessedthedireeffectsoftheBengalFamineof1943.MillionsstarvedtodeathandthismadeadeepimpressiononyoungSes’smind.ThishasledhimlatertostudythecausesandeffectsofFamines.Inhisbook‘PovertyandFamines’Senexaminesthecausesandeffectsofthe Bengal Famine of 1943, the Ethiopian Famine of 1974 and the Bangladesh Famine of1974.HisanalysesrevealsthatdeclineinfoodavailabilityisnotoftenthecauseofFamine.Itis the failure inExchangeEntitlements thathave led to theFamines,Sen terms the formerapproach as FAD (Food Availability Decline) approach and the later as FEE (Failure ofExchange Entitlement) approach. Entitlement is a semi-legal concept focussing on thebundles of goods and services that a person or family can legitimately establish commandoverusing the laws, regulations,conventions,opportunitiesandrights. Inmarketeconomicsentitlementsreflectownershipontheonehandandopportunitiesofproductionandexchangeontheother.TheapplicationoftheentitlementapproachhelpstoexplainwhytheMalthusianfocus on food availability per capita is often so badly misleading since the entitlements ofspecificgroupscouldeasilycollapseevenwhenaverage foodavailabilityperheaddeclinesverylittleorevenrises.IfonepersonineightstarvesregularlyintheWorld,Senseesitastheresultofhisinabilitytoestablishentitlementtoenoughfood.

SenonPoverty

In1971,DandekarandRathhavestudiedPovertyinIndianinacomprehensivemannerandsince then many have made useful contributions to discussion on Poverty. Earlier studiesfocused attention on the Head-Count ratio and the Income-Cap ratio. Head- count ratio isobtained counting the number of poor people and expressing it as a ratio of the totalpopulation.Incomegapismeasuredbythedifferencebetweenthepovertylineandthemeanincomeofthepoor..Whilethehead–CountratiotellsusthepercentageofpeoplebelowthePoverty– line, the Income–gap ratio tellsus thepercentageof theirmean incomeshortfallfromthePovertyLevel.TheHead-CountratioignorestheextentofPovertyandtheIncome-gapratio iscompletely insensitivetonumbersinvolved.SenproposedameasureofPovertywhich is sensitive to income distribution. The product of the Head-Count ratio (H) and theIncome-gap ratio(I), plus theproductof theHead-Count ratioand thedistributionof incomeamong the poor (GP) weighted by one minus the Income gap ratio, gives Sen’s Index ofPoverty(SIP).TheformulasuggestedbySenis:

1)SIP=H.I+H(1–I)GP

intheaboveformula,

SIP=Sen’sIndexofPovertyH=Head–CountratioI=Income-gapratioGP=DistributionofincomeamongthePoor

TheGPcanbecomputedusingthefollowingformula:

2)GP=1/100.100|(nXiYi+1-(nXi+1.Yi|

Ineqn. (2)Xi represents thecumulativepercentageof thenumberofPoorpeople,nandYistands forcumulativepercentageof incomesof thepoor.Wetake theabsolutevalueof thedifferencebetweenthesumsgiveninthebrackets.

SenonFunctioning’sandCapabilities

Sen introducedtheconceptofFunctioning’sandCapabilitiesandheuses this framework toexaminetheissuesofPoverty,Standardoflivingandfreedoms.Functioning’stelluswhataperson isdoing,capability to function reflectswhatapersoncando. According toSen thevariouslivingconditionswecanorcannotachievearefunctioning’sandourabilitytoachievethemareourCapabilities.PovertyinnothingbutafailureofbasicCapabilities.InthecontextofextremepovertyindevelopingCountries,weareconcernedwithasmallnumberofcentrallyimportantfunctioning’sandthecorrespondingbasicCapabilities,suchastheabilitytobewellnourishedandwell sheltered, the capability of escapingavoidablemorbidity andpre-naturemortality.Similarly,standardoflivingfocusesattentiononwhatlifeweleadandwhatwecanorcannotdo.Assuch,Senargues, thestandardof living is reallyamatterofFunctioning’sand Capabilities. Likewise, Sen interprets positive Freedoms in terms of Capabilities, tofunction.ThepositiveFreedomsspecifywhatapersoncanorcannotdo,orcanorcannotbe.Taking Sen’s multi dimensional view of poverty, Sabina Ali and Emma Sanosh at OxfordUniversityhaveconstructedinJune2010,anewmultidimensionalpoverty index(M.P.I). IntheM.P.I.ahouseholdisconsideredaspoorifitisdeprivedonover32%ofthetenindicatorsused.ThetenindicatorsofpovertyconsideredintheM.P.I.arethedeprivationofbasicthingssuchas:nourishingfood,propershelter,cleandrinkingwater,electricity,literacyandassets.Personswhoaredeprivedalongmanyofthedimensionsofpovertyareconsideredaspoor.Theextremecutoffratioisequaltoorgreaterthan0.32.AstheresearchstudyisbackedbyU.N.,fulldetailsofM.P.I.arepublishedintheU.N.developmentReportof2010.

SenonDevelopment

SendefinesDevelopmentasFreedom.Development,hesays,isaprocessofexpandingrealfreedoms that people enjoy. This view is different from the traditional conceptions ofDevelopmentwhich identifydevelopmentwith the rateofgrowthofGNPorpercapitaGDP.EconomicGrowth,Senopines,cannotbe treatedasanend in itsselfbut the freedom thatpeoplevaluecanbetheendaswellasthemeanstoDevelopment.SengivestopprioritytothepromotionofsubstantivefreedomswhichincludeelementaryCapabilitieslikebeingabletoavoidsuchdeprivationsasstarvation,undernourishment,escapablemorbidityandprematuremortality. The substantive freedoms also include such freedoms that are associated withliteracy,andbasicpoliticalfreedomsandcivilrights.Suchfreedomsareintrinsicallyimportant.

Sen also advocates Instrumental freedoms to people. They include Political freedoms,economicfacilities,socialopportunities,transparencyguaranteesandsocialsafetynets.

Themain aim of Development should be to enhance the opportunities the people have toimprovethequalityof their lives.Thecrucial roleofeconomicandsocialopportunities is“toexpandtherealmofhumanagencyandfreedom,bothasanendinitselfandasameansoffurther expansion of Freedom”. What is needed is a People Centered and Peoples’Participatoryapproach(PCandPPapproach)toDevelopment.

Toachievethesegoalsofdevelopment,thefollowingareneeded.

1. Apoliticaldemocracythatpromotesthewell-beingandfreedomsofpeople.

2. Astatewhichcomplementstheworkofmarkets

3. Suitableinstitutionstoenhancepeoples’capabilitiesandfreedoms.

APPENDICES

Chapter-Appendix–A.ListofNobelEconomistsS.NoNameYearofAward

1. RangnarFrischandJohnTinbergen1969

2. PaulSamuelson1970

3. SimonKuznets1971

4. J.R.HicksandK.J.Arrow1972

5. WassilyLeontief1973

6. GunnarMyurdalandHayek1974

7. KoopmansandKantarovich1975

8. MiltonFriedman1976

9. Bertil-OhlinandJamesMeade1977

10. H.A.Simon1978

11. T.W.SchultzandArthurLewis1979

12. LawrenceKlein1980

13. JamesTobin1981

14. GeorgeStigler1982

15. G.Debreau1983

16. RichardStone1984

17. Franco-Modigliani1985

18. JamesBuchanan1986

19. R.M.Solow1987

20. MauriceAllais1988

21. TrygveHavelmo1989

22.Morkowitz,MertonMillerandSharpe19901. RonaldCoase1991

2. Becker,Gary.S1992

25.RobertFozelandDouglasNorth1993

1. Hasranyi,JohnNashandShelton1994

2. RoberLucas,Jr.1995

3. MirrleesandWilliamVickrey1996

4. RobertMertonandMyronScholes1997

5. A.K.Sen1998

6. RobertA.Mundell1999

7. JamesHeckmanandDanialMcFadden2000

8. G.Akerloff,M.S.SpenceandJ.Stiglitz2001

9. DanialkahnemanandVernonL.Smith2002

10. EngleandGranger2003

11. FinnKydlandandEdwardPrescot2004

12. RobertAumannandThomasSchelling2005

13. PhelpsEdmundS.2006

14. Hurwitz,Myerson&Maskin2007

15. PaulKrugman2008

16. ElinorOstrom&OliverWilliamson2009

17. PeterA.Diamond,DaleMortensonandChristoperA.Pissarideo2010

18. ThomasSargentandChristopherSims2011

19. LyodShapelyandAlvinRoath2012

20. EugeneFama,LarsPeterHansen,RobertJ.Shiller)2013

21. JeanTirol2014

22. AngusDeaton2015

Note: Through the google search, we can find most of the books and articles of nobleeconomistsandarticlesaboutthemandtheymaybedownloaded.

Fordetails,contactwww.nobel.se/laureates/economics

Appendix–B,

TextBooksbyNobelEconomists

1. J.R.Hicks,ValueandCapital,OxfordUniversityPressandELBS

2. Samuelson,Economics,Mcgraw–HillBookCo.,NewYork,1970(12theditionwithWilliamD.Nordhus)

3. RobertMundell,ManandEconomics,TMHPub.Co,1968

4. GeorgeJ.Stigler,TheTheoryofPrice,CollierMacmillan,NewYork1966.

5. MiltonFriedman,PriceTheory,AldinePub.Co.,Chicago,Illinois.

6. PaulKrugman(andObstfeld),InternationalEconomics,Addison.

7. GunnarMyrdal,TheAsianDrama.

8. Klein,IntroductiontoEconometrics.

SomeotherTextBooks

1. JackHirshleiferandAmiharGlazer,PriceTheoryandApplications,Prentice–Hall.NewDelhi.1993

2. FergusonandGouldMicroEconomicTheory,RichardD.Irwin,IndianReprint.1996.

3. WilliamBaumol,EconomicTheory&OperationsAnalysis.

4. HendersonandQuandt,Micro–EconomicTheory,McgrawhillInc.1958

5. DavidM.Kreps–ACourseinMicroEconomicTheory,Prentice–Hall,EEE,India.1999.

6. RobertPindyeketel,MicroEconomics

7. AndrewMas-Colleletel,MicroEconomicTheory

8. CompbellR.McConnelandH.C.Gupta,IntroductiontoMacroEconomics,TMHEdn.NewDelhi.1984.

9. RangarajanandDholakia–PrinciplesofMacroEconomics

10. RudigerDornbuschet.al.MacroEconomics,TMHNewDelhi1998.

11. RobertE.Hall&Papel–McroEconomics.

12. RichardT.Froyen,MacroEconomics,AddisonWesley2001.

13. OlivierJeanBlanchard&Fisher,LecturesonMacroEconomics.

14. StephenJ.Turnovsky,MethodsofMacroEconomicDynamics.

15. LanceTaylor,ReconstructingMacroeconomics,Viva.

Note:Micro&Macroeconomicsbooksarearrangedinanascendingorderofdifficultygroup-wise.

OtherBooks:

1. PerryLewis–IntroductiontoMathematicsforStudentsofEconomics.

2. Chiang–FundamentalMethodsofMathematicalEconomics.

3. TaroYamane–MathematicsforEconomists.

4. Johnson–EconometricMethods.

5. BernardHebber–ModernPublicFinance.

6. KenBinmore–Fun&Games,AITBS,Delhi

7. Lamberten–EconomicsofInformationandKnowledge,Penguin

8. K.Basu–EconomicGraffiti,OUPNewDelhi.

9. Brearly&Myers–PrinciplesofCorporateFinance

10. KeithPilbeam–InternationalFinance.

11. KalmanJ.Cohen&Cyert–TheoryoftheFirm.

12. Chatterzee–LinearProgrammingandGameTheory.

13. StevenD.Lewitt&Duvner,SuperFreakonomics

BooksonNobelEconomists:

1. ShakeltonandLoksley,TwelveContemporaryEconomists,MacmillanPress,London,1981

2. LeonardSilk,TheEconomists,AVONBooks,NewYark.

3. MichelSzenberg,EminentEconomists,CambridgeUniversityPress,1992.

4. WilliamBreit&B.T.Hirsch,ed.LivesoftheLaureates.

5. Dr.P.R.Brahmananda,NobelEconomics,HimalayaPublishingHouse,Mumbai.

6. Stevenpressman,FiftyGreatEconomists,FoundationBooks.Delhi

7. MichaelLewis,TheRealPriceofEverything(Strand)

AbouttheAuthorV.T.Naidu

Born:20th,Aug1935inBangarammaPeta,Salur,V.Z.M.Dist.(A.P)

Education:M.A.Economics,April1956(AndhraUniversity)M.A.Economic-Stats.Apr.1958(DelhiSchoolofEconomics,DelhiUniversity)Phd.Economics,1966(S.V.University,Tirupati)Non-Degree,1966-67(UniversityofWisconsin,Madison,U.S.A)

Teaching:FacultymemberofEconomicsinS.V.University(1960-75)andinBangaloreUniversity(1970-71)andProfessorofRural–DevelopmentinS.KUniversity,Ananthapur(1975-1995)

Publications:FarmCreditandCooperativesinIndia,VoraandCo.Bombay,1968and40articlesinJournalsandPeriodicals.

AdministrativeWork:HeadoftheDepartmentofRuralDevelopmentandSociology,DeanofArts.PrincipalofS.KUniversityCollegeandRectorofS.K.University.

Awards:1)SelectedforFull-BrightandSmith-MundtFellowshipforStudyinUSAduring1966-67

2)SelectedbytheStateofAndhraPradeshfor“BestTeacher”awardforCollegeandUniversityTeachersin1983-84.