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  • Writer's pictureRachana Kadikar

Important Economic Concepts Pt. 1

Laissez-faire Economic Theory - The Laissez-faire economic system is one in which there is a free market with no interventions such as regulations, taxes, or subsidies. Developed by Adam Smith in the 1700s, this economic system relies on the fact that individuals pursuing their own interests leads to a self-regulating economy that ultimately creates economic growth. Free-market capitalism relies on laissez-faire economics, but ultimately, this system promotes inequality and poverty, as regulations and policies aren't put in place to help those who desperately need assistance.

Adverse Selection - Free market economics relies heavily on the fact that information is equal, and therefore people can make their decisions with the highest utility given all the options available to them. However, adverse selection outlines a common realistic scenario in which buyers and sellers don't have the same information, leading to transactions that aren't ideal for one party.

Public Choice Theory - Public choice theory takes economic concepts about how people make decisions in markets, and applies them to political decision-making. Instead of employers or consumers like in economics, public choice theory replaces the primary decision-making subjects with politicians, lobbyists, and bureaucrats.

Multiplier Effect - The proportional change in supply, whether it be money supply or income, that occurs when money is injected or withdrew. The money multiplier can be calculated by doing 1/(reserve requirement ratio). The Keynesian multiplier can be calculated by doing 1/(marginal propensity to save) or 1/(1-marginal propensity to consume).

Duopoly - A form of oligopoly in which two firms have significant control over a market for a certain good or service. Duopolies are typically interdependent firms, meaning that the decisions one firm makes is dependent on that of their competitor. Well-known examples of duopolies are Coca-Cola and Pepsi or Visa and Mastercard.

Consumer Sovereignty - Consumer sovereignty outlines a situation in which consumers have power over which goods are produced and that individual consumers are the best judge of what they need to maximize their own welfares. The basic idea underlying consumer sovereignty is that consumer demand drives the decisions behind which goods and services are produced.

Laffer Curve - This supply-side graph demonstrates the relationship between tax rates and tax revenue for the government. The graph takes on a backwards-C or downward facing parabola shape, in which 0% and 100% tax rates both yield 0 tax revenue. As tax rates initially increase from 0%, they experience increasing rates of change of revenue, and then reach a maximum and go down after this prohibitive rate. However, the theory behind the Laffer curve has been criticized for being overly simplistic in its depiction. In reality, there is more than one tax rate that contributes to government revenue and the curve doesn't take into account tax avoidance when calculating the points.

New Classical Theory - An economic school of thought built on classical economics that also emphasizes the importance of outside social factors on top of physical and economic needs on workers' decisions. The basic idea behind this theory is that the correct amounts of labor, capital, and technology will lead to a steady economic growth rate.

New Growth Theory - Declares that economic growth (measured by real gross domestic product) will forever increase because human's unlimited wants and desires will push them to pursue profits and increased productivity. Fundamental to the probability of this theory is adequate entrepreneurship, knowledge, innovation, and technology.

Dependency Theory - This development theory explains that despite investments from industrialized countries, non-industrialized still remain in worse off positions due to unequal distributions of power and resources because of colonialism. Neocolonialism promotes the domination of developed countries over those that are more developing through several mediums such as economic pressure and oppressive political choices.

Linear Growth Theories - Walt Rostow, an advocate for free market capitalism, outlined developmental stages that countries go through to transition from traditional societies to developed societies and achieve economic growth. These stages in order were traditional society, pre-take-off stage, take-off stage, drive to maturity, and the mass consumption stage.

Wealth Effect - When people perceive that they have higher amounts of wealth due to factors such as changes in price levels or higher stock prices, they are likely to spend more on non-essential items, which leads to rising inflation rates due to increases in aggregate demand.

Tobin Taxes - The tobin tax is a tax placed when currency is exchanged with a goal of penalizing those who try to make profits off of short-term currency trading. Governments can take advantage of this tax to make small amounts of money from the currency transactions that occur within the country.

Moral Hazard - When a party has incentives to engage in riskier behavior if it doesn't bear the full consequences of the risks taken. An example of this that we can see commonly play out in reality is people taking more risks with their goods backed up by insurance because they have comfort because worst case, their insurance will cover the damage.

Quasi-Public Goods - Quasi-public goods are those that are public, but theoretically could be restricted. Examples of these goods are roads and Wi-Fi. Normal public goods on the other hand cannot be excludable — ex. clean air.

Giffen Goods - Typically, the law of demand outlines that as the price of a good increases, the quantity demanded for that good will decline. Giffen goods are an exception to this law — as the price rises for a Giffen good, the quantity demanded also increases, creating an upward sloping demand curve. Giffen goods are commonly inferior goods in the minds of customers, so when the price increases, people are paradoxically more likely to buy it since their attitudes toward buying it changes.

Transfer Pricing - Transfer pricing outlines the rules for pricing transactions both between businesses under the same owners. These rules are put in place to avoid loopholes that alter taxable incomes through controlled transactions within a company. Countries with transfer pricing in place typically follow the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations.

Ad-valorem tax - An ad-valorem tax is one that changes based on the value of the good that it is taxing -- ex. a sales tax or value-added tax.

Fiscal drag - Occurs when the government's net fiscal transactions don't cover the amount the private economy saves due to lack of spending or excess taxation. This results in lesser aggregate demand, which leads to deflationary pressures on the economy.

Demerit Good - A good that supposedly has negative impacts on the consumer of the good that could be over-consumed if simply left to market forces. Common examples of demerit goods include cigarettes, alcohol, junk food, etc.

Monopsony - A monopoly for the factor market -- there exists only one buyer of the factors of production in a market. Since monopsonies have significant market power, they can offer lower wages than a competitive labor market would offer, causing inefficiencies in the market. In monopsonies, the labor supply is upward sloping, with a marginal factor cost lying above it.

Zero Hour Contracts - A contract between an employer and an employee in which the employer is not obligated to supply any minimum working hours, and the employee doesn't have to accept all tasks proposed to them.

Wage Differentials - Refers to differences in wage rates because of the varying factors such as location, hours, working conditions, type of product, and other similar factors.

Price Elasticity of Demand (PED) - A metric for how price-sensitive the quantity demanded of a good is. Determines if a good is relatively or perfectly elastic or inelastic. If the absolute value is less than 1, the good is relatively inelastic. If the absolute value is exactly 1, the good is unit elastic. If the value is greater than 1, then the good is relatively elastic. It can be measured by calculating:

Price Elasticity of Supply (PES) - A metric to describe the responsiveness of a good or service's quantity supplied in response to a change in its price. If the absolute value is less than 1, the good is relatively inelastic. If the absolute value is exactly 1, the good is unit elastic. If the value is greater than 1, then the good is relatively elastic. It can be measured by calculating:

Income Elasticity of Demand (YED) - The degree to which the quantity demanded for a particular good responds to changes in consumer income. If the value is positive, the good is normal, and inferior if negative. It can be measured by calculating:

Cross Price Elasticity of Demand - Ceteris paribus, it compares the percentage change in the quantity demanded for one product to the percentage change in the price of another. If the value is positive, the two goods are substitutes, and if the value is negative, the two goods are complements. It can be measured by calculating:

The Long Tail - A business approach that allows firms to make big profits by selling small quantities of difficult-to-find products to a large number of consumers rather than selling huge quantities of a small number of popular items.

Pareto Efficiency - An economic state in which resources cannot be transferred to benefit one individual without harming at least one other.

Trade Diversion - By forming a free trade agreement or a customs union, commerce is redirected from a more efficient exporter to a less efficient one. Because of the low tariff, the total cost of goods decreases while trading inside the agreement.

Rotterdam Effect - When commerce moves through ports on its route to final destinations outside of the country or trading block, there can be mistakes in the way trade is computed.

Economic Indicators: Allows analysis of economic performance and predictions of future performance. Some important ones include GDP, Price Level, and Unemployment Rate.

Capital Flight - Happens when assets or money move out of a nation quickly as a result of a major economic event or as a result of globalization. A rise in taxes on capital or capital holders could be the cause of one of these occurrences.

Progressive Taxation - A type of tax in which the tax rate rises as the amount of taxable income rises.

Proportional Taxation - A type of tax in which the tax rate remains constant regardless of whether the taxable base amount grows or lowers. The tax is proportional to the amount that is subject to taxes.

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