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Stop-Loss Order

Stop-Loss Order: "Stop-Loss Order
What does it Mean? An order placed with a broker to sell a security when it reaches a certain price. It is designed to limit an investor's loss on a security position.

Also known as a "stop order" or "stop-market order".
Investopedia Says... In other words, setting a stop-loss order for 10% below the price you paid for the stock would limit your loss to 10%.

It's also a great idea to use a stop order before you leave for holidays or enter a situation in which you will be unable to watch your stocks for an extended period of time.

Stop-Loss Order

Stop-Loss Order: "Stop-Loss Order
What does it Mean? An order placed with a broker to sell a security when it reaches a certain price. It is designed to limit an investor's loss on a security position.

Also known as a "stop order" or "stop-market order".
Investopedia Says... In other words, setting a stop-loss order for 10% below the price you paid for the stock would limit your loss to 10%.

It's also a great idea to use a stop order before you leave for holidays or enter a situation in which you will be unable to watch your stocks for an extended period of time.

Short Selling

Short Selling: "Short Selling
What does it Mean? The selling of a security that the seller does not own, or any sale that is completed by the delivery of a security borrowed by the seller. Short sellers assume that they will be able to buy the stock at a lower amount than the price at which they sold short.
Investopedia Says... Selling short is the opposite of going long. That is, short sellers make money if the stock goes down in price.

This is an advanced trading strategy with many unique risks and pitfalls. Novice investors are advised to avoid short sales.

Chartered Financial Analyst (CFA)

Chartered Financial Analyst (CFA): "Chartered Financial Analyst (CFA)
What does it Mean? A professional designation given by the CFA Institute (formerly AIMR) that measures the competence and integrity of financial analysts. Candidates are required to pass three levels of exams covering areas such as accounting, economics, ethics, money management and security analysis.
Investopedia Says... Before you can become a CFA charterholder, you must have a minimum of three years of investment/financial experience. To enroll in the program, you must hold a bachelor's degree.

Earnings Per Share (EPS)

Earnings Per Share (EPS): "Earnings Per Share (EPS)
What does it Mean? The portion of a company's profit allocated to each outstanding share of common stock. EPS serves as an indicator of a company's profitability.

Calculated as:

In the EPS calculation, it is more accurate to use a weighted-average number of shares outstanding over the reporting term, because the number of shares outstanding can change over time. However, data sources sometimes simplify the calculation by using the number of shares outstanding at the end of the period.

Diluted EPS expands on the basic EPS by including the shares of convertibles or warrants outstanding in the outstanding shares number.
Investopedia Says... Earnings per share is generally considered to be the single most important variable in determining a share's price. It is also a major component of the price-to-earnings valuation ratio.

For example, assume that a company has a net income of $25 million. If the company paid out $1 million in preferred dividends and had 10 million shares for one half of the year and 15 million shares for the other half, the EPS would be $1.92 (24/12.5). First, the $1 million is deducted from the net income to get $24 million. Then a weighted average is taken to find the number of shares outstanding (0.5 x 10M+ 0.5 x 15M = 12.5M).

An important aspect of EPS that's often ignored is the capital that is required to generate the earnings (net income) in the calculation. Two companies could generate the same EPS number, but one could do so with less equity (investment) - that company would be more efficient at using its capital to generate income and, all other things being equal, would be a "better" company. Investors also need to be aware of earnings manipulation that will affect the quality of the earnings number. It is important not to rely on any one financial measure, but to use it in conjunction with statement analysis and other measures.

Generally Accepted Accounting Principles (GAAP)

Generally Accepted Accounting Principles (GAAP): "Generally Accepted Accounting Principles (GAAP)
What does it Mean? The common set of accounting principles, standards and procedures that companies use to compile their financial statements. GAAP are a combination of authoritative standards (set by policy boards) and simply the commonly accepted ways of recording and reporting accounting information.
Investopedia Says... GAAP are imposed on companies so that investors have a minimum level of consistency in the financial statements they use when analyzing companies for investment purposes. GAAP cover such things as revenue recognition, balance sheet item classification and outstanding share measurements. Companies are expected to follow GAAP rules when reporting their financial data via financial statements. If a financial statement is not prepared using GAAP principles, be very wary!

That said, keep in mind that GAAP is only a set of standards. There is plenty of room within GAAP for unscrupulous accountants to distort figures. So, even when a company uses GAAP, you still need to scrutinize its financial statements.

Price-Earnings Ratio (P/E Ratio)

Price-Earnings Ratio (P/E Ratio): "Price-Earnings Ratio (P/E Ratio)
What does it Mean? A valuation ratio of a company's current share price compared to its per-share earnings.

Calculated as:

For example, if a company is currently trading at $43 a share and earnings over the last 12 months were $1.95 per share, the P/E ratio for the stock would be 22.05 ($43/$1.95).

EPS is usually from the last four quarters (trailing P/E), but sometimes it can be taken from the estimates of earnings expected in the next four quarters (projected or forward P/E). A third variation uses the sum of the last two actual quarters and the estimates of the next two quarters.

Also sometimes known as "price multiple" or "earnings multiple".
Investopedia Says... In general, a high P/E suggests that investors are expecting higher earnings growth in the future compared to companies with a lower P/E. However, the P/E ratio doesn't tell us the whole story by itself. It's usually more useful to compare the P/E ratios of one company to other companies in the same industry, to the market in general or against the company's own historical P/E. It would not be useful for investors using the P/E ratio as a basis for their investment to compare the P/E of a technology company (high P/E) to a utility company (low P/E) as each industry has much different growth prospects.

The P/E is sometimes referred to as the "multiple", because it shows how much investors are willing to pay per dollar of earnings. If a company were currently trading at a multiple (P/E) of 20, the interpretation is that an investor is willing to pay $20 for $1 of current earnings.

It is important that investors note an important problem that arises with the P/E measure, and to avoid basing a decision on this measure alone. The denominator (earnings) is based on an accounting measure of earnings that is susceptible to forms of manipulation, making the quality of the P/E only as good as the quality of the underlying earnings number.

Compound Annual Growth Rate (CAGR)

Compound Annual Growth Rate (CAGR): "Compound Annual Growth Rate (CAGR)
What does it Mean? The year-over-year growth rate of an investment over a specified period of time.

The compound annual growth rate is calculated by taking the nth root of the total percentage growth rate, where n is the number of years in the period being considered.

This can be written as follows:

Investopedia Says... CAGR isn't the actual return in reality. It's an imaginary number that describes the rate at which an investment would have grown if it grew at a steady rate. You can think of CAGR as a way to smooth out the returns.

Don't worry if this concept is still fuzzy to you - CAGR is one of those terms best defined by example. Suppose you invested $10,000 in a portfolio on Jan 1, 2005. Let's say by Jan 1, 2006, your portfolio had grown to $13,000, then $14,000 by 2007, and finally ended up at $19,500 by 2008.

Your CAGR would be the ratio of your ending value to beginning value ($19,500 / $10,000 = 1.95) raised to the power of 1/3 (since 1/# of years = 1/3), then subtracting 1 from the resulting number:

1.95 raised to 1/3 power = 1.2493. (This could be written as 1.95^0.3333).
1.2493 - 1 = 0.2493
Another way of writing 0.2493 is 24.93%.

Thus, your CAGR for your three-year investment is equal to 24.93%, representing the smoothed annualized gain you earned over your investment time horizon.

Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA)

Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA): "Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA)
What does it Mean? An indicator of a company's financial performance which is calculated as follows:

EBITDA can be used to analyze and compare profitability between companies and industries because it eliminates the effects of financing and accounting decisions. However, this is a non-GAAP measure that allows a greater amount of discretion as to what is (and is not) included in the calculation. This also means that companies often change the items included in their EBITDA calculation from one reporting period to the next.
Investopedia Says... EBITDA first came into common use with leveraged buyouts in the 1980s, when it was used to indicate the ability of a company to service debt. As time passed, it became popular in industries with expensive assets that had to be written down over long periods of time. EBITDA is now commonly quoted by many companies, especially in the tech sector - even when it isn't warranted.

A common misconception is that EBITDA represents cash earnings. EBITDA is a good metric to evaluate profitability, but not cash flow. EBITDA also leaves out the cash required to fund working capital and the replacement of old equipment, which can be significant. Consequently, EBITDA is often used as an accounting gimmick to dress up a company's earnings. When using this metric, it's key that investors also focus on other performance measures to make sure the company is not trying to hide something with EBITDA.

List of Venture Capital / Underwriting / IPOs Terms

List of Venture Capital / Underwriting / IPOs Terms: "Venture Capital / Underwriting / IPOs"

List of Technical Analysis Terms

List of Technical Analysis Terms: "Technical Analysis"

List of Taxes Terms

List of Taxes Terms: "Taxes"

BusinessDictionary.com - Term of the Day

BusinessDictionary.com - Term of the Day: "Term of the Day"

Economics A-Z | Economist.com

Economics A-Z | Economist.com: " C * D * E * F * G * H * I * J * K * L * M * N * O * P * Q * R * S * T * U * V * W * X * Y * Z"

Economics A-Z | Economist.com

Economics A-Z | Economist.com: "Buyer's market A market in which supply seems plentiful and prices seem low; the opposite of a seller's market."

Economics A-Z | Economist.com

Economics A-Z | Economist.com: "

Business cycle

Boom and bust. The long-run pattern of economic growth and recession. According to the Centre for International Business Cycle Research at Columbia University, between 1854 and 1945 the average expansion lasted 29 months and the average contraction 21 months. Since the second world war, however, expansions have lasted almost twice as long, an average of 50 months, and contractions have shortened to an average of only 11 months. Over the years, economists have produced numerous theories of why economic activity fluctuates so much, none of them particularly convincing. A Kitchin cycle supposedly lasted 39 months and was due to fluctuations in companies' inventories. The Juglar cycle would last 8—9 years as a result of changes in investment in plant and machinery. Then there was the 20-year Kuznets cycle, allegedly driven by house-building, and, perhaps the best-known theory of them all, the 50-year kondratieff wave. hayek tangled with keynes over what caused the business cycle, and won the nobel prize for economics for his theory that variations in an economy's output depended on the sort of capital it had. Taking a quite different tack, in the late 1960s Arthur Okun, an economic adviser to presidents Kennedy and Johnson, proclaimed that the business cycle was "obsolete". A year later, the American economy was in recession. Again, in the late 1990s, some economists claimed that technological innovation and globalisation meant that the business cycle was a thing of the past. Alas, they were soon proved wrong.


Economics A-Z | Economist.com

Economics A-Z | Economist.com: "Business confidence How the people who run companies feel about their organisations' prospects. In many countries, surveys measure average business confidence. These can provide useful signs about the current condition of the economy, because companies often have information about consumer demand sooner than government statisticians do."

Economics A-Z | Economist.com

Economics A-Z | Economist.com: "Bull An investor who expects the price of a particular security to rise; the opposite of a bear."

Economics A-Z | Economist.com

Economics A-Z | Economist.com: "Budget An annual procedure to decide how much public spending there should be in the year ahead and what mix of taxation, charging for services and borrowing should finance it. The budgeting process differs enormously from one country to another. In the United States, for example, the president proposes a budget in February for the fiscal year starting the following October, but this has to be approved by Congress. By the time a final decision has to be made, ideally, no later than September, there are often three competing versions: the president's latest proposal, one from the Senate and another from the House of Representatives. What finally emerges is the result of last-minute negotiations. Occasionally, delays in agreeing the budget have led to the temporary closure of some federal government offices. Contrast this with the UK, where most of what the government proposes is usually approved by parliament, and some changes take effect as soon as they are announced (subject to subsequent parliamentary vote)."

Economics A-Z | Economist.com

Economics A-Z | Economist.com: "Bubble When the price of an asset rises far higher than can be explained by fundamentals, such as the income likely to derive from holding the asset. The Chicago Tribune of April 13th 1890, writing about the then mania in real-estate prices, described 'men who bought property at prices they knew perfectly well were fictitious, but who were prepared to pay such prices simply because they knew that some still greater fool could be depended on to take the property off their hands and leave them with a profit'. Such behaviour is a feature of all bubbles. Famous bubbles include tulip mania in Holland during the 17th century, when the prices of tulip bulbs reached unheard of levels, and the South Sea Bubble in Britain a century later, although there have been many others since, including the dotcom bubble in internet company shares that burst in 2000. Economists argue about whether bubbles are the result of irrational crowd behaviour (perhaps coupled with exploitation of the gullible masses by some savvy speculators) or, instead, are the result of rational decisions by people who have only limited information about the fundamental value of an asset and thus for whom it may be quite sensible to assume the market price is sound. Whatever their cause, bubbles do not last forever and often end not with a pop but with a crash."

Economics A-Z | Economist.com

Economics A-Z | Economist.com: "Bretton woods A conference held at Bretton Woods, New Hampshire, in 1944, which designed the structure of the international monetary system after the second world war and set up the imf and the world bank. It was agreed that the exchange rates of IMF members would be pegged to the dollar, with a maximum variation of 1% either side of the agreed rate. Rates could be adjusted more sharply only if a country's balance of payments was in fundamental disequilibrium. In August 1971 economic troubles and the cost of financing the Vietnam war led the American president, Richard Nixon, to devalue the dollar. This shattered confidence in the fixed exchange rate system and by 1973 all of the main currencies were floating freely, at rates set mostly by market forces rather than government fiat."

Economics A-Z | Economist.com

Economics A-Z | Economist.com: "Brand The stalking-horse for international capitalism. A focus for all the worries about environmental damage, human-rights abuses and sweated labour that opponents of globalisation like to put on their placards. A symbol of America's corporate power, since most of the world's best-known brands, from Coca Cola to Nike, are American. That is the case against. Many economists regard brands as a good thing, however. A brand provides a guarantee of reliability and quality. Consumer trust is the basis of all brand values. So companies that own the brands have an immense incentive to work to retain that trust. Brands have value only where consumers have choice. The arrival of foreign brands, and the emergence of domestic brands, in former communist and other poorer countries points to an increase in competition from which consumers gain. Because a strong brand often requires expensive advertising and good marketing, it can raise both price and barriers to entry. But not to insurperable levels: brands fade as tastes change; if quality is not maintained, neither is the brand."

Economics A-Z | Economist.com

Economics A-Z | Economist.com: "Bounded rationality A theory of human decision making that assumes that people behave rationally, but only within the limits of the information available to them. Because their information may be inadequate (bounded) they make take decisions that appear to be irrational according to traditional theories about homo economicus (economic man). (See also behavioural economics.)"

Economics A-Z | Economist.com

Economics A-Z | Economist.com: "Bonds 'Gentlemen prefer bonds,' punned Andrew Mellon, an American tycoon. A bond is an interest-bearing security issued by governments, companies and some other organisations. Bonds are an alternative way for the issuer to raise capital to selling shares or taking out a bank loan. Like shares in listed companies, once they have been issued bonds may be traded on the open market. A bond's yield is the interest rate (or coupon) paid on the bond divided by the bond's market price. Bonds are regarded as a lower risk investment. government bonds, in particular, are highly unlikely to miss their promised payments. Corporate bonds issued by blue-chip 'investment grade' companies are also unlikely to default; this might not be the case with high-yield 'junk' bonds issued by firms with less healthy financials. (See yield curve.)"

Economics A-Z | Economist.com

Economics A-Z | Economist.com: "Black-scholes A formula for pricing financial options. Its invention allowed a previously undreamed of precision in the pricing of options (which had hitherto been done using crude rules of thumb), and probably made possible the explosive growth in the markets for options and other derivatives that took place after the formula became widely used in the early 1970s. Myron Scholes and Robert Merton were awarded the nobel prize for economics for their part in devising the formula; their co-inventor, Fischer Black (1938—95), was ineligible, having died."

Economics A-Z | Economist.com

Economics A-Z | Economist.com: "Black economy If you pay your cleaner or builder in cash, or for some reason neglect to tell the taxman that you were paid for a service rendered, you participate in the black or underground economy. Such transactions do not normally show up in the figures for GDP, so the black economy may mean that a country is much richer than the official data suggest. In the United States and the UK, the black economy adds an estimated 5—10% to GDP; in Italy, it may add 30%. As for Russia, in the late 1990s estimates of the black economy ranged as high as 50% of GDP."

Economics A-Z | Economist.com

Economics A-Z | Economist.com: "Big mac index The Big Mac index was devised by Pam Woodall of The Economist in 1986, as a light-hearted guide to whether currencies are at their 'correct' level. It is based on one of the oldest concepts in international economics, purchasing power parity (PPP), the notion that a dollar, say, should buy the same amount in all countries. In the long run, argue ppp fans, currencies should move towards the exchange rate, which equalises the prices of an identical basket of goods and services in each country. In this case, the basket is a McDonalds' Big Mac, which is produced in more than 100 countries. The Big Mac PPP is the exchange rate that would leave hamburgers costing the same in the United States as elsewhere. Comparing actual exchange rates with PPP signals whether a currency is undervalued or overvalued. Some studies have found that the Big Mac index is often a better predictor of currency movements than more theoretically rigorous models."

Economics A-Z | Economist.com

Economics A-Z | Economist.com: "Beta Part of an economic theory for valuing financial securities and calculating the cost of capital, known as the capital asset pricing model, beta measures the sensitivity of the price of a particular asset to changes in the market as a whole. If a company's shares have a beta of 0.8 it implies that on average the share price will change by 0.8% if there is a 1% change in the market. There is a long-running debate about whether a beta calculated from a security's past relationship with the market actually predicts how that relationship will behave in future, leading some doubting economists to claim that beta is 'dead'."

Economics A-Z | Economist.com

Economics A-Z | Economist.com: "

Behavioural economics

A branch of economics that concentrates on explaining the economic decisions people make in practice, especially when these conflict with what conventional economic theory predicts they will do. Behaviourists try to augment or replace traditional ideas of economic rationality (homo economicus) with decision-making models borrowed from psychology. According to psychologists, people are disproportionately influenced by a fear of feeling regret and will often forgo benefits even to avoid only a small risk of feeling they have failed. They are also prone to cognitive dissonance, often holding on to a belief plainly at odds with new evidence, usually because the belief has been held and cherished for a long time. Then there is anchoring: people are often overly influenced by outside suggestion. People apparently also suffer from status quo bias: they are willing to take bigger gambles to maintain the status quo than they would be to acquire it in the first place.

Traditional utility theory assumes that people make individual decisions in the context of the big picture. But psychologists have found that they generally compartmentalise, often on superficial grounds. They then make choices about things in one particular mental compartment without taking account of the implications for things in other compartments.

There is lots of evidence that people are persistently and irrationally overconfident. They are also vulnerable to hindsight bias: once something happens they overestimate the extent to which they could have predicted it. Many of these traits are captured in prospect theory, which is at the heart of much of behavioural economics.


Economics A-Z | Economist.com

Economics A-Z | Economist.com: "Bear An investor who thinks that the price of a particular security or class of securities (shares, say) is going to fall; the opposite of a bull."

Economics A-Z | Economist.com

Economics A-Z | Economist.com: "Basis point One one-hundredth of a percentage point. Small movements in the interest rate, the exchange rate and bond yields are often described in terms of basis points. If a bond yield moves from 5.25% to 5.45%, it has risen by 20 basis points."

Economics A-Z | Economist.com

Economics A-Z | Economist.com: "

Basel 1 and 2

An attempt to reduce the number of bank failures by tying a bank's capital adequacy ratio to the riskiness of the loans it makes. For instance, there is less chance of a loan to a government going bad than a loan to, say, an internet business, so the bank should not have to hold as much capital in reserve against the first loan as against the second. The first attempt to do this worldwide was by the Basel committee for international banking supervision in 1988. However, its system of judging the relative riskiness of different loans was crude. For instance, it penalised banks no more for making loans to a fly-by-night software company in Thailand than to Microsoft; no more for loans to South Korea, bailed out by the IMF in 1998, than to Switzerland. In 1998, "Basel 2" was proposed, using much more sophisticated risk classifications. However, controversy over these new classifications, and the cost to banks of administering the new approach, led to the introduction of Basel 2 being delayed until (at least) 2005.


Economics A-Z | Economist.com

Economics A-Z | Economist.com: "Barter Paying for goods or services with other goods or services, instead of with money. It is often popular when the quality of money is low or uncertain, perhaps because of high inflation or counterfeiting, or when people are asset-rich but cash-poor, or when taxation or extortion by criminals is high. Little wonder, then, that barter became popular in Russia during the late 1990s."

Economics A-Z | Economist.com

Economics A-Z | Economist.com: "

Barriers to entry (or exit)

How firms keep out competition--an important source of incumbent advantage. There are four main sorts of barriers.

*A firm may own a crucial resource, such as an oil well, or it may have an exclusive operating licence, for instance, to broadcast on a particular radio wavelength.

*A big firm with economies of scale may have a significant competitive advantage because it can produce a large output at lower costs than can a smaller potential rival.

*An incumbent firm may make it hard for a would-be entrant by incurring huge sunk costs, spending lots of money on things such as advertising, which any rival must match to compete effectively but which have no value if the attempt to compete should fail.

*Powerful firms can discourage entry by raising exit costs, for example, by making it an industry norm to hire workers on long-term contracts, which make firing an expensive process.


Economics A-Z | Economist.com

Economics A-Z | Economist.com: "Bankruptcy When a court judges that a debtor is unable to make the payments owed to a creditor. How bankrupts are treated can affect economic growth. If bankrupts are punished too severely, would-be entrepreneurs may be discouraged from taking the financial risks needed to make the most of their ideas. However, letting off defaulting debtors too readily may discourage potential creditors because of moral hazard. America's bankruptcy code, in particular its Chapter 11 protection for firms from their creditors, is particularly friendly to troubled borrowers, allowing them to borrow more money and giving them time to work out their problems. Some other countries quickly close down a bankrupt firm, and try to repay its debts by selling off any assets it has."

Economics A-Z | Economist.com

Economics A-Z | Economist.com: "


Starting out as places that would guard your money, banks became the main source of credit creation. Increasingly, however, borrowers are turning to the financial markets and to non-savings institutions, such as credit-card companies and consumer-finance firms, when they need a loan. This is reducing the profitability of traditional bank lending and has led many banks to enter new areas of business, such as selling insurance policies and mutual funds. Increasingly, too, traditional banks are selling off parcels of their loans in the financial markets by a process called securitisation.

What the most efficient split is between bank lending and other sorts of lending is debatable. Economists argue endlessly about whether an economy such as the United States, in which firms rely more heavily on the equity and debt markets than on banks to fund their investment, is better than one such as, say, Germany, in which banks have traditionally been the main source of corporate finance.

Banks come in many different forms. Commercial banks, also known as retail banks, cater directly for the general public and lend to (mostly small and medium-sized) firms. In the past, they did so largely through a network of bank branches, although increasingly these are giving way to atm machines, the telephone and the Internet. Wholesale banks largely transact with other banks and financial institutions. Investment banks, also known as merchant banks, concentrate on raising money for companies from private investors or in the financial markets, by finding buyers for their equity and corporate bonds. Universal banks do most or all of the above including, through bancassurance, selling insurance. These banks have long been a feature of continental European economies. However, in the United States financial laws such as the Glass-Steagall Act have separated different forms of banking from each other and kept banks out of the insurance business. These laws were abolished in 1999, although during the preceding couple of decades regulators effectively dismantled them by changing the way they were applied. Even so, because of these and other laws, which for many years stopped banks from operating across state borders, the United States has far more lending institutions than other countries. In 2003 there were over four lending institutions per 100,000 people in the United States, compared with fewer than one per 100,000 in the UK and France.


Economics A-Z | Economist.com

Economics A-Z | Economist.com: "Balanced budget When total public-sector spending equals total government income during the same period from taxes and charges for public services. Politicians in some countries, such as the United States, have argued that government should be required to run a balanced budget in order to have sound public finances. However, there is no economic reason why public borrowing need necessarily be bad. For instance, if the debt is used to invest in things that will increase the growth rate of the economy--infrastructure, say, or education--it may be justified. It may also make more economic sense to try to balance the budget on average over an entire economic cycle, with public-sector deficits boosting the economy during recession and surpluses stopping it overheating during booms, than to balance it every year."

Economics A-Z | Economist.com

Economics A-Z | Economist.com: "

Balance of payments

The total of all the money coming into a country from abroad less all of the money going out of the country during the same period. This is usually broken down into the current account and the capital account. The current account includes:

*visible trade (known as merchandise trade in the United States), which is the value of exports and imports of physical goods;

*invisible trade, which is receipts and payments for services, such as banking or advertising, and other intangible goods, such as copyrights, as well as cross-border dividend and interest payments;

*private transfers, such as money sent home by expatriate workers;

*official transfers, such as international aid.

The capital account includes:

*long-term capital flows, such as money invested in foreign firms, and profits made by selling those investments and bringing the money home;

*short-term capital flows, such as money invested in foreign currencies by international speculators, and funds moved around the world for business purposes by multinational companies. These short-term flows can lead to sharp movements in exchange rates, which bear little relation to what currencies should be worth judging by fundamental measures of value such as purchasing power parity.

As bills must be paid, ultimately a country's accounts must balance (although because real life is never that neat a balancing item is usually inserted to cover up the inconsistencies).

"Balance of payments crisis" is a politically charged phrase. But a country can often sustain a current account deficit for many years without its economy suffering, because any deficit is likely to be tiny compared with the country's national income and wealth. Indeed, if the deficit is due to firms importing technology and other capital goods from abroad, which will improve their productivity, the economy may benefit. A deficit that has to be financed by the public sector may be more problematic, particularly if the public sector faces limits on how much it can raise taxes or borrow or has few financial reserves. For instance, when the Russian government failed to pay the interest on its foreign debt in August 1998 it found it impossible to borrow any more money in the international financial markets. Nor was it able to increase taxes in its collapsing economy or to find anybody within Russia willing to lend it money. That truly was a balance of payments crisis.

In the early years of the 21st century, economists started to worry that the United States would find itself in a balance of payments crisis. Its current account deficit grew to over 5% of its GDP, making its economy increasingly reliant on foreign credit.


Economics A-Z | Economist.com

Economics A-Z | Economist.com: "Backwardation When a commodity is valued more highly in a spot market (that is, when it is for delivery today) than in a futures market (for delivery at some point in the future). Normally, interest costs mean that futures prices are higher than spot prices, unless the markets expect the price of the commodity to fall over time, perhaps because there is a temporary bottleneck in supply. When spot prices are lower than futures prices it is known as contango."

Microeconomics - Wikipedia, the free encyclopedia

Microeconomics - Wikipedia, the free encyclopedia: "

Microeconomics (or price theory) is a branch of economics that studies how individuals, households, and firms make decisions to allocate limited resources,[1] typically in markets where goods or services are being bought and sold.

Microeconomics examines how these decisions and behaviours affect the supply and demand for goods and services, which determines prices, and how prices, in turn, determine the supply and demand of goods and services.[2][3]

Macroeconomics, on the other hand, involves the "sum total of economic activity, dealing with the issues of growth, inflation, and unemployment and with national economic policies relating to these issues"[4] and the effects of government actions (e.g., changing taxation levels) on them.[5] Particularly in the wake of the Lucas critique, much of modern macroeconomic theory has been built upon 'microfoundations' — i.e. based upon basic assumptions about micro-level behaviour.



[edit] Overview

One of the goals of microeconomics is to analyze market mechanisms that establish relative prices amongst goods and services and allocation of limited resources amongst many alternative uses. Microeconomics analyzes market failure, where markets fail to produce efficient results, as well as describing the theoretical conditions needed for perfect competition. Significant fields of study in microeconomics include general equilibrium, markets under asymmetric information, choice under uncertainty and economic applications of game theory. Also considered is the elasticity of products within the market system.

[edit] Assumptions and definitions

The theory of supply and demand usually assumes that markets are perfectly competitive. This implies that there are many buyers and sellers in the market and none of them have the capacity to significantly influence prices of goods and services. In many real-life transactions, the assumption fails because some individual buyers or sellers or groups of buyers or sellers do have the ability to influence prices. Quite often a sophisticated analysis is required to understand the demand-supply equation of a good. However, the theory works well in simple situations.

Mainstream economics does not assume a priori that markets are preferable to other forms of social organization. In fact, much analysis is devoted to cases where so-called market failures lead to resource allocation that is suboptimal by some standard (highways are the classic example, profitable to all for use but not directly profitable for anyone to finance). In such cases, economists may attempt to find policies that will avoid waste directly by government control, indirectly by regulation that induces market participants to act in a manner consistent with optimal welfare, or by creating "missing markets" to enable efficient trading where none had previously existed. This is studied in the field of collective action. It also must be noted that "optimal welfare" usually takes on a Paretian norm, which in its mathematical application of Kaldor-Hicks Method, does not stay consistent with the Utilitarian norm within the normative side of economics which studies collective action, namely public choice. Market failure in positive economics (microeconomics) is limited in implications without mixing the belief of the economist and his or her theory.

The demand for various commodities by individuals is generally thought of as the outcome of a utility-maximizing process. The interpretation of this relationship between price and quantity demanded of a given good is that, given all the other goods and constraints, this set of choices is that one which makes the consumer happiest.

[edit] Modes of operation

It is assumed that all firms are following rational decision-making, and will produce at the profit-maximizing output. Given this assumption, there are four categories in which a firm's profit may be considered.

  • A firm is said to be making an economic profit when its average total cost is less than the price of each additional product at the profit-maximizing output. The economic profit is equal to the quantity output multiplied by the difference between the average total cost and the price.
  • A firm is said to be making a normal profit when its economic profit equals zero. This occurs where average total cost equals price at the profit-maximizing output.
  • If the price is between average total cost and average variable cost at the profit-maximizing output, then the firm is said to be in a loss-minimizing condition. The firm should still continue to produce, however, since its loss would be larger if it were to stop producing. By continuing production, the firm can offset its variable cost and at least part of its fixed cost, but by stopping completely it would lose the entirety of its fixed cost.
  • If the price is below average variable cost at the profit-maximizing output, the firm should go into shutdown. Losses are minimized by not producing at all, since any production would not generate returns significant enough to offset any fixed cost and part of the variable cost. By not producing, the firm loses only its fixed cost. By losing this fixed cost the company faces a challenge. It must either exit the market or remain in the market and risk a complete loss.

[edit] Market failure

Main article: Market failure

In microeconomics, the term "market failure" does not mean that a given market has ceased functioning. Instead, a market failure is a situation in which a given market does not efficiently organize production or allocate goods and services to consumers. Economists normally apply the term to situations where the inefficiency is particularly dramatic, or when it is suggested that non-market institutions would provide a more desirable result. On the other hand, in a political context, stakeholders may use the term market failure to refer to situations where market forces do not serve the "public interest," a subjective assessment that is often made on social or moral grounds.

The four main types or causes of market failure are:

  • Monopolies or other cases of abuse of market power where a "single buyer or seller can exert significant influence over prices or output"). Abuse of market power can be reduced by using antitrust regulations.[6]
  • Externalities, which occur in cases where the "market does not take into account the impact of an economic activity on outsiders." There are positive externalities and negative externalities.[6] Positive externalities occur in cases such as when a television program on family health improves the public's health. Negative externalities occur in cases such as when a company’s processes pollutes air or waterways. Negative externalities can be reduced by using government regulations, taxes, or subsidies, or by using property rights to force companies and individuals to take the impacts of their economic activity into account.
  • Public goods such as national defence[6] and public health initiatives such as draining mosquito-breeding marshes. For example, if draining mosquito-breeding marshes was left to the private market, far fewer marshes would probably be drained. To provide a good supply of public goods, nations typically use taxes that compel all residents to pay for these public goods (due to scarce knowledge of the positive externalities to third parties/social welfare); and
  • Cases where there is asymmetric information or uncertainty (information inefficiency).[6] Information asymmetry occurs when one party to a transaction has more or better information than the other party. Typically it is the seller that knows more about the product than the buyer, but this is not always the case. Buyers in some markets have better information than the Sellers. For example, used-car salespeople may know whether a used car has been used as a delivery vehicle or taxi, information that may not be available to buyers. An example of a situation where the buyer may have better information than the seller would be an estate sale of a house, as required by a last will and testament. A real estate broker purchasing this house may have more information about the house than the family members of the deceased.
This situation was first described by Kenneth J. Arrow in a seminal article on health care in 1963 entitled "Uncertainty and the Welfare Economics of Medical Care," in the American Economic Review. George Akerlof later used the term asymmetric information in his 1970 work The Market for Lemons. Akerlof noticed that, in such a market, the average value of the commodity tends to go down, even for those of perfectly good quality, because the buyer has no way of knowing whether the product they are buying will turn out to be a "lemon" (a defective product).

[edit] Opportunity cost

Main article: Opportunity cost

Although opportunity cost can be hard to quantify, the effect of opportunity cost is universal and very real on the individual level. In fact, this principle applies to all decisions, not just economic ones. Since the work of the German economist Friedrich von Wieser, opportunity cost has been seen as the foundation of the marginal theory of value.

Opportunity cost is one way to measure the cost of something. Rather than merely identifying and adding the costs of a project, one may also identify the next best alternative way to spend the same amount of money. The forgone profit of this next best alternative is the opportunity cost of the original choice. A common example is a farmer that chooses to farm his land rather than rent it to neighbors, wherein the opportunity cost is the forgone profit from renting. In this case, the farmer may expect to generate more profit himself. Similarly, the opportunity cost of attending university is the lost wages a student could have earned in the workforce, rather than the cost of tuition, books, and other requisite items (whose sum makes up the total cost of attendance). The opportunity cost of a vacation in the Bahamas might be the down payment money for a house.

Note that opportunity cost is not the sum of the available alternatives, but rather the benefit of the single, best alternative. Possible opportunity costs of the city's decision to build the hospital on its vacant land are the loss of the land for a sporting center, or the inability to use the land for a parking lot, or the money that could have been made from selling the land, or the loss of any of the various other possible uses—but not all of these in aggregate. The true opportunity cost would be the forgone profit of the most lucrative of those listed.

One question that arises here is how to assess the benefit of dissimilar alternatives. We must determine a dollar value associated with each alternative to facilitate comparison and assess opportunity cost, which may be more or less difficult depending on the things we are trying to compare. For example, many decisions involve environmental impacts whose dollar value is difficult to assess because of scientific uncertainty. Valuing a human life or the economic impact of an Arctic oil spill involves making subjective choices with ethical implications.

The supply and demand model describes how prices vary as a result of a balance between product availability at each price (supply) and the desires of those with purchasing power at each price (demand). The graph depicts a right-shift in demand from D1 to D2 along with the consequent increase in price and quantity required to reach a new market-clearing equilibrium point on the supply curve (S).
The supply and demand model describes how prices vary as a result of a balance between product availability at each price (supply) and the desires of those with purchasing power at each price (demand). The graph depicts a right-shift in demand from D1 to D2 along with the consequent increase in price and quantity required to reach a new market-clearing equilibrium point on the supply curve (S).

[edit] Applied microeconomics

Applied microeconomics includes a range of specialized areas of study, many of which draw on methods from other fields. Much applied works uses little more than the basics of price theory, supply and demand. Industrial organization and regulation examines topics such as the entry and exit of firms, innovation, role of trademarks. Law and economics applies microeconomic principles to the selection and enforcement of competing legal regimes and their relative efficiencies. Labor economics examines wages, employment, and labor market dynamics. Public finance (also called public economics) examines the design of government tax and expenditure policies and economic effects of these policies (e.g., social insurance programs). Political economy examines the role of political institutions in determining policy outcomes. Health economics examines the organization of health care systems, including the role of the health care workforce and health insurance programs. Urban economics, which examines the challenges faced by cities, such as are sprawl, air and water pollution, traffic congestion, and poverty, draws on the fields of urban geography and sociology. The field of financial economics examines topics such as the structure of optimal portfolios, the rate of return to capital, econometric analysis of security returns, and corporate financial behavior. The field of economic history examines the evolution of the economy and economic institutions, using methods and techniques from the fields of economics, history, geography, sociology, psychology, and political science.

[edit] Consumer theory

Preference - Indifference curve - Utility - Marginal utility - Income

[edit] Production and pricing theory

Production theory basics - X-efficiency - Factors of production - Production possibility frontier - Production function - Economies of scale - Economies of scope - Profit maximization - Price discrimination - Transfer pricing - Joint product pricing - Price points

[edit] Welfare economics

Welfare economics - Pareto efficiency - Kaldor-Hicks efficiency - Edgeworth box - Social welfare function - Income inequality metrics - Lorenz curve - Gini coefficient - Poverty level - Dead weight loss

[edit] Industrial organization

Market form - Perfect competition - Monopoly - Monopolistic competition - Oligopoly - Concentration ratio - Herfindahl index

[edit] Market failure

Collective action - Information asymmetry - The Market for Lemons - Externality - Public good - Antitrust Regulations - Social cost - Free goods - Taxes - Tragedy of the commons - Tragedy of the anticommons.

[edit] Financial economics

Efficient markets theory - Financial economics - Finance - Risk

[edit] International trade

International trade - Terms of trade - Tariff - List of international trade topics

[edit] Methodology

General equilibrium - Game theory - Institutional economics - Neoclassical economics - Austrian economics

[edit] References

  1. ^ Marchant, Mary A.; William M. Snell. Macroeconomic and International Policy Terms. University of Kentucky. Retrieved on 2007-05-04.
  2. ^ www.mcwdn.org/ECONOMICS/EcoGlossary.html
  3. ^ www.nmlites.org/standards/socialstudies/glossary.html
  4. ^ www.mcwdn.org/ECONOMICS/EcoGlossary.html
  5. ^ www.econ100.com/eu5e/open/glossary.html
  6. ^ a b c d http://www.economist.com/research/Economics/alphabetic.cfm?LETTER=M#marketfailure

[edit] Further Reading

  • Bade, Robin; and Michael Parkin. Foundations of Microeconomics. Addison Wesley Paperback 1st Edition: 2001.
  • Eaton, B. Curtis; Eaton, Diane F.; and Douglas W. Allen. Microeconomics. Prentice Hall, 5th Edition: 2002.
  • Frank, Robert A.; Microeconomics and Behavior. McGraw-Hill/Irwin, 6th Edition: 2006.
  • Friedman, Milton. Price Theory. Aldine Transaction: 1976
  • Jehle, Geoffrey A.; and Philip J. Reny. Advanced Microeconomic Theory. Addison Wesley Paperback, 2nd Edition: 2000.
  • Hicks, John R. Value and Capital. Clarendon Press. [1939] 1946, 2nd ed.
  • Katz, Michael L.; and Harvey S. Rosen. Microeconomics. McGraw-Hill/Irwin, 3rd Edition: 1997.
  • Kreps, David M. A Course in Microeconomic Theory. Princeton University Press: 1990
  • Landsburg, Steven. Price Theory and Applications. South-Western College Pub, 5th Edition: 2001.
  • Mankiw , N. Gregory. Principles of Microeconomics. South-Western Pub, 2nd Edition: 2000.
  • Mas-Colell, Andreu; Whinston, Michael D.; and Jerry R. Green. Microeconomic Theory. Oxford University Press, US: 1995.
  • McGuigan, James R.; Moyer, R. Charles; and Frederick H. Harris. Managerial Economics: Applications, Strategy and Tactics. South-Western Educational Publishing, 9th Edition: 2001.
  • Nicholson, Walter. Microeconomic Theory: Basic Principles and Extensions. South-Western College Pub, 8th Edition: 2001.
  • Perloff, Jeffrey M. Microeconomics. Pearson - Addison Wesley, 4th Edition: 2007.
  • Pindyck, Robert S.; and Daniel L. Rubinfeld. Microeconomics. Prentice Hall, 5th Edition: 2000.
  • Ruffin, Roy J.; and Paul R. Gregory. Principles of Microeconomics. Addison Wesley, 7th Edition: 2000.
  • Varian, Hal R. Microeconomic Analysis. W. W. Norton & Company, 3rd Edition.

[edit] External links

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Externality - Wikipedia, the free encyclopedia

Externality - Wikipedia, the free encyclopedia: "

In economics, an externality is a cost or benefit resulting from an economic transaction that is borne or received by parties not directly involved in the transaction.

An externality occurs when a decision causes costs or benefits to third party stakeholders, often, although not necessarily, from the use of a public good. In other words, the participants in an economic transaction do not necessarily bear all of the costs or reap all of the benefits of the transaction. For example, manufacturing that causes air pollution imposes costs on others when making use of public air. In a competitive market, this means too much or too little of the good may be produced and consumed in terms of overall cost or benefit to society, depending on incentives at the margin and strategic behavior.

In the absence of significant externalities, parties to an economic transaction are assumed to benefit, improving the overall welfare of society. If third parties benefit substantially, such as in areas of education or safety, the good may be under-provided (or under-consumed); if costs to the public exceed costs to the economic decision makers, such as in pollution, the good may be over-provided, in terms of overall benefit or cost to society. Here, overall benefit and cost to society are defined as the collective economic utility for society.



[edit] Implications

External costs and benefits.
External costs and benefits.

Economic theory considers any voluntary exchange to be mutually beneficial to both parties, for example a buyer and seller. Any exchange, however, can result in additional positive or negative effects on third parties. Those who suffer from external costs do so involuntarily, while those who enjoy external benefits do so at no cost. The left side of the chart (at right) shows externalities associated with consumption (such as the air pollution caused by driving), while the right side shows production externalities (such as water pollution from a car factory).

From the perspective of a social planner or welfare economist, negative externalities result in an outcome that is not socially optimal. From the perspective of those affected, a negative externality is a problem (pollution from a factory), or a gain (honey bees that polinate the garden). In the first case, the person who is affected by the negative externality in the case of air pollution will see it as lowered utility: either subjective displeasure or potentially explicit costs, such as higher medical expenses. The externality may even be seen as trespassing on their lungs, violating their property rights. Thus, an external cost may pose an ethical or political problem. Alternatively, it might be seen as a case of poorly-defined property rights, as with, for example, pollution of bodies of water that may belong to no-one (either figuratively, in the case of publicly-owned, or literally, in some countries and/or legal traditions).

An external benefit, on the other hand, may increase the utility of third parties at no cost to them, which could be called "free lunch". Since the collective utility of society is improved but the direct participants have no way of monetizing the benefit, less of the good will be produced or consumed than would be optimal for society as a whole. Goods with positive externalities include education (believed to increase overall productivity and therefore well-being) and health care (which may reduce the health risks and costs for third parties). Positive externalities are frequently associated with the free rider problem. For example, individuals who are vaccinated reduce the risk of contracting the relevant disease for all others around them, and at high levels of vaccination, society may receive large health and welfare benefits; but any one individual can refuse vaccination, still avoiding the disease by "free riding" on the costs borne by others.

There are a number of potential means of improving overall social utility when externalities are involved. The market-driven approach to correcting externalities is to "internalize" third party costs and benefits, for example, by requiring a polluter to repair any damage caused. In many cases, however, internalizing costs or benefits is not feasible or the true value cannot be determined.

The value of the effects of the externality are difficult to quantify because they reflect the ethical views and preferences of the entire population. It may not be clear whose preferences are most important, interests may conflict, the value of externalities may be difficult to determine, and all parties involved may attempt to influence the policy responses to their own benefit. Because it may not be feasible to monetize the costs and benefits, another method is needed to either impose solutions or aggregate the choices of society, when externalities are significant. This may be through some form of representative democracy or other means. Political economy is, in broad terms, the study of the means and results of aggregating those choices and benefits that are not limited to purely private transactions.

Laissez-faire economists such as Friedrich Hayek and Milton Friedman sometimes refer to externalities as "neighborhood effects" or "spillovers", although externalities are not necessarily minor or localized.

Outside the broadly-defined liberal political tradition, Marxists see externalities of all kinds, including pecuniary ones, as ubiquitous, being the rule rather than the exception. Production is socialized or totally interdependent. On the other hand, under capitalism, property rights, the appropriation of income, and the making of economic decisions are largely individualized. In order to solve this contradiction between socialized production and individual decision-making, Marxists often call for democratic economic planning, as a key part of socialism.(cf. Frederick Engels, "Socialism: Utopian and Scientific")

[edit] Externalities in supply and demand

The usual economic analysis of externalities can be illustrated using a standard supply and demand diagram if the externality can be monetized and valued in terms of money. An extra supply or demand curve is added, as in the diagrams below. One of the curves is the private cost that consumers pay as individuals for additional quantities of the good, which in competitive markets, is the marginal private cost. The other curve is the true cost that society as a whole pays for production and consumption of increased production the good, or the marginal social cost.

Similarly there might be two curves for the demand or benefit of the good. The social demand curve would reflect the benefit to society as a whole, while the normal demand curve reflects the benefit to consumers as individuals and is reflected as effective demand in the market.

[edit] Negative Externalities

Many negative externalities (external cost or external diseconomy) are related to the environmental consequences of production and use. The article on environmental economics also addresses externalities and how they may be addressed in the context of environmental issues.

  • Pollution of any form that causes nuisance or harm to others.
  • Individuals collectively choose to use a public transportation resource (such as roads), imposing congestion costs on all other users.
  • A business may purposely underfund one part of their business, such as their pension funds, in order to push the costs onto someone else, creating an externality. Here, the "cost" is that of providing minimum social welfare or retirement income; economists more frequently attribute this problem to the category of moral hazards.
  • A property tycoon buying up a large number of houses in a town, causing prices to rise and therefore making other people who want to buy the houses worse off, perhaps by excluding them from the housing market. These effects are sometimes called "pecuniary externalities"; many economists do not accept the concept of pecuniary externalities, attributing such problems to anti-competitive behavior, monopoly power, or other definitions of market failures.
  • Accidents caused by alcohol abuse
  • Commonized costs of declining health and vitality caused by smoking and/or alcohol abuse

In these situations the marginal social benefit of consumption is less than the marginal private benefit of consumption. (i.e. SMB <>

[edit] Positive externalities

Examples of positive externalities (beneficial externality, external benefit, external economy, or Merit goods) include:

  • A beekeeper keeps the bees for their honey. A side effect or externality associated with his activity is the pollination of surrounding crops by the bees. The value generated by the pollination may be more important than the value of the harvested honey.
  • An individual planting an attractive garden in front of his house may provide benefits to others living in the area, and even financial benefits in the form of increased property values for all property owners.
  • An individual buying a picture-phone for the first time will increase the usefulness of such phones to people who might want to call him or her. When each new user of a product increases the value of the same product owned by others, the phenomenon is called a network externality or a network effect. Network externalities often have "tipping points" where, quite suddenly, the product reaches general acceptance and near-universal usage.
  • Inventions and information - once an invention (or most other forms of practical information) is discovered or made more easily accessible, others benefit by exploiting the invention or information. Copyright and intellectual property law are mechanisms to allow the inventor or creator to benefit from a temporary, state-protected monopoly in return for "sharing" the information through publication or other means.
  • Education leads to a more civically-minded citizenry with a greater sense of altruism.
  • Flu vaccinations of school children - the children themselves are unlikely to be greatly harmed by the flu, but vaccination of school children may often be the most efficient way to protect the vulnerable elderly.
  • Leisure of the old - once retired, the old help younger generations undertaking several activities such as babysitting children, paying bills and cleaning the son or daughter's house.
  • Sometimes the better part of a benefit from a good comes from having the option to buy something rather than actually having to buy it. A private fire department that only charged people that had a fire, would arguably provide a positive externality at the expense of an unlucky few. Some form of insurance could be a solution in such cases, as long as people can accurately evaluate the benefit they have from the option.

As noted, externalities (or proposed solutions to externalities) may also imply political conflicts, rancorous lawsuits, and the like. This may make the problem of externalities too complex for the concept of Pareto optimality to handle. Similarly, if too many positive externalities fall outside the participants in a transaction, there will be too little incentive on parties to participate in activities that lead to the positive externalities.

The graph below shows the effects of a positive or beneficial externality. For example, the industry supplying smallpox vaccinations is assumed to be selling in a competitive market. The marginal private benefit of getting the vaccination is less than the marginal social or public benefit by the amount of the external benefit (for example, society as a whole is increasingly protected from smallpox by each vaccination, including those who refuse to participate). This marginal external benefit of getting a smallpox shot is represented by the vertical distance between the two demand curves. Assume there are no external costs, so that social cost equals individual cost.

Supply & Demand with external benefits
Supply & Demand with external benefits

If consumers only take into account their own private benefits from getting vaccinations, the market will end up at price Pp and quantity Qp as before, instead of the more efficient price Ps and quantity Qs. These latter again reflect the idea that the marginal social benefit should equal the marginal social cost, i.e., that production should be increased as long as the marginal social benefit exceeds the marginal social cost. The result in an unfettered market is inefficient since at the quantity Qp, the social benefit is greater than the societal cost, so society as a whole would be better off if more goods had been produced. The problem is that people are buying too few vaccinations.

The issue of external benefits is related to that of public goods, which are goods where it is difficult if not impossible to exclude people from benefits. The production of a public good has beneficial externalities for all, or almost all, of the public. As with external costs, there is a problem here of societal communication and coordination to balance benefits and costs. This also implies that pollution is not something solved by competitive markets. The government may have to step in with a collective solution, such as subsidizing or legally requiring vaccine use. If the government does this, the good is called a merit good.

[edit] Positional Externalities

Positional externalities refer to a special type of externality that depends on the relative rankings of actors in a situation. Because every actor is attempting to "one up" other actors, the consequences are unintended and economically inefficient.

An example of this would be working overtime at a job to look better than other employees. Because every employee wishes to look better than other employees, so as to get a raise or promotion, if one employee starts to work overtime then all employees must. And as each successive employee works more and more overtime, the externality gets larger and larger. No employee wants to work overtime, but each feels that he must in order to prevent being left behind.

Another example is the buying of jewelry for another person. In order for Person A to show that he values his spouse more than Person B values his spouse, Person A must buy his spouse more expensive jewelry than Person B buys. As in the first example, the cycle continues to get worse, because every actor positions himself/herself in relation to the other actors.

One solution to such externalities is regulations imposed by an outside authority. For the first example, the government might pass a law against working overtime. Thus every employee can go home and spend time at home with the family, what he/she really wants, and not worry about losing prestige at work.

[edit] Externalities and the Coase theorem

Ronald Coase argued that individuals could organize bargains so as to bring about an efficient outcome and eliminate externalities without government intervention. The government should restrict its role to facilitating bargaining among the affected groups or individuals and to enforcing any contracts that result. This result, often known as the "Coase Theorem," requires that

  • Property rights are well defined;
  • People act rationally
  • Transaction costs are minimal

If all three of these apply, individuals will bargain to solve the problem of externalities.

Thus, this theorem does not apply to the steel industry case discussed above. For example, with a steel factory that trespasses on the lungs of a large number of individuals with pollution, it is difficult if not impossible for any one person to negotiate with the producer, and there are large transaction costs. Hence the most common approach may be to regulate the firm (by imposing limits on the amount of pollution considered "acceptable") while paying for the regulation and enforcement with taxes.

The case of the vaccinations also does not fit with the Coase Theorem. The firms of the vaccination industry would have to get together to bribe large numbers of people to have their shots. Individual firms would be tempted to "free ride" and not pay the cost of these bribes. The property rights involved are not well defined.

This does not say that the Coase theorem is irrelevant. For example, if a logger is planning to clear-cut a forest in a way that has a negative impact on a nearby resort, the resort-owner and the logger could theoretically get together to agree to a deal. For example, the resort-owner could pay the logger not to clear-cut -- or could buy the forest. The most problematic situation, from Coase's perspective, occurs when the forest literally does not belong to anyone; the question of "who" owns the forest is not important, as any specific owner will have an interest in coming to an agreement with the resort owner (if such an agreement is mutually beneficial).

Also, the central government may not be needed. Traditional ways of life may have evolved as ways to deal with external costs and benefits. Alternatively, democratically-run communities can agree to deal with these costs and benefits in an amicable way.